Islamic finance operates under principles that prohibit interest. This includes loans, mortgages and financial vehicles that build interest to generate return. This framework offers various Sharia-compliant financial products, promoting fairness and equity in economic activities.
Principles of Islamic finance:
- Charging or paying interest: Under Islamic finance, interest payments are considered an exploitative practice that favours the lender at the expense of the borrower.
- Investing in businesses involved in prohibited activities: These activities include gambling and manufacturing and selling alcohol.
- Excessive risk and uncertainty: The rules of Islamic finance also ban participation in contracts with excessive risk and uncertainty.
- Profit and loss sharing: Parties entering into contracts share the profit/loss and risks associated with the transaction. No one party can benefit from the transaction more than the other.
Alternatives to interest:
- Cost-plus financing (Murabaha):
This is a common alternative to loans in Islamic finance. Murabaha is a financing structure in which the buyer and seller agree to the cost and markup of an asset. The interest is replaced with a markup, making it an acceptable form of credit. - Profit and loss sharing joint venture (Musharakah):
This is a form of joint venture in which all partners contribute capital and share in the profits/losses of an enterprise. Musharakah allows for the financier of a project or company to achieve a return in the form of a portion of the actual profits according to a predetermined ratio. Profits are shared proportionately based on the size of each partner’s investment.
There are two types of these joint ventures:- Diminishing Partnership: This is commonly used for acquiring properties. Here, the bank and investor purchase a property together. The bank slowly transfers its portion of the equity in the property to the investor in exchange for payments.
- Permanent Musharkah: This type of joint venture is often used to finance long term projects. It does not have a specific end date and continues operating as long as the participating parties agree to continue operations.
- Leasing (Ijarah):
This is a form of contract where the lessor leases the property to the lessee in exchange for a stream of rental and purchase payments, ending with the transfer of property ownership to the lessee. The rental payment serves as a substitute for interest, making it a more equitable and Sharia-compliant option for individuals and businesses.
Sharia Complaint Contracts
A contract is considered Sharia-compliant if its terms and conditions are free of the following prohibitions:
- Payment and receipt of interest: Islamic finance revolves around the prohibition of all fixed returns derived from a debt instrument and the lawfulness of profit deriving from investments. A Sharia-compliant finance investment must be part of ’real activity’ and not a financial or monetary transaction through which the mere transfer of funds is sought.
- The prohibition on investments in prohibited/undesirable businesses: Examples include those dealing in alcoholic beverages and tobacco products and restaurants, bars, and hotels with bars for prohibited activities.
- The prohibition on uncertainty (or Gharar) about the subject matter and terms of the contract: Gharar relates to the mere ‘uncertainty’ in the quantity, quality, or existence of the subject matter of a contract, and not to the risk as used in commercial terminology. Contracts must therefore be drafted as clearly as possible to avoid Gharar. In many cases, Gharar can be effectively eliminated from a contract by carefully stating its object and price.
- The prohibition on transactions involving speculation and gambling (or Masir).
