Question

While most of us are quite familiar with traditional western financial systems, most of us have little or no exposure to financial transactions under the Islamic system. Please provide a comparative discussion of the differences between Western finance and Islamic finance and provide at least 2 examples of how certain transactions in the western system would be reconfigured to comply with the restrictions governing the Islamic system.

Answer 1

The main difference between Islamic and conventional finance is the treatment of risk, and how risk is shared. The two main forms of Islamic finance are bank finance and issuing Islamic securities (called sukuk).

In conventional terminology you might think of these as debt – bank loans and bond issues respectively, but that is inaccurate. Those categories cannot be applied to pure Islamic finance. In Islamic finance interest is prohibited. If an enterprise is financed by debt with an obligation to pay interest, the risk of the business is not being shared fairly.

Instead, Islamic finance requires that finance is provided on the principle of profit and loss sharing. Under shariah law finance can be provided through several types of contract. Each type specifies how risk is shared between the enterprise and the supplier of finance.

One such contract is a mudarabah. This specifies in advance how profits and losses are to be shared between the financier and the entrepreneur. Profits are shared in a predetermined ratio, so the financier’s return fluctuates according to business profitability. Losses, except those caused by the entrepreneur’s fraud or negligence, are to be borne entirely by the financier. Contrast that with a conventional loan where the financier has a contractual right to receive interest (and capital repayment) irrespective of the condition of the borrowers’ business.

Islam tries to achieve social justice in the economy in many ways:-

• Promoting adherence to Islam: A Muslim is expected to adhere to certain core beliefs and perform certain obligatory acts. By reminding Muslims of their obligations, Islam seeks to promote stronger relationships between each person and Allah, between people and the earth, and among individuals.

• Requiring zakat: To promote justice related to the distribution of wealth, Islam imposes a property tax called zakat. Every Muslim who meets certain criteria regarding the accumulation of wealth must pay zakat, which is distributed to people in need. By taxing the property of people who acquire wealth and distributing that tax to people in need, Islam promotes the socially responsible distribution of wealth. Zakat management is part of the Islamic finance field, and zakat calculation is a separate, specialized field of study.

• Defining the state’s obligations: Per Islam, the state is also responsible for ensuring that social justice exists. Islamic scholars argue that the state should collect zakat and guide wealth distribution to make sure that everyone’s basic needs are provided for. Scholars also generally agree that states should protect the real value of money by implementing sound fiscal policy.

• Prohibiting usury (interest): For the sake of social justice, Islam prohibits interest-based transactions. No individual or business entity should hoard money in order to earn interest (or riba); instead, that money should be used to support productive economic activities.

• Encouraging shared risk: Islam encourages risk-sharing in economic transactions. When a risk is shared among two or more parties, the burden of the risk faced by each party is reduced.

• Avoiding gambling: Two Arabic words refer to transactions that involve gambling:

  • Maysir: The acquisition of wealth by chance and not by effort

  • Qimar: In modern gambling, any game of chance.

  Both types of transactions are prohibited because they’re based on uncertainty.

  The Islamic prohibition against transactions that involve gambling prevents Muslims from purchasing conventional insurance products because those products are a gamble. Instead, Islamic insurance, called takaful, is based on a very different model of risk management that involves shared risk and mutual responsibility.