Islamic Finance or Islamic banking can be described as the means through which the corporation all across the Muslim nations, including the Islamic banks and other money lending institutions, function to raise capital in accordance with the Islamic Laws or Sharia. The Islamic banking has been formalized since late 1960s. It is also known as the non-interest banking based on the principles of Shari’ah Law. The two major principles of Islamic banking are, prohibition of collection of the interest or ‘riba’ on the principal amount and sharing of the loss as well as the profit (The World Bank Group, 2015). Since, the Islamic banks do not charge interest, their earning comes from the equity participation systems, which means, if a business takes money from the banks it does not need to pay back interest but, it needs to give the Islamic bank a share in its profits. There are more than 300 Islamic banks all across the world and Islamic financial institutions manage a whooping amount more than $800 billion. This sector is growing by 10-12% annually (Reuters, 2007).
The report will discuss Islamic banking in detail further and its principles as well. A description of the main practices of Islamic banking and Shari’ah will also be given in the report. The report will also discuss the practices of Mudaraba, Murabaha and Musharaka and their principles with the help of the examples. The report will also analyze how the conventional banking differs from Islamic banking and which practices are better in which banks. All these aspects of Islamic banking will be discussed with the help of supporting evidences.
Shari’ah can be thought as the universe of Islamic ideals and laws. The word Shari’ah literally means “a well-worn path to a water source” and it promotes the idea that just like water is essential for life, Islam is essential for spiritual well- being of the humans. It is made up of rules, regulations and commandments designed by God for protecting and benefitting the mankind. It provides the framework for the well functioning of the society and defines specific morals, social, political and ethical codes of conduct. It covers two aspects of the world- worldly matters and worship (Stacey, 2018).
The Shari’ah provides ideals to Islam as a religion and without it, Islam would be without ideals. For Muslims, Islam without Shari’ah will be without any prescriptions on prayers, alms, ablution, diet, filial piety, civics, sales etc. To ensure the importance and compliance of Shari’ah in Islamic banking, there is a Shari’ah Board which governs the banking operations and provides guidelines and suggestions to these institutions (Rammal, 2006).
There are four major sources of Shari’ah as mentioned below:
The Quran: According to Muslims, the words in Quran are the direct words of Allah, transmitted by Prophet Muhammad and thus, all the Islamic laws, including Shari’ah, are mentioned in this holy book (Huda, 2018).
The Sunnah: it is a collection of written documents including the practices or traditions of Prophet Muhammad. The details related to the laws mentioned in Quran are clarified by the Sunnah.
Ijma’ (consensus): it specifies the legal ruling and it defines the consensus from the aspects of both Islamic community as well as religious authorities.
Qiyas (Analogy): It describes the reasoning, analogy and legal precedent for deciding the new case law, in case something needs legal ruling and it has not been mentioned clearly in the other sources (Huda, 2018).
The investments made in compliance with the Shari’ah law have to follow a few principles laid by Islam in order to make them Shari’ah compliant investments. While ensuring whether an investment is permissible as per Sharia’ah law, the following three principal rules need to be followed:
Absence of riba: The investment must not involve any sort of interest or riba, as it is strictly prohibited in Islam. The Shari’ah principle states that it is not acceptable for any commodity, including money, to multiply its value merely by being rented to any other person. This prohibition is for both the parties, lender cannot lend it to borrower and borrower cannot pay it to lender. However, Shari’ah allows the investor to make the return on the capital, if he/she is willing to invest the shares in the market (UBL Fund Managers, 2017).
Potential for unethical concerns in investment mix: the investment in the following commodities is not acceptable under Shrai’ah. Investment in alcohol, pornography, gambling, ancillary activity, tobacco, other banking institutions or any other activity which is prejudicial to the Islamic interests is not considered to be legal under Shari’ah law.
Nature of contract between two parties: the contracts between the two parties need to be highly transparent and valid. Shari’ah law also promotes the idea that all the contracts must be well written and well documented and all the terms and conditions of investment must be clearly mentioned for both parties, so that there are no disputes between them in future. Any contract which does not include the required information like price, delivery data, subject matter and such others is declared as guilty of “gharat” and considered to be void (UBL Fund Managers, 2017).
The two banking systems are very different from each other. The Islamic banking system is ethical banking system which uses the practices compliant with Shari’ah law and interests are strictly prohibited in this banking system. Conventional banking system, on the other hand, is an un-ethical banking system based on man-made laws and since, it is profit -oriented, it charges interests on the transactions (Jamaldeen, 2018).
In conventional banking system, money is the product apart from just being the medium of exchange, whereas, in Islamic banking real asset is the product and money is just a medium of exchange.
Islamic banking operates on the principle of sharing the profit and the losses and shares the loss of a company in case it suffers loss, whereas, conventional banks charge interest from the person even if the company is suffering loss (Academy for International Modern Studies, 2018).
In case of running finance, disbursing cash finance or working capital finance, no agreement is signed for the exchange of services and goods, whereas, in Islamic Finance, execution of agreements is must, in case of exchange of goods and services as well as disbursing the funds under Salam, Istisna and Murabaha contracts.
The Islamic banks are governed by a Shari’ah Board which consists of Islamic jurists and they look after every action taken by the banks. The conventional banks, on the other hand, involve no such Board (Jamaldeen, 2018).
The government can easily take loans from the Central Bank without the need of initiating capital development expenditure through the Money Market Operations. From Islamic Banks, on the other hand, government cannot obtain loans without ensuring that the money will be delivered to National Investment Fund.
In conventional banking, real growth of money does not take place as the money remains within few hands. In Islamic banks, on the other hand, real growth of money takes place as a result of the multiplier effect and equity sharing in the companies in which the bank invests (Academy for International Modern Studies, 2018).
The six key principles of Islamic banking are as follows:
Murabaha can be explained as a cost plus transaction in which a customer places a financial order with any Islamic financial institution for purchasing an asset or a good from any supplier. Basically, Murabaha involves three parties- the financer who provides the finance, the purchaser who places the request with the bank to buy a particular product and supplier as the third party which provides the goods or services to the customer. The bank pays the total amount to the supplier and the purchaser can pay the amount to the bank in the form of instalments or in a balloon payment later. It can be considered as a loan in the context of the conventional banks. It is similar to rent-to-own agreement in Islamic lending bank, in which the intermediary retains the ownership of the item being sold until the entire loan is paid (www.islamicfinance.com, 2015).
The key principles of Murabaha are:
Mudaraba can be explained as a form of partnership in which one of the partners invests in any business project and the other partner uses its skills to manage the investment and bring out good results for the project. It is different from a partnership as it does not involve the creation of a separate company until and unless the partners are able to manage their profits separately and effectively. The profits which are earned through this partnership can be distributed between the partners as per the pre-determined ratio. The partner who provides the capital carries loss in the Mudaraba contact, until and unless he proves that the loss in the business was due to the negligence of the mudarib or violation of the conditions they agreed upon previously. An example of Mudaraba can also be seen between the Islamic bank and the trustee or depositor where the bank is the provider of funds and the depositor is the mudarib. Mudaraba also serves as a source of funds for the Islamic banks. There are mainly two types of mudaraba contracts – restricted mudaraba (investor invests the fund into a specific type of project) and unrestricted mudaraba (where the working partner has permission to funnel funds into any type of business) (International Financial law Review, 2005).
Its key principles are:
Musharaka can be explained as a type of Shirkah al-Amwal which means sharing. It can be referred to as a joint enterprise where the parties involved need to share their profits and losses. It is used for financing the business ventures based on the Islamic law. It can also be referred to as an old fashioned technique, which is restricted to the small scale investments made by the company. It can be compared to Mudaraba in the sense that different parties are involved in the formation of the business alliance. But the major differences between these two are that in Musharaka, all the parties which are involved need to provide capital in the form of initial investment. The profits between the parties involved in it are shared on the basis of the pre-determined ratio but, the losses in this transaction are shared in the proportion of the investment done by individual parties. This makes it compulsory for the parties to make active and sharp decisions to determine the profit of the overall company. The management of investment is done collaboratively by all the parties involved (Financial Islam, 2018).
An example of musharaka is the investment in the property or real estate for earning profits. If one of the partners does not have enough amounts to buy a property, he can collaborate with the other partner and they can purchase a property together. Later, if they sell the property for any commercial purposes, the profits between them will be shared equally or in a pre-determined ratio. But, if they are not able to sell property and the property incurs loss, the losses will be shared by them in the ratio they initially invested their money (Financial Islam, 2018).
Conclusion
The above report gives an account of the terms and practices related to Islamic Finance. Islamic finance runs on the concept of no interest and is many ways different from the conventional financial institutions. The report highlights that the Islam finance runs on six certain types of principles such as Gharar, Maisir and such others. The main sources of principles for Islamic banking include Quran, Sunnah and Qiyas. The Islamic banking is quite different from conventional banking system as the conventional banking system runs for the purpose of profit majorly whereas, Islamic finance is aimed at welfare of the Islamic community. The differences between the two types of banking systems have been mentioned in this report in detail. The report highlights the difference between the two. Also, it gives an account of the practices like Musharaka, Mudaraba and others in the context of Islamic finance. Musharaka is the practice in Islamic banking which is based on a profit and loss sharing basis between the enterprises. Mudaraba and Murabaha are types of contracts between tow or multiple parties which establish a joint ventures. All the practices in Islamic banking are restricted under laws which need to be followed strictly. The ongoing activities in Islamic banks are supervised by Sharia’ah Board. These banks are spreading all across the world at great pace and are known for their welfare under fixed set of regulations. These banks are becoming technologically advanced at a higher pace than conventional banks and many European and American nations are also promoting the practices of Islamic Banking.
References
Academy for International Modern Studies, 2018. Difference Between Islamic Banking and Conventional Banking. [Online] Available at: https://www.aims.education/study-online/difference-between-islamic-banking-and-conventional-banking-system/[Accessed 19 December 2018].
Financial Islam, 2018. Musharakah. [Online] Available at: https://www.financialislam.com/musharakah.html[Accessed 19 December 2018].
Huda, 2018. What Are Sources of Islamic Law? [Online] Available at: https://www.thoughtco.com/sources-of-islamic-law-2004417[Accessed 19 December 2018].
International Financial law Review, 2005. The-three-principles-of-Islamic-finance-explained. [Online] Available at: https://www.iflr.com/Article/1984844/The-three-principles-of-Islamic-finance-explained.html[Accessed 19 December 2018].
Jamaldeen, F., 2018. Four ways conventional and islamic commercial banks differ. [Online] Available at: https://www.dummies.com/personal-finance/islamic-finance/four-ways-conventional-and-islamic-commercial-banks-differ/ [Accessed 19 December 2018].
Muslims in Calgary, 2017. Islamic Banking and Finance [2/5]: Six Key Islamic Banking Principles. [Online] Available at: https://muslimsincalgary.ca/islamic-banking-finance-25-six-key-islamic-banking-principles/[Accessed 19 December 2018].
Rammal, H.G., 2006. The importance of Shari’ah supervision in islamic financial institutions. Corporate Ownership and Control, 3(3), pp.1-8.
Reuters, 2007. FACTBOX: Key facts about Islamic finance. [Online] Available at: https://www.reuters.com/article/us-islamic-finance/factbox-key-facts-about-islamic-finance-idUSL214795420070321[Accessed 19 December 2018].
Stacey, A., 2018. What is shariah? [Online] Available at: https://www.islamreligion.com/articles/11299/what-is-shariah/[Accessed 19 December 2018].
The World Bank Group, 2015. Islamic Finance. [Online] Available at: https://www.worldbank.org/en/topic/financialsector/brief/islamic-finance[Accessed 19 December 2018].
UBL Fund Managers, 2017. Shariah-compliant Investments. [Online] Available at: https://www.ublfunds.com.pk/alameen/resources-tools/learning-center/shariah-compliant-investments/[Accessed 19 December 2018].
Uddin, M.A., 2015. Principles of Islamic Finance: Prohibition of Riba, Gharar and Maysir. Munich Personal RePEc Archive.
www.islamicfinance.com, 2015. Murabaha Contract. [Online] Available at: https://www.islamicfinance.com/2015/01/murabaha/[Accessed 19 December 2018].
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