What is Islamic Finance?

by Mohammed Ayub

Islamic finance is a rapidly growing industry that refers to the management of money in line with Islamic finance principles. Islamic finance covers all aspects of finance from borrowing, lending, investing, saving, and innovative business practices. Muslims live by a moral code, known as Sharia law, and Islamic finance is governed by the same principles to ensure that the rules are Sharia compliant in all respects.

The essence of Islamic finance is that it provides ethical and Sharia compliant solutions for Muslims who want to be actively involved in finances and money management. Islamic financing activities must be Sharia compliant in all respects.

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 main principles that Islamic finance is based on are as follows:
  • No interest (riba) should be paid or charged
  • Investment activities should stay away from industries considered haram
  • Speculation (maisir) is deemed to be akin to gambling and is impermissible
  • Uncertainty and risk (gharar) cannot be excessive
  • Every transaction must be Sharia compliant and relate to a real economic transaction
The core principle of Islamic finance is that money should not make money, it should be used to exchange services and products. Therefore, interest should not be charged or received as this is seen as a profit for the lender. Another core principle of Islamic finance is that any financial activities should not cause any harm. As a guide, this is the reason why Islamic finance products and services steer clear of industries such as porn, gambling, tobacco and alcohol (all things deemed impermissible in Islam).

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. Governments and financial sectors around the world have realized the potential and impact of Islamic finance and its economic benefits and this is one of the reasons for the growth of the Islamic Finance industry.

The core concept of Islamic economics centers on ethics and balance. Ensuring that there is balance and benefit to society and individuals. The concept of balance between:
  • The needs of the individual and the needs of society
  • Spiritual needs and material needs
  • Financial efficacy and individual morality
Islamic finance is based on a model of social responsibility and social balance that is achieved through the fair and ethical distribution of wealth. Whilst western societies and financial structures have only championed the concepts of corporate social responsibility and sustainability in the last few decades, these principles have always underpinned the Islamic economy.

The aim of Islamic finance is not to restrict any economic activity, but instead to ensure that financial responsibilities and obligations are directed towards beneficial conduct and practices.

Islamic finance is a socially responsible financial system and this is one of the reasons it is a fast growing model of financial structure globally.

Financial institutions and transactions based on Islamic finance adhere to the following key principles that differentiate them from conventional finance models:
  • Interest (riba) is prohibited
  • Uncertainty (gharar) within transactions and systems should be avoided
  • Gambling (maysir) is prohibited
  • Investment in industries that are deemed to be haram is prohibited
For outsiders, businesses, or investors looking in to the Islamic finance industry, they may wonder how Islamic banks make money if they do not charge or receive interest. Interest on loans is a huge part of traditional Western lending practices used in the United Kingdom and America. What Islamic finance offers lenders is the ability to offer ethical banking practices and services that benefit both parties to a transaction.

An important feature of Islamic finance is the role of partnership. Doing business involves taking risks and it also has the potential to lead to the generation of profits. Partnership means sharing both the risks and rewards of doing business. This means that borrowing and lending become equally rewarding for both lender and borrower.

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

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

Two mechanisms, for example, 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. Murabaha is also known as cost plus selling and is commonly used. For example, a customer may ask the bank to purchase a property for them and to sell it back to them for a higher price. The bank is able to realise a profit on the upsell, and the customer is able to purchase the property in a Sharia compliant manner.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. 

Ijara relates to leasing. An example of an ijarah transaction is one where a customer wants to purchase a car without a loan agreement. The bank will step in and buy the car and then lease it to the customer who will pay the bank rental instalments. Once the lease comes to an end the customer can acquire the car.

Musharakah is more of joint venture transaction and involves two parties investing jointly and bringing capital into the transaction. Each party is then given a share of the profit based on their respective capital investment.

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-Muslims customers.At its core, Islamic finance is about conducting business in an ethical manner in a way that benefits the entire community and are considered to be socially beneficial. Islamic finance demands that any savings plan, transactions, and investments are ethical and morally upstanding in accordance with Sharia rules.

As one of the fastest growing financial systems globally, Islamic finance is now a market that is worth billions.So, what are the main benefits of the Islamic finance model:
  1.  Financial justice - the principle of financial justice underpins Islamic finance. Whilst western financial systems focus on profit through models of interest and risk, Islamic finance advocates a profit and risk sharing approach. Financial justice is central to any Islamic finance product or service.
  2. Accelerating a growing economy - due to less risk and less uncertainty in the Islamic finance structure, investors, individuals and businesses are more likely to see growth.
  3. Stability - as Islamic finance promotes investments and transactions that carry much less risk than conventional models of investment, there is more stability to financial institutions and investments. Islamic finance is structured to avoid destabilization and debt-deflation, therefore leading to more stable economic conditions.
  4. Financial inclusion - this is perhaps one of the lesser discussed benefits of Islamic finance but it is an important issue. Islamic finance is inclusive for all - Muslims looking for a Sharia compliant financial structure, and non Muslims who are looking for alternative, ethical models of finance.
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. Muslim business owners are looking for expert 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, and loans for graduates looking to undertake further education courses. Most Islamic finance lenders have comprehensive information and learning resources about their products on their websites setting out how their contracts and guidelines meet Islamic finance rules. Mostly, the bank will use 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. An example of this would be a customer wanting to buy a property valued at £200,000. Instead of using conventional mortgage products, an Sharia finance based mortgage would require the bank to purchase the property outright and then selling the house back to you with a mark-up of say £30,000. The customer would then pay £230,000 for the property in installments paid over a period of time.

Islamic finance continues to see growth as a global financial structure that promotes equity and a reduction in disparities. Islamic finance products can seem complex, but the principles are based on simplicity and transparency. There is an increased level of pre-contract due diligence and consideration which means that parties to a transaction have additional protections. Globally, governments and people are seeking economic stability. The pandemic has added a further layer of uncertainty to the financial landscape and more and more people are looking for financial inclusion and ethical transactions. Islamic finance promotes responsibility and risk-sharing in a sustainable way. 

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