Defining Islamic Finance

What is Islamic finance? Definitions range from the very narrow (interest-free banking) to the very broad (financial operations conducted by Muslims). A useful definition is the following: Islamic financial institutions are those that are based, in their objectives and operations, on Islamic law (the Shariah). They are thus set apart from “conventional” institutions, which have no such preoccupations. This definition goes beyond simply equating Islamic finance with “interest-free” banking. It allows operations that may or may not be interest-free, but are nonetheless imbued with certain Islamic principles to be taken into account: the avoidance of riba (in the broad sense of unjustified increase) and gharar (uncertainty, risk, speculation); the focus on halal (religiously permissible) activities; and more generally the quest for justice, and other ethical and religious goals. Two aspects of Islamic finance must be singled out. First, the risk-sharing philosophy: the lender must share in the borrower's risk. Since fixed, predetermined interest rates guarantee a return to the lender and fall disproportionately on the borrower, they are seen as exploitative, socially unproductive, and economically wasteful. The preferred mode of financing is profit-and-loss sharing (PLS). Second, the promotion of economic and social development through specific business practices and through zakat (almsgiving). Most, but not all, Islamic institutions have a Shariah board – a committee of religious advisors whose opinion is sought on the acceptability of new instruments, and who conduct a religious audit of the bank's activities – as well as other features reflecting their religious status. In sum, the defining difference is that while “conventional” finance usually seeks profit maximization within a given regulatory framework, Islamic finance is also guided by other, religiously-inspired, goals.