The Concepts and Principles of Islamic Finance - dummies

By Consumer Dummies

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.

Islam is more than a religion; it’s also a code of life that deals with social, economic, and political matters. A person who follows Islam is a Muslim, and every Muslim is expected to live according to the Islamic code, which is sharia (Islamic law). Each issue addressed by sharia is entwined with all other issues; therefore, economic matters are related to religion, culture, ethics, politics, and so on.

Searching for balance in Islamic finance

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: In Islam, economic activity conducted according to sharia is, itself, an act of worship. Muslims believe they will be granted rewards or merits for sharia-compliant economic activities just as they’re rewarded for worshipping Allah (God). The key to achieving such rewards is to find balance between economic activities and spirituality. In other words, a follower of the faith shouldn’t focus on business success so much that he neglects worship, for example.

  • Balancing individual and social needs: A Muslim is expected to consider society in general when enjoying the bounties granted to her by Allah. 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.

    Islam promotes moderate consumption and prohibits extravagant spending. That word extravagant applies both to spending too much on acceptable products and activities and to spending any money at all on prohibited ones. Even though the supply of resources in this world is limited, Muslims believe that Allah has provided everything that humans need (and in an appropriate quantity). Islam ensures that humans use resources wisely by placing limits on demand through the directive to be moderate in consumption.

How to manage wealth in a way that promotes justice

A core concept of Islam is that the owner of all wealth in the world is Allah and that humans are merely its trustees. Therefore, humans must manage wealth in a way that promotes justice and prohibits 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.

Islam allows for a free-market economy where supply and demand are decided in the market, but at the same time, Islam directs the function of the market mechanism by imposing specific laws and ethics that promote social justice. Therefore, social justice is a key concept of the Islamic finance industry.

Islam doesn’t allow for a society in which a small number of people enjoy most of the wealth while many people have very little. Economically speaking, social justice is the distribution of wealth in a way that helps correct such an imbalance. Islam tries to achieve social justice in the economy in many ways, among them

  • 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.

  • Prohibiting riba (interest): Islam prohibits interest-based transactions. No individual or business entity should hoard money in order to earn interest; instead, people and businesses should use money (keep it in circulation) to support productive economic activities — those that create investment, trading, and jobs. The returns of successful economic activities are then distributed to the different parties involved; wealth is shared. You’ll see more on riba below.

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

Key principles that Islamic firms follow

Based on the core concepts of Islamic economics, Islamic finance institutions adhere to certain principles that distinguish them from conventional finance. Following are four major principles that every Islamic financial firm must follow. (Note: If a company doesn’t adhere to these principles, it can’t call itself Islamic.)

Prohibiting interest (riba)

In a riba-based transaction, the owner of the wealth gets return without making any effort and bears no risk. The person receiving the loan, on the other hand, assumes all the risk and bears the responsibility of returning to the lender both the capital and the riba no matter what the outcome of the economic activity. From the Islamic point of view, in a riba-based transaction, the lender uses the misfortune of the borrower in order to acquire wealth, which is unjust.

The prohibition against riba-based transactions means that Muslims should not take out loans from conventional banks, invest in interest-based products (such as conventional certificates of deposit, savings accounts, and bonds), or invest in funds that purchase the equity of firms that promote interest-based products (such as conventional banks).

Steering clear of uncertainty-based transactions (gharar)

Islam requires Muslims to avoid transactions that are uncertain or ambiguous; not everyone involved knows what to expect and can make an informed decision. Gharar can exist in these situations:

  • When two parties enter a contract and one party lacks complete information: For example, a party purposely withholds some information in order to wield greater control over the transaction.

  • When both parties lack control over the underlying transaction: For example, two parties enter a contract related to the sale of fish that haven’t yet been caught. Both parties lack control over that transaction because outside forces (such as weather or overfishing) may prevent the delivery of all the fish expected per the contract.

Avoiding gambling

In Islam, both the acquisition of wealth by chance (not by effort) and games of chance are prohibited because they’re based on uncertainty.

The Islamic prohibition against transactions that involve gambling prevents Muslims from purchasing conventional insurance products because conventional insurance is a gamble, and the outcome, whether the buyer ends up using the policy or not, is unjust: If a policyholder makes small payments and then receives a large sum because a misfortune occurs, that’s unjust. If she makes small payments but never receives anything in exchange for them (because no misfortune occurs), that’s unjust, too. Instead, Islamic insurance, called takaful, is based on a very different model of risk management that involves shared risk and mutual responsibility.

Avoiding investment in prohibited industries

Islam prohibits industries that it considers harmful to society and a threat to social responsibility. These industries include alcohol, prostitution, pornography, weapons of mass destruction, pork, tobacco, and illegal drugs. By prohibiting certain industries, Islam also prohibits profiting from them in any way. Therefore, an Islamic financial institution can’t finance a project or asset that is prohibited, and a Muslim investor cannot put money into a mutual fund or other equity product that funnels money to a company that participates in a prohibited industry.