How Islamic Finance Works and Why It Matters
Learn about the key features, types, and benefits of Islamic finance, a form of financial activity that follows the Islamic law.
Islamic finance is a form of financial activity that follows the principles and rules of Sharia, the Islamic law. Islamic finance aims to promote economic and social development, as well as ethical and sustainable practices, in accordance with the teachings of Islam.
One of the main features of Islamic finance is the prohibition of interest (riba), which is considered as a form of exploitation and injustice. Instead of interest, Islamic finance relies on profit-and-loss sharing arrangements, where the financier and the entrepreneur share the risks and rewards of a business venture.
Another characteristic of Islamic finance is the avoidance of speculation (maisir) and uncertainty (gharar), which are seen as sources of gambling and deception. Islamic finance also forbids investing in businesses that are involved in immoral or unethical activities, such as alcohol, pork, weapons, or pornography.
Islamic finance offers various types of financial products and services that are compatible with Sharia principles. Some of the most common ones are:
- Murabaha: A sale contract where the seller discloses the cost and profit margin of an asset to the buyer, and agrees to sell it at a deferred payment.
- Mudaraba: A partnership contract where one party provides the capital and the other party manages the business. The profits are shared according to a pre-agreed ratio, while the losses are borne by the capital provider.
- Musharaka: A joint venture contract where two or more parties contribute capital and expertise to a business. The profits and losses are shared according to their respective contributions.
- Ljara: A leasing contract where the owner of an asset leases it to another party for a fixed period and a fixed rent.
- Sukuk: A certificate that represents a proportional ownership in an underlying asset or project. Sukuk holders are entitled to receive a share of the income generated by the asset or project.
Islamic finance is a growing and dynamic sector that offers many benefits for economic growth, poverty reduction, financial inclusion, and social welfare. According to the World Bank¹, Islamic finance has expanded rapidly over the past decade, growing at 10-12% annually, and overseeing over $2 trillion in assets. Islamic finance has also attracted interest from non-Muslim countries, such as the UK², Luxembourg², South Africa², and Hong Kong², as a way to diversify their financial markets and enhance their resilience.
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