by Justin Musterman

Created on: December 17, 2006   Last Updated: March 18, 2007

In today's global economy, it may be necessary at some point for every investor or manager of a global company to incur exposure to the Islamic financial system. This system is routed in the principles of sharia. Sharia is the Islamic code of principles to which Muslims must adhere. They are a set of rules that forbid such things as alcohol consumption and eating non-halal (halal is a similar concept to kosher) meat. Sharia originates from two main sources. First, Sharia is drawn from the Qur'an, the Muslim holy book. Secondly, Sharia is based on the Sunnah, or the way that Muhammad led his life. Additionally, Sharia pertains to both the worship (also known as the five pillars of Islam) and human interaction components of Islamic life. In the financial world, Sharia becomes important in respect to its restriction of riba, or the practice of making money on money. Sharia forces lenders to creatively structure financing packages that do not include interest.

Generally, sharia compliant financial deals are structured through a contract or a series of contracts that incorporate risk and reward for both the lender and borrower. Furthermore, these contracts are divided into different types, with three major examples being: ijara, istisn'a, murabaha. The ijara contract is essentially a lease-to-own contract. However, it must be for a property or thing that is known and quantifiable. For example, an ijara contract could be used to finance the purchase of a warehouse, but could not be used for the financing of a fishing expedition since it is unknown how many fish may be caught and they cannot be seen beforehand. The istinis'a contract is essentially a derivative of a futures contract. This is used when a borrow wishes borrow funds for the creation of something for sale in the future. An example of this would be a developer borrowing to build a development, then paying back the lender the principal plus a portion of the profit. The final example that will be discussed is the murabaha contract. This contract is oftentimes only different from the secular interest bearing loans in semantics. In this case, a borrower declares up front the cost of what an investment will be and its projected profit. The lender and borrower than agree on a portion of this profit up front to be paid back.

The underlying principles of Islamic finance are beautiful, routed in moral integrity, religious tradition, and a desire to protect the unsophisticated citizen. It is also refreshing to see a section of the world staying true to a belief that was long abandoned by the Christian world. Furthermore, oftentimes, Islamic financial institutions make wonderful investments for those seeking a position in a socially responsible/ethical equity. However, like with the early banks that were prohibited from usury, many Islamic banking institutions have adopted practices which are not in the spirit of sharia law, but are technically halal. A classic example is an agreement centered on an "asset" not truly involved in the transaction. In this instance, the burrower would go to the lender looking for one million dollars to finance a construction project. The lender would tell the borrower that he likes his pen and wished to purchase it for one million dollars. The borrower would tell the lender that he likes the pen and will sell it to him, but would like to purchase it back at a later date (the maturity date of the loan) for one million one hundred thousand dollars. Therefore, the loan has been made, with interest attached in the form of shared profit and the true nature of the project concealed.

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