Islamic finance is based on Shari’a, an Arabic term that is often translated to “Islamic law.”
Shari’a provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business, and law. Shari’a Compliant financing constitutes financial practices that conform to Islamic law. Shari’a Compliant financial institutions are similar to conventional financial intermediaries in that they are profit-maximizing institutions and offer traditional banking services, but differ in certain core principles under which they operate.
Major principles of Shari’a applicable to finance and that differ from conventional finance are:
- Ban on interest (riba): under Islamic law, interest is prohibited. In a real estate setting, Shari’a Compliant financing is predominantly done through Ijara (leasing). Instead of loaning money to a prospective purchaser, the bank/financial institution obtains the property and leases it to the purchaser, who pays rental installments
- Ban on uncertainty: Uncertainty in contractual terms and conditions is prohibited all the terms and conditions of the risk are clearly stated and understood by all parties to a financial transaction.
- Risk-sharing and profit-sharing: Parties involved in a financial transaction must share both the associated risks and profits. Earnings of profits or returns from assets are permitted so long as the risks are shared.
- Ethical investments: Investment in industries that are prohibited by the Qur’an, such as alcohol, pornography, gambling, and pork based products is not allowed.
- Currency: Under Shari’a currency or money is considered only as a medium of exchange.
Islamic Finance Terms & Glossary