The Definitive Guide to Islamic Banking and Finance in 2018

We have heard the buzzword – ‘Islamic Finance’ or ‘Islamic Banking’ – from our circle of friends and families at some point in our lives before.

But what is it exactly?

Today, I am going to share with you a step-by-step guide of what Islamic Banking is all about.

This meant to provide a good summary and show how highly-applicable it is to you today in 2018 and beyond.

Let’s dive right in…

Chapter 1: What is Islamic Banking (IB)?

Islamic Banking is build upon the foundation of the Syariah (Shariah) Law, the legal code of Islam based on the Quran, and are based on principles of risk and profit-sharing. It is also known as Fiqh al-Muamalat, the Islamic rules of transactions.

With that in mind, the foundation of Islamic Banking follows a certain set of rules. They are:

1. No interest – All transactions must be interest-free, both compounding or simple interests. The concept of interest, which is known as Riba, is forbidden in Islam.

As mentioned in the Quran, Surah Al-Baqarah Verse 276,

Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, “Trade is [just] like interest.” But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah . But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.

2. Free from ambiguity – Ambiguity, also known as Gharar, is prohibited. With interest, repayments become less straightforward and uncertain.
3. No speculation – Speculation can also be categorized as gambling, which termed as Maysair. The concept of speculation and gambling may cause excessive risky behaviour which leads to the possibility of immoral practices such as fraud and scams.
4. No investments in products or services that are not permitted in Islam – Industries which are not aligned with the values of Islam such as alcohol, pork, pornography or gambling are not allowed in to be financially vested in.

These set of rules made Islamic Banking more risk adverse in its investment practices, as it typically avoids businesses that could be associated with economic bubbles.

Chapter 2: Why IB is Getting Popular?

The global IB industry has grown exponentially over the past couple of decades, recording annualized growth rates of over 15%, based on the Monetary Authority of Singapore (MAS). Based on an IMF working paper, IB is gaining worldwide attention and traction resulting from:

1. Increasing strong demand: Gaining good traction and increasing adoption rate in Islamic countries for Syariah-compliant financial products.
2. Improved system: Steady progress in legal and regulatory system for Islamic Finance to thrive in.
3. Diversification Purposes: More investors see it as an alternative financial choice where they can focus more on ethical and socially-responsible investments.
4. Resilient and Flexible: Strong ability to create financial tools to meet the needs of corporate and individual investors based on risk-sharing and involving instruments that are asset-backed.

The principles of Shariah Law also emphasizes on moral and ethical values in all dealings and this has wide universal appeal to those who look more than just financial gains.

When the financial crisis struck, from the Asian Financial Crisis in 1997-1998, to the bursting of dot-com bubble in 2001, and the Subprime mortgage crisis in 2007-2008, investors became more aware with the dangers of speculations and interests and began finding alternative investments that avoid those.

Comes Islamic Banking.

Interestingly, a study on the 2007-2008 crisis in an IMF Working Paper, shows that IB remained resilient to the crisis and its business model helped limit the adverse impact on its profitability.

Chapter 3: Overview of the Common IB Financing Arrangement

Now that you learn on the foundations behind the Syariah Law, it is also good to understand about the various permissible financing arrangements which are often found in Islamic financial products. They are mainly:

1. Profit-and-loss sharing (Mudarabah)
Mudarabah offers specialist investment by a financial expert in which the bank and the investor shares any profit. Investors may risk losing their money if the investment failed, and the bank will not charge a handling fee unless it turns a profit.

2. Partnership and joint stock ownership (Musharakah)
Musharakah is an investment partnership in which profit sharing terms are agreed in advance, and losses are capped to the amount invested.

3.  (Murabahah)
Murabahah is an exchange transaction in which the seller acquires a commodity and sell it to a buyer at a mark-up price. What separates it from the conventional transaction is that, the true cost of acquiring that commodity is revealed to the buyer. Thus, the murabahah mark-up may be seen as a service cost of the seller in sourcing and delivering the goods.

4. Leasing (Ijarah/Ijara-wa-Iqtina)
Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. On the other hand, Ijara-wa-Iqtina has a similar agreement, except that the customer is able to buy the item at the end of the contract.

I will be delve a little deeper later in some of the examples below.

Chapter 4: How does IB work?

You might be wondering – So how does IB makes money if interest is prohibited? Good question, and it is not as complicated as you might think.

Let’s look on the common Syariah-compliant financial products that are available in Singapore. They are mainly:

1. Savings Account
2. Fixed Deposits
3. Personal Financing
4. Investments

4.1 Savings Account

In Islamic Banking, banks are safekeepers of your money. As interest is prohibited in IB, you will not earn any interest from your deposits with the bank. Like-wise, the bank has no right to deduct anything from your account, for example, charging of overdraft interest.

So how does it work for IB?

The banks, at its discretion, will distribute ‘tokens’, also known as hibah, in  a form of dividends to its depositor. For example, Maybank in Singapore, offers a hibah rate of 0.1875% per annum for the first S$50,000 and 0.25% per annum for the amounts above S$50,000 at this time of writing. You may look at it as a form of goodwill from the bank for trusting your money with them. So, there is still opportunity to earn from your deposits. It is also comforting to know that the bank is aligned with the Shariah guidelines, so you can be rest assured the money you deposited is being responsibly taken care of.

On the other hand, similarly to CB, there is a “service fee” if the account falls below the minimum amount required to maintain the account. Currently for Singaporean Maybank Savings Account-i holders, there is a $2 monthly service fee if the average daily balance of S$1,000 is not maintained.

4.2 Islamic Fixed Deposit (Term Deposit)

In conventional fixed deposit, the banks provide returns to the investors in a form of a higher interest rate than a regular savings account. For Islamic Fixed Deposit, instead of interests, it is based on the Shariah contract of commodity Murabahah, or cost-plus sale. In other words, the banks will provide returns in the a form of a profit rate and this will be known upfront. The underlying asset for which this contract to be considered shariah-compliant, the banks will usually do the legwork to determine what’s fit. In Singapore today, Maybank do offer such service which is called as Singapore Dollar Term Deposit-i

4.3 Personal Financing (Home Loan)

When it comes to loans, whether personal or commercial, as we already know, banks extends credit facility that comes with interest.

Not for IB loans.

Instead, the loans are similar to that of a hire purchase, which is called a Murabahah contract. To put it simply, banks will purchase the asset on the customer’s behalf and sell it back to the customer and earn a profit from the mark-up. Just like how a normal buyer and seller relationship works. You can look at this way:

Bank’s Profit = Selling Price (to the Customer) – Cost Price (of Acquiring the Asset)

It’s that simple.

The fact is, the customer won’t be able to purchase the asset outright without the bank’s help so in return, the bank earns a profit from that value-add service.

A good example will a home loan. Let’s say you would like to purchase your first home and it costs S$300,000. The bank purchase the house at the cost price (S$300,000) and sell it to you at a mark-up price of $350,000. Assuming you pay a 20% downpayment (S$70,000) upfront and the bank agrees to a 25-years installment, your monthly mortgage payment will be around S$933 (S$280,000 over a repayment of 300 months)

The idea of Murabahah revolves around the concept of transparency and certainty. There isn’t any interest involved so the certainty of your monthly repayment is clear from the start and the alien-sounding terms like SIBOR and floating rate won’t bother you anymore.

4.4 Investments

For investment purposes, we can break it down into 2 parts, active and passive investments. Let me explain a little more below:

4.4.1 Active

Active investments are basically investments that you have to ‘actively’ monitor and continuously research, and these usually involves investing in individual stocks in a company. For example, if you feel that Apple Inc is doing well and you would like to be a shareholder, you may purchase an Apple share from your broker.

The key difference from passive investment is that you have to do the research yourself. From a syariah-compliant standpoint, the eligibility filtering is much thorough. Firstly the company should be free from non-permitted businesses such as alcohol, pork-related products, tobacco, adult entertainment to name a few.

On top of that, the financial ratios of the company should adhere to the Sharia guidelines too. Reason allow the methodology to be less speculative and more in keeping with Sharia principles.  Some that we need to take note of are:

1. Debt: Debt is less than 1/3 of total assets
2.  Cash and interest-bearing  items are less than 1/3 of total assets
3. Accounts receivable and cash are less than 50% of total assets
4. Total interest and non compliant activities income should not exceed 5% of total revenue

Note: You can check out more from the Ground Rules of the FTSE SGX Shariah Index Series.

I understand this can be daunting to newbie and inexperienced investors, but good news, there are alternatives (and much easier) way to grow your money. That leads me to my next point…

4.4.2 Passive

Passive investment is essentially the opposite of active. You do not have to do much groundwork, as someone else (i.e. fund manager) is doing it on your behalf. Some examples of the passive investments are:

1. Sukuk (Islamic Bonds)
2. Syariah-Compliant ETFs
3. Syariah-Compliant Mutual Funds

Let’s dive in to each of these:

4.4.2.1 Sukuk (Islamic Bonds)

Sukuk, or also known as Islamic Bonds, has some similarities but also key differences as compared to conventional bonds.

One of the similarities is that Sukuk are issued with specific maturity dates that requires the Sukuk issuer to buy it back when the Sukuk has matured.

However the main difference that separates Sukuk and conventional bonds is that it is an asset-backed securities instead of a debt instrument like conventional bonds. Sukuk has no debt and debtor relationship.

What it means essentially, you are not lending money to the issuer. Instead, you are buying shares in an asset. How you earn the income from this is mainly through the profit generated by the asset and from any rental payments by the issuer, and not through any loan interest.

Sukuk has been increasingly getting some awareness and steady adoption rate in Singapore. There are already some established sukuk programmes in Singapore, including Sabana REITS, which is the world’s largest listed Shariah-compliant real estate investment trust by total assets. HSBC also has its own HSBC Insurance Ethical Global Sukuk Fund which was started in 2002. Since its inception till date, it already has an average annual compounded return of 1.15%. Nothing to be excited about, but if you consider the ethical value that powers it, it may help you with the peace of mind.

4.4.2.2 Shariah-Compliant ETFs

ETFs, or also known as Exchange-Traded Funds, tracks a particular index. It is popular among newbie investors because of its requires minimal management while providing you the diversification to the best stock picks at considerable low fees.

In Singapore, we have the highly-regarded STI (Straits Time Index) ETF which gives you exposure to the top 30 companies listed on SGX. Unfortunately, it is not Shariah-compliant. If you have understand the fundamentals of IB so far here, it is not difficult to identify which ones are not.

A quick look at Nikko AM Singapore STI ETF’s prospectus, which is one of the 2 funds you can buy for STI ETF, you can see why:

Thai Beverage which primary business includes manufacturing some of the well-known alcoholic brands such as Chang Beer. Genting Singapore is vested in casinos in the likes of Resort World Sentosa (RWS). In addition, the STI ETF is heavily focused on conventional banking such as DBS, UOB and OCBC which has a strong focus in interest earnings.

So are there Shariah-Compliant ETFs?

The answer is, definitely yes. On our Singapore Exchange (SGX), we have the FTSE SGX Shariah 100 Index. They invests in a combination of 50 of the largest Japanese companies and the 50 largest companies from Singapore, Taiwan, Korea and Hong Kong. Thus, it provides you with wide exposure in the fast-growing Asian markets while maintaining the integrity of the Shariah law.

In other countries such as Malaysia, US and UK, if you happen to have accounts to trade in their stock exchanges, you can have a wider pool of Shariah-compliant ETFs to choose from.

4.4.2.3 Shariah-Compliant Mutual Funds

Mutual funds are basically active managed funds by a group of fund managers. As compared to ETF, this is the less popular option among investors as the commission fee is rather high. However, depending on the performance of the fund managers, they are capable of producing better returns than the ETF.

In Singapore, for Shariah-Compliant Mutual Funds, we have the Franklin Templeton Shariah Global Equity Fund, which can be invested with your CPF savings. However, it has a high ‘maximum’ sales charge of 5%, as compared to an ETF which is commonly less than 1%. Essentially, what that means is that if your mutual funds has a good 12% return annually, the sales charge may ‘eat’ into those returns and leave you with a 7% return, which is respectable. What about during poor economic conditions when it can only generate 4% or less? You may potentially see a negative return instead. So it’s important for you to do your due diligence and research prior to investing.

Chapter 5: Other Financial Products & Services in IB

5.1 Will Writing (Wassiyat)

Will writing, or wassiyat, is basically a way to distribute one’s portion of his or her estate (i.e. property) upon his or her death. According to Islamic teachings, it is highly encouraged to write a will, in order to avoid conflicts to the beneficiaries and to themselves.

In the Quran, Surah Al-Baqarah Verse 180, Allah s.w.t. mentioned:

Prescribed for you when death approaches [any] one of you if he leaves wealth [is that he should make] a bequest for the parents and near relatives according to what is acceptable – a duty upon the righteous.

The will must satisfy a certain set of conditions:

1. It should be witnessed by two male Muslims, who are not the beneficiaries
2. The amount to be willed away should not be more than 1/3 of his or her total assets
3. The beneficiaries of the will cannot be any of the heirs or family members who will get their share from faraid.

For the 3rd pointer, it is important to understand that the main purpose of willing out one’s property is to give part of one’s property to those who do not inherit it. Drawing up a will with instructions on how to divide one’s property according to one’s rule is not allowed, as it means one is overriding the Faraid, the Law of Inheritance, which are Allah’s commands. As Muslims, we learn to respect all of His Commands and acknowledge that He knows best.

It is highly-recommended that you seek a lawyer who is well-versed in the Muslim law to sought for the most relevant legal advice. There also Muslim-owned corporations in Singapore which offered this service such as Abdul Rahman Law Corporation, Five Pillars, Amanah Asset Management and Barakah Capital Planners.

5.2 Shariah-Compliant Insurance (Takaful)

Takaful refers to a mutual guarantee in which participants pool their money together into a common fund, and each contributor is indemnified from losses, i.e. insurance.

How it works is pretty straightforward.

Participants of this financial arrangement do not aim to make profit from the insurance operations. Risk is shared across all participants. To maintain the operations, the takaful operator may use the insurance premium to invest in Shariah-compliant investments, in which the investment gains will be channeled back to the fund. After deducting the cost of the operations from the gains, the remaining surplus may be distributed to the operator and the participants in accordance to the Shariah Law.

General takaful includes non-life insurance such as property, marine and automobile, while family takaful can include life insurance, such as term or whole life.

In Singapore, we have Helmi Hakim’s takaful.sg which focuses on NTUC Income Takaful. Do note that this takaful is an investment-linked policy (ILP), which essentially means it covers BOTH shariah-compliant insurance and investments. When it comes with ILP, the premiums are much higher as you’re not only paying for life coverage, but also investments. If you are looking for life insurance only, this may not be suitable for you. However, good news – back in 2013, Berita Harian reported that NTUC Takaful Fund has been performing well in its investments so it’s worth looking into it.

Alternatively, there is UOI, which is a member of the UOB group, that offers Al-Takaful. Currently from their website, it remains unclear whether this is an ILP or an insurance-only policy. Maybank has also recently launched Etiqa Insurance in 2015. However, it remains to be seen whether there will be an alternative Shariah-compliant insurance plan.

Now It’s Your Turn

I’ve summarized Islamic Banking in a nutshell with the different investment alternatives that you can consider.

Now I want to turn it over to you: Which of the IB investment products are you going to invest in first?

Are you going to start on active investments and choose your own Shariah-compliant stocks? Or are you going to play it safe and diversify on various stocks in Shariah-compliant ETFs?

Let me know by leaving a quick comment below right now.