Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law.
Usury in Islam
Further information: Riba
The word "riba" literally means “excess or addition”, and has been translated as interest, usury, excess, increase or addition. According toShariah terminology, it implies any excess compensation without due consideration (consideration does not include time value of money).
According to Islamic economists Choudhury and Malik by the time of Caliph Umar, the prohibition of interest was a well-established working principle integrated into the Islamic economic system.
This interpretation of usury has not been universally accepted or applied in the Islamic world. A school of Islamic thought which emerged in the 19th century, led by Syed Ahmad Khan, argued for a differentiation between sinful "usury", which they saw as restricted to lending for consumption, and legitimate "interest", for lending for commercial investment.
Types of Islamic lending
One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier mudarabah model as the basis of a riba-free banking. The bank would act as the capital partner in mudarabah accounts with the depositor on one side and the entrepreneur on the other side. This model would be supplemented by a number of fixed-return models—mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna'), etc. In practice, the fixed-return models, in particular murabaha model, were the bank's favourites, as they bear results most similar to the interest-based finance models. Assets managed under these products far exceed those in "profit-loss-sharing modes" such as mudarabah and musharakah.
Murabahah may be called an Islamic mortgage transaction, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).
An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.
There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus, the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.
Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. The Islamic Banking and Finance Database provides more information on the subject.
The Qur'an prohibits gambling (games of chance involving money). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty).
The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined ghararas "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazmof the Zahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." Other modern scholars, such as Dr. Sami al-Suwailem, have used Game Theory to try and reach a more measured definition of Gharar, defining it as "a zero-sum game with unequal payoffs".
There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to beharam.
What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk.
The "most prominent" research and training institutions listed in alphabetical order, "exclusively devoted to Islamic economics and finance", according to Muhammad Akram Khan ''
Islamic Economic Institute, previously Islamic Economics Research Centre, and before that International Centre for Research in Islamic Economics, King Abdulaziz University, Jeddah, (Saudi Arabia)
Islamic Research and Training Institute (IRTI), Islamic Development Bank (IDB) Jeddah, (Saudi Arabia)
School of Islamic Islamic Banking and Finance, previously International Institute of Islamic Economics, Islamabad, (Pakistan) (IIUI),
Institute of Islamic Banking and Insurance, London (UK)
International Centre for Education in Islamic Finance (INCEIF), Malaysia
Islamic Finance Training, Kuala Lumpur (Malaysia)
Ethica Institute of Islamic Finance, Dubai
Islamic Finance Academy, Dubai
Centre for Islamic banking and Finance Training, Kuala Lumpur (Malaysia)
Institute of Islamic Finance, London (UK)
Islamic Finance Advisory and Assurance Services, Birmingham (UK)
Islamic Finance Institute of South Africa
Centre for Islamic Finance of Bahrain, Institute of Banking and Finance (BIBF)
Centre for Banking and Financial Studies, Qatar
In Iran, it is the Securities and Exchange Organization which is responsible for compliance and innovation in Islamic products and has a "Sharia committee" to assess the compatibility of all its products with Islamic law.