Islamic Finance - Setting the example to traditional Lenders? - Spring 2009
The current banking crisis and credit crunch has shattered consumer confidence and led to a series of well documented Government bailouts. Hardly a day seems to go by without further reports of economic instability. Much of the blame lies with the sub-prime mortgage market. In this bulletin we explore the main principles of Islamic finance and consider whether it offers an alternative to conventional banks.
What is Islamic finance?
Are there any commercial banks offering Islamic finance?Surely if I don’t pay interest I will have to pay more in the long run?
Why are Islamic banks keen to lend on transactions involving commercial/residential property?
If the banks don’t charge interest why do they
bother? Do they make a return?
Are there any transactions where we would fail
to obtain Islamic finance?
Surely if I don’t pay interest I will have to pay more in the long run?
Why are Islamic banks keen to lend on transactions involving commercial/residential property?
If the banks don’t charge interest why do they
bother? Do they make a return?
Are there any transactions where we would fail
to obtain Islamic finance?
Surely Islamic banks have been affected by the
economic downturn, just like the traditional banks?
Would our business qualify for Islamic finance
funding?
What is Islamic finance?
The principles upon which Islamic finance is based have been derived from Islamic Law (known as Sharia Law), the Koran (Qur’an) and the teachings of the prophet Mohammed.
In many ways, Islamic finance is very similar to traditional lending. Like traditional financing there is still a lender and a borrower. Once the transaction is completed, the borrower acquires a tangible asset and the lender makes a return. However, there are a number of differences between Islamic financing and conventional lending.
One key difference is that under the principles of Islamic finance banks are prohibited from charging interest on their loans. This does not mean that the banks cannot make a return, they do so in other ways. The bank and borrower also share risk.
Islamic Law specifically prohibits speculative lending. Islamic banks will only lend against tangible assets or projects. Terms such as ‘hedge funds’, ‘short selling’ and ‘sub-prime’, which have been thrown into the spotlight due to the current economic crisis, are less prominent or non-existent in Islamic finance.
Because lending under Islamic finance is more strict, Islamic banks have been sheltered from the impact of the irresponsible lending and the sub prime markets, that have affected most of the conventional banks.
Are there any commercial banks offering Islamic finance?
Although there are a number of banks offering products based on Islamic principles there are only a select few which currently offer commercial lending in the UK. The main Islamic finance institutions include The Islamic Bank of Britain, The Bank of London and the Middle East, European Finance House, EIIB, Gatehouse and HSBC Amanah.
Surely if I don’t pay interest I will have to pay more in the long run?
Our experience has showed that the rates being offered by Islamic banks are very competitive when compared with conventional banks. We would recommend that you contact the banks directly in order to obtain further details.
Why are Islamic banks keen to lend on transactions involving commercial/residential property?
Islamic Banks are strictly prohibited from lending where there is any uncertainty or in transactions which deal with to speculative investments (Maisir). Such transactions are not Sharia compliant. Although almost any transaction can be tailored to be Sharia compliant, Islamic banks will favour transactions where property is involved as such transactions are less likely to breach the principles and rules governing Islamic finance.
If the banks don’t charge interest why do they
bother? Do they make a return?
Paying and receiving interest is specifically prohibited under the principles of Islamic finance. However, just like conventional banks, Islamic banks also want a return for their money. Loans are seen as an investment rather than a debt.
For example, if a business wishes to purchase a development of flats and the total value of the site is £10m such a transaction may be governed by an Ijara (lease). Once the bank has agreed to lend, the business will enter into an agreement with the bank (a promise to purchase contract) and pay a deposit. The bank (or its agent) will then purchase the site from the seller and it will then immediately lease the site to the business for a fixed term e.g. 25 years. The site will remain under the ownership of the bank until all its debt is repaid.
The business will make monthly rental payments and a capital payment to the bank, in the same way that it would make re- payments on a loan facility. As the business increases its equity in the site, the rental payments will be adjusted and the rent due will fall. Once all the payments have been made, the property will be transferred from the bank to the business.
Recent amendments to the Finance Act 2003 mean that most Islamic finance transactions will avoid payment of any additional tax. Previously, purchasers had to pay SDLT twice under some transactions.
Are there any transactions where we would fail
to obtain Islamic finance?
Islamic institutions will not lend or invest in transactions that they consider to be ‘Haraam’ or forbidden.
Islamic finance cannot be used where, any of the following are involved: alcohol, pork, conventional banking (due to interest payments), gambling and conventional insurance.
A borrower looking to increase its commercial property portfolio through the purchase of a bingo hall or casino would not be able to obtain Islamic finance.
Due to the nature of its business, it is highly likely that the income earned by the bingo hall would be used to make the rental and/or capital payments, (if the purchase was on the terms of the lease discussed on the previous page). This situation would inevitably lead to the mixing of Islamic and non-Islamic funds.
Surely Islamic banks have been affected by the
economic downturn, just like the traditional banks?
The economic events of recent months have affected every financial institution in the world. However unlike some conventional banks, the damage to Islamic banks has been superficial, mainly due to their strict lending policies.
We understand that Islamic banks presently have a greater appetite for lending when compared with some conventional banks as they have not ploughed funds into the same toxic investments, which some of the traditional banks are now being forced to write off.
Would our business qualify for Islamic finance
funding?
For the avoidance of doubt, you do not have to be Muslim to obtain Islamic finance funding. If the bank is satisfied that your business/venture is Sharia compliant and you meet its requirements, funding should be available to you.
We are currently involved in a number of property finance transactions where the funding is being provided by Islamic banks. Whereas the level of transactions being funded by traditional banks has inevitably declined in recent months, we have seen a steady growth in the Islamic Finance sector. More and more of our clients are becoming aware of and interested in alternative means of borrowing and where possible, we are assisting them.
Where we have been instructed on such matters, we have assisted the borrowers with obtaining funding and have also been involved with negotiations on the legal documents provided by the Banks’ lawyers.
If you are interested in approaching specialist Islamic banks in relation to such finance, we would be more than happy to assist you with making the initial contact with the banks, through to the completion of the deal.
Similarly, if you have any additional queries or would like to discuss Islamic finance or property finance transactions in general, please do not hesitate to contact us.
GLOSSARY OF KEY TERMS
We appreciate that you will want to look into Islamic finance in greater detail. Set out below are some key Islamic finance Terms that you may come across*:
‘Gharar’ - a transaction or contract which involves an element of uncertainty.
‘Halaal’ - anything permitted under Sharia law.
‘Haraam’ - anything prohibited under Sharia Law (e.g. receipt or payment of interest).
‘Ijara’ - a lease contract.
‘Riba’ - interest on a loan or advance.
‘Sukuk’ - an Islamic Bond.
‘Wakala’ - an agency agreement (commonly entered into between a bank and an agent acting on behalf of the bank).
(*Please note the spellings of these terms may vary)
For more information on Islamic finance please contact:
Omar Razaq
Tel: 0845 2746808
Email: omar.razaq@freethcartwright.co.uk
Chris Freeston
Tel: 0845 634 1725
Email: chris.freeston@freethcartwright.co.uk
Whilst every effort has been made to ensure the accuracy of this bulletin, it does not provide complete coverage of the subjects referred to, and it is not a substitute for professional legal advice and should not be relied upon as such.
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