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.