Islamic Finance in Practice

This article will highlight the following:

  1. Islamic financial transactions in banks, capital markets and insurance are arranged through contracts and promises that are nominated (or unilateral legally binding business).
  2. The application of these contracts and promises today is materially different from the classical equivalent.
  3. The most common contracts used in Islamic financial practices are murabahah (or trust sale ); it is also referred to as murabaha to the purchase orderer (MPO) banking.


Contracts and Nomination Promises


Arrangement of products in Islamic finance is often done by replicating conventional financial products but making them in accordance with Sharia.


Whether it is a bank account or a hedge fund, its products have been developed in conventional finance before they are replicated in Islamic finance.


The proponent saw this arrangement as an exercise in Shariah compliance, but critics argued that it avoided the prohibition of usury and gharar and did not add economic or social value.


Much of this debate, revolving around nominated contracts, promises, and their application, is legalistic.


Nominated Contract

When comparing the sale of allowable deferred payments (where the credit price is more than the spot price ) with interest-bearing loans, legal experts often consider legitimate contracts as core differences.


Special emphasis is given to contracts recognized in classical Islamic jurisprudence.


These contracts – alone or in combination with other contracts and promises (wa’ad) – are used to arrange Islamic financing.


Commonly used contracts in modern Islamic finance include murabahah (trust sale) , ijarah (leasing) , salam (futures sale with cash payment), istishna (manufacturing with forward delivery and flexible payment), wakalah (agent), mudharabah (profit sharing or investment management), musyarakah (partnership or joint ownership), qardhul hasan (loans without interest), arbun (options), and tabarru ‘ (donations).


In murabaha , or trust sales , instead of lending money with interest, investors buy goods and sell them to customers on installment loans with disclosed profits.


This contemporary version of Murabaha is also referred to as “murabaha to the purchase orderer banking” .


Disclosure of profits and reliance on seller expertise helps explain why it is classified as a trust sale among various types of credit sales.


The trust sale application is considered to make financing arrangements in accordance with Sharia, while investors get a fixed return.


From the perspective of Islamic commercial jurisprudence, evidence must be clear that legal rights and ownership of assets are passed on to investors before investors sell them to customers.


Because this is a sales contract, murabaha can create several legal problems under a country’s secular law; that is, the seller can be held responsible for guarantees, returns, compensation, environmental liability, and so on.


If the difference between spot and credit prices , which can be considered by economists as interest, is classified as profit for legal reasons, further complications can arise.


This is because the initial payment discount is usually at the seller’s discretion regardless of the duration of the contract.


This is unlike conventional monetary loans, where the initial payment discount can be specified in the contract and is legally binding.


The combination of credit and spot sales can thus effectively mimic interest-bearing monetary loans.


For example, a financier can sell goods to clients on credit and then immediately buy them back on the spot at a lower price.


This controversial method, selling credit by direct repurchase (bai al-inah) , is widely practiced in Malaysia.


Likewise, sellers can sell goods to clients on credit, which immediately sell them to third parties at lower prices.


This practice is known as monetization (bargaining) .


Both of these methods make financiers receive money now to be paid back with more money later, and assets only play a ceremonial role.


The main difference between the two modes is that more parties are involved in monetization than in sales with immediate repurchases.


This controversial method is often seen as a legal strategy that avoids the prohibition of usury.


Although using classical Arabic terminology, the modern version of the contract nominated may differ materially from the classical version.


Some scholars have justified the modification of the classical nomination contract because “Islamic banks operate in a totally different environment when compared to what has been described by classical jurists” and “new ijtihad [independent reasoning] is needed to modify the classical fiqh [jurisprudence] of the doctrine so that they become relevant in meeting the sophisticated financial needs of contemporary Muslims “(Shaharuddin, 2010).



The promise case (wa’ad) serves as a useful example of how classical Islamic commercial jurisprudence has been modified for modern Islamic finance.


Promises are an appropriate tool used in financial structuring in Islamic finance; it is unilateral and does not have to fulfill formal contractual requirements as defined in Islamic commercial jurisprudence.


In fact, the most widely used contract in Islamic finance, murabaha , also uses promises.


In murabaha , the investor assumes ownership of the asset only if it has a binding legal binding that the funder will buy the asset, which minimizes the risks associated with ownership.


Historically, the majority view in Islamic commercial jurisprudence does not consider legally binding promises.


However, in 1988, in the context of the sale of payments suspended by Islamic banks, the OKI International Islamic Fiqh Academy issued a resolution that paved the way for promises to be legally binding – depending on several conditions ( Islamic Development Bank , 2000).


Although the Academy’s resolution is in the context of credit sales, legally binding efforts have found widespread application in Islamic finance – from structuring sukuk to derivatives.


Application of Contracts and Promises


Islamic prohibitions, contractual nominations, and promises are closely related features of Islamic finance.


There are several examples to explain their fundamental role in shaping Islamic finance in commercial banking (the largest sector in Islamic finance), capital, takaful , and microfinance.


Commercial Banking

In the early days of conceptualization, Islamic banking was intended to work as a two-tier investment management (mudaraba) .


Individuals are expected to invest with banks on the basis of profit sharing, and banks, in turn, are expected to invest in business on a profit sharing basis.


However, contemporary practice is very different from that initial conceptualization.


On the liability side, Islamic commercial banks offer various types of accounts.


Some of them are deposit accounts, without the prospect of returning a deposit, using one of the nominated contracts ( wadiah , or deposit; qardhul hasan , or loan without interest).


The bank, however, can offer returns in the form of discretionary prizes (grants) .


There are also investment accounts, which may be limited or not limited in scope.

This investment account tends to be based on contracts similar to investment management (mudharabah) . Banking

regulators can assume Islamic banks have constructive legal obligations to guarantee the capital of investment account holders because this account is marketed as a substitute for conventional deposits.

Regulators can also see this guarantee as a prudential commercial obligation, similar to capital adequacy, because giving losses to account holders can cause banks to run, cause collapse and create a systemic threat to the banking sector.

Basically, whether capital guarantees are seen as legal or commercial obligations of Islamic banks, investment accounts offered by Islamic banks have capital guarantees in practice (as is done by accounts in conventional banking), even if, in theory, they are intended to be accounts for yields, where capital is supposed to risk investment returns.

On the asset side, Islamic commercial banks use these nominated contracts or combinations to offer various other financing arrangements.

For example, a combination of diminishing partnerships and rent is often used to finance homes.

The bank and the home buyer jointly buy a house and enter into a lease agreement.

Home buyers pay rent for shares owned by investors and gradually buy up investors’ shares.

At the end of the term, the home buyer fully owns the house.

In principle, this arrangement, also known as lease to buy, is entirely free from lending money at interest.

Notice here that changes can be brought about in the economic substance of the arrangement by changing several features.

If the price at which the buyer buys housing units from financiers is fixed in advance and the “rent” is based on the benchmark of interest rates – not an unusual practice in the Islamic finance industry – then the economic substance of Shariah compliant home financing is the same as conventional home financing.

Critics tend to see such home financing as Islamic in the form of law because of its dependence on the nominated contract, but not in economic substance.

According to such criticism, rather than setting a price per unit, it must be based on the market value of the property at the time of purchase.

Similarly, rent must be based on the rental market at the time of payment rather than the benchmark interest rate.

Capital market

Long-term Equity Funds

The majority of Islamic funds are long-term equity funds that use exclusive screening, thereby reducing the universe that can be invested in companies that are considered acceptable.

Generally, like the initial conventional ethical funds, Islamic equity funds follow an exclusive screening to avoid companies whose main business is against Islamic jurisprudence.

Companies to be avoided include those who receive income from alcohol, gambling, “adult entertainment”, conventional banking, and insurance.

The “sin” industry must not be limited to those mentioned in the main sources of Islam; the list has been expanded to include tobacco because, arguably, it is dangerous for life.

The biggest impact of exclusive screening is usually the elimination of the conventional financial and insurance sector, which can be the largest sector in the stock markets of developing countries.

After the initial screening is based on the company’s main business, further exclusion filters are applied to avoid businesses with very high unacceptable interest income (usually 5%).

Businesses with high interest debt (usually more than one third of market capitalization or total assets) are also avoided.

Setting a debt threshold is a difficult problem, mainly due to the absence of clear guidelines from the main sources of Islam.

The “one-third” threshold is reportedly derived from the Prophet Muhammad’s tradition of inheritance; he forbade donating more than one third of his wealth to non-relative or charity.

In addition, dividend income associated with unauthorized income must be donated to charities, although the same is not done for capital gains , which remains a matter of debate.

Screening methodologies for separating permitted and unauthorized income differ between Islamic index providers.

However, the general approach is the same.

Because companies often do not publish detailed information about revenues from separate product lines, following certain ratios can be a complex activity.

In some cases, companies that are excluded by one provider may be included by another.

The general screening process is negative, although positive alignment is also used in some cases (for example, the Islamic sustainability index).

Unlike responsible investment, Islamic investment is not known to actively use engagement with companies as a strategy.

The screening methodology applied in sharia investment, in essence, is subjective tolerance measures because no company can fulfill the Islamic criteria perfectly.

The Islamic screening methodology, like many other aspects of Islamic finance, must be seen as work in progress.

Most companies do not have Shariah compliance as a goal in the first place and fall within the parameters of Islamic financial tolerance is a coincidence not by design.

Application of strict criteria of no interest bearing debt and no income not permitted can reduce the scope of which can be invested insofar as investing in listed equity will be very difficult, if not impossible.

Islamic equity funds are not without criticism.

General criticism is that they do not have a clear agenda for justice and socio-economic development.

Some of them facilitate the flight of private capital from Muslim-majority countries to Western capital markets (Henry and Wilson, 2004).

They are also known to invest in companies, such as conventional energy, which are considered problematic in responsible investments due to environmental, social, or corporate governance issues.

Sometimes, investments are made in companies which are otherwise shunned by some Muslims as a result of corporate involvement in war and conflict.

In a critique of socially responsible investment, Hawken (2004) observed, “Muslim investors may be confused about finding Halliburton on the Dow Jones Islamic index fund”.

Critics argue that using Sharia arbitration and being feasible for investment by Islamic equity funds without a fundamental change in capital structure is theoretically possible.

For example, replacing finance leases with an equivalent in accordance with Sharia can reduce a company’s debt ratio without having to reduce interest bearing debt (El-Gamal, 2006).

Apart from such criticism, Islamic equity funds are generally seen as the most authentic form of Islamic finance because they are much closer to the distribution of risk-reward and are further away from lending money at interest than other types of products in Islamic finance.

Interestingly, at the end of 2013, in terms of assets under management, the largest Islamic equity fund, Amana Growth Fund, was based in the United States.

According to an interview with its main portfolio manager, the majority of investors are non-Muslims who are interested in these funds, perhaps because of their attractive financial performance (Barnes, 2012).

According to one report, the number of sharia mutual funds operating globally reached 786 in 2013, double that of 2007.

Total assets under management, estimated at under US $ 60 billion, are a fraction of the general estimate of Islamic finance in global assets.

Although most assets in equity funds are only long, Islamic money market funds now have more assets under management than equity funds.

Most of the funds are registered in Malaysia, Saudi Arabia and Luxembourg.

The scale of achievement remains a challenge for Islamic funds: Only 80 funds manage assets of US $ 100 million or more.


Islamic investment certificates, or sukuk (eg, plural sakk ), also translated as Islamic bonds, are often regarded as one of the most promising segments in Islamic finance.

They received a lot of attention because of their rapid growth and role as a liquidity management tool that is needed for Islamic banks.

Determining Islamic financial standards based in Bahrain, AAOIFI defines sukuk as “certificates of equal value representing an undivided portion of ownership of tangible assets, usage rights and services or (in ownership) certain project assets or special investment activities”.

Literature shows that sukukused in Muslim societies “as early as the Middle Ages, where papers representing financial obligations originating from trade and other commercial activities were issued” ( Dubai International Financial Center , 2009). Modern

sukuk was legitimized by the decision of the OIC International Islamic Fiqh Academy in 1988, which allowed the collection of assets represented in written letters or bonds.

The verdict further states that these bonds or notes can be sold at market prices, provided the composition of the group of assets represented by securities consists of the majority of tangible assets.

Sukuk have been issued by the government (e.g., Bahrain), corporations (e.g., General Electric), and other types of entities (e.g., German state of Saxony-Anhalt, World Bank).

Moody’s Investors Service, in its Special Comment on September 4, 2014, estimates that “total sovereign foreign accounts are around 36% of the $ 296 billion of sukuk outstanding in July 2014″.

Interestingly, the world’s first sukuk issue was issued not by an Islamic financial institution but by a conventional company, Shell MDS, even though it was published in Malaysia, a Muslim-majority country.

The main conceptual difference between sukuk and bonds is that sukuk must represent ownership in real assets while conventional bondholders have debt.

Thus, in principle, one should not refer to sukuk as an “Islamic bond”, which is an oxymoron , but as an “Islamic investment certificate” (Henry and Wilson, 2004).

Sukuk can be arranged in various ways, even when using the same basic nomination contract.

For example, one can arrange sukuk using investment management contracts that, economically, behave like conventional debt instruments, collective investment funds, or equity instruments.

Sukuk can be arranged with one asset or a collection of tangible assets.

Structures that involve a mix of tangible and financial assets in a collection of assets have also been permitted.

At present, there is no fixed minimum proportion of tangible assets in a portfolio that can be secured through sukuk , even though the underlying views are different.

The general structure of the underlying sukuk is rent (ijarah) .

The originator sells the asset to a special-purpose vehicle (SPV), which is a sukuk issuer , and receives the initial cash flow.

SPV leases the asset back to the originator , who pays the rent to SPV.

After the end of the agreed period, the originator, who requests the previously signed purchase and sale transaction, repurchases the asset at a fixed price.

Asset rental can consist of principal, returns, and all costs incurred to maintain the asset.

The originator therefore acts as a seller, tenant, obligor, and service agent ( Dubai International Financial Center , 2009).

As in the previous home financing example, this sukuk structure can be used to replicate conventional bonds through the following elements: lack of true sales between the originator and SPV, use of fixed price promises at which the trigger repurchases the asset, and rents pegged to benchmark rates flower.

Although it is very similar to conventional bonds, sukukconsidered to be compliant with Sharia because most are arranged on the basis of sales and leases and the results cannot be used to finance prohibited activities.

An important point in the sukuk structure is whether actual sales have occurred between the originator and the sukuk issuer .

If there is indeed a sale, the asset is indeed owned by SPV, the return comes from the asset, and the sukuk holder has no recourse to the originator if there is a lack of payment.

These true-sale sukuk are known as asset-backed sukuk , and non-sale sukuk are actually asset-based sukuk .

Sukuksupported by assets is basically securitization of most real assets, while asset-based sukuk are closer to conventional bonds.

Sukuk should be based on real assets or a collection of real and financial assets, while securities supported by assets can only use financial assets, such as loans and receivables.

In late 2007, Muhammad Taqi Usmani (2007), chairman of the AAOIFI sharia council, issued strong criticism of some magic structures .

He questioned their compliance with Sharia.

He criticized the structure for using a set of legal hoaxes to change what should have been a risk sharing investment return into conventional bonds.

Much controversy follows criticism; News reports suggest that, according to the criticism, 85% of sukuk do not comply with Sharia.

Interestingly, the sukuk leasing structure is free from criticism, although it may be asset-based and very similar to conventional bonds.

A possible technical explanation for treating the sukuk as an exception is that the net value at which the originator repurchases assets from the SPV at the end of the term is considered to be fair value.

Dusuki and Mokhtar (2010) argue, “despite the fact that sukuk supported by assets are considered closer to the spirit and principles of sukuk compared to sukukasset based, to date only 11 sukuk supported assets [or 2% of the relevant 560 issues] have been issued “.

There are several reasons offered to explain the dominance of asset based sukuk .

One reason is that investors demand fixed income as opposed to assuming the risk of an asset

The initiator also asks for financing without having to separate from the asset

, and the legal framework for securitization is often weak in emerging markets, and various taxes can be triggered in the case of actual sales (eg stamp duty, sales tax, tax capital gain )

Important issues related to sukukis uncertainty about how the underlying legal structure will occur in conventional court vis-a-vis legal bonds.

Although sukuk must comply with Islamic law, they too, like bonds, are governed by secular (usually British) law which forms the basis of sukuk issuance .

The main aspect is whether the sukuk holder has ownership rights in the underlying assets or has taken the credit risk of the originator.

A related problem regarding law enforcement is that local courts in the Gulf Cooperation Council countries may not allow recourse to sukuk assets in accordance with a UK court decision.

These concerns of enforceability can be acute where local governments have an interest in the underlying assets.

Analyzing sakk default case studies , Van Wijinbergen and Zaheer (2013) argue that “in many cases problems can be traced back to clauses and structures that make sukuk more like conventional bonds”.


  • Political Economy of Islamic Finance
  • Positive Things of the Islamic Economic System
  • Cooperation in Islam

Amid the rapid growth in Islamic finance, dealing with defaults may not be given enough attention.

The aspect of bankruptcy in classical Islamic jurisprudence (iflas) is not seen as consistent with modern bankruptcy law.

Some argue that “the main difference with the Western approach to bankruptcy lies in the absence, in classical Islamic law, from the notion of separate corporate personalities”, but there are also other differences about “damaging penalties, the hierarchy of claims and plaintiffs, and many other things” ( Reappraising the Islamic Financial Sector, 2011).


Sharia insurance (takaful) has a special form because conventional property insurance is considered inconsistent with the Islamic prohibition of excessive gharar and usury.

Exclusive insurance basically involves risk trading, and investment by a proprietary insurance company includes conventional interest-bearing debt securities.

Another argument against conventional insurance is that it has an element of gambling because the insured is considered paying a premium in the hope that the insurance company will make payments when certain events occur.

Others point out that gambling is a zero-sum game where the specified event must occur; insurance, however, is not a gamezero-sum and specified events may not occur.

In addition, insurance requires interest that can be insured on the subject, the policyholder is entitled to compensation only if the policyholder suffers a loss, and the amount of compensation depends on the amount of loss (Fisher, 2013).

In 1985, the International Islamic Fiqh Academy issued a regulation confirming that takaful – the Arabic word for solidarity – through a donation contract (tabarru) is acceptable because gharar is tolerated in this contract.

Instead of selling risk, takaful must be based on risk sharing.

By avoiding usury-based investments, arrangementstakaful , arguably, is made consistent with Islamic commercial jurisprudence.

Takaful faces its own institutional, legal and regulatory issues.

For example, the legal system in many countries does not accept the form of joint entities or cooperatives without joint capital.

Where such joint entities can be formed, it may be difficult to raise enough capital to meet regulatory requirements.

The majority of takaful providers are designated as hybrids of joint insurance and ownership, where non-profit shareholder companies operate a joint takaful collection.

Insurance protection is provided by takaful participants to one another through takaful fundsparticipants and takaful operators manage guarantees and investments on behalf of takaful participants .


The use of derivatives, especially their secondary trade, remains an area of ​​much controversy in Islamic finance.

Some reasons for requiring derivatives are clear (e.g., to deal with foreign exchange risk).

However, critics find several other reasons for being unconvincing – for example, setting interest (related to conventional interest rate benchmarks) in credit sales, calling it profit rather than interest, and then needing to manage interest rate risk.

Reasons for the controversy about secondary trade include the lack of underlying real assets, cash settlement, and real and perceived problems with speculation.

Although derivative trading in the secondary market has so far been restricted in Islamic finance, over-the-counter derivatives for hedging are increasing.

Derivative structures in Islamic finance are often created from a combination of synthetic credit sales and one-sided businesses.

For example, ” profit rate swaps ” are created when the parties effectively exchange fixed and floating interest payments, while apparently buying and selling commodities at fixed and floating rates, with the “profit” element of the floating exchange rate referring to conventional interest rates.

Swapthe profit rate can also be arranged as a series of promises in which the parties promise to exchange relevant fixed and floating interest payments at a certain time in the future.

Likewise, in cross currency exchanges, two commodity sales contracts are used to generate offsetting cash flows in currencies that are opposite of the desired maturity of the contracting parties.

A total return swap has been designed that uses a two-promise contract (wa’ad) , which exchanges returns on sharia-compliant assets with designated portfolios or referral investment portfolios that can contain conventional non-Shariah compliance assets.

Sharia scholar Yusuf DeLorenzo (2007) has criticized this structure mainly on the grounds that returns from alternative portfolios do not originate from activities that are religiously acceptable.

Iqbal, Kunhibava, and Dusuki (2012) argue, “while the Ottomans, the OIC Fiqh Academy, DeLorenzo and Kamali have not made a distinction between independently traded options and embedded options, Elgari’s differences seem to be in line with the agreement of the [call option] by AAOIFI “.

They then expressed their support for “the view that when an option is independent and can be traded independently, the premium paid for it is not permissible; however, when the option is embedded in a larger transaction, similar to urbun, and fees paid, this will be permitted “.

In March 2010, the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) released the ISDA / IIFM Tahawwut (ie, hedging) Parent Agreement to standardize certain derivative transactions that Shariah compliant

This step is considered as the first global standard documentation for privately negotiated Islamic hedging products, but so far it is not known to have gained any major appeal in the market.


Given the Islamic emphasis on justice and redistribution, Islamic finance is expected to have a natural affinity with initiatives to reduce poverty through microfinance.

Institutionally organized microfinance in Muslim-majority countries and Islamic commercial banking were introduced around the same time.

The first Islamic commercial bank, Dubai Islamic Bank , was established in 1975, and a research project that led to the establishment of the Grameen Bank in Bangladesh began in 1976.

However, Islamic commercial banking was not the main target, but in the poorer segments of society.

As with the rest of Islamic finance, Islamic microfinance also uses contracts and promises nominated to make microfinance in accordance with Sharia, and trust-sale (murabahah) is the preferred method of financing (El-Zoghbi and Tarazi, 2013).

Obaidullah and Khan (2008) identified four microfinance models that have been used by Islamic microfinance initiatives: the Grameen model, village banks, self-help groups, and credit unions.


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