This is to be the first in a series of posts over the next few days outlining the basics of Islamic finance. This one provides the basic framework and rules. We hope you find them interesting.

Introduction 

In the 1970s changes took place in the political climate of many Muslim countries which led to a number of Islamic banks, both in letter and spirit, being established in the Middle East, e.g., the Dubai Islamic Bank (1975), the Faisal Islamic Bank of Sudan (1977), the Faisal Islamic Bank of Egypt (1977), and the Bahrain Islamic Bank (1979).

Islamic banking is now one of the world’s fastest-growing economic sectors, comprising over 300 institutions in over 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia being the largest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15 percent a year.

The reasons behind the recent growth in Islamic finance are:

  • the strong demand from a large number of immigrant and non-immigrant Muslims for Sharia-compliant financial services and transactions;
  • oil wealth, with demand for suitable investments soaring in the Gulf region; and
  • the competitiveness of many of the products, attracting both Muslim and non-Muslim investors.

Islamic banking refers to a system of banking or banking activity which is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called “riba”. Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered “haram” (such as businesses that sell alcohol or pork, or businesses that produce un-Islamic media). In the late 20th century a number of Islamic banks were created, to cater to this particular banking market.

Islamic banking has the same purpose as conventional banking except that it claims to operate in accordance with the rules of Shariah, known as “Fiqh al-Muamalat” (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of “riba”. Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah) and leasing (Ijarah).

As an overview the rules of Islamic financing are summarized as follows:
a) Any predetermined payment over and above the actual amount of principal is prohibited.
Islam allows only one kind of loan and that is “qard-el-hassan” (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent.

b) The lender must share in the profits or losses arising out of the enterprise for which the money was lent.
Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shariah, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals.

c) Making money from money is not Islamically acceptable.
Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.

d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.
Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of ‘uncertain gains’ which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

e) Investments should only support practices or products that are not forbidden -or even discouraged- by Islam.
Trade in alcohol, for example would not be financed by an Islamic bank; a real-estate loan could not be made for the construction of a casino; and the bank could not lend money to other banks at interest.

For example, in an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Another approach is “Ijara wa Iqtina”, which is similar to real estate lending. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

There are several other approaches used in business deals. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company’s individual rate of return. Thus the bank’s profit on the loan is equal to a certain percentage of the company’s profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank, so that both profit and risk are shared. Such participatory arrangements between capital and labour reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, as it is Allah who determines that failure, and intends that it fall on all those involved.

Last, Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only acceptable form of investment, and moral purchasing is encouraged.

Islamic banks and banking institutions that offer Islamic banking products and services are required to establish Shariah advisory committees / consultants to advise them and to ensure that the operations and activities of the bank comply with Shariah principles.

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