A prohibition on collection and payment of interest is at the heart of Islamic financial and banking practices.
Here are some of the more common terms.
All Islamic financial activity must comply with the principles of Sharia, or Islamic law, which seeks to guide all aspects of Muslim life, extending from daily routine to financial dealings.
Riba, effortless profit or extra earning obtained free of exchange, or simply speaking, interest, is prohibited by Sharia.
Sunnah or the acts and words of the Prophet Mohammad (PBUH) is an important source in matters of interpretation, and modern Islamic financial and banking practices seek to reconcile Islamic values with modern practices. Sales transactions focusing on fixed returns are used as opposed to interest-bearing debt.
Sukuk are Islamic financial instruments, similar to bonds. Because interest is not permissible, the issuer of sukuk sells it to an investor, who rents it back to the issuer at a predetermined fee. The issuer also makes a contractual promise to buy back the bonds at a future date.
Sukuk allow for two types of Sharia-compliant transactions: musharaka and ijara. Musharaka, which means sharing, is a joint enterprise in which all the partners share profit or loss. As opposed to financiers in an interest-bearing loan who cannot suffer losses, financiers in musharaka can suffer losses if the joint venture fails. Returns are tied up with the actual profits accrued; thus, the greater the profits of the enterprise, the higher the rate of return to the financier. A specific form or procedure has not been prescribed for musharaka.
In the similar mudaraba model, an entrepreneur usually provides management expertise, which is treated as a form of capital, and shares profits with the investor. The share of expected profits is agreed at the outset, with the investor bearing all the losses. The entrepreneur must not bear any loss attributable to invested capital, but is also not allowed to take any remuneration other than profit share, unless a guaranteed wage has been agreed upon.
Under ijara contracts or leases, a known benefit associated with a specified asset is sold. Ownership is not transferred and stays with the bank. An ijara contract can be designed to return the fixed assets to the lessor at the end of the lease period, in which case the lease takes on the features of an operating lease. Under the other mechanism, the lessee can agree at the outset to buy the assets at the end of the lease period. The lease in this instance resembles hire purchase or ijara wa iqtina, literally lease and ownership.
Gharar describes a risky or hazardous sale, where details concerning the sale item are uncertain. For instance, an insurance contract contains gharar wherein either party may acquire the premium or all the profits in the event of a claim not being made. The prohibition on gharar would thus require all investment gains and losses to eventually be apportioned in order to avoid excessive uncertainty with respect to returns on the policyholder’s investment.
Maysir or gambling is closely linked to gharar and is often used to criticise conventional financial practices. Maysir exists in an insurance contract when the policyholder contributes a small premium in the hope of gaining a larger sum; the policyholder loses the premium when the event insured does not occur.
Similarly, the company will be in deficit if claims are higher than the amount contributed by policyholders.
This is a cooperative system of reimbursement in case of loss, paid out of a fund to which people and companies agree to make small regular contributions.