Islam is more than a religion. It is also a code of life that deals with social, economic, and political matters. Every Muslim is expected to live according to the Islamic code, or Shariah. Each issue addressed under Shariah is entwined with all other issues; therefore, economic matters are related to religion, culture, ethics and politics.
Islamic finance is a financial system which operates in accordance with Shariah or Islamic law. The primary difference between Islamic and conventional finance is the treatment of risk. Shariah prohibits certain elements that are common in conventional finance, such as interest and speculation. Under Shariah law, finance is based on the principle of “profit and loss sharing,” meaning a lender shares equal financial risk. Therefore, the underlying ethical code of Islam requires banks to minimize the risk of default. Since its initial conception, Islamic financing has evolved to be competitive as many other conventional loan packages. Some of the main components of Islamic finance are outlined below.
The modern Islamic finance industry is relatively young. Its timeline begins only a few decades ago. The Islamic finance is evolving rapidly and continues to expand to serve a growing population of Muslims as well as conventional, non-Muslim investors.
History of Islamic finance
The core concepts of Islamic finance date back to the birth of Islam in the 6th century; Muslims practiced a version of Islamic finance for many centuries. The modern Islamic finance industry emerged only in the 1970s, in large part because of efforts by early 20th-century Muslim economists who envisioned alternatives to conventional Western economics.
The modern Islamic finance industry is young; its timeline begins only a few decades ago. But Islamic finance is evolving rapidly and continues to expand to serve a growing population of Muslims as well as conventional, non-Muslim investors.
The core concepts of Islamic finance date back to the birth of Islam in the 6th century; Muslims practiced a version of Islamic finance for many centuries before the Islamic empire declined and European nations colonized Muslim nations. The modern Islamic finance industry emerged only in the 1970s, in large part because of efforts by early 20th-century Muslim economists who envisioned alternatives to conventional Western economics (whose interest-based transactions violate Islamic law).
In 1963 the first modern Islamic bank, MitGhamr Savings Bank, was opened in Egypt. In 1975, the Islamic Development Bank opened in Saudi Arabia and gave the Islamic finance industry an international presence. It recruited member countries and then offered them financial products to promote economic and community development. In 1979, the first Islamic insurance (or takaful) company, the Islamic Insurance Company of Sudan was established. The world’s first Islamic mutual fund, the Amana Income Fund was created in Indiana, USA in 1985. In 1990, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was created to establish industry accounting and auditing standards. In the same year the Islamic bond market was emerged when Shell MDS in Malaysia issued first tradable Sukuk; which was Islamic alternative to conventional bonds. In 1996, Citibank began to offer Islamic banking services when it established the Citi Islamic Investment Bank in Bahrain. The first successful benchmark for the performance of Islamic investment funds was the Dow Jones Islamic Market Index (DJIMI) which was established in 1999. The Malaysia-based Islamic Financial Services Board (IFSB) was established, 2002, as an international standard-setting body for Islamic financial institutions. The Islamic Bank of Britain, established in 2004 and, became the first Islamic commercial bank outside the Muslim world.
In total, more than 500 Islamic financial institutions have been established worldwide since the 1970s, including about 300 Islamic banks. In the past two decades, the Islamic finance industry has averaged growth of 14 percent per year and its assets are estimated to be worth $1 trillion. Islamic financial institutions are currently operating in 75 Muslim and non-Muslim countries.
Objectives behind Shariah
The ethics behind Shariah law do not eliminate all potential risks involved in a financial transaction, but instead seek to mitigate it, whereas conventional finance typically places the risk on the borrowing party. Ultimately, because all profits are shared between parties; in this case the lender retains the profit on the resale and the borrower retains the profit on the asset (house), both parties share equal risk. Similarly, purchasers can repay a loan at any point in time without being subject to penalty.
Islamic firms distinguish themselves by avoiding interest and speculative risk. Similarly, financing is an affordable alternative for individuals wanting to own a home without compromising their beliefs. Despite the complexity of the financial sector, by performing extensive research, individuals will soon learn that the Halal financial system poses various advantages over conventional methods.
Key principles & prohibitions in Islamic finance
Shariah law differentiates Islamic finance from conventional finance. The Islamic financial system is constructed on economic concepts specified by Shariah— a code of conduct that guides Muslims (the followers of Islam) in social, economic, and political matters. Shariah promotes balance and justice and discourages behaviors of excess. Some of the core ideas promoted by Shariah include the following:
- Allah is the owner of all wealth: Humans are merely the trustees of wealth, which belongs to Allah. Humans must manage wealth according to Allah’s commands, which promote justice and prohibit certain activities including wasting or destroying resources. Muslims have the right to enjoy whatever wealth they acquire and spend in Shariah-compliant ways.
- Individual’s balanced material quests: A Muslim’s economic activities and pursuit of wealth should balance with the spiritual aspects of life. In Islam, the economic activity conducted according to Shariah is declared as an act of worship. However, finding balance between economic activities and spirituality is main factor.
- Individual’s needs vs society’s needs: These include promoting justice in all economic activities, remembering that all people have mutual responsibility for all others and using the earth’s resources wisely.
- Social justice and free market economy: Islam does not restrict economic activity but instead directs it toward being responsible to other people and to Allah. Islam allows for a free-market economy where supply and demand are decided in the market, but it directs the function of the market mechanism by imposing specific laws and ethics. By implementing these laws, the sole purpose is to promote social justice; which means that wealth is not accumulated only by a few while most others suffer.
The Shariah prohibits those business transactions which are based on the following:
- Riba (interest): It means to increase, grow, or multiply into more than what would be due. Riba is prohibited by Islam because it creates societal injustice; in a Riba-based transaction, the owner of the wealth gets return without making any effort and the borrower carries all the risk.
- Gharar (uncertainty): It means uncertainty or to cheat or delude. Transactions based on Gharar are unclear or ambiguous; not everyone involved knows what to expect and can make an informed decision. Gharar exists when two parties enter a contract and one party lacks complete information or when both parties lack control over the underlying transaction.
- Maysir Qimar (Gambling) : It refer to transactions that involve gambling. Maysir is the acquisition of wealth by chance instead of by effort. Qimar refers to a game of chance. Both types of transactions are based on uncertainty.
- Prohibited products/industries: Islam prohibits products and industries that it considers harmful to society and a threat to social responsibility. Examples include alcohol, pork, prostitution, pornography or any product based on uncertainty or gambling.
Shariah-Compliant financial products
In accordance with Islamic law (Shariah), Islamic financial products are based on specific types of contracts. These Shariah-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Shariah-compliant contracts cannot create debt, cannot involve the payment of interest and must provide for a sharing of risk and responsibility between the involved parties.
To be valid, an Islamic contract must feature subject matter that is lawful, has value for a Muslim, and is specific enough to avoid uncertainties. The service or asset described in the contract generally must exist when the contract is being created, must be owned by the seller and must be deliverable.
Most commonly used contracts in Islamic finance are:
Contracts of Partnership
They allow two or more parties to develop wealth by sharing both risk and return:
- Mudaraba: One party gives money to another party, which invests it in a business or economic activity. Both parties share any profit made from the investment (based on a pre-agreed ratio), but only the investor loses money if the investment flops. The fund manager loses the value of the time and effort it dedicated to the investment.
- Musharaka: This contract creates a joint venture in which both parties provide investment capital, entrepreneurial skills, and labor; both share the profit and/or loss of the activity.
Contracts of exchange
These are sales contracts that allow for the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money:
- Murabaha: In this ’ cost plus’ contract, an Islamic financial institution sells a commodity to a buyer for its cost plus the profit margin and both parties know the cost and the profit in advance. The buyer makes deferred payments.
- Salam: In this ’ forward’ contract, the buyer pays for goods in full in advance, and the goods are delivered in the future.
- Istisna: This second type of forward sale contract allows to buy a project that is under construction and will be completed and delivered on a future date.
Contracts of safety and security:
These are often used by Islamic banks; these contracts help individual and business customers keep their funds safe:
- Wadia: A property owner gives property to another party for the purpose of safeguarding. In Islamic banking system the current accounts and savings accounts are based on the Wadia contract.
- Hiwala: Debt is transferred from one debtor to another. After the debt is transferred to the second debtor, the first debtor is free from his obligation. The Islamic financial institutions to use this to remit money between people.
- Kafala: A third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability. It is equivalent to ‘ surety’ or’ guaranty’ in conventional finance.
- Rahn: A customer can offer collateral or a pledge via a ‘Rahn’ contract in order to secure a financial liability.
The future of Islamic banking seems brighter than the conventional banking as the results show that the Islamic banking is not suffered from the global financial crisis to the extent conventional banking is suffered. Highly ethical, well-regulated and beneficial Islamic financial architecture is possible. Unless there are effective checks and monitoring, vested interests may use Islamic banking to bypass the ‘Ahkam’ on Riba. For example, the existing Murabahah financing banks do not directly come into the picture as buyers from the would-be suppliers. This gives dishonest fund-seekers a window for getting credit from the bank through fictitious purchases. Moreover, without effective checks and monitoring, some bankers under financial pressures may be tempted to provide funds through dummy transactions. Indeed, working in this field with more transparency, with effective corporate governance and with better interaction with relevant international, regional and national institutions, will definitely help all [those] who want to contribute to the welfare of their community as well as to the welfare of the world as a whole.