The Concept

The most distinctive element of Islamic banking is the prohibition of interest, whether "nominal" or "excessive," simple or compound, fixed or floating. Other elements include the emphasis on equitable contracts, the linking of finance to productivity, the desirability of profit sharing, and the prohibition of gambling and certain types of uncertainty. These parameters define the nature and scope of Islamic banking, as interpreted by the Shariah scholars that work with Islamic financial institutions.

Equity Instruments

Islamic law states an explicit preference for equity financing over debt financing. The classical forms of equity financing (musharaka and mudaraba) require partnership and profit sharing, to which the contemporary devices of venture capital, investment management and project financing can be compared.

In financial markets, investing in stocks and equity funds is permitted but must conform to certain guidelines. Not unlike ethical or socially responsible investing, undesirable companies and industries are screened out on the basis of both qualitative criteria (nature of business) and quantitative criteria (level of involvement with interest). Islamic investment also discourages speculation and precludes short selling, conventional debt instruments and conventional derivatives. These views go back to the prohibition of interest, gambling and certain types of uncertainty in Islamic law.

Debt Instruments

Conventional debt financing is ruled out in Islamic banking because of the prohibition of interest. Asset-backed debt financing can be designed, however, on the basis of sale (murabaha) or leasing (ijara) contracts that provide fixed income alternatives to conventional debt financing. The capital provider must have ownership of the asset, however (even if briefly), and bear the risk that comes with that ownership. Recently, cash financing (tawarruq) has also been introduced by reversing the concept of murabaha.