Important Principles & Components of Islamic Finance System

Islamic finance is rooted in the principles of Sharia, the Islamic legal system derived from the Quran and the Hadith (sayings of the Prophet Muhammad (saw)).

In this article, we will look into the core principles and components of the Islamic finance system, distinguishing it from conventional finance. It explores the prohibition of interest (Riba), the emphasis on risk-sharing, asset-backing, and ethical investments, and how these principles shape financial products and services in the Islamic world.

By understanding these foundational elements, one can appreciate the unique approach of Islamic finance to promoting economic justice and social welfare.

Let’s get into it.


What is Islamic Finance?

Islamic finance, also known as Sharia-compliant finance, is a system of banking or financial activities that adheres to Sharia (Islamic law) and its practical application through Islamic economics​​​​.

Founded on the principles of Sharia, Islamic finance is characterized by the prohibition of riba (interest) and investments in businesses providing goods or services considered contrary to Islamic principles, such as pork or alcohol​​​​​​.

The basic principles of Islamic finance revolve around several prohibitions, which are not always illegal in the countries where Islamic financial institutions operate. These include the prohibition of paying or charging interest (riba), investing in businesses involved in prohibited activities (haram), speculation (maisir), and contracts with excessive risk or uncertainty (gharar)​​.

Additionally, Islamic finance emphasizes material finality in transactions, where each transaction must be related to a real underlying economic transaction and the sharing of profit/loss and risks associated with a transaction​​.

Islamic finance and banking emerged alongside the foundation of Islam but were formalized only in the 20th century. The sector has grown rapidly, overseeing approximately $4 trillion and expanding annually at 10%–15%​​. This growth was significantly boosted in the late 20th century due to a revival in Islamic identity and an inflow of “petro-dollars” following events like the Yom Kippur War and the 1973 oil crisis​​.

Related: 3 Common Misconceptions about Islamic Finance You Should Know

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What are the Islamic Capital Markets (ICM)?

Islamic Capital Markets (ICM) is a crucial part of the Islamic financial system, where Shariah-compliant financial assets are transacted. These markets function similarly to conventional markets but are distinguished by their adherence to Islamic law, offering investment opportunities compliant with Shariah principles.

This adherence ensures that the activities and transactions in ICM are free from elements prohibited in Islam, such as usury (riba), gambling (maisir), and ambiguity (gharar)​​​​​​.

ICM primarily facilitates the trading of securities, such as stocks and Sukuk. Sukuk, often called Islamic bonds, are financial certificates that represent partial ownership in an asset, unlike conventional bonds, which represent a debt obligation.

The key instruments in Islamic capital markets include Mudarabah Sukuk (profit-sharing certificates), Ijarah Sukuk (lease certificates), Partnership Sukuk, Ordinary Stocks, and Islamic Mutual Funds.

The Islamic Capital Market comprises various players, including issuers (such as corporations, governments, and financial institutions that require capital), investors (individuals or institutions providing capital in exchange for a return), intermediaries (investment banks, asset management firms, brokerage firms), and regulators (such as the Securities Commission Malaysia). These players work together within a framework that ensures all market operations align with Islamic principles​​.

Related: Famous Islamic Finance Institutions in the US

Benefits and Challenges of ICM

The benefits of the Islamic Capital Market are significant for both issuers and investors. For issuers, it provides a source of long-term financing consistent with Islamic principles, relying on profit-and-loss sharing contracts like Mudarabah and Musharakah, ensuring a fair distribution of risk and return.

It offers investors opportunities to invest consistent with their religious beliefs, as investments in unethical sectors or haram (like gambling, alcohol, and tobacco) are prohibited. The market offers diverse investment products, including Sukuk, Islamic equities, and Islamic funds​​.

Despite these benefits, the Islamic Capital Market faces several challenges and risks. A primary challenge is the lack of standardization, as the market is still evolving, leading to different countries and regions adopting their standards and practices.

Another significant challenge is the lack of liquidity, as some Islamic financial products cannot be easily traded on secondary markets. Risks associated with the Islamic Capital Market include credit, market, and Shariah compliance risks​​.

Regulatory bodies at both national and international levels govern the Islamic Capital Market. The Islamic Financial Services Board and the Accounting and Auditing Organization for Islamic Financial Institutions are responsible for setting standards and guidelines to ensure compliance with Islamic principles​​.

The Islamic Capital Market is a vital component of the global economy, valued at almost $4 trillion. It plays a significant role in regions like the Middle East and Southeast Asia, where Islamic finance is widely accepted.

The growth of the Islamic Capital Market has led to an increase in cross-border transactions and offers potential contributions to the global economy by providing alternative financing for infrastructure projects in emerging markets.

Read Also: 5 Best Islamic Finance Books 2021 For Your Reading

Principles of Islamic Finance

Here’s a summary of the key principles of Islamic Finance that you must know:

  1. Prohibition of Riba (Interest): Riba, an increase or excess, is prohibited in Islamic finance. It refers to the practice of charging interest on loans or the exchange of unequal quantities of a given commodity. There are two types of Riba: Riba-an-Nasiyah (increase in loan or money) and Riba-al-Fadl (exchange of unequal qualities or quantities of a commodity).
  2. Profit and Loss Sharing: All partners share profits and losses in Islamic finance. This principle promotes equitable distribution and discourages unjust enrichment at the expense of others. Islamic banks often use profit-and-loss sharing as an investment product, where both the bank and the borrower share the risks and returns of the investment.
  3. Avoidance of Investment in Haram (Prohibited) Businesses: Islamic finance prohibits investment in businesses considered haram or forbidden in Islam. This includes businesses involved in alcohol, interest-based banking, unhealthy drugs, prostitution, pornography, and pork.
  4. Speculation (Maisir) Prohibition: Maisir, or speculation, is forbidden because it creates wealth by chance rather than productive activity. However, regular commercial risk-taking, a fundamental part of Islamic financial transactions, is not considered Maisir.
  5. Uncertainty (Gharar) Prohibition: Gharar refers to uncertainty, hazard, or risk. Islamic finance prohibits involvement in transactions where the outcomes are uncertain or the consequences are undetermined. Examples include derivative transactions such as forwards, futures, and options.

Financial Arrangements and Agreements in Islamic Finance

Distinct financial arrangements and instruments have been developed to comply with Islamic principles. These include:

  1. Mudarabah (Profit-and-Loss Sharing Partnership): An agreement where one partner provides capital and another manages the investment, with profits shared according to a pre-agreed ratio.
  2. Musharakah (Profit-and-Loss Sharing Joint Venture): A joint venture where all partners contribute capital and share profits and losses pro-rata. Types include diminishing partnerships, used for property acquisitions, and permanent musharakah for long-term projects.
  3. Ijarah (Leasing): The lessor owns the property and leases it to the lessee. In the case of Ijarah Muntahia Bittamleek, the lessee eventually acquires ownership​​.

In terms of investment vehicles, Islamic finance primarily focuses on equities and sukuk. Equities involve investments in company shares that do not engage in prohibited activities. Sukuk, alternative to bonds in conventional finance, represents partial ownership in an asset rather than a debt obligation​​.

Halal Investment Options for Muslims in 2024

In the evolving landscape of ethical investing, aligning financial strategies with Islamic principles is a growing focus for many investors. Let’s look into Shariah-compliant investment avenues that offer not only adherence to Islamic ethics but also competitive returns for Muslim Ummah worldwide. Perfect for both experienced and beginner investors looking to diversify their portfolios with investments that resonate with their spiritual and ethical beliefs.

1.    Stocks:

  1. Nature: Purchasing shares in a company.
  2. Halal Criteria: The company’s primary revenue must be from permissible activities. Companies involved in haram activities like alcohol, pork, gambling, or interest-based financial services are not suitable.
  3. Financial Screening: Ensuring the company is not highly leveraged, its interest-bearing assets and income from interest or other non-halal activities are minimal.
  4. Purification Process: Some scholars recommend donating a portion of income from potentially non-halal sources to charity.

Screen whether a stock or ETF is halal or not at Musaffa!

2.    Exchange-Traded Funds (ETFs):

  1. Nature: Pooled investment funds traded on stock exchanges, similar to mutual funds.
  2. Benefits: Diversification, reduces the risk associated with individual stocks or sectors.
  3. Halal Criteria: Shariah-compliant ETFs invest in a basket of halal stocks, ensuring adherence to Islamic principles.

3.    Cryptocurrencies:

  1. Nature: Decentralized digital currencies like Bitcoin and Ethereum.
  2. Halal Considerations: Avoid involvement in haram activities and interests. Some scholars recommend treating them like commodities, adhering to Islamic principles like immediate transaction settlement, and avoiding speculation.
  3. Many scholars still argue whether crypto is halal or not, so tread carefully when it comes to investing in crypto.

4. Precious Metals:

  1. Nature: Investing in metals like gold and silver.
  2. Halal Status: Generally permissible due to their tangible existence and low uncertainty.
  3. Considerations: Different schools of thought exist, especially regarding metals other than gold and silver.

5. Sukuk (Islamic Bonds):

  1. Nature: Asset-based securities, unlike conventional interest-based bonds.
  2. Halal Criteria: Structured to comply with Islamic laws prohibiting interest.

6. Real Estate:

  1. Nature: Investing in property.
  2. Halal Considerations: Ensuring the property is not generating income through haram means and avoiding interest-based mortgages.
  3. Real Estate Investment Trusts (REITs): Shariah-compliant REITs offer a less hands-on approach to real estate investment.

7. Halal Mutual Funds:

  1. Nature: Pooled funds managed by professionals, investing in a variety of assets.
  2. Halal Criteria: Designed to comply with Islamic principles.

What is the Islamic Accounting Concept?

Islamic accounting is a distinctive approach to accounting that integrates the principles and framework of Shariah, the Islamic law based on the Qur’an and the Hadith. This concept of accounting is not just about the technical process of recording financial transactions but also encompasses ethical dimensions, reflecting the values of justice and benevolence as fundamental to Islamic society.

Islamic accounting is deeply rooted in the Shariah framework, ensuring that all financial practices and transactions are in line with Islamic teachings and principles.

General Principles: Justice and Compassion:

  1. Justice: This principle is reflected in ensuring that all financial activities, especially in banking, adhere to Islamic rules and regulations. It involves avoiding income from illegal activities and ensuring transparency and fairness in financial dealings.
  2. Compassion: This aspect focuses on serving the public interest. Islamic financial institutions are expected to support the community, especially in times of need, such as by providing loans during calamities or aiding in poverty alleviation.

Islamic Financial Accounting Standards are a set of accounting standards designed to ensure quality and consistency in Islamic financial accounting. These standards are developed and maintained by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). They provide guidance in accounting policies and procedures for Islamic financial institutions.

What is the Difference Between Conventional Banking and Islamic Banking?

Understanding the differences between conventional and Islamic banking is crucial for anyone interested in the diverse landscape of global finance. Conventional banks operate on a fundamentally different set of principles compared to Islamic banks, which adhere to Shariah law. Here’s a detailed comparison between these two types of banking systems, highlighting their distinct approaches to various banking products and services.

1. Current Accounts:

  1. Conventional Banks: They do not use any specific underlying mode in their current accounts. The bank can use these funds for any investment or purpose, regardless of Shariah prohibition.
  2. Islamic Banks: Current accounts are based on the Wadia or Qard contract, where the bank is liable to pay the depositor’s money back on demand. The bank can use these funds for investment and other purposes, but it ensures that the investments do not contravene Shariah principles.

2. Saving Accounts:

  1. Conventional Banks: No specific underlying mode is used. The relationship between the bank and the customer is that of a debtor-creditor, and interest is involved.
  2. Islamic Banks: Saving accounts are governed under Mudarabah rules, aiming to provide a return on investment. The relationship is that of Mudarib and Rab-ul-Maal (partners), and profit is shared instead of interest.

3. Leasing/Ijarah:

  1. Conventional Banks: Lease commences from the day the price is paid, regardless of delivery. The customer bears all expenses and is liable for wear and tear or losses due to natural disasters. Penalties for late payment are considered income for the bank.
  2. Islamic Banks: Rentals start after the delivery of the asset. The bank, as the owner, bears purchase expenses. The customer is responsible only for misuse and negligence. Taking penalties for late payments is considered impermissible.

4. Lending/Financing:

  1. Conventional Banks: Operate on lending and borrowing money based on interest. They finance all types of industries, except those deemed illegal by law, and are primarily money lenders without involvement in trade or business.
  2. Islamic Banks: Function as trading/investment houses, not money lenders. They avoid transactions like gambling, speculation, short selling, and sale of debts. They do not finance industries harmful to society and actively participate in trade and production processes.

5. General Business Model:

  1. Conventional Banks: Treat money as a commodity and lend it against interest. The relationship with customers is primarily creditor-debtor, and compensation is always interest.
  2. Islamic Banks: Products are usually asset-backed, involving trading of assets, renting of assets, and participation in profit and loss. The relationship with customers is more diverse, including seller-buyer and partner, with compensation being profit.

Final Thoughts

Rooted in Shariah principles, Islamic finance distinguishes itself from conventional finance through its prohibition of interest (Riba), emphasis on risk-sharing, asset-backing, and ethical investments.

These principles not only guide financial transactions but also aim to promote economic justice and social welfare.

It does not only caters to the financial needs of the Muslim population but also appeals to a broader audience interested in ethical and socially responsible investing.

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