Key Features of Islamic Finance

Key Features of Islamic Finance

Islamic Finance seeks to regulate certain economic activities in order to achieve the following objectives;

1.  Equitable Distribution of Wealth

2. The Middle Path

3. Transparency in Transactions

 4. Asset Backed Financing & the Nature of Money

1. Equitable Distribution of Wealth

An interest based economic system will always lead to wealth being concentrated in the hands of the few at the expense of the many. This is because lenders will always prefer to loan money to those with the most collateral, who in turn will use the money to generate further profits. Consequently the global interest based economic system ensures the vast majority of the world’s finance is commandeered by a tiny fraction of the overall population.

Islamic Finance has prohibited the payment of interest when lending or borrowing capital. Capital must be put at some sort of risk in order to justify a return. In doing so banks, and crucially the underlying account holders, receive a share of profits and not just a fixed rate of interest.

By engaging in risk and sharing in the bank’s profits, the underlying account holders are more likely to receive a far greater slice of wealth compared with the interest normally received on deposit accounts. This in turn would lead to a much fairer distribution of wealth in society.

2. The Middle Path

Muslims are required to follow the ‘middle path’ in all matters. With regard to economics this can be defined as a path between unregulated markets on one side and excessive regulation on the other. While it is true that Islam rejects the Communist principle that private enterprise should not be permitted, it is equally fair to say that Islam also rejects unbridled Capitalism that permits individuals to disregard society’s net interests in pursuit of personal wealth.

The accepted practice of government economic intervention in capitalist economies perhaps highlights the fact that certain economic activities - of harm to the collective interests of society - should be monitored and restricted. Islamic Finance is in full agreement with the ideas of regulating economic activity but seeks to define the boundaries through divine guidance.

3. Transparency in Transactions

Islam stresses the need for transparency in transactions. A sale transaction, for example requires the existence, quantity and quality of the subject matter to be clearly stated in order for the sale to be considered valid. Islam also compels business transactions to be put in writing in order to eliminate ambiguity and reduce the potential for future disagreements.

4. Asset Backed Financing & the Nature of Money

Shariah law stresses the importance of only trading in assets of ‘inherent value.’ Any asset with ‘inherent value’ can be bought or sold at a profit, for example a computer can be purchased for £800 and sold for £1000.

It then follows that an asset without any inherent use or value cannot be traded, for example a new £20 note is worth exactly the same as a used £20 note. The note has no inherent use in its own right and simply serves as a determinant of value; hence it cannot be traded for profit.

Trading in money often leads to detrimental consequences such as the boom and bust economic cycle and as such, loaning idle capital in exchange for a profitable return runs contrary to Islam’s desired approach.