A Brief Introduction to Islamic Finance

Islamic Finance is one of the fastest-growing financial sectors in the world. This sector has shown positive prospects despite the global financial crisis that affected all of us. Currently the Islamic finance sector boasts of more than $1 trillion in assets and is growing at a rate of 20% per year. This article provides a brief introduction to what is Islamic Financing and how it is different from conventional finance.

Islamic banking is a banking system followed in Islamic countries, which complies with the principles of Islamic law, namely Shari’ah, and follows the Islamic economics.

In order to be considered Sharia-compliant, the respective financial institution or the financial transaction, must abide by the strict rules laid down by the law. One must note that the rules of finance and trade are a part of the Muslim religion and way of life. In Quran, there are strict principles against usury and uncertainty and that strongly reflects in the Islamic financial system.

Key Principles of Islamic Finance

Riba: This is one of the best-known principles of Islamic Finance. Ruba is an Arabic word, which refers to charging of interest. Sharia forbids charging or paying of interest on loans. According to Sharia, money is not considered a type of asset class, and therefore, it cannot be used to earn money. Instead of charging interest, the Islamic law calls for sharing of profits from a transaction.

Murabahah: Murabahah, or cost plus, refers to the sale of goods as a price that includes a mutually agreed upon profit margin. The price, costs, and profit margin must be clearly stated upfront to the buyer. The honest declaration of cost incurred and the profit margin added is very important.

Mudharabah: Mudharabah refers to sharing of both profits and losses. This is like an arrangement between an investor and an entrepreneur. If there are losses, the investor bears all the losses. However, the profits are shared based on a pre-determined ratio.

Gharar: The Sharia laws prohibit gharar, i.e., trading of risk. It prohibits transactions involving uncertainty of payout, or gambling. Tangible and Identifiable Asset: According to Sharia law, any transaction must be backed by a tangible and identifiable asset.

Banned Industries: Islamic finance bans investment in any industry that is banned in Quran. This includes alcohol and brewing, tobacco, weapons and armaments, or pork-based products.

In the future posts, we will go in more detail about these principles and other laws.