Back to basics: Shari’ah principles

We take you back to the credit basics to review everything you thought you already knew but were too afraid to ask ... Khalid Howladar, chairman of the Middle East co-ordination committee at Moody's in London, runs through the Shari'ah principles that govern Islamic finance

Shari'ah requires that financing should only be raised for trading in, or construction of, specific and identifiable assets. Trading in 'indebtedness' is prohibited, so the issuance of conventional bonds would not be compliant as they are usually traded and represent interest-based funding for general corporate purposes. A non-interest bearing loan, however, could be traded if priced at par value.

All sukuk (bond) returns and cashflows should be linked to assets purchased, or those generated from an asset once constructed. For borrowers to raise compliant financing they need to utilise assets in the structure. These borrowers that provide the assets are commonly referred to as 'originators'.

Prohibition of interest

As Shari'ah considers money to be a measuring tool for value and not an asset in itself, one should not be able to receive income from money alone. This generation of money from money (simplistically, interest) is known as riba, and is forbidden.

As such the trading/selling of debts or receivables for anything other than par is not permissible. However it should be noted that for some sukuk, some Shari'ah boards accept that, as long as such receivables are a small portion of the overall income flows, their presence is acceptable. Moreover, Malaysia, which has a comprehensive Islamic capital market, does not place receivables in the category of money and hence allows sukuk to be 100% backed by receivables. This is a major difference between the Far East and the Gulf.

Another consideration is that interest-based late payment penalties cannot be charged. Sukuk structures allow for delayed payment or redemption (without requiring compensation for investors) up to a certain extent, after which an event of default would be declared. Such fees are sometimes permissible if payable to charity, thereby maintaining the incentive for timely payment.

Prohibition of uncertainty

The prohibition of uncertainty, or gharar, is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract. The prohibition of the former is positive from a transaction perspective, but the latter creates issues for Islamic scholars when considering the application of derivatives.

A key issue is that derivatives in the first instance do not represent a share or claim on a tangible asset and that the exchange of cashflows (in currency swaps, for example) may incorporate riba. Such instruments could also potentially be used for speculation/gambling purposes, known as maysir, which falls foul of the principle that all profit should be earned.

However, a couple of points to note are that exchange of cashflows, where backed by assets, should be permissible - but the universe of liquid sukuk is unlikely to be liquid or deep enough to facilitate the equivalent of conventional derivative contracts in the near future. Shari'ah also incorporates the concept of maslahah or 'public benefit', denoting that, if something is overwhelmingly in the public good, it may yet be transacted. Hedging or mitigation of avoidable business risks may fall into this category.

There has been a significant increase recently in the economic and intellectual resources devoted to understanding Islamic finance and this is resulting in continuing debate amongst Shari'ah scholars. This evolution is having an impact on sukuk structures, which is demonstrated by the increasing variety seen in the market.

GLOSSARY

Riba: the practice of usury, or charging of interest.

Shari'ah: the general body of spiritual and moral obligations and duties in Islam.

Sukuk: In essence, Islamic bonds, but better described as 'trust certificates' or 'participation securities', which grant the investor a share of an asset along with the cashflows and risk commensurate with such ownership.