Islamic finance is one of the fastest growing areas of financial services, with the UK being a regional hub. Christopher McLean and Mariam Bibi look at the key components and why it could be considered by many clients.

During its short history, growth in Islamic finance has been impressive. From its birth in the late 1960s, it now represents USD 2.4 trillion assets globally, according to the Islamic Financial Services Industry Stability Report 2020.

While the majority of the industry’s assets are concentrated in the Gulf Co-operation Council (GCC) area and Malaysia, the UK is considered the western hub with Islamic finance representing USD 6.4 billion of assets.

In the UK, there are five Islamic banks, including Al Rayan Bank and Gatehouse, as well as over 20 banks operating via an Islamic Window model.

What is Islamic finance?

Islamic finance describes a financial arrangement that adheres to the principles and provisions of the Shariah. It's an alternative financial system, co-existing with a conventional system, where monetary intermediation is achieved in ways different to lending.

For example, a key aspect of conventional banking is the giving or receiving of interest, which is specifically prohibited by the Shariah. Instead, it's heavily based on trade and is asset backed. While the result of financial deal is the same, the steps taken towards accomplishing that deal are different to ensure compliance with Islamic law.

The strong underpinning of social responsibility that goes along with these principles means that increasingly, Islamic finance is seen as an ethical and fair alternative to all, regardless of whether they practice the Islamic faith or not. Due to a more risk-averse approach, Islamic institutions have proved themselves resilient in times of uncertainty.

Five pillars of Islamic finance

1 Prohibition of interest (Riba)

The avoidance of Riba is a key part of Islamic finance. In simple terms, Riba is considered to be an advantage to one party (the creditor) at the expense of another (the debtor) for no appropriate consideration.

However, Islamic finance does recognise the time value of money and makes provision for this with Shariah compliant contracts, which enable institutions to lend without interest and make a profit that is commercially equivalent to interest.

2 Prohibition of excessive risk and uncertainty

Islamic finance doesn't allow for excessive risk, prohibiting uncertainty in quality, quantity, maturity and other sales terms. All these elements of a transaction must be explicitly stated and transparent at the outset.

The rationale behind the prohibition of uncertainty is to ensure full consent and satisfaction of the parties in a contract.

3 Prohibition of unlawful commodities and services

Islamic finance mustn't be involved in any activities related to unlawful goods and services, including all related chains of production and distribution.

For example, this includes non-halal foods such as pork, weapons, gambling, alcohol, tobacco and certain aspects of the entertainment industry. Investments should be made in permissible (halal) assets.

4 Profit and loss sharing

Islamic finance is, in principle, a profit-and-loss sharing system. While it prohibits interest (Riba), it allows trade and profit-and-loss sharing instruments.

These are structures that deviate from the traditional concept of lending, allowing the relationship to turn from lending into an investment. The two main products in profit-and-loss sharing modes of financing are Musharakah and Mudarabah.

5 Need for an underlying asset

In Islamic finance, a bank either acts as a seller or a lessor, and therefore the asset is of great importance. Every transaction needs to have an underlying asset – without which the transaction is void.

An underlying asset could be a fixed asset, such as investment property, or a financial asset, which might take the form of equity.

Shariah compliance

Shariah compliance is an extremely important element of Islamic finance, with Shariah advisory or supervisory boards established to ensure this. The decisions of these independent boards are binding, and they are required to guide any institution towards Shariah compliance.

An institution cannot claim to be doing Islamic financial business unless it has a Shariah board or committee consisting of qualified scholars who are of high reputation and possess the necessary skills.

At an international level, there are two standard setting bodies for Islamic finance:

1 the Accounting and Auditing Organisation for Islamic Finance Institutions (AAOIFI)

2 the Islamic Financial Services Board (IFSB)

These boards work together with organisations such as the International Monetary Fund (IMF) or the World Bank to encourage Shariah compliance across Islamic finance globally.

Examples of Islamic banking structures

The following simplified Islamic banking structures make up approximately 70% to 80% of all Islamic finance deals globally:

Marabaha (sale and margin)

A Shariah-compliant sale transaction where the mark-up and profit is explicitly mentioned from the outset. This is the most common and widely accepted structure in Islamic finance.

Ijarah (leasing arrangement)

An agreement where a party purchases an asset and leases it to a counterparty. This is executable through a finance or operating lease. This structure can be used for real estate financing, heavy equipment financing or sukuk (bond) issuance.

Wakala (agency)

This is an agency agreement where a principal appoints an agent to perform certain responsibilities against a pre-determined fee.

This is used for several Islamic products including fixed deposits, export financing and investment funds. Either the bank or the client can be assigned as an agent, depending on the funding need and expertise.

Mudarabah (investment)

A profit-and-loss sharing partnership where one party is the capital provider, and the other party provides expertise. This is used for Islamic products, such as fixed deposits, savings and current accounts and overdraft facilities.

Islamic Window model

In the UK, Islamic finance institutions operate under three models:

1 a fully-fledged Islamic institution (eg, Gatehouse bank, Al Rayan bank)

2 the subsidiary model, where an Islamic financial institution is owned by a conventional bank (eg, Emirates Islamic)

3 the Islamic Window model

The most-common model is the latter, where a department within a conventional bank offers Islamic products. This is a cost-efficient way of operating, utilising the infrastructure of the existing financial institution.

It also allows for access to a non-Muslim client base and has been a key driver in the expansion of Islamic finance in the UK. Barclays, HSBC, Standard Chartered, JP Morgan, Deutsche Bank, BNP Paribas are just a few examples of banks all operating an Islamic Window model.

Subject to certain methods and approvals, it's possible for banks to raise funds using conventional methods and originate Shariah-compliant financing to their clients. This could be an attractive feature for lenders wishing to enter the Islamic finance market.

Our UK Debt Advisory team is working with an increasing number of clients on Islamic finance matters, including raising debt in a Shariah-compliant way. We deliver our advice from the UK and in partnership with our dedicated Islamic finance and Shariah-compliance experts from across our network in the Middle East and Asia.

For further support with Islamic finance, get in touch with Christopher McLean. 

This article was written by Christopher McLean and Mariam Bibi in conjunction with Samer Hijazi and Mazin Khalil, Global Head and Deputy Head of Islamic Finance at Grant Thornton UAE.

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