What is Islamic Finance?

What is Islamic Finance?

Islamic finance simply put is a method of conducting financial transactions, banking, and managing money with moral principles that respect Islamic law or Sharia. Islamic finance includes activities like saving, investing, and borrowing money either for business or personal transactions that are permissible under Sharia and that comply with Islamic Laws. The concept of Islamic finance also refers to the type of investments that are permissible under Sharia.

Sharia or Islamic Law constitutes a broad set of rules guiding an individual to lead an ethical life. These rules and guidelines are derived from the Qur’an and the sayings and practices of the Prophet Muhammad. The word Sharia in Arabic means “the way,” thus showing an individual the ideal way to live. In the context of Islamic finance, the rules and guidelines place an emphasises on justice and partnership. Hence, you may hear Islamic financial services often described as “Islamic finance” or “Shari’ah-compliant”

Principle of Islamic Banking

The Islamic law or Sharia recognizes money only as a medium of exchange that has no value in itself. Therefore, as per Sharia law money cannot generate more money. Islamic law prohibits the income earned through the medium of interest generated. This interest can be defined as interest generated through lending money, or interest earned by money simply sitting in an account.

Islamic finance is principally based on trading with emphasises on justice and partnership. The use of money to make money is explicitly forbidden.

The main principles of Islamic finance are:

• Wealth must be generated from lawful trade and asset-based investment
• Each transaction must be related to a real underlying economic transaction.
• Investment should have a social as well as an ethical benefit to wider society beyond pure return
• Profit/Loss and Risks should be shared
• All harmful activities (haram) should be avoided

Therefore, banks can make a profit from the buying and selling of Shari’ah-compliant goods and services. When a customer deposits money according to Islamic law, the bank needs to select a Shari’ah-compliant investment for that deposit. The profits and risks that come with the investment are shared equally with the bank. Islamic banking practices have some clear ethical advantages over more traditional banking systems, which can be seen as unprincipled.