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The Rationale for Islamic Finance

What is Islamic Finance? Finance is the management of sourcing, investing and distributing money. Therefore, Islamic finance means managing money by adhering to Islamic principles or guidelines (collectively referred to as Shariah). We need to set out the objectives of a system before we define its principles or guidelines. Similarly, Islamic law , hereafter referred… Continue reading The Rationale for Islamic Finance

What is Islamic Finance?

Finance is the management of sourcing, investing and distributing money. Therefore, Islamic finance means managing money by adhering to Islamic principles or guidelines (collectively referred to as Shariah).

We need to set out the objectives of a system before we define its principles or guidelines. Similarly, Islamic law , hereafter referred to as Shariah, also has such objectives.

These objectives were identified by a prominent Muslim scholar Ghazali (Chapra, 2008) as the safeguarding of:

  • Faith (Din)
  • Self/life (nafs)
  • Intellect (aql)
  • Progeny (nasl)
  • Wealth (ma’al)

In a broader sense, the Shariah principles aim to remove zulm (or injustice) from society. Therefore, concepts like social and distributive justice, corporate social responsibility and sustainability form the core of Islamic finance. 

How is Islamic Finance Different?

The prohibitions imposed on the Islamic financial institutions (IFIs) by Shariah make them trading institutions instead of financing institutions. This means that the IFIs follow a profit-loss sharing approach where all the transactions are asset-based or asset-backed.

For example, if a customer of an IFI wants to buy a car, the IFI will not provide the customer with a loan to help finance the car. Instead, the IFI will use one of the available Islamic financial instruments to help facilitate the customer.

For example, one instrument commonly used by IFIs is deferred payment Murabahah, which is a ‘trust sale’ (a trust sale is where profit is disclosed to the buyer).

In deferred payment Murabahah, the IFI will first buy the car for the customer and will get its legal ownership.

Then the IFI will sell this car to the customer by adding a fair markup on the cost of the car. The payment for the car will be deferred through a pre-agreed instalment schedule. A simple flow of this Islamic instrument is demonstrated below for understanding:

How is Islamic Finance Different

Ozair Siddiqui
2 min read
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