Islamic Finance Under Sharia Law: An Introduction

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Islamic finance refers to financing activities that must be compliant with Sharia law, also known as Islamic law. The Islamic finance sector is growing rapidly. Today, financial institutions in the Islamic world oversee more than $2 trillion in assets. The Islamic banking sector is growing by 15-25% per year.

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 modes of financing become more mainstreamed within the global financial system, it will be important to understand its principles.

Basic Principles

A number of principles form the building blocks of Sharia-compliant finance. Islamic finance bans 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.

Islamic Finance Quran
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Paying and Charging Interest

Islamic law is wary of lending with interest payments. It views lending relationships as favoring lenders. The law consider charging excessive interest, or riba, to be exploitative. There isn’t a consensus on what constitutes excessive interest, but the most extreme interpretation prohibits all forms of interest charged on loans.

Morally Forbidden Business Activities

Islamic finance prohibits investing in businesses engaged in activities that the Sharia considers morally questionable, such as selling tobacco, alcohol, or pork.

Islamic Finance Bans Speculative Behavior

According to the concept of maisir, speculative investing violates Sharia law. This includes gambling or other contracts that generate wealth from uncertain future events. The law regards creating wealth based on chance to be an activity that is not productive.

Derivatives Contracts and Short-Selling

Despite the prohibition on speculative practices, or maisir, there are Sharia-compliant versions of certain financial instruments that include speculative elements. For example, the International Swaps and Derivatives Association (ISDA) created the Sharia-complaint ISDA Master Agreement. This template allows Islamic financial markets to engage in options, futures, and other derivatives trading.

Types of Islamic Finance Arrangements

Certain types of traditional banking financing arrangements are not compliant with Sharia law. The following financing activities conform with Islamic law:

Profit-and-Loss Sharing Partnership (Mudarabah)

Mudarabah is also known as profit-and-loss partnership. This involves two partners: one who provides the capital and another who is responsible for managing the capital. The partners agree to split the profits based on agreed upon percentages.

Leasing (Ijara) and Islamic Finance

Leasing, known as ijara, is generally compatible with the principles of Islamic finance. It involves one party leasing property in exchange for predetermined payments. The lessor must own the leased property for the duration of the leasing period. Ownership gradually transfers to the lessee until they eventually become the owner at the end.

Islamic Forwards (Salam and Istisna)

Islamic forwards, also known as salam and istisna, are governed by many conditions. Under the forwards contract, the price for the item must be prepaid in full. This is in exchange for specific goods that will be delivered to the buyer. The various conditions governing Islamic forwards help prevent it from violating the principle of gharar, or deception.

Profit-and-Loss Sharing Joint Venture (Musharakah)

Musharakah, also known as a profit-and-loss sharing joint venture or equity participation contract, is generally compatible with Islamic finance principles. It involves an agreement among partners to contribute capital and profits based on a predetermined ratio. As equity partners, they all share in the losses in portion to the amount of capital they invested. In addition, the equity partners are liable for the actions of the other partners.

Continuing Growth of Islamic Finance

Islamic finance is still considered to be in the early stages of its development. One of the organizations spearheading initiatives to foster the sector’s growth is the World Bank. In partnership with the government of Turkey, the World Bank has established the Global Islamic Finance Development Center. Based in Istanbul, this policy institute is a hub for conducting research, advancing ideas, and advising countries interested in developing financial institutions based on Islamic finance principles.