The Basics of Sharia Finance explained

Let’s say you need some money to start a business. You approach a bank offering conventional non-Sharia finance and they give you a loan. Whether or not you turn a profit or your business fails, you must still make payments to the bank with interest. With compound interest, the longer you take to pay off the loan, the more interest you pay. So if your business loses money, the financial difficulty you’ll face will be even more severe. You’ll have no income from your business and the bank can take legal action against you. This is the reality of debt. The bank earns a surplus without having to assume risks and obtains the added income through interest, making money on top of money; getting extra from the interest just because they were in the position to lend.

The distinction in Sharia finance is clear. It aims to protect all parties, ensuring that transactions are done according to Sharia principles, on fair grounds and for the benefit of the community. Profits must be generated through trades and economic activities in the real economy (see box). In addition, business risks must be shared rather than transferred to borrowers when they take out a loan.

Real Economy

This refers to sectors of the economy concerned with actually producing goods and services, as opposed to the part of the economy that is concerned with buying and selling on the financial market

Source: Financial Times

As the Sharia prohibits dealing with interest, the products that you see in Islamic banks are generally based on one of the following concepts:

Profit Sharing  – These are profit sharing arrangements in which the financier and the receiver of funds will share the profits and loss borne from the partnership. An example is a savings or current account called Mudarabah. When you deposit money into the account, profit is given to you based on the performance of the bank. The bank needs customers to place funds with them so that they can make a profit from having received customer deposits.

Buy and Sell – Charging a profit is justified when selling a product because of the risks associated with developing, sourcing and owning the product. Buying and selling of products can be done when you require funds. Because there is no borrowing or lending arrangement, the term ‘loan’ is not used in Islamic banks. Instead, the term ‘financing’ is preferred. For a personal finance arrangement, a bank generally follows a Murabahah contract where you agree to buy from the bank commodities – metal, for example.

This is how it’s done:

I. Let’s say you require $10,000 cash. You apply for personal financing from the bank, which sells you commodities worth this amount. They charge you, for example, $10,700, with $700 being the bank’s profit.

II. At this stage, you own $10,000 worth of commodities. Next, the bank arranges to sell these commodities to a third party on your behalf. The bank then gives you the $10,000 cash, providing you with the funds you needed.

III. You now owe the bank $10,700, which you will pay in instalments until the entire sum is paid off.

Unity and social cohesion are so central among the objectives of the Quran for humankind that all conducts prohibited may be regarded as those that cause disunity, and those prescribed are to promote social cohesion. It is a natural consequence of such a system to require risk sharing as an instrument for social integration. Therefore promoting maximum risk sharing is, arguably, the ultimate objective of Islamic finance.– From the book Risk Sharing in Finance:The Islamic Finance Alternative by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor

The system envisioned by the Qur’an does not reward the rich at the expense of those in need of funds

Instead of the financier just providing funds and expecting a payment, the parties of the contract are expected to cooperate and work together, ensuring solidarity is created in the community. Those in need of help in business or trade activities should be duly supported.

The system envisioned by the Qur’an does not reward the rich at the expense of those in need of funds. This is why compound interest is prohibited, as it ensures that a brother or sister who needs help is not exploited in times of hardship. In trade, there is real movement in economic activity. The buy and sell arrangement, for example, gives the supplier of the product a chance to earn an income from selling their goods.

Sharia finance also prohibits unfair practices in transactions. The notions of fairness and justice are the cornerstone of all its activities. Products that are full of uncertainty or based purely on chance, speculation or gambling one’s positions all boil down to making money on top of money without justification. This is unfair, and is evident in the global financial crisis. A group of people benefited from manipulating transactions, causing others to face financial difficulty as a result.

Another feature unique to Islamic banking is the presence of Sharia scholars who advise and govern matters relating to the Sharia. The extent of their involvement varies between regions. In the UAE, for example, scholars govern the products of the bank and how they are implemented. In Saudi Arabia and Malaysia, however, scholars oversee products and the bank’s entire operations to ensure that they do not contravene the Sharia. Regardless of the model adopted, whenever Sharia non-compliance is found, the bank cannot profit from a transaction that was done against Sharia principles. The profit would have to be purified by giving to charity.

The Islamic financial industry is still in a development phase and is a system that is not without its own set of issues. These include limited customised infrastructure to support its model, as well as differing regulatory standards that have resulted in different practices across countries. But in a world so heavily entrenched in debt and unfair practices, it may be worth our while to appreciate the potential that Sharia finance has for true risk sharing and mutual cooperation.

Source: http://www.aquila-style.com/lifestyle/sharia_finance/basics-sharia-finance/82533/?ref=sidebar