Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws (Shariah) and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower relationship, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank; it is only concerned with the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met on time and in full by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally according to the invested capital. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Risk management in Islamic finance concerns the viability and potential profitability of a given project and has nothing to do with the investors’ personal ability to repay the capital.

Islamic financial transactions cannot involve anything prohibited by Shariah. The prohibitions include dealing in riba, alcoholic beverages, gambling (maisir), pork related industries, unethical practices such as prostitution and environmental damaging industries.

Uncertainty (gharar) is another major prohibition in Islamic finance. Uncertainty refers to events that are beyond the normal control of man such as profitability of a certain venture. It is therefore unlawful from the Islamic perspective to guarantee a predetermined amount of profit before the venture or project is concluded as the amount of profit generated is beyond the control of man. Of course effort and controls can be undertaken to ensure profitability but the actual amount cannot be determined at the onset.  

Being just and equitable does not mean at the expense of profits. Viability and profitability should be the main determinant in deciding to enter into a business transaction. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid.

Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions when the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not expected to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity and therefore has no price and cannot be traded. They are merely an intermediary to facilitate a transaction and therefore have no value on its own. The value of money is how much goods and services it can obtain.  Any exchange of money must involve not merely a trade but a productive economic activity. Any exchange of money with money must be of equal value and on spot basis, otherwise it will result in riba. Islamic economic prohibits hoarding of money. Zakat ensures that money is not kept idle and unproductive. Hoarding money will curtail economic activity and will result in economic hardship.

Islamic finance is all about financial transactions in a just and equitable manner. All parties involved in the transaction are expected to share the gains and bear the risks equitably. Islamic finance is not only for Muslims, it is for everyone who wishes to enter into an equitable financial transaction.