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An introduction to Islamic finance

Sultan Choudhury intro to islamic finance

Sultan Choudhury is chairman of Offa

 

At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety, but not to cooperate in evil or malice. In essence, it aims to eliminate exploitation and to establish a just society even by the application of the Shariah – the principles of Islamic Law – or Islamic rulings to the operations of banks and other financial institutions.

Hence, there is no real ‘lending’ for a return in Islam, since all ‘finance’ earns a profit-share, or obtains ownership interests (equity) in the assets that they fund or are earn purely fee-based remuneration. Therefore, in order to earn a return in Islamic finance, an investor has to participate in some economic activity beyond lending and bear the corresponding risk.

Islam sees no justifiable reason why a person should enjoy an increase in wealth from the use of their money by another, unless they are prepared to expose their wealth to the risk of loss also. Lawful and pure profit is earned through either sales, leasing, acquiring equity or providing services.

The above philosophy ties back to the very core principle in Islam underpinning the essence of money: money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return.

The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing – it has no value in itself and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. Interest can lead to injustice and exploitation in society – The Qur’an (2:279) characterises it as unfair or oppressive.

Though there is no interest, the cost is not free. Islamic finance incurs costs for its products and funders need to make some profits as a commercial enterprise. In bridging finance, profits that are made are from a fixed margin charged over and above the purchase of an asset. This ‘cost plus margin’ principle is used to generate the finance cost for the customer and the profit for the funder is what is left after funding costs are paid.

The key difference between Islamic finance and interest-based finance in this respect is that the cost of capital in interest-based loans is a predetermined fixed rate, while in Islamic finance, it is expressed as a ratio of profit. Therefore, under Islamic finance, the cost of capital is not comparable to a zero-interest rate.

Islamic finance is about adding value to the economy, society and the lives of people; hence, business activities which are seen to be harmful to any of these areas are not permitted for investment. It should not be that harmful activities from the Shariah paradigm are further supported and made to flourish to the detriment of the society such as gambling, alcohol, pornography etc.

The Shariah also require Islamic finance to be transparent and fair for individuals and businesses. Finance providers can’t benefit from charging fees over and above costs when a customer is late in making their payments – interest on arrears like a conventional bridge finance company is prohibited.

Islamic finance is a much more transparent and ethical way of operating and there are many investors in the UK who will relish the chance to take out short-term finance that is consistent with Shariah principles.  Brokers who can accommodate them will benefit from a new revenue channel with considerable long-term potential.

 

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