How Does Islamic Finance Work?

Islamic Finance is based on the Profit & Loss sharing principle . In other words the parties  collaborate on a venture and share realized profits or split suffered losses.

#1.- In Islamic finance, one must work for profits, and simply lending money to someone who needs it does not count as work. Under Islamic law, money must not be allowed to create more money. Instead, a bank must provide some service to “earn” its profits.

Thus, instead of traditional accounts with given interest rates, Islamic banks provide accounts which offer profit/loss. The bank uses your money to purchases assets which generate returns for the bank. The bank shares the profits with you. In Islam dealing in interest is considered unscrupulous.

#2.- High degree of uncertainty or ‘gharar’ is not allowed. All possible risks must be identified to investors, and all relevant information disclosed. Islamic finance prohibits the selling of something one does not own, since that introduces the risk of its unavailability later on.

This rules out investments in conventional derivatives, which require speculation about the future subject to excessive risks. This is the key reason why Islamic banks came  away from the 2008 global financial crisis unscathed.

#3.- Islamic finance requires you to only invest in ethical causes or projects. Anything unethical or socially irresponsible, from weapons to gambling or adult entertainment is out of bounds. This produces a very strong alignment between Islamic investments and socially beneficial enterprises.

With their emphasis on equity and investment in the real economy, the principles of Islamic finance provide a stable and productive banking sector. Rather than providing a lucrative financial alternative to investing in the real economy, Islamic banking complements and strengthens the latter. It ensures that financial capital does not lead to artificially bloated asset prices. Instead, it is made to work in the real economy, on real projects.

How Do Islamic Banks Make Money?

Islamic banks can profit from the buying and selling of approved goods and services.  Islamic finance is principally anchored on trading, and we know risk is inherent with trading. So banks and financial institutions will therefore trade in Sharia-compliant investments with the money deposited by customers, sharing the risks and profits between them.

Islamic banks are structured so that they retain a clearly differentiated status between shareholders’ capital and clients’ deposits in order to make sure profits are shared correctly. Although they cannot charge interest, the banks can profit from helping customers to purchase a property using an ‘ijara’ or a ‘murabaha’ scheme.

With an ijara scheme, the bank makes money by charging the customer rent; with a murabaha scheme, a price is agreed at the outset which is more than the market value. This profit is deemed to be a reward for the risk that is assumed by the bank.

In all cases, there are firm laws governing the types of business the banks can trade in. There should be absolutely no investment in unsuitable businesses such as those involved with armaments, pork, tobacco, drugs, alcohol or pornography.

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