Alhassan Yusif Trawule
Islamic finance is a type of financ
ing activities that must comply with
Sharia (Islamic Law). The concept can also refer to the investments that are permissible under Sharia. The common practices of Islamic finance and banking came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance occurred only in the 20th century. Nowadays, the Islamic finance sector grows at 15 per cent – 25 per cent per year.
The main difference between conventional and Islamic finance is that some of the practices and principles that are used in the conventional finance are strictly prohibited under Sharia. Sharia law sets out five categories of actions that guide a Muslim’s actions. These are acts that are: a. Obligatory, b. Meritorious, c. Commendable, d. Reprehensible; and e. Forbidden.
Principles of Islamic finance
Islamic finance strictly complies with Sharia law. Contemporary Islamic finance is based on a number of prohibitions that are not always illegal in the countries where Islamic financial institutions are operating:
a. Paying or charging an interest: Islam considers lending with interest payments as an exploitative practice that favours the lender at the expense of the borrower. According to Sharia law, interest is usury (riba), which is strictly prohibited.
b. Investing in businesses involved in prohibited activities: Islam prohibits industries that it considers harmful to society and a threat to social responsibility. These industries include alcohol, prostitution, pornography, weapons of mass destruction, pork, tobacco and illegal drugs. By prohibiting certain industries, Islam also prohibits profiting from them in any way. Therefore, an Islamic financial institution cannot finance a project or asset that is prohibited and a Muslim investor cannot put money into a mutual fund or other equity product that funnels money to a company that participates in a prohibited industry.
c. Speculation (maisir): Sharia strictly prohibits any form of speculation or gambling which is called maisir. Thus, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.
d. Uncertainty and risk (gharar): The rules of Islamic finance ban participation in contracts with the excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertain in nature investments. Gharar is observed with derivative contracts and short-selling, which are forbidden in Islamic finance.
e. Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.
f. Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the other party.
Types of financing arrangements
Islamic financial products are based on specific types of contracts. These Sharia-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Sharia-compliant contracts cannot create debt, cannot involve the payment of interest, and must provide for a sharing of risk and responsibility between the involved parties.
Profit and loss sharing financing
a. Mudarabah (Profit-and-loss sharing partnership): A mudarabah or mudharabah contract is a profit sharing partnership in a commercial enterprise. One partner, rabb-ul-mal, is a silent or sleeping partner who provides money/capital. The other partner, mudarib, provides expertise and management. The arrangement is similar to venture capital in conventional finance in which a venture capitalist finances an entrepreneur who provides management and labor.
Profits are shared between the parties according to a pre-agreed ratio, usually either 50 per cent–50 per cent, or 60 per cent for the mudarib and 40 per cent for rabb-ul-mal. If there is a loss, the rabb-ul-mal loses the invested capital, and the mudarib loses the invested time and effort. The sharing of risk reflects the view of Islamic banking proponents that under Islam, the user of capital — labour and management — should not bear all the risk of failure. Sharing of risk, according to proponents, results in a balanced distribution of income, and prevents financiers from dominating the economy.
b. Musharakah (Profit-and-loss sharing joint venture): This contract creates a joint venture in which both parties provide investment capital, entrepreneurial skills, and labor; both share the profit and/or loss of the activity. The major types of these joint ventures are:
Diminishing partnership: This type of venture is commonly used to acquire properties.
—The writer is the Head, Research Unit at the Institute of Chartered Accountants (Ghana)
