How Is Islamic Finance Different from Conventional Finance? - dummies

How Is Islamic Finance Different from Conventional Finance?

By Faleel Jamaldeen

Islam is more than a religion; it’s 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 sharia. Each issue addressed by sharia is entwined with all other issues; therefore, economic matters are related to religion, culture, ethics, and politics.

Islamic finance, then, is a financial system that operates according to sharia. 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 laws and by the finance industry rules and regulations that apply to their conventional counterparts.

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.

A Muslim believes that Islam does not 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 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, and it’s a key concept of the Islamic finance industry. Islam tries to achieve social justice in the economy in many ways:

  • Promoting adherence to Islam: A Muslim is expected to adhere to certain core beliefs and perform certain obligatory acts. By reminding Muslims of their obligations, Islam seeks to promote stronger relationships between each person and Allah, between people and the earth, and among individuals.

  • Requiring zakat: To promote justice related to the distribution of wealth, Islam imposes a property tax called zakat. Every Muslim who meets certain criteria regarding the accumulation of wealth must pay zakat, which is distributed to people in need. By taxing the property of people who acquire wealth and distributing that tax to people in need, Islam promotes the socially responsible distribution of wealth.

    Zakat management is part of the Islamic finance field, and zakat calculation is a separate, specialized field of study.

  • Defining the state’s obligations: Per Islam, the state is also responsible for ensuring that social justice exists. Islamic scholars argue that the state should collect zakat and guide wealth distribution to make sure that everyone’s basic needs are provided for. Scholars also generally agree that states should protect the real value of money by implementing sound fiscal policy.

  • Prohibiting usury (interest): For the sake of social justice, Islam prohibits interest-based transactions. No individual or business entity should hoard money in order to earn interest (or riba); instead, that money should be used to support productive economic activities.

  • Encouraging shared risk: Islam encourages risk-sharing in economic transactions. When a risk is shared among two or more parties, the burden of the risk faced by each party is reduced.

  • Avoiding gambling: Two Arabic words refer to transactions that involve gambling:

    • Maysir: The acquisition of wealth by chance and not by effort

    • Qimar: In modern gambling, any game of chance.

    Both types of transactions are prohibited because they’re based on uncertainty (gharar).

    The Islamic prohibition against transactions that involve gambling prevents Muslims from purchasing conventional insurance products because those products are a gamble. Instead, Islamic insurance, called takaful, is based on a very different model of risk management that involves shared risk and mutual responsibility.