Raising capital, managing finances, and making different investments in ways that comply with the rules of Sharia (principles of Islam), are referred to by bankers and financial experts as ‘Islamic Finance.’ This type of finance has its own ground rules and basics that we will illustrate in a simple way.
When Did It Start?
This may sound like a ridiculous question to you since the obvious answer is that: Islamic rules of finance were set thousands of years ago; to be more specific, it started in the 7th century when Islam first emerged. But what we are asking here is when did modern financial institutions begin to incorporate Islamic finance in their services.
Banks and different institutions began formalizing and offering Islamic financial services in the early 1960s. The reason behind this was the increasing demand and need for Sharia-compliant services due to the rise in oil wealth.
What Are the Basic Islamic Financing Agreements?
There are some recurring terms and financial transactions that you will encounter when practicing Islamic finance, which are:
Contracts of Partnership: here, two or more parties engage in a wealth collection activity, sharing profits and losses. These contracts include:
Mudarabah, Profit and Loss Sharing Contracts:
In simple words, Mudarabah is the process of investing in a group of mutual funds, conforming with Sharia rules. The investment is managed by financial experts. Both the part managing the investment and the investors themselves share profits and losses. The mutual funds chosen for Mudarabah exclude any companies engaging in prohibited forms of trading, e.g., alcoholic drinks.
In this contract of partnership, two parties enter an investment agreement where both contribute to capital and labor force. The profit-sharing terms in a ‘Musharaka’ contract are agreed upon in advance, where losses are determined based on the amount invested by each party.
Contracts of Exchange: In these Sharia-compliant sale contracts, different merchandise and commodities are transferred for other commodities or money. These include:
Murabaha is a cost-plus Islamic contract of exchange where banks and different financial institutions will purchase merchandise or commodity and sell it to buyers charging the original cost in addition to profit margin. These charges are agreed upon beforehand.
Salam and Istisna:
Both are forward sale contracts. In Salam, the buyer or a financial institution hired by the buyer will purchase goods and pay for them in advance and receive them in the future. With Istisna, a bank or a financial institution will buy an under-construction project on the behalf of the buyers to be delivered to them in the future after the completion of construction.
What Financial Transactions Are Prohibited in Islamic Finance?
To support Sharia-compliant contracts, Islamic finance institutions do not resort to the following transactions:
Riba: this is the Arabic equivalent of ‘interest.’ In Islam, the increase of the original amount paid; is prohibited. According to Islam rules, riba creates ‘social injustice.’
Uncertainty: referred to as ‘gharar’ in Islamic finance, any type of contract where one of the involved parties lacks the proper knowledge of the transactions performed under the terms of the contract, causing this party to make poor decisions; is prohibited.
Forbidden products and industries: any investments made through businesses trading products prohibited by Islam, e.g., alcohol and pork, or conducting any forbidden activities, e.g., gambling; are prohibited in Islamic finance.