Review of personal finance — Standard and Islamic

“Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.”― Dave Ramsey

Finance is always of great importance, be it in a business or in one’s everyday life. As it is important to manage risks in business, it is equally important to manage risks in life as well. The Banking & Finance Glossary, published jointly by SBP & IBP, define the Personal Finance as financial arrangements of the individuals or households concerning savings, deposits, installment loans or credit card facilities, lines of credits or overdraft allowed on bank accounts. The management of personal finance based on income profile, earning capacity, age, current expenses and obligations and other relevant factors; retail financial facilities provided to individuals and household by financial institutions. In simple words, Personal Finance is the management of money and financial decisions for a person or family including budgeting, investments, retirement planning. A common scenario at home to sit down with spouse and plan out spending for loan adjustments or children’s school fees. To decide to whether go out for dinner or stay back and save money by cooking at home.

To have a better understanding of Personal Finance in standard or conventional banking system as well as Islamic Banking; let’s have a closer look to both systems.

Component of personal finance

Components of personal finance might include checking and savings accounts, credit cards and consumer loans, investments in the stock market, retirement plans, social security benefits, insurance policies, and income tax management.

• Financial Position: The net worth (i.e. household assets minus household liabilities); and household cash flow (i.e. expected yearly income minus expected yearly expenses).
• Security: Protection of household in event of an emergency; for example death.
• Tax Planning: Lowering tax costs through tax reduction measures.
• Investment: Investing for financial goals; For example it is for a new house.
• Retirement Planning: Planning for future to be financially secure enough, at the time of retirement.
• Estate Planning: Planning for what will happen when you die, and planning for the tax due to the government at that time.

So, the personal finance is knowing how to budget, balance a checkbook, obtain funds for major purchases, save for retirement, plans for taxes, purchase insurance and make investments.

Personal finance planning process

As with any type of planning, Personal Finance management comes down to having a solid plan. All of the above areas of personal finance can be wrapped into formal financial plan. Commonly, these plans are prepared by personal bankers and investment advisors who work with their clients to understand their needs and goals and develop an appropriate course of action

Generally speaking, the main components of the financial planning process are: Assessment, Goals, Plan Development, Execution and Monitoring and Reassessment.

Personal finance span

As shown in the illustration (Figure #1), the main areas of personal finance are income, expenditure, saving, investments and security.

Income: The starting point for personal finance roadmap is income. It is the source of cash in-flow that an individual can use to either spend, save or invest. Common sources of income are: Monthly Salary / Hourly or weekly Wages; Bonus; Pension; and Dividends/Profit on shares.

Expenditure: Expenditure or spending includes all types of expenses an individual incurs related to buying goods or services or anything that is consumable (i.e., not an investment). All spending falls into two categories: cash (paid for with cash on hand) and credit (paid for by borrowing money). The majority of most people’s income is allocated to spending.

Common sources of spending are: Food, Rent, Entertainment, Taxes, Credit Card Payments, Mortgage Loan Re-payments/Adjustments and Travel.

All these expenses reduces the amount of cash an individual has available for saving and/or investing. Good spending habits are vital for good personal finance management. If expenses are greater than income, the individual has a deficit. Managing expenses is just as important as generating income. Typically people have more control over their discretionary expenses than their income.

Saving: Saving refers to the surplus amount between the earnings as income and spending. The difference can be directed towards savings or investments. Managing savings is a critical area of personal finance.

Common forms of savings include: Physical cash, Savings bank account and Money market securities.

Normally people keep at least some savings to manage their cash flow and the short-term difference between their income and expenses. Large amount of savings is not advisable as it earns little or no return compared to investments.

Investment: It is relates to the purchase of assets that are expected to receive back more money than originally invested, over a period of time. However. Investing carries risk, as not all assets actually end up producing a positive rate of return.

Common forms of investing include: Stocks, Bonds, Mutual funds, Real estate, Private companies and Commodities.

Investing is the most complicated area of personal finance. There are vast differences in risk and rewards between different investments. Most people seek advice with this area of their financial plan.

Security: Personal Security refers to a wide range of products that can be used to guard against an unforeseen and adverse event.

Common protection products include: Life insurance, Health insurance and Real state.

This is another area of personal finance where people typically seek professional advice. There is a whole series of analysis that needs to be done to properly assess an individual’s insurance and/or real state planning needs.

Conventional banking system

To have a better understanding of Personal Finance in standard or conventional banking system as well as Islamic Banking; let’s have a closer look to both systems.

Banking system is the most critical constituent of world economy. Banking system,which dates back to 15th century medieval Italy, are now among the most heavily regulated businesses in the world. Banks stand between depositors who supply capital and borrowers who demand capital.

What banks do? The conventional banks takes deposits (money) from customers, raise capital from lenders and then use that money to make loans, invest in securities, provide other financial services to customers, etc. Hence forging a chain of debts. These loans are then used by people and businesses to buy goods or expand business operations, which in turn leads to more deposited funds that make their way to banks. Banks also provide security and convenience to their customers. Consumers are no longer required to keep large amounts of cash. The transactions can be handled with checks, debit cards or credit cards, etc. Every day banks do financial transactions; some conducted with paper currency, but many more done with checks and various types of electronic payments. Proper accounts are credited or debited, in the proper amounts.

Maturity Transformation: Some investors wants to invest on a very short term basis, but some projects require long-term financial commitments. So, the banks borrow short-term, in the form of demand deposits and short-term certificates of deposit, but lend long-term; mortgages. By doing this, banks transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the difference in the rates as profit (Interest).

Banks keep only a small portion of their deposits on hand. When a customer comes into the bank and deposits Rs.1000; conceivably Rs.100 of that will be kept on hand in the form of cash or easily-liquidated securities. The remaining Rs. 900 will be lent out to customers as loans, or used to acquire the stock or bonds of other companies. This phenomenon is known as Fractional Reserve.

So conventionally, banks collect interest on loans and interest payments from the debt securities they own, and pay interest on deposits, short-term borrowings. The difference is known as net interest income.

What is Islamic finance?

Islamic finance is a financial system that operates according to Islamic Law i.e. Shariah. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms and insurance companies, etc. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts.

Although the Islamic finance industry seems quite young, but the Islamic theories of economics have existed since 12th century. The key concepts of Islamic economics presented by Muslim scholars are still relevant today. The political situation slows down the Islamic finance practices for a very long time. But in the 20th century did Muslim scholars and academics seriously begin to revisit these topics. The modern Islamic finance industry started to emerge in 70’s.

Islam allows for a free-market economy where supply and demand are decided by the market and not dictated by government. But at the same time, Islam directs the function of the market mechanism by imposing specific laws and ethics.

A key purpose for imposing these laws and ethics is to promote social justice; Islam and social justice are inseparable. Therefore, social justice is a key concept of the Islamic finance industry.

Islam tries to achieve social justice in the economy in many ways:

• Promoting adherence to Islam
• Requiring Zakat (taxing the property of people who acquire wealth and distributing that tax to people in need)
• Defining the state’s obligations
• Prohibiting usury (interest)
• Encouraging shared risk

Based on the core concepts of Islamic economics, Islamic finance institutions adhere to certain principles that distinguish them from conventional finance:

• Prohibiting interest (riba)
• Steering clear of uncertainty-based transactions (gharar)
• Avoiding gambling (maysir or qimar)
• Avoiding investment in prohibited industries

Shariah prohibits business transactions based on the following:

• Interest: Riba, the Arabic word for interest, means to increase, grow, or multiply into more than what would be due. Riba is prohibited by Islam because it creates societal injustice; in a riba-based transaction, the owner of the wealth gets return without making any effort, and the borrower carries all the risk.
• Uncertainty: The Arabic word gharar means uncertainty or to cheat or delude. Transactions based on gharar are unclear or ambiguous; not everyone involved knows what to expect and can make an informed decision. Gharar exists when two parties enter a contract and one party lacks complete information or when both parties lack control over the underlying transaction.
• Gambling: Two Arabic words — maysir and qimar — refer to transactions that involve gambling. Maysir is the acquisition of wealth by chance instead of by effort. Qimar refers to a game of chance. Both types of transactions are based on uncertainty; no one can know how a gamble will pay off.
• Prohibited products and industries: Islam prohibits products and industries that it considers harmful to society and a threat to social responsibility. Examples include alcohol, pork, prostitution, pornography, tobacco and any products based on uncertainty or gambling.

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Islamic Financial Products Based on Shariah-Compliant Contracts:

In accordance with Islamic law (Shariah), Islamic financial products are based on specific types of contracts. These Shariah-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Shariah-compliant contracts cannot create debt, cannot involve the payment of interest, and must provide for a sharing of risk and responsibility between the involved parties.

To be valid, an Islamic contract must feature subject matter that is lawful, has value for a Muslim, and is specific enough to avoid uncertainties. The service or asset described in the contract generally must exist when the contract is being created, must be owned by the seller (hence prohibiting short sales of stock, for example), and must be deliverable.

The most commonly used contracts in Islamic finance are:

1- Contracts of partnership allow two or more parties to develop wealth by sharing both risk and return:

• Mudaraba: One party gives money to another party, which invests it in a business or economic activity. Both parties share any profit made from the investment (based on a pre-agreed ratio), but only the investor loses money if the investment flops. The fund manager loses the value of the time and effort it dedicated to the investment. (However, the fund manager assumes financial responsibility if the loss results from its negligence).
• Musharaka: This contract creates a joint venture in which both parties provide investment capital, entrepreneurial skills, and labor; both share the profit and/or loss of the activity.\

2- Contracts of exchange are sales contracts that allow for the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money:

• Murabaha: In this cost plus contract, an Islamic financial institution sells a commodity to a buyer for its cost plus the profit margin, and both parties know the cost and the profit in advance. The buyer makes deferred payments.
• Salam: In this forward contract, the buyer (or an Islamic financial institution on behalf of the buyer) pays for goods in full in advance, and the goods are delivered in the future.
• Istisna: This second type of forward sale contract allows an Islamic financial institution to buy a project (on behalf of the buyer) that is under construction and will be completed and delivered on a future date.

3- Contracts of safety and security are often used by Islamic banks; these contracts help individual and business customers keep their funds safe:

• Wadia: A property owner gives property to another party for the purpose of safeguarding. In Islamic banks, current (checking) accounts and savings accounts are based on the wadia contract.
• Hiwala: Debt is transferred from one debtor to another. After the debt is transferred to the second debtor, the first debtor is free from her obligation. This contract is used by Islamic financial institutions to remit money between people.
• Kafala: A third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability. In conventional finance, this situation is called surety or guaranty.
• Rahn: A property is pledged against an obligation. A customer can offer collateral or a pledge via a rahn contract in order to secure a financial liability.

Sukuk in Islamic finance

Sukuk Al Mudaraba (Sukuk based on Equity Partnership)

In simple mudaraba contracts, investors are considered to be silent partners (rab al mal), and the party who utilizes the funds is the working partner (mudarib). The profit from the investment activity is shared between both parties based on an initial agreement.

The same type of contract applies to Sukuk. In a Mudaraba Sukuk, the sukuk holders are the silent partners, who don’t participate in the management of the underlying asset, business, or project. The working partner is the sukuk obligator.

How is Islamic finance different from conventional finance?

Islam is more than a religion; it’s also a code of life that deals with social, economic and political matters. Every Muslim is expected to live according to the Islamic code, or Shariah. Each issue addressed by Shariah is entwined with all other issues; therefore, economic matters are related to religion, culture, ethics and politics.

Islamic finance is a financial system that operates according to Shariah. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic laws and by the finance industry rules and regulations that apply to their conventional counterparts.

The core concept of Islam is that Allah is the owner of all wealth in the world, and humans are merely its trustees. Therefore, humans need to manage wealth according to Allah’s commands, which promote justice and prohibit certain activities. At the same time, Muslims have the right to enjoy whatever wealth they acquire and spend in Shariah-compliant ways; they don’t need to feel shame about being wealthy as long as their behavior aligns with Islam.

A Muslim believes that Islam does not restrict economic activity but instead directs it toward responsible activity that benefits other people, protects the earth, and honors Allah. In other words, Islam allows for a free-market economy where supply and demand are decided in the market — not dictated by a government. But at the same time, Islam directs the function of the mechanism by imposing specific laws and ethics.

A key purpose for imposing these laws and ethics is to promote social justice; Islam and social justice are inseparable, and it’s a key concept of the Islamic finance industry. Islam tries to achieve social justice in the economy in many ways:

• Promoting adherence to Islam: A Muslim is expected to adhere to certain core beliefs and perform certain obligatory acts. By reminding Muslims of their obligations, Islam seeks to promote stronger relationships between each person and Allah, between people and the earth, and among individuals.
• Requiring zakat: To promote justice related to the distribution of wealth, Islam imposes a property tax called zakat. Every Muslim who meets certain criteria regarding the accumulation of wealth must pay zakat, which is distributed to people in need. By taxing the property of people who acquire wealth and distributing that tax to people in need, Islam promotes the socially responsible distribution of wealth.
• Zakat management is part of the Islamic finance field, and zakat calculation is a separate, specialized field of study.
• Defining the state’s obligations: Per Islam, the state is also responsible for ensuring that social justice exists. Islamic scholars argue that the state should collect zakat and guide wealth distribution to make sure that everyone’s basic needs are provided for. Scholars also generally agree that states should protect the real value of money by implementing sound fiscal policy.
• Prohibiting usury (interest): For the sake of social justice, Islam prohibits interest-based transactions. No individual or business entity should hoard money in order to earn interest (or riba); instead, that money should be used to support productive economic activities.
• Encouraging shared risk: Islam encourages risk-sharing in economic transactions. When a risk is shared among two or more parties, the burden of the risk faced by each party is reduced.

Avoiding gambling: Two Arabic words refer to transactions that involve gambling:

• Maysir: The acquisition of wealth by chance and not by effort.
• Qimar: In modern gambling, any game of chance.

Both types of transactions are prohibited because they’re based on uncertainty (gharar).

Istisna is a financial instrument in Islamic finance in which a manufacturer agrees to complete a construction project on a future date for a fixed, agreed-upon price and with product specifications that both parties agree to. If the project doesn’t fit the contract specifications, the buyer has the right to withdraw from it.

This financial instrument provides for payment flexibility between the manufacturer and the buyer. The contract doesn’t demand that the buyer pay in advance or that the manufacturer receive only a lump sum at the time of delivery. Instead, both parties can set a schedule of payment.

Istisna instruments are widely used in the construction industry or for project financing and trade financing.

Minimizing Uncertainty (Gharar) in Istisna

Usually, a contract for a not-yet-manufactured product presents some uncertainty about the product. Islamic law prohibits finance institutions from being part of transactions that involve uncertainty (called gharar). To avoid uncertainty, the istisna contract is as detailed as possible regarding what the end product will be.

In the istisna contract, the customer approaches the bank with the desired asset’s specifications. Both the customer and the bank sign the istisna contract and then the bank manufactures the product or the asset for the customer through its agent, such as a manufacturer.

Keep in mind that a separate istisna contract exists on both sides: between the customer and the bank, and between the bank and the manufacturer.

When the manufacturing/construction project is complete, the manufacturing / construction company hands over the project to the bank, which verifies the specifications and delivers the product / project on the payment basis agreed to in that part of the istisna.

Ijara: The Arabic term ijara means “providing services and goods temporarily for a wage.” The ijara contract, as you may guess, involves providing products or services on a lease or rental basis. In the ijara contract, a person or party is given the right to use the object (the usufruct) for a period of time; the owner retains the ownership of the assets.

The ijara contract is similar to a conventional lease in which the owner rents or leases his property or goods to a lessee for a specified number of periods for a fee. For example, the lessee is responsible for normal maintenance, and the lessor is responsible for major maintenance, just as with many conventional lease contracts. However, the following features of ijara differentiate it from a conventional lease:

• The lessor must own the assets for the full lease period.
• If the lessee defaults on payments or delays payments, the lessor can’t charge compound interest.
• The leased asset’s use is specified in the contract.

Three types of ijara arrangements can exist according to sharia principles:

• Lease-ending ownership/lease with ownership (ijarawaiqtina/ ijaramuntahiabitamleek): In this ijara contract, the lessee owns the leased asset at the end of the lease period. This lease contract doesn’t contain any promise to buy or sell the assets, but the bank may offer a (verbal) unilateral promise of transfer of ownership or offer a purchase schedule for the asset.
• The lessee also is allowed to make a (verbal) unilateral promise to purchase the asset. The purchase price is ultimately decided by the market value of the asset or a negotiated price.
• Operating lease (operating ijara): This type of ijara contract doesn’t include the promise to purchase the asset at the end of the contract. Basically, this setup is a hire arrangement with the lessor.
• Forward lease (ijaramawsoofabilthimma): This contract is a combination of construction finance (istisna) and a redeemable leasing agreement. Because this lease is executed for a future date, it’s called forward leasing. The forward leasing contract buys out the project (generally a construction project) as a whole at its completion or in tranches (portions) of the project.

Murabaha: In murabaha agreements, a commodity is sold for cost plus profit, and both the buyer and seller know the cost and the profit involved. Basically, this product is a kind of trade financing instrument used by Islamic banks.

Under a murabaha contract, a bank purchases a commodity in order to supply it to a customer who isn’t financially able to make such a purchase directly. The bank sells the commodity to the customer for the cost plus profit — the profit being a markup that both the bank and customer agree on upfront.

The customer can make a lump payment when the commodity is delivered but usually sets up a deferred payment installment schedule.

Shariah scholars don’t advocate using the deferred payment system in a murabaha contract. Instead, they encourage using murabaha as a financial instrument only when other equity financing, such as mudaraba and musharaka, can’t be applied. The bank is allowed to take assets as security against potential future default by the client. However, when no such assets are available, the bank can take the commodity, which is financed by the bank.

The murabaha contract is a basic sale transaction, and certain rules need to be followed to make sure it’s Shariah-compliant:

If the client defaults on the payment, the financier isn’t allowed to charge extra fees as late payment or penalty charges. Shariah scholars allow charging additional fees in cases of loss or damage due to a client’s default, and they allow certain penalties to ensure that a buyer is not negligent. But such fees and penalties cannot be treated as income for the bank; they must be given to charity.The contract should be used only for purchases. It’s not intended to be used for financing a working capital requirement.

Here are two types of Murabaha contracts an Islamic bank may offer:

• Murabaha to the purchase orderer: In this contract, the bank specifically purchases the assets for the client’s order. The client requests that the bank purchase the good(s) on her behalf, and she agrees to buy the good(s) from the bank.
• Commodity murabaha: Interbank transactions are a source of funds for Islamic banks. The commodity murabaha is used as an instrument in Islamic interbank transactions. Generally, this financial instrument is used to fund the Islamic bank’s short-term liquidity requirement. This product was developed as an alternative to conventional interbank funding.

Commodities such as gold, silver, barley, salt, wheat, and dates, which are used as mediums of exchange, aren’t allowed to be traded under the commodity murabaha contract.

Tawarruq: Tawarruq is a financial instrument in which a buyer purchases a commodity from a seller on a deferred payment basis, and the buyer sells the same commodity to a third party on a spot payment basis (meaning that payment is made on the spot). The buyer basically borrows the cash needed to make the initial purchase.

Later, when buyer secures the cash from the second transaction, the buyer pays the original seller the installment or lump sum payment he owes (which is cost plus or murabaha).

Because the buyer has a contract for a murabaha transaction, and later the same transaction is reversed, this scenario is called a reverse murabaha. Both transactions involved must be sharia-compliant.

Tawarruq is a somewhat controversial product. Because the intention of the commodity purchases isn’t for the buyer’s use or ownership, certain scholars believe that the transactions aren’t sharia-compliant. Their argument is that the absence of any real economic activities creates interest, which is prohibited in sharia.

Generally, commodities such as gold, silver, barley, salt, wheat, and dates aren’t allowed in tawarruq.

How does tawarruq work in matters of personal finance?

First, the customer purchases a commodity (other than a medium of exchange) from the bank on a cost plus profit basis. Then the customer sells that commodity to a third party. (In reality, the customer simply authorizes the bank to sell the commodity to the third party on his behalf.)

The proceeds from the sale are credited to the customer’s account, and the customer pays back the bank (the cost plus profit).

Last Word: It’s matter of personal choice to go for either system. Consumer now have wide variety of products available to make a decision as per his own needs, requirements personal choices and believes.

[box type=”note” align=”” class=”” width=””]This article has been written by Nazir Ahmed Shaikh. The writer is a freelance columnist and is an educationist by profession. He could be reached at  nazir_shaikh86@hotmail.com.[/box]