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Elements of Shariah Banking

Islamic banking is an ethical and equitable mode of financial services that derives its principles from the Shariah (Islamic law). The Shariah is based on the Quran and the sunnah of the Prophet Muhammad (Peace be upon him), and it governs all aspects of personal and collective life. The most distinctive element of Shariah banking is the prohibition of interest, whether "nominal" or "excessive," simple or compound, fixed or floating. Other elements include the emphasis on equitable contracts, the linking of finance to productivity, the desirability of profit sharing, and the prohibition of gambling and certain types of uncertainty. These parameters define the nature and scope of Islamic banking, as interpreted by the Shariah scholars that work with Islamic financial institutions.

Equity Instruments

Islamic law states an explicit preference for equity financing over debt financing. The classical forms of equity financing (Musharakah and Mudarabah) require partnership and profit sharing, to which the contemporary devices of venture capital, investment management and project financing can be compared. In financial markets, investing in stocks and equity funds is permitted but must conform to certain guidelines.
Not unlike ethical or socially responsible investing, undesirable companies and industries are screened out on the basis of both qualitative criteria (nature of business) and quantitative criteria (level of involvement with interest). Islamic investment also discourages speculation and prohibits short selling, conventional debt instruments and conventional derivatives. These views go back to the prohibition of interest, gambling and certain types of uncertainty in Islamic law.

Debt Instruments

Conventional debt financing is ruled out in Islamic banking because of the prohibition of interest. Asset-backed debt financing can be designed, however, on the basis of sale (Murabahah) or leasing (Ijarah) contracts that provide fixed income alternatives to conventional debt financing. The capital provider must have ownership of the asset, however (even if briefly), and bear the risk that comes with that ownership. Recently, cash financing (Tawarruq) has also been introduced by reversing the concept of Murabahah.