What is Islamic Finance?
Islamic finance is a special branch of finance that involves doing financial transactions while respecting Sharia Law. The Quran provides a detailed list of the rules of life that the prophet Mohamed instructed its people to follow. Among these instructions, there are specific laws on how people should fairly engage with each other when it comes to finances. These principles that dictate commercial transactions in Islamic finance are referred to as fiqh al-muamalat. The fiqh al-muamalat specifies that:
- All participants in a financial transaction must share profit and losses (This is the principle of muḍārabah and mushārakah, as it requires all parties involved to collaborate toward reaching a common good)
- It is prohibited to charge interest (otherwise known as RIBA
Both above principles stem from one simple idea, which the Prophet Mohamed clearly explains as the commitment principle: syirkah. This principle says that all parties involved in a financial transaction must cooperate toward the common good and that no one should make a profit solely based on time. The principle that no one is allowed to make a profit based on time is the reason Islamic finance prohibits interest payments. The principle of cooperation is the reason Islamic banks always take a share in the business that they invest in, they share the risk
Islamic finance works in the following way. Banks finance money to businesses and businesses do not pay interest on the finance, but instead, share profits with the bank. The bank enters equity participation with the business. If the business loses money, the banks lose money too, as the principle of syirkah requires all parties in financial transactions to share profits and losses.
Islamic finance is geared towards the creation of value. Therefore, investing in activities and businesses that are considered forbidden, otherwise known as haram is not allowed under Islamic finance. This means that you cannot invest in activities that include selling pork, alcohol, weapons, bioengineering, and any other technology that seeks to alter the human body, gambling, and entertainment (cinema, movies, pornography). These activities are either considered immoral or unproductive to society, hence they are prohibited to invest.
Islamic finance also prohibits speculation, otherwise known as maisir. This means that financial institutions cannot engage or invest in gambling-related activities or trading financial derivatives in the financial markets. In conjunction with the maisir , there is also the principle of gharar. This second principle prohibits engaging in financial activities with excessive risk. Therefore, Islamic finance cannot be involved in the short selling of any type of equity. So, while Islamic finance allows buying long on equities. It prohibits selling short the equities.
Even though there are many differences from conventional finance, Islamic finance wants just to assure that everybody gets a fair deal and that every investment brings a tangible value to society. While this eliminates opportunities for arbitrage and interest income, it also makes finance less risky and more approachable for the common investor.