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sharing, non profit and loss sharing, and fee based products.
Islamic finance operates based on principles that comply with Shariah, the Islamic law. The key instruments
of Islamic finance can be broadly categorized into three main types: profit and loss sharing, non-profit and
loss sharing, and fee-based products.
• Ijarah: In an Ijarah contract, the financial institution purchases an asset and leases it to the
customer for a specified rental amount. The customer may have the option to purchase the
asset at the end of the lease period. This resembles a lease-to-own arrangement without
involving interest.
Islamic finance aims to adhere to Shariah principles, which prohibit the charging or paying of interest (Riba)
and promote ethical and socially responsible financial practices. These instruments provide alternatives to
conventional financial products, ensuring compliance with Islamic law.
The principles of equity, participation, and ownership are fundamental differentiators between Islamic
banking and conventional banking. These principles reflect the core values and guidelines set by Shariah,
the Islamic law, and contribute to a unique approach to financial transactions.
• Islamic Banking: Islamic banking operates on the principle of equity, which means that
financial transactions must be conducted in a fair and just manner, adhering to Shariah
principles. This includes avoiding elements such as Riba (usury or interest), excessive
uncertainty (Gharar), and investments in activities deemed non-compliant with Islamic
ethics (Haram).
• Conventional Banking: Conventional banking, on the other hand, may involve interest-
based transactions and investments in various sectors, including those that may not align
with specific ethical or moral standards.
• Conventional Banking: In conventional banking, loans are often extended without a direct
link to specific assets. The focus is on the repayment of the principal amount along with
interest. This model may lead to a higher degree of leverage and financial transactions not
necessarily tied to tangible assets.
In summary, Islamic banking differentiates itself from conventional banking through its adherence to
principles of equity, active participation in economic activities with profit and loss sharing, and emphasis
on ownership through asset-backed financing. These principles aim to create a more ethical and inclusive
financial system, aligning with the values and guidelines set by Shariah.
State the objectives of Islamic banking. Explain the reasons behind the
prohibition of Riba in Islamic banking.
Objectives of Islamic Banking:
Islamic banking operates with the following key objectives, guided by the principles of Shariah:
1. Shariah Compliance: The primary objective of Islamic banking is to ensure compliance with
Shariah principles. All financial transactions and activities must adhere to Islamic law, avoiding
elements such as Riba (usury or interest), Gharar (excessive uncertainty), and investments in
activities deemed Haram (prohibited).
2. Equity and Justice: Islamic banking aims to promote equity, fairness, and justice in financial
dealings. This includes providing equal opportunities for wealth creation and distribution, avoiding
exploitation, and fostering economic and social well-being.
3. Wealth Preservation and Growth: Islamic banking seeks to preserve and grow wealth in a
manner that is ethically and socially responsible. This involves engaging in business activities that
contribute positively to society while avoiding speculative and harmful practices.
4. Risk Sharing: A key objective is to encourage risk-sharing between the financial institution and
its clients. Profit and loss sharing arrangements, such as Mudarabah and Musharakah, embody this
principle, ensuring that both parties share in the risks and rewards of a business venture.
6. Social Welfare and Responsibility: Islamic banking aims to contribute to the well-being of society
by supporting projects and initiatives that have a positive impact on the community. This aligns
with the broader concept of social responsibility in Islamic finance.
Prohibition of Riba:
The prohibition of Riba (usury or interest) in Islamic banking is rooted in several ethical, economic, and
social reasons:
1. Social Justice: Riba is seen as exploitative and leads to social injustice by burdening borrowers
with an additional financial burden. The prohibition of Riba aligns with the Islamic principle of
ensuring fairness and justice in economic transactions.
2. Wealth Distribution: Riba tends to concentrate wealth in the hands of lenders, contributing to
income inequality. By prohibiting Riba, Islamic banking aims to promote a more equitable
distribution of wealth and reduce economic disparities.
3. Encouraging Productive Economic Activity: The prohibition of Riba encourages individuals and
businesses to engage in productive economic activities rather than relying on interest-based
financial transactions. This helps stimulate economic growth and development.
5. Stability and Fairness: Riba is seen as a source of financial instability and unfair enrichment. By
avoiding interest-based transactions, Islamic banking aims to create a more stable and ethical
financial system that benefits society as a whole.
In summary, the prohibition of Riba in Islamic banking is grounded in principles of social justice, wealth
distribution, encouragement of productive economic activity, ethical considerations, and the pursuit of a
fair and stable financial system. Islamic banking strives to align financial practices with the broader
objectives and values of Shariah.
• Structure: In an Ijara sukuk, the issuer sells an underlying asset to investors and then
leases it back from them. The rental payments made by the issuer to the investors represent
the return on investment. At the end of the sukuk tenure, the asset may be sold back to the
issuer or a third party.
2. Mudarabah Sukuk:
• Structure: Mudarabah sukuk are based on the Mudarabah concept, where investors act as
the capital provider (Rab-ul-Mal), and the issuer acts as the entrepreneur or manager
(Mudarib). Profits generated from a specific business venture are shared between the
investors and the issuer according to a pre-agreed ratio. If there are losses, they are borne
by the investors.
3. Musharakah Sukuk:
• Structure: Musharakah sukuk involve a partnership between investors and the issuer. Both
parties contribute capital to a joint venture, and profits are shared based on an agreed ratio.
In case of losses, they are shared proportionately among the investors. The sukuk may
represent ownership in the underlying assets or the business venture.
4. Murabaha Sukuk:
• Structure: Murabaha sukuk involve the sale of a commodity or asset by the issuer to the
investors at a cost-plus-profit basis. The investors then sell the asset back to the issuer at a
deferred payment. The profit for the investors is the difference between the buying and
selling prices. This structure is commonly used for financing trade transactions.
5. Salam Sukuk:
• Structure: Salam sukuk are similar to Salam contracts in Islamic finance. In a Salam
sukuk, the investors provide funds upfront to the issuer in exchange for the delivery of
specific commodities at a future date. The issuer uses the funds for its business activities,
and the profit is realized upon the delivery of the commodities.
6. Wakala Sukuk:
• Structure: Wakala sukuk involve the appointment of an agent (Wakil) by the issuer to
manage a specific investment or business activity on behalf of the sukuk holders. The agent
charges a fee for the services rendered, and any profits generated from the investment are
distributed to the sukuk holders.
7. Hybrid Sukuk:
• A zero-coupon sukuk is a type of Islamic bond that does not make periodic interest
payments (like a conventional bond). Instead, it is issued at a discount to its face value and
redeemed at its face value upon maturity. The return to investors is the difference between
the issuance price and the redemption amount.
9. Non-Tradable Sukuk:
• Sukuk are typically tradable in the secondary market, allowing investors to buy or sell them
before maturity. However, in some cases, sukuk may be issued with specific conditions
that make them non-tradable. This means the investor must hold the sukuk until maturity
to receive the expected returns.
• The term "embedded sukuk" is not a standard term in Islamic finance. It's possible you may
be referring to sukuk with embedded features or structures. For example, sukuk may be
embedded with profit-sharing arrangements, conversion options, or other features that
tailor the sukuk to the specific needs of the issuer and investors.
Sukuk provide a way for Islamic financial institutions and governments to raise capital while adhering to
Shariah principles. The specific structure chosen for a sukuk issuance depends on the nature of the
underlying assets, the financing needs, and the preferences of the parties involved.
Islamic finance strictly prohibits the payment or receipt of interest (riba). Financial intermediation in
Islamic finance involves profit-sharing arrangements, risk-sharing, and asset-backed transactions instead of
interest-bearing loans.
All financial intermediation activities must comply with the principles of Shariah. This includes avoiding
investments in businesses that involve prohibited activities (such as gambling or alcohol) and ensuring
transparency and fairness in financial transactions.
Islamic financial intermediation often involves participation in economic activities with profit-and-loss
sharing arrangements. Modes of financing like Mudarabah (profit-sharing) and Musharakah (joint venture)
align the interests of financial institutions with those of their clients.
Asset-Backed Financing:
Islamic financial intermediation emphasizes asset-backed financing, where transactions are linked to
tangible assets. This helps mitigate risk and ensures that financial activities are based on real economic
transactions.
Ethical and Social Responsibility:
Islamic financial intermediation aims to promote ethical and socially responsible investment. Financial
institutions are encouraged to support projects and initiatives that have positive social and environmental
impacts.
Islamic finance discourages speculative transactions and excessive uncertainty. Financial intermediation
activities should be based on sound business practices and avoid elements of uncertainty that may lead to
speculation.
Islamic financial intermediaries are expected to treat customers fairly and transparently. Contracts should
be clear, and the terms and conditions should be communicated in an understandable manner.
While financial intermediation is allowed in Islam, the emphasis is on conducting these activities in a
manner that promotes economic justice, ethical conduct, and the overall well-being of society. Financial
institutions in Islamic finance are expected to provide services that meet the financial needs of individuals
and businesses while adhering to the principles outlined by Shariah.