History of Islamic Finance

A Short History of Islamic Finance

For devout Muslims, financial transactions are a matter of balancing religious considerations with the demands of a modern economy. Sharia law prohibits riba(interest) and gahrar or  gharar (unequally shared risk), so many conventional Western financial processes are disallowed. However, today Muslims have a number of choices when it comes to Sharia compliant financing.

In the Middle Ages, Middle Eastern traders in the Ottoman Empire and elsewhere practiced financial transactions that were based on Sharia principles. However, it was not until the 1960s and 70s that scholars developed a uniquely Islamic economic philosophy that would address modern economic issues. This philosophy was committed to social justice, equitable distribution of wealth, and concern for the poor. It rejected both capitalism and socialism.

Modern Islamic Financing : The first Islamic bank was established in Egypt in 1964, but the first to be explicitly based on Sharia principles was created by the Organization of Islamic countries (OIC) in 1974. Islamic banks continued to proliferate throughout the 80s and 90s and today the Islamic finance market is growing at an average annual rate of 10 – 15% a year – and show no signs of slowing down. Sharia law provides an ethical framework for these financial institutions which emphasizes economic well-being and individual development as well as values such as fairness, honesty, and generosity. These Shariah compliant institutions also avoid interest, risk, and speculation.

Islamic financing institutions have developed numerous methods for establishing Shariah-compliant home purchasing and investment vehicles.

Ijara: The Ijara-wa-Iqutina (lease and ownership) Islamic home finance method establishes a rent-to-own agreement which turns the customer into a renter. The Ijarah process creates a Trust which purchases the property and leases it to the home’s inhabitants. When the customer is ready to move, the Trust must sell the home to the customer under the terms of a promise to purchase.

“The Ijara process has been used in the U.S. for more than 20 years,” explains Shoeb Sharieff, whose company, IjaraLoans.com, was the first to offer Shariah compliant financial solutions in all 50 states. “And Ijara loans conform with U.S. banking regulations and the Truth in Lending Act.”

Musharaka: In a Musharaka finance transaction, the bank or financial institution creates a joint venture partnership with the customer rather than establishing a creditor/debtor agreement. When used for Islamic home finance, a Musharaka is usually established between a customer and an investment company, which pays the majority of the home’s purchase price. The customer pays a monthly rent to the investment company and makes regular investments in the partnership to increase his or her equity in the house. A Musharaka transaction is Shariah compliant because it uses the funds that both the customer and the bank have rather than just depending on the bank’s resources.

Murabaha: Another Islamic mortgage variation is a Murabaha  in which the investment company purchases a home and sells it to the buyer at an increased cost to cover expenses incurred during the sale. The Murabaha finance vehicle is like an installment sale in which the buyer pays for the item over time in agreed-upon installments. Because the buyer is aware of this markup, the transaction is governed by an “honest declaration of cost” and thus it follows proper Islamic economic principles.