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Islamic Finance

Islamic Law (Shariah)
Shariah (Šarī‘ah) is the body of Islamic law. The term means "Way" or "Path"; it is the legal framework within which the public and some private aspects of life are regulated for those living in a legal system based on Muslim principles of jurisprudence.

Shariah deals with all aspects of day-to-day life, including politics, economics, banking, business law, contract law, sexuality, and social issues.There is not a strictly codified uniform set of laws pertaining to Shariah. It is more like a system of devising laws, based on the Qur'an, Hadith and centuries of debate, interpretation and precedent.

Islamic Banking
Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called riba in Islamic discourse.

Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). In the late 20th century, a number of Islamic banks were created, to cater to this particular banking market.

Concepts of Islamic Banking

  • Bai' al-Inah (Sale and Buy Back Agreement)
  • Bai' Bithaman Ajil (Deferred Payment Sale)
  • Bai muajjal (Credit Sale)
  • Baihaqi kasi Salam (Promissory Note)
  • Hibah (Grant)
  • Ijarah (Lease Finance)
  • Ijarah Thumma Al Bai' (Hire Purchase)
  • Ijarah-Wal-Iqtina (Lease to Own)
  • Istisna'a (Factoring)
  • Mudarabah (Profit Loss Sharing)
  • Murabahah (Markup Financing)
  • Musawamah (Barter)
  • Musharakah (Joint Venture)
  • Qard Hassan (Good Loan)
  • Salam (Futures Trade)
  • Sukuk (Islamic Bonds)
  • Wadiah (Safekeeping)
  • Wakalah (Fiduciary/Trusteeship)
  • Kafalah (Guarantee)

The Basic Principles of Islamic Banking
Islamic banking revolves around several well-established concepts, based on Islamic canons, these cover the following:

  1. First and foremost, Islamic banking must operate within the framework of Islamic religion, based on the Quran and Sunnah. Hence only Halal activities are allowed. This holds ethics paramount and, consequently those activities forbidden to Muslims, i.e. gambling, liquor, hoarding and usury based lending are strictly avoided. The Bank does not, for example finance liquor manufacturing, transportation, storage or distribution companies. Scholars trained in Islamic law (Islamic Jurisprudence) “Shariah” screen the suitability of investments on an ongoing basis and provide guidance on products to the Bank's management.

  2. Interest, known as Reba in Islam is forbidden. Hence, all banking activities must avoid interest. Instead of interest, the Bank earns profit (mark-up) and fees on financing facilities it extends to customers. Also, depositors earn a share of the Bank's profit as opposed to interest.

  3. Partnership and the Sharing of Risks. Another principle of Islamic finance is based on profit sharing partnership between the parties involved in a transaction.

The return on savings and investment accounts are variable and dependent on the Bank's performance and the profits from Halal business transactions only. While these profits are not necessarily guaranteed and are subject to a degree of risk, these are managed professionally to ensure better returns than many other conventional alternatives.

Current accounts do not earn income as they are taken as Qard, from depositors to the bank and because they can be drawn on demand by customers without notice. They do not bear any risk of loss either since they are kept as a safekeeping, Wadiah or Amanah.

Differences between Islamic and Conventional Banking

Characteristics Islamic Banking System Conventional Banking System
(Interest based)
a
Business Framework
Based on “Shariah” Islamic laws, Shariah scholars ensure adherence to Islamic laws and provide guidance.
a
Not based on religious laws or guidelines, only secular banking laws
Balance Between Moral and MaterialRequirement The requirement to finance physical assets which banks usually take ownership of before resale reduces over extension of credit.
a
Excessive use of credit and debt financing can lead to financial problems.
Equity Financing with Risk to Capital

Available. Enables several parties, including the Islamic Bank to provide equity capital to a project or venture. Losses are shared on the basis of equity participation while profits are shared on a pre-agreed ratio. Management of the enterprise can be in one of several forms depending on whether the financing is through Mudaraba, Musharaka, etc.
a

Not generally available through commercial banks, but through venture capital companies and investment banks which typically take equity stakes and management control of an enterprise for providing start-up finance.
Prohibition of Gharar
Transactions deemed Gharar are prohibited. Gharar denotes varying degrees of deception pertaining to the price and quality of goods received by a party at the expense of the other. Derivatives trading e.g. options are considered as having elements of Gharar.
a
Trading and dealing in derivatives of various forms is allowed.
Profit and Loss Sharing All transactions are based on this principle. Returns are variable, dependent on bank performance and not guaranteed. But the risks are managed to ensure better returns than deposit accounts. Consumers can participate in the profit upside i.e. in a more equitable way than receiving a predetermined return. This principle is not applied. Returns to depositors are irrespective of bank performance and profitability. The customer as depositor is like a lender and does not share in the success of the enterprise beyond receiving a fixed rate of predetermined interest. Unlike the Islamic system the depositor cannot theoretically gain subject to improved bank performance
a

Islamic Insurance (Takaful)
Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. The concept of Takaful is not a new concept; in fact, it had been practiced by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1,400 years ago.

Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

In modern business, one of the ways to reduce the risk of loss due to misfortunes is through insurance which spreads the risk among many people. The concept of insurance where resources are pooled to help the needy does not contradict Shariah.

However, conventional insurance involves the elements of uncertainty in the contract of insurance, gambling as the consequences of the presence of uncertainty and interest (Al-riba) in the investment activities of the conventional insurance companies that contravene the rules of Shariah. It is generally accepted by Muslim jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah.

Islamic Equity Funds
Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 12–15% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products.

Since the launch of Islamic equity funds in the early 1990s, credible equity benchmarks were established by Dow Jones Islamic market index and the FTSE Global Islamic Index Series.


 

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