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How does Islamic finance work?

https://www.quora.com/profile/Said-Bourrich

I’ll explain using a scenario to make things simpler:

My friend James wants to start a soda company named J-Cola and needs a loan. Fortunately I have $100,000 to spare and agree to lend it to him at 6% monthly interest.

But then catastrophe strikes.

Apparently J-Cola had a bitter taste that didn’t do well with customers so it went bankrupt its first year. Yet I still demand payment on my loan including the interest. James cannot repay me as he is now unemployed and his company is losing money.

So I take him to court to shake some money out of him.

This is a sin in Islam.

  • It is not permitted to charge interest in Islam, the Quran itself explicitly forbids this.
  • Furthermore I cannot demand payment on the loan when the commercial venture is a failure in Islam. According to Islam, risk must be shared by both of us in the form of equity. So the act of lending money itself can be sinful in many circumstances.
  • According to Islam, I cannot exploit James who is a fellow human who just wants to improve his life through commerce. It would be cruel and sinful to force him into poverty for mere colored paper that has some numbers on it.

    Reader: Ok Said, but how does Islamic finance work then?

    Let’s return to the scenario but this time use Islamic finance.

    James proposes I lend him money for his soda company named J-Cola. I must ask myself:

    • “Is Soda halal (permitted) in Islam?”

       

      If it is, then I can participate. Furthermore, I cannot lend him money as that is exploitative. Instead I explain Islamic finance to James who likes the idea and agrees to go along with it. So I buy J-Cola and sell it to James bit by bit.

      Instead of lending the $100,000 for the machines and modifications to James’ empty shed (our factory). I buy the machines and pay for the modifications directly.

      In other words, I own 100% of J-Cola and sign an Islamic/sharia-compliant agreement stating that we share profits (since it is James’ idea and he is CEO) and I sell parts of the company whenever James asks.

      In 2018, J-Cola earns $100,000 in profit. According to our sharia contract, James gets 85% of the profit and I get 15%.

      James decides to use his $85,000 profits to then buy 30% of J-Cola from me. This goes on until 2022 when James owns all of J-Cola.

      However if J-Cola fails in 2018 and actually goes bankrupt, then the sharia-compliant agreement states I cannot pursue James. We worked as partners, I provided the money and he provided his competence and time.

      So I lose money but James lost a year of his life (since he spent the year as J-Cola’s CEO). My $100,000 can be replaced but James will never get to relive 2018.

      That is the profit/loss sharing model of Islamic finance.

      Some Muslims have become accustomed to the Western way of doing things so there is another model known as Ijaarah which is just leasing. But that’s a whole other thing.

      Source:

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We need to know this because....???

I do know that Muslims do not generally charge tax on fellow Muslims. It is forbidden by Islamic laws/practice.

I read someplace where when the Muslims conquered India they charged a tax on Hindus, but not on fellow Muslims.

Muslims are not supposed to charge interest on fellow Muslims.

Perhaps Chief can confirm this... 

V

Explainer: how does Islamic finance work?

 

At the World Islamic Economic Forum in London, David Cameron has announced the UK is to become the first non-Muslim country to issue Shariah-compliant bonds and that a special Islamic index will be created on the London Stock Exchange. These moves represent a recognition of Islamic finance’s unique model, and of the important role it has to play in providing stable economic growth.

To understand why the UK is so keen to promote this investment, it is worth understanding exactly what sets Islamic finance apart from western models of banking and finance.

The relatively nascent Islamic finance industry finds itself sitting at the cusp of great opportunities but also confronted with major challenges. In the past few years, it has made great advances. Since 2006, the asset base has grown by 150% and is forecast to reach US$1.8 trillion this year. Given the stability Islamic banks offer, and the strict constraints under which they function, this is a tremendous achievement.

More importantly, this growth is accompanied by a promise of far greater stability than the conventional financial sector provides. This is because of the stringent conditions that Islamic products come with.

Strings attached

To begin with, in Islamic finance, one must work for profits, and simply lending money to someone who needs it does not count as work. Under Islamic law, money must not be allowed to create more money. Instead, a bank must provide some service to “earn” its profits.

Thus, instead of traditional accounts with given interest rates, Islamic banks provide accounts which offer profit/loss. The bank in turn purchases assets with your money, which generate returns for the bank. In particular, charging high interest rates to someone in need is considered unscrupulous, leaving no space for business models like Wonga.com’s.

Second, high degrees of uncertainty or gharar are not allowed. All possible risks must be identified to investors, and all relevant information disclosed. Islamic finance prohibits the selling of something one does not own, since that introduces the risk of its unavailability later on.

This rules out investments in conventional derivatives, which require speculation about the future subject to excessive risks. This is also the key reason why Islamic banks survived 2007 unscathed (caveat: while no exposure to derivatives saved them initially, weak risk controls meant that they were left exposed to declines in real asset prices as the real economy went into recession).

Third, Islamic finance requires you only invest in ethical causes or projects. Anything unethical or socially irresponsible, from weapons to gambling or adult entertainment cannot be invested in. This produces a very strong alignment between Islamic investments and socially responsible funds.

With their emphasis on equity and investment in the real economy, the principles of Islamic finance provide a stable and productive banking sector. Rather than providing a lucrative financial alternative to investing in the real economy, Islamic banking complements and strengthens the latter. It ensures that financial capital does not lead to artificially bloated asset prices. Instead, it is made to work in the real economy, on real projects.

Higher costs

But Islamic institutions pay for this responsible version of banking through incurring higher costs. For this reason, these banks have been confined to the Middle East and a few other Muslim countries for a long time. At home, they have usually been subsidised by indulgent states committed to Islamic banking.

International growth has also been limited due to the absence of well developed regulatory regimes abroad that are capable of understanding and monitoring Islamic transactions including ordinary accounts, mortgages, bonds and insurance.

However, with its expanding product range, rapid growth, and generally increased maturity, it has been drawing increasing interest from leading financial markets. On top of it is the desire to tap into the massive liquidity these institutions offer. This of course is a key reason for the UK government’s announcement that it will be issuing Shariah-compliant bonds (apart from London’s desire to cement its position as a leading financial market).

This has long been a demand of Islamic banks - to enter a market they need some AAA assets to invest in and such bonds will offer exactly that.

We are now likely to see more steps being taken by other markets to accommodate Islamic banking. These will remove some of the quirks that raise costs for Islamic products (for instance, Islamic mortgages that may be taxed twice because of double buying and selling of houses) and facilitate further expansion.

Global competition

Expansion to the world’s major financial markets pits Islamic banks against much bigger and established players, but the greater size also enables them to standardise products and bring costs down to a level where they can compete head on with conventional banks.

But decades of functioning in well cushioned home markets means Islamic banks have become more relaxed and inefficient than their conventional rivals who operate in a more competitive environment. The coming five years will thus be extremely interesting.

Islamic banks will be making their way into new markets where regulators are increasingly open to accommodating this financial model. In doing so, they will attract many customers from conventional banks. But in order to retain them and make the most of this opportunity Islamic banks will need to develop far more robust risk management protocols than what they currently boast. They will also need to invest heavily in reorganisation and raise the level of human resource they depend on right now.

Naturally, some of them will be able to do all this better than others. But regardless of who wins these battles, their arrival on these shores can only be good for existing financial markets.


 

Here is another article.

Django
Last edited by Django

That wonga.com has a 200 percent interest repayment.  That is a good legal racket. It is better to borrow from the Italian mob. They have lower interest rate.

Prashad
Last edited by Prashad
Prashad posted:

That wonga.com has a 200 percent interest repayment.  That is a good legal racket. It is better to borrow from the Italian mob. They have lower interest rate.

That would be illegal. Anyway, you are way out on the left field with your comment.

it is worth understanding exactly what sets Islamic finance apart from western models of banking and finance. No?

Mitwah
Chief posted:

Vish,

Muslims are not supposed to charge interest period!

In Islam it is a great blessing to write off monies the are owed to you if the person cannot repay.

Hey Chief, I am going to convert to Islam. You being a staunch and devout Muslim, I need to borrow $100,000 to start madrasas. Not sure here in middle America it will prosper. What do you think?

FM
Mitwah posted:
Prashad posted:

That wonga.com has a 200 percent interest repayment.  That is a good legal racket. It is better to borrow from the Italian mob. They have lower interest rate.

That would be illegal. Anyway, you are way out on the left field with your comment.

it is worth understanding exactly what sets Islamic finance apart from western models of banking and finance. No?

Wonga.com rates are on their website.  Do your homework before attacking me.

 

Wonga.com

6 monthly repayments you control

Borrow£200-£600
Term6 months
Daily interest0.75%
 
Borrow£600 over 6 months
Interest rate274% pa (fixed)
Representative1,086% APR
Total amount payable£1138.29
Five repayments of£189.72
One final repayment of£189.69

 

At least the Italian mob only charges you 100% interest rate. You got a better deal borrowing from the loan shark.

Prashad
Last edited by Prashad

Prashad, that's illegal here in Canada. It's Usury.  Anyway this thread is about Islamic Loans . Go start your own thread glorifying your loan sharks and don't try to derail a thread that I started. 

Mitwah

Mitwah that is what I am saying.  You should attend your local Mosque and sign up for Islamic banking or you will have to borrow from Wonga to pay for your toilet cleaning supplies when you back up Moses in Granger's toilet.

Prashad
Prashad posted:

Mitwah that is what I am saying.  You should attend your local Mosque and sign up for Islamic banking or you will have to borrow from Wonga to pay for your toilet cleaning supplies when you back up Moses in Granger's toilet.

Bhai, have you ever heard about OPM. When was the last time you too a vacation?

Mitwah

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