Principles of Islamic Finance

Islamic finance refers to a system of finance based on Islamic law (commonly referred to as Sharia4). Islamic financial principles are premised on the general principle of providing for the welfare of the population by prohibiting practices considered unfair or exploitative. The most widely known characteristic of the Islamic financial system is the strict prohibition on giving or receiving any fixed, predetermined rate of return on financial transactions. This ban on interest, agreed upon by a majority of Islamic scholars, is derived from two fundamental Sharia precepts:

• Money has no intrinsic worth.
Money is not an asset by itself and can increase in value only if it joins other resources to undertake productive activity. For this reason, money cannot be bought and sold as a commodity, and money not backed by assets cannot increase in value over time.
• Fund providers must share the business risk.
Providers of funds are not considered creditors (who are typically guaranteed a predetermined rate of return), but rather investors (who share the rewards as well as risks associated with their investment). Islamic finance, however, extends beyond the ban of interest-based transactions. Additional key financial principles include the following:
• Material finality.
All financial transactions must be linked, either directly or indirectly, to a real economic activity. In other words, transactions must be backed by assets, and investments may be made only in real, durable assets. This precludes the permissibility of financial speculation, and therefore, activities such as short selling are considered violations of Sharia.
• Investment activity.
 Activities deemed inconsistent with Sharia, such as those relating to the
consumption of alcohol or pork and those relating to gambling and the development of weapons of mass destruction, cannot be financed. In broader terms, Sharia prohibits the financing of any activity that is considered harmful to society as a whole.
• No contractual exploitation.
Contracts are required to be by mutual agreement and must stipulate exact terms and conditions. Additionally, all involved parties must have precise knowledge of the product or service that is being bought or sold. The jurisprudence used to engineer Sharia-based financial contracts is complex. Scholars must complete several years of training before becoming certified to issue financial rulings. The industry’s most prominent Islamic finance scholars are in general agreement on the basic set of financial precepts listed above. However, there is no centralized Sharia finance authority, and consequently, there can be conflicting views on the implementation of these principles in designing and extending Islamic financial products.

refference

http://www.cgap.org/gm/document-1.9.5029/FN49.pdf