Islamic finance is a term used to describe a type of finance that complies with sharia, the religious law derived from the Quran and the Hadith. In sharia, making money from money is not permitted. It views money as a measuring tool, a medium of exchange, not an ‘asset’ in itself which means that organisations operating in compliance with sharia do not charge interest.
From the mid-70s, when modern banks started to offer sharia-compliant products, Islamic finance grew into a global industry and is continuing to expand.
Examples of Different Islamic Finance Contracts
Financial products in Islamic Finance are based on specific types of contract. They include but are not limited to:
Contracts of safety and security – used by Islamic banks in order to safeguard the funds of both individual and business customers.
- Wadiah – the bank undertakes to keep the customers’ deposit safe and return it on demand, however, the bank has no obligation to pay profit or interest.
- Rahn – when a valuable asset such as property is placed as collateral against an obligation in order to secure a financial liability.
- Hiwala – a contract used with respect to debts. It is the transfer of debt from one party to another freeing the first debtor from their obligation
Contracts of partnership – agreed between two or more parties to develop wealth mutually by all parties sharing the risk and return.
- Murdaraba – money is given from one part to another to invest in a business of economic activity. Both parties share the risk and any profit made from the investment. However, if the investment fails to succeed, it is only the investor who loses money.
- Musharaka – money, skills and labour are fronted by both parties in a joint venture and both share the results of the investment, be it profit and/or loss.
How does Islamic Finance work?
Islamic finance is a model based on sharing risk between financial institutions and the individuals that use them. Instead of charging interest, wealth is generated through legitimate trade and investment in assets, however, it cannot be invested in assets that Islam forbids such as alcohol, pork, tobacco, and gambling.
An example of sharia compliance is how mortgages work in Islamic finance. Traditionally the client would borrow the money from the bank to buy the house and then pay back that loan with interest. In Islamic finance, there are two schemes: ijara or murabaha.
With an ijara there is no deposit but the bank makes money from renting the property to the client while the client pays back the mortgage.
With a murabaha the bank buys the property and then sells the property to the client at a slightly higher price. This is paid back in pre-agreed instalments but the property officially belongs to the client.
Sukuk, sharia-compliant bonds work in a similar vein. The money is not lent but rather the investor holds a share of whatever the money is spent on. The investor earns income not from interest but from profit generated by that asset or rental payments from the issuer. At the end of the term, the issuer buys back the share of the asset from the investor.
Investments or contracts involving high levels of uncertainty or speculation, essentially gambling, are not permitted meaning trading in shares, derivatives, or short-selling are not carried out under Islamic finance.
Conventional insurance, therefore, is also not permitted as paying in advance for an event that may never happen introduces elements of gambling. It also creates a situation where one party benefits at the expense of the other. There are instead sharia-compliant products available where elements of agency and profit-sharing are written into the contract.
Who is Islamic Finance available to?
It is available to everyone and you do not have to be a Muslim to use Islamic financial services. It is growing in popularity with non-Muslims, particularly due to its principles of ethics and transparency. The Islamic financial market is much more developed in countries like the United Arab Emirates and Malaysia, but Islamic banks and financial institutions in countries where Islam is not the predominant religion are starting to develop a presence, and conventional banks are starting to offer more in the way of sharia-compliant products.
Examples of Islamic banks:
- Abu Dhabi Islamic Bank
- Al Rajhi Bank
- Al Rayan Bank
- Bank of London and The Middle East (BLME)
- Gatehouse Bank
- Kuwait Finance House (KFH)
- Qatar Islamic Bank (QIB)
Conventional banks offering Islamic financial services:
- ABC International Bank
- Bank of Ireland
- BNP Paribas
- Citi Group
- Deutsche Bank
- Lloyd’s Banking Group
- Royal Bank of Scotland
- Standard Chartered