Principles of Islamic Finance
By Sharjeel Ahmad , Director, Operations at Inaya Consultancy Services Pvt. Ltd.
On 2011-03-01

Principles of Islamic Finance

 

Islamic Finance appears a very murky subject to study, and is often clouded with a lot of ignorance. A very interesting aspect of this domain is that it was hitherto being believed that practical implementation of this concept is very difficult. Almost all these speculations result due to ignorance of people with respect to the concepts of Islamic finance. People also feel that Islamic finance is something out of this world and is not congruent with the existing financial scenario. Through this column, we try to look at these aspects and in turn, learn about Islamic finance in a more practical and objective way.

 

Let’s start by looking at the concept of Islamic banking and finance from the conventional banking and finance domain. In a conventional banking setup, a bank or financial institution generates funds and invests in some activities and gains profit or incurs losses. It further distributes the returns to its customers who have contributed in generating the funds for investment. Consider the three concepts of i) generating funds, ii) investing, and iii) distributing the returns. An Islamic bank or financial institution would work exactly the same way: generating funds, investing, and distributing returns to its customers. However, an Islamic bank/financial institution would differ from conventional banks/financial institutions: in what sense would it differ is what we look at first in this introductory module. We need to reckon these differences to be able to comprehend and analyze how Islamic banking/finance can be implemented in the present day scenario.

 

Before we explore the differences; though, let’s first look at the basic principles or building blocks of Islamic banking/finance. After we have this knowledge of the principles of Islamic banking/finance, it would become easier for us to comprehend the differences. Even before we look at these principles, we need to look at the sources from where we acquire the information related to Islamic banking and finance. As the name itself suggests, Islamic banking/finance finds its origin and source in the Quran, which is a comprehensive dossier describing how a practicing believer (Muslim) must conduct himself/herself with respect to this world and the Hereafter. Another important source of information is the Hadiths, or the Prophetic Traditions. Based on these two primary sources, the Islamic law or Sharia is reckoned. Sharia or Islamic law can be broadly divided into categories, Ibaadat or worship, and Muamlaat or transactions. Islamic finance comes under the category of Muamlaat or transactions. As per the conventions, this category of Sharia law allows whatever is not prohibited. Consequently and as a corollary, any investment that is NOT PROHIBITTED is allowed as per Sharia.

 

Let’s now look at the guiding principles on which Islamic banking/finance is based upon:

 

§  Prohibition of Riba [Interest]: Implies that interest payment is prohibited. In other words, when an Islamic bank/financial institution distributes the returns of its investments to its customers, the returns must not contain any element of interest in it. This is the basic differentiating factor between conventional and Islamic banks/financial institutions. [Note that Riba is a vast term with multiple interpretations by different schools of thought. We will Insha Allah provide elaboration on this topic in later issues.]

 

§  Prohibition of Gharar or Undefined Risk, Uncertainty, and Speculation: Implies that any transaction involving uncertainty, risk, and speculation is unlawful. Therefore, an investment that includes wide speculations with unknown implications is not permitted. Examples of such transactions could include futures and options.

 

§  Encouragement of Profit and Loss Sharing: Implies that a transaction must encourage sharing of both profit as well as losses by all the parties involved.

 

§  Contract: Implies a mutual agreement between all the transacting parties. In Islam, all transactions are based on intentions; however, Islam encourages documenting these intentions and agreements between all transacting parties to ensure a fair and just environment. Contracts are the most important part of all Sharia-compliant transactions; an otherwise legal transaction may become illegal and prohibited based on specific contracts.

 

§  Conditionality: Implies that making one contract conditional upon another contract is prohibited. Therefore, if the return on an investment were subject to the fulfillment of a condition included in some other contract, it would be unlawful as per Sharia.

 

§  Prohibited Commodities: Implies that transacting in commodities and activities declared Haraam or unlawful in Islam is prohibited. For example, investing in liquor or pork products is unlawful as per Sharia.

 

§  Compliance with Islamic Principles: Implies that an Islamic bank/financial institution maintain a religious board that can audit all transactions and ensure they are Sharia-compliant.

 

§  Public Need or Necessity: Implies that investments focusing on public need and urgency are given priority in terms of investment decisions. Therefore, it is more objective to invest in projects that could help alleviate problems of poor countries as compared to investing in amusement parks in a rich country.

 

Therefore, if we were to differentiate between a conventional bank and an Islamic bank in terms of generating funds, investing, and distributing returns, it would be as shown in Table 1:

 

 

Investment Parameters/Bank Type

Conventional Bank/Financial Institution

Islamic Bank/Financial Institution

Generating Funds

§  Generate funds through all available sources

§  Do not consider the lawful and the prohibited in terms of Sharia

§  Generate funds only through Sharia-compliant means, such as profit/loss sharing agreements

Investing

§  Invest in all available options

§  Do not consider the lawful and the prohibited in terms of Sharia

§  Invest only in Sharia-compliant options

§  Do not invest in prohibited transactions such as alcohol and pork products

Distributing Returns

§  Almost a majority of banks/financial institutions agree to give a fixed return (interest) to the customers

§  The fixed return (interest) is paid irrespective of the profit/loss incurred on the investment

§  Almost a majority of banks/financial institutions keep a large portion of profit with themselves while forwarding only a partial amount to customers as interest

§  Often the large portion of profit retained by the banks/financial institutions is reinvested, resulting in the creation of pseudo or plastic money

§  Retention of large portions of profit increases the rich-poor divide

§  Returns generally distributed in proportion to the investments made by the customers

§  All parties share profit as well as losses (as and when incurred)

§  No creation of pseudo or plastic money

§  Narrow down the gap between rich and poor

 

 

Questions and problems related to this module can be addressed to sharjeel.ahmad@inayaconsultancyservices.com Please tag the subject line with “Learn Islamic Finance”.

 










   


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