Islamic finance

A form of financing that is made in a way that complies with the requirements of Shariah or Islamic law; that is financing upon which no interest (riba ) is charged; that does not involve certain forms of speculative investment (ghara ); and does not involve forbidden (haram ) activities (such as the sale or consumption of alcohol or gambling). Acceptable forms for financing real estate (i.e. the grant of an 'Islamic mortgage') may be effected in a number of different ways: (i) A transfer of the subject property to the lender who then grants the borrower a right of occupation subject to a payment that covers the cost of the property, plus a payment for the right of occupation (an arrangement that is based on trade financing whereby instead of providing trade finance with interest the trader buys the commodity and then sells it later with a markup to cover the holding cost—murabaha). At the end of the term the borrower owns the property outright; (ii) A form of 'lease purchase' or 'hire and purchase' agreement (ijara-wa-iktina ) by which the financier owns the property and receives regular payments to cover the purchase cost of the property and a premium before the title is granted to the occupier; (iii) The borrower takes title to the property and pays part of the cost himself, with the balance being advanced by an Islamic institution that, in turn, retains a lien on the property until the amount due is repaid in full, with the payment of the balance being made by installments (bei bi thameen ). (iv) A form of joint venture or partnership (musharakah ) whereby profits are shared by agreed amounts and losses according to the capital invested. Thus, a property may be acquired with each party providing part of the capital and the 'financier' and occupier share the equity value of the property when the property is sold. Unlike a conventional mortgage, with an 'Islamic mortgage', in most cases, title to the property is retained by the bank until payment is made in full. In the case of a residential property, these forms of Sharia-compliant loans may be referred to as 'home purchase plans'.

Islamic finance may also take the form of leasing (ijara), or a 'bond with leasing' (sukuk al-ijara). (Sukuk being a form of asset-backed bond that provides each beneficiary with a proportional share of the underlying asset). Usually the subject property is acquired by an independent vehicle (a 'special-purpose vehicle' (SPV) that immediately leases the property to another SPV (usually an entity formed by the original owner of the property). The Islamic investors acquire shares in the second SPV and that entity then leases the property to the end-users or tenants. The owner SPV may be financed by third-party debt or equity and the income for the tenants is used to pay a return on that equity. At the end of a fixed period of time, the Islamic-investor SPV may have an option to purchase the property from the owner SPV at the original cost when the third-party financing is repaid in full. The Islamic investors then resell the property to realize its overall return for the 'holding period'. Construction financing may take the form of Istisna'a whereby one party agrees to provide a property at a predetermined price and to an agreed specification. The price would include the holding cost from inception to transfer of title. See also usury.

Terms in bold are defined elsewhere in the Encyclopedia.
Further explanation of the style of reference material is provided in the User Guide (available to subscribers)