Islamic banking is also called partnership financing because it is based on the principle of partnership between the bank and its clients in sharing profits and losses. Islamic banking has the same objectives as traditional financial activities: to generate profit for the financial institution by borrowing capital in accordance with Islamic law. Since Islam prohibits conventional borrowing of money at interest, Islamic rules for transactions have been developed. The main principle of Islamic banking is based on risk sharing, which is a component of trading, rather than the transfer of risk involved in traditional banking. Affiliate products and services are available to everyone regardless of religion. Partnership finance is based on the following basic principles:
Compliance with ethical standards and social justice. For example, some types of activities and goods are prohibited (production and trade in alcohol, tobacco products; gambling and some others). Equal distribution of responsibility and risks. Relations between the parties in most types of transactions are built not on the basis of a “creditor-debtor” scheme, but on the basis of a partnership. If in traditional finance the lender receives remuneration regardless of the success of the borrower, then in partnership finance the partners jointly bear the risks of losses. All terms of contracts must be discussed in advance. Contracts with excessive risk and a high degree of uncertainty are prohibited, for example, traditional insurance and various derivative financial instruments (gharar).
Transactions must be made only in relation to real activities and assets. Because money is a medium of exchange and a measure of value rather than a real asset, in partnership finance it cannot be transacted on its own as in traditional finance. Therefore, usury and interest on loans (riba), as well as speculation and receiving income from random events (maysir) are prohibited. To receive income, you must either transact in a real asset or invest in a real economic activity and assume all associated risks.
Basic operations and transactions of the Islamic financial model:
Financial institutions are offering new banking or investment products for Muslims based on Shariah standards and AAOIFI, taking into account religious characteristics.
Musharakah (joint venture, profit and loss sharing)
Several investors combine their assets (cash, means of production, competencies) within the framework of one business project. The size of the share depends on the contribution of each individual participant to the financed project and its expenses, or by agreement, losses are proportionally distributed among all participants in the transaction.
Murabaha (analogous to a traditional loan, cost plus markup)
An alternative to a traditional loan: a trade agreement between a financial institution and a client, when the financial institution purchases a certain product for further resale and receives income in the form of a fixed amount — a markup that cannot be increased after signing the agreement.
Mudarabah (analogous to a traditional deposit, profit distribution)
Profit from a joint project is distributed between the financial institution and the client in accordance with the terms of the agreement — this is a tool of passive income instead of traditional deposits. In this case, only the client bears financial losses.
Qard-hasan (interest-free loan)
An individual or legal entity can receive a loan from a financial organization without interest, subject to timely repayment of the debt — for example, for the implementation of socially significant projects. The client himself determines the amount of remuneration for services, which is called hiba (gift) and is not obligatory.
Ijara (analogous to traditional leasing)
Property owned by a financial institution is transferred for temporary use to another person in exchange for rental payments instead of interest payments, as in traditional leasing. The leased property remains the property of the financial institution, but the client can buy it back under the preemptive right.
Sukuk (Islamic securities)
An analogue of traditional bonds, the yield on which usually depends on the performance of the issuer’s transaction/transactions.
Salam (Islamic futures, deferred delivery)
This is a sale in which the seller undertakes to deliver certain specified goods to the buyer in exchange for a price payable in full on the spot at the time of closing.
Istisna (a contract for the delivery of an asset in the future)
A contract for the purchase and sale of an asset that will be delivered at a future date in accordance with a specific request. Istisna is the second type of sale, when goods are sold before they are produced. It refers to an order to a manufacturer to produce a specific product for a customer. If a manufacturer undertakes to produce a product for a customer from his own material, an istisna transaction occurs. But for the legality of this transaction, it is necessary that the price be set by agreement of the parties, and the necessary qualities of the goods to be produced be fully discussed between them.