Islamic Finance

What are the fundamental principles that shape the Islamic financial system? How are debt and entrepreneurship financed in the Muslim world?  We examine the Islamic model of finance and  its products, how they are used to help eliminate the cyclical nature of poverty, and the impact of Islamic finance on the countries in which it has been adopted.

 The Five Pillars of Islam 

The foundation of Islamic finance is based on the five major tenets (pillars) of Islam:

The first is shahada, or creed, which translates as ‘to know or believe without suspicion, as if witnessed.’  This idea is synonymous with western religious ideas of faith, which is to believe without absolute confirmation.

The second is salats, the daily prayers made by faithful Muslims.  There are five calls to prayer during the day and people take time out of their busy schedules to kneel and pray.

The third pillar is swam, which is the period of religious fasting during the month of Ramadan.

The fourth pillar of the faith is zakat or almsgiving to the poor.

The fifth pillar of the Islamic faith is the hajj or religious pilgrimage taken to Mecca, Islam’s Holy Land.

These five pillars are the foundation of Shari’a, or divine law, which has two components.  One of these components is known as ‘revealed shari’a’, which is the law that comes directly from the Qur’an and the teachings of Muhammad (peace be upon him) in the hadith, known as the sunna.  These writings provide real life applications of the Qur’an’s teachings.  The other component is what is known as ‘non-revealed shari’a’, which are practices or beliefs that are a result of a consensus of Islamic scholars (Malkawi).

The influence Islamic divine law has on everyday life is extraordinary. Nassar M. Suleiman, states that:

Shari’a Law must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services sustains the growth and advancement of the Islamic way of life (The Pak Banker).

The impact the divine law has on the practice of finance is evident.  Shari’a law has guidelines on the types of activities that are permitted within a financial institution if it is to be considered ‘Shari’a compliant.’  Shari’a prohibits a financial institution from investing in or supporting businesses that deal in the sale or production of pork or alcohol; nor can the institution be involved with businesses that profit from gambling operations.  In addition, there are several key aspects of Islamic financial institutions, which set them apart from their western counterparts.

Distinctive Features of Islamic Finance

The first and most contradistinctive feature of Islamic finance is there is no concept of the time value of money.  A dollar is worth the same today as it is to someone three months from now.  This is in stark contrast to the western view of money – a dollar is worth more to me now than it is three months from now.  According to modern (western) finance theory, for those three months, I could have that dollar sit in a bank account and earn interest for three months so that once three months have passed, I will have more than a dollar.  Therefore, when I am lending money to someone and not getting it back for a period a time, I am to be compensated by the borrower for the opportunity cost of not receiving interest from that money.

Second, and closely linked to not having a time value of money is the Qur’an’s strict prohibition against the collection of interest or riba, which is sometimes translated also as usury or exploitation.  The prohibition stems from the belief that money and profits are earned.  The charging of interest is considered unlawful gain, as the financial institution is not really providing any service to the borrower, but is profiting from merely existing and being able to lend money.  Some adherents to this belief view people that store their money in banks as hoarders, believing that money is not be socked away in banks earning interest, but should be used to support entrepreneurs and the development of Islamic enterprise.

Third, risk taking or gharar is to be avoided as much as possible.  In an Islamic contract the price, quantity, and time of payment must be known prior to entering into the contract with the other party.  This practice ties in to some of the other characteristics of Islamic finance, but may have something to do with the culture and customs of the people that settled the area.  The Middle East is home to people whose ancestors were nomadic, tribal people, who lived off of the land and never took more risk than was necessary.  This history of risk avoidance seems to continue to play out in the region’s financial sector.  However, it is this aspect of Islamic business that we again see the impact that the teachings of Allah.  Life insurance, a familiar financial instrument for most in the West, is shunned by Muslims because Allah knows the time and place of each person’s passing, their time on this earth being predetermined.  Mechanisms have been developed to help ameliorate the consequences of the risk of death from everyday life, with the focus on zakat, social security, and laws of inheritance that allow people to take care of their family members after they pass (Malkawi).

The fourth feature of Islamic finance that makes it stand apart from conventional, western finance is the understanding that money is not a commodity.  When buying and selling products either on the street or through a business contract, money does not change hands until the item being purchased is physically present.  In other words, farmers or car producers cannot sell their produce or merchandise until the goods have reached the intended consumer (Malkawi).  This requirement is related to risk (the previous feature of Islamic finance). The demand for payment at delivery helps to reduce any unforeseen price fluctuations between the onset of a contract and the final delivery of the product under contract.  The immediate exchange of goods for payment also shields the buyer from any problems that may arise for the seller during production that may delay or interrupt the ability for final delivery.

The last major requirement for a financial institution to be considered ‘Shari’a complaint’ is that contracts provided by these institutions share the risks and rewards of the contract evenly between all parties involved (Ali).  This idea is again in contrast with the western world’s idea of contracts and profits in the financial sector.  In the west, the finance is a zero sum game: for every person that earns a positive return or profit from their investment, that profit comes from someone else’s loss.  Often in Islamic contracts, there will be an equal distribution of positive return among all parties, but losses will be reserved for those most heavily invested financially. Those parties contributing technical knowledge or other non-monetary support are not subject to the loss of an investment if there is one.

These ideals present in Islamic finance lead to the development of ‘customized’ financial products that mimic those used in the western/conventional financial industry, but are considered to be in accord with Shari’a Law.  There are five major types of debt and equity products from which to draw in order to finance debt as well as invest in the development of business throughout the Islamic world.

Islamic Compliant Financial Products

1. Murabaha

The most widely used financial debt instrument in Islamic finance is a sales contract known as Murabaha, which is a ‘cost plus margin’ contract.  In this contract, the financial institution, most commonly a bank, purchases a product for a client and then charges an agreed-upon fee on top of that price. The bank receives repayment for the total amount (fee plus price of product) from the client over a period of time (Ali).  For example, an individual comes to the bank and wants to purchase a car.  Suppose the car costs 40,000 dirhams (the currency of the United Arab Emirates). The borrower and the bank agree that the borrower will pay the bank back 44,000 dirhams for the car.  In this example the bank goes out and purchases the car for 40,000 dirhams from the dealer and the borrower in turn makes periodic payments to pay the bank back the 40,000 dirhams for the car plus the 4,000 dirhams margin due to the bank.

2. Ijara

The second major type of debt financing, known as an Ijara, is primarily used for the leasing of large equipment or real estate to businesses.  The major difference between the murabaha and the ijara is the method of repayment to the financial institution.  As the collateral being provided to the business is so large, the bank may choose to either rent the land or equipment or sell the collateral to the borrower and receive a share of the profits generated from its use (Ali).  As in western lease contracts, the collateral belongs ultimately to the financial institution. At the end of the lease, ownership of the asset returns to the bank, unless another agreement has been made that allows for title transfer to the borrower at the end of the lease term.

3. Sukuk

The final debt product is referred to as Sukuk, which is an asset-backed, medium-term note made on a specific income-producing collateral, similar to a loan for a business (Ali).  The bank that makes this type of loan contract does not receive interest payments because they are not allowed in Islamic Finance. Instead, the financial institution receives a return from the performance of the collateral for which the loan was made.  For example, a client borrowing money for his or her business, does not pay the loan back with interest, but uses profits generated from operations to repay the loan to the bank.

4. Musharaka

Equity based products include the Mudaraba and the Musharaka.  These are partnerships in which the parties involved bring either monetary or knowledge-based capital to the table for investment.  The Musharaka is a partnership in which both parties contribute money and develop a joint venture for investment.  Profits are shared on an agreed upon basis and not always in direct proportion to the amount of financial capital invested (Ali).  Loss is shared equally among all parties involved to remain in line with one of the main tenets of Shari’a finance: the sharing of risks and rewards in financial contracts.

5. Mudaraba

The other equity product alternative is a partnership known as the Mudaraba, with one party bringing financial capital, while the other party contributes business knowledge capital to the venture.  Again like the Musharaka, rewards are shared among all parties involved on an agreed upon basis.  However, only those parties that contribute financial capital suffer financial loss.  This is an important distinction for the Mudaraba contract – it places equal importance on both financial and knowledge-based investment (Ali).  The parties providing the ideas and ongoing training for the business venture are viewed as equally important to the venture.  There is also an understanding that these parties cannot provide initial funding and will therefore, not be able to sustain financial hardship.

The Use of Islamic Finance

             Islamic finance is not only applied to those that have the means to operate in the financial sector, but is also being used to bring the poor into the business world.  The ‘Islamic Financial Model’ divides the poor in the Islamic world into two groups, the employable, bankable group and the unemployable, non-bankable group (Ali).

Those considered to be bankable can gain access to the financial products described above, with some oversight by the financial institution providing the financing.  Three main debt and equity products are utilized to assist bankable Muslims in beginning their entrepreneurial endeavors.  The Murabaha, or sales contract, can be used, which allows for the borrower to be financially and intellectually assisted by the bank.  The bank and borrower decide on the type of business to be developed, the products made, and the suppliers used to help support operations.  This is a mutually beneficial activity, as the borrower gets real world business exposure and the bank mitigates its risk by ensuring that it has set the borrower up with a solid business plan as well as strong suppliers that the bank trusts.

The Mudarabah may be used to support entrepreneurial businessmen whot bring solid ideas for a business to the table, but need financial backing to get started.  The equity financing model is perfect in this situation.  The bank provides the financing and some business knowledge, but the intellectual expertise resides with the businessman. The traditional Mudarabah contract ensures profits and losses are borne equally.  Should the aspiring businessman have all the technical and business knowledge necessary to start his or her business, but lacks the start-up capital, the bank can provide an Ijara for this borrower and lease capital equipment to him alleviating large start up costs of running a business (Ali).

As a result of this financial and basic business training provided by the banking institutions, strict oversight of these business operations is maintained.  The borrowers are monitored, as in western finance, to ensure continuity of repayment on any business loan.  However, in contrast to the western financial model, late payments by these borrowers do not incur late payment penalties.  One reason for this leniency is the belief that any financially stressed borrower will be further burdened by such penalties.  In addition, the idea of charging additional fees when attempting to alleviate these disadvantaged businessmen, can be seen as exploitation.

For those considered non-bankable, businesses and financial institutions alike provide zakat in the form of food and clothing, scholarships, or the establishment of schooling centers to teach the poor valuable trades so they can become productive members of society (Ali).  As one of the five pillars of Islam, zakat plays a major role in an individual’s life, both personally and professionally.  In some parts of the Muslim world, this form of almsgiving is required of individuals and businesses alike.  If no such requirement exists for individual contributions, companies must take it upon themselves to set up zakat funds on behalf of their employees, similar to a 401k system in the United States.

In addition to community investment, financial institutions can also make interest free loans to the poor as a way to give back to those in need.  This practice is sometimes linked to banks that earn interest on deposits from customers, a practice forbidden by the Qur’an, so this almsgiving is a way to offset the poor view that may be cast upon these institutions for profiting off of others.  This focus on the poor in the Islamic faith is a result of the Shari’a, which says the divine law should permeate all aspects of an individual’s life and work to improve the Islamic way of life.  It is not unusual for businesses in the west to ignore the poor, as the gap between the rich and poor gets greater.  The almsgiving and interest free loans are two ways for Muslims to try and close the gap between the rich and poor and to stop the cycle of poverty (Ali).

 Impact on Muslim Societies

             It is important to examine how the impact of the Islamic financial model on Muslim countries that previously had no exposure to these financial tools.  Generally speaking, the movement of Islamic finance through the Muslim world has provided two overarching benefits to individuals and economies.

First, on an individual level devout Muslims now have an investment and savings vehicle in which to deposit or gain access to funds that had previously been unavailable to them (Imam and Kangni).  Prior to the establishment of Shari’a compliant financial institutions, the conventional banking method used was unavailable for religious reasons to Muslims who held tightly to the Qur’an’s teachings.  This situation left people with virtually no system in which to invest and very few options when it came to accessing cash from a bank.  This lack of financing disadvantaged devout Muslims in terms of financial and economic development. The religious did not have access to debt financing for large purchases, lease financing for capital equipment or entrepreneurial start-up capital.  A case in point, the CEO of SYM International Finance Corp reports that 94% of citizens in Senegal do not have a savings account (Permatasari and Qayum).

Now that Shari’a complaint institutions have made their way into several Middle Eastern, African and Asian countries, the comparison with conventional banking centers with respect to the cost of borrowing is surprising.  The Reserve Bank of India reports that Indian Muslims’ credit to deposit ratio was 47%, compared to 74% for non-Muslim Indians.  Perhaps the financial institution’s adherence to the tenets of Islam helps to make borrowing money from these institutions more cost effective than their conventional counterparts (Kumar).  The International Monetary Fund reports the lack of Islamic financial centers has left Islamic nations without adequate project funding and has slowed the development of commerce in these developing nations (Permatasari and Qayum).  There is a belief among some that the ability for Islamic banks to flourish in these developing nations is due in part to the fact that poorer nations often cling closer to their religion as a foundation of their way of life. Consequently a financial institution associated with the Islamic faith is an attractive alternative to the western banking centers that may exist in these nations (Permatasari and Qayum).

The second benefit of the spread of Islamic Finance throughout the Middle East and other Muslim countries is the adoption of shared risk/reward financing.  The Shari’a compliant financial institutions that are infusing capital into the Middle East, Asia, and Africa serve as ‘shock absorbers’ against the commodity based cash flows prevalent in that region (Imam and Kangni).  For example, one of the major commodities found in the Middle East is oil.  The world demand for oil causes prices to rise and fall, creating uncertainty in cash flow levels.  The partnerships supported by Islamic financial institutions provide a buffer against volatility as they help absorb losses in downtimes and share profits during the good times.  This ability to provide some assurance to investors helps strengthen faith in the system and encourages individuals to invest money and develop industry within their own countries.

Studying the spread of Islamic finance throughout the Muslim world, researchers discovered two salient characteristics about the nature of the country into which this financial system is spreading. The first is that the countries in which Islamic finance has thrived most effectively are those that already contain established western or conventional banking centers (Imam and Kangni).  It appears as though the Islamic and conventional banking systems seem to complement each other, rather than serve as adversarial systems.  As in any religion, there exists a spectrum of ‘devout belief’ spanning those who strictly follow the teachings of the Qur’an and the Prophet Muhammad, to those that rarely feel the impact of their faith on a daily basis. In countries where there are both conventional and Shari’a complaint banks, there are options for every investor, devout or not, Muslim or Catholic.  This system provides access to capital through a system that fits with individual investors’ personal beliefs.

Secondly, the success of the Islamic financial institutions within a country is not tied to the stability of the local government (Imam).  The Islamic faith has an overwhelming influence on the daily lives of devout Muslims that affects the daily activities of financial institutions.  Therefore, the driving force behind the development and operation of Islamic financial institutions is not the practices and laws of humans, but is found in a religion that supersedes human law.  As Islamic compliant banks are funded by the followers, local governments can exert little influence the operations of banks.  In addition, the prohibition of interest collection forces an Islamic bank to find revenue outside the conventional methods making it less susceptible to interest rate changes.

 Topics for Further Research

             One area of dissension among researchers is the question of whether interest is still a part of Islamic finance despite its prohibition by the Qur’an.  Another topic of debate is how the Islamic finance will handle payment defaults and breaches of contracts.  Finally, with the development of the Islamic financial model throughout the Middle East, Africa, and Asia, there is a new investment market backed by Shari’a compliant contracts offered by financial institutions.  It should be interesting to see if these products will be held to the same standard as the underlying contracts.







Dr. Ali, Amal El Tigani, ‘Islamic Finance Solutions: The Role of Islamic Finance in Poverty Alleviation,’ Journal of American Academy of Business, Cambridge, Volume 16, Number 2, March 2011, pp. 304-310


Imam, Patrick and Kpodar, Kangni, “Good for Growth? The spread of Islamic banking can spur development in countries with large Muslim populations,” Finance & Development, December 2010, pp. 44-45.


Kumar, John Satish, “BSE Hopes to Score with Shariah Index,” The Wall Street Journal, December 27, 2010,, access date 6 March 2011


Malkawi, Bashar, “Financial Derivatives in the West and in Islamic Finance,” The Banking Law Journal, Volume 128, Issue 1, 2011, pp. 50-71


Permatasari, Soraya and Qayum, Khalid, “Pakistan, Afghanistan, Senegal Pushing Banking for Growth: Islamic Finance,” Bloomberg,, access date 10 March 2011.


“Pakistan: Understanding Shariah Finance and Islamic Banking in American Finance,” The Pak Banker, Lahore: August 27, 2009 via ProQuest,…pe=PQD&rqt=309&TS=1299461602&clientId=42567&cc=1&TS=1299461602



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