After gradually becoming formalized since the seventh century, Islamic finance has evolved into a $2.5-trillion industry with specialized institutions across over 80 countries worldwide. By 2024, it is expected to gain $1 trillion more, per a 2019 report from the State of Global Islamic Economy.
And while it represents just 1 percent of all global financial assets, Islamic finance has been growing faster than its conventional counterpart in the 2019 report. Though dampened by the pandemic, the industry is showing much promise as it continues to compete directly with Western banks.
Want to know how you can work your way through Islamic finance solutions? This article offers the top answers to your four most pressing questions about it.
1. What is Islamic finance?
Islamic finance refers to the process individuals and entities undertake to raise funding within the parameters set by Sharia Law as part of the Islamic tradition.
Islamic finance also describes the types of investments permissible under this religious law. Such are deemed as socially responsible investments that come in forms unique from conventional financing.
2. How do Islamic finance solutions work?
The most distinguishing trait of Islamic finance is its strict compliance with the Sharia. These finance solutions often base their offerings with utmost compliance with the rules of the Islamic religion, including prohibitions that may not necessarily be illegal in countries where Islamic financial institutions operate.
Plus, parties involved in an Islamic finance contract are also expected to share profits or losses as well as risks that come with it. No single individual or entity is allowed to gain more from the transaction than the rest of the parties involved. This is often the reason why it is considered a socially responsible investment.
To learn more about how Islamic finance works, below are other principles you need to understand:
Forbidding financing for businesses that engage in activities frowned upon by Islam.
Islamic laws prohibit the production and consumption of alcohol and pork among its believers. Since these are deemed “haram” or “forbidden” under the Sharia Law, investing in businesses that engage in such activities is also not allowed.
Prohibiting exploitative interest.
Islam considers taking interest payments from borrowers an exploitative practice in favor of lenders. Following this premise, Sharia law considers interest as usury or “riba,” which is forbidden in Islamic finance.
Contracts with excessive risk and uncertainty are prohibited.
According to the rules the industry follows, contracts with too much uncertainty or risks are illegal. This is why “gharar” – the measure of risk and uncertainty legitimacy – is observed to identify short-selling or derivative contracts that are barred in Islamic finance.
Forbidding gambling or speculation.
The Islamic law prohibits any form of gambling or speculation (also called “maisir”). This means that any Islamic financial institution should never get involved with contracts that involve ownership that relies on uncertain future events.
3. How is Islamic finance different?
Aside from the Islamic finance key principles mentioned above and its compliance with Sharia, other factors that distinguish it from conventional finance include:
- How risk is treated
- How risk is shared
Islamic finance comes in two primary forms: Sukuk (or Islamic securities) and bank financing. In conventional finance, these terms might be mistaken for debt, like bond issues and bank loans, respectively. But such terms cannot be associated with Islamic finance, at least not in its pure form.
Remember that interest is prohibited in this type of finance because of what the Sharia dictates. This is because financing gained through debt with interest puts the borrower at a disadvantage because the risk is not shared fairly.
Pure Islamic finance mandates that financial assistance is provided with both profits and losses shared fairly across the involved parties. This doesn’t necessarily need to be equal, though, as different types of contracts provided under the Sharia law specify how risk can be shared between the financier and the receiving enterprise (more on this later).
An example of this is mudarabah, or profit-and-loss sharing partnership.
This contract indicates a predetermined ratio of profit and loss sharing between the involved parties. This means that the financier’s ROI will depend on the profitability of the business, unlike conventional microfinance solutions where financiers have the right to receive both capital repayment and interest. Losses will also be borne solely by the financier (except those that resulted from the entrepreneur’s negligence or fraud).
4. How do Islamic loans work?
Islamic loans are all about providing financial and banking solutions while maintaining principles in accordance with Sharia law.
But since institutions engaged in this type of financial services are not allowed to thrive from charging interest, Islamic financial solutions and banks basically “invest” in businesses, properties, and other assets that yield ROI upon successful payment of the loan.
To understand this better, you must learn about the permissible arrangements Islamic financing has. Besides mudarabah, these are:
In ijarah, a lessor leases a property he owns to the lessee for steady rental and purchase payments. This contract ends in the transfer of the ownership of the property to the lessee at the end of the contract period.
Musharakah: Profit-and-loss sharing joint venture
Similar to mudarabah, the musharakah involves profit and loss sharing across partners. The only difference is that all partners must contribute to the capital. Everyone involved in this joint venture also shares profits and losses pro-rata, or according to the percentage of their share.
There are two major types of musharakah:
- Diminishing Partnership – This joint venture entails banks and investors teaming up to acquire properties. After the purchase, the bank gradually transfers its share of the equity to the investor in exchange for regular payments.
- Permanent Musharakah – A distinguishing characteristic of this venture is its lack of a specific end date. In other words, it is a joint venture that continues for as long as all participating parties agree to do so, making it the appropriate contract for financing long-term projects.
Murabaha: Installment Sale
This entails an intermediary buying a property with a clear and complete title and documentation. After the purchase, the intermediary investor will offer the property to a prospective buyer for a sale price that includes some profit.
Once the sale agreement is set, payment can be made outright in a lump sum or through installment or deferred payments.
While this credit sale or “cost-plus financing” is acceptable in Islamic finance, it should not be confused with interest-bearing property loans.
As the growth of Islamic finance continues, people are becoming more enlightened about its benefits. Make sure you know how to work your way through it with this article as a guide.