Islamic finance was created in order to provide balance between the religious and ethical believes on the one hand and investing money on the other. Moreover, it is believed that based on Islamic worldview, the Islamic finance incorporates ethical dimensions in economics.
Nowadays, Islamic banking principles are important to acknowledge by legal practitioners because of the growing Middle Eastern market, and the increasing law firms in which interact with banks that apply Islamic banking principles.
However, before digging into Islamic finance’s key principles, it is important to have a background on its source and appreciate Islamic Law (Shari’ah).
Sources of Shari’ah
Firstly, Islam derives its principles mainly from the holy Qur’an and Sunnah (Traditions of the Prophet Muhammed SWT). Thus, it includes many aspects in an individual’s life dealing with subjects such as ritual, marriage, divorce, inheritance, penal laws, commercial transactions and many other things (Chartered Institute of Management accountants, An introduction to Islamic finance).
Islamic Sharia’ah and finance
Shaira is not merely a system of law, its scope is much wider than that, in which covers the private and public matters of an individual’s life.
Under Sharia Law, Interest is prohibited, and that is the main element that identifies Islamic finance. Islamic finance is a term that reflects financial business that is not contradictory to the principles of the Shari’ah. Unlike conventional finance, specifically speaking, conventional banking business, it is based on taking interests from providing loans to the public Therefore, the banker-customer relationship is always a debtor-creditor relationship.
What differentiates Islamic banking from the latter is the receiving of interest which is specifically prohibited by the Shari’ah. It is prohibited to increase wealth by a structure of interest-based finance, but rather it is seen as a disruption to the individuals and the society as a whole (Chartered Institute of Management accountants, An introduction to Islamic finance).
Riba is a term relating to collection of interests on loans; it is built on the concept that receiving something on the exchange of nothing is immoral. As a result, Interest-bearing loans are prohibited under Shari’ah. Moreover, the prohibition of Riba has led for alternative framework of banking and finance, and it is reflected in equity-based profit and loss sharing methods within Islamic, which will be explained later on.
Moreover, the key principles of Islamic finance could be explained in the following:
Prohibition on interest-based loans, and using other Sharia compliant alternative methods. The share of profit, loss and risks because Islam encourages partnership and social integration and is keen not to guarantee a fixed amount of returns without calculating the risk.
Returns are related to effort and not luck, therefore, speculation is prevented…
It ensures that every aspect of the contract is clear in order to avoid any misassumption when it comes to the price, nature or description of the commodity. Therefore, contractual dealings and relationships are clear and fully documented.
It ensures the development and dissemination of wealth in every way that benefits the society as a whole by prohibiting the hoarding of money and wealth. As a result, there will be a spread of economic benefit.
Prohibition of unethical investment and dealings in certain products or sectors, such as alcoholic beverages, weapons, gambling, pork and suspicious financial transactions.
The alternatives that are usually applied in Islamic finance are mainly the following:
In simple words, murabaha is a transaction between three parties; the seller, the borrower and the financing party (usually a bank). Moreover, the financing party buys the intended asset that is identified by the borrower, and then sells it to the borrower for the original price plus a profit element (generally calculated based on a benchmark figure such as LIBOR). Therefore, the borrower pays the price plus the profit in instalments to the financing party (Practical Law).
In this case, the price and profit should be clear to all the involved parties.
This is a technique in which creates a partnership between and investor and investment manager.
Usually, the investor is a party in which wishes to fund the bank in providing professional, managerial and technical know-how to manage the investment. Therefore, the investment manager does not provide any capital, but is only concerned with his time and effort at risk. The investor should expect risk and bear it all alone (except in cases of investment manager negligence).
Whenever there is profit, the investment manager gets a fee for the work done, and at the end of the contracts the investment manager returns the capital to the investor with any profits minus any profits earned (Practical Law).
However, the funds should not be invested in Sharia prohibited sector as it was mentioned previously under the key principles of Islamic finance.
Similarly, to the above, this is a technique used to finance the purchase of a certain asset (complied with Shari’ah). Thus, the parties are the financing party and the client (lessee), in which pays a rental fee for its equipment or property until the end of the lease term (calculated by reference to a benchmark such as LIBOR), which then may give him the option to purchase the asset before or on the end of the lease term. Therefore, it the rent may consist a party of a capital in order to finance his final purchase. However, there is an obligation on the lessee to maintain his asset, such as obtaining the needed insurance and conducting the repairs (Practical Law).