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Institute of Halal Investing
Demystifying Islamic Finance through Research
What is Islamic finance?
Many commonly used conventional financial products run afoul of Islamic prohibitions of riba (translated as usury or interest) and gharar (translated as risk or uncertainty).
As a result many Muslims are left facing a tough decision about whether to use conventional financial products that violate their faith or to forego purchasing a house or car until they can save, on their own or with help from family, enough money to purchase it outright.
Islamic finance is a set of financial products designed in consultation with a Shari'ah board to comply with the fiqh al-mu'amalat (Islamic law pertaining to financial transactions). A Shari'ah board is composed of several mufti, experts in Islamic jurisprudence qualified to issue fatawa (religious decrees). If the Shari'ah board decides the products are permitted (halal), they issue a fatwa (religious decree), which certifies the product's Shari'ah-compliance.
Although Islamic finance began solely on the retail level offering deposit accounts and home and auto finance, it has expanded significantly, particularly in the past five years, to include corporate and government finance, investing and insurance.
How is Islamic finance different from conventional finance?
The most often cited difference between conventional and Islamic finance is the prohibition of paying or receiving interest. While this is an important difference the Islamic financial and economic system has grown around a more significant difference with the conventional system. The Islamic financial system at its base is asset-based, instead of currency-based, as conventional financial systems are.
In an Islamic financial system, money has no value on its own, and therefore cannot be traded for a profit. Profit is allowed (and encouraged) so long as it is not earned from trading money (riba, commonly translated as interest or usury) or identical goods, speculation (gharar) or gambling (maysir) or investment in, production of or sale of prohibited business. The prohibited businesses are alcohol, pork-related products, conventional financial services such as banking and insurance and entertainment (hotels, casinos, cinema, pornography, music, etc.). In addition, most scholars believe that tobacco and weapons/defense should be included in the list of haram (prohibited) businesses.
Instead of interest, which is prohibited, Islamic finance is organized around risk- and profit-sharing partnerships. The different types of these partnerships are described below, but in general, the partners agree to a set distribution of the profit. If the business instead makes a loss, it must be distributed according to the capital contribution of the partners. Under mudarabah, for example, one partner is the sole contributor (rabb-ul-mal) of capital and he is responsible for any losses incurred while the entrepreneur (mudarib) loses only the effort of his work. There are also leasing (ijara), cost-plus (murabaha) and deferred sales (these financial instruments, as well as others, are described separately below).
Islamic finance is guided by Shari'ah law described in the Qur'an and the Hadith. The responsibility for interpreting the Qur'an and Hadith is left to the Ulama (experts). In modern financial institutions that offer Shari'ah-compliant products, recognized experts are brought together in a Shari'ah board where they decide which products are compliant and which are not.
For a more in depth analysis of Islamic business financing, the book Islamic Finance, by Maulana Justice (Ret.) Taqi Usmani is available our website (in the "Books" section). Sheikh Usmani is considered one of the preeminent scholars on Islamic finance and serves on many financial institutions' Shari'ah boards.