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What you need to know about Islamic Banking and Finance - Part 2Let us start this session by acknowledging the fact that some people usually get confused about the operations of Islamic finance and often conclude that it is just a dressed up conventional banking. Islamic finance is different from conventional structure in many respects. One of such differences lies in the fact that in Islamic banking, transaction is tied to a real asset. It invests its fund drawn from depositors in tangible assets and services; buys and leases out asset and of course invests in businesses. Thus, the adherence on real asset makes Islamic banking free of compound interest as obtainable in conventional loan system. This is because asset and services cannot be compounded. In essence, it is clear that Islamic banking employs the purchase and sale of real items, unlike its conventional counterpart, that indulges in borrowing and lending ephemeral things.
Apart from the fact that transactions in Islamic finance must be based on real asset, it is imperative to indicate that any sort of interest, speculation and gambling is not tolerated in business dealings including banking system. Specifically, Islamic finance prohibits any predetermined payment over and above the amount of principal; it prescribes that all activities undertaken by all the parties must be of value to them; it ensures that every contract possesses all its essential elements and that all the essential elements meet the necessary stipulated conditions; and finally, it maintains that investment or transactions should not be based on interest-based asset, manufacture or sale of forbidden products or objects such as tobacco, pork, alcoholic beverages, etc as well as non permissible entertainment activities like pornography, beauty pageant and the likes.
The profit or the return in Islamic banks is based on the actual investment account unlike in the convention where the interest is predetermined or fixed in advance. Islamic financial institutions charge profit on investment; this is accomplished by engaging or participating in a business with the customers or client through provision of the required asset. Consequently, if a client defaults whether wittingly or otherwise in a conventional system, he or she will be liable for additional interest for the extra period but a defaulter in Islamic system is not charged any additional payment unless where it is established that the default is intentional. However, any penalty charges that may be imposed on such defaulter will not be treated as an income accruable to the bank but will be channelled towards charity. Such penalty fees are usually meant to deter the customers from defaulting intentionally.
Although the principles of Shari'ah regulate that banks and financial institutions should be structured on an interest-free basis, it does not suggest that these institutions are charitable organizations. As a result, the investors share in the profits earned on investment or the customers get financed and the concerned financial institution earns its income legitimately from the stipulated proportion of the profit or mark up. So, it's actually a win-win situation.
Principally, banking products and instruments can be categorised into equity, trading, leasing and debt. While all of these products are adopted and applied in the conventional banking, Islamic finance only accepts and applies equity, trading and leasing. More so, Islamic finance prefers equity financing over debt financing that is, of course fundamentally, based on asset because profit and loss sharing are said by the Islamic jurists to be more consistent with the Maqasid Shariah (objective of Shariah). Thus, equity based financial instrument occupies superior status over debt based financial instruments even though the latter is widely adopted than the former.
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