Aaron Dabbaghzadeh, InwestCo Founder & CEO, deciphers the benefits of using “Shariah” trade finance in a bear market.
The Federal Reserve took drastic action in June to smooth the highest inflation rate in the US in four decades by instituting a rate increase of 0.75 percentage point. This increase in the Fed rate for federal funds is intended to combat the higher-than-expected consumer price index.
With an expected interest from the federal funds past 3% in the coming year, the financing percentages could therefore rise to more than 6%. Such high rates increase the cost of capital and acquisition fees, making it difficult for the average entrepreneur to bear market. Under these circumstances, here are ways you can use Shariah trade finance (Islamic banking) as an alternative means of financing.
Islamic banking in a nutshell
Islamic banking or financing refers to financial transactions that comply with Sharia law and are based on the precepts of Islam. These concepts are derived from the Quran and the laws governing commercial transactions are known as fiqh al-muamalat. Islamic banking is based on two fundamental principles.
1. Sharing profits and losses.
2. The prohibition on collecting interest.
These two basic principles can make sharia financing very desirable for the entrepreneur. However, obtaining funding from countries within the Gulf Cooperation Council (GCC) reserves is not as easy as it sounds unless you follow the guidelines and provide opportunities under the right circumstances.
In general, Arabs prefer doing business with people they know and like, and for them building bonds based on personal trust is essential as it creates a strong bond. In GCC business communities, who you are and who you know (in Arabic, wasta) is critical in business communities.
Wasta basically translates as ‘connections’ or ‘influence’ and the exact translation in Arabic is ‘middle’. With this way of banking, it pays to invest time in getting to know and trust your business contacts.
The Fundamental Differentiations
There are many banking systems worldwide, but conventional and Islamic banking is the most well-known.
The primary function of conventional banking is: to lend (from the Federal Reserve or savers) and lending this borrowed money to generate a profit from the interest income.
In contrast, the Islamic financial system is based on a partnership idea. In Islamic banking, shareholders, savers and borrowers share equally in profits and losses. If the borrower defaults or does not generate a profit, the bank does not profit either.
Therefore, Islamic financial organizations tend to be more risk-averse in their investment strategies and therefore use heavy due diligence before financing any venture. They also avoid companies that may have to deal with economic bubbles.
The financing requirement
There are several GCC investment firms and banks interested in financing the foreign initiative, but most of their investment mandates are standard across the board. Through years of working with GCC Financing Resources, we have witnessed a greater interest in financing viable projects in the growth phase.
While these companies have diverse investment portfolios, in my experience they are most focused on supporting initiatives in:
• Sustainable energy projects such as solar, hydropower and wind.
• Real estate projects in the residential, commercial and industrial sectors.
• Technology projects such as waste management and pharma-tech.
On the contrary, businesses with goods or substances prohibited by the Qur’an, such as alcohol, gambling and pork, are prohibited. Islamic banking can thus be seen as a culturally different form of ethical investing.
Types of Islamic Loans
Islamic banks mainly benefit by charging a surcharge (known as murabahah) or shareholding (known as mudarabah), where a borrower has to give the bank a portion of their profits.
Murabahah is similar to a rent-to-own system in the non-Muslim world. Instead of charging interest, the seller/lender makes a religiously permissible profit on the sale of goods, which allows the buyer to make payments over time; profits are based on the contractual terms between the borrower and the bank.
Mudarabah is more similar to trustee financing or passive partnership where no fixed interest is collected along with the principal of the loan. For example, a bank could lend money to a company with equity participation, and the company would then give the bank a share of its profits according to an agreed-upon profit-sharing ratio (earnings ratio).
Some banks also offer wadiah (custody), musharaka (joint venture), and ijara (lease) as complementary forms of Islamic banking and financing.
More recently, pioneering Sharia scholars have laid the foundation for modern riba-free banking, with the introduction of a two-pronged mudarabah model in which the bank acts as a capital partner with the depositor on the one side and the borrower on the other. This idea led to the development of fixed return models. In practice, fixed return models, especially the murabaha model, have become the mainstay of the industry rather than complements, as their results are most comparable to those of interest-based financing models.
With this approach to banking, the rate of profit can be relatively lower than the rate of interest, especially in a bear market, because expected profit margins are narrower and federal rates do not drive profit rates.
Outlook for Islamic banking
Despite the Covid-19 pandemic, Islamic assets managed to expand by over 10% in 2020. According to research published in 2020 by the Islamic Corporation for the Development of the Private Sector (ICD) and Refinitiv, Islamic financial assets have expanded from $1.7 trillion in 2012 to $2.8 trillion in 2019 and are expected to reach approximately $3.7 trillion by 2024. This expansion is mainly attributed to the growing economies of Muslim countries (especially those that have benefited from oil price increases).
Worldwide there are about 520 banks and 1,700 mutual funds who adhere to Islamic principles.
It comes down to
Shariah financing is an age-old practice that is gaining popularity worldwide, and the ethical and economic precepts of Islamic finance are attracting attention from outside the Muslim community. Given the expansion of Muslim countries, the globalization of trade and the rising demand for affordable finance, this industry is expected to fuel the growth and evolution of numerous companies in the coming years.