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What Is Islamic Finance?

Islamic finance is a financial system that operates according to Islamic law (which is called sharia) and is, therefore, sharia-compliant. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts.

Although the Islamic finance industry itself is quite young, Islamic theories of economics have existed for more than a millennium; by the mid-12th century, in fact, many Muslims scholars had presented key concepts of Islamic economics that are still relevant today.

But political and social turmoil put the brakes on Islamic finance for a very long time; only in the 20th century did Muslim scholars and academics seriously begin to revisit these topics (and, in doing so, set the stage for the modern Islamic finance industry to emerge in the 1970s).

The search for balance

Islamic economics is based on core concepts of balance, which help ensure that the motives and objectives driving the Islamic finance industry are beneficial to society.

  • Balancing material pursuits and spiritual needs

  • Balancing individual and social needs

The belief that Allah is the owner of all wealth

A core concept of Islam is that Allah is the owner of all wealth in the world, and humans are merely its trustees. Therefore, humans need to manage wealth according to Allah’s commands, which promote justice and prohibit certain activities.

At the same time, Muslims have the right to enjoy whatever wealth they acquire and spend in sharia-compliant ways; they don’t need to feel shame about being wealthy as long as their behavior aligns with Islam.

The promotion of a responsible free-market economy

A Muslim believes that Islam doesn’t restrict economic activity but instead directs it toward responsible activity that benefits other people, protects the earth, and honors Allah. In other words, Islam allows for a free-market economy where supply and demand are decided in the market — not dictated by a government. But at the same time, Islam directs the function of the market mechanism by imposing specific laws and ethics.

A key purpose for imposing these laws and ethics is to promote social justice; Islam and social justice are inseparable. Therefore, social justice is a key concept of the Islamic finance industry.

Islam tries to achieve social justice in the economy in many ways:

  • Promoting adherence to Islam

  • Requiring zakat (taxing the property of people who acquire wealth and distributing that tax to people in need)

  • Defining the state’s obligations

  • Prohibiting usury (interest)

  • Encouraging shared risk

Islamic firms follow a set of key principles

Based on the core concepts of Islamic economics, Islamic finance institutions adhere to certain principles that distinguish them from conventional finance:

  • Prohibiting interest (riba)

  • Steering clear of uncertainty-based transactions (gharar)

  • Avoiding gambling (maysir or qimar)

  • Avoiding investment in prohibited industries

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