Principles of Islamic Financial System

Islamic finance may be viewed as a form of ethical investment, or ethical lending and is prohibiting interest charging whether it is "nominal" or "excessive," simple or compound, fixed or floating. Islamic financing is an ethical and equitable mode of financial services that derives its principles from the Shariah (Islamic law). The Shariah is based on the Quran and the Hadits of the Prophet Muhammad (Peace be upon him), and it governs all aspects of personal and collective life. Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values. Islamic unit trusts would never invest in companies involved in gambling or any food which is considered as Haram such as alcoholic beverages, or porcine food products. Other elements include the emphasis on equitable contracts, the linking of finance to productivity, the desirability of profit sharing, and the prohibition of gambling and certain types of uncertainty.

The basic principles of an Islamic financial system can be summarized as follows:

It is not allowed to charge interest. Interest is defined as money earned on the lending out of money. Prohibition of riba, a term literally meaning "an excess" and interpreted as "any unjustifiable increase of capital whether in loans or sales" is the central tenet of the financial system. Any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is not allowed. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of "interest" as widely practiced.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits. It is symbolized by successful entrepreneurship and creation of additional wealth. Whereas interest is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if the business are losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.
It is promoting Risk sharing. Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits.

Money is considered as "potential" capital. Money is treated as "potential" capital--that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital. Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. In order for a Shariah-compliant financier to earn a return on his money, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset. Hence, there is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn purely fee-based remuneration. Conventional loans therefore tend to be re-cast as sale-and-purchase or lease-then-buy transactions.

Speculative behavior is prohibited. An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling, and risks. Speculative transaction is called Gharar in Islam, means an excessive, speculative uncertainty, as in casino-gambling games or in a sale of goods in a situation where the seller offers his goods for sale without a proper description to the buyer, hence making it impossible to ascertain precisely what the buyer is paying for. In such a situation the sale and purchase contract would be void in Islam. In financial markets, investing in stocks and equity funds is permitted but must conform to certain guidelines. Undesirable companies and industries are screened out on the basis of both qualitative criteria (nature of business) and quantitative criteria (level of involvement with interest). Islamic investment also discourages speculation and prohibits short selling, conventional debt instruments and conventional derivatives.

Islam upholds Sanctity of contracts. Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard. In addition to this, Islam are opposing zalim, meaning oppression or excessive unfairness between the parties to the contract. Read more!

Rukn (Pillars) of Mudharabah

Mudharabah is cooperation between an investor who gives fund/ capital to a party who will manage the fund/ capital for trading. Mudharabah has three rukn (pillars).
First, there are two or more parties; they are investor, and care taker/ organizer.
Second, object of the cooperation, this included fund/ capital, business and profit.
Third, saying the agreement orally (sighat).

The first pillar, two or more parties should involve in the cooperation, they are the investor and the care taker or organizer. All parties should have competencies required (jaiz al tasharruf), meaning that all parties are mature enough (baligh), have normal sense (not idiot), rasyid (normal) and are allowed to make transaction to their wealth.


The second pillar, object of cooperation included fund/ capital, type of business and profit.
a. Fund/ Capital
The requirements of capital are as follows:
1. Fund/ Capital should be in the form of monetary exchange (al naqd). The base is Ijma, or goods in which the value is determined before the transaction.
2. Fund/ Capital which is given should be known clearly.
3. Fund/ Capital which is given should be determined before the transaction.
4. Fund/ Capital which is given should be received by the care taker/ organizer directly, and he can make transaction with it.

So in Mudharabah, capital should be known, and given to care taker (mudharib), also it should be in monetary value like gold, silver or a common monetary exchange. It should not be in form of goods, unless the value of the goods is calculated based on value of money at the time the transaction taken place, so the value of the goods become the capital of Mudharabah.

It is important to have clarity of total value of the capital to determine the profit sharing. If the capital are in form of goods and are not clear at the time of transaction, the value of the goods may changes as the time goes by and it may lead to dispute at the time of profit sharing.

b. Type of business
The requirements for type of business are as follows:
1. It is in trading sector.
2. It is not putting the care taker/ organizer in difficult position, example the capital should be used to trade on very expensive jewelry or diamond which is very rare and difficult to trade.
3. It is not prohibited by Shariah like alcoholic beverage or pork.
4. There is a time limit or time frame of the investment.

c. Profit
The purpose of any work is to get profit. In Mudharabah the requirement of profit are as follows: 1. Profit is only for the parties who joined the cooperation. It is not allowed to share the profit with the party who are not involving in the cooperation.
2. Profit sharing is for both parties, it is not allowed to give the profit only for one party.
3. It is required to have the clarity of the profit.
4. It is required to define the percentage of profit sharing for the investor and the care taker/ organizer.

While at the time of sharing the profit, we need to see the following:
1. Profit sharing is done based on the agreement by both parties, but the investor need to bear all the loss.
2. The care taker/ organizer should define his part from the profit sharing. If both parties are not defining it, then the care taker/ organizer should receive salary, and the profit will become the right of the investor.
3. The care taker/ organizer should not receive his part from the profit sharing before he hand over the whole fund/ capital to the investor. If there is any profit and loss at the same time, the loss should be covered from the profit. It’s mean that the profit is defined from the excess of the initial fund/ capital.
4. Profit can be shared at the middle of the cooperation as long as it is agreed by both parties.
5. Profit sharing should be done after final calculation has been done for the cooperation.
There are two applications for final calculation:
- To do the final calculation at the end of the cooperation, so the investor can withdraw the fund/ capital and ends the cooperation.
- Finish cleansing toward the profit calculation. This is done by cashing all the assets and calculates the value. At this time the investor is allowed to withdraw the capital. He is also allowed to re-invest the capital with the new contract/ agreement. The contract cannot be rolled over without making new contract.


The third pillar, saying the agreement orally (sighat the transaction).
Sighat is saying the transaction by both parties who join the cooperation. It shows the expression and desire of doing the cooperation. The Mudharabah transaction is considered valid by saying the desire of doing the cooperation and by doing the transaction.

More explanation about this topic can be found here.
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