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The 4 main concepts of Islamic Finance

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Many will already be aware that Islamic and conventional banking differ in several ways. There are a few important principles of Islamic Finance that govern the banking system and differentiates it from conventional banking. When trying to understand Islamic finance, one must remember that it is based on the Quran and Islamic teachings which emphasises on moderation and fairness for the prosperity of not just individuals but the community and nation, too.

Riba is prohibited

Riba has been translated as usury or excess, and in Islamic teachings, the giving or taking of interest is prohibited. The main reason for this is that Islam believes that lending with interest is an unjust practice that is only advantageous to the lender, while exploiting the borrower.

Instead, Islamic financial institutions offer a variety of financing alternatives for customers based on mutual sharing of the profits and losses and leasing arrangements.

Avoiding ambiguous transactions (gharar)

Islamic finance does not support contracts where items being transacted are uncertain or are of ambiguous nature and where parties involved have unclear expectations or lack certain knowledge to make informed choices. It is considered a form of gambling, an act which is prohibited in Islam. By avoiding these ambiguous arrangements, the customer is protected fairly and avoids excessive risks. As such, Islamic banks will not participate in investments in derivatives, options and futures.

Avoiding investments in prohibited activities

Muslims are prohibited from engaging in transactions that are un-Islamic in nature. This includes gambling as it involves risk-taking and uncertain outcomes. Other prohibited transactions are those that involve investments in alcohol, pork and the like. As such, Islamic financial institutions will not finance ventures involving prohibited activities. Likewise, Muslim investors cannot invest in projects that participate in un-Islamic activities.

Profit- and loss-sharing (mudarabah)

To ensure fairness, Islamic banking is one where customers become “partners” of the financial institution and whatever profits or losses are shared together. For example, to finance the purchase of a house, an Islamic financial institution may offer to purchase the property outright and sell it to the customer at an agreed marked-up price paid in instalments over a period of time, at the end of which, the property ownership is turned over to the customer.

Islamic Finance: Past, present and green future

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Banking is already a confusing topic as it is, but now with Islamic financing entering the mainstream market, many are getting even more confused. To clear the air, let’s take a look at what it is all about.

It is not a new system

Many think that Islamic financing is something new simply because they’ve only just heard about it. In actual fact, Islamic economic theories and concepts have a long-established history, spanning more than a millennium. Due to changes in geopolitics and social upheavals across history, much of Islamic economics concepts were not practised. Instead, global nations utilised Westernised banking methods. But now, with Islamic financing available for everyone, consumers like you and I will have more options to choose from.

It is based on Islamic law

Islamic financing abides by the Islamic law which sets out the fundamental principles of banking in Islam. The term used to describe it is “syariah compliant” which serves to provide assurance to Muslim consumers that the products and services offered observe the fundamental rules of Islam. Having said that, Islamic banking services are not limited to the Muslim population only.

It is gaining world-wide attention

Well, Islamic finance appeared on the modern consumers’ radar as recently as the 1970s but has gained much attention and favour. It is estimated that there are about 1,400 Islamic financial houses operating in more than 80 countries worldwide today. The value of syariah-compliant assets stand at US$2.4 trillion today. The growth continues with experts predicting Islamic financing value of assets to reach US$4 trillion by 2030.

Islamic banking in Malaysia is big business

Islamic banking set foot in Malaysia in the 1980s after the Islamic Banking Act 1983 was enacted. Malaysia welcomed the first Islamic Bank at that time and since then there have been many others who followed suit. Today, Islamic banks are a norm side-by-side with conventional banking institutions. In fact, besides full-fledged Islamic banks, there are also foreign-owned ones, while conventional financial institutions have also diversified to offer Islamic products among their product and service offerings.

The future is sustainable

There’s no doubt that Islamic financing is experiencing a boom worldwide. Global leaders in the industry are Malaysia, Saudi Arabia and Luxembourg with the United Kingdom coming in aggressively into the market as well. To remain competitive, Islamic financial institutions must seize the opportunity to offer sustainable financial instruments to a public that is increasingly mindful of the stresses of our planet. Green financing that aligns with the United Nations Sustainable Development Goals are the way of the banking future.

Conventional Loan vs Syariah-compliant loan

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When it comes to financing and getting loans, Malaysia’s financial institutions offer a variety of products and services. For the average consumer like you and I, this can cause headaches. But fret not, because the main thing to understand is that there are two main types of financing, namely conventional loans and Islamic loans. While the latter is gaining popularity, many are still in the dark about it.

What are they, what are the differences between the two and why would you choose Islamic financing over conventional ones? Let’s clear the air on these two products so you can make an informed choice right away when approaching your local bank for financial assistance.

What is a conventional loan?

A conventional loan is when a bank lends you some money and you pay the amount borrowed back to them in installments over a specified period of time. The payback amount is usually inclusive of some amount of interest that is regarded as a profit to the bank. Interest rates can be a fixed rate or based on a floating rate.

What is an Islamic loan?

Meanwhile, an Islamic loan works on a slightly different concept. When you want to borrow money from the bank to buy a house for example, the bank essentially “buys” the house on your behalf and sells it to you at a profit.

A contract is drawn up to define the profit rate to the bank, and these can be either a fixed or a floating rate. Similar to a conventional loan, the payment to the bank is staggered over a period of time.

It is important to note that Islamic loans adhere to Islamic laws known as Syariah law. At the same time, it is also closely monitored by the financial industry’s rules and regulations.

How do I choose?

For Muslims, the choice is easy. Many will choose to go for an Islamic loan provided by an Islamic banking institution as it is in line with their religious beliefs and they are assured of a “halal” or clean product.

This is because Islamic financing adheres to the principles of Islam and follows Islamic banking and economics practices. It rules out activities that are prohibited by the religion.

For example, Islamic financing prohibits investments in businesses or activities considered “haram” or sinful in Islam such as gambling houses or alcohol production businesses. By taking out an Islamic loan, Muslim borrowers are assured that the money transacted comes from “clean” sources.

I’m not a Muslim. Can I still choose Islamic financing?

Certainly! There is no reason why non-Muslims cannot utilise Islamic financing. There is no discrimination factor against non-Muslims in such a case. In fact, non-Muslims who are selective over the sources of their finances may find that the concept of Islamic financing agreeable.

In a nutshell, Islamic finance works like a normal bank in that it delivers financial products and services to customers. The main differences are:

  1. The concept of borrowing and lending is slightly different from conventional banks. In Islamic financing, there is no concept of interest. Instead, the financing is based on the concept of sharing, sale or leasing.
  2. Islamic banks engage in morally-acceptable activities, thus will not indulge in financing socially questionable activities such as gambling and other vices.