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  • Writer's pictureAdministrator - Usman & Partners

Islamic Finance vs Conventional Finance

Islamic finance and conventional finance are two distinct systems of financial management that are guided by different principles and values. The key differences between these two systems are rooted in their underlying beliefs, practices, and ethical considerations. Here are some of the fundamental differences:


**1. Ethical Foundations:**

- **Islamic Finance:** Islamic finance is based on Sharia, the Islamic law derived from the Quran and the Sunnah (teachings and practices of Prophet Muhammad). The primary principle is to adhere to ethical and moral standards, and transactions that involve interest (riba) and uncertainty (gharar) are prohibited.

- **Conventional Finance:** Conventional finance is not bound by religious principles and focuses primarily on economic efficiency and profitability. Interest-based transactions are common, and profit maximization is a central goal.


**2. Prohibition of Interest (Riba):**

- **Islamic Finance:** Charging or paying interest is strictly prohibited in Islamic finance. This is based on the belief that earning money through lending without bearing risk is exploitative and unjust.

- **Conventional Finance:** Interest is a core component of conventional finance. Banks and financial institutions typically charge interest on loans and offer interest-bearing accounts.


**3. Risk Sharing:**

- **Islamic Finance:** Islamic finance encourages risk sharing and emphasizes fairness in transactions. Profit and loss sharing (Mudarabah and Musharakah) are common principles, where parties share both profits and losses based on agreed-upon terms.

- **Conventional Finance:** Conventional finance often relies on debt-based transactions, where one party lends money and charges interest regardless of the outcome of the borrower's ventures.


**4. Asset-Backed Transactions:**

- **Islamic Finance:** Islamic finance promotes asset-backed transactions, where tangible assets or real economic activities back financial products. This minimizes speculation and ensures a direct link between financial transactions and the real economy.

- **Conventional Finance:** While conventional finance can also involve asset-backed transactions, it is more common to see debt-based securities and derivatives that may be disconnected from real assets.


**5. Prohibition of Speculation (Gharar):**

- **Islamic Finance:** Excessive uncertainty and speculation (gharar) are discouraged in Islamic finance. Contracts with uncertain outcomes or excessive ambiguity are generally prohibited.

- **Conventional Finance:** Conventional finance may involve speculative activities and derivatives trading, where outcomes can be uncertain.


**6. Ethical Screening:**

- **Islamic Finance:** Islamic finance includes ethical screening (known as Sharia-compliant screening) to ensure that investments align with Islamic values. Industries such as alcohol, gambling, and pork production are typically avoided.

- **Conventional Finance:** Conventional finance does not typically incorporate ethical or religious screening when making investment decisions.


**7. Social Responsibility:**

- **Islamic Finance:** Islamic finance emphasizes social justice and sharing wealth with the less fortunate through mechanisms like Zakat (charitable giving) and Sadaqah (voluntary charity).

- **Conventional Finance:** While some conventional financial institutions engage in corporate social responsibility, it is not a fundamental principle of the system.


It's important to note that the specifics of Islamic finance can vary based on interpretations of Sharia and local regulations. Both systems have their merits and challenges, and individuals and businesses often choose one over the other based on their values, beliefs, and financial goals.

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