Islamic Finance 101: A Primer
As interest and opportunities in the world of Islamic finance continue to grow, business schools worldwide are duking it out to educate students on structuring Islamic investments. The inherent conservatism contained within Islamic portfolios is becoming less of a deterrent as the potential for returns is nearing that of conventional portfolios.
The factor that distinguishes Islamic finance from conventional finance is that the former is founded upon the understanding that it is compliant with the principles and precepts of Islamic law or Shariah. Shariah is not a codified body of law. It consists of general rules and principles derived from the Quran (the Muslim holy book), the practices (sunnah) and sayings (hadith) of the Prophet Mohammed. These general principles are capable of interpretation and development to address new issues or circumstances that arise from time to time. The Shariah has been supplemented by extensive Islamic jurisprudence (fiqh) developed over centuries by different schools of thought. It is important to note that, while all the schools of thought agree on the fundamental Shariah principles enshrined in the Quran, sunnah and hadith, they sometimes hold differing views on their interpretation and application.
On March 4, 2009, the Vatican issued a statement in its official newspaper, Osservatore Romano, stating: “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.” The principles underlying Islamic Finance assert that all transactions are:
(a) Free from taking or receiving interest/usury or riba
This does not mean that there is no cost of capital in an Islamic system. Islam recognizes capital as a factor of production but does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. Because of the restriction on interest-earning investments, Islamic banks must obtain their earnings through profit-sharing investments or fee-based returns.
(b) Sharing equally in profit and loss
When loans are given for business purposes, the lender, if he wants to make a legitimate gain under the Shariah, should take part in the risk. If a lender does not take part in the risk, his receipt of any gain over the amount loaned is classed as interest. Under this principle, equity participation is strongly encouraged.
(c) Backed by tangible assets (this can also include intellectual capital)
Money is viewed only as a medium of exchange in order to define the value of an asset, and has no value in itself. Therefore, it cannot be allowed to give rise to more money by simply being put into a bank or lent out.
(d) Free from uncertainty and speculation (derivatives are to be avoided)
This encompasses a sale of a good which the seller is not in a position to deliver as well the making of a contract which is conditional upon an unknown event. These transactions are prohibited due to elements of uncertainty, speculation or gambling.
(e) Screened for ethical behaviour
Investments can only be made to support practices or products that are not prohibited by the precepts of Islam such as alcohol, pornography, gambling and pork products. This principle is similar to the act of socially responsible investing.