Oct 28, 202312 min read

Islamic Finance

Updated: Jan 19

Abrar Chowdhry

Introduction

This is a brief paper on Islamic Finance, and I have chosen to write about this topic due to several reasons. First and foremost, it is because we try to be obedient and loyal to Allah سبحانه وتعالى in all aspects of our life because we have faith in him, love him and fear him.

All praise be to Allah سبحانه وتعالى who has given us Islam. That Islam which is more valuable than the entire earth full of gold. As Allah سبحانه وتعالى has bestowed upon us such an amazing mercy and blessing, we must remain firm upon the Deen, in all its aspects, as shown by our beloved Rasul ﷺ in his Sunnah.

Islam is more than just a religion. it is a way of life, a complete guide and code to life. Anyone who follows that code, that guidance, will In Sha Allah have success in the Dunya and hereafter.

As Islam provides guidance to every aspect of life, I have chosen to discuss in this paper

Islamic Finance. This is a topic which is not discussed very often among the general public; however, I believe there is a need for us all to understand the basics of Islamic Finance. This is because we live in a time where the international finance model is based upon Kufr as opposed to Shariah. Therefore, it can be very easy to fall into Haram.

Islamic Finance is a broad term and covers many areas such as wealth on an individual level, but also international finance and economy. In Sha Allah I will briefly touch on the key issues in the coming pages.

Riba (Usury)

As mentioned above, today the international finance and economy is based upon Usury (Interest). This is a clear and major difference between Islamic Finance and today’s economic and finance system.

Firstly, let us understand what Usury is. The Cambridge Dictionary defines Usury as “the activity of lending someone money with the agreement that they will pay back a very much larger amount of money later”. This is broadly in line with the definition in accordance with the Shariah. In the Shariah, Usury can be defined as described in the Tafseer of the following verse:

“Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah سبحانه وتعالى has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns to [dealing in interest or usury] - those are the companions of the Fire; they will abide eternally therein.” [Surah Al-Baqarah 2:275]

One key aspect of Islamic Finance is that there is fairness and justice in the society. In the current global economic and financial position, there is a significant amount of inequality in wealth, and this is a known fact. The main reason for this is due to the interest system being in place. The interest system takes advantage of poor individuals and nations, and the rich abuse their position. For example, many banks and other lenders loan funds to individuals at extortionate interest rates, which means that the individual is at a significant loss and the lenders are making significant sums of money. From a logical perspective therefore, it is clear how unjust the interest system is.

In the UK, there are many instances where interest exists where we may feel that we have no other alternative. For example, many students in the UK choose to take up further education at university. However, some may not appreciate that these loans attract significant rates of interest, and therefore these loans, from a financial perspective, are not advised (of course from the Shariah perspective, they are also not advised). Thus, we should advise students to avoid University where it is at the cost of paying interest. Alhamdullilah there are other excellent alternatives to university such as apprenticeships.

From the above, I believe we can satisfactorily conclude that Interest, from a logical perspective, is unjust and unfair and should be avoided.

From a Sharia perspective, Allah سبحانه وتعالى has clearly made it Haram:

“God has permitted trade and has forbidden interest” [Surah Al-Baqarah 2:275]

As Muslims, we have no choice but to accept and follow the commands of Allah سبحانه وتعالى and Rasul Muhammad ﷺ. We also believe that the commands are good for us, whether we understand them or not. From the above discussion, I believe it is clear that Riba is harmful for us as individuals and as a collective nation. It is also clear from viewing the consumers of Riba that, although they may have extreme amounts of wealth, the wealth does not have any blessing in it nor are they content. This is proven by the saying of Allah.

“God destroys interest and gives increase for charities” [Surah Al-Baqarah 2:276]

In terms of the punishment of indulging in Riba, this is Jahannam as explained by the saying of Allah:

“But whoever returns [to dealing in interest or usury] -those are the companions of the Fire; they will abide eternally therein” [Surah Al-Baqarah 2:275]

What is even more scary is that Allah جل جلاله has given an even more severe warning for those who indulge in Riba by saying:

“And if you do not, then be informed of a war [against you] from God” [Surah Al-Baqarah 2:279]

With this ayah, I conclude this section and pray Allah سبحانه وتعالى protects us from the evils of Usury. Naturally, some Non-Muslims will disagree that with the modern-day economy, not having interest is impossible. They may even claim that the Holy Qur’an’s prohibition is outdated! (Allah protect us all from having such an opinion). Of course, the Holy Qur’an is never outdated, and is always modern and applicable (and should always be applied). Refer to the Islamic Banking section below which provides further narrative around this.

Earning and Spending

Earning

Allah is the Provider and Sustainer, and we should put our faith in Allah سبحانه وتعالى that he shall provide for us as evidenced by the following verse:

“And there is no creature on earth but that upon God is its provision” [Surah Hud 11:06]

On the Day of Judgement, a person will be questioned on how he had earnt and spent his wealth, as proven by the below Hadith:

Ibn Mas'ud narrated that the Messenger of Allah ﷺ said: "The feet of the son of Adam shall not move from before his Lord on the Day of Judgement, until he is asked about five things: about his life and what he did with it, about his youth and what he wore it out in, about his wealth and how he earned it and spent it upon, and what he did with what he knew." [Jami’ Tirmidhi 2416]

The above Hadith highlights the importance of earning and spending. When we are looking for a source of sustenance, we must always remember that Allah سبحانه وتعالى is watching and remember that we should not sacrifice little profits in the Dunya for the everlasting destination of the Akhira. We may also be tested in our wealth, yet this test is to elevate our ranks and we must strive to be patient especially at this time:

“And We will surely test you with something of fear and hunger and a loss of wealth and lives and fruits, but give good tidings to the patient” [Surah Al-Baqarah 2:155]

Spending

When we are spending our wealth, this again should be in line with the guidance given in the Holy Qur’an and Sunnah. Many people may choose to spend over the limit and show off and this is something to avoid as Allah سبحانه وتعالى states in the Holy Qur’an:

“Indeed, the wasteful are brothers of the devils, and ever has Satan been to his Lord ungrateful” [Surah Al-Isra 17:27]

Furthermore, it is worth mentioning that in today’s society, there are many new avenues where money can be spent. We should remain vigilant as to where our money is going. For example, many UK employers invest the employee’s pensions in haram companies (such as Alcohol/Gambling businesses etc…). As Muslims, we need to ensure that our money is not being invested into Haram.

Charity

Charity is another key point I wish to discuss. In Shariah there is optional charity and compulsory charity, Zakah. As all our property belong to Allah, we should never feel reluctant to spend money in the path of Allah, especially in the month of Ramadan. Surely, if we have the correct intention, In Sha Allah, Allah سبحانه وتعالى shall reward us for this charity in the hereafter, and we will wish then that we had spent more in the Dunya on charity.

I mentioned above that in the society today, there is a lot of inequality and injustice in wealth. A study by Forbes has shown that in the USA, the Top 3 individuals (Bill Gates, Jeff Bezos and Warren Buffet) own around $345 billion, which is more than the combined wealth of the bottom 50% of all Americans. This means that 3 individuals own the wealth equivalent to hundreds of millions of Americans. This statistic is driven by the interest system, as explained, and the poor spreading of wealth, and thus highlights injustice in modern society. One key aspect of Islamic Finance is that there is fairness and justice in society, and that all the wealth is not controlled by a small number of individuals. Therefore Allah, the most wise and the most merciful has given a system of Zakah.

Zakah

Zakah literally means purify. In Shariah, it is the compulsory donation of wealth in the path of Allah سبحانه وتعالى with 2.5% of a person’s wealth subject to Zakah. Only individuals who hold wealth greater than the “Nisaab” level are mandated to pay Zakah. Throughout the Holy Qur’an, Allah سبحانه وتعالى mentions giving Zakah numerous times and thus highlights its importance.

There is also great wisdom in Zakah. As mentioned previously, regarding Shariah commands, as Muslims we have no choice but to accept them. However, we can see, in the case of Zakah, the clear undeniable benefit to society. If we take the above example. The Top 3 individuals in the USA own around $345 billion, 2.5% of which is circa $9 billion. Clearly, if the Zakah system were to be in place, society would be much fairer, and this is an undeniable reality. Some Non-Muslims may object that individuals work for their wealth and should not be mandated to such commands.

The answer to this objection (from a Humanitarian and logical perspective) can be as follows:

We should look out for our fellow humans. We have been privileged with great wealth. Not everyone is born into a rich family.
As humans we inherently feel good when we do a virtuous act such as charity. So giving to those poorer than us will improve our happiness in life.
2.5% is quite a small amount as you can keep 97.5% of your wealth.
Our children may see us giving charity, and they will do the same when they grow up. Therefore, they are brought up with strong moral values and the society is much fairer in the long term.

We do not give Zakah solely for the above logical reasons, we give it to obey the commands of Allah. The above logical reasons are merely to illustrate some of the wisdom behind the commands. From a Shariah perspective, the answer is simple. All our property belongs to Allah, so we should be grateful for what we have and give Zakah and Charity. It is from the mercy of Allahسبحانه وتعالى that he also rewards us for giving charity.

Now in many countries there is the system of Taxation which, in some respect, looks to improve wealth equality. There are however a few fundamental flaws within the taxation system. For example, looking at the UK Tax Legislation it is noted:

Tax rates can be punitive on less wealthy individuals. For example, an individual on a modest salary can be paying tax at 32% (20% income tax + 12% national insurance).
Wealthy individuals have resources available to them which can help them to avoid their tax liability.
Wealthy corporations again can pay little or next to nothing in tax.
For the wealthy individuals, the tax rate can also be seen to be unreasonably high at 47%.

Zakah as an alternative to Tax is far more effective in having a fair society as it does not possess any of the inherent weaknesses mentioned above.

Islamic Banking

(Source: An Introduction to Islamic Finance by Mufti Taqi Usmani)

The traditional and modern-day banking system is entirely revolved around secular capitalism. The issue with this is that individuals and corporations are given unbridled power to make economic decisions. Their liberty is not controlled by any divine being or any moral guidance. In other words, the way in which they operate does not follow the guidance given in the Holy Qur’an and Sunnah. This is despite every Dollar note having the saying “In God We Trust”. This attitude has allowed a number of practices which cause imbalances in the society. Interest, gambling, speculative transactions tend to concentrate wealth in the hands of the few. This in turn creates monopolies which paralyses the market forces.

Islamic Banking on the other hand follows a set of divine principles, given by Allah سبحانه وتعالى and his Rasul Muhammad ﷺ. Key concepts within Islamic Banking are Musharakah and Mudarabah. These have been discussed below.

Musharakah

‘Musharakah’ is a word of Arabic origin which literally means sharing. In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. It is an ideal alternative for the interest based financing. In the modern capitalist economy, interest is the sole method of financing. Since Islam has prohibited interest, this method cannot be used for providing funds of any kind. Therefore, musharakah plays a vital role in an economy based on Islamic principles.

Interest predetermines a fixed rate of return on a loan advanced by the lender irrespective of the profit earned or loss suffered by the debtor, while musharakah does not impose a fixed rate of return. Rather, the return in musharakah is based on the actual profit earned by the joint venture. The lender in an interest-bearing loan cannot suffer loss while the lender in musharakah can suffer loss if the joint venture fails to produce fruits.

Islam has termed interest as an unjust instrument of financing because it results in injustice either to the creditor or to the debtor. If the business suffers a loss, it is unjust on the part of the lender to claim a fixed rate of return; and if the business earns a very high rate of profit, it is injustice to the business to give him only a small proportion of the profit leaving the rest for the lender.

According to Islamic principles, a lender must determine whether he is advancing a loan to a) assist the debtor on humanitarian grounds or b) he desires to share his profits. If he wants to assist the debtor, he should resist from claiming any excess on the principal of his loan, because his aim is to assist him. However, if he wants to have a share in the profits of his debtor, it is necessary that he should also share him in his losses. Thus, the returns of the financier in musharakah have been tied up with the actual profits accrued through the enterprise. The greater the profits of the enterprise, the higher the rate of return to the financier. In this way, musharakah tends to favour the common people rather than the rich only. This can therefore be a halal vehicle of financing, whilst satisfying the economic conditions.

Musharakah also avoids the risk around recession, as secular capitalism is the key driver of economic depression, for example the 2008 Subprime Mortgage Crisis in the USA.

Mudarabah

“Mudarabah” is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-mal”, while the management and work are an exclusive responsibility of the other, who is called “mudarib”.

The difference between musharakah and mudarabah can be summarised in the following points:

In mudarabah, the investment is the sole responsibility of rabb-ul-mal.
The rabb-ul-mal has no right to participate in the management which is carried out by the mudarib only.
If any loss is suffered, this is borne by the rabb-ul-mal only, because the mudarib does not invest anything.
In Musharakah the liability is often unlimited, however in Mudarabah the liability of rabb-ul-mal is limited to his investment, unless he has permitted the mudarib to incur debts on his behalf.
In Mudarabah, all the goods purchased by the mudarib are solely owned by the rabb ul-mal, and the mudarib can earn his share in the profit if he sells the goods profitably.

To illustrate the above points, in the UK, Al Rayyan bank operate under the principles of Mudarabah. For example, an individual may open an account with Al-Rayyan Bank. Al-Rayyan Bank and the individual agree upon the profit sharing ratios. Once agreed, Al-Rayyan bank will then invest the funds with the hope of the making a profit. Say after one year, a profit is then made. This profit will then be distributed in accordance with the profit-sharing agreement.

Feasibility of Islamic Banking in the modern economy

I mentioned above that some non-Muslims may object and say that a world without interest is simply not possible. However, having discussed the above, it is clear that in theory, Islamic Banking can successfully work and be implemented today.

In practice, it is feasible as it is already a significant market. As per the Financial Times News Article in June 2018: “there are 1,407 Islamic financial institutions globally, from retail to investment banks and asset managers. The 2017 ICD-Reuters report put the Islamic finance industry at $2.2tn of assets in 2016 and forecast that it would grow to $3.8tn of assets by 2022”

Islamic Banking is a very detailed topic, and I have only noted above the key principles. Mufti Taqi Usmani has written a book called “An Introduction to Islamic Finance” which is beneficial

for further reading.

Conclusion

To summarise, I would like to reiterate that, as Muslims, we are obliged to follow the commands of Allah سبحانه وتعالى and his Rasul Muhammad ﷺ. This is not only in our Salah, in our daily actions, in our other rituals of Deen, but we must follow the Holy Qur’an and Sunnah in every aspect of life. Our Deen provides guidance on every aspect of life, from putting on clothes to how to run an economy and business. We follow the guidance in the Holy Qur’an and Sunnah to please Allah سبحانه وتعالى and his Rasul Muhammad ﷺ with the hope that we may enter Jannah in the hereafter.