What is Islamic Finance?

by Andrew - Marketing Team

What is Islamic Finance?

Managing money and doing business in line with Islamic principles.

Islamic finance is where the rules of Sharia law are applied to day-to-day activities that involve money. This has very practical implications for how Muslims do business. 

The underlying principle of Islamic finance is that money is just a tool to aid commerce - the buying and selling of products and services. Cash itself is seen as having no value. However, it adds value to society by making transactions easier.

Understanding how Islamic finance works

A fundamental principle of Islamic finance is that money should not make money, which means that charging or paying of interest is to be avoided. 

A second principle is that money should serve the good of society and not harm it. The charging of interest is considered to be ‘riba’, that is, exploitation or usury. This principle also means investing in activities considered damaging to society, such as alcohol, gambling and tobacco, are to be avoided.

Another important feature of Islamic finance is the role of partnership. 
Doing business involves taking risk and it also has the potential to lead to the generation of profits. Partnership means sharing both the risks and rewards of doing business. 

How Islamic finance is different

Many of the finance products used by UK businesses are not appropriate for Muslims wanting to apply Sharia law, particularly because of the desire to avoid paying or receiving interest. These business owners are looking for finance solutions, such as bank accounts and financing schemes, that are Sharia-compliant.

There are a growing number of Sharia-compliant, or halal, finance products on the market, such as savings accounts that are interest-free. Instead, the bank uses the depositor’s funds for activities that generate profits, in accordance with Islamic principles. Some of these profits are paid to the depositor. 

Sharia-compliant alternatives to mortgages come in various forms. These involve the bank buying some or all of the property and then selling it back to you over a period of time and making a profit to cover its fees.

Sharia-compliant business finance

Doing business, which includes both taking risks and making profits, is acceptable within Islamic finance. 

It’s also accepted that businesses require an injection of working capital in order to grow. What’s not permissible is the paying or receiving of interest, gross uncertainty or gambling. Several mechanisms have been developed that allow business owners to raise working capital, while avoiding these prohibitions. 

Two mechanisms, termed mudarabah and musharakah, allow the business owner to raise funds through profit and loss sharing. The finance provider takes some ownership, or equity, in the business, allowing them to benefit from a share in the profits made.

However, equity financing is not always appropriate. The owner of a growing business may not want to exchange some of the ownership in return for capital, particularly if the funding need is relatively short-term.

One Sharia-compliant alternative, which avoids giving the funder a stake in the business, is known as a commodity murabaha agreement. 

A basic murabaha agreement gives a business owner the resources they need to develop their business. These resources are assets that they can put to work in the business, such as equipment or inventory. The business owner buys the assets and agrees to pay for them over a period of time. These payments include an element of profit - being a markup that the funder and business agree on upfront.

The commodity murabaha differs from the basic agreement, in that the business owner is typically looking for and receives working capital, not business assets. The working capital for a commodity murabaha is raised through a series of transactions in the commodities market. This sequence of transactions ensures the business owner receives the working capital needed, financed by an obligation to make payment over an agreed term. All the transactions are structured to ensure they are compliant with Sharia law. 

Other forms of Sharia-compliant finance exist and more will evolve, to meet the changing needs of businesses. These mechanisms are available to all, both Muslim and non-Muslim. 

At its core, Islamic finance is about conducting business in an ethical manner in a way that benefits the entire community. 

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