What is Islamic Finance?

Islamic finance is a financial system which functions according to Islamic law (known as Shariah) and is, thereby, Shariah-compliant. Similar to traditional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. Although, these entities are governed both by Islamic law and the finance industry rules and regulations which apply to their traditional counterparts.

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Concept of Islamic Finance

Although Islamic finance was initiated back in the seventh century, it has been institutionalised eventually after the late 1960s. This procedure was impelled by the immense oil wealth which encouraged renewed interest in and demand for Shariah-compliant products and practices. The concept of risk sharing is key to Islamic banking and finance. It is important to comprehend the function of risk-sharing in generating capital. Simultaneously, Islamic finance requests the prevention of riba (usury) and gharar (ambiguity or deception).

Significant Financial Terms

Profit and Loss Sharing Contracts (Mudarabah)

The Islamic bank pools investors’ money and accepts a share of the profits and losses. This procedure is agreed upon with the depositors. So, what does the bank invest in? A group of mutual funds screened for Shariah compliance has emerged. The filter resolves company balance sheets to establish whether any origins of income to the corporation are forbidden. Organisations holding too much debt or engaged in prohibited lines of business are ruled out. Furthermore, to actively controlled mutual funds, passive funds exist too. They are located on such indexes such as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Declining Balance Shared Equity

Declining balance shared equity calls for the bank and the investor to buy the home collectively. It is generally used to finance a home purchase. The bank eventually transfers its equity in the house to the individual homeowner, whose payments establish the homeowner’s equity.

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Lease to Own

This arrangement is similar to the declining balance one described above, except the financial institution puts up most, if not all, of the money for the house and agrees to sell the house to the eventual homeowner at the end of a fixed term. A portion of every payment goes toward the lease and the balance toward the home’s purchase price.

Instalment Sale (Murabahah)

An instalment sale begins with a mediator purchasing the home with a free and clear title to it. The mediator investor then agrees on a sale price with the potential buyer; this cost includes some profit. The purchase can be made absolute (lump sum) or via a series of deferred (instalment) payments. This credit sale is an acceptable form of finance and is not to be perplexed with an interest-bearing loan.

Leasing (Ijarah)

Leasing, or Ijarah, involves selling the right to use an object (usufruct) for a specified duration. One requirement is that the lessor must own the leased object for the course of the lease. An alteration on the lease, ‘ijarah wa iqtina’, offers for a lease to be written where the lessor agrees to sell the leased object at the lease’s end at a preordained residual value. This assurance binds only the lessor. The lessee is not compelled to buy the item.

Islamic Forwards (Salam and Istisna)

These are exceptional types of financing, used in certain forms of business. These are an omission to gharar. The cost for the item is prepaid, and the item is delivered at a set point in the future. As there is a host of requirements to be matched to render these contracts valid, the aid of an Islamic legal advisor is generally needed.

Fundamental Investment Vehicles

Owing to the amount of prohibitions defined by Shariah, several traditional investment vehicles like bonds, options, and derivatives are prohibited in Islamic Finance. The two significant investment vehicles in Islamic finance are :-

Equities

Shariah permits investment in company shares. Although, the organisations must not be convoluted in the activities forbidden by Islamic laws, like lending at interest, gambling, production of alcohol or pork. Islamic finance also enabling private equity investments.

Fixed-Income Instruments

As lending with interest payments is prohibited by Shariah, there are no traditional bonds in Islamic finance. Although, there is an equivalent of bonds known as sukuk or “Shariah-compliant bonds”, the bonds symbolise partial ownership in an asset, not a debt obligation.

Labuan – Shariah Compliant Businesses

Malaysia has always played a significant ground-breaking role in Islamic financial services, displaying an extensive regulatory framework for Islamic banking, finance, takaful and asset management.  Furthermore, it acts as an extension to and in support of the Labuan International Business and Financial Centre has also been an ingenious for Islamic financial products. To attract more Islamic banks financial institutions to Labuan, under the Malaysia International Islamic Financial Centre’s initiative, Islamic banks in Labuan have been offered greater versatility like exemption from keeping physical presence in Labuan.

Islamic banks incorporated in Labuan can open offices anywhere in Malaysia, subject to consideration by Labuan’s Financial Services Authority. Additionally, there is no limitation on staffing and amount of operational offices to be opened outside Labuan, and Islamic banks can perform business in foreign currencies under this regulation.

To understand about Islam finance, its significance, essential terms, and its compliance in Labuan; feel free to book a complimentary session with our QX Trust consultants at CONTACT US  or consultant@qx-trust.com.