Understanding Islamic Finance

Islamic Finance, unlike western finance systems, is largely influenced by Islamic precepts, which govern its structure and activities. The most important aspect is the replacement of paying or receiving of a fixed or pre-determined interest rate with a profit and loss-sharing plan in which rate of return to financial assets held with banks is unknown. The rate of return is not fixed prior to undertaking a transaction. It differs from traditional banking, and unlike traditional banking; the matter of what prudential standards are applicable to Islamic banks has received little attention.

Islamic finance is governed by Islamic precepts as already mentioned, and more particularly, Shariah law, which, totally bans speculation, rather stipulating that income has to be derived in the form of profits and shared business risk instead of interests or assured returns. The piece further delves into the pivotal legal principles which shape Islamic Finance, with special interest in derivatives. This is in addition to taking a deeper look into the valuation models which assist in illustration of the Shariah-compliant deviation from conventional finance options via an implicit derivative scheme.

In real-life practice, Islamic Finance differs markedly from its paradigm version and its implementation takes place in myriad ways which are centered between the benchmark case and conventional banking practices. The degree to which this difference is pronounced differs from one nation to another. Among the most common financial instruments in the recent times, are the derivatives and despite being important, they remain few and differ from one country to another, with much fewer numbers being recorded in nations where their compatibility to the structure of capital markets required redevelopment around Shariah-compliant schemes.

Derivatives are stated as being financial products developed in response to the need for financial innovation aimed at addressing market needs. They are basically a response to the prevailing need to control risk with increasingly complex business environs. They are primarily a response to the need to manage risks within a rapidly metamorphosing business environment. In Islamic finance, they marginally differ from the derivatives as known is conventional banking practices.

Islamic Finance Derivatives

As suggested earlier, there are lots of Shariah compliant derivatives in the market. All these derivatives are expected to meet the general requirement or criteria in order to be considered acceptable, or rather halal as Islam puts it. At the basic level, all the instruments as well as transactions are expected to be free and do not fall within the following five items.

• Riba (meaning usury),
• Rishwah (implying corruption),
• Maysir (implying gambling),
• Gharar (meaning unnecessary risk), and
• Jahl (to mean ignorance).

It should be emphasized that as much as riba can be in multiple forms, all kinds of it are prohibited and unaccepted within the concept of Islamic finance, even one gets positive returns without taking any risks. In the case of gharar, there is actually no consensus as to what it actually encompasses and was generally used to refer to unnecessary risks, deceit, or uncertainty that is self-induced. With regard to financial transactions, it is considered or treated as looseness of the base contract that either one or each of the involved parties lack certainty of the possible outcome. On the other hand, Masyir when looked at from the point of financial instruments is one where outcome is solely reliant on chance for instance, gambling.  Lastly, it is jahl which refers to the party’s ignorance.  Looking at this from a financial stand-point, it is unacceptable if either of the parties involved in the transaction gains as a result of the ignorance of the other party.

There exists a number of Islamic derivative alternatives, most of which are premised on the Shariah law as already mentioned earlier. The chapter outlines quite a number of these alternatives noting that the most salient aspect of the system is riba prohibition.

Categories of Islamic Finance Contracts

On the basis of the earlier mentioned principles, Islamic banks offer financial contracts falling within five fundamental groups. These include:

• Non-interest bearing demand deposits;
• Mudaraba,
• Murabaha,
• Musharaka, and
• Ijara.

In modern commercial banks, the conventional checking accounts do not bear interests on deposits and given that Islamic Financial Institutions (IFI’s) discourage deals based on interest, many often demand for these accounts. In ideal situations, IFIs are not supposed to charge a fee on checking accounts given that they are free to hire the depositors’ funds, in line with the reserve requirements, if at all any exists, to the assets which are earning. This is however not the case in real situations. Based on deposit sizes, service charges and fees are charged to meet operational costs.

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