Saudi Central Bank (SAMA) official, Fahad Abdullah Al-Dossari, said the Kingdom of Saudi Arabia’s financial industry has assets worth nearly SAR 3 trillion (close to $800 billion). This, according to a 2021 Islamic Financial Services Board report, comprises 28% of the world’s total Islamic financial assets, effectively making KSA rank first globally when it comes to Islamic financial asset size.
One of the drivers of Saudi Arabia’s financial industry growth is the prevalence of financial institutions offering Shariah-compliant financing instruments. For instance, Murabaha enables Saudi Arabia residents and citizens to use an installment plan without a credit card to finance purchases.
It is clear that Shariah-compliant financing tools are vital to the Islamic financial ecosystem as they allow people to participate in the financial markets, particularly to finance their purchases and economic activities, in a way that is in accordance with Islamic laws.
What Does Shariah Compliance Mean?
Shariah-compliant financing (SCF) refers to financing tools and instruments that adhere to fundamental Islamic principles. Without them, residents and citizens of Muslim countries have no financing recourse, and economic activity in these countries will naturally stall.
According to the Asian Development Bank (ADB), the following are the fundamental principles of Shariah-compliant financing:
1. Interest Prohibition
A financing instrument cannot charge interest. As such, Islamic law-compliant instruments utilize profit and loss sharing. Note that profit is allowed, but it must be proportionate to the risk undertaken; earning a profit on zero risk represents interest and, thus, is prohibited.
2. Fairness, Transparency, and Certainty
Financial dealings must be fair, transparent, and clear to ensure the weaker party will not be exploited. There must therefore be full disclosure for all contracting parties to ensure knowledge and information are fully and equally shared, as asymmetric information distribution, which occurs when one party has more information than the other, can lead to one party taking advantage of the other.
3. Asset-Based Financial Transactions
Every financial transaction must be based on and directly linked to an underlying asset (i.e., something with value). Making money out of money, which is what happens when you lend money at interest, is not allowed.
4. Ethical Investments
Financing must also be used only on ethical investments. Investing in anything that can harm the community (e.g., alcohol, pornography, gambling, weapons, etc.) is unacceptable.
3 Types of Shariah-Compliant Financing Instruments
The following are three Shariah-compliant financing instruments.
Murabaha financing is one of the most widely used Shariah-compliant financing instruments in Saudi Arabia. In fact, the total value of Murabaha contracts has grown 40% by the third quarter of 2021, a 110% year-over-year increase when compared to the 19% annual growth rate it registered by the end of Q3 2020.
Murabaha operates on the principle of cost-plus-profit. It has three parties: the customer, the seller, and the financial institution.
In this financing agreement, a customer wants to purchase a particular product or specific goods from a seller, so he asks a financial institution to finance the transaction. The financial institution buys the product or goods from the seller, assuming the risk of ownership, then agrees to sell it to the customer.
In murabaha, the customer and the financial institution agree on a cost-plus-markup purchase price. The amount the financial institution paid to the seller, plus the financial institution’s markup, must be fully disclosed before the transaction can be executed.
The customer and the financial institution then agree on the payment terms. They may agree that the customer will pay the cost-plus-markup amount at a future date. They may also agree on an installment plan, in which case the cost-plus-markup is divided equally among the number of required payments (e.g., 36 payments across a 36-month term). The payment timings and due dates are determined beforehand.
In murabaha, the financial institution is the owner of the product or goods bought from the seller. The customer becomes the owner only after paying off the full cost-plus-markup amount indicated in the contract.
Mudaraba is a financing arrangement between two parties. One party (i.e., rabb ul mal) provides the capital investment, while the other party (i.e., mudarib) is the entrepreneur that provides the work.
A mudaraba is a partnership agreement where one party agrees to finance the project while the other party agrees to work and provide the effort required to make the project a success.
In mudaraba, the two parties agree to share in the project profit. The profit-sharing terms (how much each party’s share in the profits) are clearly established before the commencement of the agreement. The terms of the project are all made clear from the start, including what the economic activity is, how much funds the capital partner will invest, what these funds will buy or cover, and what the working partner will contribute.
In case of financial losses, the capital partner bears all financial losses. That’s the risk the financial institution undertakes for a share of the profit. For their part, the working partner’s risk involves not seeing any returns on his efforts.
Musharakah financing involves a partnership between two or more parties, where each contributes capital to a project. For instance, a medical institution can partner with an investment group in a project to establish a private hospital in Jeddah. Musharakah financing is commonly used for business investments, real estate development, and joint ventures.
Both profits and losses are shared among the partners in musharakah. The profits are distributed based on an agreed-upon ratio, while losses are shared proportionally to the respective capital contributions.
There does not need to be an exclusive capital partner and an exclusive working partner, and each partner may take a management role. However, the agreement may designate one or more persons with management responsibilities; whatever the case, the terms must all be agreed upon before the contract is executed.
In musharakah, the partners are considered each other’s agents, so any work done by a partner (as long as it is in accordance with the terms of the partnership agreement) is deemed to be authorized by all partners.
Musharakah can be used to finance a home. The financial institution and the home buyer form a partnership to buy a piece of property. If the home buyer pays 20% of the home purchase price and the financial institution pays the remaining 80%, there’s a 20%-80% split in home ownership between the homeowner and the bank.
Every month, the home buyer will pay the bank a fixed amount for a set period of time (say 15 years). The fixed amount and the term of the agreement must be predetermined before contract execution.
Every month, part of the home buyer’s payment will go to cover rent, while the rest will go towards increasing the home buyer’s share of equity. If the rightful monthly rental rate is SAR 3,000 ($800), SAR 2,400 ($640) of the fixed monthly payment goes to rent payment in the first month when the bank still owns 80% of the property.
The fixed monthly payments gradually reduce the portion of the monthly fee that goes towards rental payment while gradually increasing the amount that goes towards equity payment.
Islamic financial institutions cannot charge late payments and must show leniency when the home buyer has a valid reason for his non-payment or late payment. If there’s no real reason for the late or non-payment, a penalty paid to a charitable institution may be required by the bank; of course, any such terms must all be included and covered in the musharakah agreement.
Harnessing the Power of Shariah-Compliant Financing
Shariah-compliant financing instruments in Saudi Arabia offer a diverse range of options that cater to the unique financial requirements of individuals, businesses, and institutions.
Murabaha, mudaraba, and musharakah financing are some of the most commonly used instruments, each with its distinct characteristics and applications. The availability of these Shariah-compliant instruments further strengthens Saudi Arabia’s position as a leading hub for Islamic finance.