Islamic Finance For Dummies
Islamic finance is a global financial system that complies with sharia (Islamic law) — a code of conduct that guides all aspects of Muslim life. Sharia prohibits certain elements that are common in conventional finance, such as interest and speculation. As the world's Muslim population increases, the demand for Islamic financial firms and products is growing dramatically.
Key Sharia Principles and Prohibitions in Islamic Finance
Sharia law differentiates Islamic finance from conventional finance. The Islamic financial system is constructed on economic concepts specified by sharia — a code of conduct that guides Muslims (the followers of Islam) in social, economic, and political matters. Sharia promotes balance and justice and discourages behaviors of excess. Some of the core ideas promoted by sharia include the following:
Allah (God) 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 sharia-compliant ways.
Material pursuits must be balanced with an individual's spiritual needs. A Muslim's economic activities and pursuit of wealth should balance with the spiritual aspects of life. Economic activity conducted according to sharia is, itself, an act of worship, but finding balance between economic activities and spirituality is key. A Muslim is expected to seek moderation in the material world — to avoid being either miserly or too materialistic.
An individual's needs must be balanced with society's needs. A Muslim needs to consider society in general when enjoying Allah's bounties. These considerations include promoting justice in all economic activities, remembering that all people have mutual responsibility for all others, and using the earth's resources wisely.
Economic transactions should take place within a just, responsible, free-market economy. Islam does not restrict economic activity but instead directs it toward being responsible to other people, to the earth, 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. A primary purpose for imposing these laws and ethics is to promote social justice: a balance in which wealth is not accumulated only by a few while most others suffer.
In support of these principles, sharia prohibits business transactions based on the following:
Interest: Riba, the Arabic word for interest, 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.
Uncertainty: The Arabic word gharar 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.
Gambling: Two Arabic words — maysir and qimar — 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; no one can know how a gamble will pay off.
Prohibited products and industries: Islam prohibits products and industries that it considers harmful to society and a threat to social responsibility. Examples include alcohol, pork, prostitution, pornography, tobacco, and any products based on uncertainty or gambling.
Islamic Financial Products Based on Sharia-Compliant Contracts
In accordance with Islamic law (sharia), Islamic financial products are based on specific types of contracts. These Sharia-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Sharia-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 (hence prohibiting short sales of stock, for example), and must be deliverable.
Here are some of the most commonly used contracts in Islamic finance:
Contracts of partnership 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. (However, the fund manager assumes financial responsibility if the loss results from its negligence.)
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 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 (or an Islamic financial institution on behalf of 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 an Islamic financial institution to buy a project (on behalf of the buyer) that is under construction and will be completed and delivered on a future date.
Contracts of safety and security 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 banks, current (checking) 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 her obligation. This contract is used by Islamic financial institutions to remit money between people.
Kafala: A third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability. In conventional finance, this situation is called surety or guaranty.
Rahn: A property is pledged against an obligation. A customer can offer collateral or a pledge via a rahn contract in order to secure a financial liability.
Timeline: The Evolution of Islamic Finance
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).
Here are some of the key events in the short history of the modern Islamic financial industry:
In 1963, the Mit Ghamr Savings Bank in Egypt was opened, becoming the first modern Islamic bank on record.
Also in 1963, the Pilgrims Saving Corporation of Malaysia — although not a bank — began to incorporate basic Islamic banking concepts.
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. (Muslims cannot purchase conventional insurance products because those products involve interest-based transactions, uncertainty, and gambling, which are all prohibited by Islamic law.)
In 1986, the Amana Income Fund, the world’s first Islamic mutual fund (which invests only in sharia-compliant equities), was created in Indiana.
In 1990, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was created to establish industry accounting and auditing standards.
Also in 1990, the Islamic bond market emerged when the first tradable sukuk — the Islamic alternative to conventional bonds — were issued by Shell MDS in Malaysia.
In 1996, Citibank began to offer Islamic banking services when it established the Citi Islamic Investment Bank in Bahrain.
In 1999, the Dow Jones Islamic Market Index (DJIMI) was established, becoming the first successful benchmark for the performance of Islamic investment funds.
In 2002, the Malaysia-based Islamic Financial Services Board (IFSB) was established as an international standard-setting body for Islamic financial institutions.
In 2004, the Islamic Bank of Britain became the first Islamic commercial bank established 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.