Islamic Finance or Sharia-Compliant Finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic Economics. Source of Sharia is the Quran (word of Allah), Sunnah (Authentic hadith of Prophet Muhammad-saw), Ijma (consensus of the muslim scholars) and Qiyas (process of deductive analogy).
The Main focus of Islamic Finance is on transparency, cooperative venture, risk sharing and ethical investing which attracts both Muslims and Non-Muslims.
Islamic finance has started to grow in international finance across the globe, with some concentration in few countries. Today, Islamic banking has become one of the fastest growing segments of the international banking and capital markets. Considerable growth of Islamic finance in recent years seems to point to its resilience and broad appeal, partly owing to principles that govern Islamic financial activities, including equity, participation, and ownership.
In theory, Islamic finance is resilient to shocks because of its emphasis on risk sharing, limits on excessive risk taking, and strong link to real activities. Empirical evidence on the stability of Islamic banks, however, is so far mixed. While these banks face similar risks as conventional banks do, they are also exposed to idiosyncratic risks, necessitating a tailoring of current risk management practices. The macroeconomic policy implications of the rapid expansion of Islamic finance are far reaching and need careful considerations.
Basic Principles of Islamic Finance
1. Avoidance of Gharar (Uncertainty): Gharar refers to entering into a contract in absolute risk or uncertainty about the ultimate result of the contract and the nature and/or quality and specifications of the subject matter or the rights and obligations of the parties. Gharar contains characteristics such as risk, hazard, speculation, uncertain outcome, and unknown future benefits.
2. Avoidance of Maysir (Speculation): Maysir (speculation) or any game of chance. Maysir refers to easily available wealth or acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar (similar to Maysir) means the game of chance; one gains at the cost of other(s) right. Maysir is prohibited by Holy Qura’n [ 2: 219 and 5: 90] as well as in Hadiths.
3. Prohibition of Riba (Interest): Under Islamic financial system money is mere a medium of exchange and not a factor of production independently. Human labour is required in addition to money to earn a return, hence there is no fixed return for capital, however capitalist can participate in business under profit and loss sharing with or without participation in management of entity Implication of this principle of Islamic finance is discouraging time value of money in its conventional banking sense.
4. Finance Only for Halal (Permitted) Business: There are various prohibited businesses (based on Quran & Hadiths) in which investment for Muslims (Islamic banks) is prohibited. Activities such as liquor, pork, pornography, adultery, dance clubs, conventional banking, insurance etc. are unlawful, hence earning return through investment in any of these activities is not allowed under Islamic financial system. Nothing is Haram except what is prohibited by a sound and explicit Nas [Verse of Qura’n and an authentic Sunnah].
5. Profit & Loss Sharing: According to this principle capitalist demanding profit on capital should also participate in loss as well. An investor can earn return on his investment subject to risk of loss, hence concept of risk free return is disappeared under Islamic financial system.
Conventional & Islamic Financial System: Similarities & Differences:
Various Types of Islamic Financial Instruments
RIBA (INTERST): An Economic Slavery
As per Islamic Law, money is considered as only a mean of carrying out transactions. Any earning on the same in the form of Interest (Riba) is prohibited. Riba counts in fact amongst the most destructive sins in the religion of Islam, ranking amongst the seven deadly sins mentioned by Prophet Muhammad (pbuh), a severe list of sins that also includes murder.
Riba is considered economic slavery, which makes the poor poorer, and the rich richer; a practice that prevents the poor from overcoming their weakened financial conditions and prospering. The one lending the money is not providing a service, instead solely profiting from the lending of money. This practice denies the poor the opportunity to get out of their situation. The one with the capital will remain rich for life since they eliminate the possibility of suffering losses and expanding their wealth as they extract funds from lending money.
Consuming Riba is the only crime that God the Almighty declared and waged war against those who consume it.
Riba is often translated to the English word Usury means, the illegal action or practice of lending money at unreasonably high rates of interest. Whereas usury is understood as the lending of money at a high rate of interest, the word Riba — as stated in Islam and the terminology of the Holy Quran — is the lending of money on interest regardless of the rate of interest, whether low or high.Riba is considered an unnatural growth of wealth; an unjust transfer of wealth; an unethical and harmful act, and a means of devouring the wealth of others. The act of Riba prevents wealth from circulating in the economy.
In the wholly Quran four verses are about Riba (interest) revealed on different occasions. The first verse is in Surah Al-Rum 30:39 whereby displeasure of Allah is disclosed for interest based practices. The second verse is in Surah An-Nisaa 4:161 where interest charging was disclosed as sinful act of Jews. The third verse is part of Surah Al-Imran 3:130 whereby prohibition of Riba (interest) was declared “O those who believe do not eat up riba doubled and redoubled. “The last verse revealed is reported in Surah Al-Baqarah 2:275 whereby severe punishment is declared for those dealing in interest “Those who take interest will not stand but as stands whom the demon has driven crazy by his touch.
That is because they have said: ‘Trading is but like riba’. And Allah has permitted trading and prohibited riba. So, whoever receives an advice from his Lord and stops, he is allowed what has passed, and his matter is up to Allah. And the ones who revert back, those are the people of Fire. There they remain forever”.
Types of Riba
I. Riba al-Nasiyah: The interest of delay. This is the addition of a surplus or an extra amount to an originally transacted sum for the party awaiting delivery of what he or she has transacted for. Loans today almost always fall into the category of riba al-nasi‘ah. Any commodity that gains its increase simply because of time passing is riba al-nasi‘ah.
Example of Riba-al-Nasiyah: If Mr. A lends Rs.1000 to Mr. B (a borrower) with a condition that Mr. B shall return him Rs.1100 after one month. In this case, the extra amount of Rs. 100 is Riba or Interest.
II. Riba al-Fadl: The interest of excess. Riba Al-Fadl is the unequal exchange of like commodities. One trades gold, silver, wheat, etc. for a greater amount of the same commodity from another. The Prophet(pbuh), said: “Sell gold for equal [amounts of] gold, sell silver for equal silver, sell dates for equal dates, sell wheat for equal wheat, sell salt for equal salt, sell barley for equal barley. Should one transact in excess, it is riba (interest). Yet sell gold for silver as you like hand-to-hand, sell barley for dates as you like hand-to-hand.”
During the dark ages, only the first form (Riba An Nasiyah) was considered to be Riba. However, the Holy Prophet(pbuh) also classified the second form (Riba-al-Fadl) as Riba.
Islamic Finance In India
Islamic Finance / Islamic Banking has huge potential in India as India is the third largest Muslim Populated country and as per projection, by the end of 2050, India will be the world’s largest Muslim populated country.
The participation of Banks in Islamic finance, what we refer to as Islamic Banking, has always been stuck in the abeyance for the lack of clarity in the Indian legal structure. The Banking Regulation Act, 1949 favours the ‘banking with interest system’, the operation of ‘banking without interest’ faces challenges in the form of various regulations, such as restrictions of profit sharing business, restriction on owning immovable property other than banking assets, SLR requirements, etc. However, it shall be pertinent to note that there is no specific legal bar on Islamic finance, though banks may be deferred from participating due to the Banking Regulation Act, nothing stops other financial institutions such as NBFCs. Hence, though Islamic finance products may be offered by entities other than banks, the participation of banks shall remain in abeyance till RBI takes any further steps.
In 2008, the financial sector reforms committee of the RBI, led by Raghuram Rajan, had recommended setting up of interest-free banking facilities in India. However, it did not mention Islamic banking or Sharia banking. Extract from the said report, named – A Hundred Small Steps- Report of the Committee on Financial Sector Reforms, as follows:
“Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region. While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.
In report 2015-2016 of The committee on medium-term path on financial inclusion, it again raked up the issue as in absence of non-interest banking, a section of the population was not being able to take part in the banking system. The report also said: “It is observed that some sections of the Indian society have remained financially excluded for religious reasons that preclude them from using banking products with an element of interest. Towards mainstreaming these excluded sections, it is proposed to explore the modalities of introducing interest-free banking products in India in consultation with the Government.” The committee recommended that, “commercial banks in India may be enabled to open specialised interest-free windows with simple products like demand deposits, agency and participation securities on their liability side and to offer products based on cost-plus financing and deferred payment, deferred delivery contracts on the asset side.”
Meanwhile, the CPM in Kerala toyed with the idea, and after getting a go-ahead from the RBI, launched Cheraman Financial Services Limited, a co-operative on the lines of the practice of the Islamic banking system, with a corpus of Rs 250 crore. It was established with equity participation of Kerala State Industrial Development Corporation (KSIDC) and private investors, mostly Gulf-based NRIs. So, the concept of interest-free banking, which could have bolstered the economy by inviting huge investment from the West Asian countries, is not new to India.
Indian Centre for Islamic Finance (ICIF) in 2016 said, “if the proposal of RBI become a reality, huge investments from countries like UAE, Qatar and Bahrain will flow into India.” Islamic window in conventional banks will lead to trillions of dollars from Gulf nations getting invested in India from Islamic Financial Banking.
In December 2016, in a written reply to the Lok Sabha, minister of state for finance, Santosh Kumar Gangwar, had said, “The objectives of the financial inclusion for which Islamic banking was explored by RBI has no relevance, as government has already introduced other means of financial inclusion like Jan Dhan Yojana and Suraksha Bima Yojna for all citizens.” Apart from this, no financial reason was given so far.
In 2017, Reserve Bank of India has dropped the proposal for introduction of Islamic banking in the country. The idea, once pushed by former RBI governor Raghuram Rajan, has died a natural death, as it were, given the amount of resistance it managed to create. However, it seems that the reason for nixing the proposal is more political than financial. It appears that just the presence of the word “Islamic” is enough reason to summarize that the current government and his ideological parent will not be comfortable with the idea of serving up interest-free products guided by Sharia law for Indian banking consumers.
India wants to become economic giants but it will not possible until the large group of population (second majority) remain excluded from mainstream economy. For the Muslims Islamic finance could open new doors, enabling the betterment of this community and achievement of the goal of financial inclusion for all. This will also help to open new avenues for flow of substantial funds in the market. It will help in mobilize large amounts of money from Muslims who participate very little in conventional banking. This will also help to channelize huge amounts of Investments from Gulf and other Muslim countries that India is currently loosing.
Misconception About Islamic Finance System
Islamic Finance is having the misconception that it is meant only for Muslims. But in fact, it is an alternative to conventional financial system which is meant for people of all religions. Islamic banking has barriers in India but it can be addressed with some flexibility and modifications in regulations which ultimately depend upon the political will. With huge marketing India, influence from Muslim community will help to growth of Islamic financial system.
We are living in the world, where more than 25% of population are followers of Islam. Islam is the second most followed religion globally, and hence, Islamic Finance can simulate the growth of business sector by providing much needed financing, while also release the untapped sources of capital as some investors may only be willing to invest in product that are permissible under their faith. As living in the globalizing economy, we cannot ignore the Islamic Financial System.
Islamic financial system ensures justice between savers and investors. By demolishing risk free return and promotion of profit and loss sharing, justice is ensured for both parties i.e. capital supplier as well as capital user. As a model of modern commercial banking, initially capital is supplied by depositors and later on by bank to business community. Under Islamic financial system bank can invest in businesses to earn variable return based on actual results of activities and share profit earned with depositors based on agreed sharing formula. Hence it is ensured to distribute the actual outcome and none is to bear risk alone and none is to earn with zero risk.
Three key principles govern Islamic finance: equity, participation, and ownership. These principles imply that in an Islamic financial system, financing can only be extended to productive activities, trade, and real assets—thus it is often considered an asset-based financial system. If fully complied with, these principles ensure appropriate leverage and help limit speculation and moral hazard.
Importantly, the application of interest free banking cannot be said to be limited to a particular faith. The nuances caused by unchecked interest rates, and exploitation of the poor by debt trap of the high interest loans has its impact across geographies.
Bonus Note: For Successful Business As Per Islamic Law