Islamic Finance and Mortages in the UK

Chapter 1: Introduction

Around two million people in the UK are hesitating to get a mortgage from conventional banks or building societies because of religious obligations. Most of them are Muslims and like to obey the rules of Islam. Conventional banking systems offer the customers to pay interest against their loan or mortgage. According to Islam interest is called “riba”, which is forbidden by the rules of the Holy Quran. So how can the Muslims buy a home or get a loan where they cannot pay the interest. Most of Muslims are confused from where they can borrow money. Go with the conventional banks or newly established Islamic banks, who are not so much experienced in the UK mortgage market.

According to Usmani (2005) the main drawback in interest based system is financier has no concern with money when he gives an interest bearing loan to a client. But in Islamic financial contract cash money is not given to client, first of all they purchase the commodity and transfer to client then all profit and loss will be distributed between parties according to agreed terms and conditions (Usmani, 2005). As the Islamic Sharia is not permitting to pay or receive any interest from conventional nor even from any person or agency, so especially any Muslim is not allowed to use conventional mortgage for religious faith. It is experienced that home or property purchase is too expensive by using the cash on hand. To solve this problem the financial organisation or the bank buy the property or house with their name act as a landlord and the client pay the rent plus some money for the contribution for the property. When the term finished predetermined by the lender and the client the property is transferred to the client that means the client absolutely buy the property.

According to Harding (2009) the Sharia serves mostly as a guide to personal conduct, though some rules are drafted into the legal codes of majority-Muslim states. It’s founded, we’re always told, on revealed truth from the Qur’an and exemplary stories from the Hadith, the sayings and doings of the Prophet. But the real influence of the Sharia lies in the way this material is constantly read and recast by modern Islamic scholars, reinventing old traditions or asserting new ones. Whatever they take it to be, growing numbers of Muslims are keen to stay on the path when it comes to banking and finance. The global Muslim population is upwards of 1.3 billion – roughly one in every five people on earth – and, with a religious revival of twenty or thirty years’ standing, the way of Islam is now a crowded thoroughfare. It is plied by a great diversity of travellers from different parts of the world; some have money to burn, others next to none, but anybody with a modicum of wealth is nowadays a potential opportunity for banks offering Sharia-compliant retail services: current accounts, straightforward financing schemes and home-ownership plans (Harding, 2008). In some countries in the World like Iran, Pakistan and Sudan all banks are currently operating through Islamic financial law but other Muslim major countries like Indonesia, Bangladesh, Malaysia, GCC countries and North African countries operating both conventional and non-conventional banks. Islamic banking services run by Islamic bank and some conventional banks. In the UK some high street banks like HSBC Amanah, Bank of London and the Middle East (BLME) are the main two conventional banks that offer Islamic banking to the customers from all background.

According to UN-HABITAT (2005) Islamic financial systems are located within the larger context of Islamic religious, ethical and economic systems. Islamic finance has seen annual growth rates of over 15% and the Islamic capital invested in global financial institutions is currently estimated at US$1.3 trillion. A key growth area is in the provision of Islamic mortgages, both within the Arab world and in Europe and North America (UN-HABITAT, 2005). Over the last few years some of the UK conventional high street banks like Lloyds TSB, HSBC have introduced Islamic products in several of their branches. In the year 2005 Lloyds TSB bank plc introduced Islamic products to some of its branches. A panel of Islamic scholars look after and guide the bank according to Sharia i.e. the Islamic rules for the Islamic products offered by the bank. Another high street bank HSBC has introduced Islamic products on the brand name Amanah. These two conventional banks are offering wide range of services with different windows on the basis of the Islam, like home insurance, mortgage, current accounts, pension etc.

The Islamic Bank of Britain is the first Islamic bank in the UK started its operation in the year 2004 which welcomes Muslim and non-Muslims alike as customers. It is operating with a few branches mainly in London, Birmingham, Leicester and Manchester where Muslim people are majority. All of their financial products are approved by a committee of Islamic scholar, called the Sharia Supervisory Committee. All of the committee members are expert of the Islamic rules and finance as well. They introduced the banking system, mortgage and other related products as Halal, which may be accepted by the Muslim and non-Muslim customers.

The Prime Minister of the UK Gordon Brown has pledged support for the growth of Islamic finance (BBC news, 13 June 2006). The UK is acting as “a gateway” for the growing industry. In another report of BBC news (17 October 2008) in the midst of turmoil in the global financial system, there is one branch of finance that aims to operate within strict moral and ethical boundaries – Islamic finance. One expert on Islamic finance, Durham University professor Rodney Wilson, points out that no Islamic financial institution has yet failed in the current crisis. He contrasts “excessive risk-taking” in the mainstream financial sector with “a fairly classical banking model” still followed by Islamic institutions (BBC news, 17 October 2008).

According to FSA (2007) The Islamic financial market as well as the Islamic mortgage market has become exceptionally complicated as well as increasingly competitive. Today, practically most of the financial institutions in the western countries are attracting the customers through Islamic finance whether by Islamic Sharia complaint, “Islamic windows” or some other Islamic financial product, like the Islamic mortgage marketing. Most of the expansion of Islamic finance in the UK has taken place in the last five years, but the continuation of Sharia-compliant transactions in the London financial markets goes back to the 1980s (FSA, 2007). .

Aim

The aim of this paper is to provide a thorough outline of the main principles of Islamic finance and practice of Islamic Finance especially in the field of home finance in the UK. The paper emphasises the core principle of Islamic finance i.e. Sharia and Sharia complaint practices in the field of Islamic mortgage market, providing an insight view to understand and find out the effectiveness throughout the Muslim population as well as non-Muslim communities in the UK. By the end of the paper the readers should have a greater appreciation of the various types of ways to find the right mortgage products to be within the Sharia complaint environment as well as get an understanding of the effectiveness with .these kind of products. Through a mixture of different types of graphical presentations of some factors involving in the Islamic financial environment, the UK government policies, difference and comparison between the Islamic mortgage and the conventional mortgage, some examples of different types Islamic halal financial products effective in other developing countries in the world will be presented to get an overview the wide range of factors involved in evaluating and analysing the Islamic mortgage market.

Objectives

• Understand the core principles of Islamic finance
• Relate the principles to the Islamic mortgage
• The key features of Islamic mortgage
• Different types of Islamic contract relating to mortgage
• Analyse Islamic mortgage prospect in UK from the various point of views

Dissertation formation

Chapter 1

– Introduction of the objectives & subjects and discuss limitations.

Chapter 2

– Literature review: This chapter will consist of the academic review of the literature on Islamic finance, types of contracts involved in Islamic mortgage and overall review of Islamic mortgage market in the UK.

Chapter 3

– Research Methodology: This chapter will outline the research methodology adopted as well as its possible ways of application by the primary and the secondary data collection.

Chapter 4

– Data and Analysis: In this important chapter various data will be presented through table, chart and different opinions and findings derived from primary research and secondary research to examine the effectiveness of Islamic mortgage market in the UK.

Chapter 5

– Conclusion: This chapter will present the overall conclusion of the study.

Chapter 6

– Recommendation: This chapter will make recommendations, some of which will be general while others will be specific to what will need to be done in the future by the Islamic financial institutions in the UK.

Chapter 2: Literature Review

2.1 Background of Islamic Finance

The Organization of Islamic Conference (OIC) expressed “Islamic financial institution as a financial institution whose statutes, rules and procedures expressly state its commitment to the Principles of Islamic Sharia and to the banning of the receipt and payment of interest on any of its operations” (Hassan, 1999, p.60). Sharia is the path or lifestyle of Muslim, shown and cited in the Holy Qur’an, the sayings and conduct of the prophet Mohammed (PBUH), and the ruling of Islamic scholars.

2.2 Principle of Islamic Finance

McKenzie (2009) stated that “the underlying financial principles in Islamic finance have remained unchanged historically since their development over 1,400 years ago. Financial products must be certified as Sharia compliant by an expert in Islamic law. Certification requires that the transaction adheres to a number of key principles that include:

– Backing by a tangible asset, so as to avoid ‘speculation’ (gharar).

– Prohibition of interest payments (riba).

– Risk to be shared amongst participants.

– Limitations on sale of financial assets and their use as collateral.

– Prohibition of finance for activities deemed incompatible with Sharia law (haram), such as alcohol, conventional financial services, gambling and tobacco.” (McKenzie, 2009)

2.2.1 Riba (Interest)

“The interest that you give in order to increase the wealth of the people, does not increase in the sight of Allah; and the Zakat that you pay in order to win Allah’s approval, its payers do indeed increase their wealth” (Surah Al-Rome no. 39 cited in Shafi and Usmani, 1997, p.67).

2.2.1.1 Prohibition of Riba (Interest)

“The word riba literally means ‘increase’, ‘addition’, ‘expansion’ or ‘growth’” ( Sulaiman, 2003). According to Institute of Islamic Banking and Insurance website (2010) Riba means increase or addition and commonly understood as “interest” charged or received on lending though the legal definition goes beyond just interest.It is one of the three fundamental prohibitions in Islamic finance, the other two being gharar and maysir. . Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. In simple terms Riba covers any return on money on money, whether the interest rate is fixed, floating, simple or compounded and at whatever rate which is guaranteed irrespective of the performance of the investment, is considered riba and is so prohibited. Riba, in all forms, is strictly prohibited in Islamic tradition as it is considered an unjust return that leads to unjust enrichment (Institute of Islamic Banking and Insurance website, 2010)

According to Usmani (2005) “exclusion of interest from financial activities does not necessarily mean that the financier cannot earn a profit. If financing is meant for a commercial purpose, it can be based on concept of profit and loss sharing, for which musharakah and mudarabah have been designed since the very inception of Islamic commercial law” (Usmani, 2005, p.10). According to Chapra (1986) it is however, not every increase or growth which has been prohibited by Islam. In the Shariah, riba technically refers to the “premium” that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity. In this sense, riba has the same meaning and import as interest in accordance with the consensus of all the fuqaha (jurists) without any exception (Chapra, 1986).

2.2.2 Gharar

“The Arabic word gharar means risk, uncertainty, and hazard” (Obaidullah, 2005).

According to Institute of Islamic Banking and Insurance website (2010) Gharar is one of the three fundamental prohibitions in Islamic finance, the other two are riba and maysir. Gharar means uncertainty, hazard, chance or risk. Technically Gharar can explained by the Institute of Banking and Insurance, “sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does not know whether it will come to be or not, such as fish in water or a bird in the air. It is an exchange in which one or more parties stand to be deceived through ignorance of an essential element of the exchange. Thus it refers to an element of absolute or excessive uncertainty in any business or contract (Institute of Islamic Banking and Insurance website 2010).

Makhlouf (2000) described “there are several types of gharar , all of which are disallowed (haram). The following are some examples:

– Selling goods where the seller is unable to deliver,
– Selling known or unknown goods against an unknown price, such as selling the contents of a sealed box, in absence of any concept of its contents or value in the buyer’s mind,
– Selling goods without proper description, such as shop owner selling clothes with unspecified sizes, without providing the buyer the option to inspect the goods,
– Making a contract conditional on an unknown event, such as when my friend arrives if the time is not specified,
– Selling goods on the basis of false description,
– Selling goods without allowing the buyer the properly examine the goods” (Makhlouf, 2000).

Institute of Islamic Banking and Insurance website (2010) describes gharar as “Deception through ignorance by one or more parties to a contract. Gambling is a form of gharar because the gambler is ignorant of the result of the gamble. Gharar can occur in several ways, all of which are haram (Institute of Islamic Banking and Insurance website, 2010).

2.2.3 Maysir

According to Institute of Islamic Banking and Insurance website (2010) “Maysir is one of three fundamental prohibitions in Islamic finance. Maysir is explained as Games of chance or gambling, trying to earn easy money without having to provide equivalent consideration. A prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth. The prohibition on Maysir is often used as the grounds for criticism of conventional financial practices such as speculation, conventional insurance and derivatives” (Institute of Islamic Banking and Insurance website, 2010). The Qur’an states that are translated in English, “intoxication, games of chance, worship of idols, and divination by arrows are but an abomination, Satan’s hand I work; avoid it then, so that you might prosper! By means of intoxicants and games of chance Satan wants only to sow enmity and hatred among you, and hinder you from the remembrance of God and from prayer […]” (The Qur’an 5:90-91 cited Rohmatunnisa, 2008). Schoon (2007) explained “Maysir(or speculation) is an event in which there is a possibility of total loss to one party. Maysir has elements of gharar, but not every gharar is maysir” (Schoon, 2007)).

2.3 Types of Islamic Contracts

2.3.1 Mudarabah (finance by way of trust)

Institute of Islamic Banking and Insurance website (2010) An investment partnership with profit-loss-sharing implications. One or more partners as investors (Rab al Mal) provide 100% the capital to an entrepreneur (the partner who provides entrepreneurship and management known as Mudarib) to undertake a business activity. Profit is shared between the partners on a pre-agreed ratio, any loss is borne only by the investing partner(s) alone. For the Mudarib the loss is the share of the expected income for the efforts put into the business activity. The investors have no right to interfere in the management of the business but can specify conditions that would ensure better management of the capital money. In this way Mudarabah is sometimes referred to as a sleeping partnership. As a financing mode, an Islamic bank can provide capital to a customer for a business activity. The customer provides the expertise, labor and management; profits are shared between the bank and the customer according to predetermined ratio while financial losses are borne by the bank and the bank risks losing the capital invested with the customer which justifies the bank’s claim to a share of the business profit. Islamic banks also apply the concept of Mudarabah to pay a return on customer deposits held in investment account. The Bank becomes wholly responsible and liable in the management and investment the customer deposits and utliises the funds as business capital by the bank, the bank will have the right to manage the funds as it thinks fit in permissible activities that it considers are profitable and share the profit on the basis of the agreement made between the bank and the customer (Institute of Islamic Banking and Insurance website, 2010)

According to Siddiqui (n.d) In this mode, the bank, at the request of its client, purchases the specified goods from a third party against payment. Immediately on the transfer of ownership of the goods as also obtaining its physical or, in most cases, the constructive possession, the bank sells these goods to the client at cost plus an agreed fixed profit margin. The client then takes physical possession of the goods and undertakes to pay the price to the bank either in instalments or in lump sum, at an agreed later date. The instances are not lacking where customers of the bank and the seller of the goods are sister concerns. In yet many other cases, the customers of the bank purchase the commodities themselves as agents of the bank and then they repurchase the same commodity from the bank for a cost plus profit to be paid at a mutually agreed later date. In many cases of Murabaha, there is therefore, only a change of name (Siddiqui, n.d).

2.3.2 Musharaka (finance by way of partnership)

According to Institute of Islamic Banking and Insurance website (2010) The literal meaning of Musharakah is sharing, an investment partnership with profit-loss-sharing implications. All the partners contribute capital towards the financing to undertake a business activity. The partners share profits on a pre-agreed ratio while losses are shared according to each partner’s capital contribution. The business activity may be managed by all, some, or just one of the partners. Musharakah allows Islamic banks to provide financing for purchase of an asset required by a customer; the bank invests capital in the co-ownership in the asset with the customer, instead of providing interest-bearing loans. The bank will achieve a return on its capital contribution in the form of ashare of the actual profits earned, according to a ratio agreed in advance. However, unlike atraditional creditor, the bank will alsoshare inany losses. Musharakah is often used by Islamic banks for financing large projects. The concept is distinct from fixed-income investing. A contract of partnership in which two or more partners provide capital and share profits or losses as the case may be. An investment partnership with profit-and-loss sharing. A musharakah contract is similar to a mudarabah contract, the difference being that in a musharakah all the partners contribute to the capital and share in both the profit and the loss. They also have the right, but not the obligation to participate in the management. All partners have a right to participate in the management of the project. However, the partners also have a rig ht to waive the right of participation in favour of any specific partner or person. Profit is shared as per-agreed ratio while the loss is shared in proportion to the capital contributed (money invested by each partner. The term also refers to a financing technique adopted by Islamic banks instead of lending on interest. It is an agreement under which the Islamic bank provides funds which are mingled with the funds of the client and both are entitled to share in the resulting profit on a pre-agreed ratio and share the loss in accordance with their capital contributions. Also termed as a joint venture. Two forms of Musharakah are: Permanent Musharakah and Diminishing Musharakah (Institute of Islamic Banking and Insurance website, 2010).

Saeed (1996) distinguishes three types of Musharaka: the commercial Musharaka, decreasing participation and permanent participation. In a “commercial Musharaka”, which is the most common form, the purpose of the transaction can be the purchase of plant, manufacturing equipment or commodities. Here, the transaction is fixed in its duration and capital provision is mostly short-term. Consequently, the liquidation of the project occurs quickly and capital turnover and returns are usually high. The second type of Musharaka, a Musharaka with “decreasing participation”, is mainly used for project financing in the industrial and agricultural sector and serves to transfer full ownership of the assets in the long-run to the business invested in. The bank’s invested capital is repaid in instalments and the bank receives a proportion of the project’s cash flows for a specified period of time. Profit-sharing can be exercised in three different manners: the bank can either receive its share of the profit on a regular basis (which is sometimes associated with prohibited Riba) and reacquire its capital out of the remaining profits of the partner, or the partner annually buys back a part of the bank’s share in the business including profits, or the partner repurchases the bank ‘s share in bulk after the termination of the Musharaka contract. All three forms are practiced by Islamic banks. Finally, in a “permanent participation Musharaka”, the bank actively contributes to the management of the business financed and shares in the profits and losses until the end of the Musharaka contract (Saeed, 1996 cited Rohmatunnisa, 2008).

2.3.3 Murabahah (cost-plus financing)

According to Institute of Islamic Banking and Insurance website (2010).

“Cost-plus financing – a contract sale between the financier or bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties. As a financing technique, it involves the financier or bank purchasing goods required by the client. The goods are then sold to the client with a mark-up. Repayment, usually in instalments is specified in the contract. Some have questioned the legality of this financing technique with mark-up on cost because of its similarity to riba or interest. Mark up or Cost plus financing. The word Murabaha is derived from the Arabic word Ribh that means profit. Originally, Murabaha was a contract of sale in which a commodity is sold onward at profit. The seller is obliged to tell the buyer the original cost price and the profit mark-up. This contract has been modified a little for application in the financial sector. In its modern form Murabaha has become the single most popular technique of financing amongst the Islamic banks all over the world. The Murabaha mode of finance operates in the following way: The client approaches an Islamic bank to get finance in order to purchase a specific commodity. An interest-based bank would lend the money on interest to this client. The client would go and buy the required commodity from the market. This option is not available to the Islamic bank, as it does not operate on the basis of interest. It cannot lend the money on interest. It cannot lend money with zero interest rate, as it has to make some profit to be in the business. The bank purchases the commodity on cash and sells it to the client on an agreed profit mark-up. The client buy the commodity from the bank on deferred payment basis. Thus, the client gets the commodity on credit for which financing would have been required and the Islamic bank makes some profit on the amount it has spent in acquiring the commodity and selling it on to the client(Institute of Islamic Banking and Insurance website, 2010).

Anotherway Murabahah was described by Bakhshi (2006) is the most popular form of Islamic financing. Within a murabahah contract, the bank agrees to buy an asset or goods from a third party at the request of its client, and then resell the goods to its client with a mark-up profit. The client purchases the goods either against immediate payment or for a deferred payment. This technique is sometimes considered akin to conventional interest-based finance. However, in theory, the mark-up profit is quite different. The mark-up is for the services the bank provides – seeking and purchasing the required goods at the best price. Furthermore, the mark-up is not related to time because, if the client fails to pay a deferred payment on time, the mark-up does not increase due to delay and remains as pre-agreed. Most importantly, the bank owns the goods between the two sales and so assumes the title and the risk of the purchased goods, pending their resale to the client. This risk involves all risks normally contained in trading activities, in addition to the risk of not making the mark-up profit, or if the client does not purchase the goods from the bank and whether they have a justifiable excuse for refusing to do so (Hourani cited Bakhshi, 2006)

2.3.4 Ijara (leasing)

According to Institute of Islamic Banking and Insurance website (2010)Lit: letting on lease. Technically, sale of a definite usufruct in exchange for a definite reward. Commonly used for wages, it also refers to a contract of land lease at a fixed rent payable in cash. It is contrary to “Muzarah” when rent is fixed as a certain percentage of the produce of land banks. It is an arrangement under which an Islamic bank leases equipment, a building or other facility to a client against an agreed rental. The rental is so fixed that the bank gets back its original investment plus a profit on it.

Lit: letting on lease or simply, leasing. Technically, sale of a definite usufruct in exchange for a definite reward. Used for hire of services for wages and also refers to a lease of an asset at a fixed rent payable. As in a normal lease transaction, a lessor who owns the leased asset will lease it to another party (the lessee) in exchange for payment of rental. The lessee will get the full benefit of using the lease asset within the specified period for as long as he adheres to the lease terms and conditions. At the end of the lease period, the leased asset will be returned to the lessor.There are some other variants of leasing which incorporate the transfer or option to transfer ownership of the leased asset from the lessor to the lessee at the end of the lease period; these are referred to as;

Ijarah Thumma Bai – Lease Agreement Incorporating sale of leased asset at the end of the lease period.

Ijarah Muntahiya Bil Tamleek – Lease Agreement with option to own the leased asset at the end of the lease period.

Ijarah Wa Iqtina – Lease Agreement with option to acquire the leased asset at the end of the lease period. Often used in the context of home purchasing

Ijarah wa Iqtina extends the concept of Ijarah to a hire and purchase agreement. It is a contract under which the Islamic bank finances equipment and machinery, building or other facilities for the customer against an agreed rental together with a unilateral undertaking by the bank or the customer that at the end of the lease period, the bank’s ownership in the leased asset would be transferred to the customer. The rental is so fixed that the bank recovers its investment plus a profit. Ijarah wa Iqtina extends the concept of Ijarah to a hire and purchase agreement. It is a contract under which the Islamic bank finances equipment and machinery, building or other facilities for the customer against an agreed rental together with a unilateral undertaking by the bank or the customer that at the end of the lease period, the bank’s ownership in the leased asset would be transferred to the customer. The rental is so fixed that the bank recovers its investment plus a profit. Ijarah wa Iqtina extends the concept of Ijarah to a hire and purchase agreement. It is a contract under which the Islamic bank finances equipment and machinery, building or other facilities for the customer against an agreed rental together with a unilateral undertaking by the bank or the customer that at the end of the lease period, the bank’s ownership in the leased asset would be transferred to the customer. The rental is so fixed that the bank recovers its investment plus a profit. Ijarah wa Iqtina extends the concept of Ijarah to a hire and purchase agreement. It is a contract under which the Islamic bank finances equipment and machinery, building or other facilities for the customer against an agreed rental together with a unilateral undertaking by the bank or the customer that at the end of the lease period, the bank’s ownership in the leased asset would be transferred to the customer. The rental is so fixed that the bank recovers its investment plus a profit (Institute of Islamic Banking and Insurance website, 2010)

“A form of leasing contract in which there is a transfer of ownership of service (for use of an asset) for a specified period for an agreed upon lawful consideration. Instead of lending money on interest, Ijarah allows a financial institution to earn profits by charging rentals for the use of the asset. Often used by Islamic banks for financing. Under this scheme of financing an Islamic bank purchases an asset as per specification provided by the client. The period of lease and the lease rental fee are set in advance and may be determined by mutual agreement according to nature of the asset. During the period of the lease, the asset remains in ownership of the bank (as lessor), but the client (as lessee) has the right to use it (Institute of Islamic Banking and Insurance website, 2010)

2.3.5 Salam (advance purchase)

According to Khan (1996) salam is essentially a transaction where two parties agree to carry out a sale/purchase of an underlying asset at a predetermined future date but at a price determined and

fully paid

for today. The seller agrees to deliver the asset in the agreed quantity and quality to the buyer at the predetermined future date. This is similar to a conventional futures contract however, the big difference is that in a Salam sale, the buyer pays the entire amount in

full at the time the contract is initiated

. The contract also stipulates that the payment must be in cash form. The idea behind such a ‘prepayment’ requirement has to do with the fact that the objective in a Ba’i Salam contract is to help needy farmers and small businesses with working capital financing. The buyer in a contract therefore is often an Islamic financial institution. Since there is full prepayment, a Salam sale is clearly beneficial to the seller. As such, the

predetermined price is norma