Islamic finance refers to those practices of finance that are in accordance with the Sharia (Islamic law). This is why it is also known as Sharia-compliant finance. The means through which corporations, lending institutions and banks raise capital in the Muslim world have to be in accordance with the Islamic law. Not all types of investments are permissible under the Islamic law.
The basic concepts of Islamic finance have been mandated since the beginning of Islam in the seventh century. However, it was only in the late 1960s that efforts to formalize these concepts began. These steps coincided with the flow of oil wealth, which fuelled renewed interest in Sharia-compliant practices.
How is Islamic Finance Practiced?
The core concept of Islamic finance is its definition of usury and risk. Islamic law considers lending (to earn interest payments) as an act that unduly favors the lender against the borrower. It considers money as just a measure of value. Islamic finance does not give money the status of an asset, prohibiting usury or interest, since it is an income from money.
Risk sharing as part of raising capital has been made mandatory. Thus, in a Sharia-compliant financial system, banks and otherlending institutions share the profit as well as the loss of the enterprise to which a loan has been given. Also, law prohibits thesale and purchase of such items the existence of which is uncertain. This category of items may include:
- Premiums to insure against something that may or may not occur.
- Derivatives that are used to hedge against possible outcomes.
Notably, equity financing is permissible under Islamic finance. However, there is a rider that those companies raisingfinance through this method should not be engaged in the prohibited businesses, such as the production of alcohol.
The basic guiding force of Islamic finance is its aim to achieve socio-economic equality. This may be considered as its merit. However, since its tenets do not completely adhere to the principles of mainstream finance, its practice is constrained.
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