The Main Requirements of Islamic Finance

The Main Requirements of Islamic Finance

The Quran contains explicit rules regulating personal status, contracts, property, civil and criminal law, and the economic system.

The main prescriptions relating to financial transactions are: the prohibition of riba’ [1] (i.e. the payment of a fixed or determinable interest on funds); and the prohibition of economic practices that involve the concept of gharar (deceptive uncertainty), maysir (speculation) and har?m (prohibited behaviour).

The Prohibition of Riba

In the Quran, there are several verses that condemn riba’, which literally means “increase, addition and surplus”. These originate from a pre-Islamic practice whereby the amount due was doubled if the debtor proved unable to repay the debt at maturity.[2]

The scope of riba’ has been debated since the early days of Islam. The fundamental problem is finding a consensus on the scope of the “interest rate”, which is usually considered to be either an unjustified increase or a surplus gain. Some scholars have argued that the prohibition of riba’ refers to practices adopted in the pre-Muslim “time of ignorance” (riba al-jahiliyya) and that it should not apply to all forms of interest. [3]

Islamic scholars have also tried to provide a theoretical basis for the ban, in terms of ethics and economics. There is no consensus amongst scholars on how to identify the illah (effective cause) which constitutes the criterion for acceptability or non-acceptability in accordance with Shari’ah rulings on the prohibition of riba’. However, the prohibition of interest is based on the assumption that there can be no gain without risk-taking. Divine prohibition of usury, which is a common feature of the three monotheistic religions,11 does not, in fact, prohibit every return on capital or trade. Its purpose is to protect the weaker contracting party. Some scholars state that, since capital does not have a stable value over time and space, its price cannot be fixed ex ante but must take account the actual economic benefits the debtor has enjoyed upon its usage. Therefore, there must be a link between the results of the usage of capital and the amount paid for it.

Some scholars add secular and economic arguments to the religious motivation for the prohibition:

“interest-free” finance could more effectively lead to full employment of resources, while “interestbased” finance would, by its very nature, be more volatile and instable, and therefore detrimental to economic development. In an interest-based system, the major criterion for the allocation of credit is the creditworthiness of the borrower, whereas, in an Islamic financial system, it is the productivity of the project that is more important. [4]

This encourages the channelling of credit to productive projects. And this line of reasoning becomes even more compelling with regard to the prohibition of speculation (maysir). Speculation is considered to be responsible for many of the most serious financial crises. However, since classical times, Islamic law has leant itself to reconciling commercial development with religion, making a wide range of financial transactions possible.

The Prohibition of Gharar and Maysir

Speculative transactions are deemed to involve a type of unjust increase prohibited by the Quran. The underlying motivation is to ensure a fair correspondence between the expected benefits and obtained benefits of both parties to a contract. All activities that contain elements of uncertainty, such as commercial transactions in which there is uncertainty about an asset or its price, are covered by the prohibition of gharar (uncertainty) and maysir (gambling) stipulated in the Quran.

Because an element of uncertainty can be found in almost all commercial transactions, it is excessive gharar [5] that is prohibited. For example, excessive gharar can be identified in the case of insurance contracts. Futures, forwards and other derivatives also fall under gharar, as there is no certainty that the object of the sale will exist at the time the trade has to be executed.

These instruments are also subject to the prohibition on maysir, which condemns the speculative exploitation of legal uncertainty in order to draw an unjustified (because it is unfair) advantage. In addition, speculation (maysir) is seen as diverting resources from productive activities.

Gharar and maysir render a contract null and void.14 However, there can be some exceptions to this general principle. Given the important role of derivatives in the management and allocation of risk and in financial innovation, some Islamic economists are making an effort to structure Shari’ah compliant financial contracts that are similar to derivatives. They argue that some Islamic contracts (e.g. salam and istisna’ contracts) have certain features in common with derivatives (e.g. futures or forward contracts).

For insurance products, Islamic jurists have developed a Shari’ah-compliant system based on mutual cooperation and assistance (commonly known as takaful). They aim to create a structure very similar to that of conventional mutual insurance.[6] Participants in the takaful pay a sum of money (tabarru’) to a mutual cooperative fund, which is then used for compensation should this be necessary. The takaful company acts as the manager of the fund; there is an agency contract and remuneration is seen as a share in any surplus – this being the difference between the takaful fund and any payments made. Funds are usually invested on the basis of Shari’ah-compliant contracts, particularly those featuring mudarabah.

Prohibitions under the Quran also include haram (forbidden) activities, which are primarily related to tobacco, pornography, arms, alcohol, pork and gambling.

Profit And Loss-Sharing

The Islamic prohibition on paying interest has to be considered in the wider framework of the Islamic economy. This is much more than just a doctrine against usury. Islamic finance fits into the general context of the Islamic economic system; the creation of an economic order in which social solidarity and belonging to the community are core values, in which the principles of equity and inviolability of contractual obligations are ensured, and where there are effective links between financial transactions and real economic activity. Islam recognises the role capital plays in production. Although the Quran forbids the creation of money by money, it does allow money to be used for trading tangible assets and for conducting business which may generate profits.

Loans are permitted if the interest is linked to the profit or loss obtained from the investment and the predetermined rate is replaced with a profit commensurate with the result of a real economic activity. For Islam, it is “profit” rather than “interest” that is closer to its sense of ethics and fairness.

The concept of profit involves the idea of sharing the risks of both gains and losses, and symbolises entrepreneurship and wealth creation. [7] Although this is the foundation of the profit and loss-sharing system on which Islamic banks should ideally be based, in practice, this kind of contract plays only a secondary role. [8]

Angela Di Maria, European Central Bank Islamic Finance in Europe


[1] Under Islamic law, there are two main categories of riba’: (1) riba al-duyun or riba al qurud (riba’ arising from fi nancing) and (2) riba al-buyu’ (riba’ arising from trade). The latter can take the form of riba al-fadl (which arises from a surplus/increase relating to an exchange of unequal qualities or of quantities of the same commodity) or riba al-nisa (which arises from the delay relating to a non-simultaneous exchange of equal qualities and of quantities of the same commodity). Riba al duyun involves a charge on a fi nancing which is associated with a time delay (riba al nasi’ah). See Algaoud, L and Lewis M., 2007.

[2] In particular, the prohibition is based on different verses in which riba’ is contrasted with alms to the poor.

[3] In Egypt there have been several official pronouncements defending conventional forms of interest, including fatwa from the Grand Mufti of Cairo ruling that interest provides security to small investors and is thus permitted, and from the Grand Sheikh of Al-Azhar University affirming that interest paid on some kind of bank deposits (investment accounts) can be considered as profi t distributions that are pre-determined by mutual consensus.

[4] It is also argued that an interest-based fi nancial system has a pro-cyclical effect.

[5] There are two types of gharar in Islamic commercial jurisprudence: (i) major uncertainty which is unacceptable; and (ii) minor uncertainty which is tolerable.

[6] The sector only started developing in the late 1970s.

[7] This is consistent with the commercial environment in which Islam fl ourished; Prophet Muhammed himself and his wife Khadija were both involved in commercial activities.

[8] A study on Malaysia (Chong and Liu, 2007) shows that only a negligible proportion of Islamic bank fi nancing is strictly PLS-based and that Islamic deposits are not interest-free, but they are closely pegged to conventional deposits.