What is Asset Backed Financing in Islamic Banking?
According to the Islamic religion, not all investments and financial transactions are allowed for Muslims, and each of them must be compliant with the sources of Shariah or Islamic laws. Conventional financing usually involves loans or investments made to earn riba or interest, which Islam prohibits. For financing purposes, Islamic scholars designed the Shariah Complaint Islamic financial instruments/products, replacing interest-based loans with asset backed financing in Islamic banking and finance. These Shariah-compliant financial modes are grounded on the principles of risk-sharing and asset ownership, which distinguishes them from conventional banking systems. As the global embrace of Islamic finance continues to grow, the adoption of asset backed financing in Islamic finance has seen a significant increase.
“Research indicates that global Islamic finance assets are expected to reach $7.69 trillion by 2030, underlining the significant growth potential of this sector”.
Islamic Finance Industry Size
Interest (Riba) VS Asset Backed Financing in Islamic Banking
- Banks receive cash investments, lend them as loans, charge higher interest on those loans, pay back a lower interest to the cash owner, and keep a profit. Such transactions are based on Riba (interest), which Islam strictly prohibits.
- Islam doesn’t allow the idea of earning a “fixed and agreed profit” from lending money. Anything related to those interests will make any activity/instrument/bank/product forbidden (according to Islam).
- Murabaha, Ijarah, and more Islamic financial methods replaced “interest financing” from other banks.
- Regardless of the nature of that Islamic financial model, it will always relate to financing in tangible assets and instruments instead of debt.
- For example, an Islamic bank would finance a startup with a “Profit and Loss Sharing Model” instead of a simple/compound interest.
6 Principles of Asset Backed Financing in Islamic Finance and Banking
Asset-backed financing provides several benefits:
1. Tangible Assets
All asset backed financing in Islamic finance must be linked to real, physical assets such as property or commodities. It ensures that all transactions are linked to tangible assets, conforming to Sharia law’s prohibition of speculative financial practices.
2. Prohibition of Riba (Interest)
As discussed, lending/borrowing money and agreeing to pay/receive a fixed cash interest on that transaction is forbidden in Islam. Islamic banking prohibits riba (interest), emphasizing ethical investments.
3. Risk Sharing
One key element relates to agreeing to pay/receive a fixed amount of interest on financing. Islamic instruments are based on principles of shared risksk, and the principles of risk management for Islamic banking and finance are applied to the transactions.
4. No Speculation (Gharar)
Transactions must avoid excessive uncertainty (gharar), with clear terms and asset ownership established.
5. Ethical Investment
Financing must support activities deemed permissible (halal) under Islamic law, excluding industries like alcohol or gambling.
6. Economic Stability
By tying investments to real assets, asset backed financing in Islamic finance contributes to economic stability, reducing the likelihood of financial bubbles and crises commonly associated with unIslamic investments.
Reasons for the Growth of Asset Backed Financing in Islamic Finance
Asset backed financing has experienced a notable expansion in recent years, driven by several factors. They include:
- Increasing demand for ethical finance in both Muslim and Non-Muslim countries.
- Supportive Regulatory Frameworks have been introduced by many Muslim and Non-Muslim countries.
Global Figures on Asset-Backed Financing Growth
| Year | Global Islamic Finance Assets (in Trillion USD) |
| 2020 | 2.88 |
| 2021 | 3.08 |
| 2022 | 3.25 |
| 2023 | 3.41 |
| 2024 | 4.16 |
Tools for Asset Backed Financing in Islamic Finance
Many products are designed on the principles of Islamic banking and finance that are used for asset backed financing in Islamic finance. Below is a comparison of key products and their applications:
| Product | Description | Application |
| Ijarah | An Islamic lease agreement, where the bank buys and leases an asset to the client. | Used for equipment and property financing. |
| Murabaha | Cost-plus-profit sale agreement. | Used for the purchase of goods and assets. |
| Musharakah | Joint venture partnership. | Applies in project financing. |
| Sukuk | Islamic bonds. | To finance infrastructure and large-scale projects. |
1. Ijara
In an Ijara contract, the bank purchases an asset and leases it to the client for a pre-agreed period and rental amount.
2. Murabaha
Murabaha involves the bank purchasing an asset and selling it to the client with a specified mark-up.
3. Musharaka
A Musharaka contract is a form of partnership where both bank and client contribute capital to a project, sharing profits and losses based on their investment ratio.
4. Sukuk
Sukuk represents ownership in an underlying asset, entitling investors to a proportionate share of the income produced.
Challenges Faced by Asset Backed Financing in Islamic Finance
Despite its advantages, asset-backed financing in Islamic banking also faces several challenges:
- Limited awareness and understanding of the advantages of Islamic banking and finance hind its adaptation.
- Regulatory discrepancies across different jurisdictions complicate Islamic banking and finance operations.
- Lack of universally accepted standards for Shariah compliant Islamic banking practices.
- Shortage of Skilled Islamic Banking and Finance Professionals.
AIMS’ Role in Developing Skilled Islamic Finance Professionals
The growth of the Islamic finance sector is stymied by a shortage of trained Islamic finance professionals with expertise in both “finance and Sharia law”. By integrating Islamic financial laws into educational curriculums, individuals can develop a solid understanding of the asset backed Islamic financial system.
AIMS is based in the UK and offers specialized Islamic banking and finance programs, such as Islamic finance and banking courses, postgraduate diploma in Islamic banking and finance or a Masters in Islamic Banking and finance, to significantly enhance the knowledge and skills of professionals in Islamic banking and finance sector globally.
How Does Assets Recycling Through Islamic Finance Work?
In asset backed financing in islamic finance, assets recycling refers to the reuse of an asset to generate further financial transactions while ensuring compliance with Islamic principles. In asset backed financing in Islamic banking, this is achieved through structures that involve transferring ownership or usufruct (the right to use the asset) in ways that ensure ongoing productive use.
Examples
- Ijara contracts leasing an asset multiple times to different customers. The idea is to ensure its utility and financial return over time.
- Another example of asset recycling is the Sukuk (Islamic bond). Where the underlying asset is used to back the issuance of bonds. Like that, it will generate returns for investors while adhering to the Asset Backed nature of Islamic finance.
Summary
- Asset backed financing in Islamic finance ensures a Shariah-compliant, risk-sharing approach to financial transactions by grounding all operations in tangible assets.
- Through the prohibition of elements like gharar and riba, Islamic banking supports ethical, asset-driven economic activity.
- Asset backed financing in Islamic banking is gaining momentum globally due to its sustainable and ethical alternative to conventional banking and finance.
- Addressing the challenges it faces through education, standardization, and regulatory harmonization will ensure its growth and wider acceptance, further solidifying its role in the global financial market.