Islamic finance - basic glossary

Islamic finance is underpinned by shariah law. Islamic law is derived from three primary sources - the Qur'an, Islam's Holy Book, believed by Muslims to be the direct word of Allah revealed to the Prophet Mohammed, the Sunnah, the Sayings and Acts of the Prophet Mohammed and three secondary sources.

Central to this canon of law is that which is halal - permissible - and that which is not - haram which is explicitly prohibited by the Qur'an or the Sunnah. Business activities are haram when they make money in unacceptable ways - that includes making or selling alcohol, pork, pornography, interest-based financial products and anything involving gambling or gaming.

Amanah - أمانة

Reliability or trustworthiness, an important matter in Islamic society, in general, and in business and finance, in particular. It has a specific financial reference to assets held in trust for someone else.

Bai muajjal

A deferred payment contract.

Bay' al-gharar

Is an exchange in which there is an element of deception to one or both parties through ignorance of the goods, the price, or through faulty description of the goods. Gambling is a form of gharar because the gambler is ignorant of the result of his gamble.

Fatwah - فتوى

A religious decree - not the kind of general threat that it is frequently misunderstood to be.

Fiqh - فقه

Islamic jurisprudence, the science of the Shariah and an important source of Islamic economics.

Gharar

Uncertainty, hazard, chance or risk. According to Yasaar, a leading Shariah compliance firm: "Technically, gharar means the sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk of hazard in which one does not know whether it will come to be or not, such as fish in water or a bird in the air. [It includes] deception through ignorance by one or more parties to a contract". There are several types of gharar, all of which are haram. The following are some examples:

- Selling goods that the seller is unable to deliver

- Selling known or unknown goods against an unknown price

- Selling goods without proper description

- Selling goods without specifying the price

- Making a contract conditional on an unknown event

- Selling goods on the basis of false description

- Selling goods without allowing the buyer to examine the goods properly

Hawala

Cheque, draft, bill of exchange, promissory note. The system, which relies on trust, has been used down the centuries for settling international accounts, by book transfers. A debtor passed on the responsibility of payment to his debt to a third party who owes the former a debt. Hawala has got a bad name in recent years because of its supposed involvement in terrorist financing, though it is simply the ancient (and highly-efficient) equivalent of 20th century offerings from, say, Western Union, and 21st century offerings by mobile phone operators.

Ijara

This is a form of leasing, and a classic Islamic finance product. It involves a contract where the bank buys and then leased an item to a customer for a specified rental over a specific period. The duration of the lease, as well as the basis for rental, are set and agreed in advance. The financial institution retains ownership of the item throughout the arrangement and takes back the item at the end. The benefit and cost to each party must be clearly spelled out in the contract to avoid any ambiguity (gharar).

Ijara wa iktana

Ijara-wa-iktana is in essence a lease to purchase - similar to Ijara, except that the customer agrees to buy the equipment at the end of the lease period, at a pre-agreed price. Rentals paid during the period of the lease constitute part of the purchase price. Often, as a result, the final sale will be for a token sum.

Ijara with diminishing musharaka

The Principle of Ijara with diminishing musharaka (see below) is commonly used in house-buying. Diminishing musharaka means that the financial institution's equity in the assets declines with capital payments made by the "purchaser", over and above the rental payments.

Istisnaa

This is a contract for the production of goods where the manufacturer takes the responsibility for providing the finished product made to specified standards and specifications and at a pre-agreed price. The price may be payable either before the work starts or at a specified time, depending on progress, or on delivery. Stage payments on building contracts are typical examples.

Mudharaba

This takes the form of a contract between two parties, one who provides the funds and the other who provides the expertise. They agree to the ivision of accrued profits in advance. Any loss is borne by the capital owner (the rab al maal), although in that case the "entrepreneur" ( the mudharin) would take no fee. This is not to be confused with:

Murabaha

This is a contract whereby a financial institution buys goods for a customer from a third party and then resells the goods to the customer a pre-agreed price on deferred payment terms. This is a widely used concept, and accounts for significant amounts of the business of many Islamic banks, in commerce (to by raw materials and capital equipment, for instance), in real estate to provide housing finance and in consumer markets to finance cars, etc. A bai muajjal, a deferred payment contract, and others with similar titles, work in pretty much the same way.

Musharaka - مشارك

Musharaka comes closest to the western "private equity", where tow or more investors work in partnership. Profits are shared by prior agreement; losses however are split according to the proportion of capital injected. All partners have a right to participate in the management of the project. However, they can waive the right of participation in favour of any specific partner of person. There are two main forms of musharaka - permanent and diminishing. Permanent musharaka is suited to major, long-term projects. Diminishing musharaka, with and easier exit route, is frequently used to finance imports letters of credit and domestic trading.

Quard

A Quard is a loan, free of profit, and amounts to the same as a traditional western current account. Most banks will make modest qards to needy people as appropriate.

Rab al maal

Capital owner.

Riba - ربا

This is the Arabic word for usury and is explicitly prohibited as a major sin in the Qur'an as well as in the Sunnah. Most modern Islamic law scholars agree that fixed rate interest - a "risk-free" or guaranteed rate of return - is the same as usury. Thus it is not permissible for a Muslim to give or receive interest. Riba and "interest" are used interchangeably.

Sukuk - صكوك

A sukuk is the equivalent of a fixed income bond. It entitles the holder to the benefits of the income stream of the assets baking the certificate.

Takaful

Conventional insurance is prohibited under Shariah law because it may involve gharar or riba. Takaful is a form of mutual Islamic insurance that offers joint risk sharing in the event of a loss by one of its members.

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Thu 28 Aug 2008