How Islamic Financing Differs from Conventional Western Financing Finance Essay

According to the Oxford Business Group Sharia law prescribes the ethical responsibilities of the Muslim faithful and forms the basic principles of Islamic financing. Islamic financing must therefore follow the teachings of the holy Quaran and the Sunnah which prescribe the Muslims way of life. For centuries these laws have been governing financial transactions and trade amongst Muslims .The group further states that Islamic financing encompasses the range of financial transactions that comply with provisions of Sharia or Islamic law. As Fisher, Lou & Hoffmans( 2012, pg, 156) assert Sharia laws prohibit charging interest (ushuru), gambling and engaging in illegal business.

Accordingly, Islamic financing is dissimilar from conventional western financing where charging interest on money lent or borrowed is at the epicentre of many transactions. Moreover, Islamic financing prohibits engaging in contractual agreements with uncertainty. Provisions of Islamic financing demand that all parties entering into any contract must be fully aware of the true nature of such a transaction. Furthermore, business transactions that depend on speculation are forbidden by Sharia. Consequently, returns from a business venture should only be derived from the efforts of the parties involved in the transaction.

The economic advancement in many Islamic nations underlined the need to formulate strategies to capture this growing market. Today, the Islamic finance industry has witnessed exponential growth brought about by discovery of oil in most Middle East nations. The industry's worth last year was estimated to be worth round $1.3 trillion (The Economist Online, 2010).

How Islamic financing differs from conventional Western Financing

Although Islamic finance prohibits interest, profits derived from combining elements of finance are enterprises are still acceptable. Essentially, it is an equitable profit-sharing, risk-sharing form of financing. As Wang (2011) argues, most elements of the financial instruments are present in both Islamic and conventional Western financing models. The differences are usually occasioned by the approach to such services rather than the underlying principles. Moreover, there is a stronger element of equitable participation in Islamic banking as opposed to conventional banking. Some of the underlying principles of Islamic banking include

Ijarah

Ijarah is a lease agreement where the lessor assumes ownership of an asset for a specific time period and pays the agreed fee for the duration. The leased item must retain constant value over the lease duration the term of the lease. Consumable items are therefore not permissible in such transactions. The lessor covers maintenance and insurance costs of the assets throughout the period of the agreement. Ijarah is similar to conventional hire purchase contracts. Assets that may be used in this mode of financing include capital assets such as vehicles and land (Iqra Sense 2012).

Murabaha - Cost-plus financing / buy-sell arrangement

In this transaction the borrower asks the lender to purchase an asset on the premise that the borrower will eventually purchase the asset at a higher price.A  Repayment can be done in a lump sum or by instalments. The lump repayment is known as A  Bai' Bithaman Ajil or deferred payment sale agreement. On completion of such a transaction all land titles are transferred to the borrower. For such a transaction to be valid all parties must have been fully aware of the conditions and the asset in question must not be haram (Iqra Sense 2012).

Bai' al-Inah - Sale and buy-back

Under this transaction the borrower purchases an asset from the lender on a deferred payment basis.A The asset is then resold immediately to a lender for cash at a discount.A  This mode of financing is normally used to mitigate against insolvency of the lender after the transaction (Iqra Sense 2012). An Istisna is a transaction agreement for acquisition of goods whereby a predetermined price is fixed by the parties. However, the seller is liable for any damage to the goods until they change ownership to the buyer. Bai Salam is an upfront payment by the purchaser for Shariah compliant assets that the seller undertakes to supply to the purchaser at a date in the future (Iqra Sense 2012).

MusharakahA 

In this arrangement, a lender and a borrower agree to make a capital contribution towards the financing of an asset. The Parties further agree to share profits from the transaction at an agreed ratio before the actual transaction. Similarly any losses are shared at a proportional ratio to their initial contributions (Iqra Sense 2012).

Tawarroq finance

A Lender may also agree to purchase an asset on behalf of the borrower then sell it back to the former.A  The Borrower may later sell the asset to a third party buyer while repaying the lender in instalments (Iqra Sense 2012).

Mudharabah

Under Mudharabah a trustee who provides skill and expertise in managing assets for Islamic investors earn an agreed share of the profits. However, they cannot claim any right to the assets since they merely act as managers (Iqra Sense 2012).

Implications Islamic Financing

Today's Sharia compliant banking can be traced back to the petro- dollar boom of the 1980's. The current market for Islamic finance today is worth around $1.3 trillion. This represents a viable market proportion that should not be ignored by any commercial bank. Islamic financing helps in militating against risks of defaulting on loans, since the loans are interest free. This risk is inherently higher in conventional banking than Islamic banking (Beck, Kunt & Merouche 2010, pg 6). On the flipside, investors may shy away from making deposits which do not earn any interest.

However, the legal complexities of fully implementing Islamic financing may inhibit more banks from adopting such products (Beck, Kunt & Merouche 2010, pg 7). Furthermore, the strict adherence to provisions of Sharia laws by most Muslims may drive away potential clients if they perceive any violations of such laws. More institutions should adopt the system since the underlying principle of risk sharing in Islamic finance further minimizes the negative impact of financial crisis. The equitable nature of savings and investment in Islamic banking further increases client's motivation to monitor the bank. Since banks adopting this system have the moral obligation of protecting clients from unfair enrichment, they become more proactive in the management process (Wang, 2011).

Conclusion

Islamic financing has witnessed tremendous growth in the past. Nations with predominately Muslim populations and the ever increasing cash from crude oil in the Middle East further provides more opportunities for growth. To take advantage of this market segment, all financial players are advised to adopt Sharia compliant banking into their long term strategies.

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