Islamic finance refers to financing activities that must comply with Sharia law, also known as Islamic law. The Islamic financial sector is growing rapidly. Today, financial institutions in the Islamic world manage more than $2 trillion in assets. The Islamic banking sector is growing at 15-25% annually.
In addition to growing in Muslim countries, Islamic finance is gaining interest in non-Muslim countries such as the UK, Hong Kong, South Africa and Luxembourg. As Sharia-compliant forms of financing become more mainstream in the global financial system, it will be important to understand their principles.
A set of principles form the building blocks of Shariah-compliant finance. Islamic finance prohibits certain commonly accepted practices in the world of traditional finance. Islamic Banking stresses the importance of avoiding riba (charging excessive interest). Another overarching concept is the avoidance of gharar: deceptive or speculative practices.
Pay and calculate interest
Islamic law is cautious about lending with interest payments. It sees credit relationships as a favoritism of lenders. The law considers the charging of excessive interest, or riba, to be exploitative. There is no consensus on what constitutes excessive interest, but the most extreme interpretation prohibits all forms of interest being charged on loans.
Morally Prohibited Business Activities
Islamic finance prohibits investments in companies engaged in activities that Sharia deems morally questionable, such as selling tobacco, alcohol or pork.
Islamic finance prohibits speculative behavior
According to the Maisir concept, speculative investing violates Sharia law. This includes gambling or other contracts that generate wealth from uncertain future events. The law considers fortune-making based on chance to be an activity that is not productive.
Derivative Contracts and Short Selling
Despite the ban on speculative practices, or maisir, there are Sharia-compliant versions of certain financial instruments that contain speculative elements. For example the International Swaps and Derivatives Association (ISDA) prepared the Sharia lawsuit ISDA Master Agreement. This template enables Islamic financial markets to trade options, futures and other derivatives.
Types of Islamic Financial Arrangements
Certain types of traditional bank financing arrangements are not compliant with Sharia law. The following financing activities comply with Islamic law:
Profit and Loss Sharing Partnership (Mudarabah)
Mudarabah is also known as a profit and loss partnership. There are two partners: one who provides the capital and another who is responsible for managing the capital. The partners agree to split the profits according to agreed percentages.
Leasing (Ijara) and Islamic finance
Leasing, known as Ijara, is generally consistent with the principles of Islamic finance. Here, a party rents property against predetermined payments. The lessor must own the leased asset for the duration of the lease. Ownership gradually passes to the lessee until he finally becomes the owner.
Islamic Forwards (Salam and Istisna)
Islamic Forwards, also known as Salam and Istisna, are subject to many conditions. In the futures contract, the price of the item must be paid in full in advance. This is in exchange for certain goods being delivered to the buyer. The various conditions governing Islamic redirects help ensure that they do not violate the principle of gharar or deceit.
Profit and Loss Sharing Joint Venture (Musharakah)
Musharakah, also known as profit-and-loss-sharing joint venture or equity-sharing agreement, is generally consistent with the principles of Islamic finance. It is an agreement between the partners to bring in capital and profits based on a predetermined ratio. As equity partners, they all participate in the losses in the amount of their invested capital. In addition, the equity partners are liable for the actions of the other partners.
Continuous growth of Islamic finance
Islamic finance is still considered to be at the beginning of its development. One of the organizations leading initiatives to encourage the growth of the sector is the World Bank. In cooperation with the Turkish government, the World Bank Global Islamic Financial Development Center. Based in Istanbul, this political institute is a hub for conducting research, promoting ideas and advising countries interested in developing financial institutions based on the principles of Islamic finance.