Understanding The Principles Of Islamic Finance And How They Differ From Conventional Finance

Shakira
Post : March 16, 2023

How did Islamic Finance become popular? Well, the keystone of the economic development of a country is the finance sector. In recent years, financial crises have become common due to several flaws in the traditional financial system. 

However, there's a rise in Islamic finance globally, which helps to reduce financial disasters. Due to its simple and just ways of dealing with finance, more and more people are seeking this option for their needs. 

Let us first understand what it is all about. 

Islamic finance is based on Islamic laws or Sharia. The primary sources are the Quran and the Sunnah of the Prophet Muhammed (PBUH). The context of Islamic finance strongly emphasises justice. 

The principles are simple and easy to understand. They are: 

  • All unlawful activities must be avoided.
  • Wealth must be generated justly.
  • Risks should be shared
  • Investments should have ethical and social benefits. 

There are certain prohibitions: 

  • Paying and receiving interest (riba). 
  • Uncertainty where extreme risk is involved. 
  • Dealing and investing in businesses such as alcohol, pork, gambling, or anything that is considered haram in Islamic sharia. 
  • It is prohibited to involve in matters where you are uncertain about the subject and the terms of the contract. 

Since it is clearly forbidden to pay and receive interest under Sharia law, Islamic financial services must earn in lawful ways. This may be done through a fee earned for the services provided by them or a profit share on the assets that are invested in the finance. 

The prime feature of Islamic Sharia concerning finance is that the lender must share in the risk when commercial loans are made. Otherwise, the amount received for the loan will be considered interest. 

How does it differ from Conventional finance?

Conventional finance is the traditional method used all over the world. It is a transaction solely based on the interest rate of the loan or borrower funds. 

Let us understand the difference between Islamic finance and Conventional finance. 

Comply with the rules of Sharia

Islamic finance must comply with the rules of Sharia while the conventional finance system does not have to. Conventional Finance charge interest (Riba) and may also involve Sharia-prohibited dealing such as gambling, alcohol etc there can also be uncertainty with a conventional finance system.

How risk is handled and shared?

The main difference between Islamic and Conventional finance is the way in which the risk is shared. 

Islamic finance applies the same technique as the conventional finance system but avoids unlawful aspects. To reduce the risks, they monitor the business that they help to fund. Islamic financial services confront distinctive risk management concerns. 

Profit and loss sharing

Finance provided by Islamic finance is based on the principle of profit and loss sharing. Under the sharia law, there are several types of contracts through which finance can be provided. 

The two primary types of Islamic finance (called Sukuk) are bank financing and the granting of Islamic securities. 

Most commonly these are referred to as debt-bond offers and bank loans but these do not apply to the proper Islamic finance methods. 

As interest is forbidden in Islam, the risk cannot be equally shared when a business is being financed by debt with a commitment to interest. Instead, cash is distributed on a profit-and-loss basis by Islamic finance. 

Under sharia law, finance can be provided through a range of transactions. All contracts clearly specify how risk should be shared between the loan provider and receiver. 

Differences in loan offerings

The most important role in Conventional finance is Interest. This is a distinct difference in both Islamic and Conventional finance. 

Conventional financial systems cannot operate without dealing with interest. Since Islamic finance does not deal in interest-based transactions, they are built on four main principles: no gambling, no speculating, no usury and ethical investing. 

Conventional services provide loans with a fixed percentage of interest rate as a return. Whereas Islamic financial services make money by profit and loss sharing, collecting fees for the services provided and trading. 

It allowed them to receive profit on the investments but not on loans provided. 

Social responsibility

Islamic finance plays a vital role when it comes to social responsibilities. The essence of Islamic economics is to achieve equality. 

Social responsibility means all actions performed by Islamic financial services fulfil ethical and religious responsibilities. 

They are also responsible to provide sharia-compliant services and committed to following the principles of Islam in all of their transactions and services they provide. 

Conclusion

When it comes to Islamic and Conventional finance, there are not many differences. The prominent aspects are vital for both systems to function respectively. This relates to interest, intention and risk. Both systems can be easily told apart by those key aspects. 

A good understanding between Islamic finance and the Conventional finance system will help you to make the right choice in life without having to dishonour your religious beliefs. This will make your life easier and better. And that’s mainly why you need to get in touch with Afiyah Financial Services

 

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