Islamic Finance Unveiled: What’s Fact and What’s Fiction.
Islamic Finance has emerged as an alternative and counterpart to conventional finance in the last few decades. Although it has proven to be a reliable and often profitable system, it isn’t without its critics. Many people, in and outside the Muslim world have criticized Islamic Finance for many reasons. While some argue about its profitability, others out right reject the concept and claim its just another way of charging interest. In this article, we will try to tackle some of these myths and hopefully provide a clearer understanding to Islamic finance and what is fact and what is fiction.
What Is Islamic Finance?
First, lets understand what the basis for Islamic Finance is. Islamic Finance refers to any business, investment or profit which adheres to the laws of Islam (Sharia). This means that the business must not involve any form of Riba (usury), Gharar (Uncertainty) and Maysir (Gambling). Likewise, any form of Shariah non-compliant activities are to be avoided, like alcohol, prostitution and pork.
Apart from that, it is important to remember that Islamic Finance concerns itself with not only the what but the how as well, meaning that just because the result is the same doesn’t mean the business is Shariah compliant. If the business is conducted in a way that is contrary to Islamic law, it will be null and void.
Contracts of Islamic Finance
So, what are some of the contracts that can be used to ensure the business is according to Islamic Law?
Here are some of the common contracts used in Islamic Finance and Banks to promote Shariah compliancy:
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Murabaha (Cost + Profit Sale)
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Mudharaba (Profit Sharing Partnership)
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Musharakah (Joint Investment Partnership)
Murabaha Financing
This is one of the most common and straight forward modes of Islamic finance. The concept is simple, you approach an Islamic Finance Institution and ask for financing, whether that is home financing or car financing. The company buys the car on your behalf and then sells it to you for a markup. You then pay the price plus the profit in monthly instalments.
Mudharaba Financing
This type of financing is based on the principle of profit and risk sharing. One party provides the capital while the other party deals with business activities. The profits are shared between the parties based on a pre-agreed ratio. However, the losses will only be incurred by the investor since they are the ones who are solely financing the project.
Musharakah Financing
Another type of Financing that is based on the principle of profit and loss. A joint investment partnership in which both parties are partners in the asset and share profit and loss. Both parties invest and are involved in the business, and whatever profit they receive is split between them on a pre agreed ratio. As for the losses, since both partners are equal in this venture, they will both take a loss according to the capital they have provided.
These are just some of the basic contracts used in Islamic Finance.
Unveiling the truth
Now that we have a brief understanding of what Islamic Finance is, it’s now important to learn what Islamic Finance isn’t.
Fiction: Islamic Finance is only for Muslims
One of the biggest misconceptions about Islamic Finance is that it only can be practiced by Muslims. The fact is, While the premise of Islamic Finance is based in the laws of Sharia, there are many benefits like risk sharing and ethical investing which make Islamic Finance attractive to people outside the Muslim World.
Fiction: Islamic Finance Institutions are not competitive enough
Islamic Banks and institutions often charge a profit rate that is equal to or sometimes higher than the interest rate. This is due to several reasons. One, the bank has a fixed profit rate which exposes it to a higher credit risk and no repricing mechanism. And two, there are various operational and legal costs that are involved that are reflected in the pricing. This allows them to compete with conventional banks and provide alternate options for banking.
Fiction: Islamic Finance is Just Conventional Finance wrapped in Arabic Packaging
Many people argue that Islamic Finance offers similar services to conventional finance but just replaces it in Arabic terminology to look different. While the result in both services might be the same, the process is quite different, IFIs adhere to Sharia law which prohibits any use of Interest in their dealings and makes sure that the business activities are Shariah compliant, while conventional banks hold themselves to no such standard.
Conclusion
In conclusion, Islamic Finance provides various options to clients who are not only religiously inclined but also to those who are looking for an ethical option without compromising performance and profit. And even though they provide similar products and yield similar results, the procedure and process are vastly different.
