What are the differences between Islamic and conventional finance?
The main difference between conventional finance and Islamic finance is that some of the practices and principles that are used in the conventional finance are strictly prohibited under Sharia laws.
Principles of Islamic Finance
Islamic finance strictly complies with Sharia law. Contemporary Islamic finance is based on a number of prohibitions that are not always illegal in the countries where Islamic financial institutions are operating:
These differences are:
1. Paying or charging an interest
Islam considers lending with interest payments as an exploitative practice that favors the lender at the expense of the borrower. According to Sharia law, interest is usury (riba), which is strictly prohibited.
2. Investing in businesses involved in prohibited activities
Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The activities are considered haram or forbidden. Therefore, investing in such activities is likewise forbidden.
3. Speculation (maisir)
Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Thus, Islamic financial institutions cannot be involved in contracts where the ownership of good depends on an uncertain event in the future.
4. Uncertainty and risk (gharar)
The rules of Islamic finance ban participation in contracts with the excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertain in nature investments. Gharar is observed with derivative contracts and short-selling, which are forbidden in Islamic finance.
In addition to the above prohibitions, Islamic finance is based on two other crucial principles:
⦁ Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.
⦁ Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the other party.