5 financial changes for the future - what should we be looking out for?

WHAT IS ZAKAT?

Zakat is one of the five pillars of Islam. It is an obligatory act of worship and is also a mandatory form of charity for Muslims. It has always been seen as a means by which people can achieve social impact through the redistribution of their wealth. The five pillars of Islam are the absolute fundamentals of Islam and include the following:

• Faith (shahada)
• Prayer
• Zakat
• Fasting
• Hajj

Every Muslim is expected to fulfil these five pillars of Islam which serve as the very fundamental acts of worship prescribed by the Islamic faith.

Paying zakat, sometimes referred to as almsgiving, is an obligation for every Muslim who is able to and serves to bring economic equality, fairness, and to rebalance societal injustice.

The Obligations Of Zakat

Muslims who have the financial means and capability are required to pay zakat. They must donate 2.5% of their wealth (see our zakat calculator to work out how much you need to pay). The 2.5% is calculated on money and assets.

The aim of zakat funds is to ensure that they are used to provide the basic necessities for families and communities in need. These needs can include the provision of food, shelter, clothing, education and healthcare.

One of the most important elements of zakat is that payment of it is seen as a means of purifying your wealth whilst demonstrating empathy and compassion for others. In fact, the word zakat actually means 'cleansing' or 'purifying'.

The whole concept is based on the idea that once an individual donates a percentage of their wealth to charitable causes, they fulfil their moral obligation to serve others and build stronger communities and economies. Zakat is particularly important in times of crisis, as it can be used to alleviate hardship via the distribution of wealth.

Zakat is not the same as sadaqa which is encouraged but not obligatory. Zakat is an annual payment that is worked out in a specific way and spent in a specific way.

The Exemptions From Zakat

There are some important exemptions to be aware of when it comes to zakat.

Firstly, there are exemptions for those people who do not have to pay zakat and these include:

• children
• the mentally ill
• the infirm and elderly
• slaves
• Non-Muslims
• the very poor

WHO CAN RECEIVE ZAKAT?

Islamic finance principles set out clearly who can receive zakat. Those eligible to receive zakat include the following:

• Poor people
• The needy
• Debtors who cannot repay their debts
• Orphans
• Widows
• The stranded and destitute
• Travellers
• Slaves or captives
• New Muslims
• Those fighting a just cause

It is very important that when you pay zakat the recipients meet the eligibility criteria set out in Sharia law. Always make the intention of helping those who are in need and adhering to the principles of Islamic finance.

WHAT ROLE DOES SOCIAL JUSTICE PLAY IN ISLAM?

Social justice is one of the fundamental principles of Islam and Islamic finance. The Islamic framework is centred on social justice in all aspects from individual behaviour, to financial transactions, to how we behave in relationships with others.The teachings of Islam place great significance on ethical and moral behaviour. Islam promotes social justice by emphasizing the importance of the following concepts:

• Anti-discrimination: all humans are seen as equal in Islam and discrimination in any form is prohibited. In fact, the Prophet Mohammad's final sermon reiterated how important it was to treat everyone equally and fairly.
• Economic equity: Islam promotes economic justice by ensuring there are frameworks in place for wealth distribution. Zakat plays a key role in the distribution of wealth. Furthermore, the prohibition on interest further prevents exploitation and inequality.
• Charity: as already mentioned the concept of charitable giving is an essential element of Islam. Charitable giving takes place via zakat and sadaqa (amongst other forms of donation). Muslims are encouraged to consistently donate to the poor.
• Gender equality: as mentioned above, Islam believes that men and women are equal and it actively promotes gender rights (particularly those of women) and equality. The Quran consistently mentions treating people with respect and fairness.
• Legal justice: Sharia rules set out the legal framework within which Muslims operate and these rules focus on justice, fairness, and equity. The legal judicial system in Islam operates to ensure that justice and fairness are implemented.
• Ethical behaviour.

The Potential Of Zakat

The actual potential of zakat is large, and estimated to be valued in the region of $200 billion - $1 trillion (this is according to research from the Institute of Development Studies and the World Bank). It is difficult to estimate the exact amount paid each year, but it is clear that Muslims who pay zakat on an annual basis are some of the biggest and most consistent charity givers in countries across the world.

Whilst the Western world is still learning about the impact and potential of zakat, Muslim economies have harnessed the potential of zakat for many decades by establishing leadership institutions to manage and distribute zakat. In addition, Muslim countries have had discussion and debate with scholars relating to zakat and how best to use it, incorporating it into fiscal policy.

HOW DOES ZAKAT HAVE A SOCIAL IMPACT?

• Empowers individuals and communities
• Alleviates poverty
• Optimisation of social good
• Social cohesion building
• Wealth distribution
• Funding charitable projects (such as climate and environment change programmes, education, and healthcare initiatives and practices)
• Economic development
• Promote social justice

An underlying philosophy of Islamic finance and Zakat is the concept of mobilising finance for the greater good. Islamic finance embodies socially responsible actions whether from companies or individuals.

Zakat And Sustainable Development Goals

As zakat is applicable to all Muslims across the globe, it is one of the largest and most successful forms of philanthropy. It acts as one of the largest methods of wealth transfer from the rich to the poor that takes place consistently and with clear guidelines.

Inspired by the Islamic faith, zakat is taking on relevance in countries throughout the world including the UK, United States, Australia and beyond.

Alleviating poverty, inequality, and hunger are not only central tenets of Islam and Islamic finance, but they are also part of the UN's sustainable development goals. According to the Quran there are 8 categories eligible for zakat (see above) and these all align strongly with sustainable development goals.

Some countries such as Indonesia have started collaborating with zakat donors to achieve partnership working towards sustainable development goals. This is a win-win for Muslims as Islam and Sharia rules relating to financial transactions state that every person should seek to work collaboratively and fairly for the good of society.

Conclusion

The power of zakat to harness social impact through charity is undeniable. When you clearly understand what zakat is and its function in society it becomes clear that zakat has the power and potential to alter lives and bring equity.

Introduction
Equity financing refers to a particular method of funding a business to sustain and grow its operations. Equity involves raising funds by issuing shares for investors. Investors who buy shares of a company become shareholders and can earn investment gains if the stock price rises in value or if the company pays a dividend. Dividends are typically cash payments as a reward to shareholders for investing in the company. Equity finance allows a company to raise these funds without borrowing from conventional banks, which typically charge interest. In equity financing, there is no promise to repay the investment like in a loan arrangement, nor is there an interest component.

Impact
Equity finance has no impact on a firm's profitability, but it can dilute existing shareholders' holdings because the company's net income is divided among a larger number of shares. This means that the overall number of shares have increased but the percentage of shares owned by a shareholder decreases. For example, let's say a company has 100 shares outstanding, and an investor owns ten shares or 10% of the company's stock. If the company issues 100 additional new shares, the investor now has 5% ownership of the company's stock since the investor owns five shares out of 200. In other words, the investor's holdings have been diluted by the newly issued shares.

Generally, equity finance has the following characteristics:

• Shareholders get a level of ownership in the company
• Shareholders do no receive any interest payments, but may receive a dividend
• The investment is generally permanent without any maturity
• Upon liquidation, shareholders through equity financing are generally last to be paid

Sources of Equity Financing

• Funds are generally raised through the following methods when financing through equity issuance:
• Personal finances / bootstrapping - most small business begins this way
• Venture capital (VC) - businesses who specialise in making investments in companies in whom they see potential
• Private investors / angel investors - like VC, but they are usually individuals rather than firms
• Family & friends - taking cash from people you know in exchange for part ownership
• Crowdfunding or equity crowdfunding - a recent method of fundraising which gives the public early or exclusive access to a product or service in exchange for up-front funds. Equity crowdfunding involves offering shares for funds at an early stage
• Government - in certain circumstances a government grant may be available for small businesses
• IPO (or initial public offering) - to float your company on a stock exchange and sell shares to the public

Shariah structures for Equity Financing
There are two famous structures in Islamic Finance which are used to establish equity financing, they are Mudaraba and Musharaka.

Mudaraba
Mudaraba refers to a relationship between an investor (Rab al maal) and an investment manager (Mudarib) to establish a profit-sharing partnership to undertake a business or investment activity. Under this structure, the Rab al maal provides the financing or funds and the Mudarib provides the professional, managerial, and technical know-how to carry out the business or manage the investment. The Mudarib must invest the funds in a Shariah compliant way. The parties share in any profits according to a pre-agreed ratio. In a Mudaraba, the Mudarib:

• Puts only its time and effort at risk and does not contribute any capital.
• Is not responsible for any losses of the venture. Losses, however, are borne entirely by the Rab al maal.

Musharaka
A Musharaka is an investment partnership or joint venture compliant with Islamic principles. In a Musharaka, the financing party and its client contribute assets (cash or property) to a joint venture and share in the profits of the joint venture in agreed percentages. The joint venture is structured so that the financing party receives its initial investment plus a return that is usually calculated by a reference to a benchmark. Losses, however, are shared in accordance with the parties' initial investment. All Musharaka parties have the right to exercise control over the joint venture but it is typically managed by the client.
Musharaka is similar to Mudaraba except that in a Mudaraba only the financing party bears the losses associated with the joint venture or partnership.

WHAT IS BANKING?

When we talk about banking, we are discussing the products and services offered by the financial industry including lending money, facilitating payments, and managing accounts. Banking services are available to individuals, companies, and governments. There are some key differences between commercial banking and Islamic banking.

Banks and financial institutions play an important role in the economy. Not only do they facilitate financial transactions, but they also act as intermediaries between businesses, between borrowers and savers, and between lenders and businesses.

Banks facilitate transactions and manage credit and debit accounts. The role in the economy goes beyond managing money. They are also responsible for ensuring the financial systems remain stable, and they are therefore subject to regulation and oversight by central banks.

The regulation of banks ensures that there is ongoing prudent financial management, and risk mitigation in addition to compliance with legal standards.

COMMERCIAL BANKING - HOW DOES IT WORK?

Commercial banking is a traditional form of banking used across the globe, especially in Western economies. In its very basic form, commercial banking relates to the services and activities that banks can provide to individuals, entrepreneurs, businesses and governmental organisations.

Commercial banks undertake various activities, including:

• Payments: commercial banks facilitate incoming and outgoing payments, transfers, cheques.
• Debit and credit cards: commercial banks provide customers with debit and credit cards
• Trading: banks also facilitate national and international trade by enabling international payments and foreign exchange transactions.
• Investment services: commercial banks offer brokerage services and accounts, advisory services, and information about investment options.
• Corporate banking: commercial banks offer the corporate world specialised corporate services to encourage and facilitate corporate trade and transactions.

Main Principles Of Commercial Banking

One of the main underlying principles of commercial banking is the payment and receipt of interest. A commercial bank makes money by earning interest on loans and financial instruments that it provides to businesses, individuals, and large corporations.

Commercial banks also make money from the fees they charge for their products. For example, when offering loans and mortgages, the bank will usually charge a fee for this service.

Commercial banking rests on the following main principles:

• Profitability - as with any commercial business, the banks main focus is on profitability.
• Liquidity - liquidity refers to the ability of assets to be quickly converted into cash/ money.
• Solvency - commercial banks need to be solvent at all times. What this means is that they have financial sufficiency and capability. This level of solvency enables banks to remain in competitive markets with enough capital.

ISLAMIC BANKING - HOW DOES IT WORK?

Islamic banking is very different to traditional commercial banking. Islamic banking is based on Islamic finance principles and guidelines. These guidelines follow Islamic Sharia law. Sharia law prohibits the receipt or payment of interest, as this is considered to be deeply unethical and exploitative.

Sharia compliant banking, underpinned by Islamic finance principles, does not charge or pay any form of interest. This does raise the question of how do Islamic banks make a profit if they do not charge interest to the customer.

The answer to this lies in the structure and the practices within Islamic finance institutions. Instead of making profit through interest, Islamic banks profit through equity sharing and partnership arrangements. These arrangements ensure that the profits and losses are shared between the parties.

Let's have a look at the way Islamic banks operate and how they make a profit:

• Profit and loss sharing - Islamic banks rely on Sharia concepts such as musharaka (cost-plus financing) and mudaraba (partnership based financing). The former requires both the customer and the bank to contribute capital and share in any profits arising from the investment. Mudaraba is a slightly different arrangement where the bank provides the capital and the individual manages the running of the business. Both these arrangements facilitate profit sharing in an equitable way.
• Asset-backed finance - Islamic banks rely on asset-based finance arrangements. Often, this means that the bank or financial institution will purchase an asset at the request of the customer and then sell it back to them. The sale back is at a higher price which is usually paid back in instalments.
• Investments - Islamic banks are permitted to engage in investment activities. However, the difference between Islamic banks and conventional banks is that Islamic banks retain control over the industries they invest in. They do not invest in industries that are deemed to be impermissible in Islam (ie, gambling, porn, alcohol). Additionally, any investment activity is not interest based and is not speculative or uncertain. This means the level of risk is often lower than the investment activities of commercial banks.

Key Principles Of Islamic Banking

As already mentioned above, the main principles relating to Islamic banking are derived from Sharia law. Sharia law guides Islamic finance and differentiates it from conventional commercial banking.

The key principles of Islamic banking are:

• No interest - there is a strict prohibition on interest (riba). This means that any deposit or payment does not accrue or attract interest in any form.
• Profits and losses - Islamic finance centres on the notion of equitable relationships and non-exploitative relationships. This means that there has to be equitable sharing of profits and losses between the parties.
• No uncertainty - excessive uncertainty is not permissible in Islamic banking. This means that any investor, entrepreneur, business, or leader looking to engage in activities needs to ensure that the trade or investment is not uncertain or ambiguous. Financial transactions should be transparent and solution based.
• Ethical and social responsibility - Islamic finance is underpinned by the key concepts of ethical behaviour and social responsibility. There is an onus on those with control to ensure that the parties engage in activity that does not adversely affect others and that benefits society as a whole.
• No speculation - it is important for Islamic banking to ensure that financial activities are based on real economic transactions, not hypothetical or speculative activities.
• No excessive debt - again, to ensure there is equity and transparency, Islamic finance requires that excessive debt is avoided. Islam promotes responsible borrowing and lending practices.

Commercial Banking Services Vs Islamic Banking Services

The main difference between commercial banking and Islamic banking are the main principles which guide the banking activities. As already discussed, Islamic banking does not rely on interest payments or interest based activities.

Whilst commercial banks rely on interest as a fundamental component when it comes to lending and borrowing, Islamic banks are more focused on a profit-loss sharing arrangement.

Whilst both commercial and Islamic banks offer a variety of financial products and services, Islamic banks have to ensure they are compliant with Sharia rules about financial activities. Islamic banks provide similar services to commercial banks (loans, mortgages, savings accounts etc) but the key difference is that they offer Sharia compliant alternatives to their clients.

Islamic banks actively avoid financial deals and transactions that are deemed to be risky and speculative such as derivatives and trading securities. The ethical and social responsibility element of finance is not something that features as heavily in commercial banking as it does in Islamic banking.

Commercial banks aim to generate and maximise profits through interest that is earned on lending and other banking services. For Islamic banks, interest is prohibited, so they look to Sharia compliant ways of generating profits.

It is important to remember that both Islamic and commercial banking aim to offer financial services to meet their clients needs. Islamic banking is favoured by Muslims because the principles of Islamic finance mean they remain compliant with their religious obligations. However, Islamic finance has a much wider appeal to customers across the Muslim and non-Muslim world.

The Regulatory Framework For Banking In The Uk

In the United Kingdom, the regulatory framework is managed by the Financial Conduct Authority.

As part of its supervisory and regulatory role, the Financial Conduct Authority aims to protect the customers of financial institutions that offer any form of financial product or service. The Financial Conduct Authority also ensures that it promotes healthy competition between financial service providers.

Risk Management In Commercial Banking

Risk management and mitigation are essential tasks for banks. Not only does risk management ensure that banks have a risk management strategy in place, but it also ensures banks remain compliant with the relevant regulatory regime in place.

Commercial banks assess risks on an ongoing basis to ensure that they can maintain their financial stability. Risk management also prevents unexpected losses that could occur and help the bank prepare for long-term viability and market fluctuations. Ultimately, commercial banking is arguably more volatile that Islamic banking as it places itself in a more fluctuating, interest and economy based market.

Islamic banking mitigates risk by avoiding interest based transactions, and discouraging speculative behaviour. The risk and reward is shared between the parties, this leads to shared responsibilities when it comes to risk.

Risk Management Is Islamic Banking

Risk management in Islamic banking is different from the risk management in conventional commercial banks.

Islamic finance promotes the forecasting of financial risks and ensures the necessary risk mitigation strategies are in place from the outset. Under Sharia rules and guidelines, Islamic banks manage risk via practices which actively mitigate risk. These practices include ensuring that is an equitable profit and loss sharing arrangements. Islamic finance also requires that parties to a transaction share the risk, so one party is not left dealing with huge losses.

Through intense screening and due diligence, Islamic banks assess feasibility in a more rigorous way than commercial banks. This helps them identify potential issues before they arise and mitigate risks early on.

Islamic banks will usually have Sharia compliant scholars and boards working with the bank and ensuring it is compliant and regulated. These boards provide Islamic guidance on complex transactions and reduce the risk exposure. Many Islamic banks will also ensure they have contingency funds and reserves to deal with unexpected events and losses.