Islamic
Finance - A brief overview
Since the 1970s, Islamic finance has emerged as a new reality in the international financial scene. Its philosophies and principles are however, not new, having been outlined in the Holy Quran and the Sunnah of Prophet Muhammad (p.b.u.h.) more than 1,400 years ago.Islamic finance represents a departure from conventional banking, as it is based on the principals of equity participation, risk and profit-and-loss sharing arrangements.
Unlike a conventional bank, which is basically a borrower and lender of funds, Islamic finance essentially deals with transactions between its depositors, on the one side, and a partnership with entrepreneurs, on the other, when employing depositors' funds in productive direct investments.
The essential feature of Islamic finance is that it is interest-free.
It is important to understand the distinction between interest and profit. Many people see interest and profit as the same thing, especially when considering financial transactions, as sometimes the sums involved are very similar. In reality, interest is just a sub-set of profit.
Interest is the profit a bank makes when it lends money and interest is the profit a customer receives on deposited funds. However the Quran makes it clear that entering into transactions that involve ‘riba’ or interest are ‘Haram’ (forbidden). All forms of Islamic finance will therefore avoid the lending of cash for profit and will normally create the profit by using the underlying ‘commodity’ or ‘asset’ in the transaction.
The fact that sometimes you can compare the amount of interest paid or received to the profit on an Islamic transaction does not mean that they are the same thing.
When banks calculate the profit they need to make from Islamic transactions, they very often make similar considerations, in terms of risks, profit margin and overheads as interest based transactions. We can compare this to goods sold in shops. For example, ‘Halal’ food is similar in price to non-halal food, as all shops will have similar considerations to make in terms of their overheads and profit margins.
Over the years different methods and terminologies have evolved in Islamic finance and some of those most commonly used are explained in our glossary section.
