According to the World Bank, Islamic finance is estimated at about $2 Trillion and is growing 10-12% annually!
Keep in mind that Islamic banking and finance is not reserved for Muslim countries, as nations such as the Hong Kong, South Africa, United Kingdom, and Luxembourg are also showing interest and applying it towards their system. According to the World Bank, “Islamic finance is equity-based, asset-backed, ethical, sustainable, environmentally- and socially-responsible finance. It promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and social welfare.”
What are the principles of Islamic Finance?
- Prohibition of interest (riba)
- This aspect is prohibited as the lender receives returns without any efforts, while the borrower holds all associated risks.
- Prohibition of uncertainty (gharar)
- This implies the ambiguity or lack of control of a transaction or contract by both parties.
- Prohibition of gambling (maysir and qimar)
- The effortless attainment of funds based on chance or uncertainty is forbidden.
- Prohibition of non-Shariah investment (arms, alcohol, tobacco)
- Any industry or investment that is harmful to the Islamic society and morals are prohibited.
Thus, Islamic finance requires the investment to be made towards real and tangible assets and not those that are unclear or ambiguous. Furthermore, a lender’s returns must be related to risks , in order to avoid riba. In a sense, the lender acts as a shareholder or partner in the transaction rather than a simple creditor.
The mentioned financial method is not merely Shariah controlled but is intertwined with the finance industry. Banks, fund managers, investment and insurance companies, along with fund managers all play a significant role in shaping Islamic finance and banking.
What are its instruments?
Certain contracts and financial methods are implied to follow the aforementioned principles while boosting an Islamic society and economy. Let’s examine some of these contract types:
Murabaha: A good is sold with an additional profit margin. Both parties are aware of the product cost and the accrued profit in the transaction. The buyer has the option to pay in full or installments.
Ijara: A bank purchases the desired assets for the client and asks for a fixed rental payment. The asset is owned by the bank but may be given over to the client once the payments are fully made.
Mudaraba: One party acts as the investor of capital whereas the other is an investor of time and expertise (fund manager). In the instance that the situation faces failure, financial losses are only attributed to the investor. If the losses are due to negligence then it is the fault of the fund manager. Overall profits are shared on a pre-settled agreement.
Istisna: A manufacturer agrees to complete a construction project on a fixed date and with a fixed price as agreed by both parties. Advance or full payments are not needed until the finishing date and buyer has the right to withdraw from the contract upon misstatements or wrongful delivery.
Musharaka: Both parties provide capital , expertise and effort and mutually share the profit and losses.
Salam: A bank or finance institution makes an upfront payment for a client’s goods and delivers it later.
Sukuk: Certificates of ownership which represent equal shares of an asset, service, or project. Returns are linked directly to the assets.
How does it work in the energy industry?
In a jointly written article published by Hamed Ghoddusi and Sajjad Khoshroo, lawyer and expert in Islamic Finance, he mentions that the energy sector is one of the largest receivers of global investment and “out of this amount, 740$ billion will be spent in the power sector, 621$ billion in the oil sector, and $399 billion in the natural gas sector.” Furthermore, as a large portion of these reserves are located in the Middle East Islamic finance is a topic that should surely be considered. It is stated in his article that Islamic finance has penetrated into Saudi Arabia at 35%, Iran at 100%, Bahrain at 46% and Qatar at 30%.
Khoshroo believes that Islamic finance has a leading role in energy project financing across the Middle East as it contains various Shariah-compliant tools for different needs. The article states, “energy projects contain certain important features, such as large fixed costs, volatile output prices, long duration of the project, and in some cases the threat of nationalization.”
What are the most common financing structures and instruments in the energy sector?
“The istisna-ijara structure has emerged as the product of choice for Islamic project financings, followed by the wakala-ijara structure. These products are well-suited for project finance as they offer the certainty of regular payments throughout the life of the financing with the flexibility of tailoring payments and tenor in a manner that allows Islamic financiers to match the cash flows of the project and achieve profit margins comparable to that of conventional financiers.”
Moreover, it is mentioned in the article,
“Project sukuk is also set to play an important role in the Islamic project finance market going forward given strong demand from Middle Eastern investors, attractive pricing, increased standardization, and political commitment to develop the region’s capital markets. The murabaha structure will continue to play an important supporting role for providing short-term financing for working capital facilities and equity bridge financing given its flexibility and low-risk. What remains to be seen is the utilization of Islamic hedging (tahawutt) and Islamic insurance (takaful) as part of project.”
What can be concluded?
With its booming growth, one should not limit Islamic finance and banking to the Middle East. The UK alone has over 20 banks that offer Islamic finance options with 5 fully Shariah-compliant licensed banks. With that said, in accordance to reports, we can consider the UK as the leading Western hub for Islamic finance. As stated in Hong Kong’s government site, Sukuk model was also implemented in Hong Kong as laws were carefully amended in 2013 and 2014 for its compliance. Furthermore, Islamic finance should certainty be an option for construction and energy sector projects due to its flexibilities and low risks. Thus, a global consideration must be made towards this specific financial system and structure.