The Evolution of Islamic Finance - Coursework Example

Islamic banking and finance for many Muslims are more than a system of mere commercial transactions. The central feature of the Islamic banking system is the prohibition in the Quran of the payment and receipt of riba or interest. A closely related principle of the Quran is the prohibition of speculation. Both of these prohibitions were extended and elaborated on by the Prophet Mohammad through Sunnah. The Quran, which is the Islamic holy book, and Sunnah which are the deeds, statements, and unspoken approvals of Mohammad, are the two main sources of Islamic law, commonly referred to as the shariah. Although riba in a broad sense means any unlawful advantage by way of excess or deferment, in the context of financial transactions it is commonly understood to mean any form of interest. In recent years, there has been an attempt on the part of Islamic laws scholars and Islamic Financial institutions to re-examine interest, or usury, rather than charging any interest. However, the debate now appears to be over, however, and the prohibition of riba continuous to be viewed as a prohibition of all interest.

The Islamic Financial system rejects the concept that a borrower is liable for the repayment of the funds borrowed and a predetermined return on those funds, regardless of the performance of the borrower’s business. Under the Islamic system, this rejection of interest is replaced with the concept that the lender assumes the risk of the borrower’s business and shares in the profits and losses of that business. Money is not considered to be capital on which a return may be obtained, but only “potential capital” requiring the services of an entrepreneur to put it to actual productive use. The lender who advances money for trade or production can only contract to receive a share of the profit because he is just a part-owner of the enterprise‘s capital and has to share in the risk of the enterprise. Put simply, the Islamic Financial system replaces debt financing with equity financing (Hayes 1998 p12).

All the traditional Islamic financial instruments derive their legitimacy and validity under Islamic law either because Mohammad himself adopted them or because they were in practice in his time and he either expressed his approval of them or he did not prohibit or make any changes in them.