Islamic finance is an emerging sector of the financial industry, rooted in Islamic jurisprudence.
The initial idea behind Islamic finance was to enable the world’s 1.8 billion Muslims to conduct their financial affairs in compliance with Shariah principles, taking into account the prohibition of riba/interest/usury in Islam. Over time, however, Islamic finance has gained greater global significance due to its ability to offer:
- Growth potential
- Broad recognition
- Suitability for addressing real-world financial challenges
- Freedom from speculation
- A resilient model in times of global crisis
- Suitability for structured financing
In this guide, you will learn about the history of modern Islamic finance, the various methods or instruments used in Islamic finance, and how they integrate with international trade. At the end of the guide, we also provide a glossary of key terms.
Where Did Islamic Finance Come From?
Islamic finance is based on principles rooted in Islam and derived from it:
- Quran
- Sunnah (teachings, actions, or sayings of Prophet Muhammad)
Although these sources are primary for Islamic finance, the use of the following sources is also permitted to achieve consensus and facilitate logical reasoning:
- Ijma (consensus)
- Qiyas (analogy)
- Ijtihad (independent reasoning)
Islamic finance is continuously evolving to meet the growing challenges of the global financial system.
A Brief History of Modern Islamic Finance
While Islamic finance is as old as the religion itself, the establishment of specialized financial institutions and banks occurred in the 20th century.
Here are some key historical events that led to the development of the modern Islamic financial system:
- 1950s: In the late 1950s, the first experimental local Islamic bank was established in rural Pakistan, which did not charge interest on loans.
- 1963: The first modern Islamic bank was founded in rural Egypt by economist Ahmad El-Naggar to attract people who did not trust state banks.
- 1973: The influx of “petrodollars” and “global re-Islamization” following the 1973 oil crisis contributed to the development of the Islamic banking sector, which spread worldwide from 1975 onwards.
- 1975: The Islamic Development Bank was established with the task of providing project financing in member countries.
- 1979: The first modern commercial Islamic bank, Dubai Islamic Bank, was established, along with the first Islamic insurance (or Takaful) company, Sudanese Islamic Insurance Company.
- 1980-1985: Islamic investments gained widespread adoption throughout the Muslim world, attracting deposits with promises of “high profits” and “religious guarantees” provided by Islamic jurists who issued fatwas condemning conventional banks and recommending their Islamic counterparts.
- 1986: Amana Income Fund, the world’s first Islamic mutual fund (which invests only in Sharia-compliant stocks), was created in Indiana.
- 1990: In Algeria, a group of Islamic financial institutions (now headquartered in Bahrain) established the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The Islamic bond market also emerged in 1990 when Shell MDS in Malaysia issued the first tradable Sukuk — an Islamic alternative to conventional bonds.
- 1995: Globally, 144 Islamic financial institutions were established, including 33 state banks, 40 private banks, and 71 investment companies.
- 1996: Major American bank Citibank began offering Islamic banking services by establishing the Islamic Investment Bank Citi in Bahrain.
- 1999: The first successful benchmark for assessing the performance of Islamic investment funds — the Dow Jones Islamic Market Index (DJIMI) — was created.
- 2002: The Islamic Financial Services Board (IFSB) was established in Malaysia as an international body setting standards for Islamic financial institutions.
Two decades later, global Islamic financial assets grew to $2.8 trillion in 2019 and are projected to reach $3.7 trillion by 2024, according to the 2020 Islamic Finance Development Report.
Prohibitions in Islamic Law
Islamic finance significantly differs from conventional finance, including the prohibitions listed below:
- Riba (Usury)
- Gharar (Uncertainty)
- Maysir and Qimar (Gambling)
- Unfairness
- Illicit contracts
However, the key distinction is the concept of Riba/interest/usury (hereinafter referred to as “Riba”).
Riba is defined as:
“Any loan that entails some benefit (monetary or non-monetary) is Riba.”
While Riba is prohibited in Islam and primarily associated with loans, there are other ways and methods to conduct financial transactions that are permissible in Islam, such as:
- Partnership, for example, Musharaka, Mudaraba
- Sale, for example, Murabaha, Musawamah, Istisna, Salam
- Agency, for example, Wakalah
- Guarantee, for example, Qafala
- Lease, for example, Ijarah
In this guide, we will examine each of them in turn.
Methods of Islamic Financing
In the modern financial industry, all the aforementioned methods of Islamic financing are available and actively used according to client requirements and feasibility in line with the business model.
Partnership
Musharaka — a type of partnership where all partners contribute capital to conduct business. However, the management of the business can be carried out by one or all partners. The profit-sharing ratio is agreed upon at the beginning of the partnership and may differ from the investment share. However, any loss is always shared proportionally to the investment share.
Mudaraba — a type of partnership where one partner provides capital, and the other offers expertise. The profit-sharing ratio is agreed upon at the beginning of this partnership. However, in the event of losses, the capital-contributing partner loses their money, while the other partner only loses their time and effort.
In both of these types of partnerships, absolute profit cannot be agreed upon; only the profit-sharing ratio based on the profits earned from the partnership can be agreed upon.
Sale
Murabaha — a type of sale where the seller discloses the cost of the goods to the buyer, i.e., the sale price is communicated as the cost plus profit. This means that the buyer knows the seller’s cost of sale.
Musawamah — in this case, the cost of the underlying goods is not disclosed, and the seller informs the buyer only of the sale price.
Istisna — describes a sale where the main goods need to be produced, i.e., it is a production order. According to Shariah laws, the buyer has the option either not to make a down payment or to make a partial or full down payment at the time of order, while the seller must manufacture and deliver the goods in the future.
Salam — used for the sale of homogeneous goods, primarily in agricultural transactions. The goods being sold do not exist at the time of sale and must be delivered in the future. In such a sale, the buyer must make a 100% down payment at the time of order, while the seller must provide the goods in the future. A reasonable delivery time must be agreed upon, especially if the goods are seasonal.
Important Note: According to Islamic sales rules, a sale cannot be concluded if the object of the sale does not exist at the time of sale. However, Istisna and Salam are two exceptions to this rule.
Another important rule is that the price of the goods must be established at the time of sale/order and cannot be changed after the transaction is concluded.
Agency
Wakalah — an agency agreement where one party (principal) can hire another party (agent) to provide a specific service based on the agent’s expertise. In turn, the principal agrees to pay the agent a commission for the service.
If the service is provided according to the agent’s agreement, the principal must pay the agent the due commission, regardless of whether the service benefited the principal or not. However, in cases where the agent’s negligence is proven, they must compensate the principal for the incurred losses.
Guarantee
Qafala — this term is used for guarantees where the guarantor can charge a fee for ancillary services related to providing a guarantee for the applicant.
Lease
Ijarah — this method is used when one party (owner) leases something to another party (lessee). Ijarah can be used for both tangible goods (e.g., leasing houses) and intangible goods (e.g., providing services, similar to Wakalah).
Unlike sales, where the price cannot be changed after the transaction is concluded, Ijarah contracts allow the rental fee/commission to remain either fixed or variable.
The Role of Islamic Finance in International Trade
Banks and financial institutions play a crucial role in international trade by connecting buyers and sellers of goods and services. Despite the apparent simplicity, the process of moving goods or services from the seller (exporter) to the buyer (importer) involves numerous stakeholders, such as customs authorities, shipping companies, freight forwarders, warehouse management agents, etc.
All these stakeholders use various trade products, including letters of credit, documentary collections, open account trade, import credits, invoice discounting, pre/post-shipment financing, discounting, guarantees, and structured solutions such as receivables financing or supply chain financing, etc.
While alternatives to Islamic banking for all the solutions offered by conventional banks are available, well-established, and operationally similar, the key distinction of Islamic financing is the distribution of responsibility among different parties and the sharing of risk/profit. This differs from traditional financing, where the financial institution primarily acts as a creditor without sharing any risk.
Example
Suppose a client in Dubai wants to open a letter of credit (LC) to import machinery from China.
A conventional bank would open a letter of credit for a fee for its client without assuming any risk related to the underlying goods. If the client later requires financing for the imported machinery, an import credit would be provided.
An Islamic bank can offer three types of solutions based on different scenarios:
Wakalah Letter of Credit — where the bank acts as the client’s agent to import the machinery for a fee. This option is suitable when the client does not require financing.
Murabaha Letter of Credit — where the bank acts as the owner of the machinery, assumes the risks associated with the import, and sells the machinery on-site (if financing is not required), in installments, or with deferred payment to the client according to the client’s requirements. Alternatively, the bank can also lease the machinery (Ijarah) to the client for a specified period.
Musharaka Letter of Credit — where the bank acts as a partner with the client to import the machinery. This method is suitable if the client needs partial financing. Upon receiving the documents, the bank can sell its share to the client on-site, in installments, or with deferred payment, or provide its share of ownership in a lease (Ijarah).
Everything an Islamic bank offers can also be obtained through conventional financing. However, as seen from this example, an Islamic bank will not simply be a creditor; rather, the relationships will be based on risks and rewards.
Alternatively, it can be said that Islamic banking solutions primarily facilitate asset-based transactions (both tangible and intangible) and stimulate economic activity while preventing speculation, phantom trade, trade-based money laundering, and reducing the risk of manipulation.
The Future of Islamic Finance
Islamic finance is dynamic and continuously evolving with changes in the macroeconomic environment. Considering the upcoming challenges in the post-pandemic world (COVID), Islamic banks are changing their business methods by utilizing technology.
For example, Islamic banks are required to physically verify inventories in certain modes, such as Murabaha, Musharaka, Istisna, Ijarah, and Salam, where the bank acts as the owner of the goods. However, to comply with SOPs, these have been replaced with virtual visits.
Similarly, banks are now exploring various blockchain solutions to minimize physical interactions when submitting requests, documents, and sales contracts. This is in addition to expanding the use of their own specialized online platforms.
Banks are also transitioning to electronic document solutions, and an important aspect of this is the shift to electronic bills of lading, which will become a paradigm shift in the operations of key stakeholders, i.e., shipping lines, customs, and banks.
Glossary
Ijarah — leasing an asset by the owner to the lessee
Islamic — governed by Shariah jurisprudence
Istisna — sale of goods that do not currently exist and need to be manufactured
Qafala — a guarantee issued by a guarantor on behalf of the applicant
Mudaraba — a partnership where some partners provide capital, and others provide services.
Murabaha — a sale where the seller discloses the cost to the buyer
Musawamah — a sale where the cost is not disclosed by the seller to the buyer
Musharaka — a partnership where all partners contribute capital.
Riba — profit (monetary or non-monetary) above the loan
Salam — sale of a homogeneous product for 100% prepayment when the product does not currently exist.
Sale — exchange of one valuable thing for another valuable thing with mutual consent
Sukuk — Islamic bonds using Shariah-compliant underlying modes.
Tawarrruq — also known as commodity Murabaha, where a sale is used to obtain capital, although the underlying commodity is not required by the buyer.
Wakalah — an agency agreement where the agent provides services for a fee