It is often misunderstood that the Islamic financial system involves only the absence of interest and only applies to those who practice the Islamic faith. Although the paying or receiving of interest is strictly forbidden to the many million practicing Muslims all over the world, this system can be an alternative to the existing method for everyone. Further, the concept of Islamic finance involves more than zero interest. There are other principles such as prohibition of guaranteed earning, transactions to comply with a set of Islamic laws known as Shariah, and the emphasis on the element of business risk.
The conventional banking and financial institutions exist today based entirely on the concept of interest-bearing instruments. It is hard to imagine that there is an alternative to the interest-bearing financial system. This alternative method is commonly known as Islamic finance because of its deep roots in the Islamic religion.
The Islamic financial system is based upon the sharing of profit and loss, rather than on the payment of interest. Although the system does not allow for the payment or receiving of interest, there are a wide variety of instruments allowed that investors can choose from depending on his or her risk tolerance. The main idea behind the Islamic financial system is more than generating wealth. It is a financial system intended to promote economic growth while maintaining the morals of the communities.
Although the method of interest-free economy has not been very well known by the general public, there is an emergence in the understanding and application of this concept by the Muslim communities as well as the traditional financial institutions. This is partly due to the growing interest by the Muslims for options that do not involve interest to satisfy their religious obligations. Further, the Western financial institutions are taking a closer look at this system not only to reach the niche market but because there is money to be made.
The Islamic financial system is complicated and rooted in a deep religious belief. Therefore, to understand the concept, one must first understand and appreciate the basic principle of the religion. Islamic financial history is traced back to the religion of Islam that began over 1400 years ago. The Muslims' lives are bound by the Islamic laws known as the Shariah.
The Islamic financial system is shaped by the Holy Quran strict forbidden of riba. As Al-Omar and Abdel-Haq (1996) defines, Riba as "an excess or increase". Technically meaning an increase which is a loan transaction or exchange for a commodity accrued to the owner (lender) without giving an equivalent counter-value or recompense ('iwad) in return to the other party; every increase which is without an 'iwad or equal value". Riba has often been interpreted as being synonymous with interest.
However, some schools of thought define riba to include not only interest but also speculation, unlawful capital gains, monopoly, hoarding, and absentee rents. Riba is stated explicitly in the Holy Quran thus not open for interpretation. The paying or receiving of interest or dealing with interest-bearing instruments is strictly prohibited to the Muslims. As Iqbal (1997) states, "describing the Islamic financial system simply as 'interest-free' does not provide a true picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating risk sharing, individuals' rights and duties, property rights, and the sanctity of contracts". The definition of riba consequently determines the prescribed structure of Islamic banking and also the permissible banking instruments. One key element of Islamic finance is the requirement of an element of risk normally associated with doing business. However, one must keep in mind that risk in business sharing is allowed whereas risk in the form of gambling or mere speculation is prohibited by Islamic Law. The main idea is that investors should spend their effort searching for projects that are sound, that adhere to the Shariah, and share in the success or failure of the project. The objective is that investments should provide a stimulus to the economy and encourage entrepreneurs to maximize their efforts. The profit or losses should be shared by all parties involved and earnings may not be guaranteed or predetermined.
In addition, Islamic financial system restricts investments in certain business sectors whose products are forbidden by the Shariah such as alcohol, pornography, or gambling to name a few. This limitation also extends to those with questionable moral values that may not have been directly stated in the Islamic laws such as tobacco industries, anything that may harm the environment, or genetic experiments such as cloning. The latter is open for various interpretations depending on the various schools of thought. The need to clarify certain aspects of the laws resulted in the involvement of the religious council known as the Shariah Board. The Board is an advisory board which acts as Islamic legal counsel in certifying the compliance of activities with Islamic principles. These restrictions are not unlike the idea of Socially Responsible Investments now available among the Western conventional financial institutions.
In short, there is more to the Islamic financial system than the absence of interest. In addition, the system also restricts any activities that do not comply with the Shariah, and there needs to be an element of business risk involved by the participating parties. Within these parameters there are many investment products currently available that are permissible under Islamic laws.
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