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Islamic finance – A Creation of the Modern Era

In the early 20th century, in response to the arrival of western, interest-based banking into Muslim countries, Islamic scholars sought to explore and develop alternative models where money is used in a productive manner and the rewards of wealth are derived from profit-and-loss sharing arrangements that imply risk-sharing. With the first Islamic finance-based institutions emerging in the 1960’s the sector has developed at a substantial rate with each passing decade seeing more and more sophistication and broadening of its market.

Today, the main Islamic finance and products and instruments, such as banking, sukuk, funds and takaful, set out to achieve the same business goals as conventional financial products and instruments, but within the constraints of Islamic rulings


Islamic finance is a financial system that operates according to Islamic law (which is called Shariah) and is, therefore, Shariah-compliant. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts. 

Islamic economics is based on core concepts of balance, which help ensure that the motives and objectives driving the Islamic finance industry are beneficial to society. This involves promoting justice and prohibiting certain activities. 

Based on the core concepts of Islamic economics, Islamic finance institutions adhere to certain principles that distinguish them from conventional finance. These are: 

  • Prohibiting interest (riba) 
  • Steering clear of uncertainty-based transactions (gharar) 
  • Avoiding gambling (maysir or qimar) 
  • Avoiding investment in prohibited industries 


The core responsibility of guiding and supervising institutions offering Islamic financial products rests with respectable Shariah Scholars typically appointed as the Shariah Advisors and members of Shariah Boards of individual institutions. 

Islamic Banking

The main categories within Islamic finance are:  

  • Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period
  • Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract
  • Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit
  • Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis
  • Musharaka is an investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested. 
Islamic Capital Market

The Islamic capital market is an integral part of the Islamic financial system. It enables the efficient mobilisation of resources and an optimal allocation thereof, thereby complementing the financial intermediary role of Islamic institutions in the investment process. Although this market functions similarly to the conventional capital market, any financial arrangement it facilitates has to be in line with the Shari’ah principles. The instruments below offer alternatives to conventional instruments. 

  • Islamic equity funds offer transparency in relation to industries and companies invested in; incorporate financial screening to ensure Shariah compliance; seek a diversified portfolio to reduce risk and the liquidity to allow investors wants or needs to cash out
  • Islamic bonds (Sukuk) provide undivided shares in the ownership of tangible assets relating to particular projects or special investment activity whereby investors are entitled to a share in the revenues generated by the Sukuk assets
  • Islamic funds screen out: investments in conventional financial services or debt instruments which make financial returns by earning interests or excess; investments in businesses that involve activities/products which are forbidden by the Shariah principles; and engaging in transactions involving speculations which are seen as being akin to gambling
  • Islamic real estate investment trusts (iREITsinvests primarily in incomeproducing, Shari’ahcompliant real estate and/or single purpose companies whose principal assets comprise Shari’ah compliant real estate allowing a portion of iREIT funds to be invested in other Sharia’h compliant asset classes 
Islamic Insurance (Takaful)

Takaful is a type of Islamic insurance, where members contribute money into a pooling system in order to guarantee each other against loss or damage. Takaful-branded insurance is based on Sharia, Islamic religious law, and explains how it is the responsibility of individuals to cooperate and protect each other.  

Wakala Model
In a wakala-based takaful product, the takaful operator works as an agent on behalf of the takaful participants, who are called the principals. The takaful operator manages the fund and receives a pre-agreed percentage of the participants’ fund or fixed fee; this management fee is called a wakala fee. In addition, the takaful operator may charge a performance-based fee, which is its incentive to manage the fund as well as possible. The takaful operator determines what fee(s) to charge after consulting with the sharia board. Any fees it collects are placed in the shareholders fund and are used to reward the shareholders as well. Note that any surplus that the takaful fund or the sharia-compliant investments generate goes back to the participant contributions. 

Mudaraba Model
Mudaraba is an Islamic contract based on a financial partnership in which one party (an investor) gives money to another (a fund manager) for the purpose of investing it in a business or economic activity. When a takaful product is based on Mudaraba the shareholders of the takaful company (mudarib) share the profit of the fund with the policyholders (rab al mal). The takaful company is not liable for any loss as the participants’ fund bears the loss. The takaful company receives a percentage of the fund’s surplus (if one exists) and a percentage of any profit from investments made by the fund. 

Combination Principal-agent relationship and partnership
This is the most widely used model in the takaful industry and it is typically structured using the wakala contract with the takaful company acting as the agent for the fund management and receiving a fee for underwriting the fund alongside a mudaraba contract where the takaful company acts as the fund manager for managing investments and shares the profit for the investment of the takaful fund. 

The company does not receive any portion of a surplus in the participants fund in the combination takaful structure.