Islamic finance is a way of managing money and doing business while adhering to the moral principles of Islam. It covers banking and finance matters such as saving, investing, and borrowing. The laws that many Muslims live by are known as ‘Shariah’. So, you may hear Islamic financial services described as ‘Shariah-compliant’.
The common practices of Islamic finance and banking came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance occurred only in the 20th century. Nowadays, the Islamic finance sector grows at 15-25 percent per year, while Islamic financial institutions oversee over $2 trillion, according to CFI.
Principles of Islamic finance
Islamic finance strictly complies with Sharia law. Some of the major principles of Shariah-compliant finance and banking include:
Paying or charging interest
Islam considers lending with interest payments as an exploitative practice that favors the lender at the expense of the borrower. According to Sharia law, interest is usury or riba, which is strictly prohibited.
Investing in businesses involved in prohibited activities
Some activities, such as producing and selling alcohol or pork, or gambling, are prohibited in Islam. The activities are considered haram or forbidden. Therefore, investing in such products or activities is likewise forbidden.
Speculation (maisir)
Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Therefore, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.
Uncertainty and risk (gharar)
The rules of Islamic finance ban participation in contracts with excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertainty in investments. Gharar is observed with derivative contracts and short-selling, which are forbidden in Islamic finance.
In addition to the above principles, Islamic finance is based on two other crucial principles:
- Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.
- Profit and loss sharing: Unlike the interest-based commercial banking system where all the pressure is on the borrower, Islamic finance is based on the belief that the depositor, the bank, and the borrower should all share the risks and the rewards of financing business ventures.
Islamic finance products and services
Sukuk
Sukuk (Islamic bond or Sharia-compliant bond) is an Islamic financial certificate that represents a portion of ownership in a portfolio of eligible existing or future assets. They can be considered as an Islamic version of conventional bonds.
Sharia prohibits lending with interest payments, which is considered usurious and exploitative in nature. Thus, bonds are forbidden in Islamic finance.
Takaful
Takaful is a type of Islamic insurance where members contribute money into a pool system to guarantee each other against loss or damage. Takaful-branded insurance is based on Sharia, which explains how individuals are responsible to cooperate and protect one another. Takaful policies cover health, life, and general insurance needs.
Murabaha
Murabaha is an Islamic financing structure in which the seller and buyer agree to the cost and markup of an asset. It’s also referred to as cost-plus financing. The markup takes the place of interest, which is illegal in Islamic law.
Murabaha isn’t an interest-bearing loan or qardh ribawi. It’s an acceptable form of credit sale under Islamic law. The purchaser doesn’t become the true owner until the loan is fully paid, as with a rent-to-own arrangement.
Mudarabah
Practical Law defines Mudarabah as an Islamic finance technique in which a lender or investor and a borrower or investment manager establish a profit-sharing partnership to undertake a business or investment activity.
Under this structure, the lender provides the financing or funds and the borrower provides the professional, managerial, and technical know-how to carry out the business or manage the investment.
Musharakah
Musharakah is a joint enterprise or partnership structure in Islamic finance in which partners share in the profits and losses of an enterprise. Since Islamic law does not permit profiting from an interest in lending, Musharakah allows for the financier of a project or company to achieve a return in the form of a portion of the actual profits according to a predetermined ratio.
Differences between Islamic finance and conventional finance
Conventional banks only have one mode of financing for their customers and that is a loan. Conventional banks have designed several products such as credit cards, running finance, car/house loans, and long-term loan facilities for different customer segments but all of them simplify to a loan advanced by a bank to its customer.
Meanwhile, Islamic banks primarily work using three modes of finance, namely, rental arrangements, trade/sale basis, and partnerships.
Islamic current accounts are Qard-based and funds are invested in Sharia-compliant avenues. However, in conventional banking, customer’s deposited funds are used in money lending and interest-earning businesses.
Meanwhile, saving accounts in conventional banks are based on a loan basis and conventional banks pay interest earned on loans to their depositors as returns. Meanwhile, in Islamic banks, saving accounts are based on the concept of Mudarabah and Islamic banks pay out actually earned profits on shariah-compliant transactions.
Conventional banks offer services on debt for both depositors and borrowers. Therefore, they do not share risk with any of the customers. Meanwhile, Islamic banks share risks with their customers.
The growth of Islamic finance globally
The global Islamic finance industry is witnessing remarkable growth, with total assets reaching $3.3 trillion by the end of 2023, an increase of 8 percent compared to the previous year, according to S&P Global’s global head of Islamic finance.
The sukuk market also saw good but softening growth. S&P expects sukuk issuances to hover between $160 billion and $170 billion in 2024, furthering the industry’s asset growth.
Familiar challenges for the industry persist, namely the concentration of demand in a small number of countries and the complexity of transactions and standards. Islamic finance struggles to attract interest beyond its core markets like countries across Central Asia and Africa, and parts of Europe.
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FAQs:
What is Islamic finance and how does it differ from conventional finance?
Islamic finance is a way of managing money and doing business while adhering to the moral principles of Islam. Islamic finance is based on the belief that money should not have any value in and of itself. It is just a way to exchange products and services that do have value.
What are the core principles of Islamic finance?
The main principles of Islamic finance are that wealth must be generated from legitimate trade and asset-based investment. The use of money for the purposes of making money is expressly forbidden.
How does Islamic finance avoid interest or riba?
Religious practice forbids riba, even at low interest rates, and it is considered both illegal and unethical or usurious. Islamic banking has provided workarounds to riba, including a profit-sharing system in which borrowers agree to return a portion of profits as payment for the loan.
What are the most common Islamic finance products?
The most common Islamic finance products include Mudharabah, Wadiah, Musharakah, Murabahah, Ijar, Hawala, Takaful, and Sukuk.
What is Sukuk and how does it work in Islamic finance?
Sukuk is an Islamic financial certificate that represents a portion of ownership in a portfolio of eligible existing or future assets. They can be considered as an Islamic version of conventional bonds.
