Core Elements of Islamic Finance - Essay Example

Islamic Finance Islamic finance may be defined as a financial system whose operations are compliant to Islamic law, known as Sharia, and are directed by Islamic economics (Zepeda 19). Therefore, it may also be referred to as Sharia-compliant finance. The similarity between the Islamic finance system and conventional financial systems is that they both feature banks, insurance firms, capital markets, investment companies and fund managers. However, in Islamic finance, apart from the regular rules and regulations applicable to the conventional finance industry, there are additional rules stipulated by Islamic law and founded on the concept of balance. This aims to ensure that the target and purpose of the Islamic finance industry benefit the society by balancing spiritual needs with material pursuits, as well as social and individual needs. This paper will discuss ways in which Islamic finance can be seen as an innovative way that could substantively redefine finance and also why it is substantively different from conventional finance. Core Elements of Islamic Finance Islamic finance is different from conventional banking and the core notion behind it is that God (Allah) owns all the wealth in the world, over which man is only a trustee. Humans, therefore, have an obligation to manage the wealth in accordance with the commands of Allah that prohibit activities which do not promote justice (Rammal & Zurbruegg 69). One major reason for imposing Islamic ethics and law on finance is to promote and uphold social justice, since Islam is deemed to be inseparable from social justice. Islamic finance is based on the core perspective that prohibits the practice of usury, which means lending money to earn interest, also known as riba. Sharia law defines it as an excess compensation that has no due consideration. Effectively, this underlying factor redefines finance from the Islam point of view. However, it does not expressly preclude an agreed-upon return on investment by the transacting parties, where any reference to interest only sets standards for the return on investment for transparency purposes. The implication is that interest is not used in the transaction, although capital is not just provided to investors without a return. This concept stems from the fact that Sharia law does not recognize money as having intrinsic value, but rather, only as a measure of value whose use should not be paid for. This makes Islamic finance an asset based industry, in contrast to the currency based conventional finance system, and investments are structured on the ownership or exchange of assets, with money only acting as a payment medium to effect transactions (Rammal & Zurbruegg 73). Innovations of Islamic Finance Islamic financial institutions have taken advantage of some of the misgivings of conventional finance and launched innovative initiatives that have supported their steady progress. Deficiencies have led people to seek alternatives and move away from the conventional system. The strong ethical orientation, on which Islamic finance is based, as well as the connection of the movement of Islamic finance with the modern resurgence of Islamic civilization, is appealing even to non-Muslims. Islamic finance has the potential to establish a closer link between financial and real segments of the economy. Innovative products like Musharakha and Mudaraba, which mean equity participation and partnership financing respectively, ensure profit sharing that is based upon partnership principles (Timur 791). Another Islamic view of finance is that it emphasizes on risk and profit sharing, rather than the notion of risk transfer as seen in conventional finance and banking. For example, the Murabaha product (which refers to a cost-plus sale) and other trade-based finance modes undertake trade with a mark-up and facilitate financing on short-term basis in a similar fashion to purchase finance in conventional finance. However, the difference is that a bank may buy an asset from a seller and agree on the resale mark-up with a buyer, without any interest on the loan. This curbs the exchange of contemporary money for future, prospective money, promising to reduce the borderless expansion of credit and reduce speculation. This attribute further makes it more suitable for a globalizing economic platform, where conventional finance systems have not elicited enough trust from poor communities (Timur 802). Differences between Islamic Finance and Conventional Finance Islamic finance is structured to comply with Sharia law as stated by the Quran and serves the expectations and interests of the Muslim community through the offering of financing modes acceptable to Islam. On the other hand, conventional finance is founded on secular practices of the respective nations and the creditor-debtor relationship between the customer and the bank, where the consideration between a banker and a borrower is interest (Rosly 101). Money’s opportunity cost in conventional finance is also reflected in the interest. Islamic finance does not implement restrictive measures in economic activities; rather, it directs the industry towards responsible and moral activities that honor Allah and benefit other people, especially the poor. This is achieved by allowing the free market economies in which the market decides supply and demand, unlike conventional finance where supply and demand are largely decided by secular government rules and regulations. Further, the secular guidelines in conventional finance permit trading of all instruments of finance, including derivatives that Islamic finance prohibits (Rosly 109). Advantages of Islamic Finance In conclusion, it is important to bear in mind that Islam does not forbid wealth accumulation, but promotes awareness of shared responsibility for the difficulties the poor go through (Mahlknecht 39). This is reflected in one of Islam’s obligatory acts (five pillars) known as zakat, which means giving a portion of one’s wealth towards charity. Therefore, implementing principles of Islamic finance on a large scale in the financial markets has the potential of resulting in beneficial investments from which people across the wealth spectrum can gain. Such rewards can expand to substantial regional, national, and global levels of stability. Although Islamic finance is an old concept that was suppressed by political factors, it has reemerged as a relatively new concept that promotes transparency and simplicity as it connects financial markets to economic activities. It is characterized by the concept that institutions and people participating in financial products relate as partners or sellers and buyers in their transactions, as opposed to borrowers and lenders. It generally links investment and savings; avoids economic bubbles and bursts; spurs economic development; encourages longer-term investment; reduces the effect of harmful practices and products; and strives for more stability (Mahlknecht 53). Works Cited Mahlknecht, Michael. Islamic Capital Markets and Risk Management. London: Risk Books, 2009. Print. Rammal, H., & Zurbruegg, R. “Awareness of Islamic Banking Products among Muslims: The Case of Australia.” Journal of Financial Services Marketing, 12.1 (2007-03): 65–74. Print. Rosly, Saiful A. Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Investments, Takaful and Financial Planning. New Jersey: AuthorHouse, 2006. Print. Timur, Kuran. “The Absence of the Corporation in Islamic Law: Origins and Persistence.” American Journal of Comparative Law, 53.4 (2005-09): 785–834. Print. Zepeda, Rodrigo. “Enhancing Islamic Finance through Risk Benchmarking.” The Capco Institute Journal of Financial Transformation, 9.38 (2013-10): 17-34. Print. Read More