Unit
- Sharia as a legal framework: Sharia provides comprehensive guidance for Muslims, derived from the Quran and Sunnah. In finance, it establishes permissible (halal) activities and prohibits harmful practices such as interest (riba) and excessive uncertainty (gharar).
- Objectives of Sharia (Maqasid al-Sharia): The higher purposes include preservation of faith, life, intellect, lineage, and wealth. Islamic banking aligns with these objectives by promoting fairness, transparency, and social welfare.
- Sources of Sharia law: Primary sources are the Quran and the Sunnah (traditions of Prophet Muhammad). Secondary sources include ijma (consensus), qiyas (analogy), and ijtihad (independent reasoning) used by scholars to address new financial situations.
- Core prohibitions in Islamic finance: Riba (usury/interest), gharar (uncertainty/deception), maysir (gambling), and transactions involving haram goods (alcohol, pork, etc.) are strictly forbidden. All contracts must avoid these elements.
- Permissible contracts: Islamic finance uses asset-backed and risk-sharing contracts such as trade (murabaha), lease (ijarah), partnership (musharaka), and profit-sharing (mudaraba). These contracts have underlying tangible assets or services.
- Role of Sharia scholars: Each Islamic bank has a Sharia Supervisory Board (SSB) of qualified scholars who approve products, monitor compliance, and issue fatwas (legal opinions) to ensure operations remain Sharia-compliant.
- Application to modern banking: Islamic banks replicate conventional functions like deposit-taking, lending, and investment but restructure them to comply with Sharia. For example, instead of paying interest on deposits, banks offer profit-sharing on investment accounts.
- Global regulatory bodies: Organizations like the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) set standards for accounting, governance, and prudential regulation in Islamic banking.
- Asset backing requirement: Every Sharia compliant transaction must be linked to a tangible asset or service to avoid speculation and pure monetary exchange. This ensures that money serves as a medium of exchange rather than a commodity, reducing systemic risk and promoting real economic activity.
- Profit and loss sharing (PLS) principle: Islamic banks emphasize partnerships where both parties share profits according to pre agreed ratios and losses proportionally to capital contribution. This fosters mutual responsibility and discourages excessive debt. PLS arrangements are central to mudaraba and musharaka contracts.
- Ethical investment screening: Islamic banks apply filters to exclude investments in sectors like alcohol, gambling, tobacco, weapons, and conventional finance. They also avoid excessive leverage and interest bearing instruments. This screening aligns portfolios with Islamic values and often appeals to ethical investors beyond Muslim communities.
- Deposit products in Islamic banking: Current accounts use qard (interest free loan) where the bank guarantees the principal but may pay no returns. Savings and investment accounts operate on mudaraba profit sharing, where the bank acts as manager and depositors share in the bank’s profits from halal investments.
Regulatory Requirement
Regulation: AAOIFI Sharia Standard No. 1
All Islamic financial institutions must establish a Sharia Supervisory Board to ensure compliance with Sharia rules. The board must have at least three qualified scholars and issue annual compliance reports.
Quick Revision
- Sharia governs all aspects of Islamic finance, derived from Quran and Sunnah.
- Core prohibitions: riba, gharar, maysir, and haram goods.
- Permissible contracts are asset-backed and risk-sharing.
- Sharia Supervisory Boards ensure ongoing compliance.
- AAOIFI and IFSB provide global regulatory standards.