Islamic Finance Basics

By: Priyanka Boghani
27-Apr-2010

According to a report released in 2007 by the Financial Services Authority (FSA), the UK's population is approximately 3% Muslim. Given the UK's position as a leading financial hub in the world, it is no surprise that the Bank of England and the Financial Services Authority (FSA) have been closely involved in the development of Islamic Finance.

The Basics of Islamic Finance

Islamic finance operates on the basic principle that all transactions are carried out without interest or 'riba'. Islamic banks include religious scholars on their boards to ensure that their operations comply with the Islamic law, Shari'ah. Modern Islamic banking has developed mechanisms to allow interest income to be replaced with cash flows from productive sources. The Islamic economic model adheres to a risk and profit-sharing philosophy and, in this respect, rewards performance in a similar way to equity-based transactions.

Essentially, due to the religious considerations investment possibilities are limited to those that are acceptable within Shari'ah law - in the same way that 'green' investments are limited by environmental concerns.  As Islamic finance is an intrinsic part of the global market, any investor can take put money into this area.  

An overview of Islamic Finance

Investments are structured on exchange or ownership of assets rather than currency. In an Islamic mortgage transaction, a bank does not loan the borrower money, rather it buys the property itself from the seller and resells it to the customer at a profit. Risk, therefore, is always shared between at least two parties like a joint business venture. Money is seen purely as potential capital.

Speculative behaviour of any kind is prohibited under the Shari'ah law, therefore any form of gambling and contractual uncertainty is avoided. Under Islamic Finance principles, conventional bonds are considered as 'riba' and are therefore not allowed. However, 'sukuk' the Islamic equivalent of a bond, has been in the spotlight recently.

In March, UK Islamic banks and governmental bodies pushed for the UK's first sukuk. A new lobby, called the UK Islamic Finance Secretariat (UKIFIS), will consist of a group of Islamic finance experts, the FSA and the UK Trade and Investment authorities, as well as experts from banks, law firms and accountants representing the industry to UK authorities in legislative, fiscal, regulatory and political matters, according to Reuters.

What are Sukuk?

Sukuk are certificates of ownership to an asset pledged by the issuer to raise capital. They are structured to avoid the Islamic prohibition on interest payments.  Whilst a bond is usually an agreement between the lender and the customer where the customer will repay the debt according to certain terms, Sukkuk involves both parties taking partial ownership of the debt.  By paying investors with the cashflow generated by specific assets, investors are not required to take ownership of these assets themselves.

The importance of Islamic Finance in the UK

According to the Islamic Finance Council in the UK, London has a sophisticated Islamic market in Europe, hosting many Islamic banks such as the Islamic Bank of Britain. As Sukuk is growing increasingly popular among Gulf countries, the value of these financial products is expected to rise up to $1 trillion over the next 10 years.  Therefore, the London economy is expecting them to account for a considerable part of its infrastructure, and is actively working to attract further Sukuk listings.