What is Islamic Finance?
The basis for all Islamic finance lies in the principles of the Sharia, or Islamic Law, which is taken from the Qur’an and from the example of Prophet Muhammad (peace be upon him). The Islamic form of finance is as old as the religion of Islam itself.
Central to Islamic finance is the fact that money itself has no intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive money from someone and expect to benefit – interest (known as riba) is not allowed. To make money from money is forbidden – wealth can only be generated through legitimate trade and investment in assets. Money must be used in a productive way.
The principal means of Islamic finance are based on trading – it is essential that risk be involved in any trading activity. Any gains relating to the trading are shared between the person providing the capital and the person providing the expertise.
Types of Sharia Finance
The term Sharia refers to Islamic law as revealed in the Qur’an and through the Sunnah of the Prophet Muhammad (peace be upon him).
The authority of Sharia is drawn first and foremost from the specific guidance laid down in the Qur’an.
The second main source is the Sunnah, which is what the Prophet Muhammad (peace be upon him) said, did, or approved of, and refers to the way in which the Prophet Muhammad (peace be upon him) lived his life.
The third source is Ijma’a (consensus), which involves the interpretation and analysis of newly arising issues by eminent qualified scholars of Figh who will arrive at a consensus or ruling about the issue in question.
The fourth source is Qiyas (analogy), which is the process of analogical reasoning from a known injunction to a new injunction. According to this method, the ruling of the Qur’an and Sunnah may be extended to a new problem provided that the precedent (asil) and the new problem (far’a) share the same operative or effective cause (illah).
The fifth source is Ijtihad, which is, the effort of a qualified Islamic jurist to interpret or reinterpret sources of Islamic law in cases where no clear directives exist.
The principles of Islamic finance are as old as Islam itself.
Ijara is a form of leasing. It involves a contract where the finance provider buys and then leases an item – perhaps a consumer durable, for example – to a customer for a specified rental over a specific period. The duration of the lease, as well as the basis for rental, are set and agreed in advance. The finance provider retains ownership of the item throughout the arrangement and takes back the item at the end.
Ijara-wa-iktana is similar to Ijara, except that included in the contract is a promise from the customer to buy the equipment at the end of the lease period, at a pre-agreed price. Rentals paid during the period of the lease constitute part of the purchase price. Often, as a result, the final sale will be for a token sum.
Ijara with diminishing Musharaka
The principle of Ijara with diminishing Musharaka can be used for home-buying services. Diminishing Musharaka means that the finance provider reduces their equity in an asset with any additional capital payment you make, over and above your rental payments. Your ownership in the asset increases and the finance provider decreases by a similar amount each time you make an additional capital payment. Ultimately, the finance provider transfer ownership of the asset entirely over to you.
Mudaraba refers to an investment on your behalf by a more skilled person. It takes the form of a contract between two parties, one who provides the funds and the other who provides the expertise and who agree to the division of any profits made in advance. In other words, the funder would make Sharia compliant investments and share the profits with the customer, in effect charging for the time and effort. If no profit is made, the loss is borne by the customer and the funder takes no fee.
In a Mudaraba contract, the expert who manages the investment is known as a Mudarib.
Murabaha is a contract for purchase and resale and allows the customer to make purchases without having to take out a loan and pay interest. The finance provider purchases the goods for the customer, and re-sells them to the customer on a deferred basis, adding an agreed profit margin. The customer then pays the sale price for the goods over instalments, effectively obtaining credit without paying interest.
Musharaka means partnership. It involves you placing your capital with another person and both sharing the risk and reward. The difference between Musharaka arrangements and normal banking is that you can set any kind of profit sharing ratio, but losses must be proportionate to the amount invested.
Riba means interest, which is prohibited in Islamic law. Any risk-free or guaranteed interest on a loan is considered to be usury.