Home Financing in Islamic Finance
Islamic banking practitioners (with the help of Islamic scholars) have utilized a number of instruments that are acceptable within Shari’a to offer Islamic home finance products in a modern day economic system. The commonly used methods for the purchase of property are ijara (lease) with diminishing musharaka (diminishing partnership) and murabaha (a sale transaction for costs plus profit).
Conventional banks use interest-based loan contracts as the main instruments to provide finance to their customers. As a result of interest being prohibited by Islam, Islamic financial institutions cannot provide traditional products and services, which involve interest based contracts. Therefore, contemporary Islamic jurists and financial practitioners have had to adopt and develop a number of instruments and facilities to allow Islamic banks to operate an interest free system. Islam does not deny that capital deserves to be rewarded, but Islamic teachings present “risk sharing” finance as the most efficient and correct way to provide finance. Therefore, an Islamic financial institution mainly uses profit/loss sharing contracts on both sides of its balance sheet. On the liabilities side, it invests depositors’ funds in various types of businesses. A portion of the earned profit is paid to depositors in a pre Islamic determined profit sharing ratio. The depositors’ profit is not and should not be determined ex-ante. On the assets side, the Islamic financial institution uses various kinds of non-interest based contracts as finance instruments; for example profit/loss sharing contract (musharaka), investment partnership (mudaraba), leasing contract (ijara), cost-plus financing contract (murabaha), and istisna’a contract (manufacturing or construction finance). Almost all of these types of contracts have been or can be used to provide home finance. The market and customers demand, the legal environment and the financial institution preferences will be the main factors to decide which of these contracts the best to be used is. The most significant Islamic home finance instruments used are:
- Murabaha, which provides a fixed rate of return to the financial institution; and
- Two instruments that provide the flexibility to vary the return to the financial institution: _ Ijara wa iqtina; and _ Ijara with diminishing musharaka.
The term murabaha refers to a special type of sale where the seller has to disclose the costs plus the profit made from the transaction. In order to use the murabaha contract as a financing technique, the Islamic financier incorporates the feature of credit sale (or deferred payment) in the murabaha contract. The modern murabaha contract has become a very popular technique of financing amongst the Islamic banks as it provides similar risks to conventional interest based loan. The murabaha finance instrument operates in the following way:
The customer approaches an Islamic bank to get finance in order to purchase a specific commodity. The bank purchases the commodity in cash and sells it to the customer for the cost plus a profit. Since the customer does not have the funds, he/she buys the commodity on a deferred payment basis. Thus, the customer attains the commodity for which he/she wanted and the Islamic bank makes some profit from the sale price. The transaction will usually follow the following steps:
- The customer determines their needs (i.e. identifies the house he/she wants to purchase and agrees the initial price with the seller). The customer then applies to the bank and promises to buy the house from the bank if the bank agrees to provide the finance;
- The bank notifies the customer of its approval of financing the house. The bank then purchases the house from the seller for the initial price agreed with the customer and obtains title of the house before selling it to the customer;
- The two parties (the bank and the customer) sign the murabaha sale contract for the agreed new price (which is the cost plus the profit) to be paid over the term of the contract, and the bank transfers the legal title to the customer; and the customer pays the new price through monthly installments.
The bank cannot change or increase the sales price after concluding the murabaha sale. Any increment on the sale price would be considered interest. The whole of the murabaha-based home finance transaction is to be completed in two different sale contracts: one through which the bank acquires the house, and the other through which the bank will sell the house to the customer. The murabaha principle creates a fixed, predetermined indebtedness. This has made the murabaha principle attractive for Islamic banks as an alternative to interest rate based transactions. However, this mode of finance receives some criticism as it incurs high transaction costs and is inflexible compared to interest based transactions. Murabaha is a sale contract, this means that the sale price will not change for the duration of the contract. Therefore, the murabaha-based instrument provides a fixed rate of return on home finance.
The term ijara refers to a leasing contract. The ijara contract has not been used traditionally for finance purposes; rather it was used for normal leasing activities. However, Islamic banks have found that leasing is one of the main recognized types of finance throughout the world and it is a lawful transaction according to Shari’a, therefore it makes perfect sense to develop new financial instruments based on ijara, including home finance instruments. The home finance ijara-based instrument are usually called “ijara wa iqtina” (lease and purchase), which is in a way similar to financial lease and hire purchase.
Under this agreement, the Islamic bank purchases the house selected by the customer, and the customer enters into two contracts with the bank – a leasing contract and a promise to sell. The first contract is a leasing contract where the customer agrees to pay periodic rent to the bank during his occupancy of the house until the end of the ijara contract term, and the second contract is a promise to sell, where the bank undertakes to sell the house to the customer, usually for a nominal price at the end of ijara contract. The rent paid by the customer can be usually reviewed on a quarterly or semi-annual basis allowing the rent rate to be changed based on an agreed benchmark, usually London Interbank Offered Rate (LIBOR) or Karachi Interbank Offered Rate (KIBOR) or similar indices. The customer pays the bank monthly installments; each installment is a combination of a variable rent payment under the leasing contract, together with a fixed payment to pay for the house price which usually will be divided over the term of the contract. The ijara wa iqtina method for home finance has decreased in popularity due to the fact that technically, the customer is paying rent, although part of this rent is to cover the purchase of the property; this part of the rent payment does not create any ownership right as the ownership will only be transferred at the end of the contract when the customer will exercise the promise to sell
Diminishing musharaka and ijara-based home finance-Home financing based on diminishing musharaka and ijara is unique to Islamic finance. It is based on the idea of shared equity rental. Under this housing finance instrument, the customer and the bank jointly acquire and own the house. The bank then leases its share of the house to the customer on the basis of ijara. The bank will allow the customer to gradually purchase the bank’s share so that the share of the bank reduces and the customer share increases gradually over time, until the end of the contract term, where the customer will become the sole owner of the house. The customer will make two monthly payments; the first is for the rent charged by the bank for allowing the customer to use the bank’s share in the house. The rent rate is normally bench marked to LIBOR, KIBOR or similar indices. The second payment is for the acquisition of a portion of the bank’s share. The bank will sell its share usually at the same purchase price of the property and any depreciation or appreciation of the house value will be passed to the customer.
The musharaka and ijara based home finance transaction usually follow the following steps:
- The customer identifies the house and agrees the price with the seller. The customer then will apply to the Islamic bank to finance the house; and
- The bank notifies the customer of its approval. Then both the bank and the customer buy the house and become partners. At this stage, both parties will first sign the diminishing musharaka contract where the bank agree to sell its share to the customer over the term of the contract, and then will sign the ijara contract where the bank leases its share to the customer. The bank will usually keep legal title of the house for the duration of the contract, and the diminishing musharaka contract will record the customer’s share (or the customer’s beneficial interest). The bank and the customer will share the costs, pro rata, of all major costs including the provision of the house insurance, but all the expense related to the ongoing use of the house should be paid by the customer. Both partners will also share the risks associated with the house ownership in accordance with each partner’s share. If the house is destroyed during the lease period, both parties, as partners, should suffer the loss. If the leased house loses its usufruct without any misuse or negligence from the customer side, then the bank will not be entitled to receive any rent until the house is restored to usable form. Ijara is a lease contract; this means that the rent can be reviewed periodically. The review period is usually set at quarterly or semiannual basis but can be as long as a few years or as short as a month. This makes ijara more flexible than murabaha as it provides a variable rate of return, which can be locked as long as required.
In Pakistan Islamic banking industry is using almost 55% Mix out of its total financing mostly in housing finance using murabaha, ijara and diminishing musharaka.
Working capital financing in Islamic Finance
The number of Shari’a-compliant avenues available to solve Working capital financing needs is increasing. At present, many options are potentially available, in particular for Working capital financing requirements (WC1), with the number of some other Working capital financing solutions (WC2) available that are now on the rise. As we have seen, in addition to murabaha, it is possible to use ijara, istisna’a, and diminishing musharaka to provide Working capital financing Working capital financing (WC1). Based on recent innovations and efforts in product development, a new musharaka based product has emerged, which acts as a substitute for the conventional running finance facility, and may offer a solution to composite Working capital financing needs of all kinds hence, it is referred to as latest Working capital financing (WC3) . In addition, so far tawarruq and salam-based solutions have been developed to meet Working capital financing (WC2) needs, but are not that widely available. In this regard, certain reservations exist about employing tawarruq as a general tool for finance; however, the exact profit calculation method is based on a somewhat complex formula, but is fully disclosed to the
client, and in addition to the bank-client basic profit distribution formula, involves the use of investment category weightings to derive weighted average liabilities (among other things). Since the purpose here is mainly to outline the product, and for need of brevity, a full working cannot be displayed. use of salam for Working capital financing (WC2) does not share such controversy, especially given that it may be reasonably argued that the very raison d’eˆtre for salam is to fulfil the need of providing liquidity to producers.
In practical terms, as with so many products, with regards to Working capital financing requirements too we find differences in the products on offer across jurisdictions. For instance, in the Middle East we find that murabaha is used most often for Working capital financing (WC1) needs, and tawarruq for Working capital financing (WC2), though not widely. In contrast, in Pakistan diminishing musharaka has also been used for Working capital financing (WC1), and perhaps most notably, the running musharaka account (which meets both Working capital financing needs) is available, although only with one bank at the moment. In Sudan, salam is often used for Working capital financing (WC2). By bringing together the different possibilities for addressing Working capital financing needs, including both the products which are in operation, as well as those which are theoretically workable (even if not being applied anywhere at present), the aim has been to provide a useful overview on existing Shari’a-compliant solutions for Working capital financing needs. It is hoped that there can be a move away from predominantly using murabaha and tawarruq for Working capital financing F, given the substantial range of products that can be adopted to fulfil most working capital requirements in line with the Shari’a.
Equity markets in Islamic Finance
Other than debt instruments, another significant development of the Islamic capital market is the establishment of clear guidance on the types of equities that comply with Shari’a requirements. Given the popularity of investing in equities, much debate took place as to which equities were available for Muslim investors. Initial efforts were made in Malaysia in 1983 when Bank Islam Malaysia Bhd published its first list of Shari’acompliant equities. This was later followed by the introduction of a list of eligible equities in June 1997 by the Securities Commission of Malaysia. As the Shari’a guidance for screening stocks became acceptable, this facilitated the establishment of Islamic indices. The first Islamic equity index was introduced in Malaysia by RHB Unit Trust Management in May 1996. This was followed by the launching of the Dow Jones Islamic Market (DJIM) Index by Dow Jones & Company in February 1999, the Kuala Lumpur Shari’a Index by Bursa Malaysia in April 1999 and the FTSE Global Islamic Index Series by the FTSE Group in October 1999. In the last few years Standard & Poors have followed suit with their own Shari’a compliant index.
Another asset class that benefited from the Shari’a screening guidance is the Islamic investment funds. The Amana Income Fund, the first Islamic equity fund to be established in the US, was formed in June 1986 by members of the North American Islamic Trust −an organization in Indiana, which oversees the funding of mosques in the country. In 1987, Dallah AlBaraka Group established two companies, namely Al-Tawfeek and Al- Amin, which were specifically dedicated to the development of Islamic equity funds. These companies have successfully launched a number of Islamic funds focusing on such diverse sectors such as real estate as well as international equities. Later, the entry of international banks in the Islamic market leads to a proliferation of structured products, ranging from capital protected certificates to long-term investment certificates.
The Shari’a screening process of equities is based on a number of filters:
- Haram or non-Shari’a-compliant business activities. These include financial institutions that derive their income from interest-based products, businesses engaged in alcohol, pork, entertainment such as pornography, hotels, casinos and other related sectors that infringe Islamic principles as well as some sectors of the defence industry that are engaged in offensive weaponry. Normally, the tobacco sector is also excluded;
- Highly leveraged companies that are burdened with conventional debt. Only companies that have a ratio of debt to 12 months trailing market capitalization of less than a third are allowed;
- Companies that derive a high proportion of income from interest. Companies that have total cash and securities in excess of one third of their 12 months trailing market capitalization are excluded; and
- Companies having a significant portion of non-income generating assets. Hence companies that have accounts receivables higher than one third of 12 months trailing market capitalization are also excluded. The above screening is mainly for DJIM indexes. The FTSE Islamic index base its ratios on the total assets of the company, whereas Standard & Poors generally follow the guidance of the DJIM index.
In Pakistan KSE Meezan Index (KMI-30) is a stock market index on the Pakistan Stock Exchange in Pakistan of thirty companies that have been screened for Islamic Shariah criteria. The index was introduced in 2009 and the base period for this Islamic index is 30 June 2008. It was created as a joint effort by the Karachi Stock Exchange (now known as Pakistan Stock Exchange) and Al-Meezan Investment Bank (now known as Meezan Bank Limited). The index is calculated using free float market capitalization. At any point in time, the level of the index reflects the free float market value of selected Shariah-compliant shares in comparison with the base period. KMI-30 is recomposed semi-annually.