Growth Potential Islamic Mortgages in the UK

Abstract

Chapter 1: Introduction

1.1 Contextual Background

1.2 Research Aims and Objectives

1.3 Research Questions

1.4 Report Structure

Chapter 2: Literature Review

2.1 Islamic Finance and its Widespread Emergence

2.2 Common Islamic and Conventional Banking Products

2.2.1 Common Islamic Banking Products

2.2.1.1 Debt Based Transactions

2.2.1.1.1 Ijara (lease)

2.2.1.1.2 Ijara wa iktina (leasing and purchase)

2.2.1.1.2 Istisna’a (Forward Commissioned Sale)

2.2.1.1.2 Bai Mujjal (Credit Sale/Sale on Deferred payment basis)

2.2.1.1.2 Salam (Advance Sale)

2.2.1.1.2 Murabaha (Cost-Plus/Mark-Up)

2.2.1.2 Capital Market Financial Products- Deposit Accounts

2.2.1.2.1 Wadiah (Safekeeping)

2.2.1.3 Equity Based Transactions

2.2.1.3.1 Mudarabah (Partnership Financing/Joint Ownership)

2.2.1.3.2 Mushrakah (Equity Financing)

2.2.2 Conventional banking

2.2.2.1 Personal Loans

2.2.2.2 Credit Cards

2.2.2.3 Home-Equity Loans

2.2.2.4 Home-Equity Line of Credit

2.2.2.5 Cash Advances

2.2.2.6 Small Business Loans

2.3 Comparison of Islamic Banking and Finance with Conventional Banking and finance

2.4 History and Development of Islamic Finance in the UK

2.4.1 Timeline

2.5 Key Islamic Banks and Financial Service providers in the UK

2.5.1 ABC International Bank plc Islamic financial services

2.5.2 Citi

2.5.3 Al Rayan Bank (formerly Islamic Bank of Britain)

2.5.4 Abu Dhabi Islamic Bank (ADIB)

2.6 Islamic Mortgages

2.6.1 Diminishing Mushrakah

2.6.2 Ijara Wa Iqtina Structure (lease to own concept)

2.6.3 Murabaha Structure

2.7 General Characteristics of Conventional Mortgages

Chapter 3: Research Design and Data Collection

Secondary Data Methods

A Descriptive, Qualitative, Quantitative and Analytical Research

Reasons for choosing this methodology

Limitations and Recommendations

Estimates of the Muslim Demographic in the UK

The UK mortgage market

Islamic Mortgage Market in the UK

Economic and Social Conditions of Muslims in the UK

Chapter 4: Data Analysis and Interpretation of Research Material

A Comparative Analysis of Islamic and Conventional Mortgages

Past global mortgage crisis and the consequential 2008 global financial disaster

Competitive Advantages of Islamic Banking over Conventional Banking

Profile Analysis of Muslim Community in the UK and their need for Islamic Banking

The Ideological Difference

Financial Needs and attitudes of the Muslim Community in the UK

Chapter 5: Conclusion and Reflection

Islamic Banking Outlook: Opportunity, Risks and Challenges

Bibliography

 Abstract

 

This dissertation explores the numerous Islamic banking products in order to gain a comprehensive understanding of Islamic mortgages. While there has been extensive research carried out on the Islamic Banking and Finance industry, the primary aim of this research is to carry out an in-depth study analysing Islamic Mortgage services to understand if they have the growth potential to serve as an alternative to conventional home loans in the UK mortgage market. This investigation is carried out using methodologies involving secondary research methods of qualitative and quantitative data around current trends of the Islamic mortgage market in the UK, a growing Muslim demographic in Britain and their needs for Islamic financial products to further understand and analyse the prospects of Islamic home loans in the UK.

Introduction

 

 

1.1 Contextual Background

The earliest Islamic financial institutions were set up almost a quarter of a century ago (Alharbi, 2015). Following this, the Islamic banking industry has expanded significantly over the years. For the last 30 years, Islamic finance has considerably increased in popularity at an international level. It has now been widely adopted in both Muslim majority and non-Muslim majority countries (Belouafi and Chachi, 2014). Another reason for its attractiveness is an increase in demand by Muslims around the world for financial services that are free from interest and therefore compliant with Islamic laws/principles also known as the Shariah (Ainley et al., 2007; UKTI, 2014; (Hamwi and Aylward; 1999)). To cope with this widespread need and emergence, financial institutions all over the world are trying to keep up with the rapid development of this alternative banking system.

Today the Islamic banking structure has developed immensely and is implemented either entirely or partially by several financial institutions all over the world. The Islamic banking system also runs parallel to the conventional banking system in countries like Malaysia, Bahrain, the GCC countries, etc. (Hamwi and Aylward; 1999). Furthermore, numerous international and local banks have incorporated this system into their operations by launching several Islamic financial products. For instance, the international giant HSBC has an Islamic banking branch called Amana while Citi bank also has an Islamic banking division called Citi Islamic (UKTI, 2014). According to most secondary sources used in this research to investigate the concept of Islamic banking system, most financial institutions based on Islamic principles are cost-effective, and have performed strongly in recent years (Hamwi and Aylward; 1999). In addition, the resilience of Islamic Banks lies in the fact that they are highly capitalized as compared to conventional banks (Siddiqi, 2006).

Worth nearly $2 trillion, Islamic finance is rapidly growing at a rate of 10-15% a year across the world with the UK emerging as a global hub for its services (Ainley et al., 2007; Khan and Bhatti, 2008). This growth can also be largely attributed to Britain’s relatively large Muslim community that seeks to access financial products that are compatible with their beliefs (UKTI, 2014; Mansoor Khan and Ishaq Bhatti, 2008). With an increase in the Islamic banks’ capital on hand, strong developments in the Islamic banking procedures, products and services, the growth of infrastructure and real estate sectors in the EU and the UK, mass migration and the resulting increase in the country’s youth population of second generation millennial Muslims who are looking to purchase affordable housing; there has been a growing demand for Islamic home loans and purchase plans in Britain (Yueh, 2014; Tameme and Asutay; 2012). Furthermore, owing to the rise of housing requirements in the UK market, Islamic mortgages are increasing in demand (Tameme and Asutay; 2012).

1.2 Project Aims and objectives

The primary aim of this research is to look into the different categories of Islamic home loans and purchasing plans, evaluate and compare Islamic mortgages to conventional mortgages in the UK, gather market trends on a growing base of Muslim customers in Britain, and carry out a profile analysis of this segment to determine their social and economic conditions, requirements and attitudes toward an alternative to conventional home loans and purchase plans. Most importantly, this information will be used to evaluate the demand and growth prospects of Islamic mortgages in the UK banking sector.

The purpose of this research will be achieved through the objectives which mainly include critically reviewing the literature in relation to the different mortgages offered by the UK’s domestic banks, and by assessing the driving factors behind the rise of such services in this country. This dissertation will attempt to accomplish the aim of this research by analysing secondary research methodologies of qualitative and quantitative data.

 

1.3 Research Question

The hypothesis of this research will be thoroughly investigated to reach a conclusion by answering the following research question.

Based on current trends, customer demographics and financial needs, do Islamic mortgages have the growth potential to serve as an alternative to conventional home loans and purchase plans in the UK’s home financing market?

 

1.4 Report Structure

This paper is mainly structured into 5 chapters each of which are further elaborated below

Chapter 1: Introduction

This chapter provides a brief introduction and contextual background to the emergence and development of the Islamic Banking system around the world and in the UK. In addition, this chapter presents the fundamental purpose of the research, its aims and objectives and identifies the specific question the research aims to answer.

Chapter 2: Literature Review

This chapter will deliver an in depth explanation of the Islamic banking system, common Islamic banking products, and a comparison between both Islamic and conventional banking systems. Following this, the chapter will provide an elaboration of the role of Islamic banking in the UK.  Additionally, the literature review will look into the concept of both Islamic and conventional mortgages. Details of some of the country’s domestic banks that offer Islamic mortgages will also be covered.

Chapter 3: Research Methodology and Data Collection

This chapter will cover an outline of the research plan and discuss how secondary research methods will be used to gather and collect qualitative and quantitative data for analysis. Additionally, historical and thematic analytical methodologies will be used to arrive at a conclusion. Potential weaknesses, scope and limitations of the research will also be discussed in this section as this dissertation will largely rely on secondary sources to reach a conclusion. This chapter will also offer an insight into the UK mortgage market and the function of shariah-compliant mortgages in the UK’s home financing market.

Chapter 4: Data Analysis and Interpretation of Research Material

This chapter will aim to present the findings of the undertaken research and assess the results of the secondary sources to derive a conclusion about the research topic. This chapter will combine and analyse data from multiple sources to identify certain trends and analyse those trends to carry out a comparative analysis of conventional mortgages to Islamic mortgages and determine if they offer competitive advantages over conventional financing products.

A profile analysis of the Muslim community and their ideological differences will be conducted in this section to determine their financial need for home financing that are consistent with their beliefs and conclude the outlook of Islamic mortgages in the UK. This chapter will therefore present the results of the analysis as evidence to validate the research topic and answer the research question set out in this dissertation. Chapter 4 will draw on the findings of the analysis and link it to the research covered in the literature review to make an argument to validate the research topic/question.

Chapter 5: Conclusion

The final conclusion will be associated with the aims and objectives of the dissertation from the Introduction chapter. This chapter will provide a summary on the implications of the research covered in the previous chapters about the outlook of Islamic Mortgages in the UK market and the opportunities and challenges presented by them.

 

2.1 Islamic Finance and its Widespread Emergence

Islamic Banking is a financial system primarily based on the principles of Islamic Law also known as the ‘Shariah’. Most Islamic banks around the world offer numerous financial products and services that are confined within the Islamic framework, thereby differentiating them from most conventional banks (Rahman and Riyadh, 2016). The Shariah law is mainly derived from two important elements of the Islamic faith; the ‘Quran’ which is the Islamic sacred book, and the ‘Sunnah’ which are the practices and teachings of the Prophet Muhammad, a key historical figure in Islam (Ayub, 2009). These key principle sources provide context for the legal system followed by most Islamic countries around the world. Some of the central ideologies of the Islamic banking system include; the prohibition of transactions involving Interest (Riba), oppression (zulm), speculation (gharar) and other forbidden goods and services such as pork, wine, non halal meat, gambling, pornography, etc. (Rahman and Riyadh, 2016).

This system also promotes the equal distribution of wealth within an economy by endorsing the concept of Islamic tax, also known as, ‘Zakat’. However, most importantly, the Shariah forbids usury or ‘Riba’ which refers to the payment or receipt of an amount in excess of the principal amount in a loan transaction. According to proponents of Islamic banking, an interest transaction allows the lender to receive a guaranteed return without participating in any form of risk, all of which is borne by the borrower who also provides the effort, skill and labor. Therefore, the prohibition of ‘Riba’, according to most scholars, prevents the lender from taking advantage of the borrower thereby promoting justice (Kettell, 2008). Another key principle in Islamic finance is that money is not considered to have an ‘intrinsic value’ (Kettell, 2008). Islamic banking does not regard money as an asset, and hence, forbids charging anything for its use (Ahmed, Asutay and Wilson, 2014). Islamic banking, primarily, engages in trade and investment transactions involving tangible assets in order to create more wealth. This system, primarily based on the Quran, also calls for transparency in all trade transactions whereby each party must have all the information about the asset being traded (Lewis and Algaoud, 2001; Ayub, 2009)    (Abu Bakar, 2012).

Through the prevention of Riba, Islamic banking also aims to avoid ‘zulm’ which is a common term used to denote any type of exploitation, injustice or oppression. This term is also used to refer to someone who either exploits others by taking away their rights or by not carrying out their responsibility towards them. In addition, Islamic banking calls for the avoidance of ‘gharar’ which is an unknown fact or condition as in a speculative transaction. An excess of gharar, according to most scholars, can make a contract unacceptable and cancellable.

A further key endorsement of the Islamic financial system is the sharing of profit and risk. In Islam, ‘there should not be any reward without taking a risk.’ Hence, the risk and profit should be shared between the person who provides the capital (the lender), and the person who provides labor (the entrepreneur). The Shariah strongly disapproves of a guaranteed return on any form of investment by any party in a contract, regardless of the risks involved. This law applies to both the lender and the entrepreneur in a partnership agreement. Therefore, the labor is not allowed to receive a payment unless it is based on the work he does, and the person providing the capital is not allowed to benefit from any reward if he hasn’t been exposed to any form of risk.

 

Islamic Banking typically allows for circulation of funds on the liabilities side of a bank’s balance sheet. This finance mobilization is primarily implemented by means of ‘Murabaha’ (Cost-Plus/Mark-Up) and ‘Wakalah’ (Principal/Agent) contracts which are discussed later.The customer can also provide Islamic Banks with interest free loans in the form of demand deposits. On the other hand, the funds on the asset side of an Islamic bank are invested on the basis of profit-and-loss sharing or debt-creating contracts. Since fixed interest is prohibited in Islamic Banking, the supplier of funds-in this case the bank depositor- takes on the role of an investor who shares in the business risk and profits.The depositors of an Islamic bank are allowed to obtain a share of its net earnings depending on the amount and tenure of their deposit. As per Islamic guidelines, depositors must be informed in advance of the method used for sharing the net earnings with the bank.

Almost every Islamic Bank around the world, has its own Shariah advisory board that can be consulted to ensure that the bank’s activities are carried out within the confinements of the Islamic jurisprudence. Prior to agreeing for funding for any proposed venture, the business proposal is evaluated by banks for feasibility and compliance with Islamic law.

Today Islamic banking is estimated to be worth?? with several Islamic financial institutions operating worldwide. Its fundamental tenets of promoting social justice and economic prosperity for the whole community has made it an attractive sector not only in Muslim countries but also in Asia, Africa, the US, Europe and the UK. This widespread emergence of the field has led Islamic bankers to exploit commercial opportunities, latest developments and sophisticated techniques associated with financial investments and transactions to offer profitable and ethically motivated mortgage products to penetrate the UK home financing market.

2.2 Common Islamic and Conventional Banking Products

2.2.1 Common Islamic Banking products

Islamic banks provide a variety of Shariah-compliant financial products. The following information discusses some of the most common modes of financing offered by Islamic banking institutions: (Bassel Hamwi, Anthony Aylward, 2010)

2.2.1.1 Debt based transactions

In Islamic banking, most debt based transactions are only allowed if there is an underlying asset involved. The majority disbursements offered by Shariah-complaint financing institutions usually fall under the following categories:

2.2.1.1.1 Ijara (lease)

This mode of financing is generally provided by several Islamic banks around the world. Ijarah is primarily a leasing contract which is usually extended to clients for renting capital equipment and other fixed assets. In this contract, the bank purchases the equipment needed by the borrower and then rents it out for a certain fee (Ayub, 2009; Rahman and Riyadh, 2016; (Chong and Liu, 2009)). This fee and the lease period is pre-determined in the contract. The equipment remains under the ownership of the bank for the entire length of the lease period after which the possession may be transferred to the borrower depending on the terms of the contract (Chong and Liu, 2009).

2.2.1.1.2 Ijara wa iktina (leasing and purchase)

This mode of funding is similar to an Ijarah contract whereby the client is obligated to purchase the equipment at the end of the lease period. In this contract, the client buys the equipment at a pre-determined price. In addition, the prior rental fee is considered a payment for part of the price (Ayub, 2009).

2.2.1.1.3 Istisna’a (Forward Commissioned Sale)

In this contract, the seller is responsible for the production of goods and equipments according to the buyer’s requirements. These goods or equipments are then delivered to the buyer at a mark-up price, previously agreed upon between the bank and the buyer. This form of financing is usually confined to construction projects. Also, an Istisna’a contract requires the buyer to pay the price over a certain time period, according to a payment schedule agreed by both parties beforehand. As an alternative, this contract can also entail the provision of funding manufacturing or construction projects.

 

2.2.1.1.4 Bai Mujjal (Credit Sale/Sale on Deferred payment basis)

This contract is a form of credit sale whereby the bank purchases the commodity required by the borrower who is then obligated to purchase the asset from the bank once it is under its ownership at a certain profit margin.  This contract enables the buyer to repay the bank in instalments or as a collective lump sum at a certain date in the future (Chong and Liu, 2009). The amount paid to the bank for the commodity can be higher than, equal to or lower than the cash price.

2.2.1.1.5 Salam (Advance Sale)

A Salam Contract involves an advance sale whereby the payment for goods is made in advance but their delivery takes place at a future date (Chong and Liu, 2009).

2.2.1.1.6 Murabaha (Cost-Plus/Mark-Up)

Under this type of financing, the Islamic bank buys the goods needed by the borrower and re-sells it to them at a certain mark-up rate agreed by both parties beforehand. In this contract, the client approaches the financial institution with a request of the commodities it wants to purchase (Chong and Liu, 2009). The bank then purchases these commodities and allows the client to repay the institution in instalments. These instalments can be paid according to a pre-determined schedule included in the contract (Chong and Liu, 2009).

2.2.1.2 Capital Market Financial Products- Deposit Accounts

2.2.1.2.1 Wadiah (Safekeeping)

The word ‘Wadiah’ originally means custody or safekeeping. This is a service provided by several Islamic banks that allows clients to deposit their cash or other items with the Islamic institution which then takes the responsibility of their security.

2.2.1.3 Equity Based Transactions

 

2.2.1.3.1 Mudarabah (Partnership Financing/Joint Ownership)

This contract is a form of partnership that mainly involves 2 parties which include the provider of funds (also known as rub al mal) and the provider of labor, capital and expertise (also known as the Mudarib). In this agreement, both parties share the profit according to a pre-specified ratio. However, in the event of a loss, the Rub al mal bears all the financial risk while the Mudarib is not paid for any labor provided due to his inability to generate funds. In this mode of financing, the banks typically assume the role of the ‘Mudarib’ while the depositors are regarded as the ‘Rub-al mal’. However, when the bank lends out the money to a borrower, it becomes the Rub al mal while the borrower assumes the role of a Mudarib

2.2.1.3.2 Mushrakah (Equity Financing)

In a Mushrakah contract, two or more parties contribute an initial capital for funding a project. In this agreement, the proceeds are divided according to a pre-determined proportion but the losses are shared based on the initial contribution made by each party (Chong and Liu, 2009).

2.2.2 Conventional banking

Most conventional banks, like Islamic banks, are derived from the basic principal of financial intermediation between the Savings Surplus Units and the Savings Deficit Units. However, for the most part, these banks make their profits from the difference between the interest they pay on their liabilities (such as deposits, etc.) and the interest they earn on their lending (loans, etc). Conventional banks can be strictly commercial where they don’t participate in investment activities and their shareholding is limited to a small percentage of their total worth. However, they can also take the form of an investment bank where they have more options for raising funds. In addition, they can also be a combination of both. (Lee Khee Joo, Chin Nyuk Sang, Pamela Chin, 2010)

Commercial banking facilities primarily include retail short term credit for short term financial needs and trade financing, while investment banks provide facilities such as consultation services for corporate finance, assisting companies with issuing and listing shares, and stock brokerage and investment portfolios handling services.

Other common conventional banking facilities include:

• Mobilization of savings through current, savings and fixed deposit accounts between customers, and other Financial Instruments.
• Payment services for customers to exchange payments and money.
• Loan offerings to individuals and corporations for short term financing needs, investment and other expenditures.
• Providing financing services to Governments by investing in Government securities, bonds, T-Bills etc.
• Offering numerous other banking amenities.

Financial institutions all over the world provide various kinds of loans for a wide variety of purposes such as personal needs, starting up a new business, buying a house, etc. Below are some common categories of loans, their features and their suitability for different financial needs (Curtis, 2008).

2.2.2.1 Personal Loans

This mode of finance is provided by several commercial banks and is used by individuals for their own personal expenses. These loans are usually short-term and are expected to be repaid within a few years. Personal loans are typically used to cover small expenses and are generally provided based on the creditworthiness of the client (Sartoris, 1972). They also don’t require any collateral which is why they are unsecured. Obtaining these loans typically require proof of income and assets that are worth the same amount being borrowed. Furthermore, high interest rates are charged on these loans, and they cannot be used to fund large scale projects because they are short term (O’Neill and Xiao, 2015).

2.2.2.2 Credit Cards

A credit card is a card that allows holders to take a loan for short-term financing, which can be repaid later. They are widely popular and usually used for point-of-sale purchases. They are also accepted as a means of payment. Consumers are encouraged to use this form of financing because of its convenience. As a result of which, they end becoming burdened with debt. By owning a credit card, holders have access to extra dollars’ worth of credit. However, in order to be able to get a card, they have to go through a credit evaluation procedure. Interest rates on credit cards are usually quite high as compared to other means of loan financing (Caldwell, 2017).

2.2.2.3 Home-Equity Loans

This mode of financing allows borrowers to use the value of their house to acquire a loan. The amount of loan is calculated based on the difference between the market price of the house and the outstanding amount on the mortgage (Corradin and Popov, 2015). Home-equity loans are usually long-term loan, offered for a period of around 15-20 years with affordable interest rates and are primarily for people who want to borrow large sums of money (Corradin and Popov, 2015). However, it can be difficult to pay off a home-equity loan and even a small increase in interest can make it unaffordable for the borrower.

2.2.2.4 Home-Equity Line of Credit

Like home equity loans, this form of financing borrowers to get a long-term loan based on the value of their house. It involves a revolving line-of-credit whereby customers have to pay a commitment fee in order to be able to borrow a certain amount of money (Salter, 2014). Home Equity Line of Credit allows mortgagors to borrow up to a certain limit by having the option of either borrowing less or up to the limit, but not more (Hodges, 2008; Salter, 2014).  The borrower can also use a certain amount of the loan, pay back a part of it and borrow again.It is tax deductible and good for large funding ventures.

2.2.2.5 Cash Advances

Cash advances are short term loans that are offered by several credit card companies. Customers can usually obtain this loan without anydifficulty (O’Neill and Xiao, 2015). However, cash advances only offer a small amount of financing and are not suitable for large financial needs. In addition, they are not tax deductible and charge high interest rates and service fees (O’Neill and Xiao, 2015).

2.2.2.6 Small Business Loans

This loan mainly allows entrepreneurs to obtain financing to start their own small businesses. To qualify for this loan, the person must submit a business plan to the bank which then has to get approved. The individual is also personally responsible for guaranteeing the loan by offering his own assets as securityif the business doesn’t do well. The amount extended for this purpose is typically for a long term and depends on the business itself. The terms of this loan may differ from institution to institution. The downside of this loan is that it may be difficult for borrowers to get their business plan approved by the bank.

 

2.3 Comparison of Islamic Banking and Finance with Conventional Banking and finance

One fundamental difference between the Islamic and conventional banking system is that the Islamic system is based on the Sharia and strongly enforces the prohibition of transactions involving ‘Riba’, ‘Gharar’, etc; while the latter is based on a largely manmade capitalist ideology (Beck, Demirgüç-Kunt and Merrouche, 2013). In conventional banking, a loan contract involves the payment and receipt of interest. This interest is the price of the loan and represents the opportunity cost of money. The traditional banking system also treats money as a commodity or asset and allows for more wealth to be created from it. This is typically done by using the time-value-of-money as a means of calculating interest which is then charged to borrowers on the loans lent to them. Islamic banking, on the other hand, is primarily based on making a profit from trade and investment transactions in real assets, products, goods and services (Kettell, 2008). Money is only regarded as a medium of exchange in this system. Therefore, contracts concerning the disbursement of cash by conventional banks do not involve an exchange of goods and services whereas cash disbursements made by Islamic banks require an agreement involving the exchange of goods and services. These agreements can take the form of ‘Murabaha’, ‘Salam’ and ‘Istisna’ contracts among others (Rahman, 2007).

Additionally, the conventional banking system is mainly based on a debtor-creditor relationship between the bank itself and its depositors, on one hand, and alternatively between the bank and its borrowers. Furthermore, this system typically allows the lender (in this case, the depositors of the banks and the banks themselves) to obtain a pre-determined guaranteed interest or return without taking any risk in an investment or a loan while the borrower is left to bear all the risk (Rod, ALHussan and Beal, 2015). However, the Islamic banking system mandates all parties to share the risk and rewards of any given project between themselves. The parties in this case would mainly include the provider of funds (investor or lender) and the user of funds (the entrepreneur who provides labor, skils, etc). The Islamic banking system, therefore, emphasizes a relationship based on investment by offering several equity based financial products such as Mudarabah and Mushrakh which are of a participatory nature. These products allow the financial institutions to treat their clients as their partners by investing their money in feasible and Islamically acceptable projects after which the profits and losses are shared according to a mutually agreed proportion. Also, because conventional banks are guaranteed a fixed income from their disbursements, they do not focus much on evaluating projects that are funded by their loans. However, Islamic banks tend to give more consideration to assessing the project financed by them because they have a motivation by sharing in the profit and loss. Moreover, conventional banks charge a penalty when the loan is defaulted or not paid on time, whereas Islamic banks do not charge any such penalties, and in some instances give discounts if the loans are repaid earlier.

 

A further difference is that a conventional bank has to make sure that it is able to repay all its depositors regardless of the nature of deposit account a customer may have. However, an Islamic bank is mainly required to guarantee those deposit accounts that are part of its ‘Wadiah’ service, but if a depositor invests his money in a ‘Mudarabah’ account, he is then required to share the loss as well. Conventional banks can also invest in goods and services such as alcoholic products, tobacco, casinos, pornography etc. that are Islamically unacceptable (Beck, Demirgüç-Kunt and Merrouche, 2013). Islamic banks, on the other hand, do not invest in such products despite the fact that they may be lawful in countries in which they operate.

Most conventional banks also mainly try to pursue their own interest over their clients’ interest which in turn doesnot guaranteegrowth with equity. Islamic banks, nevertheless, pay strong attention to their clients’ interest and hence make sure that growth is achieved with equity (Beck, Demirgüç-Kunt and Merrouche, 2013). A further difference is that conventional banks, particularly commercial ones, can easily borrow money from the money market as opposed to Islamic banks because they don’t have to make sure that their borrowing is based on an underlying asset or that it is Shariah-compliant. Islamic banking also tries to maximize profits based on the principles of Shariah which heavily regulates its entire economic and financial system, while conventional banking tries to do the same without having to follow any such rules, and can easily take part in numerous trading transactions such as the heavily unregulated derivatives market. Conventional banks also tend to focus more on the credit worthinessof their clients whereas Islamic banks pay greater attention to the feasibility and profitability of the projects.In Islamic banking, a client’s credit worthiness falls under the category of profitability, in addition to other things.

Therefore, Islamic banking principles are strongly based on moral and ethical values derived from the sharia and focus on forming a relationship with clients that involves treating them as partners, investors, traders, buyers and sellers. Consequently, the Islamic banking system is based on the principle of justice and equity whereby the output of a project is fairly distributed between the two parties (AIMS).

2.4 History and Development of Islamic Finance in the UK

Despite having a long history, Islamic Finance has had the most significant global developments over the last 30 years whereby the industry has grown rapidly, accounting for more than $1.1 trillion in assets, 716 Islamic financial institutions over 61 countries generating a profit over $13.1 billion profit from transactions involving real assets, and by avoiding excessive credit (UKTI, 2014).

Islamic finance came to the UK in the 1980s with commodity based Muarabaha transactions and the launch of Al Barakara International, Britain’s first Islamic bank in 1982 (Alharbi, 2015). These early developments can be largely attributed to predominantly cater to the investment needs of a growing and wealthy client base from the Middle East in the 1980s that was looking for customised Shariah-compliant financial products for leasing purposes, and project and trade financing (Alharbi, 2015; (Hussain, 2014)). This helped the industry gain further traction and led the UK to provide political and regulatory support and in 2000 the Islamic finance working group was formed. Headed by former chairman of Barclay’s Bank, Andrew Buxton and Eddie George of the Bank of England, the group comprised of representatives from the Treasury, FSA financial institutions, the Council of Mortgage Lenders and members of the Muslim community (UKTI, 2014).

Since then the UK government and regulators have constantly worked to draft and establish Alternative Finance clauses and other similar bills to allow for a fair and similar treatment of Islamic Banks and their clients as their conventional counterparties (Hussain, 2014). As a result of these efforts, the Industry has slowly developed over the years to offer a wide variety of financial services as an alternative to conventional financing services. This rapid growth has, therefore, led the UK to become the 9^th largest country by Shariah-complaint assets. There are now more than 20 institutions in the country offer Islamic finance and 6 full-fledged Shariah-compliant banks. Additionally, there are several Shariah compliant institutions listed on the AIM and LSE (Khan and Bhatti, 2008).

A further key reason why Islamic financial institutions are attracted to the UK is due to its outstanding reputation of fund management as approximately £5.1 trillion assets are currently under management in the UK with around nine fund managers that provide Islamic asset management services. Other reasons include the UK’s strong regulatory framework, supportive government policies and a preeminent reputation pushing for financial innovation (Hussain, 2014). In addition to positioning itself as a vibrant, multicultural and tolerant society, the UK has also manged to establish itself as a world leader in providing Islamic Banking and finance education at several institutions and universities in recent years thereby paving the way for the UK to become a frontrunner in this industry outside the Muslim world (Hussain, 2014).

Development of Islamic Financial Institutions and Regulatory policies associated Islamic Finance and mortgages in the UK

Timeline

1982

Establishment of Al Baraka International Bank to accommodate the needs of a growing number of Muslim clients from the Middle East

1996

United Bank of Kuwait

• Islamic Mortgages

2001

Creation of the Islamic Finance working group by the Bank of England. The group was headed by Eddie George to study barriers faced by Islamic financial institutions in the UK and ways to foster their development

2003

• HSBC Amanah

• Treasury and Investment services
• Private Banking
• Formation of HM Treasury and Revenue and Customs Tax Technical group to investigate the nature of Islamic Banking and Finance in detail the technical concerns associated with it.
• Finance ACT-Stamp Duty Land Tax altered to eliminate double stamp duty on alternative property financing arrangements such as Islamic mortgages. A double charge could have otherwise occurred when a financial institution buys property for resale to individuals.

2004

Islamic Bank of Britain

• First Islamic Retail Bank

2005

• European Islamic Investment Bank Plc
  • First wholesale Islamic Investment Bank in the UK

• Lloyds TSB
  • Current Account

• Bank of London and he Middle East
  • Wholesale Islamic Investment Bank

• QIB UK (European Finance House)
  • Wholesale Islamic investment bank

• Government. legislated for Murabaha instruments as a purchase and resale arrangement

2006

• Authorization by the UK government of financing arrangements involving diminishing or shared ownership for property or assets also known as diminished Musharaka.

2007

• Establishment of HM Treasury Islamic Finance Experts’ Group to foster and direct government effort for supporting development of Islamic finance in the UK. The Group panel comprised of people from the Government, Muslim community and legal and advisory firms.
• FSA regulation of Home Purchase Plans.

2011

• Establishment of UK Islamic Finance Secretariat, a multi-sector body involved in the promotion and development of Islamic Banking and finance in the UK.

2013

• Establishment of Islamic Finance Task Force, a ministerial led task force with the purpose of promoting the UK as a central hub for Islamic finance and to attract inbound investments.
• Abu Dhabi Islamic Bank (ADIB)
  • Representative Office

(Source: UKTI, 2014)

Key Banking and Financial Service Providers in the UK

Below are some key banks and financial service providers in the UK that offer Islamic financing products:

There are about 20 international banks in the UK that offer Islamic financial products and services out of which 6 are full-fledged sharia compliant, more than any other country in Europe.

ABC International Bank plc Islamic financial services

Headquartered in Bahrain with a subsidiary in London, this bank has a long and successful history of Islamic banking in both countries. In London, its core service include providing sharia-compliant banking services to UK and European customers such as corporate and trade financing (ABC Annual Report, 2016). It is also among a growing number of banks exploiting financing niche opportunities that cater to the funding requirements of the real estate sector in the UK according to the Islamic principles (Alharbi, 2015, ABC Annual Report, 2016). In 2016, ABC carried out Islamic financial transactions in excess of $700 million including real estate projects. One of its most notable projects was the South Bank Tower formerly known as the King’s Reach Tower (UKTI, 2014).

Citi

A frontrunner in international Islamic Banking. Citi established its global Islamic banking in London in 1981. Since then it has successfully arranged and carried out billions of dollars’ worth of Islamic transactions including project financing and Islamic investment products (UKTI, 2014).

Al Rayan Bank (formerly Islamic Bank of Britain)

Established in 2014 to provide full-fledged Sharia-compliant retail financing products to, IBB is considered a leading institution for the British Islamic finance industry.  With around 120 employees serving 50,000 customers, it currently offers the widest range of Sharia compliant financial products in the UK (Alrayanbank.co.uk, 2017).

Abu Dhabi Islamic Bank (ADIB)

Established in 1997 and headquartered in Abu Dhabi, the bank carries out all its transactions based on Islamic Law to offer financial solutions. ADIB set up operations in London in 2013 to offer a wide range of services to businesses and individuals in the UK and particularly high-profile profile clients from the UAE with investment interest and stakes, seeking Islamic financing services (Davies, 2012). The bank offers a wide variety of services including savings accounts and real estate financing and property management assistance services (Alharbi, 2015).

Islamic Mortgages

https://www.theguardian.com/money/2008/jun/29/mortgages.islam

 

Although there are no direct laws regarding mortgages in the Quran, the concept of Shariah-compliant mortgages are based on the divine laws concerning trade and rent.  In other words, the rules about Islamic mortgages are derived from general Quranic principles regarding trade contracts. One of the reasons why Muslims prefer Islamic mortgages to conventional mortgages is because the latter are based on interest- an excess payment by the borrower to the lender with no connection to the value of the asset that the loan is for. Conventional mortgages are, hence, prohibited in Islam because the lender gets a guaranteed return at the expense of the borrower, irrespective of any consideration for the original purchase price of the home.

 

To reiterate, Islam does not oppose the generation of wealth but enforces that it must be made through partnerships, the sharing of profit and loss, and justice. Therefore, many Islamic banks around the world have established models of Islamic mortgages based on these principles. In addition to Muslim clients, these mortgages are also available to non-Muslim customers. However,they are more popular with Muslims because it gives them an alternative option to interest-bearing conventional mortgages that are in accordance with the Islamic doctrine.

Most full-fledged Islamic banks, and conventional banks engaged in partial shariah-compliant operations offer mortgages that usually fall under the categories of Diminishing Mushrakah, Murabaha and  Ijara Wa Iqtina (Hussain, 2011).

Diminishing Mushrakah (Diminishing Partnership)

This mode of mortgage financing is based on the concept of sharing the desired ownership of the house or property. In a Diminishing Mushrakah mortgage contract, the borrower and the bank buy the desired house of the borrower’s choice whereby each party makes a contribution to buy the house. This entitles both with a share in the house. However in the mushrakha the borrower must also enter a ‘promise to buy’ contract which obligates him to purchase the bank’s share in the house through deferred payments over a specified period of time.

Throughout the tenor of the contract, the borrower has the right to reside in the house by paying rent to the bank. When the contract finishes, the borrower acquires full ownership of the house. This contract is, however, mostly available for purchase of finished or existing homes or properties and not those that are under construction or property on leased land. Depending on the contract, the borrower might be asked to contribute a certain percentage of the total price of the house at the beginning, with the bank paying the remaining amount.

This initial contribution by both parties specifies the ownership proportion that the bank and the borrower have at the beginning of the contract. In a Mushrakah contract, the property is purchased in the borrower’s name who is also responsible for looking after the house while the bank maintains its ownership until its original contribution is purchased by the borrower.

Ijara Wa Iqtina Structure (lease to own concept)

In this mode of financing, the client who wishes to buy a property first negotiates the price of the property with the seller, and then approaches the bank that then purchases the property. This property is then transferred to the bank’s full ownership and registered under its name after which it is leased out to the borrower based on a certain lease contract that specifies the time period. Along with this, the customer also enters a ‘promise to buy contract’ obligating him to purchase the property from the bank at the original amount the property was bought for. The client then pays the bank a periodic lease payment after which the property is eventually sold to the client at the original price.This payment is spread over an agreed period of time, during which, the customer also pays the financier a rent for using the property. Once the agreed period of time has elapsed, ownership of the property is transferred to the customer. This contract can last up to several years. In this contract, payments are reviewed periodically and change according to interest rates.

Murabaha Structure

In this contract, the customer approaches the bank with a request to buy a desired property for which he also negotiates the price with the seller. The bank then buys this property from the seller and resells it to the borrower at a mark-up profit that can be repaid in deferred payments. This is done instead of the bank lending money to the buyer to buy the house. In this contract the property is registered under the banks names from the start of the transaction.This acts as a collateral against a possible default by the borrower. A Murabaha contract does not allow the bank to force the borrower to pay a penalty if a late payment is made. Some Murabaha contracts require the client to pay an immediate deposit to the bank while the remaining amount can be paid in fixed instalments over the life of the contract.

General Characteristics of Conventional mortgages

A mortgage loan is a secured loan on property by a lender.  The property in a mortgage contract serves as collateral for the money that has been loaned. It is important to keep in mind that a mortgage is actually a security for the debt and not a debt in and of itself. Mortgage contracts are typically long term and require that the title of the house be registered in lender’s name instead of the borrowers (Bhutta, Ringo and Kelliher, 2016); Jung, 1962).However when the borrower meets his obligations to the contract, the title is then transferred to his name. A mortgage contract ends when the borrower satisfies all the terms of the contract or when the property is taken for foreclosure (Chinloy, 1995).

Most mortgages are taken by people who are interested in buying property or building a house. The general characteristics of a mortgage loan includes, among other things, a loan amount, the duration of the loan, an interest rate (charged on the loan), the way the loan is to be returned overtime, etc. (Bhutta, Ringo and Kelliher, 2016; Jung, 1962). These features can differ from contract to contract. The reason why mortgages are so popular is because not everyone has enough cash on hand to buy a house. The interest rate on a mortgage represents the risk taken by the lender (Chinloy, 1995. This form of funding is popular for purchasing both residential and commercial properties in many parts of the world. Other basic elements of a mortgage contract include a physical property, a borrower who wants to buy the house, a lender (usually a bank or financial institution), and the mortgage which is basically a collateral for the person lending the money (Jung, 1962, Chinloy, 1995). Most banks usually ask borrowers to make a down payment on the mortgage. This down payment represents a part of the cost of the property (Jung, 1962).

Mortgage contracts can also have certain conditions concerning the use or sale of the property, the principle amount (the actual amount loaned out to buy the property), an interest amount, and foreclosure or repossession which allows the lender to foreclose or take back the property. In many countries, mortgages are monitored and controlled by governments who establish and regulate legal requirements, control parties involved in a mortgage by regulating the banks in their country, etc. These regulations usually differ from country to country depending on the legal, financial, and regional conditions (Chinloy, 1995).

The timely repayments are estimated according to certain formulas and usually entail a periodic payment for the duration of the loan. This amount and the number of times it needs to be paid can also be subject to changes depending on the borrower who can increase or decrease this amount as well (Bhutta, Ringo and Kelliher, 2016). Lender institutions such as banks usually offer mortgage products in order to earn interest. Because they finance these loans by borrowing from sources such as deposits, the cost of borrowing on the mortgage is determined by the cost of borrowing for the banks ((Bhutta, Ringo and Kelliher, 2016; Giliberto and Thibodeau, 1989). Mortgage lenders also carry out a thorough background check and credit worthiness of the borrower, and if the borrower is unable to repay the loan, the bank can take back the house or foreclose it in order to acquire the original loaned amount. Also, some mortgages may prevent the borrower from prepaying the entire loan and in most instances require the borrower to pay a penalty if the loan is repaid earlier (Bhutta, Ringo and Kelliher, 2016).

Mortgages can generally be fixed rate, variable rate, or a combination of both; fixed for a while and then variable after that. In a fixed rate mortgage, the interest rate remains fixed for the period of the loan so the borrower pays a predetermined periodic payment which also includes the principal payment (Uberti, Landini and Casellina, 2014). In a variable rate mortgage, the interest is fixed for a while and then becomes variable according to some kind of market index (Uberti, Landini and Casellina, 2014; Bhutta, Ringo and Kelliher, 2016). The cost of borrowing to the borrower in a mortgage contract is also based on his credit risk as well as other factors such as interest rate risk (Uberti, Landini and Casellina, 2014).