With the continuing development of many Muslim states and the growth in wealth throughout those states, an increasing number of Muslims have sought to invest their wealth without breaching the strictures of Islam against riba (interest). The resultant development of the Islamic banking and financial world has led to a growing pool of “Islamic” money looking for a home in investments which are consistent with the values of the Islamic faith.

Whilst Islamic and conventional financing may initially appear incompatible, the structural issues involved are not insurmountable. Financiers in both Islamic financial institutions and conventional banks have been rapidly developing techniques to provide the methods and tools required to create investment opportunities for this “Islamic” money which can be integrated, with the assistance of experienced professional advisers familiar with the principles both of Islamic and conventional finance, with established conventional financing structures. 

Islamic banking – concepts and constraints

Islam is not only concerned with the relationship between man and God but is also a system of beliefs. Justice, equity, fairness and morality are values which underpin the entire Islamic way of life, of which commerce is only a part. These beliefs are governed by the body of Islamic jurisprudence generally referred to as Shariah. This law is derived from various sources and is open to different interpretations. Accordingly, many financial institutions have a religious board or a Shariah adviser to ensure compliance with the principles of Shariah and to provide an opinion, or fatwa, when required.

These principles include:


The charging of any interest, or riba, is strictly prohibited – any return on money employed should be linked with the profits of an enterprise. The concept of riba extends beyond interest and usury, and although it was not given a precise definition by the Prophet Muhammad, it can perhaps best be described in terms of a prohibition of exploitation by one party who owns a product that includes money or capital and which another party wishes to acquire. Whilst interest is the classic example of this, it is probably better to think in terms of unfair exploitation.


The Shariah does not permit speculation or gambling, or maisir. As a result, many Islamic financial institutions feel unable to enter into derivative transactions such as swaps, futures, options or contracts that insure for a profit.

Prohibited investments

Investments involving certain products, such as pork, alcohol or armaments, and activities such as gambling, are prohibited. Islamic institutions may (depending on the view taken by their Shariah committees) encounter difficulties with investments in businesses such as hotels and the entertainment industry.


Profit cannot be assured and an Islamic financial institution must assume at least part of the risk of a given transaction. There can be no guarantee of a fixed return. Equally, depositors with Islamic institutions may not invest on the basis of a guaranteed return. However, taking security is permitted in order to guard against negligence, wilful wrongdoing or breach of contract by parties to the contract.


The existence of uncertainty, or gharar, in a contract is also prohibited as it requires the occurrence of an event which may not occur. When entering into a contractual relationship, there must be “full disclosure” by both parties because a transaction which is tainted with gharar will not be permitted. Any type of transaction where the subject matter, the price or both are not determined and fixed in advance will be viewed with suspicion under Shariah law.


Trade and enterprise, which can generate real wealth for the benefit of the community as a whole, are encouraged between partners sharing profits and losses. Hoarding money is improper; money is merely a means of exchange and should not be treated as a commodity.

Islamic banking system

Banking services

Islamic financial institutions raise the bulk of their funds through two main sources – current accounts (where funds can be withdrawn on demand) and investment accounts (where withdrawals are on notice or otherwise restricted). Generally, the following services are offered:

Current accounts

These do not earn the depositor any income, whether directly or indirectly. The deposits represent on-balance sheet loans by the depositors to the Islamic financial institution that is required to maintain a liquidity ratio of 100 per cent for such accounts. If the funds are used by the Islamic financial institution for productive purposes, such employment is at the bank’s risk and any profits accrue to the bank. Fees are sometimes charged by the Islamic financial institution for the management of such accounts.

Investment accounts

The management of these funds will normally be for a specified period and in enterprises selected at the discretion of the Islamic financial institution that acts as trustee. Profits and losses are shared between the investors, who also bear the risk of loss. The Islamic financial institution will receive a management fee from any profits generated. These funds will often be off-balance sheet as funds under management.

Savings accounts

These do not enjoy a predetermined rate of interest, but do entitle the depositor to a profit share at the end of the financial year. This figure will be derived from the profits that the Islamic financial institution has earned from the funds on deposit throughout the year. A management fee is payable and once again the risk of loss is borne by the depositor. In addition, there may be restrictions placed on the frequency with which a depositor may make withdrawals or at least a requirement to give notice of such a withdrawal.


These are only provided in cases of genuine need, emergency or where a client has sufficient funds but is temporarily unable to gain access to them. In such circumstances, the Islamic financial institution may decide to grant an interest-free loan, or Qard Hassan, which could be converted into an equity stake in the client company, subject to any restrictions in that company’s constitutional documents, any shareholder’s agreement or applicable law.

Financing methods

Islamic financing institutions have developed a wide range of techniques which allow them to uphold the religious and legal principles outlined above whilst enabling them to offer viable financial products.

There are a number of principal techniques that have evolved through continuous transactional refinement, as well as variations on their themes. It may also be possible for other “conventional” facilities (eg, guarantee facilities) to be offered, provided these do not stand in isolation but are linked to an underlying Islamic structure characterising the agreement.

These techniques include the following:

Ijara (operating lease)

This encompasses the leasing of machinery, equipment, buildings and other capital assets. The Islamic financial institution (or a subsidiary) will purchase the asset in question and lease it to the ultimate customer for an agreed rental which may be fixed in advance or subject to occasional review by a mutually acceptable third party, such as an international firm of accountants. Attitudes of Islamic financial institutions towards insurance of the asset vary, as some Shariah committees may feel that imposing an obligation on the lessee to insure the asset is not permissible. Premiums are likely to be paid by the Islamic financial institution, even if they are recovered through rentals or otherwise.

Ijara wa iqtina (finance lease)

This is a leasing structure coupled with a right available to the lessee to purchase the asset at the end of the lease period (Bay’ al-Wafa). The lessee will agree to make payments into an Islamic investment account (with any profits being for the benefit of the lessee) to be used in or towards financing the ultimate purchase of the asset in question. These instruments have been used in a variety of cross-border applications for an increasing range of asset classes including ships, aircraft, telecommunications equipment and power station turbines.

Mudaraba (participation or trust financing)

This arrangement involves two parties, the managing trustee (Mudarib) and the beneficial owner (Rab al Maal). The Islamic financial institution may either put up all the funds itself and undertake responsibility for investing them, or alternatively it can provide funds to the customer who then acts as Mudarib. The funds so provided will usually be those of its investors rather than the Islamic financial institution, with the Islamic financial institution acting as trustee for those investors and thereby assuming fiduciary responsibilities. The borrower retains a fixed percentage of the profits, the Islamic financial institution’s reward is a fixed share in the balance of the revenue generated by the investments and the remainder goes to the investors. There is no guarantee that the Islamic financial institution’s investment will be returned or that a profit will be generated.

Sukuk (bond issue)

Sukuk essentially amounts to commercial paper that provides the subscriber with ownership or part ownership in the underlying asset. Typically, a special purpose company will purchase the asset in question and lease it to the ultimate purchaser under back to back arrangements and will issue Sukuk certificates under a note issuance facility entitling the holders of the Sukuk to a pro rata ownership of the asset and a right to receive a proportion of the rental payments. The Sukuk may be issued in a tradeable form.

Murabaha (cost-plus financing)

The Murabaha technique is used extensively to facilitate the trade finance activities of Islamic financial institutions. The Islamic financial institution purchases and takes title to the necessary equipment or goods from a third party. Depending on the accounting treatment desired, it will do so either directly or through an agent and may use its own funds or those of its investors. The Islamic financial institution then sells on the equipment or goods to its customer at cost plus a reasonable profit. All of the above contracts are undertaken at the request of the customer. Deferred payment terms may be agreed and the arrangement may be secured. Such arrangements are not considered to be contrary to Shariah law as,by taking title to the equipment or goods, the bank is assuming a risk which entitles it to some profit. As the price of the equipment or goods is fixed, the customer is not affected by fluctuations in the base lending rate. This simplifies cash management for the customer.

Istisna’a (construction financing)

A variation of the Murabaha is Istisna’a. Originally used to finance the sale of unripe fruit and other foodstuffs, in present day applications it has been used for the advance funding of major industrial projects or large items of equipment such as turbines for power plants, ships or aircraft. The Islamic financial institution funds the manufacturer during the construction of the asset, acquires title to that asset on completion and either immediately passes title to the developer on agreed deferred payment terms or, possibly, leases the asset to the developer under an Ijara wa Iqtina.

Bai Salam (payment for future delivery)

Bai Salam in its simplest form is the advance payment in full of the purchase price by the purchaser for specified assets which the seller undertakes to supply to the purchaser at a later date. Islamic schools of jurisprudence vary as to their views on whether the assets which are the subject of a Bai Salam transaction should be available in the market at the time of the contract or whether it suffices that the assets will be available at the date set in the contract for delivery. They differ also as to the minimum period of time there should be between the date of contract and delivery of the assets. As a form of financing, the purchaser is able to acquire the assets by advance payment at a discounted price and subsequently sells the assets upon delivery, either back to the seller or to a third party for a profit. The purchaser may also sell on the assets by way of a parallel Bai Salam contract for a profit upon the price it paid and for delivery to occur on the date specified in the original contract. Bai Salam differs from Istisna’a financing in that Istisna’a must always be utilised for assets which are to be manufactured whereas Bai Salam has a wider scope than this. Also, unlike under an Istisna’a contract, the purchase price for the asset under a Bai Salam must be paid in full at the outset and the date for delivery must also be fixed. This is not a fundamental requirement under an Istisna’a.

Arbun (pre-purchase of right to acquire asset)

The use of the principle of Arbun in modern day financing has met with varying levels of approval amongst the schools of Islamic jurisprudence. In basic terms, an Arbun contract provides for the purchaser to make a deposit (which forms part of the purchase price) for the purchase of particular assets at a later date on the understanding that, should the sale of the assets not proceed (for instance if the purchaser elects not to proceed), the seller will be permitted to retain the deposit. The Arbun contract has been likened to an option. A clear understanding of the Islamic requirements for this mode of financing are required in order to ensure that it satisfies the principles of Shariah and is not held to be speculative or uncertain.

Musharakah (equity financing)

This is very similar to the Mudaraba contract, except that the customer puts up part of the equity. The Islamic financial institution and the customer provide financing for a specified project in agreed proportions. All parties have the right to participate in the project but the parties also have the right to waive such rights. Furthermore, in the event of loss, both parties will bear the losses in proportion to their participation. Profits and losses are shared in direct proportion to the respective contributions of the participants. The Islamic financial institution may receive an agreed management fee.


With the increasing size and complexity of transactions, Islamic financial institutions are becoming involved in transactions where several institutions are prepared to participate, including project finance transactions. To enable transactions to be syndicated, Islamic financial institutions have developed instruments which rely upon the principles of agency and trusteeship. A contract often referred to as a “Special Mudaraba” will be entered into between the Islamic financial institution leading the transaction, as Mudarib, and the other Islamic financial institutions participating in the transaction as the Rab al Maals. The Special Mudaraba will stipulate the conditions of the participation and describe in detail the underlying contract documents to be entered into by the Mudarib, the purpose for which the funds should be employed and the obligations of the parties involved. The transaction will be monitored and managed by the Mudarib and the Rab al Maal will not normally have a direct relationship with the party to whom the finance is being provided.

In the past three or four years the Mudaraba agreement has been superseded by the Wakala-based investment agency agreement which may also be referred to as a participation agreement. The documents are usually identical in their legal effect and terms but are more favourable to the investment agent regarding fees. An investment agent will be entitled to receive his fees regardless of whether or not the investments make a profit (other than in the case of wilful default, gross negligence or fraud on his part) which is not the same as under Mudaraba principles, where the Mudarib can only receive a fee if there is a profit.

Islamic funds

The concept of a mutual fund is understood and well recognised from an Islamic perspective, with the idea of a “partnership” between the financial institution and investors, whereby the institution will exercise control over and invest a pool of funds on behalf of such investors. Certificates are produced as evidence of these investments and they may either be registered or in bearer form. Such certificates may mature at a fixed date, at a fixed interval after issue, at call or at a fixed interval after call. As with Mudaraba, there is no guaranteed return and any profits are on a proportional basis. The investor is not liable for losses beyond the amount of the capital initially subscribed and the manager (which need not invest its own money) would not bear a share of any losses other than its own time and effort.

In structuring these transactions, conventional “market” documentation has been adapted and used for the establishment of a mutual fund. Particular care is taken to ensure that the company’s prospectus and memorandum of association prevent the fund company from charging interest or practising usury in any form. Similarly, the fund company is forbidden from investing in interest-bearing equities or in companies whose principal activities involve investments in prohibited products or services (see above) although in certain circumstances a purification of returns approach may be adopted to counteract these. It is also necessary to provide that, when applying for units, investors would not receive interest on their application monies between the time such monies are received and the time the units are issued. All of the fund documentation is, therefore, carefully reviewed to ensure that such sensitivities are recognised throughout.

In addition, provision will often be made in the constitutional documents of a fund company for the election of a religious supervisory board or Shariah committee. From a business perspective, the Shariah committee may not be able to assess what does or does not constitute a sound investment. However, its role is different and will involve confirming whether or not an investment which has been approved for business reasons is acceptable from an Islamic perspective.

Integrating Islamic and conventional financing for projects

A project sponsor should not be discouraged from seeking capital from Islamic institutions by the belief that the demands of the Shariah exclude the use of non-Islamic finance. Indeed, with the increasing difficulty in recent years of securing conventional financing for some large infrastructure projects, sponsors are realising that their projects can provide such an investment and are tapping the Islamic financial markets as a source of funding, especially for projects under development in the Islamic world. Provided the Islamic facility is kept separate from the other facilities to avoid being tainted by riba, Islamic financial institutions can become involved in projects (notwithstanding that interest may be paid under the conventional facilities). In the vast majority of Muslim countries, a conventional banking system is specifically legislated for and exists in parallel with the Shariah, so that a person seeking finance is permitted to obtain capital from both conventional and Islamic sources. An Islamic financier is looking for a return on its capital which compares with interest that a conventional bank would expect. The many financing techniques developed largely answer the substantive issues raised in structuring the Islamic financing to ensure that such financing is by way of investment and not by way of conventional loan.

A willingness to use Islamic financing by project sponsors brings a number of benefits. Islamic financial institutions have increasingly large resources which remain largely unaccessed and their involvement in projects, many of which are currently being developed in parts of the world with significant Muslim populations, can enhance the reputation of a project and increase its attraction to central and local government. Conventional lenders are becoming increasingly comfortable with the concept of integrated Islamic and conventional financings, although they have been reluctant in the past to participate in projects with just an Islamic element. With sensible structuring and coordination provisions, however, the concerns of conventional lenders can be addressed.

In one case of an independent power project financing, three Islamic facilities were incorporated into the financing alongside conventional commercial and export credit facilities. A syndicate of Islamic financial institutions provided the project company with senior facilities including a working capital facility and a letter of credit facility. The working capital facility and a further senior facility used a “mark-up” financing technique developed from the Murabaha contract. The project company agreed to sell certain project assets for a basic price to each syndicate, such assets being simultaneously resold to the project company for a “marked-up” price, repayable by the project company in instalments on a similar repayment schedule to the conventional loans.

The amounts owing under the Islamic facilities rank pari passu with the conventional senior facilities. As the Islamic facilities did not, however, specify the exact “return” on capital to the Islamic financiers, the project coordination and inter-creditor agreements included mechanisms for ascertaining which amounts payable under the Islamic facilities were analogous to principal and interest under the conventional facilities, thereby allaying the conventional lenders’ concerns, particularly in relation to the calculation of priority payments both from normal operating income and in the event of an acceleration on default.

Similar concerns arose (and were addressed) in the Hidd II power and water desalination project which closed in early 2002. That financing included a US$200 million conventional term loan facility backed by cover from the Swiss export credit agency, ERG. An Islamic facility comprising an Istisna’a and an Ijara wa Iqtina (together with a Special Mudaraba) for US$55 million completed the financing. Both facilities shared 12-year maturities. Issues relating to Total Loss, insurance proceeds and allocation of proceeds were covered in detail in an intercreditor agreement.

Property investment and development

Property investment and development falls naturally within Islamic financing principles and any of the principal methods described above may be used.

Ijara wa Iqtina, or leasing with a right provided to the lessee to purchase the property, is a commonly used form of financing and standard documentation can be adapted with relative ease. In the United Kingdom, care needs to be taken to ensure that the incidence of taxation is taken into account and the liability for tax falls equitably on the parties. In other respects, English real property law facilitates Islamic financing transactions and provides adequate protection for the separate interests involved, with the emphasis on equity and the concept of trusteeship.

Mudaraba, or participation financing, is also commonly used in the context of limited partnerships for the acquisition or development of real property.

Istisna’a can also be used to provide property development financing for the development of property on a post-acquisition basis.


With the growing amount of capital under Islamic management, the development of Islamic financing techniques and the requirements for infrastructure development in the Muslim world, it is clear that there are increasing opportunities for the use of Islamic financing in funding projects. With an appreciation of the relevant principles of the Shariah and the ability to address the concerns of conventional lenders, borrowers and project sponsors are now demonstrating that it is possible to successfully combine conventional and Islamic finance.