In the field of finance, some of the most popular concepts that have been around for many centuries revolve around the so-called “time value of money.” For those unfamiliar, this is the notion that one dollar today is more valuable than one dollar tomorrow. Why? Because the person who has that dollar today can invest it and realize a rate of return. So, by the time tomorrow arrives, that will now be more than a dollar.
Well, this is why investors who borrow funds always have to pay interest on their loans. After all, the lender who gives them the money could have invested it elsewhere to make some passive income on it. So, it seems pretty normal to have to pay a certain portion of interest when receiving a loan from a third party. Unless one looks at the timeless concepts that come with Islamic finance.
Where Finance and Religion Intersect
Islamic finance is a theory derived at the crossing between religion and some of the common financial principles. It is important to note, however, that the religion won the battle by a large margin as most strategies in Islamic finance favour religious tendencies of those who identify with this faith. To better understand this notion, consider how the previously described idea of the “time value of money” is addressed here.
Although most people in Western society would consider it reasonable to have to pay a certain level of interest on a loan, Islamic finance condemns it. The basis for this stance on the issue is the fact that money is viewed as nothing more than a medium of exchange. Thus, being able to make new money on the existing money is counterintuitive to the teachings that come from Sharia. So, most people who are proponents of Islamic finance will completely disallow interest on either side of the equation. Thus, lenders will not be able to charge their borrowers more money just because they are allowing them to use their medium of exchange.
Profit and Loss Sharing
The next crucial concept to this ideology revolves around profit and loss sharing. Fortunately, most people are fairly familiar with these ideas as there are business models where profit and loss sharing are very common. What is meant by it in Islamic finance, however, is that there should be no absent investors who get to deposit their money into a venture and wait to make more money with minimum effort. Instead, they should all be treated as active partners of that business and lose money whenever the business itself loses money. Of course, the same applies to the vice-versa scenario when the business starts making money and becomes profitable.
Another common practice in Islamic finance relates to profits that financial intermediaries make on asset purchases and sales. For instance, when a financial corporation buys something with the intention of reselling it, they will have to increase its selling price as well as implement interest and penalties for those who decide to get a loan to make the purchase.
Well, given that Sharia disallows interest, Islamic finance operates by relying on the concept of “mark-up” profits. Meaning, they determine what their purchase price for an asset was and add the mark-up to that asset in the amount of the profit that they would like to keep. Then, the original price and the mark-up combined to give the new selling price. The importance of this concept must be stressed because it permits those who use this particular style to still realize returns without having to do it through interest or any time-based monetary return.
Effects of Implementation in North America
Islamic finance has already found its way to the United Kingdom. Its arrival to this side of the world and the continent of North America, however, has been delayed. The reason why is that the countries in this region have financial systems that have been in place for centuries and typically operate counter to the principles of Islamic finance. Thus, making radical changes to them is not going to be easy and could take a long time. Nevertheless, implementing Islamic finance would definitely help the society as there would be no interest expenses for the demand side of the market while the supply side still gets to realize returns through strategies like mark-up profits.
Mohamad M. Sawwaf is the Chief Executive and Co-Founder of Manzil