Islamic finance is a financial system that operates according to Islamic law (which is called Shari’ah) and is, therefore, Shari’ah-compliant. 

Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts.

Principles

Islamic economics is based on core concepts of balance, which help ensure that the motives and objectives driving the Islamic finance industry are beneficial to society. This involves promoting justice and prohibiting certain activities.

Based on the core concepts of Islamic economics, Islamic finance institutions adhere to certain principles that distinguish them from conventional finance. These are:

  • Prohibiting interest (riba)
  • Steering clear of uncertainty-based transactions (gharar)
  • Avoiding gambling (maysir or qimar)
  • Avoiding investment in prohibited industries

The core responsibility of guiding and supervising institutions offering Islamic financial products rests with respectable Shari’ah Scholars typically appointed as the Shari’ah Advisors and members of Shariah Boards of individual institutions.

Islamic Banking

The main categories within Islamic finance are:

  • Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. This contract involves one party granting another party the right to use an item that belongs to him for a predetermined amount of time in exchange for a predetermined fee.
  • Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract. At the conclusion of the contract's term, the lessor transfers ownership of the assets and properties that were leased to the lessee.
  • Mudaraba is a profit–sharing partnership wherein one party (rab al maal) contributes capital and the other party (mudarib) contributes labour and skill.
  • Murabaha is a contract where the bank buys an item and then sells it to the customer on a cost-plus markup/profit. The cost price or profit must be known to the customer.
  • Musharaka is a joint venture/partnership in which profit and loss are shared by parties.

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Islamic Capital Market

The Islamic capital market is an integral part of the Islamic financial system. It enables the efficient mobilisation of resources and an optimal allocation thereof, thereby complementing the financial intermediary role of Islamic institutions in the investment process. Although this market functions similarly to the conventional capital market, any financial arrangement it facilitates has to be in line with the Shari’ah principles. The instruments below offer alternatives to conventional instruments.

  • Islamic equity funds offer transparency in relation to industries and companies invested in; incorporate financial screening to ensure Shari’ah compliance; seek a diversified portfolio to reduce risk and the liquidity to allow investors wants or needs to cash out
  • Sukuk provide undivided shares in the ownership of tangible assets relating to particular projects or special investment activities whereby investors are entitled to a share in the revenues generated by the Sukuk assets. They are essentially financial products with Shari’ah-compliant terms and structures that aim to produce returns comparable to those of traditional fixed-income securities like bonds. According to the ‘Islamic Finance: global trends and the UK market report 2022’, it is the second-largest sector of Islamic Finance after Islamic banking.
  • Islamic funds screen out investments in conventional financial services or debt instruments which make financial returns by earning interests or excess; investments in businesses that involve activities/products which are forbidden by the Shari’ah principles; and engaging in transactions involving speculations that are seen as being akin to gambling
  • Islamic real estate investment trusts (i-REITs) invest primarily in income-producing, Shari’ah-compliant real estate and/or single-purpose companies whose principal assets comprise Shari’ah-compliant real estate allowing a portion of i-REIT funds to be invested in other Shari’ah-compliant asset classes

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Islamic Insurance (Takaful)

Takaful is a type of Islamic insurance, where members contribute money into a pooling system in order to guarantee each other against loss or damage. Additionally, it is the smallest sector in the Islamic Finance market. 

  • Wakala Model: In a wakala-based takaful product, the takaful operator works as an agent on behalf of the takaful participants, who are called the principals. The takaful operator manages the fund and receives a pre-agreed percentage of the participants’ fund or fixed fee; this management fee is called a wakala fee. In addition, the takaful operator may charge a performance-based fee, which is its incentive to manage the fund as well as possible. The takaful operator determines what fee(s) to charge after consulting with the Shari’ah board. Any fees it collects are placed in the shareholders’ fund and are used to reward the shareholders as well. Note that any surplus that the takaful fund or the Shari’ah-compliant investments generate goes back to the participant contributions.
  • Mudaraba Model: Mudaraba is an Islamic contract based on a financial partnership in which one party (an investor) gives money to another (a fund manager) for the purpose of investing it in a business or economic activity. When a takaful product is based on Mudaraba the shareholders of the takaful company (mudarib) share the profit of the fund with the policyholders (rab al-mal). The takaful company is not liable for any loss as the participants’ fund bears the loss. The takaful company receives a percentage of the fund’s surplus (if one exists) and a percentage of any profit from investments made by the fund.
  • Combination of Principal-agent relationship and partnership: This is the most widely used model in the takaful industry and it is typically structured using the wakala contract with the takaful company acting as the agent for the fund management and receiving a fee for underwriting the fund alongside a mudaraba contract where the takaful company acts as the fund manager for managing investments and shares the profit for the investment of the takaful fund. The company does not receive any portion of the surplus in the participants’ fund in the combination takaful structure.

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