on the stock exchange. A shariah board at the securities commission was put in place to regulate the issuance and sale of shariah-compliant capital market instruments such as sukuk. Malaysia masterfully maintains a dual-banking system in which conventional banks and Islamic banks operate simultaneously.
Undoubtedly, Malaysia enjoyed the position of being a thought leader in the sphere of Islamic finance and generously shared its understanding of shariah-compliant products and principles not only with the rest of the Muslim world but with the non-Muslim world as well. Institutions such as J.P. Morgan, Citibank, Barclays, and HSBC all have Islamic banking divisions catering to either investment banking or wealth management. HSBC offers the brand of HSBC Amanah and Standard Chartered took pains to develop the brand of Standard Chartered Sadiq. International rating agencies such as Moody's and Standard & Poor's have worked with industry professionals and developed mechanisms of rating shariah-compliant institutions and financial instruments. International fund managers and hedge funds now have in place methodologies of screening asset classes for shariah-compliance for their clients. Dow Jones has in fact developed a shariah index for all the major indices it develops, including FTSE 100 and Nikkei 225 index, the BRIC index, and the GCC index, thus facilitating shariah-minded investors in guiding their capital in a manner that fulfills certain shariah guidelines. In post–September 11 times, for financial institutions to adopt the word shariah in their brochures is quite an achievement.
These are no minor achievements to say the least, but has Islamic banking provided a viable alternative to conventional banking? As many architects of Islamic banking were likely attached to the Islamic Development Bank, there is also a strain of disillusionment that Islamic banking has gone astray, or gone commercial. IDB was and is a public policy institute funded not by shareholders but by governments. Its aim is to fund projects and make a nominal return on the financing provided. The technology of Islamic banking was transferred to the commercial sector, and to compare an Islamic bank driven by the aims of maximizing returns to the IDB is like comparing J.P. Morgan to the World Bank. Both entities exist for different purposes. One can argue that there are not enough Islamic micro-finance banks, or Islamic venture capital firms, or Islamic SME fund houses, but that is not the fault of the concept of Islamic banking. Capital providers or investors must see the light and allocate capital to such enterprises; academics and scholars cannot do so.
Islamic financial institutions therefore offer financial products using shariah-compliant contracts. The “impact” of these products is the same on a client or an investor, in that if an Islamic bank facilitates the purchase of a new car, the beneficiary of the purchase must pay the bank back with profit. There is no free lunch. IFIs rely on the same model of financial intermediation that conventional banks, insurance companies, and asset management companies do, and that is the “pooling of funds.” Islamic banks collect funds from customers using shariah-compliant contracts, and use these funds to finance assets or make investments. The capital of the Islamic bank is not used to fund assets, but is used as a buffer to cushion losses. All profits generated are shared with depositors. Conventional banks absorb losses in entirety, whereas Islamic banks in some circumstances pass on losses to their customers.
Takaful companies also pool in funds of participants. Participants contract to contribute to a pool of funds that will be used to indemnify the participants if they suffer losses from specific events. Participants do not buy insurance policies from insurance companies; they seek to protect themselves and each other against adverse events. In practice no participant in a takaful plan knows any other participant, so such claims may only be interpreted as being cosmetic. Takaful operators are then hired to manage the underwriting process for a fee.
Fund managers also work on a contract of agency or wakalah and are compensated by investors for above-market performance by healthy commissions like in conventional firms. The road thus far shows the Islamic financial services industry converging toward the conventional industry and many critics feel this does not in any way fulfill any broader goals of Islam. Critics have a point, but we leave it up to the readers to determine that during the course of reading this book.
The Islamic financial services industry is built around 16 or so fundamental contracts. We first study these contracts and then later see how they are reengineered or modified to develop financial products. The criticism of the modifications is left up to the reader.
Chapter 2
Bai al Inah
We do not attempt to overwhelm the reader with a plethora of Arabic words and we translate every relevant word in English for ease of understanding. Bear in mind that in a study of Islamic laws, sciences would have previously been impossible without a knowledge of Arabic and we thank all those scholars who have made efforts to translate works into language of everyday use or the language of trade, which is English today.
This chapter focuses on the controversial contract of bai al inah, a construct of a sale and buyback between two parties that creates cash flows that resemble a loan structure.
Definitions of Bai al Inah
Bai means sale, tijarat means trade, and ribbh means profit on a sale. Bai al inah or inah is a sale contract that existed in the time of the Prophet (saw).
Bank Negara Malaysia defines bai al inah in the following manner: “Bai' 'inah refers to an arrangement that involves sale of an asset to the purchaser on a deferred basis and subsequent purchase of the asset at a cash price lower than the deferred sale price or vice versa, and which complies with the specific requirements of bai al'inah.”12
The International Financial Services Board, a standard-setting body for Islamic banks, defines bai al inah as follows: “A contract involving the sale and buy-back transaction of assets by a seller. A seller sells an asset to a buyer on a cash basis and later buys it back on a deferred payment basis where the price is higher than the cash price. It can also be applied when a seller sells an asset to a buyer on a deferred basis and later buys it back on a cash basis, at a price which is lower than the deferred price.”13
Bai al inah refers to an arrangement that involves a sale and buyback. An asset is sold by a seller to a counterparty on a deferred payment basis, creating a debt obligation on the said counterparty. Immediately, the original seller buys the asset back for a spot price. This second leg of the transaction creates the cash flows that resemble disbursement of a loan. As bai al inah is a sale contract, it must follow the requirements of contract law for sale and purchase transactions. A sale contract requires 14 conditions:14
1. Presence of two parties, a buyer and a seller.
2. Both parties must be sane persons.
3. Both parties must have the legal capacity to contract.
4. There must be in existence a subject matter of the sale, an asset or a good.
5. This asset must be a permissible asset.
6. The underlying economic activity behind the sale must be permissible.
7. There must be an agreed purchase price of the asset and an agreed mode of payment.
8. The seller must disclose all features of the asset involved.
9. The buyer must have the right to inspect the asset.
10. There must be an offer (to sell from the buyer) and there must be an acceptance (to purchase).
11. Once the sellers have sold the asset they have surrendered all claims of ownership to the asset in exchange for the purchase price, whether the purchase price is paid on spot or on deferred basis.
12. Even if the buyers fail to pay for the asset if the purchase was made on credit terms, the sellers do not have the right to repossess the asset, they only have a right over the purchase price.
13. The seller may obtain a collateral from the buyer under the contract of rahn (to be discussed later), to ensure a deferred payment