An important area of Shariah is the set of rules that govern financial transactions and commercial activities. Islamic Finance refers to those activities - including insurance - that conform to Shariah Law.
There are many similarities between Islamic and conventional banking. However conventional banks often base their products on the accumulation of interest which is forbidden in Islam as usury.
The rules of Shariah governing the functioning of Islamic banking are known as Fiqh al-Muamalat (the Islamic rules of transaction). The main objective of Islamic banking is based around equally sharing the profit and loss of transactions and hence eliminating usury ("Riba").
There are numerous interpretations of the Islamic laws of transactions used by Islamic banks all over the world. However the most important and common are:
- Profit Sharing (Mudharabah)
- Safekeeping (Wadiah)
- Joint Venture (Musharakah)
- Cost Plus Sale (Murabahah)
- Leasing (Ijarah)
Islamic mortgages and finance arrangements
There are various rules governing an Islamic mortgage transaction. For instance, when a buyer wants to buy a property from the vendor, he or she approaches the bank in the normal way. However, instead of lending the buyer the money, what the bank does is buy the property from the seller themselves and then re-sell it to the buyer at a profit. Such an arrangement is called Murabahah.
ljara wa Elqtina, is another such arrangement under Islamic mortgage transactions. This is similar to real-estate leasing. Vehicle finance is handled in a similar fashion in order to comply with Shariah Laws. Under Islamic banking for financing vehicles, the Islamic bank buys the car and leases the car to the customer for a monthly rent. The bank retains the ownership of the vehicle under its name until the end of the Contract.
For business deals, Islamic banks make use of several other methods that are compliant with Shariah. One of the most popular is where the banks go into equity partnership to finance companies that need capital and agree a profit sharing ratio. In such an approach the company's rate of return sets the basis for the rate of return the bank will receive according to the pre-agreed profit sharing ratio. This makes the bank’s profit share on the finance equal to a certain percentage of the company's profits. This profit-sharing arrangement comes to an end only once the total principal amount of finance (or the banks equity in the company) is purchased back by that company. This practice is called “Musharakah”.
Venture capital funding of an entrepreneur providing labour can also be financed by the Islamic bank. This comes under the practice in Islamic banking, known as “Mudarabah”. Once again, the basis of this arrangement is profit sharing. And in such arrangements the bank and the entrepreneur together share the profits and risks involved. Participatory arrangements like this under Mudarabah help result in a balanced distribution of income generated through the ventures, eliminating the sort of monopolising of the economy.
Islamic banking – as the name itself suggests, is purely based on Islamic financial principles – and is therefore strictly restricted to deals which are acceptable under Islam. Such deals exclude those which involve alcohol, pork, gambling and other Haram practices. Islamic banking promotes ethical investment and Shariah-compliant activities.
These rules clearly define what is Haram (prohibited) and what is Halal (permissible) in a financial transaction.
Shariah prohibits
- Riba - Interest or Usury
- Maysir or Qimar - Gambling and Speculation
- Gharar - Uncertainty
- Exploitation
- Unfairness
- Any connection to Haram activities or products (consumption of alcohol/pork)
Shariah requires
- Risk and reward sharing
- Fairness and transparency
- The sanctity of contracts