Islamic Finance

Financing activities that must comply with Sharia (Islamic Law)

What is Islamic Finance?

The rules governing Islamic Finance are derived from the Shari'ah. The Shari'ah is a
framework of Islamic Jurisprudence derived from the primary sources: The Qur'an
and the teachings of the Prophet Muhammad (pbuh) known as the Sunnah. In addition
to which there is a dynamic secondary source of common law rulings and scholarly
interpretations referred to as Fatwa's. These fatwas are the results of human
interpretation of the Shari' ah, of its texts, or its principles, or a combination of the
two; they are not the word of God. Islamic law, it must be remembered, is more a
process than a code, and the results of legal deliberations may differ when different
methods are employed. Several fatwas are indicative of an acceptance on the part of
Shari'ah Supervisory Boards of new realities in the marketplace and of their
willingness to understand and work with these to the extent that Islamic religious and
legal principles will allow. Such an attitude has ever characterized the best in Islamic
legal thought.

Islamic finance is a type of financing activity that must comply with Sharia
(Islamic Law). The concept can also refer to the investments that are
permissible under Sharia.

entral to Islamic finance is the fact that money itself has no intrinsic value.
As a matter of faith, a Muslim cannot lend money to, or receive money
from someone and expect to benefit – interest (known as riba) is not
allowed. To make money from money is forbidden – wealth can only be
generated through legitimate trade and investment in assets. Money must
be used in a productive way.  In order to be Sharia compliant, money must
be used in a productive way.

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% per year, while Islamic financial
institutions oversee over $2 trillion.

The main difference between conventional finance and Islamic finance is

that some of the practices and principles that are used in conventional
finance are strictly prohibited under Sharia laws.

Principles of Islamic Finance

Islamic finance strictly complies with Sharia law. Contemporary Islamic

finance is based on a number of prohibitions that are not always illegal in
the countries where Islamic financial institutions are operating:
1. Paying or charging an 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 (riba), which is strictly prohibited.

2. Investing in businesses involved in prohibited activities

Some activities, such as producing and selling alcohol or pork, are

prohibited in Islam. The activities are considered haram or forbidden.
Therefore, investing in such activities is likewise forbidden.

3. Speculation (maisir)

Sharia strictly prohibits any form of speculation or gambling, which is

called maisir. Thus, Islamic financial institutions cannot be involved in
contracts where the ownership of goods depends on an uncertain event in
the future.

4. 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 prohibitions, 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/loss sharing: Parties entering into the contracts in Islamic
finance share profit/loss and risks associated with the transaction. No
one can benefit from the transaction more than the other party.

Types of Financing Arrangements

Since Islamic finance is based on several restrictions and principles that do
not exist in conventional banking, special types of financing arrangements
were developed to comply with the following principles:

1. Profit-and-loss sharing partnership (mudarabah)

Mudarabah is a profit-and-loss sharing partnership agreement where one

partner (financier or rab-ul mal) provides the capital to another partner
(labor provider or mudarib) who is responsible for the management and
investment of the capital. The profits are shared between the parties
according to a pre-agreed ratio.

2. Profit-and-loss sharing joint venture (musharakah)

Musharakah is a form of a joint venture where all partners contribute

capital and share the profit and loss on a pro-rata basis. The major types of
these joint ventures are:

 Diminishing partnership: This type of venture is commonly used to

acquire properties. The bank and investor jointly purchase a property.
Subsequently, the bank gradually transfers its portion of equity in the
property to the investor in exchange for payments.
 Permanent musharkah: This type of joint venture does not have a
specific end date and continues operating as long as the participating
parties agree to continue operations. Generally, it is used to finance
long-term projects.

3. Leasing (Ijarah)

In this type of financing arrangement, the lessor (who must own the
property) leases the property to the lessee in exchange for a stream of rental
and purchase payments, ending with the transfer of property ownership to
the lessee.

Investment Vehicles

Due to the number of prohibitions set by Sharia, many conventional

investment vehicles such as bonds, options, and derivatives are forbidden
in Islamic finance. The two major investment vehicles forbidden in Islamic
finance.
1. Equities

Sharia allows investment in company shares. However, the companies must

not be involved in the activities prohibited by Islamic laws, such as lending
at interest, gambling, production of alcohol or pork. Islamic finance also
allows private equity investments.

2. Fixed-income instruments

Since lending with interest payments is forbidden by Sharia, there are no

conventional bonds in Islamic finance. However, there is an equivalent of
bonds called sukuk or “Sharia-compliant bonds.” The bonds represent
partial ownership in an asset, not a debt obligation.

Conclusion
Islamic finance as it exists today has been shown to reduce
economic efficiency by increasing transaction costs, without
providing any substantial economic value to its customers. Many
have argued that the industry is actually demand driven, and hence
jurists and lawyers engaged in Shariʿa arbitrage provide value, by
bringing conventional financial products to a market segment that
would not have access otherwise. Thus, proponents of that
argument assert, Shariʿa-arbitrage mechanisms should be seen as
enabling juristic efforts to recharacterize modern financial
transactions (takhrij fiqhi), rather than legal stratagems to
circumvent prohibitions (hiyal Sharʿiyya). Moreover, the argument
continues, to the extent that Islamic legal restrictions have
economic content, the gradual progress of Islamic finance toward
increasingly more efficient and more authentically Islamic
products will eventually allow the industry to serve the Islamic
ideal.
In fact, however, Islamic finance has been largely a supply-driven
industry, with jurists who participate actively in Shariʿa arbitrage
helping to expand the industry's customer base through indirect
advertisement (at various conferences and publications), as well as
religious admonishment that Muslims should avoid conventional
finance. The form-above-substance juristic approach to Shariʿa
arbitrage has also been shown to squander the prudential
regulatory content of premodern Islamic jurisprudence, while
reducing economic efficiency for customers through spurious
transactions, not to mention legal and jurist fees.