What is Islamic Finance?
Islamic finance and banking is a system of finance and financial tools that are
compliant with the principles of Islamic law (Shari’ah).
In terms of finance, Shari’ah
explains in detail the ethical concepts of money and capital, the relationship
between risk and profit and the social responsibilities of financial institutions.
What is Interest (Riba)?
The most well-known aspect of an Islamic financial system is the prohibition
of paying or receiving interest on capital.
Essentially, any positive, fixed,
predetermined rate tied to the maturity and the amount of principal, which is
guaranteed irrespective of the performance of the investment, is considered riba
and is so prohibited.
This prohibition is not to be confused with a rate of return or
profit on capital, as the earnings and sharing of profit is very much encouraged
within Islam.
Moreover, profit, determined ex post, symbolizes the creation of
additional wealth through successful entrepreneurship, whereas interest,
determined ex ante, is a cost that is accrued irrespective of the outcome of
business operations, and may create wealth, even if there are business losses.
What is Risk and Uncertainty (Gharar)?
Contractual risk is also forbidden. In general, this prohibits the selling of goods
or services that the seller is not in a position to deliver or the making of a
contract which is conditional on an unknown event.
You cannot sell something
you do not own. Also, the price and nature of the goods being transacted are
defined in detail and agreed upon by both parties, thereby avoiding a sale that
may represent a gamble ( for example, conventional short sales or sales on
margin are prohibited).
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