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Understanding Islamic banking principles and its application to investing

August 12, 2018 By KK

islamic-finance

In the past few months, I’ve been sharing on-and-off with a Muslim colleague on generating passive income and my own journey to financial freedom. It was through these discussions that I was reminded of the existence of Islamic banking. As someone who has read next to nothing on this topic, I thought I’ll do some reading of my own and present my findings here.

(Disclaimer: I’m a free thinker and do not presume to know everything about Islam or its guiding banking principles. While I endeavour to make sure the information is accurate as far as possible, take it with that caveat in mind.)


Islamic Banking Guiding Principles

There are generally 3 major interlinking principles that guide what Muslims can or cannot invest in:

1) Prohibition of Interest (Riba)

Earning of interest is specifically prohibited in Islam. There are 2 reasons for this.

Firstly, the concept of interest implies guaranteed returns with no element of profit and risk sharing. This ties in with the 3rd principle.

Secondly, guaranteed returns encourages investors to turn a blind eye to how the funds are being used. It is thought that society suffers as a result if riba infects the entire economy. This also ties in with the 2nd principle.

2) Ethical and Moral use of funds

This principle means that you can only invest in ventures that are beneficial to society and not in vice industries. Well known haram (forbidden by Islamic law) areas include:

  • The sex industry
  • Alcohol
  • Pork
  • Gambling and speculation
  • Drugs

3) Risk and Profit sharing

This principle prescribes that profit is “good profit” only when the various parties participating in a venture take their proportionate share of risk and their proportionate resulting profit/loss. In relation to debt instruments, it is viewed that you are not taking any risk as you are guaranteed a return. Under Shariah law, you are essentially an economic leech and a sinner.

Implications of guiding principles

These guiding principles create certain areas that are strictly off limits, while also create various grey areas that are open to interpretation on what you can or cannot invest in. I’ll go through each asset class and discuss whether it is Halal according to the principles, while also highlighting any Shariah compliant alternatives that the banking industry has come up with similar characteristics.

1. Saving Deposits / Fixed deposits

Savings and fixed deposits in their traditional sense are prohibited due to interests paid. For Islamic savings deposits, hibah (gift/donation) is paid instead at the bank’s discretion.

As for Islamic fixed deposits, a popular model used is called murabahah (fixed cost plus model). For example, if you put $10k into the account, you effectively purchase $10k of commodities that the bank agrees to buy back at maturity at a fixed price including markup. The “interest” you earn is the fixed profit margin agreed at the start, thus mimicking the properties of fixed deposits.

As an interesting sidepoint, Maybank seems to deposit the profits the day after you make the deposit, unlike FDs that pay out at maturity.

2. Bonds / Debt instruments

Traditional bonds and debt instruments are a definite no as they pay interest. That said, there is a popular bond-like instrument called Sukuk, or “Islamic bonds”. Sukuk is usually tied to a specific venture / asset and investors are paid from the underlying profits and cash flows from the asset. It is a investment trust of sorts.


3. Equities / REITs

Equities generally comply with Shariah law provided the company’s activities do not contravene the 2nd principle. Muslim equity investors have to be extra careful to understand the company’s business activities and make sure they are not engaging in vice. This should already be practised anyway even if you are non-Muslim.

The grey area that I’ve come across is equities of companies with debt like property developers, construction companies or REITs. Some say it is a strict no-no, while others say it is OK as long as it is not a significant proportion of the balance sheet. The debate over what “a significant proportion” means is also a matter of interpretation. Throw in the fact that most of the world’s companies are funded by debt to some degree and you have a real practical application issue on your hands. Makes you wonder how the Kingdom Holding Company (Investment vehicle of Saudi Prince Alwaleed) reconciles these grey areas in his own equity investment strategy.

As a sidepoint, the world’s largest Shariah compliant REIT by asset value Sabana REIT is listed on the SGX.

5. Derivatives (Futures, options, etc)

This is another grey area due to the nature of derivatives trading. Derivatives trading are generally speculative in nature and thus haram. With that said, futures and options do serve a purpose in risk management if not traded speculatively.

6. Cryptocurrencies

There is little discussion on whether this is haram or not, but I would argue that it is haram based on its speculative and volatile nature, and lack of real world value. Crypto HODLers will argue with me till the cows come home, but for now, I think I am right.

Final Thoughts

Islamic banking and investing is a form of ethical and socially responsible investing that Muslims have to follow as far as possible in their quest for financial freedom. Navigating its guiding principles and grey areas can be complicated. My advice, as a practical free thinking outsider, is to find a middle ground you are comfortable with so that you can explain your actions when you meet your maker.

Happy Hunting,
KK

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Filed Under: Invest Tagged With: Investment, Islamic Finance


Reader Interactions

Comments

  1. mhalim says

    August 13, 2018 at 8:28 am

    Hi KK,
    Great post. With respect to “a significant proportion” of debt, you may wish to Google papers on “AAOIFI ratios”.
    It’s generally one third or “33.33%” for most of the ratios involved. This ratio was derived directly through ijtihad (scholarly exertion) from the Islamic tradition of Prophetic narrations.

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