Islamic religious law/sharia is the basis of the Islamic finance. These laws agitate for fairness and equality in the society by upholding ethical, social, moral and religious factors. On the other hand, Islamic finance is practiced by Muslim community and complies with the Islamic rules, codes of practice and principles.
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The foundation of Islamic law is derived from the word Sallam that means peace. The roots of Islamic banking and finance are based on religion of Islam and include three elements: akhlaq, aqidah and sharia. Aqidah is a creed that requires a believer not to be in suspicion, akhlaq sets out the ethical code of conduct of how they are supposed to behave, while sharia are laws that govern all aspects of Muslims life socially, spiritually, politically and economically.
Islamic laws categorize behaviors by nature of actions of people. For instance, actions are classified as recommended, obligatory, reprehensible, permissible and prohibited. Every category of action is punishable by Allah. For instance, Wajib is an obligatory act and is rewarded by Allah; failing to observe acts such as prayers is punishable. Hara is an action that is forbidden hence attracts heavy punishment. It is a sin and includes actions such as drinking alcohol and gambling. Islamic laws govern the actions and behaviors of the Muslim. These laws are categorized into two: main and minor.
The main source of law is the Quran, which provides guidelines on how Muslims live and worship. It teaches both divine and external factors of the lives of the Muslims. The book is holy among Muslim community and it guides the structuring of the Islamic banking. The book has various verses, which object to riba or giving and payment of interests. It has helped Muslims in setting out their banking principles and policies. Other main sources of Islamic law are sunnah, ijma, and Qiyas. Minor sources of Islamic law include Urf, ijtihad, istinsan, and istislah.
Another important aspect in the Islamic finance concerns a contract. A contract is an agreement between two parties. The agreement should be binding, legal, acceptable and meaningful. Contracts are grouped into three categories; invalid, valid and void. The Islamic commercial law is applied in the operations of Islamic banking and it deals with legal ramifications and contract issues.
For the contracts to be binding and transparency, various elements should be met. There must be an offerer and an offeree between the parties. There should be a seller who makes an offer and a buyer who accepts it. This can be done either orally, written, signs or through an agent. There should be a subject matter and consideration, which should comply with the sharia laws. This should exist at the time of making the contract and should be deliverable. All the parties should also know the specifications of the contract.
Sharia laws are classified based on nature and legal consequences. For instance, those classified under nature include unilateral contracts, bilateral contract and quasi contract. In unilateral contract, one party makes the contract while the second party has the obligation to accept or reject the contract. In a bilateral contract, promises made are bounding to all parties. Example of this contract include partnerships and contract of exchange. Quasi contracts are not popular in Islamic law. This contract is not formal but terms are followed as defined in the contract and are therefore legitimate. Those classified based on legal consequences include sahih, fasid, batil, lazin, nafidh, mawquf and ghayr lazim contract.
In Islamic banking, contracts are important in achieving transparency and conformity in structuring transactions. A number of contracts are applied in Islamic banking. These include contract of exchange, contract of usufruct, gratuitous contract, participation contract and supporting contract.
Contract of exchange is one of the primary contracts that allow exchange of goods and property for the owner to the buyer at a fixed price or through barter trade. Contract of usufruct allows a third person to benefit from another person’s property. Example of this kind of contract is leasing. Gratuitous contracts are entered for charity or benevolence purposes, whereby, a bank or an individual provides or awards a gift to someone without commensurate exchange. Participation contracts are risky, reward sharing and aim at encouraging creation of wealth through partnership arrangements. Examples include trust financing and partnership financing. Supporting contracts applicable in Islamic banking include collateralized financing, whereby an asset is set aside for collateral payment of certain obligations.