Islamic banking is poised to become a key fixture of Oman’s financial sector, following the recent announcement that His Majesty Sultan Qaboos bin Said has approved the formation of Oman’s first Islamic bank. Last month’s Client Alert provided an introduction to the religious, philosophical and economic principles that underpin Islamic finance. This month, we present an overview of some of the classic Islamic banking structures that are commonly used in jurisdictions where Islamic finance is already well established.
Mudaraba (capital provision)
This is an arrangement between an Islamic bank and an entrepreneur in which the bank contributes the capital to fund an entrepreneur’s company, in exchange for a share of the company’s profits. The two most notable features of a mudaraba are that (i) the bank contributes all of the company’s capital, and the entrepreneur contributes his ideas, technical expertise and management skills but no capital, and (ii) the bank and the entrepreneur share the profits of the company according to a pre-agreed scale, while the company’s losses would be absorbed entirely by the bank. A mudaraba structure is well suited to up-and-coming entrepreneurs who possess exceptional business ideas or talents, but lack the financial resources to get their company off the ground.
Musharaka (joint venture)
Under a musharaka, both the Islamic bank and the entrepreneur contribute capital to the entrepreneur’s company. The company’s profits are shared according to a formula that the parties pre-agree, and losses are apportioned pro rata to the parties’ respective capital contributions. Although management of the company may be however the parties agree, it is common for both the entrepreneur and representatives of the bank to be actively involved. A musharaka structure is well suited for an Islamic bank’s proprietary investment activities.
An ijara is a lease structure in which the Islamic bank will buy a specified asset, and lease it to the banking customer at a specified rental price for a specified length of time. It is important for the terms of the lease to be Sharia (Islamic religious law) compliant – for example, not to charge interest or penalties that would be considered usurious and therefore haram (prohibited). Frequently, an ijara will include the option for the customer to purchase the asset at a specified price at the end of the lease period.
Sukuk (Islamic bonds)
Sukuk, or Islamic bonds, are securities representing an ownership interest in an asset or pool of assets. The assets underlying the sukuk will themselves be structured as Sharia-compliant vehicles – such as mudaraba or musharaka. The payments that sukuk bondholders receive are not designated as interest payments, but rather as returns derived from the profits of the business underlying the bonds.