Islamic finance is one of the fastest developing areas of finance which has grown at between 10 to 15 percent annually over the past decade. Islamic finance is now widely accepted as an alternate form of finance as it continues to expand into an increasing number of non-Muslim countries. Over the past decade, legislative reforms have been introduced in a number of jurisdictions, including major financial centres such as the UK, Hong Kong and Singapore, in order to place Islamic finance on an equal footing with its conventional counterpart.
Islamic finance is considered to be a more ethical form of finance and some practitioners have argued that due the prohibition on gharar (uncertainty) and maysir (speculation) in Islamic finance, its expansion may act as a stabilizing force in otherwise volatile global financial markets. Whether this is true remains to be seen, but it is clear that the structuring constraints of Islamic finance meant that Islamic banks were less exposed to some of the more speculative forms of investment which led to the 2008 global financial crisis, and were therefore not as severely affected.
So what is Islamic finance and how does it differ from conventional finance? It could be argued that on a practical level, Islamic finance is no different from its conventional counterpart and has more or less the same economic effect as a conventional loan. However, at a conceptual level, the principles and transactions in Islamic finance make it an altogether different form of finance.
This article, which assumes familiarity with Islamic finance concepts and LMA loan documentation, explores the similarities and differences between Islamic and conventional finance. The discussion below focuses primarily on ijara (lease) and murabaha (cost plus sale) financing structures, being the two most commonly adopted ones in recent years. Other equity based financing structures such as mudaraba and musharaka have become less prevalent following the criticism of the use of fixed price purchase undertakings in such structures by AAOIFI’s chairman in 2008.
As is well known, Shariah prohibits riba (interest) and therefore an Islamic financier cannot simply rent money like conventional banks. The provision of finance in a shariah compliant manner enables the financier to earn a return but without charging interest per se. An Islamic financier makes financing available by entering into an underlying transaction with the customer, the provision of finance being a consequence of this transaction and not the primary object. The Islamic financer earns its return by participating in this underlying transaction, either by charging a profit or mark-up on the sale of an asset, via a profit sharing arrangement or by renting a tangible asset to the customer. In order to further explain this, the following sections of this article compare the mechanics of an Islamic facility with a conventional loan.
A conventional loan agreement can broadly be divided into five parts; (1) the facility disbursement and repayment mechanics; (2) the yield protection clauses; (3) commercial provisions dealing with warranties, covenants and events of default; (4) syndication provisions; and (5) boilerplate clauses. Of these, Islamic facilities differ only in respect of the first two, and to an extent, the syndication mechanics. The commercial and boilerplate provisions have less to do with shariah principles and are subject to agreement among the parties, and therefore tend to be similar to conventional facilities.
Disbursement and Repayment Mechanics
The prohibition on interest necessitates that the Islamic facility must be made available through the participation by an Islamic financier in an underlying “transaction”, as a consequence of which the financier makes funds available to the customer. This may take the form of a sale (murabaha or tawarruq), a leasing arrangement (ijara), an equity or agency based participation interest (mudaraba, musharaka or wakala) or a procurement contract (istisna or salam). For example, a murabaha transaction involves the financier acquiring an asset for the customer, followed by the sale of the asset to the customer at an agreed mark-up. This purchase and sale forms the basis on which the customer takes on ‘debt’. The cost price of the asset is equivalent to principal whereas the mark-up forms the equivalent of interest in a conventional loan. The mark-up is calculated in a manner similar to interest and is indexed by reference to an interest rate benchmark. The tawarruq, a variant of the murabaha, involves the sale and purchase of commodities, with the customer selling the commodity onwards to realise cash. The repayment can be structured by reference to a variable rate with the parties entering into a series of murabaha contracts, with the rate of return on each contract fixed on the contract date by reference to the screen rate.
Similarly, in an ijara, the disbursement is structured as a sale and lease back of a tangible asset between the customer and financier. The asset sale enables the disbursement, whereas the leaseback to the customer creates the repayment obligation. Again, the rental payment is divided into a fixed portion, being the equivalent of principal, and a variable element, being the equivalent of interest. The variable rental is calculated by reference to an interbank benchmark rate, thus giving the financier a same return as a conventional loan.
Other profit sharing structures such as wakala (agency), mudaraba (investment agency) and musharaka (partnership) involve the provision of finance by the financier, which is to be used by the customer to generate a return which is shared with / paid to the financier. The parties specify an expected return, which is calculated by reference to an interest based benchmark, and any excess is paid back to the customer by way of an incentive fee. Any shortfall in the expected return can be bridged by a liquidity facility or a third party guarantee.
Although the disbursement and repayment mechanics of an Islamic facility appear to be very different from conventional loan, the basic operation and effect is the same. In an ijara facility, for example, the customer requests disbursement of the facility by submitting a notice of intent to sell property to the financier. Thereafter parties enter into a purchase agreement whereby the property is acquired by the financier in consideration of the purchase price, being the equivalent of principal in a conventional loan facility. The purchased property is then leased back to the customer, creating the repayment stream. Similarly in a murabaha facility, the customer makes a written request in the form of a purchase notice to the financier, who will purchase an asset or commodity on its behalf. The financier thereafter offers to sell the asset or commodity to the customer under an offer notice, which is accepted by the customer by countersigning an acceptance notice, creating a sale contract. A tawarruq involves an additional step whereby the customer sells the commodities to a commodity broker to realise cash from the commodities purchased. Sometimes the financier will act as the customer’s agent and complete both steps on its behalf, and will simply disburse cash to the customer. These mechanics are similar to, albeit more elaborate than, a disbursement request in a conventional loan.
Further, the repayments are structured periodically with a definite maturity date by which the entire facility must be repaid. In terms of disbursement and repayment, an Islamic facility is structured so as to ensure that its economic effect and operational mechanics are identical to a conventional facility.
Prepayment and break costs
Prepayment of Islamic facilities may require, depending on the mode of financing used, careful structuring in order to replicate the economic effect of a conventional facility. For example, in order to prepay a murabaha facility, the customer must repay the full contract price due at the end of that murabaha period, including the full mark-up (without discounting for early repayment) in addition to the cost price. Such prepayment overcompensates the financier since all of the prepaid amount is not ‘due’, in a conventional sense, until the end of the murabaha period. The additional amount prepaid is usually refunded by the Islamic financier by way of a discretionary rebate, which ensures that the customer is not worse off under the Islamic facility as compared to its conventional counterpart. Although the rebate is kept ‘discretionary’ for Shariah compliance purposes, financiers which fail to give any rebate will risk reputational harm.
In addition, depending on the Islamic financier’s shariah board, some banks will deduct break costs from the rebate amount, whereas other shariah boards will not allow this. The latter interpretation is more consistent with the principles of shariah, given that the deduction of ‘opportunity and funding costs’ from delayed interest payments are unanimously rejected by the shariah scholars.
In case of a partial prepayment, a new murabaha contract, for an amount equal to the outstanding principal (following prepayment), will be entered on the date of partial prepayment, which amount is then rolled over for a new murabaha period.
Under an ijara facility, voluntary prepayment is structured as a repurchase of part of the leased asset by the lessee pursuant to a sale undertaking granted by the lessor. A mandatory prepayment takes the form of a forced sale of the asset by the lessor to the lessee under a purchase undertaking granted by the lessee. The lessor, however, continues to retain ’ownership’ of the asset, which will be transferred once all lease payments are completed. The purchase undertaking is exercised at a certain exercise price, which is calculated as being equivalent to the outstanding principal and interest.
Given that the lease rental is fixed at the beginning of each rental period, additional costs cannot be added mid-lease. Break costs may, however, be included as an additional cost payable to the lessor on account of the lessor’s added administrative burden of dealing with an unscheduled repayment. The financier may also recover break costs by including a prepayment fee equal to 1 or 2% of the amount prepaid. Where break costs are structured as a prepayment fee, it becomes payable with each prepayment, irrespective of whether the prepayment is made at the end of a lease period or in the middle of it, and may therefore overcompensate the financier.
Yield protection clauses
Yield protection clauses in conventional facilities ensure that the lender receives its expected rate of return by making the borrower responsible for any additional costs or taxes (excluding corporate income tax payable by the lender) which may be payable in connection with the facility. Like their conventional counterparts, Islamic financial institutions do not like to see their yields squeezed by such costs or taxes, and will build in protections to pass such costs on to the customer.
Like conventional loans, customers of Islamic banks are required to indemnify the bank against any increased costs incurred by the financier, provided such costs are incurred due to the provision of the facility. Whereas conventional loan documentation will require increased costs to be reimbursed on demand, increased costs in an Islamic facility can only be charged as part of the profit or rent and added to the next murabaha contract period or lease period. This is because a murabaha contract or a lease is a fixed contract whereby the purchase price or rent is agreed upfront; the financier cannot charge additional sums during the term of the contract.
Where the increased cost arises in the last lease period, the amount may be added to the exercise price under the purchase undertaking payable on maturity.
Tax gross up and indemnity
Islamic facility documents will also typically require the customer to ensure that all repayments are grossed up so that the financier receives the amount it would have received if no tax deduction was applicable. Any gross-up amounts will be added to the mark-up / profit or rent in the murabaha or ijara contract respectively.
An indemnity payment, on the other hand, must be added to the next rollover of the facility.
Since a murabaha is a fixed price contract and the cost price and mark-up cannot be increased during the term of the contract, any additional amounts payable such as increased costs or tax indemnity must be included as part of the mark-up for the next murabaha contract.
Indemnity payments (such as increased costs or tax indemnities) are sometimes drafted as repayable on demand, but this approach goes against the grain of the underlying transaction and ideally these costs should be added at the next cycle.
Ownership Taxes under Ijara
Under an ijara facility, a financier, as owner of the leased asset, becomes liable to pay certain taxes related to ownership which cannot be passed on to the lessee under shariah principles. In addition, the owner is responsible for insurance and major maintenance costs related to the leased assets.
Since the Islamic financier does not wish to be responsible for these additional costs, in practice, these costs are paid by the lessee as service agent for on behalf of the lessor, and are then set off against supplemental rentals charged to the customer in the next rental period.
Default interest or late payment fees
The Islamic equivalent of default interest in a conventional facility is a “late payment charge” calculated at 1 to 2% of the outstanding amount. The calculation of this late payment fee is similar to the calculation of conventional default interest payment. This late payment fee is permissible in Islamic facilities provided it is intended as an inducement to the customer to make timely repayments. It cannot be charged as additional compensation payable to the financier for the greater risk of servicing a loan in default. The Islamic financier may only deduct is actual costs (excluding funding and opportunity costs) from such late payment fee, and donate the remainder to a charity approved by the financier’s shariah board.
Where a profit rate or lease payment is linked to a benchmark rate, market disruption provisions must be included to enable the parties to determine the applicable rate in case the benchmark rate for that currency and period is no longer available. In these instances, a conventional loan would include a number of standard fall-back provisions such as an interpolated or reference bank rate, failing which banks would charge the borrower its cost of funds. These provisions may fall foul of the Islamic prohibition against uncertainty since it may not be possible to determine an interpolated or reference bank rate either. Further, given the difficulty of calculating the ‘cost of funds’ for an Islamic bank (which raises funds in the interbank market through a combination of murabahas and mudarabas or other profit sharing arrangements), the Islamic financing documents will typically specify a fixed profit or rental amount in case a market disruption event occurs.
Syndication of Islamic facilities
Unlike a conventional facility where the agency and security agency provisions are set out in the facility agreement itself, the syndication provisions in an Islamic facility are contained in a separate investment agency (mudaraba) agreement.
It is impractical for each member of an Islamic syndicate to separately enter into an underlying “transaction” with the customer(s) in order to make the Islamic facility available. Accordingly, syndicated Islamic facilities are structured so that one institution, acting as the agent, enters into the underlying Islamic transaction with the customer, and that agent then enters into a back to back investment agency arrangement with the syndicate. The investment agent receives funds from the syndicate under the investment agency agreement, and thereafter invests these proceeds via a bilateral Islamic facility with the customer. Unlike a conventional syndicated facility, the syndicate members in an Islamic facility do not have a direct relationship with the customer and must, in the case of a default, rely on the investment agent to enforce its rights and pass through any recovered amounts.
In general, the rights and protections given to the investment agent are similar to a facility or security agent under a conventional facility.
So are Islamic facilities more than window dressing?
As should be apparent from the above discussion, although Islamic facilities are highly structured, the economic return and allocation of risk in an Islamic facility is substantially similar to a conventional facility. Islamic financing documents mimic conventional documents and try to reconcile shariah concepts with the framework of a conventional facility.
Despite the above similarities, there are some material respects in which an Islamic facilities differ from conventional ones.
First, irrespective of the jurisdiction in which the Islamic facility is made available, Islamic facilities cannot be structured to charge an amount that resembles compound interest.
Islamic facilities, by and large, require tangible assets to form the core of the financing transaction, making it generally difficult to enter into highly speculative and uncertain transactions.
Islamic financiers also assume a greater risk compared to conventional banks, thereby justifying the higher pricing of Islamic facilities.
In a murabaha facility, for example, the financier assumes a risk of fall in commodity prices between the time of purchase and resale. This risk is minimal as the commodities are held by the financier for a brief period of time but in times of price volatility could pose an issue.
Furthermore, in structures such as murabaha, unless the customer and financier continue to enter into new murabaha contracts for subsequent periods, Islamic financiers cannot continue to accrue mark-up/profit on the outstanding sums once a default has occurred and the facility is accelerated. In such circumstances, the amount payable under the murabaha contract becomes fixed and it cannot be increased on account of the delay in payment. This risk can be somewhat mitigated by taking a third party guarantee.
Further, as noted above, the return for Islamic banks in the event of a default is reduced further since late payment fees in Islamic facilities cannot be pocketed by the financier but must be paid to a charity approved by the shariah board.
In the context of an ijara facility, a total loss of the underlying asset (with no fault on the part of the customer) will discharge the customer from making any further lease payments to the financier, since the subject matter of the lease has ceased to exist. As the asset is likely to be insured, the financier’s primary risk is that the insurance proceeds may be insufficient to repay the facility in full, and it will have no further claim against the customer, except perhaps an indemnity or a claim for the customer’s failure to procure adequate insurance (as services agent of the financier). The bank therefore assumes the risk of total loss.
Finally, Islamic financiers can only transact with businesses or invest in assets that are shariah compliant. Therefore, Islamic financial institutions cannot lend to entities or businesses involved in the production or consumption of alcohol, pork, gambling, armaments or pornography, or in any other socially harmful or unethical venture which is repugnant to the principles of shariah.
For the most part, the risk and reward in an Islamic facility is substantially similar to a conventional facility. Critics therefore argue that the underlying transaction, whether an ijara or murabaha etc, only serves to whitewash an otherwise prohibited interest based arrangement.
Shariah scholars have responded to this criticism by arguing that even though the return earned and the risk taken by Islamic financiers is similar to that of conventional lenders, the manner in which this return is earned is halal. It is argued that in a murabaha transaction, for example, the Islamic financier takes the risk of a fall in commodity/asset price, albeit for a short period, by purchasing and selling the assets to the customer, thus being entitled to a return on the trade. In the context of an ijara, it is argued that the Islamic financier takes the risk of ownership of the leased asset and charges rent, the rent being its compensation for taking such risk. The mere fact that the profit or rent is calculated by reference to an interest rate benchmark does not make the transaction un-Islamic.
Islamic financing techniques developed in trading societies, within the framework of the prohibition on interest, in order to facilitate commerce and trade. The financier therefore acted as partner or trading counterparty, and shared some of the risk, thus justifying the payment of a return from the venture. Whether contemporary Islamic financing techniques which seek to mimic conventional lending arrangements with fixed rates of return do justice to the principles of shariah is still a matter of debate amongst scholars and practitioners.
However, given the commodification and standardization of loan markets, it is perhaps impractical to assume that Islamic banks will be able to operate on the basis of non-standardized and non-benchmarked rates of return; Islamic banks cannot be expected to act like private equity providers. Reconciling the principles of shariah with modern banking is a balance which will continue to fuel further innovation in this area, perhaps bring Islamic finance ever closer to the underlying ideals of shariah.