The basic principles underlying Islamic financial transactions are that the purpose of financing should not involve an activity prohibited by Shari’a (Islamic law) and that the financing must not involve riba (the giving or receiving of interest) and should avoid gharar (uncertainty, risk, and speculation). For example, because gambling is against Shari’a, any arrangement to finance a casino would always be against Shari’a. Islamic finance promotes the sharing of risk and reward between contracting parties. The degree of sharing varies by contract. An example of financing that involves a relatively high degree of risk-and-reward sharing is venture capital; a contract that has a relatively low degree of risk-and-reward sharing is sale of an asset on installment credit. Contemporary Islamic finance integrates these principles and the other Islamic law in a wide variety of products and services to fulfill the growing global demand for Shari’a-compliant investment and financing. The unfold of Islamic financial principles is supported by the fact that Islam allows the wealth accumulation as long as the source of wealth generation does not violate Islamic principles. Emergence of Contemporary Islamic Finance According to Iqbal and Molyneux (2005), partnerships and profit-sharing ventures coherent with the doctrine of Islam were usually used to finance useful activities even prior to the teachings of the Prophet Muhammad. Throughout time, however, as the center of economic magnitude shifted to the Western world, the profit sharing approach to structuring financial transactions fell out of favor and Western financial institutions came to dominate the capital markets. Islamic financial institutions gradually succumbed to the ways of the West and adopted interest based financial transactions (Iqbal and Molyneux 2005). This literature asserts that the basic principles of what is now known as Islamic finance were not followed in what Westerners call medieval times. This monograph presumes that Islamic financial principles have an ancient origin. The establishment of the Mit Ghamr Islamic Bank in Egypt in 1963 is often viewed as the starting point of the modern Islamic banking movement. Evidence exists, however, that interest-free commercial financial transactions existed in various parts of the Muslim world several decades earlier. For instance, the institution Anjuman Mowodul Ikhwan of Hyderabad, India, made interest-free loans to Muslims as early as the 1890s. Another institution in Hyderabad, the Anjuman Imdad-e-Bahmi Qardh Bila Sud, was established in 1923 by employees of the Department of Land Development and, within 20 years, had assets worth US$2,240 and was distributing loans of US$100 to US$135 per month. The bank had a membership of 1,000, which included Muslims and non-Muslims. By 1944, it had reserves of US$67,000. These organizations made small loans to small businesses on a profit-sharing basis. Their activities continue to this day. In the early 1960s, the convergence of political and socioeconomic factors ignited interest in the revival of faith-based Islamic financial practices, including the prohibition of usury, or the giving or receiving of interest (riba). Although “usury” is commonly used today to mean an excessive rate of interest, it applies in this context to any charging of interest for the use of money. Iqbal and Tsubota (2006) asserted that, although the prohibition of riba is the core of the Islamic financial system, the system’s prevailing practices also reflect other principles and doctrines of Islam, such as the admonition to share profits, the promotion of entrepreneurship, the discouragement of speculative behavior, the preservation of property rights, transparency, and the sanctity of contractual obligations. The Islamic financial system “can be fully appreciated only in the context of Islam’s teachings on the work ethic, wealth distribution, social and economic justice, and the expected responsibilities of the individual, society, the state, and all stakeholders” (p. 6). Objectives of Shari’a in Islamic Finance The objectives of Shari’a and the objectives of Islamic financial institutions may differ. The principal objective of Shari’a as explained in literature on Islamic finance is economic justice through equitable distribution of resources. The objective of Islamic financial institutions is the pursuit of profits without violating Shari’a. The shareholders of and investors in Islamic financial institutions. Among the most important policies or goals pursued by the Islamic financial system are the following: Ã¢â‚¬Â¢ Shari’a-compliant financial products and services. To be Shari’a compliant, the financial products and services must not be based on the payment or receipt of interest. Ã¢â‚¬Â¢ Stability in money value. Stability in the value of money is believed to be enhanced by requiring that currency be backed by an underlying asset, which enables the medium of exchange to be a reliable unit of account. Islam views money as a store of wealth and as a means of exchange but does not view money as a commodity that should be bought and sold at a profit (Ismail 2005). Ã¢â‚¬Â¢ Economic development. The mechanism of sharing profits leads to a close working relationship between bank and entrepreneur and is believed to encourage economic development as a result of the bank’s equity-type stake in the financed project (versus an interest-only or fixed profit potential). Ã¢â‚¬Â¢ Social development. Zakat (a religious charity) is paid by Muslims and deposited into a fund that is distributed to the poor directly or through religious institutions. Zakat is imposed at a rate roughly equivalent to 2.5 percent of the market value of an individual’s real and financial property. The understanding is that social welfare and development of the poor are improved through the collection of zakat. Ã¢â‚¬Â¢ Resource optimization. Funding is provided only for projects that, in the bank’s estimate, have the most favorable return-for-risk forecasts, in addition to meeting the criterion of being socially beneficial. Ã¢â‚¬Â¢ Equitable distribution of resources. The distribution of income and resources of Islamic financial structures is intended to be proportionate to the value offered by participating parties.
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