Islamic Banking and its Principles on Risk Finance Essay

The key element of Islamic banking is that the risks of financial transactions should be evenly divided between depositor and investor, that is between bank and client. Interest in the sense of asking a fee for merely lending money, is prohibited, as long as the lender is not running any risks themselves. Speculative contracts such as futures and options are also forbidden.

A practical consequense of these Islamic principles is that the relationship between investor and depositor becomes one of reciprocity. Banks are necessarily more involved with their clients' activities. A non-Islamic bank might lend the money to its client, and not bother what he does with it as long as the interest is paid on time. The Islamic bank, on the other hand, wants to make sure that its client is doing well, because their relationship is one of profit-sharing.

Islamic banking is based on standard contracts. I will mention a few, to illustrate the point. The Mudaraba contract is the investment of money by either the bank or the client in return for a share in the profits. In this contract only the investor is liable for losses. In the Musharaka, on the other hand, both sides share the risk of loss as well as profit, in proportion to their respective investments. Then there is the Murabaha, which is the sale of materials and equipment by the bank to the client for an amount which is higher than their cost price, and which has to be paid in instalments. The Murabaha is the easiest and least risky contract, because banks know the return on their venture without risking their own capital.

Most of the derivatives incorporate gharar (absolute risk), gambling and interest and support speculative activities. Islamic legal rules, particularly the ban on Gharar and on the sale of debt for debt, do not allow transactions devoid of real/productive activities. Derivatives involving such financial contracts which themselves are prohibited in Shariah (Riba based bonds & forward foreign exchange where mutual exchange is not simultaneous, for example) are clearly un-acceptable according to the Shariah principles.

In case the underlying assets are equities and commodities it would be seen whether or not Riba and Gharar are involved.

According to some writers 'Arbun'can become a basis for developing some kinds of Shariah compliant options - contract by which one party buys the right to purchase from the other party specified goods for a specified price on a certain date.

'Arbun' is a void contract according to a Hadith, and the three schools of Islamic law. Only Hanabalah uphold 'Arbun' with the condition imposed by some of them that time should be stipulated for the option. The OIC(Organisation of the Islamic Conference) Fiqh Academy has also endorsed 'Arbun' but only if time limit is specified. Even if 'Arbun' is accepted as valid transaction, most of the derivatives current in the market would still be unacceptable from Shariah angle due to involvement to Gharar and Riba.

A Call Option can be considered near to Bai al Arbun in the sense that the seller does not return the premium or advance payment to the buyer in case the latter does not exercise the purchase option and the buyer loses the option premium even if the option is exercised and the contract is confirmed. In case of Bai al-Arbun, however, the option premium is adjusted in sale price when the contract is confirmed. However, this subject of derivatives needs extensive research.

When it comes to insurance Islam have their own concept, the main concept of Islamic insurance is that it is an alternative to conventional insurance, with characteristics and features that comply with shariah requirements. This is done by eliminating the objections against conventional insurance.

The main features of Islamic insurance are:

A¢â‚¬A¢ Cooperative risk sharing by using charitable donations to eliminate gharar and riba;

A¢â‚¬A¢ clear financial segregation between the participant (insured) and the operator (insurance company);

A¢â‚¬A¢ Shariah-compliant underwriting policies and investment strategies.

I will now explain the points above.

Within the Co-op insurance the characteristics of a cooperative include self-responsibility, democracy, equality, equity, solidarity, honesty, openness, social responsibility, and caring for others. While mutuality or cooperative risk sharing is at the core of Islamic insurance, it cannot alone create an Islamic insurance operation. Islamic insurance is based on more than one relationship: The first relationship is a mutual insurance contract between policyholders (contributors) and each other. This is similar to a pure mutual insurance relationship, taking into consideration the concept of donation, Instead of premiums. The main features behind cooperative insurance are:

Policyholders pay premiums to a cooperative fund with the intention of it being a donation to those who will suffer losses (tabarru)

Policyholders are entitled to receive any surplus resulting from the operation of the cooperative insurance fund.

Policyholders are liable to make up for any deficits that result from the operation of the cooperative insurance fund.

Clear Segregation Between Participant and Operator:

In conventional insurance, the insurance company is a for profit organization that aims to maximise profit by accepting the financial burden of others losses. The insurance company is owned by shareholders who receive any profit and are responsible for financing any deficit.

Under Islamic insurance, the system is that the insurance company's role is restricted to managing the portfolio and investing the insurance contributions for and on behalf of the participants.from my research I found that there are four different models in operation: The mudarabh model, the wakalah model, the hybrid mudarabh-wakalah model, and the pure cooperative model (non-profit).

The last point is

Shariah-Compliant Policies and Strategies:

Ethical insurers invest money in a responsible way in industries that are ethically sound and do not harm the environment or people( like the Norwegian pension fund) . Islamic insurance is similar, except that the ethical considerations are extended to those which do not contravene the religion of Islam and are monitored by a shariah board, which is part of the company structure. In particular, the investment and underwriting policies need to be free of any involvement with the prohibited activities of gambling, alcohol, pork, armaments, tobacco, and interest-bearing activities, loans, and securities.

Word count: 1529

All Islamic words and economic glossary I used is from:

https://www.islamic-world.net/economics/word/b.htm or the websites I used.

Websites:

A¢â‚¬A¢ Institute of Islamic Banking and Finance: www.islamic-banking.com

A¢â‚¬A¢ Islamic Banking and Finance: www.islamicbankingandfinance.com

A¢â‚¬A¢ Middle East Insurance Review: www.meinsurancereview.com

https://www.pide.org.pk/pdf/psde%2018AGM/A%20Broader%20Definition%20Of%20Riba.pdf

https://www.suite101.com/content/what-is-riba-a91216

Other Sources :

The previous group works done by my group ( James, Hassan, Ali and me)

Handouts given in class (a short review of the historical critique of usury) by Wayne A.M Visser and Alastair McIntosh , searching for the Mecca of finance. ( used them to gain more understanding)

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