Islamic Banking and Finance: An Overview

Islamic finance is an elaborate system of banking based on the guidelines outlined in the Quran and the Sunnah. This system is based on Islamic principles which mandate the sharing of profit and loss, and the avoidance of riba (interest), gharar (uncertainty), and maysir (gambling). Islamic banking provides an alternative to conventional banking and has become increasingly popular among the Muslim community in recent years for allowing individuals and businesses to get financing without violating Islamic principles.

The industry is based on the standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) which is the global standard-setting body for the Islamic finance industry. It is an independent, not-for-profit organization that develops and issues accounting, auditing, and governance standards for Islamic financial institutions. AAOIFI’s standards are designed to ensure the integrity and transparency of Islamic finance products, as well as to provide a framework for financial institutions to operate within. The standards have encompassed the teachings of all major Islamic sects it has been instrumental in standardizing the Islamic finance industry and its standards are recognized globally.

Islamic Banks are heavily influenced by conventional banks, hence, substitutes for conventional products are always sought out by the Islamic Banking sector. Islamic banks generate income by offering a variety of services and products that are in accordance with Islamic principles. These include murabaha, ijara, and musharaka, which are all sources of financing that do not involve interest. Islamic banks also offer services such as risk management, asset management, and trust management. Additionally, many Islamic banks invest in the stock market, invest in Sukuk (Islamic bonds), and provide services related to venture capital and private equity.

Below are a few examples of the Islamic compliant products and financing instruments provided in Islamic Finance:

Mudaraba:

Mudaraba is a contract between two parties – one party provides the capital and the other provides the labor, such as marketing, planning and management. The profits generated from this contract are shared in accordance to the terms of the agreement, while the losses are shouldered by the party providing the capital. This type of financing is a common form of Islamic banking as it avoids riba (interest), gharar (uncertainty), and maysir (gambling), all of which are prohibited by Islamic law. It is also an attractive option for businesses seeking financing as it allows for a greater degree of flexibility and risk sharing than traditional forms of financing.

Murabaha:

Murabaha is a type of financing that involves the sale of a commodity or service at a price higher than the cost price. The payment is usually deferred, and the buyer returns the purchase amount in installments plus an agreed-upon profit margin. This type of financing is common in Islamic banking as it avoids the prohibition of riba (interest) and gambling. Murabaha is an attractive option for businesses seeking financing as it allows them to purchase goods without having to pay the full price upfront.

Ijarah:

Ijarah, another form of Islamic financing, is a contract between two parties in which one party provides the use of an asset to another party for a specific period of time in exchange for payment. This type of financing is similar to leasing and allows the buyer to use an asset without having to purchase it outright. It is often used to finance the purchase of expensive goods such as cars or houses, and avoids riba (interest), gharar (uncertainty) and maysir (gambling). Ijarah is an attractive option for businesses seeking financing as it is based on the principles of fairness and provides access to the asset without having to purchase it upfront.

Islamic Derivatives:

Derivatives are an important part of the financial system and Islamic finance is no exception. Derivatives can be used in Sharia-compliant ways, as long as they comply with the Islamic law. For example, derivatives can be used to hedge against risk and to manage liquidity. Islamic scholars have determined that some derivatives may be permissible under certain conditions, such as if there is no use of leverage, if the party has expertise in the derivative, or if there is no exchange of interest or “riba”.

The increasing popularity of Islamic Finance has made it incumbent upon banking lawyers to seek out the knowledge necessary for the drafting of Islamic Sharia compliant contracts.