What Is Sharia law?
Sharia law, within the context of finance, refers to the moral and ethical principles derived from Islamic religious texts and traditions that govern financial transactions and activities. It forms the foundational Financial Law for Islamic finance, guiding everything from banking and insurance to investment. Adherence to Sharia law in financial dealings ensures that activities align with Islamic tenets, emphasizing justice, fairness, and social responsibility. Key prohibitions under Sharia law include charging or paying interest (Riba), excessive uncertainty (Gharar), and gambling (Maysir). Instead, Sharia law promotes profit and loss sharing and requires transactions to be backed by tangible assets, linking finance to the real economy.
History and Origin
The principles of Sharia law governing economic and financial conduct trace back to the early days of Islam, rooted in the Quran and the teachings of the Prophet Muhammad. For centuries, these principles naturally influenced commercial activities in Muslim-majority lands. However, the formal establishment of modern Islamic finance, seeking to create contemporary financial institutions and products fully compliant with Sharia law, began in the mid-20th century. Pioneering experiments with interest-free banking emerged in Egypt in the early 1960s, notably with the Mit-Ghamr Islamic Saving Associations. Formally, Islamic banking started to gain traction in the late 1970s with the establishment of the first major Islamic commercial bank, the Dubai Islamic Bank, in the United Arab Emirates in 1975, followed by similar institutions. This period marked a significant movement to institutionalize Sharia law principles within the financial sector globally.7
Key Takeaways
- Sharia law prohibits interest (Riba), excessive uncertainty (Gharar), gambling (Maysir), and investments in industries deemed unethical or harmful (e.g., alcohol, pork, conventional arms).
- It emphasizes justice, fairness, risk-sharing, and asset-backed transactions.
- Financial contracts under Sharia law must have a real economic purpose, connecting financial activity to the underlying economy.
- Compliance is overseen by Sharia supervisory boards or scholars within Islamic financial institutions.
- Sharia law aims to foster financial inclusion, social welfare, and ethical investment.
Interpreting Sharia law
Interpreting Sharia law in the complex landscape of modern finance requires deep expertise in both Islamic jurisprudence and contemporary financial instruments. Financial transactions and products are structured to avoid prohibited elements while fulfilling the objectives of Sharia, such as promoting equitable wealth distribution and preventing exploitation. For instance, instead of conventional loans with interest, Sharia-compliant financing might utilize concepts like Murabaha (cost-plus financing), Ijarah (leasing), or Musharakah (joint venture). These structures aim to ensure that returns are generated from legitimate trade or productive assets, aligning financial gains with real economic activity. Institutions offering Sharia-compliant products typically have Sharia supervisory boards that review and approve all offerings, ensuring their adherence to Islamic principles and ethical guidelines for ethical investing.6
Hypothetical Example
Consider a hypothetical individual, Sarah, who wishes to purchase a home in a Sharia-compliant manner. In conventional finance, she would obtain a mortgage involving interest payments. Under Sharia law, a direct interest-bearing loan is prohibited. Instead, an Islamic bank might offer a Murabaha or Ijarah structure.
In a Murabaha transaction, the bank first purchases the house Sarah wants. The bank then sells the house to Sarah at a higher, pre-agreed price, payable in installments over a set period. The additional amount charged by the bank is not considered interest but a profit margin on the sale of the asset. Sarah gains ownership of the house, and the bank earns a legitimate profit from a trade transaction, fulfilling the principles of Sharia law. This arrangement ensures the transaction is asset-backed and avoids riba, allowing Sarah to achieve homeownership in line with her beliefs.
Practical Applications
Sharia law is practically applied across a wide spectrum of the global financial system, primarily through Islamic financial institutions. These include Islamic banks, Takaful (Islamic insurance) companies, and Islamic investment funds. One prominent application is in the issuance of Sukuk, often referred to as Islamic bonds. Unlike conventional bonds that pay interest, Sukuk represent an ownership share in tangible assets or a proportionate share in a business venture, with returns derived from the performance of the underlying asset or project. Governments and corporations worldwide utilize Sukuk for funding infrastructure projects and other development initiatives, providing Sharia-compliant avenues for capital raising. The global Islamic finance industry has seen rapid growth, with the World Bank actively supporting the development of Sharia-compliant finance tools to promote financial inclusion and economic development.5 Islamic finance also plays a significant role in fostering socially responsible investing by screening investments for adherence to Halal (permissible) activities and avoiding those deemed haram (forbidden), such as alcohol, gambling, and conventional arms manufacturing.
Limitations and Criticisms
Despite its rapid growth and increasing global acceptance, the application of Sharia law in finance faces certain limitations and criticisms. A notable challenge arises from the need for standardization across different jurisdictions and interpretations by various Sharia scholars. This can lead to inconsistencies in product design and regulatory frameworks, potentially hindering cross-border transactions and market integration.4 Critics sometimes argue that some Islamic financial products, particularly those based on debt-like structures such as Murabaha, closely mimic conventional interest-based transactions, questioning the true spirit of Sharia compliance.3 Furthermore, the limited availability of Sharia-compliant instruments for liquidity management and interbank markets can pose challenges for Islamic financial institutions. Ensuring strict adherence to ethical principles, especially concerning the emphasis on ethics and social objectives beyond mere profitability, remains an ongoing area of discussion and development within the industry. The industry also grapples with the need for a deeper integration of profit-and-loss sharing models, which are seen as the ideal in Sharia law but are less prevalent than debt-based instruments.2
Sharia law vs. Islamic finance
While closely related, "Sharia law" and "Islamic finance" are distinct concepts. Sharia law is the comprehensive Islamic legal and ethical framework itself, encompassing all aspects of life, including economic conduct. It provides the foundational principles and prohibitions, such as the ban on riba (interest) and the emphasis on tangible asset-backed securities.
Islamic finance, on the other hand, is the practical application and operationalization of these Sharia principles within the modern financial system. It refers to the industry, institutions, products (like Sukuk), and services designed to comply with Sharia law. Therefore, Sharia law is the theoretical and jurisprudential guide, while Islamic finance is the tangible manifestation of those guidelines in real-world financial activities. One cannot exist without the other; Islamic finance is the system built upon Sharia law.
FAQs
Q1: Is Sharia law only for Muslims?
A1: While Sharia law is derived from Islamic principles, its application in finance often appeals to both Muslims and non-Muslims. Many find the emphasis on ethical and socially responsible investing, asset-backed transactions, and risk management to be attractive, regardless of their religious beliefs.
Q2: How is Sharia law applied to investments like stocks?
A2: For stock investments to be Sharia-compliant, they must undergo a rigorous screening process. This involves ensuring the company's primary business activities are Halal (e.g., not alcohol, gambling, or conventional banking). Additionally, financial ratios are scrutinized to ensure the company does not have excessive interest-bearing debt or impermissible income from non-Sharia-compliant activities.
Q3: What is the role of a Sharia Supervisory Board?
A3: A Sharia Supervisory Board (SSB) is a body of qualified Islamic scholars who advise Islamic financial institutions on matters of Sharia law. They review and approve all products, services, and operations to ensure compliance with Islamic principles. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) provides globally recognized standards for these boards.1