How does Islamic finance work?

If we examine the objectives of Shariah, we can extract a common theme from them, which is the removal of Zulm or injustice from society. We do this by requiring that all financing complies with Shariah law, for example, ensuring that the institutions are dealing with financial products that do not contain any of the prohibited features. This makes the Islamic financial system somewhat different from capitalism. 

Islamic Finance vs. Capitalism

One may make the case that the Islamic financial system is not fundamentally different from the Western one. Scholars mostly have consensus over the general permissibility of the right to private property and limited liability in Shariah, which are two of the fundamental pillars of capitalism. However, the third pillar, which is ‘rationale’, has a different meaning in capitalism and Islamic finance. This will define How does Islamic finance work.

Rationale translates to logic or reasoning. With reference to a financial system, rationale means that the person working hard should get more rewards. This is in comparison to the person who is not working as hard. However, the Islamic economy does not see this reward as merely ‘profit’ or ‘income’.

As such, concepts like:

• corporate social responsibility (CSR)
• sustainability, and ethics.

Do not necessitate infusion into the Islamic financial system by assuring conformity with foreign frameworks. These concepts are installed directly in the ‘rationale’ of the Islamic financial system.  For example, the Islamic financial system advocates dealing in real transactions and the flow of wealth in the economy.

There is the concept of Zakat in the Islamic financial system, where a person has to give out a portion of their savings back to the economy (i.e. discouraging the accumulation of wealth, and promoting social and distributive justice). This circulation of wealth favours the idea of asset-backed or asset-based transactions.

The economy will suffer a loss of real assets to trade on if people start putting money away in savings accounts instead of using it. Consequently, asset amassment can result in financing mechanisms that fuel economic bubbles such as:

• The trading of collateralized debt obligations (CDOs).

Which is blamed for contributing to the real-estate crisis in the United States in 2008).

Check out our course on: Introduction to Islamic Finance