What is Islamic finance?

[rakibul]

What is Islamic finance?

Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. The objectives (maqsid) of Islamic finance transactions may be summarised as below:

1.To be true to the Shari’ah principles of equity and justice;
2.Should be free from unjust enrichment;
3.Must be based on true consent of all parties;
4.Must be an integral part of a real trade or economic activity such as a sale, lease, manufacture or partnership.

Islamic finance in a broad sense was practiced predominantly in the Muslim world throughout the Middle Ages, involving various contracts fostering trade and business activities with the development of credit. In Spain and the Mediterranean and Baltic states, Islamic merchants became indispensable middlemen for trading activities. In fact, many concepts, techniques, and instruments to finance trade were later adopted by European financiers and businessmen.In contrast, the term “Islamic finance” in the modern sense appeared only in the mid-1980s. In fact, all the earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either “interest-free” or “Islamic” banking.  Islamic finance is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. This closes the door to the concept of interest and precludes the use of debt-based instruments. The system encourages risk-sharing, promotes entrepreneurship, discourages speculative behaviour, and emphasises the sanctity of contracts.

Basic financial instruments
Islamic markets offer different instruments to satisfy providers and users of funds in a variety of ways: sales, trade financing, and investment.Basic instruments include cost-plus financing (Murabaha), profit-sharing (Mudarabah), leasing (Ijarah), partnership (Musharakah), and forward sale (Salam). These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets.

Fundamental principles of Islamic finance
The basic framework for Islamic finance is a set of rules and laws, collectively referred to as Shari’ah, governing economic, social, political, and cultural aspects of Islamic societies. The Shari’ah originates from the rules dictated by the Qur’an and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad (pbuh). Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the teachings in the Qur’an and Sunnah.

The fundamental principles of an Islamic financial system can be summarised as follows:

Prohibition of interest
The prohibition of interest is founded on the prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales”; this is the central tenet in mutual dealings.  More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of “interest” as widely practiced.This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Risk sharing     
Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits.Money as “potential” capital. Money is treated as “potential” capital - that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognises the time value of money, but only when it acts as capital, not when it is “potential” capital.

Prohibition of speculative behaviour
Islamic finance prohibits transactions featuring speculation including extreme uncertainties, gambling, and risks. Therefore, transactions in Islamic finance should be backed by real assets.

Sanctity of contracts
Islam teachings upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of symmetric information and moral hazard.

Shari’ah-approved activities
Only those business activities that do not violate the rules of Shari’ah qualify for investment. For example, any investment in businesses dealing with alcohol, gambling, and casinos would be prohibited. Project finance, which puts emphasis on equity participation in transactions involving real assets, is natural fit for Islamic finance.Simple financial derivatives, such as forward contracts, are being examined because their basic elements are similar to those of the Islamic instrument of deferred sale. They may be used to hedge the risk of owning assets that are subject to unexpected price fluctuations, e.g. foreign currencies, commodities. However, innovations that have resulted in creating exotic financial derivatives to generate lucrative profits through speculation behaviour are prohibited, such derivatives may be equated to a descrition by Warren Buffet, as “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."  Warren Buffet is an American business magnate, investor, and philanthropist, considered by some to be one of the most successful investors in the world.

Microfinance
Microfinance is another candidate for the application of Islamic finance. Islamic finance promotes entrepreneurship and risk sharing, and its expansion to the poor could be an effective development tool, particularly for economic development of marginalised communities as well as poverty alleviation. The social benefits are obvious, since the poor currently are often exploited by lenders charging usurious rates.

Reference:https://www.islamic-banking.com/explore/islamic-finance