This document provides an overview of Islamic finance by differentiating it from the theoretical Islamic economy. It explains that the Islamic economy model prohibits interest and encourages social justice, but remains theoretical as no country fully implements it. Islamic finance, on the other hand, applies Islamic principles like prohibiting interest (riba) to individual transactions within the Western economic model. It works within current systems to develop Sharia-compliant products. The document then discusses how Islamic institutions must adhere to Sharia law as defined by the Quran and hadith. It explains that interest is forbidden in Islam due to unfair risk allocation. Finally, it introduces Islamic capital markets, using Saudi Arabia as an example.

1. An Introduction to Islamic Finance
Sean Dalton
The Difference between the Islamic Economy and Islamic Finance
When discussing business and finance under Sharia (or
“Islamic law”), it is essential to differentiate between discussing the
Islamic economy as a concept and Islamic finance as a practicality. The
Islamic economy is a theoretical economic structure to be used on a
local, national, and global scale that encompasses and adheres to the
Sharia in all forms, promoting both social and economic justice for
its participants. Its advocates speak highly of the distinction between
halal (lawful) and haram (forbidden) goods and services; the Islamic
economy also forbids of all economic activity that is morally or socially
injurious to society as well as advocates judicious spending, reducing
surpluses for the well being of the community as a whole, preventing the
accumulation of wealth by a few, and providing social justice without
inhibiting individual enterprise.1
This economic theory encourages
many procedures such as eliminating interest-based loans (also known
as “Riba” loans), pricing goods and services in terms of a commodity
index, and abolishing selling and trading in securities and goods that
the seller or trader does not have title to, among other procedures.
While it provides a very concrete hypothetical economic
model, the Islamic economy remains just a theory. Currently, there
are no countries that fit the description of an Islamic economy, though
some are closer than others. The reason for this is practical. Currently,
the rest of the world espouses a Western economic theory in which
many of the things considered “haram” by Sharia scholars are critical
SEAN DALTON is a graduate of The College of William and Mary. He
wrote the paper as an undergraduate Finance major at the College. Sean
would like to thank Sultan Mofti, Professors Julie Agnew and Gjergji Cici,
and his family for thier assistance.

2. 27Islamic Finance
to the inner workings of the economic model. To truly establish an
Islamic economy, so many changes on a political, economic and social
level would have to occur in the country of its origin as well as in its
trading partners and multinational corporations operating within that
country that the price of establishing an Islamic economy would be too
high for any one nation to bear the burden of change. Thus, the Islamic
economy remains merely a guideline for Islamic economic institutions
to follow, as opposed to an actual practice.
Islamic finance, however, is the practical application of using
Sharia while still working within the Western economic model.
Unlike the Islamic economy, Islamic finance is more direct in trying
to apply Sharia principles to individual transactions and securities
to make them Sharia-compliant but also valuable to investors under
the Western economic model. This model includes such principles
as “Mudarabah, Musharaka, Ijara, and Salam financing” and items
such as “Islamic sokouks” (all of which will be discussed in detail later
under the Mechanics of Islamic finance section of this paper) in an
attempt to supply Islamic products and services to Muslims. While
these products are based on the Sharia, they are not exclusively Muslim
and have many practical applications both in Islamic and non-Islamic
companies. While they have roots in the same social and economic
justice principles of the Islamic economy, these Islamic finance methods
and securities differ because they are single transactions or securities
that can be used and applied easily and efficiently as needed.
Because of the wealth of information and the intricate nature
of these two subjects, this report focuses specifically on Islamic finance.
Even a topic such as Islamic finance is so complicated, especially to those
unfamiliar with the Sharia, that it is a subject that could and has filled
many books and publications. This report is designed to give a broad
enough overview of the subject to convey the essentials and a working
knowledge of the subject, its products and offerings, and its future impact
on the global economy and global economic agents. It is imperative that
this report is seen as an undergraduate-level research report done during
merely a month of research in the Kingdom of Saudi Arabia and the
United Arab Emirates, and that more in depth information and answers
be found in graduate- and doctoral-level books and publications.

3. 28 The Monitor - Winter 2011
The Sharia and its Impact on Finance
Islamic institutions are, by their nature, Islamic. Thus any
understanding of the business and financial environment done with
or using an Islamic-based business needs a brief understanding of the
religion of Islam.
The main source of religious teaching and rulings comes from
the Qur’an (sometimes spelled Koran), the book of laws and rules that
Muslims believe were delivered by God to the Prophet Muhammad, and
theSunnah,orcollectionofthesayingsoftheprophetMuhammad.Along
with the Bible (both Old and New Testaments, which Muslims believe
were delivered by prophets), these constitute the basis for all decisions
and the basis of all actions both in the personal and professional lives of
Muslims. It is, to the Muslim people, the definitive guide to all aspects of
life, including business transactions. Thus, it is imperative for an Islamic
economic institution to comply with the Sharia (the complete set of rules
stemming from the Qur’an and Sunnah). To ensure this, many banks
and financial institutions have, as an independent oversight committee,
a Sharia board to oversee that the practices of the institution remain
compliant with the Sharia. Comprising of at least three religious scholars
who are experts in Islamic laws and transactions (or “Fiqh al Mu’amalat”)
in addition to business, finance and economics, these committees
work similarly to auditors and to make sure that, within their bank or
institution, funds are invested in a way that does not violate the Sharia
and to ensure that transactions the bank engages in are not “haram” or
forbidden. As such, these committees play an extremely important role
in keeping institutions aligned with their mission statements to be Sharia
compliant. They are also the ones to whom questions and new ideas for
services or product offerings are brought to be ruled on in terms of their
permissibility under the Sharia.
It is scholars like these who pioneered Islamic banking in the
1940s and 1950s. Looking for a way to return to the original teachings
of the Qur’an and remove themselves from colonialist influences, these
early Muslim economic scholars established the first modern Islamic
bank in Egypt in the 1970s. Since its inception, Islamic finance and
banking has maintained the established principals set forth in the
Qur’an on dealings in economic matters.

4. 29Islamic Finance
The Islamic View of Interest
The biggest apparent difference between Western and Islamic
models of finance and banking concerns interest. In the Qur’an and
under Sharia, interest is expressly forbidden in any form. The prophet
Muhammad says,
Those who eat Riba [interest] will not stand (on the
Day of Resurrection) except like the standing of a
person beaten by Shaitan (Satan) leading him to
insanity. That is because they say: ‘Trading is only
like Riba,’ whereas Allah has permitted trading
and forbidden Riba. So whosoever receives an
admonition from his Lord and stops eating Riba
shall not be punished for the past; his case is for
Allah; but whoever returns (to Riba), such are the
dwellers of the Fire-they will abide therein.2
In many other verses as well, the forbidding of interest is one of the
main concepts specified the in Qur’an for business and business dealings.
The essential Islamic belief is that interest is an unjustified because it does
not adequately share the risk of an opportunity between an investor and the
debtor. In the event of a default, the debtor must still repay the premium
and the interest of the loan, which does not fairly allocate the risk of an
opportunity.ManyWesterneconomistshavecomeupforreasonsjustifying
interest: it is a reward for savings, pays the investor for the temporary loss of
capital, and combats inflation and potential loss of liquid assets. However,
when probed, advocates for interest do not explain why the interest rate is
almost always above that of inflation or why interest should be the market
regulator for the supply and demand for money. Why, Islamic economists
ask, should interest be paid for one’s postponement of enjoyable present
goods or paid for abstaining from diminishing one’s present capital which
would otherwise be diminished by the ravages of time and consumption?3
Thus, the unfair allocation of resources in dealing with interest serves no
purposeinthetermsoftheIslamiceconomy.Thisreligiousruling,orfatwa,
has become very widely accepted within the Arab community; thus, there
is an increased push among pious Muslims to find new and innovative
ways to provide products and services that are Riba-free.

5. 30 The Monitor - Winter 2011
Islamic Capital Markets
To truly explain many of the intricate dealings of the Islamic
finance system, they must be viewed within the broader lens of Islamic
capital markets. This report uses the Kingdom of Saudi Arabia’s capital
markets as the basis for this section for two reasons; first, they are the
most adherent to Sharia law and thus is more different and traditional
in adhering to Islamic economy ideals than other Islamic countries and
second, they are in the country where the writer of this report spent the
most time and had greater access to information on the financial markets.
In 1984, the Islamic Fiqh Council (the highest religious court
in the Kingdom of Saudi Arabia) ruled on the stock exchange and,
by association, all capital market exchanges. The list of positive things
about the exchange were that it created a permanent market, made it
easier for companies to raise capital, added liquidity to the markets and
created an easy determinant of prices. However, the council also saw that
differed transaction (futures contracts) are not in unison with Islamic
teachings and that the practices of “short” selling and forward rates go
directly against the Sharia. The Council’s ruling on the exchange passed,
reconfirming that a capital markets exchange is permissible under Islamic
law. However, the Council stated, since the capital markets have such a
wide opportunity to be used either for good or evil, each transaction must
be independently viewed and ruled on to determine the permissibility of
the action. Many transactions that are used, taught, and applied in the
West have been deemed impermissible under the Sharia. In addition
to the stipulation that all shares of companies bought must be halal
(or Sharia-compliant), a number of other rules have been established
specifically when working and trading in Saudi Arabia:
• Deferred deals are permissible only if the goods are in
possession of the seller and the payment or transfer of goods
must occur in the same setting when the deal is done.
• Transactionsinbuying/sellingacompany’ssharesarepermissible
only if they are not a haram business (they do not deal in
pork products, alcohol, pornography or pornography-related
endeavors, products or services that deal with promiscuity,
gambling or receive more than 30% of their income from
interest-bearing securities). However, it is perfectly permissible

6. 31Islamic Finance
to deal with the parent company of a subsidiary that does
manufacture or provide haram products and services if you can
be assured that the money will not be used for the subsidiaries
that manufacture or provide haram products or services.
• Differed transactions of various kinds of securities that are
not in the seller’s possession are not permissible (thereby
eliminating short-selling where the seller borrows the shares
from a third party with intent to re-purchase the shares for
the third party at a lower price).
• Dealing in currencies is permissible so long as the exchange
takes place at the same sitting as the contract is made.
Delayed delivery of the currency is haram, or impermissible.
• Whenreturningpaymentinanothercurrency,thepayments
must be made in the currency stated in the contract, or in
an accepted foreign currency at the current currency rate to
equal the same amount of the mutually-agreed upon deal.
Investment Banking in Saudi Arabia
As a major growth industry and one of the main focuses of this
research,investmentbankinginSaudiArabiaisaveryimposingtopicwhen
viewed with no background on the subject matter. However, investment
banking in Saudi Arabia is extremely similar to investment banking in the
West in its practices and operations. There are select differences, however,
in companies and their cash flows in Saudi Arabia and around the Middle
East. The market for investment banks there is growing, as are the capital
markets, but the situation is still tricky to navigate as they are still recently
developing in the region. Again, because Saudi Arabia is most difficult to
understand and most traditional in the ways of Islamic finance, this report
focuses exclusively on dealing with investment banking in Saudi Arabia.
The criteria for bankruptcy and financial distress are, in ways, both
more and less complicated than those in the United States. As opposed to
Chapter 7 and 11, declaring a company in financial distress and insolvent,
the Saudi government has criteria in 11 categories. If a company does not
meet a specific number of these criteria based on its business type and the
size of the business, it is declared bankrupt. If a bankruptcy does occur
and the company cannot be saved, the order of liquidating value to the

7. 32 The Monitor - Winter 2011
stakeholders exactly follows the Western model, with senior bondholder
being first in priority down to eventually the shareholders.
In terms of projecting cash flows, the calculations are a little
different than their Western counterparts. With no domestic tax in the
Kingdom of Saudi Arabia there is no tax shield to capture in trying to
assess the value of the cash flows of the firm. However, foreign investors
and foreign companies working in the Kingdom of Saudi Arabia are
taxed, making the calculations slightly different when working under a
partnership in Saudi Arabia. In the case where there is a mixture of local
and foreign partners or investors, the taxes incurred are a portion of the
foreigner’s share of the profit, leaving the local partners and investors
free of taxes. Due to this rule, when trying to value a Saudi Arabian
company, the free cash flows of a firm must be discounted to only the
firm’s equity, not the entire firm.While some Islamic scholars will accept
a company issuing a debt of less than 30% of the firm’s net worth, an
ideal situation would have a firm funded entirely by equity. Regardless
of the composition of the company, the same Western models of the
“Weighted Average Cost of Capital” works in helping compute the cost
of capital and the value of the firm. They only difference is that there
are no tax shields to take advantage of because there are no corporate
taxes in Saudi Arabia. Thus, it is only the cost of the firm’s equity that
comes into account when trying to value a company.
Withtheprohibitionofinterest-backedsecurities,situationswhere
companies need to raise large amounts of capital quickly focus more on the
offerings of an IPO and the backing of high net worth private investors.
While an IPO is an attractive way to raise capital from a Western point
of view, the fact is that ownership of a company is still tied very closely to
the heart of the Arab people. Thus, an IPO offered in Saudi Arabia is a
bittersweet opportunity for a company, where the benefits include a fresh
influx of capital but the downsides include the notion that management
is losing control of their company. A stipulation of the IPO process in the
Kingdom of Saudi Arabia is that only Saudi nationals are allowed to invest
in an IPO during the first week of the offering. Non-Saudi investors must
wait until exactly one week from the IPO to invest in the company’s shares,
givingSaudisacompetitiveadvantageininvestinginthenewcompanyand
giving preference of a company’s ownership to a Saudi citizen as opposed

8. 33Islamic Finance
to any foreigner. Along the same lines, mergers and acquisitions (M&A)
currently do not constitute a large portion of business in the Middle East of
in Saudi Arabia. This, however, is changing as more and more Saudis and
Arabs travel and work abroad, returning with a much more Western view
of ownership in a company and a much more aggressive nature towards
M&A. With the continuing development and maturity of the economy,
more investors will be looking to take advantage of the M&A departments
of financial firms, and it is expected that with the maturity of the Saudi
economy there will be an increased demand for M&A, with a developed
and profitable M&A market in about 10-15 years.
The Mechanics of Islamic Products and Services
The Assets of an Islamic Bank
Like any conventional Western bank, an Islamic Bank has many
different services it offers to its customers. They offer current accounts,
savings accounts and investment accounts for their customers. Current
accounts are the exact same as they are in Western countries, where
deposits are guaranteed. Savings and investment accounts operate slightly
differently, however. Without interest, financiers have developed a system
to ensure they remain competitive with Western banks. Some banks do so
with a looser interpretation of the Sharia; every account is given a once-a-
year “gift” depending on the amount held in the savings account of every
member. However, other banks look at this practice as implicit “Riba” and
forbid the practice. Another method is by treating the savings accounts,
with the permission of and based on the risk-tolerance of the customer,
as an investment account where the funds in each account are merged
with other accounts based on a similar risk tolerance profile and invested
with the bank acting as the money manager. In return, the savings account
holder receives a pre-determined amount of the profit from the project.
However, the savings account, in the event of a monetary loss by the
project, forfeits the capital with no guarantee of return.
Murabaha as “Cost-Plus Financing”
One of many Islamic-based financing tools is Murabaha or, as it
is known in the West, “Cost-Plus Financing.” It can be used for numerous

9. 34 The Monitor - Winter 2011
purposesandcanbeusedonacommercial,corporateandinvestmentbanking
scale. Unlike a conventional bank where a loan is given to the borrower with a
timelineforrepaymentoftheprincipalandtheinterest, Murabahacanachieve
the same goals without dealing in a Riba-based transaction. The customer first
approaches a bank and explains how much money is needed and for what
purpose. The bank, assuming that the customer is financially sound and
meets the criteria by using standard qualitative and quantities analysis such
as financial statements analysis that is used by corporate banks worldwide
to qualify for the financing, places the order for the good or service on the
customer’s behalf. The bank then buys the item in its own name, where the
title transfers from the seller to the bank. The bank then proceeds to sell the
goods or services to the customer over a prolonged time for installments at
the purchase price in addition to a mutually agreed profit margin. This profit
margin can be calculated by the bank’s own criteria, either by finding a profit
margin by calculating the profit based on the market-to-market commodity
index(atheoryespousedbytheIslamiceconomyscholars)or,morerealistically,
by using an interest rate. While this last method is frowned upon by the most
conservativeofShariascholars,itisatthemomenttheeasiestandmostreliable
way to calculate the profit margin.
This method can be applied on many different levels, depending
on the amount of capital needed. On a commercial and retail level, the
bank can purchase goods or services outright, such as purchasing a car
for an individual or the purchase of a home for a family. For larger-
scale financing on a corporate and investment level, the bank usually
purchases a commodity (typically, banks use the London Metals
Exchange to help fund these purchases but can use any commodity,
equity, currency or other securities to help raise capital for its purchase)
which it then resells to the customer who can then sell the commodity
on the spot market to receive the capital directly, and repays the bank
over a period of time as written in the contract. This larger-scale method
is typically a transaction used for financing larger scale products, such
as the construction of a building or other large-scale expenditures.
However, in trying to replicate this process outside of the Middle
East, financiers have run into two major issues. The multiple buying and
selling steps change the title of the goods frequently, causing increased tax
events and making it an expensive transaction in certain incidences in the

10. 35Islamic Finance
West. Also, selling the goods or services to the customer for an increased
price may constitute capital gains for the financial intermediary and incur a
capital gains tax. Some banks have tried to solve this problem by including
a “rider” provision in the contract, stating that the customer agrees to pay
any taxes incurred by the bank; however ,many Sharia experts have come
forward to say that this invalidates the Sharia compliance of the transaction.
In addition to the tax difficulties, many laws prohibit banks in the West
from engaging in direct transactions on behalf of the customer or to take
title of the property. However, this can be avoided by using a SPV (Special
Purpose Vehicle) to buy and sell the goods and services for the customer.
Another issue is that of repayment. The Sharia states that if the borrower
is under financial distress he must be allowed to postpone payment until
he is financially sound enough to do so. Thus, it may be difficult for a
bank or financial institution to recoup its investment if there is an economic
downturn or if the business becomes unprofitable. Another issue is that in
a direct transaction where the financial intermediary purchases a specific set
of goods or services on behalf of a customer, the customer is not obligated to
purchase the goods or services from the bank once the bank has placed the
order. Thus, the bank is taking a risk by purchasing the goods because the
customer may not ultimately buy them from the bank. While this is a very
unusual occurrence, it is still a stipulation that cannot be avoided in making
the contract Sharia compliant. However, to ensure that this stipulation is
not abused, banks keep records of their clients’ past transactions and do
regular credit history checks before agreeing to a contract with the customer.
Musharaka—PLS Partnership
In dealing with general financing for a company or entrepreneurs,
banks offer a product and service known as Musharaka, or “Profit-Loss
Sharing Partnership” (also known as PLS). In this transaction, the customer
requests a specific sum of money from a financial institution who, after due
diligenceandmakingsurethatthecustomermeetsthecriteriaforMusharaka,
agrees to finance the customer as a partner in its business endeavors. Using
the money that depositors have put into the bank’s investment account the
customer enters into a contract with the bank stating that in return for the
capital it agrees to share in a pre-determined proportion of the profits with
the bank. Thus, it is a partnership on two levels, with the depositors acting

11. 36 The Monitor - Winter 2011
as the providers of capital and the bank as the manager of funds in the first
tier, and the bank as the provider of capital and the customer as the manager
of funds in the second tier. This transaction goes well beyond the simple
debtor-creditor relationship, however, because both parties agree on the ratio
in which profits will be shared between them beforehand, the treatment of
both parties is uniform in the event of a loss (with the financier losing the
principal and the manager deprived of the time, labor and effort), and both
parties are treated equally if there is contract infringement, with the financier
having to repay the investment to the manager if he violates the contract and
the manager repaying the financier if there is a violation of the contract. The
bank remains a partner until the manager buys out the bank’s partnership in
the company by repaying the premium. The share of profits must be shared
as a percentage of profits, instead of promising a specific amount, because
guaranteeing a specific amount constitutes Riba and invalidates the Sharia
compliance of the contract. Not unlike a joint-venture agreement of the
Westernworld,itpromotesveryprogressiveideasandhelps encouragebetter
resource management and distinguishes good performance from bad by
tracking the profits generated by the manager, instead of the performance of
thecompany.Theprofitthebankreceivesfromthepartnershipisdistributed
to the holders of the investment and savings accounts with an amount going
to the bank for successfully managing the investment. In the event of a loss
by the partnership, however, the bank is not guaranteed to recoup its capital.
Thisserviceseemstohavemanyimplicationsatthelocalandregional
bank level, where the bank can be in direct communication with its partners
and, by living and interacting nearby, can keep track of their progress. The
main point of concern here is that it may be difficult to accurately predict
which enterprises may be profitable and requires local and regional banks
to increasingly better its employees to not only exercise due diligence on
every transaction but also to establish and encourage communication within
the bank and with its customers and depositors. This need to improve its
workings both inside and outside the bank would eventually help the bank
become financially stronger and have strong ties with the well-being of
the local community. Although ideal for local and regional banks, this can
be used on a wider scale purpose to help larger companies in complicated
financial maneuvers and transactions, though it requires banks to follow a
conservative approach in dealing with corporate financial transactions.

12. 37Islamic Finance
Ijara—Islamic Leasing
Islamicleasing,knownasIjara,isaShariacontracttotakeadvantage
of the renting the “right to use” an item, which cannot be consumed or
destroyed in the process, where the financial intermediary would purchase
the item and then lease it back to the client for a predetermined term. The
financial institution owns the title and leases the “right to use” to the lessee
who would use the item according to the agreed-upon leasing contract.
The client pays a monthly or periodic fair price (ideally based upon the
marked to market price under the Islamic economy model). Under Ijara,
the bank or financial intermediary maintains the asset in terms of repair
and gradual use, and afterwards disposes of the goods according to the
Sharia. One of the most important factors of the contract is that the item
being leased must be a non-fungible item. The beneficiary use of the item
can be the use of an asset (such as a home) the facility of an asset (the use of
a car or x-ray machine) or the work or productive services of an individual
(defined as any person who can offer defined, valuable work such as a
engineer or specialist). Items such as money and food cannot be leased
because they cannot be used without being consumed for their purpose,
clearly invalidating the Sharia compliance of the contract.
Another factor of Ijara is Ijara-wa-imtilak or Ijarah-wa-iqtiara,
known as the Islamic “leasing-to-own.” Under the leasing-to-own program,
the monthly payment has 2 parts: the gradual purchase of the item, goods or
service by the lease and the rental of the actual asset at the prevailing market
price. In many ways it operates similarly to Western-style leases, with the
only differences being that the lessee is not contractually obligated to see the
lease to fulfillment and that, if the lessee is unable to pay the stipulations of
the contract due to unfortunate circumstances such as illness or financial
difficulty. This type of leasing requires the bank or financial intermediary to
engage in activities beyond financial intermediation and is very conducive to
the formation of fixed assets and medium to long term investments.
Bai Salam Financing—Forward Purchasing
Bai Salam financing is a forward purchase with prepayment of
the price. Mainly used to finance sectors such as agriculture, agro-based
industries, and the rural economy as a whole, it is useful for farmers and
agro-based industries who sell their crops in a contract to a financial

13. 38 The Monitor - Winter 2011
institutionataspecificpricewithavolatiledeliveryofthecropsuntilharvest
time. This financing is important to both parties because in addition to
locking in essentially a futures price for their crops, the farmers receive cash
that can be used as working capital for their farms during the planting,
growing and harvesting seasons. It also provides an incentive to enhance
production as the seller will spare no effort to produce at least the quantity
needed for the settlement of the loan taken at the advance price of goods.
Bai Salam can also lead to a more stable commodities market and price
stability because it enables savers to direct savings to investment outlets,
without waiting, until harvest or until they actually need industrial goods
without being forced to spend savings on consumption. This method can
also be used for trading commodities for public and private sectors as well
as the purchases of measurable, countable goods or services. Buy-back and
rollover provisions, however, are not allowed and invalidate the Sharia.
Islamic sokouks—Islamic Bonds
Islamic sokouks are Islamic securities that are similar investment
instruments to bonds in the Western economy. Like bonds, sokouks are
offered by a company or organization directly to investors and can be
bought and sold on an exchange for a price determined by their riskiness,
payoff and liquidity. However, that is the last place where Islamic sokouks
resemble Western bonds. Unlike bonds, Islamic sokouks are tied to real
assets and are repaid through the lease-to-own of those assets. Thus,
when a company issues an Islamic sokouk, it is for a specific purpose
and asset, which the bearer of the sokouk owns, and leases back to the
company over a period of time. The process begins when the company
or organization decides to issue an Islamic sokouk offering for a specific
need (which can be either for a tangible or intangible asset) such as the
construction of a new building. The credit of the issuer is reviewed by the
financial intermediary and the underwriter of the offering which then
finds investors willing to purchase the sokouk. When the investor(s)
purchase the sokouk, they fully own the asset and lease it to the company
for a specified price over a period of time, ending with the maturity of
the sokouk and the purchase of the asset from the investors for the initial
price of the sokouk. Thus, it works like a bond in that at its maturity, the
price of the sokouk is repaid and the coupons instead are lease payments

14. 39Islamic Finance
for the use of the asset. The sokouks can be engineered to compete with
conventional Western bonds in that they can be either a fixed or floating
sokouk, the maturity can be whatever the need for the sokouk is, and
the coupon is still a coupon, making the pricing and trading of sokouks
identical to conventional Western bonds.
One of the major differences between a bond and an Islamic
sokouk is the riskiness of the asset. Unlike conventional Western
bonds where the risk is only in the event of financial distress and
bankruptcy, the Islamic sokouk investors carry the full risk of the
asset. In the example of issuing a sokouk for the construction of
a new building, the bearer of the sokouk assumes all the liability
without repayment if the building collapses or burns down, though
many banks offer insurance for the asset the sokouk is used to
fund. Thus, there is an increased risk because of the asset risk of the
investment. The rate of payment for a sokouk is based on the asset
risk of investment, the credit rating of the issuing organization, the
liquidity of the sokouk market, and the benchmark rate (the two
most commonly used are the LIBOR rate and the SIBOR, the Saudi
Interbank Overnight Rate) prevailing in the capital markets. With
recent developments in the financial world, experts are still trying
to pioneer financial equations to figure out how to standardize the
rate of a sokouk. Like Western bonds, Sokouks can be and are of
all credit ratings, from AAA-level sokouks to junk sokouks, making
them easy to classify, trade, and use for numerous financial strategies
and tactics such as LBOs and other complicated maneuvers.
Having only existed for 10 years or so, Islamic sokouks come with
their share of issues. Because of the increased asset risk of the Sokouk,
it can be incredibly expensive to issue by an organization because the
increased rate needed to make them attractive to international investors
who could easily invest in a conventional bond. In addition, the new
developments trying to be implemented by Islamic financiers often
raise legal or Sharia issues that must be carefully analyzed before going
forward. . Islamic finance experts are trying to tackle some of these
issues by engineering ways that make sokouks a security that are a blend
between preferred stock and a bond, but this is a process that takes time
and is being carefully monitored by legal and religious authorities.

15. 40 The Monitor - Winter 2011
The Current State of Islamic finance and its Place in the International
Financial Markets
Developing New Islamic Finance Products and Services
A unique relationship has developed between Malaysia and Saudi
Arabia in the development of Islamic finance and banking. The newest
developments of Islamic finance are being pioneered in Malaysia, which
has a very high Muslim population. These new developments are often
experiments in Islamic finance and try to find new products and services that
areShariacompliant.ExpertsontheIslamiceconomyandtheoreticalIslamic
finance developers are striving to develop new and revolutionary products
and services both in implementing products and services on a local level as a
test and in papers for academics. Once the Malaysian financiers believe they
have developed a new product or service, it must then gain the approval of
religious authorities. As the most respected authorities on the Sharia, it falls
to Saudi sheiks (sheik is another term for a learned religious scholar) to give
planst the seal of approval and to approve them for implementation on a
larger scale. Thus, to pioneer any new developments takes time and many
levels of approval before they can finally be offered to the public.
Where Is Islamic finance Taking Hold?
Islamic finance is very quickly becoming a global phenomenon.
Obviously, countries where there is a very large Muslim population
are seeing an increase in Islamic banking and services. Developed in
Egypt, the Middle East is a major center of Islamic finance and is
where the majority of Islamic finance and banking services are being
implemented. In more religious countries, such as Saudi Arabia, many
conventional financial intermediaries are partnering or developing
Sharia-compliant divisions and services to cater to very pious Muslims.
Even for more secularized Muslims and non-Muslims and in
countries where Islam is not the majority religion, many are flocking to
Islamicfinanceandbankingbecauseofthestrongtiesthatitsorganizations
build with the local community and businesses. Due to this focus on
local development and its easy-to-implement style, many impoverished
nations could easily benefit from the implementation of an Islamic

16. 41Islamic Finance
finance process in their country. This can be mainly seen in neighboring
nations to countries with large Muslim populations, such as Southeast
Asia (spreading from Malaysia) and the northern half of Africa.
With the increase of the Muslim population in Europe, there
has been an increase in Islamic finance on both a community and on a
national level. In many cities where there is a large and localized Muslim
population, many local and regional banks utilizing Islamic products and
services have sprung up to help the local Muslim population, with the
United Kingdom currently being the leader country for the establishment
of local Islamic banks. On a national level, both the governments of Spain
and numerous German states have issued sokouks for civil development,
showing that both some of the strongest and weakest economies in
Europe understand the benefits of utilizing asset-based loans.4
In the United States, many of the larger financial institutions
are developing specialist divisions to cater to many high net worth Arab
individuals and to begin large-scale implementation for Muslims living
and working in the United States. However, there has been very little
development in the regional or local level in Islamic banking and services
because of the dispersion of the Arab and Muslim population in the
United States. Another problem in the development of Islamic finance in
the United States is, in the post-September 11 world, Arabs and Muslims
are often distrusted and are thought to have ties to terrorist groups and
activities. While this is merely prejudice and racism, it nevertheless stands
as an issue for the development of Islamic finance and banking in rural
America. For this reason, many pioneers trying to bring Islamic finance
and banking products and services to the United States instead refer to
the products and services as “Responsible Banking.”5
Regardless of its
name, it will still take time for the United States to embrace an Islamic
finance model because of the complexity of changing and the legal issues
in trying to implement an Islamic finance model.
Notes
1
The Institute of Islamic Banking and Insurance, www.islamic-banking.com.
2
The Qur’an, Al-Baqara, Chapter #2, Verse #275.
3
The Art of Islamic Banking and Finance, Yahin Abdul-Rahman.
4
http://www.worldservicesgroup.com/publications.asp?action=article&artid=2153.
5
http://www.csrdigest.com/2009/01/socially-responsible-banking/.