Islamic Financing



Uncontrolled capitalism has caused the global economy into a plunge into an unprecedented crisis. Adding to the distress, economists worldwide are expecting the global economy to experience a double dip in the near future. This calls in for a need for eradicating huge bubbles of fiat money and assets brought in by capitalism and build up a real and stable economy. In this project, we try to study Islamic banking and financing as an alternate mode of financing as a remedy. In the wake of crisis, world has slowly started to shifting to this alternate financing model which offers a wide range of complexly engineered tools viz., Mudaraba, Murabaha, Musharaka, Istisna, Musaqat, Ijara and a lot more as has been discussed in the upcoming chapters. Salient features of each have also been studied.

Islamic finance is based on principles of shariah, or “Islamic law.” Major principles of shariah are a ban on interest, a ban on uncertainty, adherence to risk- sharing and profit sharing, promotion of ethical investments that enhance society, and asset backing. The international market for Islamic finance has grown between 10% to 15% annually in recent years. Islamic finance historically has been concentrated in the Persian Gulf countries, but has expanded globally to both Muslim and non-Muslim countries. There is huge and growing market potential for Islamic finance in the India. Through international and domestic regulatory bodies, there has been effort to standardize regulations in Islamic finance across different countries and financial institutions, although challenges remain.

Islamic banking is essentially banking in consonance with the ethos and value system of Islam and governed in addition to the conventional good governance and risk management rules, by principles laid down by Islamic law, Shariah. It is, however, not confined to interest free banking, which is a narrow concept. In addition to non-acceptance of interestbased transactions, the fundamental tenet is that of fairness. It envisages ethical practices, contributions towards a more equitable distribution of income and wealth and active participation in achieving the goals and objectives of an Islamic economy.

Need for Islamic Banking

The collapse of major Wall Street institutions, notably Lehman Brothers, and the subsequent global financial crisis and economic recession, Islamic banking is seriously being considered and has emerged as a possible alternative to the conventional banking because of the following reasons:

• It is based on Ethical and Socially Responsible Investments (SRI) • It aims at Equity and Justice and leads to poverty alleviation

• It acts to new imension to assets andactual projects aiming to support real economic growth instead of financial engineering

• It provides services to under banked populations ignored by conventional banks

Basic Tenets of Islamic Banking and Finance

The basic tenets of Islamic banking and finance can be put down as under;

1. Prohibition of interest-based (riba) transactions;
2. Ban on speculation and excessive risk taking (gharar);
3. Islamic tax system (zakat);
4. Discouragement of the production of goods and services which contradict the value pattern of Islam (haram)


Perhaps the most far reaching of these is the prohibition of interest (riba). The payment and acceptance of riba, which are the fundamentals of conventional banking system is explicitly prohibited in Islamic banking and thus investors must be compensated by other means. Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest. In banning riba, Islam seeks to establish a society based upon fairness and justice.

A loan provides the lender with a fixed return irrespective of the outcome of the borrower's venture. It is much fairer to share the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied. Hence, what is forbidden in Islamic precepts is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking.


Another feature condemned by Islamic banking is economic transactions involving elements of speculation, gharar. Buying goods or shares at low price and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to avoid a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large. Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit.

This is based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

A number of transactions are treated as exceptions to the principle of gharar: sales with advanced payment (bai' bithaman ajil); contract to manufacture (lstisna); and hire contract (jIara). However, there are legal requirements for the conclusion of these contracts to be organized in a way, which minimizes risk.


A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning "pure") is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim's annual income in cash or kind from all forms of assessed wealth exceeding nisab. Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and on the profits as described in the Handbook of Islamic Banking.


A strict code of 'ethical investment' is prescribed and hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat. Investments should only support practices or products that are not forbidden or even discouraged by Islam. Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community, while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint. In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks.

Principles of Islamic Banking

Prohibition against the payment and receipt of a fixed or predetermined rate of interest

The essential feature of Islamic banking is that it is interest free. Islam prohibits Muslims from taking or giving interest regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. However, the Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production, but does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. Islam allows the owners of capital a share in the surplus, which is uncertain. Profit sharing permissible in Islam, while interest is not, as in the case of the former, it is only the profit sharing ratio, not the rate of return itself that is pre-determined. Profit- making is acceptable in Islamic society as long as these profits are not unrestricted or driven by the activities of a monopoly or cartel. Islam deems profit, rather than interest, to be closer to its sense of morality and equity because earning profits inherently involves sharing risks and rewards. Profit making addresses the Islamic ideals of social justice because both the entrepreneur and the lender bear the risk of investment.

Sharing risks and rewards

The prohibition of a risk free return and permission of trading makes the financial activities in an Islamic set-up real asset-backed with ability to cause 'value addition'. Islamic banking system is based oh risksharing, owning and handling of physical goods, involvement in. the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income.

Permissible Forms of Businesses

The forms of businesses allowed under Islamic banking include joint ventures based on sharing of risks 8 profits and provision of services through trading, both cash and credit, and leasing activities. Though the apparent similarity between trade profit in credit sale and Riba in loaning is not denied in literature, trade has been permitted and Riba is prohibited. Profit has been recognised as 'reward' for (use of) 26 capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits.

Making money from money is not acceptable

Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest).

Reference :

http://www. newhorizon-islamicbanking.com/index.cfm
Bindu Vasu “Islamic Banking- Banking for a Change”
Mufti Barkatulla “Ethical Fusion”, Islamic Banking and Finance Vol.7 Issue 3 No.23






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