Islamic Finance: Principles and Practices

This report provides an overview of Islamic finance, including its principles and practices. It covers Shari’ah law, conditions of investment, and key principles of Islamic banking. It also explores Murabaha, Mudaraba, and Musharaka, and compares conventional banking to Islamic banking. The report offers expert insights and analysis on Islamic finance.

Islamic Finance

Table of Contents
Introduction................................................................................................................................3
Shari’ah law...............................................................................................................................3
Purpose...................................................................................................................................4
Sources of Shari’ah................................................................................................................4
Conditions of investment according to the Sharia'a law............................................................5
Conventional banking vs. Islamic banking................................................................................6
Six Key principles of Islamic banking.......................................................................................7
Murabaha and its principles.......................................................................................................8
Mudaraba and its principles.......................................................................................................9
Musharaka................................................................................................................................10
Conclusion................................................................................................................................11
Bibliography.............................................................................................................................11

Introduction
Islamic Finance or Islamic banking can be described as the means through which the
corporation all across the Muslim nations, including the Islamic banks and other money
lending institutions, function to raise capital in accordance with the Islamic Laws or Sharia.
The Islamic banking has been formalized since late 1960s. It is also known as the non-interest
banking based on the principles of Shari’ah Law. The two major principles of Islamic
banking are, prohibition of collection of the interest or ‘riba’ on the principal amount and
sharing of the loss as well as the profit (The World Bank Group, 2015). Since, the Islamic
banks do not charge interest, their earning comes from the equity participation systems,
which means, if a business takes money from the banks it does not need to pay back interest
but, it needs to give the Islamic bank a share in its profits. There are more than 300 Islamic
banks all across the world and Islamic financial institutions manage a whooping amount more
than $800 billion. This sector is growing by 10-12% annually (Reuters, 2007).
The report will discuss Islamic banking in detail further and its principles as well. A
description of the main practices of Islamic banking and Shari’ah will also be given in the
report. The report will also discuss the practices of Mudaraba, Murabaha and Musharaka and
their principles with the help of the examples. The report will also analyze how the
conventional banking differs from Islamic banking and which practices are better in which
banks. All these aspects of Islamic banking will be discussed with the help of supporting
evidences.
Shari’ah law
Shari’ah can be thought as the universe of Islamic ideals and laws. The word Shari’ah
literally means “a well-worn path to a water source” and it promotes the idea that just like
water is essential for life, Islam is essential for spiritual well- being of the humans. It is made
up of rules, regulations and commandments designed by God for protecting and benefitting

the mankind. It provides the framework for the well functioning of the society and defines
specific morals, social, political and ethical codes of conduct. It covers two aspects of the
world- worldly matters and worship (Stacey, 2018).
Purpose
The Shari’ah provides ideals to Islam as a religion and without it, Islam would be without
ideals. For Muslims, Islam without Shari’ah will be without any prescriptions on prayers,
alms, ablution, diet, filial piety, civics, sales etc. To ensure the importance and compliance of
Shari’ah in Islamic banking, there is a Shari’ah Board which governs the banking operations
and provides guidelines and suggestions to these institutions (Rammal, 2006).
Sources of Shari’ah
There are four major sources of Shari’ah as mentioned below:
The Quran: According to Muslims, the words in Quran are the direct words of Allah,
transmitted by Prophet Muhammad and thus, all the Islamic laws, including Shari’ah, are
mentioned in this holy book (Huda, 2018).
The Sunnah: it is a collection of written documents including the practices or traditions of
Prophet Muhammad. The details related to the laws mentioned in Quran are clarified by the
Sunnah.
Ijma’ (consensus): it specifies the legal ruling and it defines the consensus from the aspects
of both Islamic community as well as religious authorities.
Qiyas (Analogy): It describes the reasoning, analogy and legal precedent for deciding the
new case law, in case something needs legal ruling and it has not been mentioned clearly in
the other sources (Huda, 2018).
Conditions of investment according to the Sharia'ah law
The investments made in compliance with the Shari’ah law have to follow a few principles
laid by Islam in order to make them Shari’ah compliant investments. While ensuring whether

an investment is permissible as per Sharia’ah law, the following three principal rules need to
be followed:
Absence of riba: The investment must not involve any sort of interest or riba, as it is strictly
prohibited in Islam. The Shari’ah principle states that it is not acceptable for any commodity,
including money, to multiply its value merely by being rented to any other person. This
prohibition is for both the parties, lender cannot lend it to borrower and borrower cannot pay
it to lender. However, Shari’ah allows the investor to make the return on the capital, if he/she
is willing to invest the shares in the market (UBL Fund Managers, 2017).
Potential for unethical concerns in investment mix: the investment in the following
commodities is not acceptable under Shrai’ah. Investment in alcohol, pornography, gambling,
ancillary activity, tobacco, other banking institutions or any other activity which is prejudicial
to the Islamic interests is not considered to be legal under Shari’ah law.
Nature of contract between two parties: the contracts between the two parties need to be
highly transparent and valid. Shari’ah law also promotes the idea that all the contracts must
be well written and well documented and all the terms and conditions of investment must be
clearly mentioned for both parties, so that there are no disputes between them in future. Any
contract which does not include the required information like price, delivery data, subject
matter and such others is declared as guilty of “gharat” and considered to be void (UBL Fund
Managers, 2017).
Conventional banking vs. Islamic banking
The two banking systems are very different from each other. The Islamic banking system is
ethical banking system which uses the practices compliant with Shari’ah law and interests are
strictly prohibited in this banking system. Conventional banking system, on the other hand, is
an un-ethical banking system based on man-made laws and since, it is profit -oriented, it
charges interests on the transactions (Jamaldeen, 2018).

In conventional banking system, money is the product apart from just being the medium of
exchange, whereas, in Islamic banking real asset is the product and money is just a medium
of exchange.
Islamic banking operates on the principle of sharing the profit and the losses and shares the
loss of a company in case it suffers loss, whereas, conventional banks charge interest from
the person even if the company is suffering loss (Academy for International Modern Studies,
2018).
In case of running finance, disbursing cash finance or working capital finance, no agreement
is signed for the exchange of services and goods, whereas, in Islamic Finance, execution of
agreements is must, in case of exchange of goods and services as well as disbursing the funds
under Salam, Istisna and Murabaha contracts.
The Islamic banks are governed by a Shari’ah Board which consists of Islamic jurists and
they look after every action taken by the banks. The conventional banks, on the other hand,
involve no such Board (Jamaldeen, 2018).
The government can easily take loans from the Central Bank without the need of initiating
capital development expenditure through the Money Market Operations. From Islamic Banks,
on the other hand, government cannot obtain loans without ensuring that the money will be
delivered to National Investment Fund.
In conventional banking, real growth of money does not take place as the money remains
within few hands. In Islamic banks, on the other hand, real growth of money takes place as a
result of the multiplier effect and equity sharing in the companies in which the bank invests
(Academy for International Modern Studies, 2018).
Six Key principles of Islamic banking
The six key principles of Islamic banking are as follows:

 Charging or paying interest in the Islamic banking system is strictly prohibited. The
first principle states that all the forms of Riba are strictly prohibited and the Islamic
rules on transactions are created in a way that they prevent the use of riba on any
transaction done by the institutions under Islamic finance (Uddin, 2015).
 The second principle states that the Islamic finance institutions cannot invest in the
businesses which are considered to be Haram. The businesses involving selling pork
or alcohol are strictly prohibited. Also, the businesses related to producing media such
as pornography or gossip columns are also not allowed.
 Charging any additional charges for the late payments are also not allowed under
Islamic finance. Any fixed payment financial transactions such as murabahah are
governed under this policy. However, there are some of the authors which state that
the late fees payments can be charged if these charges are donated to the charity later.
The banks are also allowed to charge extra fees if the owner deliberately denies
paying the amount on time.
 Maisir, which means gambling in usual terms but means “speculation” in Islamic
Finance, is forbidden in Islamic banking. According to this principle, the involvement
of a person or a company in contracts in which the ownership of the goods depends on
occurrence of a preset or uncertain event in future is considered to be maisir and is
strictly prohibited (Uddin, 2015).
 Gharar, which means uncertainty, is also forbidden under Islamic law. It is ruled out
in Islamic finance as they are perceived to involve excessive risks and foster
fraudulent behaviour (Uddin, 2015).
 The contracts need to be approved by the Shari’ah and contracts must be clear in all
aspects. The contracts must ensure that all the aspects of the agreement between the

two parties are clearly mentioned and no conflicts must arise in future (Muslims in
Calgary, 2017).
Murabaha and its principles
Murabaha can be explained as a cost plus transaction in which a customer places a financial
order with any Islamic financial institution for purchasing an asset or a good from any
supplier. Basically, Murabaha involves three parties- the financer who provides the finance,
the purchaser who places the request with the bank to buy a particular product and supplier as
the third party which provides the goods or services to the customer. The bank pays the total
amount to the supplier and the purchaser can pay the amount to the bank in the form of
instalments or in a balloon payment later. It can be considered as a loan in the context of the
conventional banks. It is similar to rent-to-own agreement in Islamic lending bank, in which
the intermediary retains the ownership of the item being sold until the entire loan is paid
(www.islamicfinance.com, 2015).
The key principles of Murabaha are:
 It must be a mark-up transaction.
 It must involve three parties- the financer, the purchaser and the supplier.
 The Murabaha is a fiduciary contract where the relationship between the buyer and
seller is built on the virtue of trust.
 The agreed payment can be paid to the bank in the form of instalments or in a balloon
payment.
 The bank has the authority to ask the customer for posting any guarantee or collateral
for mitigating the risk associated with such contracts.
 The bank can impose penalties on late payments provided they agree to pay the late
payment to the charities or any philanthropic organizations
(www.islamicfinance.com, 2015).

Mudaraba and its principles
Mudaraba can be explained as a form of partnership in which one of the partners invests in
any business project and the other partner uses its skills to manage the investment and bring
out good results for the project. It is different from a partnership as it does not involve the
creation of a separate company until and unless the partners are able to manage their profits
separately and effectively. The profits which are earned through this partnership can be
distributed between the partners as per the pre-determined ratio. The partner who provides the
capital carries loss in the Mudaraba contact, until and unless he proves that the loss in the
business was due to the negligence of the mudarib or violation of the conditions they agreed
upon previously. An example of Mudaraba can also be seen between the Islamic bank and the
trustee or depositor where the bank is the provider of funds and the depositor is the mudarib.
Mudaraba also serves as a source of funds for the Islamic banks. There are mainly two types
of mudaraba contracts – restricted mudaraba (investor invests the fund into a specific type of
project) and unrestricted mudaraba (where the working partner has permission to funnel
funds into any type of business) (International Financial law Review, 2005).
Its key principles are:
 The management of investment is the sole responsibility of the mudarib.
 The assets acquired by the mudarib are considered to be the sole possessions of rab-
ul-amal.
 The capital provider has the authority to stipulate the type of investment mudarib
might undertake (International Financial law Review, 2005).
Musharaka
Musharaka can be explained as a type of Shirkah al-Amwal which means sharing. It can be
referred to as a joint enterprise where the parties involved need to share their profits and
losses. It is used for financing the business ventures based on the Islamic law. It can also be

referred to as an old fashioned technique, which is restricted to the small scale investments
made by the company. It can be compared to Mudaraba in the sense that different parties are
involved in the formation of the business alliance. But the major differences between these
two are that in Musharaka, all the parties which are involved need to provide capital in the
form of initial investment. The profits between the parties involved in it are shared on the
basis of the pre-determined ratio but, the losses in this transaction are shared in the proportion
of the investment done by individual parties. This makes it compulsory for the parties to
make active and sharp decisions to determine the profit of the overall company. The
management of investment is done collaboratively by all the parties involved (Financial
Islam, 2018).
An example of musharaka is the investment in the property or real estate for earning profits.
If one of the partners does not have enough amounts to buy a property, he can collaborate
with the other partner and they can purchase a property together. Later, if they sell the
property for any commercial purposes, the profits between them will be shared equally or in a
pre-determined ratio. But, if they are not able to sell property and the property incurs loss, the
losses will be shared by them in the ratio they initially invested their money (Financial Islam,
2018).
Conclusion
The above report gives an account of the terms and practices related to Islamic Finance.
Islamic finance runs on the concept of no interest and is many ways different from the
conventional financial institutions. The report highlights that the Islam finance runs on six
certain types of principles such as Gharar, Maisir and such others. The main sources of
principles for Islamic banking include Quran, Sunnah and Qiyas. The Islamic banking is
quite different from conventional banking system as the conventional banking system runs
for the purpose of profit majorly whereas, Islamic finance is aimed at welfare of the Islamic

community. The differences between the two types of banking systems have been mentioned
in this report in detail. The report highlights the difference between the two. Also, it gives an
account of the practices like Musharaka, Mudaraba and others in the context of Islamic
finance. Musharaka is the practice in Islamic banking which is based on a profit and loss
sharing basis between the enterprises. Mudaraba and Murabaha are types of contracts
between tow or multiple parties which establish a joint ventures. All the practices in Islamic
banking are restricted under laws which need to be followed strictly. The ongoing activities
in Islamic banks are supervised by Sharia’ah Board. These banks are spreading all across the
world at great pace and are known for their welfare under fixed set of regulations. These
banks are becoming technologically advanced at a higher pace than conventional banks and
many European and American nations are also promoting the practices of Islamic Banking.
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