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.