Things Prohibited in Islamic Finance

Things Prohibited in Islamic Finance

To comply with the Shari’ah, certain activities are prohibited in Islamic finance.

The following activities are strictly prohibited in Islamic finance:

Charging and receiving interest (riba):

A lender charging a straight interest, irrespective of how the underlying assets fare disobeys the concept of risk sharing, partnership, and justice. Thus, representing money being used to make more money. Investment in companies that conduct borrowing excessively is also prohibited.

Investments in unethical businesses (haram):

Investing in businesses that deal with activities like alcohol, gambling, drugs, pork, pornography, or anything else that Shariah considers unlawful or undesirable is prohibited.

Investments in transactions that involve speculation, uncertainty, or extreme risk (gharar):

This type of investment is considered gambling, which is prohibited (haram). For example, investing or speculating on the futures and options markets is prohibited. Mutual insurance (which relates to uncertainty) is permitted if it is related to reasonable and unavoidable business risk.

Uncertainty about the subject matter and terms of contracts:

Selling something that one does not own is prohibited. Investing in special financial techniques that are available for contracting to manufacture a product for a customer is considered as investing in a product that one doesn’t own, as the product hasn’t been made yet. A manufacturer can promise to manufacture the product under certain agreed specifications at a determined price and on a fixed date and in this case, the risk taken is by a bank that would commission the manufacturer and sell the goods to a customer at a reasonable profit for undertaking this risk. Thus, the bank is exposed to considerable risk. Avoiding contractual risk in this way means that transactions have to be explicitly defined from the outset. Hence, complex derivative instruments and conventional short sales or sales on margin are prohibited under Islamic finance.

Things Permitted in Islamic Finance

As mentioned above, the receipt of interest is not prohibited in Islamic finance. Hence, when Islamic banks provide finance, they have to find other means to earn their profits. This can be done through the profit share relating to the assets in which the finance is invested or can be via the fee that is earned by the bank for the service provided. The essential feature of Islamic law is that when commercial loans are made, the lender must have a share in the risk. If this is not so, then any amount received over the principal of the loan will be regarded as interest.

The following activities are permissible financing instruments in Islamic finance:

Profit and Loss Sharing Contracts (Mudarabah):

The Islamic bank pools together investors’ money and accepts a share of the profits and losses, as agreed upon with the depositors beforehand. The bank invests in a group of mutual funds screened for Sharia compliance. These investments are then filtered to determine whether any sources of income for the business are prohibited. Companies that hold a lot of debt or are engaged in forbidden lines of business are excluded. In addition to actively managed mutual funds, passive funds also exist. They are based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Declining Balance Shared Equity

Commonly used to finance a home purchase, declining balance shared equity calls for the bank and the investor to purchase the home jointly. The bank will then gradually transfer its equity in the house to the individual homeowner, whose payments comprise the homeowner’s equity.

Lease to Own

This arrangement is akin to the declining balance of shared equity. The financial institution or bank puts up most of the money for the house and agrees to sell the house to the eventual homeowner at the end of a pre-decided fixed term. A portion of every payment goes toward the lease and the balance goes towards the home’s purchase price.

Instalment Sale (Murabaha)

An installment sale starts with an intermediary buying the home with a free and clear title to it, which is then sold to a prospective buyer at an agreed-upon sale price. This price includes some amount of profit. This purchase can be made either outright (lump sum) or through a series of deferred (installment) payments. This credit sale should not be confused with an interest-bearing loan as it is an acceptable form of finance.

Leasing (Ijarah)

Leasing or Ijarah involves selling the right to use an object for a specific time. The condition followed must be that the lessor should own the leased object for the duration of the lease. A variation on the lease, ‘ijarah was ‘Latina, provides for a lease to be written where the lessor agrees to sell the leased object at the lease’s end at a predetermined residual value. This promise binds only the lessor and the lessee is not obligated to purchase the item.

Islamic Forwards (Salam and Istisna):

These are used for certain types of business and are not that common. The price for the item is paid in advance and the item is delivered at a definite point in the future. The help of an Islamic legal advisor is usually required as there is a host of conditions to be met to render such contracts valid.

Some permissible Basic Investment Vehicles are:

Equities

Sharia law allows investment in company shares (common stock) as long as those companies do not engage in any forbidden activities (haram). Investment in companies can be in form of shares or by direct investment (private equity).

Fixed-Income

Retirees who want their investments to comply with the principles of Islamic finance face a dilemma in that fixed-income investments include riba, which is forbidden. Hence, specific types of investment in real estate provide steady retirement income while not running afoul of Sharia law. These investments can be direct or securitized, such as a diversified real estate fund.

Basic Insurance Vehicles

As traditional insurance is not permitted as a means of risk management in Islamic law, a possible Sharia-compliant alternative is a cooperative (mutual) insurance. Investors contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed amongst the policyholders.