Islamic finance: what are the key principles and how does it work?
Whether it’s workplace pensions or private investment, Muslims like to ensure their cash isn’t being used to violate Islamic principles
Islamic finance allows Muslims and non-Muslims alike to save, invest and borrow while adhering to the principles of the sharia, or Islamic law.
A key Islamic finance concept is that money has no intrinsic value, but goods and services do. The payment or collection of interest, known as riba, is forbidden (haram) in Islam.
Another important principle is to avoid investing money in haram industries, such as alcohol, weapons, adult entertainment, pork and tobacco, which are considered to be harmful.
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Speculation or gambling, known as maisir, is also prohibited in Islamic finance because it creates wealth from chance instead of productive activity — and there is a ban on contracts involving excessive risk or uncertainty (gharar).
“It’s about trying to create a better world and a fairer flow of money and value through society,” said Ibrahim Khan, co-founder of the Islamic Finance Guru advice website.
“That’s why unethical things like alcohol, pornography and all of the other stuff would be not allowed to be invested in, because we don’t want that kind of world.”
He added: “Interest-bearing lending is problematic as well, for the same reason that it leads to inequality.”
Profits and risk should be shared by parties involved in a financial transaction, and each transaction should be tied to a real underlying asset, such as property or commodities.
How is sharia-compliance achieved?
Various methods have been devised to help Muslims comply with sharia principles while getting a mortgage, taking out insurance or investing their savings.
For instance, murabaha is a financing system for buying assets that avoids the payment of interest. Instead of credit, a bank buys an item and sells it to the customer, who pays for it in instalments that include a disclosed fee for the lender — which is not considered interest as it is payment for a service.
Ijarah is a lease finance agreement where a bank buys an item, such as a home, for a customer and leases it back to them for an agreed period and a pre-agreed fee. Ijara wa iqtina is a similar concept, but the customer can buy the asset at the end of the contract, a little like hire purchase.
Other options include mudaraba, a profit-sharing partnership where one party contributes capital and the other provides labour and skill. Many Islamic bank accounts and some Islamic funds are structured on the basis of mudaraba, finance expert Mufti Faraz Adam has said.
Musharaka is a joint venture in which profits and losses are shared. Another option is sukuk — often called an Islamic bond — which is a form of debt finance that cannot hold interest.
Then there are Islamic investment funds, which pool investors’ money and buy shares in large companies that have been approved as sharia-compliant.
These shares are usually purchased on the secondary market, so investors aren’t directly financing these companies. But firms can still benefit indirectly as this can boost and stabilise their share price, making it easier for them to raise finance or purchase other businesses.
A deeper pool of willing buyers can also lower the firm’s cost of capital when it next issues debt or equity, Khan explained.
Many funds copy (or “track”) the investments chosen by Islamic indexes, ready-made groups of stocks screened for sharia-compliance and run by third party providers, though some do actively pick their own investments.
These funds are overseen by sharia scholars, who supervise and certify their activities.
Most sharia-compliant UK pension schemes are tied up in one of these funds, the HSBC Islamic Global Equity Index.
What are the standards?
There are various standard-setters in the Islamic finance space, with some slight differences in their methodologies for calculating sharia-compliance.
Chief among them is the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (Aaoifi).
Most agree that a business can be sharia-compliant if no more than 5% of their total income comes from haram sources.
But any profits from haram sources must be donated to charity, a process known as purification.
Scholars apply a formula on an annual, or sometimes quarterly, basis to calculate the impure portion of each company’s revenue. The funds either deduct this themselves and donate it to charity, or publish a breakdown of how much investors should purify.
Aaoifi also has financial screening criteria to decide if a company is sharia-compliant to invest in. Neither a company’s interest-bearing debt (the money it owes others and must pay interest on) or its interest-earning investments (such as those in conventional bonds or savings accounts) should exceed 30% of its current value, based on the amount all of its shares are worth.
There is, however, no regulator enforcing any of this. A 2022 report by TheCityUK, an industry-led body representing UK-based financial and related professional services, argued that in the UK, the government, regulators and other authorities “cannot opine on whether a particular Islamic finance activity or product is sharia-compliant or not because as secular institutions, they cannot take a view on religious standards”.
What’s the compromise?
These standards are actually “a compromise position”, Khan explained.
“Because if you’re allowed to have any level of interest-bearing debt in your companies, then that is actually a problem,” he added.
Under Islamic law, riba and other haram activities are “equally problematic”, he said.
This compromise position emerged in the early 2000s because Islamic scholars wanted Muslims to have access to sufficiently high-value markets to invest their money for long-term retirement and growth purposes, he explained.
So are Muslim investors profiting from ‘unethical’ business activities?
On Tuesday, Hyphen revealed that six major Islamic investment funds have shares worth more than a billion dollars in companies whose technology has reportedly helped Israel’s war effort in Gaza.
Currently, these funds are not screening out companies involved in activities that, whilst not explicitly haram, many Muslims might consider to be deeply unethical.
For instance, companies profiting from illegal Israeli settlements or selling cloud computing to the Israeli military can be deemed sharia-compliant under the Islamic finance standards vetting system.
These funds are not purifying dividend income in relation to such activities — so British Muslims could be unknowingly profiting from unethical activities.
Islamic savings accounts, however, don’t appear to be affected by this.
They tend to invest primarily in property-backed financing and sukuk. Savings accounts are generally structured to prioritise more stable returns, whereas investment funds can be more volatile but also potentially have higher returns.
Islamic finance expert Shaista Mukadam, a senior lecturer at Birmingham City University, called for the establishment of a regulator to ensure in-depth sharia-compliance checks are being carried out.
She said: “We need regulatory bodies in the Islamic finance space to make sure that all these organisations are going through one more check where people have the Islamic finance understanding as well as the accounting and finance understanding to try and check that the entire structure, the entire company, the entire system, is more sharia-compliant than it is at the moment.”
