Following all the various Islamic financial terms is no easy feat. Trying to balance them with western banking is even harder!
Fortunately, Crescent Wealth Supr is here to help with both. Use our simple guide and glossary of Islamic finance, banking and investment terms to help you navigate your way through.
What Is Islamic Finance?
Islamic finance is an all-encompassing term for many different principles. Overall, it’s a way of financing things that complies with Islamic, or Sharia, law. But it can also refer to the types of investments that are allowed under Sharia law.
Islamic banking and finance has been around for as long as the religion itself. This said, the formal Islamic finance as we know it today has only been around since the 20th century.
The main difference between Islamic finance and conventional finance is the practices and principles that guide them. Many of the investments and lending agreements conventional banking institutions allow are strictly prohibited in Islamic laws.
Principles of Islamic Finance
Islamic finance is based on two simple principles.
First, each transaction must be linked to a real underlying economic transaction. In other words, making money from money is not allowed.
The second principle revolves around the idea of profit and loss sharing. This means parties entering into an Islamic financial contract share both the risks and gains of the contract. No one party can benefit from the agreement more than the other.
There’s also a number of prohibitions under Islamic finance, all closely linked to these two core principles.
Paying or charging interest on lending is considered exploitative by Islam. It favours one party, the lender, over the other. Interest is usury, or riba, according to Sharia law.
It’s also forbidden to invest in businesses involved in activities Islam considers haram. For example, producing alcohol, manufacturing weapons or selling pork and so on. As these activities are forbidden, investing in them is similarly forbidden.
Sharia also forbids maisir, which is any form of speculation or gambling. What this means for finance is that Islamic finance may not involve contracts where ownership is dependent on uncertain events in the future.
The final prohibition, gharar, forbids contracts with excessive risk and uncertainty. In real terms, this is mostly related to things like short-selling and derivative contracts among others. Islamic law essentially sees these contracts as likely to be exploitative and therefore go against the two core principles of Islamic finance.
What these translate into for Islamic financial institutions today is different types of financing arrangements to comply with these principles and prohibitions.
Types of Islamic Financing Arrangements
There’s a variety of special financing arrangements that comply with Islam. Conventional banks don’t offer these in general. They include the following arrangements:
Mudarabah
Mudarabah refers to a profit and loss sharing partnership. This is an agreement where the financier, or rab-ul mal, provides the capital to the other partner, the mudarib. The latter partner is responsible for the management and investment of the funds.
The profits are shared between the parties on a pre-agreed ratio.
Musharakah
Musharakah refers to a joint venture. All parties involved contribute capital as well as share all profit and loss on a pro-rata basis. There’s a couple of different types of joint ventures, including:
- Diminishing partnership
- Permanent musharakah
A diminishing partnership is most often used to purchase properties. The investor and bank jointly purchase the property. The bank will gradually transfer its portion of the equity to the investor as they make payments over time.
Permanent musharakah has no specific endpoint. It often continues indefinitely operating provided all parties are happy to continue. It’s used to finance long-term projects.
Ijarah
Ijarah is a kind of leasing agreement. The owner of the property leases it to another in exchange for an agreed amount of payments. This agreement ends with the property being transferred to the paying party.
Investment Vehicles
The prohibitions and principles in Sharia mean many conventional investment vehicles are forbidden. Things like derivatives, bonds and options are all prohibited by Sharia. In Islamic finance, there are two main types of investment vehicles.
Equities
Sharia does allow investment into company shares, so equities are allowed. Private equity investments are similarly common. This said, the companies must not be involved in activities deemed haram by Islam, so for example gambling or alcohol companies would be forbidden.
Fixed-Income Instruments
Because conventional bonds are forbidden due to the interest payments involved, Islamic finance has its own kind. It’s known as Sukuk, or sharia-compliant bonds.
The difference between bonds and Sukuk is that the latter represent partial ownership of an asset. So unlike with conventional bonds, there’s no debt obligation.
Glossary of Islamic Finance, Banking and Investment Terms
Though we’ve gone over the main principles and key terms in Islamic finance, there are still plenty more terms you might come across. For your ease, we’ve put them into a simple alphabetical glossary with definitions below.
A – E
Al Ajr: A fee, wage or commission for services.
Amana/Amanah: This refers to reliability and trustworthiness being of important value in financial dealings. It may also refer to deposits held in a trust.
Al Wadia: Refers to the discounted re-selling of goods.
Al Rahn Al: This is an arrangement wherein an asset is used as collateral for a debt.
Al Wadiah: Safe-keeping.
Bai Muajjal: This is what’s known as a deferred payment contract and is similar to a Murabaha contract. The lender buys the goods on behalf of the other party and then sells the goods back to them at an agreed price. The other party can choose to pay a total balance or pay in installments.
Bai al Arboon: A sale agreement where a security deposit is provided as part payment towards the total price.
Bai al Dayn: A kind of debt financing that provides financial resources for commerce, services and production. It’s a short term agreement and may not last longer than a year.
Bai al Salam: An advanced payment for goods to be delivered at a later, fixed date. It’s most commonly used in the agricultural industry to secure goods.
Bai Bithaman Ajil: Similar to a murabaha contract, this refers to a contract where the sale of goods is on a deferred payment basis. The goods are bought by the lender, which subsequently sells the goods back to the payee. The bank is allowed to include a small mark up price for their service.
Baitul Mal: Treasury
F – L
Fatwah: A religious decree
Fiqh: Islamic jurisprudence. The understanding, implications, practice and science of Sharia.
Gharar: We touched on this earlier in the article, but it can be used in other contexts. It may refer to any uncertainty, risk, chance or hazard involved in financial matters.
Hawala: A mechanism for settling international accounts via book transfers
Haram: Unlawful
Ijarah wa lqtina: Similar to the Ijarah we mentioned above, this refers to a type of contract where the bank finances the leased goods on behalf of the client. The client agrees to purchase the leased goods at a later date.
Istisna: Means progressive financings. This refers to a contract where goods are acquired progressively, in accordance with the progress of work or a project.
It’s all a bit wordy, but a great example is the purchase of a house still to be constructed. In this type of contract, payments would be made to the builder at certain stages of build progression.
Ju’alal: A lawful price for performing any service. This is how Islamic financial institutions are allowed to put a small mark-up in their agreements as they’re providing a service.
M – Z
Mudaraba: Occasionally spelt modaraba instead, this is a type of trust financing we touched upon above, but we’ll delve into it a little more.
It refers to a business contract in which one party brings capital and the other labour. The profit share is pre-determined by mutual agreement.
However, the loss is only applicable to the lender of capital. Though, if there is a loss, the other party is not due any funds for their labour.
The financier is referred to as the ‘rab-al-maal’ and the labouring party as the mudarib.
Murabaha: Also occasionally morabaha or cost-plus financing. This is a contract of sale where the seller declares his costs and profit in order to gain financing. The bank looks at the profit over cost and agrees on a deferred financial repayment agreement based on this assessment.
Qard Hasan: This refers to interest-free loans. Most Islamic banks provide interest-free loans to their customers, particularly for the most in need.
Sadaqah: Charitable giving
Takaful: Islamic insurance based on the principle of Ta’awon, mutual assistance. This insurance provides mutual protection of all assets or property and joint risk sharing in the event of a loss.
Crescent Wealth Can Help
We hope you found our guide and glossary of Islamic finance, banking and investment terms helpful. But if you have any questions or need any advice, Crescent Wealth Super is here to help you every step of the way. get in touch.
