What is “What is Islamic Finance”?
Islamic finance refers to financial activities that are in compliance with Sharia (Islamic) law. One of the key principles in Islamic finance is the prohibition of interest (riba) neither paid nor received. In addition, since Islamic law does not recognize money and money instruments as a commodity, returns must be tied to a real asset, and risk should be shared on a joint basis, for example, structured as a partnership. Other key principles include the prohibition of speculation (maisir) and uncertainty/risk (gharar), as well as trading in non-Sharia compliant products such as alcohol and pork.
Key Learning Points
- Islamic finance refers to financial activities as well as investments that are compliant with Sharia (Islamic) law
- Key principles are the prohibition of paying or charging interest, involvement in uncertain/risky activities, and speculating
- Investing in companies that are involved in non-Sharia compliant activities involving alcohol, pork, and gambling are prohibited
- Although its concepts date back to the middle ages, Islamic finance occurred as a formal and structured establishment in the financial system in the 20th century
- According to a study by the Foreign and Commonwealth Office, Islamic finance represents over $1.2 trillion of the international financial system, and the sector is developing fast
Islamic Finance Principles
As Islamic finance differs from conventional financial services and prohibits certain activities, there are special types of arrangements that have been developed in order to be compliant with Sharia law.
This type of agreement relates to profit-and-loss sharing (according to a pre-agreed ratio) and is structured as a partnership agreement in which one party provides the capital to another who is in charge of its management and investment.
This is a type of financing agreement that is similar to leasing. It requires the lessor to pay the property and lease it to the lessee, while in return receiving rental payments and at the end, the property ownership is transferred to the lessee.
This is a type of partnership, in which all parties contribute capital and share the profit and loss proportionally. The two major types of Musharakah are structured in the following ways:
– The institution (bank) and investor jointly purchase a property. Then the institution gradually transfers its portion of ownership to the investor in exchange for regular payments. This is a type of diminishing partnership.
– Usually, when financing longer-term projects, the parties agree to continue operations without a specific end date. This is a permanent type of agreement.
While the Sharia law allows investing in equities and private equity, as long as they are compliant with the Islamic law (i.e. not having exposure to interest, alcohol, gambling, pork, etc.), there are no conventional bonds in Islamic finance due to their lending and interest payment elements. However, a bond equivalent that represents partial ownership in the asset instead of a debt obligation called “sukuk” does exist.
Below is a multiple-choice question to test your knowledge, download the accompanying excel exercise sheet for a full explanation of the correct answer.