Islamic finance operates on ethical principles derived from Sharia law, shaping financial practices in Muslim-majority countries and beyond. These principles aim to create a just and equitable financial system that aligns with Islamic values and promotes social welfare.
Key Islamic financial instruments have been developed to facilitate Sharia-compliant transactions and investments. These instruments provide alternatives to conventional financial products while adhering to Islamic principles, such as the prohibition of interest and the requirement for asset-backed transactions.
Principles of Islamic finance
Islamic finance operates on ethical principles derived from Sharia law, shaping financial practices in Muslim-majority countries and beyond
These principles aim to create a just and equitable financial system that aligns with Islamic values and promotes social welfare
Prohibition of riba
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الاصدار الأول - المجلة الأكاديمية للأبحاث والنشر العلمي View original
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, commonly translated as interest or usury, is strictly forbidden in Islamic finance
Extends beyond simple interest to include any unjustified increase in capital, whether in loans or sales
Encourages and discourages exploitation of borrowers
Alternative profit-generating methods developed to comply with this principle (profit-sharing, lease agreements)
Profit and loss sharing
Fundamental concept in Islamic finance promoting fairness and shared responsibility
Both parties in a financial transaction share profits and losses according to pre-agreed ratios
Encourages entrepreneurship and discourages excessive risk-taking
Common forms include and Musharakah partnerships
Asset-backed transactions
All financial transactions must be backed by tangible assets or economic activity
Prohibits speculative activities and gambling ( and maysir)
Ensures financial stability by linking transactions to real economic value
Examples include (cost-plus financing) and (leasing) contracts
Key Islamic financial instruments
Islamic finance has developed various instruments to facilitate Sharia-compliant transactions and investments
These instruments aim to provide alternatives to conventional financial products while adhering to Islamic principles
Mudarabah contracts
Partnership agreement between capital provider (rab al-mal) and entrepreneur (mudarib)
Profits shared according to pre-agreed ratios, losses borne by capital provider
Used in investment accounts and Islamic fund management
Mudarib contributes expertise and management, rab al-mal provides capital
Musharakah partnerships
Joint venture agreement where all partners contribute capital and expertise
Profits and losses shared according to capital contribution or pre-agreed ratios
Used in project financing, real estate development, and business partnerships
Allows for active participation of all partners in management and decision-making
Murabaha cost-plus financing
Sale contract where the bank purchases an asset and resells it to the client at a markup
Markup disclosed and agreed upon by both parties
Commonly used for trade financing and asset purchases (vehicles, machinery)
Payment can be made in installments, making it similar to conventional loans but Sharia-compliant
Ijara leasing agreements
Islamic alternative to conventional leasing
Bank purchases asset and leases it to the client for a fixed term
Ownership risks remain with the bank, while the client benefits from asset usage
Can include a purchase option at the end of the lease term (Ijara wa Iqtina)
Sukuk: Islamic bonds
represent a Sharia-compliant alternative to conventional bonds in Islamic finance
Provide a way for governments and corporations to raise capital in compliance with Islamic principles
Structure of sukuk
Asset-backed securities representing ownership in tangible assets, usufruct, or services
Issued as certificates with face value based on the underlying asset's value
Sukuk holders receive a share of profits generated by the asset, not interest
Typically have a fixed term and can be traded on secondary markets if based on tangible assets
Types of sukuk
Ijara sukuk: based on leasing agreements
Mudarabah sukuk: based on profit-sharing partnerships
Musharakah sukuk: based on joint venture agreements
Murabaha sukuk: based on cost-plus financing arrangements
Wakala sukuk: based on agency agreements
Sukuk vs conventional bonds
Sukuk represent ownership in assets, while bonds are debt obligations
Sukuk returns based on asset performance, bonds pay fixed or floating interest
Sukuk typically asset-backed, bonds often unsecured
Sukuk structures must comply with Sharia principles, bonds have no such restrictions
Risk profile differs due to asset ownership and profit-sharing nature of sukuk
Islamic banking practices
Islamic banking operates on principles that align with Sharia law, offering financial services without interest
Aims to provide ethical and socially responsible banking solutions to Muslim and non-Muslim customers alike
Interest-free banking models
Profit and loss sharing accounts replace interest-bearing savings accounts
Investment accounts based on Mudarabah or Musharakah principles
Fee-based services for transactions and wealth management
Use of Islamic financial instruments for financing and investment activities
Sharia-compliant accounts
Current accounts operate on Qard Hassan (benevolent loan) principle
Savings accounts based on Wadiah (safekeeping) or Mudarabah contracts