How does Islamic Financing Work | Prohibitions in Islamic Finance

Islamic Financing System

Islamic financing respects a number of principles dictated by the Quran, the Sunna (prophetic tradition) or Fiqh (Islamic jurisprudence). The main prohibitions or restrictions of the Shari a include for Islamic financing system are:-

Prohibitions in Islamic Finance System

1. The interest (Riba)

The prohibition of riba is a fundamental rule of Islam. The Shari a considers money as a simple means of exchange. Consequently, money alone cannot be the object of a contract or used as a means of making a profit. This requirement prohibits the collection of any interest in return for the making available of a sum of money. Under Shari a, the collection and receipt of interest (fixed or variable) is strictly prohibited and any obligation to pay interest is deemed void.

2. The Uncertainty (Gharar)

In Muslim law, contracts containing elements of uncertainty are deemed to be void. A contract not affected by Gharar is a contract in which all fundamental terms (such as price, subject matter, identity of parties and deadlines for execution) are clearly defined on the day of its conclusion. This rule is rigorously applied by the scholars. It is thus rare to provide for suspense conditions relating to the characteristic elements of the contract in the Islamic financing documents. The scholars also strongly encourage the satisfaction of all preconditions before the contract is signed.

3. Speculation (Maisir)

Operations which are based on pure speculation in order to make a profit are illegal (haram) and therefore null in Muslim law. This principle notably closes Islamic investor’s access to the market of derivatives as a source of profit primarily and prevents them from participating in the speculative trading of securities of companies. There is, however, a clear distinction between pure speculation and speculative activity in the sense of not certain but carried out in an “entrepreneurial” way, which is perfectly lawful insofar as it is at the service of creation Or investment in a business.

4. Unfair Enrichment / Unfair Exploitation

Contracts in which one of the parties unfairly exploits or otherwise unfairly perceives a gain to the other party is also deemed void. Indeed, according to Shari a principles, a Muslim must generate profit only from transactions or activities in which he invests and on condition that he shares the risks (this rule refers to the “three p principle”: sharing of losses and profits).

Sharing is not necessarily egalitarian, but it must be determined according to an agreed-upon allocation key. Under this rule, a financial donor is formally prohibited from making 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. The 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 which he actually incurred as a result of the late payment.

Any amount not corresponding to such expenses shall be distributed to charities. The 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 which he actually incurred as a result of the late payment. Any amount not corresponding to such expenses shall be distributed to charities.

5. 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 (eg investment in a hotel selling alcohol).

6. 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. Beyond these prohibitions, Islamic Finance must be a driving force for the economy and must therefore actively participate in the creation of added value. It must not be confined to a money-making role!