The Ethical Foundations of Islamic Finance

Over the past decade, the Islamic finance industry has experienced a rapid annual growth rate of 10–12percent. Sharia-compliant financial assets are currently estimated at $2 trillion, including both Islamicbanking and non-banking institutions, Islamic capital markets, Islamic money markets, and Islamicinsurance, also known as takaful. Islamic finance is an emerging sector that is equity-based, asset-backed, ethical, sustainable, and promotes risk sharing and socio-economic justice.

One of the essential elements of the Islamic financial system is its rejection of interest, also known asusury or riba. This principle stems from the Quranic prohibition of usury; a principle shared by allAbrahamic faiths. While Judaism and Christianity have different interpretations regarding theprohibition of usury, Islamic law has preserved its traditional stance on the subject. This prohibition hasbeen integrated into the economic lifestyle of Muslims who choose to abide by the legal injunctions oftheir faith.

The basis for Islamic finance are the principles laid out by Islamic commercial jurisprudence, derivedfrom the Quran through the legal reasoning of modern Sharia scholars. Although the principles arederived from religious texts and the interpretations of religious scholars, the underlying ideals are notexclusive to the faithful. These are common ethical ideals shared throughout human history.

The prohibition of interest, according to Sharia scholars, is based on their interpretation that money wascreated as a medium of exchange and therefore does not have a value in and of itself. Charging interest,they conclude, allows one to create money simply by having money, treating currency as a commodity,which they believe it is not. Islam encourages human effort and risk taking when it comes to reaping thebenefits of a transaction. Lending money on interest, and profiting from it, flies in the face of that risk. Intraditional models of financing, the lender transfers the risk to the borrower, thereby “costing” or“earning” nothing.

In traditional non-Islamic financing, if the borrower incurs a loss, the lender would still profit from the transaction. This is considered a financial injustice and an unethical practice according to not only Islamic legal jurisprudence but also secular proponents of a more progressive financial system. Trading is praised in Islamic law; in order to make a profit, an Islamic financial institution should obtain ownership in the asset that they finance in order to earn a share of the profit. The lender must participate in thesharing of risk so that there is fairness in earning the returns.

Gharar, in Islamic finance, refers to deliberate ambiguity or deception (e.g., short selling, gambling,obfuscated contract terms). Avoidance of gharar is another critical ethical concept in the Islamicfinancial system. Scholars argue that gharar-based transactions, occur when one party benefits from theloss of others under the conditions of uncertainty. Many scholars argue that gambling represents themost extreme form of gharar.

Asset classes are groups of securities that exhibit similar characteristics, behave similarly in themarketplace, and are subject to the same laws and regulations. Islamic asset management institutions divide their asset classes in accordance with the prohibitions so that investors can align theirinvestments to their values. Many short-selling transactions are widely considered impermissible underthe Islamic financial system, when they involve selling an asset that is not owned by the seller.

The Islamic financial system prohibits the trading of products and services that are considered harmfulfor a society’s well-being. The Islamic financial system promotes economic and social justice, and thewell-being of individuals in a collective society; the basis of Islamic finance is an ethical foundation thatis shared across cultures and borders.