Islamic Financing Principles | Basic Concepts to Remember

Islamic Financing Principles

When it comes to know the basic Islamic financing principles, then remember that it is strictly forbidden for a lender to realize a financial profit resulting from late payment penalties paid by a debtor in default of payment. On the other hand, it is permissible (and accepted by a number of scholars) for a lender to impose the payment of penalties for delay, since this is an incentive for prompt payment.

However, late payment penalties collected by the financier may be retained by the financier only to the extent that they correspond to the sum of the costs actually incurred by him as a result of the late payment. Any amount not corresponding to such expenses shall be distributed to charities. Let’s have look at the basic Islamic financing principles that must be in your mind as business entrepreneur.

Principles of Islamic Financing | Basic Concepts

Below is list of 8 Islamic financing principles that must be in your mind as Muslim.  

1. Financing / Ethical Investments

Islamic financing cannot have as its object an investment in an activity prohibited by Shari a. No investment can therefore be made by an Islamic financier when dealing with haram products or illicit activities such as alcohol, armament, pig meat, pornography or games of chance. Examining the compatibility of investments and financing with Shari a can sometimes be complex (e.g. investment in a hotel selling alcohol).

2. The hoarding

To the extent that the Shari a considers money as a simple means of exchange of no intrinsic value, hoarding is strongly discouraged or even condemned. A Muslim can accumulate legitimately acquired wealth, but he must be careful to spend or invest that wealth wisely. When a Muslim has an annual income greater than a certain amount, he is obliged to return a part of it to a defined category of the population including especially the needy. It thus conforms to the obligation to pay zakat, one of the five pillars of Islam.

3. Overview

The structure of the Islamic investment fund must be in conformity with the Shari a. This implies that the investment objectives themselves must be compatible with the Shari a principles (investment in the strict sense, the underlying investment criteria and the terms and conditions of such investments and the treatment of investors).

4. The fund structure

In order to set up an Islamic investment fund, it is essential to ensure that the structure, management and investments made by the fund are themselves compatible with the Shari a. For example, a Shari a-compliant investment fund must be set up and managed either on the basis of a Moudaraba (described above) or under a wakala agreement (also described below).

Under a wakala agreement (mandate agreement), the person or entity responsible for making the investments (the wakil) acts as an agent on behalf of the investment fund and, indirectly, investors. As in the case of a Mudaraba, wakil invests the investor’s funds on behalf of the investor. The wakil can then be remunerated on the basis of fixed fees or according to an indexed amount on the performance of the invested funds, or also according to a system combining these two methods of remuneration. The asset management contract, whether concluded in the form of a wakala or a Mudaraba, must in principle mention the obligation of the investment manager.

The manager must also act at all times in the best interest of the fund it represents. As part of the organization of the structure of a Shari a-compliant investment fund, a compliance committee is normally appointed. The reputation of the scholars plays a preponderant role in the choice of their designation. For example, investors in a certain region may be more likely to invest in a fund of which they know the members of the compliance committee.

Similarly, due to the possible divergence between scholar opinions at a regional and sometimes even international level, it is not unusual to designate scholars in a committee whose views on investment are known, or whose influence on the target market is important. The work of the Shari a Compliance Committee consists mainly of verifying and analyzing the fund’s structure and the role of the asset manager, Review the fund documents and the terms and conditions of the prospectus and determine the appropriate investment criteria. The role of the scholars may lead them to issue fatwas,

5. The Fund’s investment objectives and investments

As noted above, the Shari a Compliance Committee is responsible for defining investment criteria for investments made by the Fund. As a rule, companies operating in haram sectors are not considered acceptable investments for an Islamic fund. However, the committee of each investment fund remains of course free to express its own opinion as to the compatibility or otherwise of the activity of such enterprises with the principles of Shari a.

6. The terms of investment and the treatment of investors

The Shari a principles requires equal treatment of all investors. According to some scholars, equal treatment of investors in an investment fund can only be effective if it is offered to each investor to acquire the same class of units (thus allowing each holder to own of the same rights).

However, this analysis is not universally accepted and some scholars argue that the issuance by the same company of several forms of shares giving rise to different rights is in accordance with the Shari a. Investors, in spite of the heterogeneity of their portfolio of securities, must therefore be treated on an equal footing. However, it is recognized that each investor must be treated equally, in particular in terms of dividends, return on investment, subscription price, repayment of the redemption price and voting rights.

7. Financial ratios

In order to determine whether a company that is the subject of an investment is compatible with the Shari a, scholars examine the financial resources from which the company derives its income. As mentioned above, the transactions generating interest are prohibited by Shari a. However, to the extent that any company is in one way or another indebted, it is generally considered that a certain debt ratio is acceptable. Based on a market practice and a contemporary fatwa issued by the Shari a Board of the Dow Jones, it is recognized that a company’s debt / equity ratio cannot exceed 33%.

The very principle of interest being haram, it should not be permissible for a society to be haramed, Islamic or non-Islamic financing of securities that may generate interest. Despite this, it is generally accepted that a company may invest up to one third of its market value in interest bearing securities. It is also recognized that investments in derivatives (futures and options) are prohibited insofar as such instruments intrinsically involve speculative aspects and are therefore considered to contain an element of gharar.

According to the same reasoning, short selling is also incompatible with Shari a principles. It is also recognized that investments in derivatives (futures and options) are prohibited insofar as such instruments intrinsically involve speculative aspects and are therefore considered to contain an element of gharar. According to the same reasoning, short selling is also incompatible with Shari a principles. It is also recognized that investments in derivatives (futures and options) are prohibited insofar as such instruments intrinsically involve speculative aspects and are therefore considered to contain an element of gharar. According to the same reasoning, short selling is also incompatible with Shari a principles.

8. Current developments

A wide variety of Islamic structured funds have developed in very diverse forms and in many jurisdictions. In many cases, Islamic funds are set up alongside pre-existing conventional funds, which invest in a wider range of assets. Such a structure allows managers the flexibility to exploit existing opportunities in different market sectors. If Islamic investors are always looking for investment opportunities in line with the Shari a, the structures in place tend naturally towards more diversification and sophistication.