The Islamic financial system refers to the framework and practices of finance that are under Islamic law, known as Sharia. It is based on principles derived from the Quran and the teachings of Prophet Muhammad (PBUH). 

Islamic financial institutions offer a range of products and services that comply with these principles. Some common Islamic financial instruments include profit-sharing contracts (Mudarabah), cost-plus financing (Murabahah), leasing (Ijarah), partnership (Musharakah), and diminishing partnership (Mudarabahah).

The objective of the Islamic financial system is to promote ethical and equitable financial practices that align with Islamic principles, while also addressing the financial needs of individuals and businesses. It has gained global recognition and has a significant presence in various countries, providing an alternative financial system for those seeking Sharia-compliant financial solutions.

Sharia and its Role in the Islamic financial system

The Islamic financial system is based on the principles of Sharia, which is the moral and ethical code of conduct for Muslims. Sharia-compliant finance operates under Islamic law, which prohibits certain practices such as interest (riba), uncertainty (gharar), and investments in sectors considered unethical in Islam, such as alcohol, gambling, and pork.

In Islamic finance, transactions are structured to ensure fairness and shared risk between parties.

Islamic financial institutions also have supervisory boards or committees of scholars who ensure compliance with Sharia principles. They provide guidance and oversight to ensure that financial products and services adhere to Islamic ethical standards.

The key features of the Islamic financial system include

Prohibition of interest (riba): One of the fundamental principles of Islamic finance is the prohibition of interest-based transactions (riba). By eliminating interest, Islamic finance seeks to prevent the negative consequences associated with excessive debt and usury. 

This prohibition encourages responsible borrowing and lending practices, reducing the likelihood of financial crises and fostering economic stability. Islamic finance prohibits the charging or receiving of interest on loans or investments. Instead, it promotes profit-sharing and risk-sharing arrangements. 

Prohibition of uncertainty (gharar): Islamic finance discourages speculative transactions and contracts with excessive uncertainty or ambiguity.

Ethical investment principles: Islamic finance prohibits investments in sectors that are considered unethical in Islam, such as alcohol, gambling, tobacco, and pork. It promotes investments in sectors that contribute to the well-being of society, such as healthcare, education, and renewable energy.

Risk-sharing and asset backing: Islamic finance promotes risk-sharing between parties involved in financial transactions. It encourages tangible asset-backed transactions and discourages excessive financial speculation.

Instead of charging interest, Islamic financial institutions often enter into partnerships or profit-sharing arrangements (e.g., Mudarabah or Musharakah) with their clients. 

This encourages a fair distribution of risks and rewards, aligning the interests of lenders and borrowers. Risk-sharing fosters a more stable financial system and reduces the likelihood of economic imbalances.

Advantages of the Islamic financial system and Sharia

The Islamic financial system offers numerous benefits that stem from its principles and practices derived from Islamic law (Shariah). These benefits encompass economic, ethical, and social aspects, making Islamic finance an attractive alternative to conventional finance. 

Here are some key advantages:

Ethical and socially responsible: Islamic finance operates on principles that prohibit activities considered unethical in Islam, such as charging interest (usury) and engaging in speculation or gambling. This focus on ethical and socially responsible investments promotes economic stability and discourages exploitative practices.

Risk-sharing and fairness: Islamic finance emphasizes risk-sharing between lenders and borrowers, promoting fairness in financial transactions. Instead of charging interest, which can burden borrowers, Islamic financial institutions enter into partnerships or profit-sharing arrangements with their clients. This system ensures that both parties share in the risks and rewards of the investment.

Asset-backed financing: Islamic finance encourages and emphasizes the concept of asset-backed financing, meaning that financial transactions must be tied to tangible assets or economic activities. This approach ensures that investments are supported by real assets and contributes to more stable and sustainable economic growth. Asset-backed financing also discourages speculative behaviour and reduces the reliance on financial derivatives, which can lead to market volatility.

Stability and resilience: The prohibition of interest-based lending and excessive speculation in Islamic finance helps to reduce the likelihood of financial bubbles and economic crises. By promoting transparency, risk management, and real asset values, Islamic financial institutions aim to create a more stable and resilient financial system.

Inclusive and equitable: Islamic finance seeks to promote economic justice and inclusivity. It encourages the provision of financial services to all members of society, irrespective of their social or economic status. Islamic microfinance, for example, focuses on providing small loans to low-income individuals and entrepreneurs, enabling them to start or expand their businesses.

Long-term orientation: Islamic finance promotes a long-term orientation in investment decisions. It discourages short-term speculative behaviour and encourages sustainable economic development. This emphasis on stability and long-term planning can contribute to more sustainable economic growth.

Conclusion

The objective of Islamic finance is to promote economic and social justice while adhering to religious principles. It has gained significant attention and popularity worldwide, with Islamic financial institutions like Afiyah and many others operating in many countries and offering a wide range of products and services that comply with Sharia principles.