The contribution of the Muslim world to a new international economic order is based upon a renewed application of Islamic law, the Shariah, in modern economic and financial transactions.
These measures in the finance sectors must be seen as an integral part of an attempt to develop the Islamic ideal of society and economy, based on the Islamic principles of social justice and humanity.
The Islamic banking approach implies - beyond religious implications - a conceptually different relationship between finance and economic activity.
The lender-borrower link is replaced by equity risk-sharing between a capital provider and an enterpreneur.
The main consequence of this different approach of Islamic economics is the prohibition of paying or charging interest.
The elimination of interest from the economic system is meant to "promote economically just, socially fair, and ethically correct dealings according to Islamic principles, foster the solidarity and cohesion of the Muslim ummah, harmonise trade, create powerful economic incentives, and bring about cooperation and co-participation in all walks of life."
Besides the key principle of the prohibition of interest, a second major Quranic precept, related to money, is the prohibition of the practice of hoarding.
One should put money to productive use for oneself and the community.
The solutions proposed are the sharing of profit and an emphasis on the value of labour as opposed to capital as the source of income.
Behind these principles and precepts lie the full philosophy of Islam and its specific value system. It intends to establish an equitable relationship between the rights of the individual and society by establishing harmony through eliminating conflicting interests.
The economic rationale for eliminating interest is based on values of justice, efficiency, stability and growth.
On the subject of stability, the argument is put forward that an interest-based economy has a built-in tendency toward inflation, because the creation of money is not related to productive investments, either at the level of the central banks or at the level of commercial banks.
To appreciate the implications of Shariah upon economic and financial transactions, the major institutions of Islamic law related to these
sectors have to be analysed. Like any other developing system, the Islamic system also has a certain flexibility, making possible its adaption to new socio-economic situations and requirements.
In the capital structure, Islamic banks rely mainly on their shareholders and depositors, who are primarily individuals. Within the banking community, Islamic institutions are rather small, because of their shareholder structure being made up of the general private public of the host country.
While Islamic commercial banks operate on the national basis, Islamic investment and holding companies may have either a national or an international mandate.
The interdiction of taking or charging interest affects all activities of Islamic finance institutions as regards both the utilisation of funds. It is worthwhile to note that there exist different interpretations on how to apply the term 'riba' (interest) in today's economic and financial transactions. The 'modernists' are aiming for a new interpretation of Islam in general, and support an interpretation by the spirit of the law and not by the letter. Thus it is contended that the Quran has prohibited usury and not legitimate interest. The majority of Islamic economists maintain, however, that interest is also prohibited for productive credits the term 'riba' meaning increase and that therefore all repayments above the original loan amount are illicit. The Islamic banks in operation today follow this latter line of thought in their activities.
The concept of equitable risk-sharing between capital provider and enterpreneur is central to Islamic banking activities. Given these basic considerations of interest-free finance and equitable risk sharing, Islamic finance institutions may engage in the following activities for their customers:
(a) Participation Financing (Musharaka)
The bank provides part of the equity and working capital requirement of a project, and shares with the entrepreneur any profits or losses. Profits are shared according to a pre-agreed ratio. Losses, however, are borne in proportion to the capital contribution.
(b) Trust Financing (Mudaraba)
The bank provides all capital required. The client provides the management skill for a given project, again on a predetermined profit-sharing basis. Losses, in this case, are borne by the bank alone, the client losing the value of his or her work.
(c) Cost-Plus-Trade Financing (Murabaha)
The financial institution purchases raw materials, goods, or equipment at cost and sells them to the client on a cost-plus-negotiated profit margin.
(d) Rental Financing (Ijar)
The bank acquires equipment or buildings and makes them available to the client on a straight forward rental basis.
(e) Lease-Purchase Financing (Ijar we Iktina)
The arrangement is similar to the above except that the client has the option of acquiring ownership of the rented equipment or building by paying instalments into a saving account. The re-investment of this accumulated capital works in favour of the client, allowing him or her to offset rental cost.
Islamic finance institutions can also provide interest-free loans for projects. Furthermore, the various activities mentioned above can be combined in various forms to meet the finance requirements of modern economics.