Islamic Finance and Economics Full And Simple Guide

Uncover the essence of this dynamic field with our quick and simplified guide to “Islamic Finance and Economics.” This comprehensive article aims to demystify key concepts surrounding Islamic economics, shedding light on its pivotal role, overarching importance, fundamental principles, distinctive characteristics, and much more.

Whether you’re a novice seeking to grasp the basics or an enthusiast eager to deepen your understanding, join us on a journey through the fundamentals of Islamic Finance and Economics. Gain clarity on its principles, explore its significance, and discover how it shapes financial landscapes with its unique approach. Dive into a wealth of knowledge as we unravel the intricacies of Islamic Economics, providing you with a valuable resource for unlocking the mysteries of this fascinating domain.

Definition of Islamic Economics:

Islam has a set of moral values about individual and community behavior. Islamic Economics introduces a unique economic system that complies with such values. In this context, Islamic Economics can be defined as the knowledge of economic activities and processes in terms of Islamic teachings and principles.

What is Islamic Finance?

Islamic finance refers to finance or banking activities that comply with Islamic laws, rules, and principles. Islamic banking system should be in accordance with Islam morals that assert justice, integrity, and equal opportunity. Modes of Islamic banking/finance include:  Mudarabah (a form of business contract in which one party brings capital and the other personal effort), Wadiah (deposit of funds or assets), Musharaka (equity partnership), Murabahah (financing structure in which the seller and buyer agree to the cost and markup of an asset), and Ijara (providing services and goods temporarily for a wage).

What is the importance of Islamic banking?

The importance of Islamic banking lies in the fact that it offers benefits for economic growth, reducing poverty and fostering shared prosperity. It is an equity-based, asset-backed, ethical, sustainable, environmentally- and socially responsible finance. It promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and social welfare.

How is Islamic finance different from conventional finance?

Islamic finance is different from conventional finance as the former mainly relies on the Risk Sharing principle which requires the contracting parties to mutually share the risk and the reward of a contract and that all parties do not violate the Islamic property rights principles. On the other hand, conventional systems depend on debts; interest repayments are compulsory regardless of business performance. While Islam regards money as only a medium of exchange and a measure of value, conventional economic systems regard money as a commodity that is sold and rented for profit.

Principles of Islamic Economics:

The principles of Islamic economics are derived from the Quran and Sunnah. Its main objective is to provide an atmosphere of justice between individuals and prevent any unjust acquisition of material resources. Here are some principles of Islamic economics: (cited from Dr Mohamed Imad Ali’s essay Principles of Islamic Economics)

1. Man is the successor to Allah’s commands:

Man was not created in vain. He was created by Allah to worship Him and follow His commands in each aspect of life. This will ultimately lead to a successful and balanced life, and more importantly an eternal happiness in the hereafter as a reward to Man’s obedience to Allah’s commands.

2. Wealth and Resources:

The world is full of abundant resources that are not distributed equally so humans can create relationships based on mutual interests. Every human being has an equal right to acquire these resources through righteous means.

3. Economic Trust: 

As people do not earn money equally, Islam sets a rule that can maintain balance in society; it is required that a part of the surplus earned by a person should go to one who is not able to earn. This principle is known as Economic Trust. Allah (SWT) has made it obligatory for every able individual to pay annually a portion (2.5%) of the surplus earned to the poor and the needy. In addition to the legal obligation (Zakat) Islam also encourages individuals to spend in the optional charity (Sadaqah) for social welfare.

4. Economic Activities:

Economic activities include production, distribution and consumption. Islam offers guidelines for these three processes. As for the production process, it shall be performed according to necessities, then comforts and then followed by luxuries. Towards distribution, it should be done justly. those involved in the production should acquire their share, without any deception. Towards consumption, extravagance and waste are prohibited. Moderation and self-control are encouraged.

5. Trade and Business:

Freedom of trade is allowed in Islam. However, commodities that are clearly prohibited in the Quran and Sunnah are not permitted. Few conditions are imposed on commercial business only to protect the interest of the involved parties and society as well.

6. Role and Nature of Money:

Money in Islam is not considered as a commodity, contrary to current international economic systems. Islam regards money as only a medium of exchange and a measure of value. 

7. Debt in Islam:

Generally, one’s involvement in debt is not encouraged in Islam unless it is a necessity. The person getting into debt must have the intention and the ability (both actual and potential), to repay the debt even before entering the transaction.

8. Savings in Islam:

To avoid one’s indulgence in debts as much as possible, Islam encourages saving a portion of wealth for future uncertainties and requirements.

What is the Role of Ethics in Islamic Finance?

The role of ethics in Islamic finance is crucial. It is based on a set of ethical principles that are derived from Quran and Sunnah which are considered guidelines for Muslims to follow in every aspect of their lives. Islamic Finance should operate on the basis of justice, equality and integrity.

Islamic Finance  prohibits unethical activities such as usury, gambling, hoarding, cheating and trading in pork, wine or weapons. Meanwhile, it encourages partnerships based on cooperation, transparency and risk -sharing profits. It highly values real economic activities that lead to economic and social growth.

How is Wealth Distributed in an Islamic Economic System?

Wealth is distributed in an Islamic economic system in a way that narrows the gap between the rich and poor as much as possible. According to Islamic rules (Shariah), those who have directly participated in the production of wealth are not the only legitimate sharers in wealth, the underprivileged section of society is entitled to take share too. Allah (SWT) says:

“In their wealth there is a known right for those who ask for it and those who have need for it.” 

(70:24-25)

Every wealthy Muslim is obliged to pay annually 2.5% of the surplus earned to the poor and the needy-this is called Zakat (almsgiving). Also, an Islamic economic system mainly encourages wealth circulation. It does not allow any individual or group to have a monopoly over the primary sources of wealth and has given every member of society an equal right to derive benefit from them. 

How does Islamic Finance Contribute to Economic Stability?

In Islamic Finance, transactions should be linked to tangible assets. It prohibits speculation or high-risk businesses. It promotes real financial activities that lead to economic stability and growth. Meanwhile, by prohibiting interest-based loans, Islamic banking reduces the negative effect of debt accumulation, which threatens not only individuals but countries with huge economies. The profit-loss sharing principle -which is the essence of any Islamic finance- positively encourages productivity, healthy competition and performance improvement-all are important factors of economic stability.

Six Main Characteristics of Islamic Economic System:

The Islamic Economic system has six main characteristics. They are based on accountability, responsibility, mutual trust, equity, justice and equal opportunity. These characteristics can be summarized as follows:

1. Prohibition of Interest: 

Interests on loans are totally forbidden, because money is not considered as a value of its own. Funds should be an interpretation of real economic activities that lead to social growth.

2. Prohibition of Speculation:

Speculation or gambling is prohibited in Islamic finance because it creates wealth from chance instead of productive activity.

3. Legalized Earnings: 

Islam emphasizes on legitimate and Halal earning. Prophet Mohammed (PBUH) has clearly mentioned the importance of legitimate earning. Asked about the best sort of gains, he said (PBUH)

“a gain which a man works with his hands, and all legitimate activities.”

(Ahmad, 1576.)

Accordingly, any economic activity should not include any forbidden commodities such as alcohol or pork. It should be in accordance with Islamic laws that are meant to benefit the whole community and prevent unethical acts.

4. Paying Zakat (almsgiving):

Zakat means that every wealthy Muslim is obliged to pay annually a portion (2.5%) of the surplus earned to the poor and the needy. It serves as a means of social welfare and wealth redistribution.

5. Sincerity in business transactions:

Honesty in business dealing is fundamental in Islam. There should be clear dealing between seller and buyer. If a seller sells his goods or things on a fake basis, then he will be guilty for that. Islam condemns all fraudulent business dealings.  

6. Fulfilling all business obligations:

Islam strictly emphasizes on fulfilling all promises to establish an atmosphere of mutual trust and respect. Prophet Mohammed (PBUH) asserted that Muslims are bound by their stipulations. All items between the parties, either seller or buyer, must be stated clearly and fulfilled so as not to lead to any dispute.

How Does Islamic Finance Promote Risk Sharing?

Islamic finance promotes the risk-sharing principle; it means risks and profits between the parties involved in any financial transaction are shared by both financial institutions and depositors/savers with a pre-determined ratio. Risk could be defined as the probability of occurrence of an event resulting in a loss. Risk is not limited to default risk, but extends to any type of risk that would eventually cause losses (e.g., market risk, capital risk, economic risk, etc.) According to Shariah, risk thus presented should be shared by the lender and the borrower instead of being shifted to only one party (which is the case in debt-based contracts). In this context, Islamic profits depend on the performance of the enterprise or the business venture itself and therefore cannot be fixed ex-ante.

What is the prohibition of interest (Riba) in Islamic Finance?

The prohibition of interest (Riba) in Islamic Finance is pivotal. Islamic law (Shariha) completely prohibits the charging and receiving of interest on loans or debts. Allah (SWT) says:

“Those who consume interest will stand ˹on Judgment Day˺ like those driven to madness by Satan’s touch. That is because they say, “Trade is no different than interest.” But Allah has permitted trading and forbidden interest. Whoever refrains—after having received warning from their Lord—may keep their previous gains, and their case is left to Allah. As for those who persist, it is they who will be the residents of the Fire. They will be there forever.” (2:275) 

Riba is regarded as an unethical and exploitative practice that increases poverty. Interests on debts are at the root of every financial/banking crisis. Societies of not just poor countries but the biggest and economic countries suffer from huge costs due to excess reliance on debts.

What are the different types of contracts in Islamic Finance?

There are different types of contracts in Islamic finance, all of which depend on profit-loss sharing (PLS) principle. They can be summarized as follows: (cited from islamicmarket.com)

1-Profit and loss sharing (Mudarabah): 

A contract between two parties; one provides the capital and the other provides the labor to form a partnership to share the profits by certain agreed proportions.

2- Joint venture (Musharakah):

It is a financial contract between two or many parties to establish a commercial enterprise based on capital and labor. The profit and loss are shared at an agreed proportion according to the amount of contribution.

3- Cost plus (Murabahah):

It refers to a sale of a good or property with an agreed profit against a deferred or a lump sum payment. There are two contracts in Murabahah: the first contract is between the client and the bank, whereas the second contract is between the bank and supplier. The client (purchaser) orders a certain commodity through the bank, the bank then buys the commodity from the supplier and sells it to the client with specified profit whereby the client can make a lump sum or a deferred payment to the bank.

4- Leasing (Ijarah):

It contains two parties are involved therein: the lessee and leaser. The leaser (bank) is the real owner of the asset or property, and it is rented out to the lessee until full payment is received. The lessee has the option to keep the asset at contract maturity or give it back to the bank. If all payments are received, the lessee can keep the asset but at a higher price than the usual asset price.

5-Salam: 

It is another contract where full payment for a good is paid in advance but the delivery of the good is made at an agreed future date.

What is Ijara in Islamic Finance?

The term Ijara refers to “Islamic leasing”; It is a contract between two parties where the first party -the owner of an asset or property- gives the second party the right to rent his asset or property for a specified period in exchange for a predetermined amount of money. It is a binding contract and hence neither party can end it without mutual agreement unless the contract is breached by either party.

What are the Advantages and Disadvantages of Islamic Finance?

Islamic finance- just as conventional ones- has its pros and cons. Advantages of Islamic Finance can be summarized as follows:

1. Prevention of Exploitation and Enhancement of Effective Economic Performance:

 Since Islamic Finance prohibits interests on money loans and encourages profit-loss sharing businesses, it prevents exploitative acts and distributes wealth according to performance-related bonuses and rewards. This will mean a huge boost in productivity, healthy competition amongst staff, and motivating employees to perform to the very best of their abilities. 

2. Asset-Backed Financing:

Islamic Finance only accepts financial transactions that are backed by physical assets or real economic activities. This reduces speculation and encourages a sustained economic boost.

3. Moral Framework:

Based on Islam’s teaching and principles, Islamic finance prohibits unfair, untransparent and dishonest transactions. It overall ensures values of justice, cooperation and equity. This appeals not only to Muslims who must abide by their religious principles, but also to individuals concerned with moral attitudes. 

Disadvantages of Islamic Finance can be summarized as follows:

1. Lessens control power of initial owners:

In equity investment, the bank takes part of the equity shares of the business and takes part in profit and loss sharing in the business. Equity investors usually take part in owners and decision-making process companies, therefore diluting the control powers of the promoters (initial owners) of the business.

2. Limitation of Business Fund:

Since Islamic finance prohibits funding unethical trading in ammunition, tobacco, alcohol or pork meat processing, it limits the range of business activities that are accepted worldwide.

3. Lack of Standardization:

Islamic banks operating in Muslim and non-Muslim countries do not have a worldwide set of regulations-leading to variations in practices. In this context, investors may regard Islamic banking unreliable and untransparent especially for cross-border transactions.

What are the challenges and opportunities in Islamic Finance?

Islamic Finance faces several challenges that can be summarized as follows: 

1-Small Assets and Capital Size:

The average size of Islamic banks’ assets is still small compared to that of conventional banks. For example, the size of assets of the largest Islamic bank amounted to a meager 1 percent of the assets of the largest bank in the world.

2-Liquidity:

Islamic banks are operating with a limited set of short-term traditional instruments, and there is a shortage of products for medium- to long-term maturities.

3- Lack of Diversification:

Islamic banks often concentrate on a few selected sectors and avoid direct competition. This increases their exposure to new entrants, especially foreign conventional banks that are better equipped to meet these challenges.  

4-Weak Risk Management and Governance Framework: 

Islamic banks according to some studies suffer from weak internal control which may result in operational risks and expose an Islamic bank to potential losses. On the other hand, The role of

Shariah boards represent challenges to the governance of Islamic financial institutions.

5- Theory-Practice Gap:

Although Islamic financial system encourages risk-sharing financial contracts, the practice is very different from the theory, especially in case of risk-sharing instruments. The share of equity and other partnership-based instruments like Musharakah and Mudarabah is less than 10 percent which is very different from the structure of the assets predicted by the theoreticians.

Islamic finance has opportunities for growth and innovation:

 Islamic banking institutions can target a fresh High-Net-Worth client base. Non- Muslims reverting to more ethical investments can offer Islamic institutions significant opportunities for expansion. Non-Muslim scholars at the Anderson Graduate School of Management, University of California, have pointed out that, “Islamic finance will be less prone to inflation and less vulnerable to gambling-like speculation, both of which are fueled by the presence of huge quantities of debt instruments and derivatives.” Islamic banking, if comprehensively implemented in its original form, can be an ethical solution for preventing future financial crises. (Cited from www. Eurekahedge.com)

Islamic Finance in USA:

Islamic Finance in the USA started in the 1980’s and it significantly grew from the late 1990s in accordance with the growth of the Muslim population in the USA. There are currently 25 Islamic financial institutions in operation in the US, the top three of which, according to asset size, are the American Islamic Finance House, University Bank (through its subsidiary University Islamic Financial)

and the Harvard Islamic Finance Project. Noteworthy, the Islamic finance in the United States is a still limited market compared to conventional banking and investment options.

Islamic Economics Books:

There are many valuable Islamic Economics Books. If you are interested to know more about Islamic economics, here is a list of the most recommended books:

1-An Introduction to Islamic Finance by Mufti Taqi Usmani

2-Introduction to Islamic Banking and Finance: an economic analysis by M Kabir Hassan, Salman Ahmed Shaikh & Selim Kayhan

3-The Principles of Islamic Economics by Muhammad Baqir Al-Sadr

4-Islamic Capital Markets a comparative approach 2nd Edition by Obiyathulla Ismath Bacha & Abbas Mirakhor

 Finally, Islam is a comprehensive religion. It draws a practical guideline for Muslims to follow in every life aspect including their economic dealings to ensure the prevalence of justice, honesty and equity of chances. If you want to explore more about the beauty of Islam and why it is spreading.