The principles of Islamic banking and finance

The Islamic financial system

Islamic finance is first and foremost an ethical finance that places a lot of importance on a value system that is mainly based on avoiding what is prohibited. This value system is also based on a balance between private interest and public benefit, the values of fairness, transparency, etc. These are very important values that must be respected. These are very important values that should always be reflected in actions and transactions. Originally, Islamic banking depended only on the opinions (fatwas) issued by Muslim jurisconsults (sheikhs) who are true connoisseurs of the jurisprudence of economic transactions. Then, the writings on this subject were generally critical of the communist and capitalist systems. The foundations of Islamic finance began to take shape in the third quarter of the century. They are seen as a subject of study and as an industry. It is from this moment that researchers in theology as well as in economics have taken the trouble to focus on how to differentiate aspects of the traditional financial system.

Work has also been done to find a way to satisfy the customers of the financial companies, without forgetting to grant a respect for the fundamental principles of the Muslim law. This is how a set of institutions as a bank and instruments came into being. This is how the attentions were then focused on the Islamic financial system which is a system accompanied by principles, values, mechanisms. In fact, Islamic banking has decided to institutionalize the concepts of this finance. The Islamic finance system is far from being a divine system. It is rather dynamic and can develop according to the perceived changes in the environment. Islamic financial institutions like a bank include Islamic insurance companies or Takaful, Islamic investment funds and bond issuers. There are 300 Islamic financial institutions as bank spread over 75 countries worldwide. As a result, the assets to be managed exceed one trillion dollars.

The basic principles of Islamic finance

The basic principles of Islamic banking and finance include not only "riba" or the prohibition of lending at interest. There are also other principles that are important.

1-      Riba: the prohibition of lending at interest

Riba is something that is totally forbidden in the Qur'an. According to a narration in the Holy Scripture it has been clearly stated that the Prophet cursed the one who takes and the one who gives. This means that when you lend, you are not allowed to ask for a return. The profit is the price of the loan. Yet from a fundamental point of view, in a loan, one cannot expect to generate a profit. The prohibition of interest-based lending applies both to the contractual profit on the loan as well as to any form of late interest or interest disguised as penalties and commissions. In the Islamic religion, when you lend money, you cannot receive any profit or gain. This fund cannot be considered as an asset that can generate income by itself. However, the lender has the right to receive income from the activity that was carried out with his money.

2-      Al Gharar: the prohibition of excessive risk

All operations based on finance must always be carried out with complete clarity and transparency. Thus, each actor and participant is always aware of everything that happens during their exchanges. Therefore, transactions in which values are not exactly determined, or which present an excessive risk, are prohibited. The same applies to transactions that depend essentially on chance or on future elements that are difficult to predict. Therefore, no financial contract can be established if its object is too ambiguous. This may be insurance based on natural disasters or weather conditions that may have adverse effects on crops.

3-      The backing of real or tangible assets

In all respects, Islamic finance is always linked to the real economy. Therefore, it is necessary that real and tradable assets take care of all financial transactions. On the other hand, investments in derivatives (futures contracts, forwards, etc.), in which an actor can sell an asset that he does not own, are not considered as financial transactions. This is also a principle reminiscent of the prohibition of Gharar, which is speculation and allows the sale of assets that are not yet available to us.

4-      Profit and loss sharing

All risks based on an operation cannot be assumed by only one party. In this situation, the other party does not have the right to transfer all risks to the contractor. In any financial contract, both the lender and the contractor must bear the risks associated with the transaction. This being the case, when an investor decides to entrust his funds to the entrepreneur so that his project can be launched in order to prosper his business. Also, both actors must share all eventualities of losses.

5-      The prohibition to sell what one does not own

There is no better justification for the profit generated by ownership or by sale than ownership. It is only a justification that is the translation of the rule that was quoted in one of the previous paragraphs. The fact of owning an asset obliges its owner to bear the risks related to its profit in the event that the project is not fruitful. This is what has caused intermediation services to be seriously regulated. This rule must be respected especially when it comes to the purchase or resale of assets, whether through a bank or any other financial institution.

6-      Prohibition of illicit activities

Islamic finance is a finance that is both ethical and responsible. Thus, all operations that have any relation with pork, alcohol, weapons, gambling, or pornography are prohibited from financing. However, all products that do not respect Islamic morality are prohibited.

7-      Prohibition of deferred exchange of standard values

A saying of the Prophet had made it known that there can be no exchange of standard values of the same nature if it is not done face to face. This concerns all exchanges such as gold for gold, silver for silver, etc. These exchanges must be done hand to hand and in the same proportions.

The instruments involved in Islamic finance

From the fundamental principles of Islamic finance, we can draw some instruments that have invested in the emergence of products and concepts that are unique to them: financing instruments, participatory instruments, as well as instruments of non-banking institutions.

Many want to know a little more about where Islamic finance will be in 20 years, given the rules to follow and the instruments that come into play. In 2017, the size of the Islamic asset market reached 2,666 billion dollars. This can be thanks to the geographical development. South America, Egypt, Asia and the Middle East will indeed be affected by this development. By 2030, the Islamic population may increase considerably. This will also have a positive effect on Islamic finance.

Basically, Islamic finance is nothing like Western finance because of all its principles and practices. However, this finance is now practiced by a large number of global players. Moreover, in practice, Islamic funds have bypassed several prohibitions, after receiving the approval of Sharia boards. As a result, the possibility of receiving a pre-defined interest is not ruled out, in order to make the project profitable. In terms of contingencies, the Sharia boards have given permission to some insurance companies if they operate in the manner of common funds.