Characteristics of Islamic Finance

Islamic vs Conventional Finance


One of the most important characteristics Islamic financing is that is an asset-backed financing. The conventional / capitalist concept of financing is that the banks and financial institutions deal in money and monetary papers only. That is why they are forbidden, Islam does not recognize money as a subject-matter of trade, except in some special cases. Money has no intrinsic utility; it is only a medium of exchange; Each unit of money is 100% equal to another unit of the same denomination, therefore, there is no room for making profit through the exchange of these units inter se. Profit is generated when something having intrinsic utility is sold for money or when different currencies are exchanged, one of another. According to ethical finance, the profit earned through dealing in money (of the same currency) or the papers representing them is interest, hence prohibited. Therefore, unlike conventional financial institutions, Islamic finance is always based on illiquid assets which create real assets and inventories.

The real and ideal instruments of financing according Shari’ah laws are Musharakah and Mudarabah. When a financier contributes money on the basis of these two instruments it is bound to be converted into the assets having intrinsic utility. According to Islamic Economics laws, profits are generated through the sale of these real assets. Financing on the basis of Salam and Istisna` also creates real assets. The financier in the case of Salam receives real goods and can make profit by selling them in the market. In the case of istisna`, financing is effected through manufacturing some real assets, as a reward of which the financier earns profit.

Financial leases and Murabahah, are not originally modes of financing. But, in order to meet some needs they have been reshaped in a manner that they can be used as modes of ethical financing, subject to certain conditions, in those sectors where Musharakah, Mudarabah, Salam or Istisna` are not workable for some reasons.

Islamic Instruments are clearly distinguishable from the interest-based financing on the following grounds:

  1. Islamic finance operates differently from conventional financing where the financier gives money to his clients as an interest-bearing loan, after which he has no concern as to how the money is used by the client. In the case of Murabahah attitude, on the contrary, no money is advanced by the financier that he wishes to purchase a commodity, therefore, Murabahah is not possible at all unless the financier creates inventory. In this manner, financing is always backed by assets.
  2. In the conventional financing system, loans may be advanced for unethical purposes. A gambling casino can borrow money from a bank to develop its gambling business. A pornographic magazine or a company making nude films is as good customers of a conventional bank as a house-builder. Thus, conventional financing is not bound by any divine or religious restrictions. But the Islamic banks and financial institutions cannot remain indifferent about the nature of the activity for which the facility is required. They cannot effect Murabahah financing system for any purpose which is either prohibited in Shari`ah or is harmful to the moral health or the society;
  3. It is one of the basic requirements for the validity of Murabahah that the commodity is purchased by the commodity before selling it to the customer. The profit claimed by the financier is the reward of the risk he assumes. No such risk is assumed in an interest-based loan.
  4. In an interest bearing loan, the amount to be repaid by the borrower keeps on increasing with the passage of time. In Murabahah, on the other hand, a selling price once agreed becomes and remains fixed. As a result, even if the purchaser (client of the Bank) does not pay on time, the seller (Bank) cannot ask for a higher price, due to delay in settlement of dues. This is because in Shari`ah attitude there is no concept of time due of money.
  5. Leasing is ethical too because the financing is offered through providing an asset having usufruct. The risk of the leased property is assumed by the lessor / financier throughout the lease period in the sense that if the leased asset is totally destroyed without any misuse or negligence on the part of the lessee, it is the financier / lessor who will suffer the loss.

The views expressed in this article are the author’s own and do not necessarily reflect Saray Consultancy’s editorial stance.