slamic finance is a financial system that operates according to Islamic law (which is called sharia) and is, therefore, sharia-compliant. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts.

Although the Islamic finance industry itself is quite young, Islamic theories of economics have existed for more than a millennium; by the mid-12th century, in fact, many Muslims scholars had presented key concepts of Islamic economics that are still relevant today.

But political and social turmoil put the brakes on Islamic finance for a very long time; only in the 20th century did Muslim scholars and academics seriously begin to revisit these topics (and, in doing so, set the stage for the modern Islamic finance industry to emerge in the 1970s).

The search for balance

Islamic economics is based on core concepts of balance, which help ensure that the motives and objectives driving the Islamic finance industry are beneficial to society.

  • Balancing material pursuits and spiritual needs

  • Balancing individual and social needs

The belief that Allah is the owner of all wealth

A core concept of Islam is that Allah is the owner of all wealth in the world, and humans are merely its trustees. Therefore, humans need to manage wealth according to Allah’s commands, which promote justice and prohibit certain activities.

At the same time, Muslims have the right to enjoy whatever wealth they acquire and spend in sharia-compliant ways; they don’t need to feel shame about being wealthy as long as their behavior aligns with Islam.

The promotion of a responsible free-market economy

A Muslim believes that Islam doesn’t restrict economic activity but instead directs it toward responsible activity that benefits other people, protects the earth, and honors Allah. In other words, Islam allows for a free-market economy where supply and demand are decided in the market — not dictated by a government. But at the same time, Islam directs the function of the market mechanism by imposing specific laws and ethics.

A key purpose for imposing these laws and ethics is to promote social justice; Islam and social justice are inseparable. Therefore, social justice is a key concept of the Islamic finance industry.

Islam tries to achieve social justice in the economy in many ways:

  • Promoting adherence to Islam

  • Requiring zakat (taxing the property of people who acquire wealth and distributing that tax to people in need)

  • Defining the state’s obligations

  • Prohibiting usury (interest)

  • Encouraging shared risk

Basic financial instruments

Islamic markets offer different instruments to satisfy providers and users of funds in a variety of ways: sales, trade financing, and investment.

Basic instruments include cost-plus financing (Murabaha), profit-sharing (Mudarabah), leasing (Ijarah), partnership (Musharakah), and forward sale (Salam). These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets.

Fundamental principles of Islamic finance

The basic framework for Islamic finance is a set of rules and laws, collectively referred to as Shari’ah, governing economic, social, political, and cultural aspects of Islamic societies. The Shari’ah originates from the rules dictated by the Qur’an and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad (pbuh). Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the teachings in the Qur’an and Sunnah.

The fundamental principles of an Islamic financial system can be summarised as follows:

Prohibition of interest 

The prohibition of interest is founded on the prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales”; this is the central tenet in mutual dealings.

More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of “interest” as widely practiced.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Risk sharing

Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits.

Money as “potential” capital. Money is treated as “potential” capital – that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognises the time value of money, but only when it acts as capital, not when it is “potential” capital.

Prohibition of speculative behaviour

Islamic finance prohibits transactions featuring speculation including extreme uncertainties, gambling, and risks. Therefore, transactions in Islamic finance should be backed by real assets.

Sanctity of contracts

Islam teachings upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of symmetric information and moral hazard.

Shari’ah-approved activities

Only those business activities that do not violate the rules of Shari’ah qualify for investment. For example, any investment in businesses dealing with alcohol, gambling, and casinos would be prohibited. Project finance, which puts emphasis on equity participation in transactions involving real assets, is natural fit for Islamic finance.

Simple financial derivatives, such as forward contracts, are being examined because their basic elements are similar to those of the Islamic instrument of deferred sale. They may be used to hedge the risk of owning assets that are subject to unexpected price fluctuations, e.g. foreign currencies, commodities. However, innovations that have resulted in creating exotic financial derivatives to generate lucrative profits through speculation behaviour are prohibited, such derivatives may be equated to a descrition by Warren Buffet, as  “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”  Warren Buffet is an American business magnate, investor, and philanthropist, considered by some to be one of the most successful investors in the world.