Islamic banking schemes
Islamic banking schemes are financial products and services that comply with Islamic law (Shariah) and principles. Some of the common Islamic banking schemes are:
Mudarabah: A person with capital (Rab-ul-Maal) provides funds to an entrepreneur (Mudarib) who uses it to invest in a business venture. For example, a person with surplus funds provides capital to a small business owner who uses it to expand their business. The profits from the business are shared according to a pre-agreed ratio.
Musharakah: Two or more partners contribute capital and/or labor to a joint venture. For instance, two friends decide to start a clothing business together. They both contribute an equal amount as capital and agree to share the profits and losses equally.
Murabahah: A bank purchases a good or asset on behalf of a customer and sells it to them at a markup. For example, a customer wants to buy a car but doesn’t have the funds. The bank buys the car and sells it to the customer at a markup, which the customer pays in installments.
Ijarah: A leasing contract where one party rents a good or asset to another party for a fixed period and fee. For instance, a person leases their property to someone in exchange for rent.
Takaful: An Islamic insurance scheme where participants pool their money to provide mutual protection and assistance to each other in case of loss or damage. For example, participants in a Takaful scheme contribute money into a pool that is used to financially support a member when they experience a covered loss. Yes, in a Takaful scheme, participants do have the opportunity to receive a portion of the surplus or profit generated by the scheme. This is one of the key features that differentiates Takaful from conventional insurance.
In a Takaful scheme, participants contribute money into a pool, which is then used to pay claims for losses suffered by any of the participants. The pool is managed and invested by a Takaful operator on behalf of the participants. If there is a surplus in the pool at the end of a financial period (i.e., the contributions and investment returns exceed the amount paid out in claims), this surplus may be distributed back to the participants.
However, it’s important to note that the distribution of surplus is not guaranteed and depends on several factors, including the performance of the investments, the amount of claims paid, and the expenses of managing the Takaful scheme. The specific terms and conditions regarding surplus distribution are usually outlined in the contract between the participants and the Takaful operator.
It’s also worth noting that while participants in a Takaful scheme share in the profit and loss of the Takaful business, they do not give the risk to the Takaful company as occurs in conventional insurance. This principle of mutual risk-sharing is a fundamental aspect of Takaful.
As always, it’s recommended to carefully read and understand all terms and conditions before participating in a Takaful scheme or any other type of financial product.
Sukuk: An Islamic bond that represents proportional ownership in an underlying asset or project. For example, an Islamic bank issues Sukuk certificates for the construction of a new building. The investors who purchase these certificates have proportional ownership in the building and receive a share of the income generated by it. Yes, like all investments, Sukuk also carries risks. These include:
- Credit risk: If the issuer cannot meet its obligations.
- Market risk: If the value of the Sukuk or underlying asset changes.
- Liquidity risk: If the Sukuk cannot be sold quickly.
- Price risk and Interest rate risk: Price risk and interest rate risk are inherent risks associated with Sukuk, an Islamic financial certificate similar to a bond in Western finance.
Price Risk: This is the risk that the price of the Sukuk will decrease. This can happen due to various factors such as changes in market conditions, economic indicators, or the financial health of the issuer. For example, if the issuer’s financial condition deteriorates, investors may sell off their Sukuk, causing the price to fall.
Interest Rate Risk: Although Sukuk does not involve interest in the conventional sense (as interest or “Riba” is prohibited in Islamic finance), it is still subject to changes in the general level of interest rates. This is because when interest rates rise, the fixed return provided by Sukuk becomes less attractive compared to other investments, leading to a decrease in the price of Sukuk. Conversely, when interest rates fall, Sukuk becomes more attractive and its price can increase.
These risks are inherent because they are a natural part of investing in financial markets and cannot be completely eliminated. However, they can be managed through diversification, careful selection of investments, and other risk management strategies.
- Default risk: If the issuer fails to make the necessary payments.
When investing in a Sukuk, the project carries risk, and the Sukuk issuer and holder take on a share of this risk. This differs from bonds, where a bondholder has no risk. The bond issuer borrows money from the bondholder, and the success or delivery of the project has no bearing on payments to the bondholder.
It’s important to note that while these risks exist, they can be managed with careful planning and consideration. Always consult with a financial advisor or conduct thorough research before making any investment decisions.