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We are pleased to share that Axis Law Chambers has contributed the Pakistan chapter for Law Business Research’s Asset Management Review for 2018. This is the first time that the Asset Management Review contains a chapter on Pakistan and we are delighted to be part of this publication. The publication is available on the following […]
We are pleased to share that Axis Law Chambers has contributed the Pakistan chapter for Law Business Research’s Asset Management Review for 2018. This is the first time that the Asset Management Review contains a chapter on Pakistan and we are delighted to be part of this publication. The publication is available on the following link:
Sameer Khosa, Partner and Maria Farooq, Senior Associate This Article reviews the legal and regulatory framework governing mobile payment systems in Pakistan. Over the last few years, there have been growing efforts in Pakistan to increase the usage of digital and mobile payment services as an alternative to cash based transactions. While the […]
Over the last few years, there have been growing efforts in Pakistan to increase the usage of digital and mobile payment services as an alternative to cash based transactions. While the more traditional “mobile banking services” – through which customers of a bank can access their bank accounts via their mobile devices – are being offered by various banks in Pakistan, increased attention is being paid to “mobile payment” services which can include the creation and issuance of new payment instruments in a mobile manner. Some prominent examples of such services are providers that offer issuance of virtual debit cards, and digital or e-wallets.
Digital wallets1 in particular can position themselves almost as a functional alternative to a traditional basic bank account because (if the full suite of services are offered) they are not only able to reflect stored value for their users, but the users can also utilize the stored value to acquire goods or services. However, the existing regulatory regime in Pakistan is structured in a way that creates confusion amongst service providers as to which permissions/approvals / authorizations are required by each of the entities that are involved in the provision of these services.
In this article, we explore the basics of a digital wallet, introduce the current regulatory regime that is applicable to such product offerings, discuss some of the common structures, and some of the limitations of the regulatory regime that have acted as inhibitors to faster growth of the mobile financial services industry.
Generally, digital wallets can be understood as electronic applications that are used to store a user’s payment / loyalty card information on an electronic device such as a smartphone. These digital wallets then allow consumers to make electronic transactions such as making payments to merchants and/or transferring funds through the application to the wallets of other users.
Importantly, even though a digital wallet is packaged and presented as one application for a user, often there are multiple actors that combine to make such a wallet operational and effective. For example, one entity could provide the technological interface with the user, another could be the provider with whom the monetary account is residing, while a third could be the entity that processes the payment transactions. In the Pakistani context, there are already examples of private companies partnering with banks in order to enable consumers to create digital wallets that are linked with a bank account. For instance, FINCA Microfinance Bank Limited recently partnered with FINJA (Pvt.) Ltd. to launch a digital wallet known as SimSim. Anyone with a valid CNIC can create a SimSim account using their internet-enabled mobile phones.2 Money can be added to this digital wallet through various methods such as debit/credit cards.3
Given that a digital wallet involves the maintenance of value, the utilization of that value for acquiring goods and services, a payment processing function where that value is reflected in currency, and a technological UI aspect, it is essential to understand what aspects of the regulatory regime applies to each function.
At its essence digital wallets in Pakistan are considered part of the larger mobile financial services industry and thus the main regulator is the State Bank of Pakistan. The key pieces of legislation are: (1) The Payment Systems and Electronic Fund Transfers Act, 2007 (“PEFTA”), (2) The Rules for Payment System Operators and Payment Service Providers issued by the SBP under PEFTA (the “PSO/PSP Rules”) and (3) the Branchless Banking Regulations issued by the SBP (the “BB Regulations”).
As per the aforesaid regulatory regime, entities involved in the provision of a digital wallet can fall in to one of the following categories: (1) a payment system operator/payment service provider (the “PSO/PSP”), (2) a bank licensed by the SBP, (3) a branchless banking agent and (4) an electronic money institution.
PEFTA and the PSO/PSP Rules regulate inter alia PSO/PSPs. Under the said laws a PSO/PSP is any entity that is engaged in providing payment systems related services like electronic payment gateway, point of sale gateway etc. – basically providing an electronic platform for clearing, processing, routing and switching of electronic transactions.4 A “payment system” is defined as a system relating to payment instruments, or transfer, clearing, payment settlement, supervision, regulation or infrastructure thereof.5 Whereas, a “payment instrument” is any instrument whether tangible or intangible that enables a person to obtain money, goods or services or otherwise make payment (but excludes notes, bills of exchange or cheques).6
While much depends on the specific structure of each service (the end service can be structured in multiple ways at the back end) digital wallets that can be used to make payments to merchants will likely have at least some component that falls within the category of a payment instrument as defined in PEFTA. Further, the processing of payments from that payment instrument inevitably requires there to be a ‘system’ relating to the payment instrument in question i.e. a payment system.
Under PEFTA and the PSO/PSP Rules, a “payment system” can be operated only by a PSO/PSP.
Any company which operates (or wishes to operate) as a PSO/PSP must obtain approval from the State Bank by following the application procedure prescribed in the PSO/PSP Rules. In order to obtain such an approval, the PSO/PSP must inter alia be a company registered under the Companies Act, 2017 (previously the Companies Ordinance, 1984) and have a minimum paid-up capital of Rs. 200,000,000/-. A PSO/PSP also cannot act as a custodian of a consumer’s money or perform any banking functions e.g. take deposits.
This does not mean that every digital wallet provider itself is a PSO/PSP. However, where the wallet provides the ability to purchase from merchants, the wallet provider would likely at least need to partner with a PSO/PSP that would process the payments made by users of that wallet service.
Up till now, the most common way in Pakistan of providing mobile financial services has been through the Branchless Banking Regulations, which allows companies to become “agents” of existing banks. Under the BB Regulations, banks (operating through agents instead of branches) can create a “branchless banking account” by using an agency or JV agreement with a non-bank entity. A “branchless banking account” is an account maintained by a consumer in a bank in which credits and debits may be effected by virtue of electronic fund transfers.
In this case, although the user never interacts with the bank directly (there are no branches) he/she is an account holder of the underlying bank. The account resides with, payment instruments are issued by, and also settled by the bank at the back end. The wallet provider – the entity that interacts with the user – is simply the agent of the bank and utilizes the regulatory approvals and payment infrastructure of the underlying bank.
A real life example of this structure is SimSim (mentioned above). According to information publicly made available about the platform, FINJA (Pvt.) Ltd. has not obtained any approval under PEFTA or the PSO/PSP Rules. Instead, it acts as a super-agent of FINCA Microfinance Bank Limited and has received authorization from the State Bank to do so under the BB Regulations. Thus, by collaborating with FINJA (Pvt.) Ltd., FINCA Microfinance Bank Limited has allowed its customers to have a branchless bank account in the form of a SimSim wallet. The balances shown on the SimSim wallet are only a reflection of the actual account balances of the customer residing with FINCA Microfinance Bank Limited. Importantly, since there is nonetheless an electronic fund transfer being effected through the SimSim wallet, a PSO/PSP has to be part of this product offering. In case of SimSim the electronic fund transfers are actually effected by 1-Link – a PSO/PSP.7
However, the growth of mobile payment services has highlighted some of the limitations of utilizing the BB Regulations for the provision of digital wallet type services to users. This is only natural because the BB Regulations govern “banking activities” only and are primarily aimed at offering flexibility to the financial institutions. One such obvious limitation of this structure is of course the fact that although the customer base is often developed by the wallet provider, the underlying customer relationship established is with the bank. Thus if the wallet provider wishes to change banks, the customers on that platform may not automatically migrate to the new bank.
Another issue with the existing regulatory regime is that digital wallets also have the potential of being included in the ambit of a third type of mobile financial service – that of “electronic money” as defined under PEFTA. PEFTA defines electronic money as inter alia an electronic store of monetary value on an electronic device that may be used for making payments. Further, under PEFTA an undertaking that issues means of payment in the form of electronic money is required to obtain a license from the State Bank. As yet, the State Bank has not issued any rules and regulations regarding the registration, procedures, requirements, and standards in order to be licensed as an electronic money institution. This adds to the uncertainty around the applicable regulatory regime.
In conclusion, it is clear that although there are many innovations in the financial technology sector that are being introduced in Pakistan, the regulations covering the mobile financial services market lack the requisite clarity to drive faster growth. To this end, allowing the new entrants to move away from a bank led, branchless banking model through the issuance of a detailed regime for electronic money institutions may go a long way in spurring further growth. Much of course will depend on the content of those regulations.
 The terms “digital wallet” and “e-wallet” are used interchangeably in this article. The terms are widely used for a whole variety of IT enabled financial services from vendor specific stored value credit, to closed loop cards, to branchless banking accounts.
 See: Quarterly Branchless Banking Newsletter, Jan-Mar 2017, Issue 23, State Bank of Pakistan, http://www.sbp.org.pk/publications/acd/2017/BranchlessBanking-Jan-Mar-2017.pdf
 Rules 2(p) and 6(1) of the PSO/PSP Rules
 Section 2(1)(zd) of PEFTA
 Section 2(1)(zc) of PEFTA
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This article is published for information purposes only and does not constitute legal advice. Axis Law Chambers will not be liable in case of any loss, damage or liability suffered by anyone as a consequence of relying on the contents of this article.
Haroon Baryalay, Partner This article considers the most common structures employed in Islamic finance and deals with some of the criticisms surrounding its practice. Introduction Islamic finance is one of the fastest developing areas of finance which has grown at between 10 to 15 percent annually over the last decade. In addition to […]
Haroon Baryalay, Partner
This article considers the most common structures employed in Islamic finance and deals with some of the criticisms surrounding its practice.
Islamic finance is one of the fastest developing areas of finance which has grown at between 10 to 15 percent annually over the last decade. In addition to Muslim majority states, Islamic finance continues to expand into an increasing number of non-Muslim countries. Over the past decade, legislative reforms have been introduced in several jurisdictions, including major financial centers such as the UK, Hong Kong and Singapore, to place Islamic finance on an equal footing (from a regulatory and tax angle) with its conventional counterpart.
Islamic finance is considered as being a more ethical form of finance and some practitioners have argued that due to the prohibition on gharar (uncertainty) and maysir (speculation) in Islamic finance, its expansion may act as a stabilizing force in times of volatility in global financial markets. Whether this is correct remains to be seen, but it is clear that the structuring constraints within Islamic finance meant that Islamic banks were less exposed to some of the more speculative forms of investment which led to the 2008 global financial crisis, and were therefore not as severely affected.
So what is Islamic finance and how does it differ from conventional finance? It could be argued that on a practical level, Islamic finance is not different from its conventional counterpart and has the same economic effect as a conventional loan. However, at a conceptual level, the principles and transactions in Islamic finance make it an altogether different form of finance.
As is well known, Shariah prohibits riba (interest) and therefore an Islamic financier cannot simply rent money like a conventional bank.¹ The provision of finance in a shariah-compliant manner therefore has to enable the financier to earn a return but without charging interest. An Islamic financier therefore makes funds available to its customers by entering into a real underlying transaction; the entry into such transaction forms the basis on which funds are advanced to the customer. In turn, the Islamic financer earns a return by being a party to this transaction, either by charging a profit or mark-up on the sale of an asset, via a profit-sharing arrangement or by renting a tangible asset to the customer.
A conventional loan agreement can broadly be divided into five parts; (1) the facility disbursement and repayment mechanics; (2) the yield protection clauses; (3) commercial provisions dealing with warranties, covenants and events of default; (4) syndication provisions; and (5) boilerplate clauses. Of these, Islamic facilities differ only in respect of the first two, and to an extent, the syndication mechanics. The commercial and boilerplate provisions have less to do with shariah principles and are subject to agreement among the parties, and therefore tend to be similar to conventional facilities.
This article, which assumes familiarity with Islamic finance concepts and LMA loan documentation, explores the similarities and differences between Islamic and conventional finance. The discussion below focuses primarily on ijara (lease) and murabaha (cost plus sale) financing structures, being the two most commonly adopted ones in recent years. Other participation based financing structures such as mudaraba and musharaka have become relatively less prevalent following the criticism of the use of fixed-price purchase undertakings in such structures by AAOIFI’s chairman in 2008 (although they are still used in many IF transactions). The following sections compare the mechanics of an Islamic facility with a conventional loan.
Disbursement and repayment mechanics
The shariah prohibition on interest necessitates that the Islamic facility must be made available by the participation of the customer and Islamic financier in an underlying “transaction”, as a consequence of which the financier makes funds available to the customer. This transaction may take the form of a sale (murabaha or tawarruq), a leasing arrangement (ijara), an equity or agency based participation interest (mudaraba, musharaka or wakala) or a procurement contract (istisna or salam). For example, a murabaha transaction involves the financier acquiring an asset for the customer, followed by the sale of the asset to the customer at a pre-agreed mark-up. The financier purchases the asset on spot and sells it to the customer on deferred payment basis. The purchase and sale of an asset or commodity forms the basis on which the customer becomes indebted to the financier. The cost price of the asset is equivalent to principal whereas the markup forms the equivalent of interest in a conventional loan. The markup is calculated in a manner similar to interest and is indexed by reference to an interest rate benchmark. The tawarruq, a variant of the murabaha, involves the sale and purchase of commodities, with the customer selling the commodity onwards to realise cash. The repayment can be structured by reference to a variable rate with the parties entering into a series of murabaha contracts in succession which roll over the facility on each repayment date. The rate of return on each contract can be fixed on the contract date by reference to the prevailing interest rate benchmark. In practice, the economic effect of such a facility is identical to a conventional loan.
Similarly, in an ijara, the disbursement is structured as a sale and leaseback of a tangible asset between the customer and financier. The asset sale enables the disbursement, whereas the leaseback to the customer creates the repayment obligation. Again, the rental payment is divided into a fixed portion, being the equivalent of the principal, and a variable element, being the equivalent of interest. The variable rental is usually calculated by reference to an interbank benchmark rate, thus giving the financier the same return as a conventional loan.
Other profit sharing structures such as wakala (agency), mudaraba (investment agency) and musharaka (partnership) involve the provision of finance by the financier to the customer under strict conditions. The customer invests the finance in a venture which helps generate a return. This return is then shared between the customer and financier in a pre-agreed proportion. As a mode of finance, the parties will usually specify an expected return, which is calculated by reference to an interest-based benchmark, and any excess is paid back to the customer by way of an incentive fee. Any shortfall in the expected return can be bridged by a liquidity facility, a third-party guarantee, or the build-up of a reserve which can be drawn down as needed in order to ensure the financier always receives the expected return.
Although the disbursement and repayment mechanics of an Islamic facility tend to be very different from a conventional loan, the basic operation and effect is the same. In an ijara facility, for example, the customer requests disbursement of the facility by submitting a notice of intent to sell property to the financier. Thereafter parties enter into a purchase agreement whereby the property is acquired by the financier in consideration of the purchase price, being the equivalent of principal in a conventional loan facility. The purchased property is then leased back to the customer, creating a repayment obligation through rental payments.
Similarly, in a murabaha facility, the customer makes a written request to the financier to purchase an asset or commodity on its behalf. The financier thereafter sells the asset or commodity to the customer by issuing an offer notice, which is accepted by the customer, creating a sale contract. A tawarruq involves an additional step whereby the customer sells the commodity to a commodity broker on spot basis to obtain cash. Sometimes the financier will act as the customer’s agent and complete both steps on its behalf, and will simply disburse cash to the customer. Like a conventional loan, the repayments in an Islamic facility are structured to ensure periodic principal and interest payments are made to retire the facility.
In terms of disbursement and repayment, an Islamic facility is structured so as to ensure that its economic effect and operational mechanics are, for all practical purposes, identical to a conventional facility.
Prepayment and break costs
Prepayment of Islamic facilities may require, depending on the mode of financing used, careful structuring to replicate the economic effect of a conventional facility. For example, in order to prepay a murabaha facility, the customer must repay the full contract price due at the end of that murabaha period, including the full markup (without discounting for early repayment) in addition to the cost price (principal) due on that next repayment date. Such prepayment overcompensates the financier since all of the prepaid amount is not ‘due’, in a conventional sense, until the end of the murabaha period. The additional amount prepaid is usually refunded by the Islamic financier by way of a discretionary rebate, which ensures that the customer is not worse off under the Islamic facility as compared to a conventional loan. Although the rebate is kept ‘discretionary’ for Shariah compliance purposes, financiers which fail to give any rebate will risk reputational harm. In case of a partial prepayment, a new murabaha contract, for an amount equal to the outstanding principal (following prepayment), will be entered on the date of partial prepayment, which amount is then rolled over for a new murabaha period.
In addition, depending on the Islamic financier’s shariah board, some banks will deduct break costs from the rebate amount, whereas other shariah boards do not allow such deduction as it is compensation linked to cost of funding. The latter interpretation is more consistent with the principles of shariah, given that the deduction of ‘opportunity and funding costs’ have been unanimously rejected by shariah scholars.
Under an ijara facility, voluntary prepayment is structured as a repurchase of part of the leased asset by the lessee pursuant to a sale undertaking granted by the lessor. A mandatory prepayment takes the form of a forced sale of the asset by the lessor to the lessee under a purchase undertaking granted by the lessee. The lessor, however, continues to retain ’ownership’ of the asset, which will be transferred once all lease payments are completed. The purchase undertaking is exercised at a certain exercise price, which is calculated so as to be equivalent to the outstanding principal and interest.
Given that the lease rental is fixed at the beginning of each rental period, additional costs cannot be added during the tenor of the lease. Break costs may, however, be included as an additional cost payable to the lessor on account of the lessor’s added administrative burden of dealing with an unscheduled repayment. They can also be added to the variable rental payable in the next rental period. The financier may also recover break costs as a prepayment fee. Where break costs are recovered via a prepayment fee, they are likely to overcompensate the financier. However, as noted above, most shariah scholars do not favor the recovery of costs related to funding of the facility.
Yield protection clauses
In conventional facilities, yield protection clauses ensure that the lender receives its expected rate of return by making the borrower responsible for any additional costs or taxes (excluding corporate income tax payable by the lender) which may become payable in connection with the facility. Like their conventional counterparts, Islamic financial institutions do not like to see their yields squeezed by such costs or taxes, and will build in protections to pass such costs on to the customer.
Like conventional loans, customers of Islamic banks are required to indemnify the bank against any increased costs incurred by the financier, provided such costs are incurred due to the provision of the facility. Whereas conventional loan documentation will require increased costs to be reimbursed on demand, increased costs in an Islamic facility can only be charged as part of the profit or rent and added to the next murabaha contract period or lease period. This is because a murabaha contract or a lease is a fixed contract whereby the purchase price or rent is agreed on upfront; the financier cannot charge additional sums during the term of the contract. Where the increased cost arises in the last lease period, the amount may be added to the exercise price under the purchase undertaking payable at maturity.
Tax gross-up and indemnity
Islamic facility documents will also typically require the customer to ensure that all repayments are grossed up so that the financier receives the amount it would have received if no tax deduction was made. Any gross-up amounts or indemnity payments will be added to the markup/profit or rent payable in the following murabaha or ijara contract period.
Since a murabaha is a fixed price contract and the cost price and markup cannot be increased during the term of the contract, any additional amounts payable such as increased costs or tax indemnity must be included in the markup for the next murabaha contract.
Indemnity payments (such as increased costs or tax indemnities) are sometimes drafted as repayable on demand, but this approach goes against the grain of the underlying transaction and ideally these costs should be added at the next cycle, if any, or to the termination payment.
Ownership taxes under ijara
Under an ijara facility, a financier, as the owner of the leased asset, becomes liable to pay certain taxes related to ownership which cannot be passed on to the lessee under shariah principles. In addition, the owner is responsible for insurance and major maintenance costs related to the leased assets.
Since the Islamic financier does not wish to be responsible for these additional costs, in practice, these costs are paid by the lessee as service agent for on behalf of the lessor and are then set off against supplemental rentals charged to the customer in the next rental period.
Default interest or late payment fees
The Islamic equivalent of default interest in a conventional facility is a “late payment charge” calculated as a percentage of the outstanding amount. Some scholars take the view that the amount must be fixed and cannot be a percentage of the outstanding facility. A late payment fee is permissible in Islamic facilities provided it is ‘intended’ as an inducement to the customer to make timely repayments. The fee cannot be charged as additional compensation to the financier on account of the greater risk of servicing a loan in default. The Islamic financier may only deduct its actual costs (excluding funding and opportunity costs) from such late payment fee, and donate the remainder to a charity approved by the financier’s shariah board.
Where a profit rate or lease payment is linked to a benchmark rate, market disruption provisions must be included to enable the parties to determine the applicable rate in case the benchmark rate for that currency and period is no longer available. In these cases, a conventional loan would include a number of standard fallback provisions such as an interpolated or reference bank rate, failing which banks would charge the borrower its cost of funds. These provisions are likely to violate the Islamic prohibition against uncertainty since it may not be possible to determine an interpolated or reference bank rate either. Further, given the difficulty of calculating the ‘cost of funds’ for an Islamic bank (which raises funds in the interbank market through a combination of murabahas and mudarabas or other profit sharing arrangements), the Islamic financing documents will typically specify a fixed profit or rental amount in case of a market disruption event occuring.
Syndication of Islamic facilities
Unlike a conventional facility where the agency and security agency provisions are set out in the facility agreement itself, the syndication provisions in an Islamic facility are contained in a separate investment agency (mudaraba) agreement.
It is impractical for each member of an Islamic syndicate to separately enter into an underlying “transaction” with the customer(s) in order to make the Islamic facility available. Accordingly, syndicated Islamic facilities are structured so that one institution, acting as the investment agent, enters into the underlying Islamic transaction with the customer, and that agent then enters into a back to back investment agency arrangement with the syndicate. The investment agent receives funds from the syndicate under the investment agency agreement, and thereafter invests these proceeds via a bilateral Islamic facility with the customer. Unlike a conventional syndicated facility, the syndicate members in an Islamic facility do not have a direct relationship with the customer and must, in the case of a default, rely on the investment agent to enforce its rights and pass through any recovered amounts. This makes Islamic lenders particularly vulnerable to bankruptcy risk of the investment agent.
In general, the rights and protections given to the investment agent are similar to a facility or security agent under a conventional facility.
Are Islamic facilities more than window dressing?
Although Islamic facilities require careful structuring to ensure compliance with shariah principles, the economic return and allocation of risk in an Islamic facility is substantially similar to a conventional facility. Islamic financing documents mimic conventional documents and try to reconcile shariah concepts with the framework of a conventional facility.
Despite the above similarities, there are some material respects in which Islamic facilities differ from conventional ones.
First, irrespective of the jurisdiction in which the Islamic facility is made available, Islamic facilities cannot (for shariah reasons) be structured to charge the equivalent of compound interest.
Islamic facilities require tangible assets as part of the financing transaction, making it generally difficult to enter into highly speculative and uncertain transactions.
It is argued that Islamic financiers also assume greater risk compared to conventional banks, thereby justifying the sometimes higher pricing of Islamic facilities. In a murabaha facility, for example, the financier assumes a risk of fall in commodity prices between the time of purchase and resale. This risk is minimised as the commodities are held by the financier only momentarily, but in times of price volatility could pose an issue. In an ijara, the Islamic financier assumes the risk of ownership, and total loss, of the leased asset. A total loss (with no fault on the part of the customer) will discharge the customer from any further payment obligations towards the financier. Although the financier’s risk can be mitigated through insurance, the financier still faces the risk that the insurance proceeds may be insufficient to repay the facility in full. In such event, the financier will have no further claim against the customer, except perhaps an indemnity claim if the customer has failed to procure adequate insurance (as services agent of the financier).
A default under an Islamic facility tends to pose its own set of challenges. In a murabaha facility, Islamic financiers cannot continue to accrue markup/profit on the outstanding sums (once a default has occurred and the facility is accelerated) unless the customer and financier continue to enter into new murabaha contracts for subsequent periods. A late payment fee is usually a fixed amount and will not cover missed mark-up or rental payments. In such circumstances, the amount payable under the murabaha contract becomes fixed and cannot be increased on account of the delay in payment. In an ijara, once the purchase undertaking is exercised, the amount payable by the customer becomes fixed and cannot be increased by charging further rentals. Any loss suffered by the bank on account of delayed payments may only be recovered by way of an indemnity claim. Further, an Islamic bank cannot keep late payment fees (equivalent to default interest) charged to customers and must pay such amounts (after deducting expenses) to a charity approved by its shariah board.
Finally, Islamic financiers can only transact with businesses or invest in assets that are shariah compliant. Therefore, Islamic financial institutions cannot lend to entities or businesses involved in the production or consumption of alcohol, pork, gambling, armaments or pornography, or in any other socially harmful or unethical venture which is repugnant to the principles of shariah.
For the most part, the risk and reward in an Islamic facility is substantially similar to a conventional facility. Critics, therefore, argue that the underlying transaction, whether an ijara, murabaha or any other, only serves to whitewash an otherwise prohibited interest based arrangement.
Shariah scholars have responded to this criticism by arguing that even though the risk and reward of an Islamic financier is similar to that of a conventional lender, the manner in which this return is earned is halal. It is argued that in a murabaha transaction, for example, the Islamic financier takes the risk of a fall in commodity/asset price, albeit momentarily, by purchasing and selling the assets to the customer, thus being entitled to a return on the trade. In the context of an ijara, it is argued that the Islamic financier takes the risk of ownership of the leased asset, the rent being its compensation for taking such risk. They argue that mere fact that profit or rent is calculated by reference to an interest rate benchmark does not make the transaction un-Islamic.
Islamic financing techniques were developed in medieval trading societies, within the framework of the shariah prohibition on interest, to facilitate commerce and trade. The financier therefore acted as partner or trading counterparty, and shared some of the risk, thus justifying the payment of a return from the venture. Whether contemporary Islamic financing techniques, which seek to mimic conventional loans, do justice to the principles of shariah is still a matter of debate amongst scholars and practitioners.
However, given the commodification and standardization of today’s loan markets, it is perhaps impractical to assume that Islamic banks will be able to operate based on non-standardized and non-benchmarked rates of return; Islamic banks cannot be expected to act like private equity providers. Reconciling the principles of shariah with modern banking is a balance which will continue to fuel further innovation in this area, perhaps bring Islamic finance ever closer to the underlying ideals of shariah.
 There is a minority view of Islamic thought which considers the prohibition on riba as being limited to excessive interest. Existing Islamic finance documentation is based on the assumption that interest is prohibited in all its forms. This article, therefore, follows the majority view.
This article is published for information purposes only and does not constitute legal advice. Axis Law Chambers will not be liable in case of any loss, damage or liability suffered by anyone as a consequence of relying on the contents of this article.
You can download a PDF version of this article by Clicking Here