What Is Sharia?

Sharia (also known as "Shariah" or "Shari'a") is an Islamic religious law that governs not only religious rituals but also aspects of day-to-day life in Islam. Sharia, literally translated, means "the way."

There is extreme variation in how Sharia is interpreted and implemented among and within Muslim societies today. This is especially prevalent for its financial laws.

Key Takeaways

  • Sharia refers to an Islamic religious law that governs day-to-day life, including financial matters, in Islam.
  • In finance, Sharia establishes guidelines for investment and banking. Examples of these guidelines is the prohibition against investment in alcohol- and tobacco-related businesses and against collecting interest.
  • Sharia-compliant finance is a fast-growing line of business among banks and investment houses because investors are eager to work with booming oil economies.

Understanding Sharia

Sharia-compliant finance is an area of modern finance that is growing among many banks and investment houses. This is due in part to investors eager to work with the Middle East as oil prices continue to increase. Western financial services firms are beginning to offer Sharia-compliant investment vehicles that neither pay interest, nor benefit from gambling. Sukuk is the Arabic name for financial certificates and refers to Sharia-compliant bonds.

According to a PwC report, the investor base for Sharia-compliant bonds consists of groupings in three geographies: countries in the Gulf Cooperation Council and Malaysia, countries with a sizeable Muslim population, such as Pakistan and India, and US and Europe—where the Muslim population is relatively small but has significantly more disposable wealth.

Ways Sharia Establishes Guidelines for Making Investments

Sharia prohibits the collection of interest paid by a borrower to a lender. Neither party can engage in this practice, which is a staple of many types of financial arrangements and transactions. This naturally can include loans and mortgages, as well as financial vehicles that build interest to generate a return. Investing in conventional banking and insurance firms therefore can be prohibited under Sharia.

The activities of business that are invested in under Sharia are also relevant. Companies that may not be invested in include brewers and other producers of alcoholic beverages. Producers and distributors of pornography are likewise banned. Companies that create products such as ham and bacon are disallowed from investments. The producers of weapons and related armaments are not to be invested in. Makers of tobacco and tobacco-related products also may not be invested in. Businesses that are not directly engaged in but derive more than 5% of their revenue from proscribed activities are also prohibited.

A Sharia Board consisting of Islamic scholars must be established in each fund that claims to adhere to Sharia principles. The board evaluates each investment decision. Businesses that are also deemed by the Sharia Board as prejudicial against the principals of the faith are disqualified from being invested in.

The various tenants of Sharia law mean that investment strategies must be developed that can accommodate these restrictions. This does mean that followers of the faith who abide by Sharia cannot engage in sizable portions of the market. There are Sharia-compliant funds that exist to adhere to the restrictions of the faith.

In late 2007, a Sharia index was launched on the Tokyo Stock Exchange. This index includes companies that comply with Sharia law. The companies included in this index are screened on a daily basis and exclude non-Sharia-compliant companies such as casinos and alcohol and tobacco companies.

In the West, Sharia-compliant investments are similar to socially responsible investments.

Example of Sharia

Sukuks can be asset-based or asset-backed. Islamic bonds are examples of the former while securitized assets are examples of the latter. Within existing capital markets, transactions involving Sukuk are adapted to suit Islamic jurisprudence. A Special Purpose Vehicle (SPV) created for the purpose issues certificates in capital markets. Proceeds from the sale are used to purchase an asset using principles of ijarah.

In this type of transaction, an intermediate entity buys the asset and leases it back to the SPV. The SPV has an option, i.e., the right but not the obligation, to buy the leased asset before its terms expires. Alternately, proceeds from the original sale are invested using principles outlined in a Wakala transaction. In this type of transaction, the investment, again, is temporary and is executed using a special agent, known as Wakeel, for the purpose.