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 is an Islamic religious law that governs the day-to-day life of its Muslim followers.
  • Sharia establishes guidelines for investment and banking. It includes not investing in alcohol- and tobacco-related businesses or collecting interest.
  • Sharia-compliant finance is a fast-growing line of business among banks and investment houses, partly because investors are eager to work with booming oil economies in the Middle East.
  • An example of a Sharia security is a Sukuk, which is the Arabic name for financial certificates and refers to Sharia-compliant bonds.

Understanding Sharia

Sharia-compliant finance is an area of modern finance that is growing among many banks and investment houses. Western financial services firms are beginning to offer Sharia-compliant investment vehicles that neither pay interest nor benefit from gambling. This is due in part to investors being eager to work with the booming oil economies of the Middle East, which are primarily Islamic.

Sharia Investment Requirements

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 forbidden under Sharia.

The activities of businesses are very relevant. Other companies that may not be invested in include brewers and producers of alcoholic beverages, producers and distributors of pornography, and creators of pork products, such as ham and bacon. It's also prohibited to invest in manufacturers of weapons and related armaments, as well as producers of tobacco and tobacco-related products.

Businesses that are not directly engaged in but derive more than 5% of their revenue from proscribed activities are also prohibited.

There are Sharia-compliant funds that exist to adhere to the restrictions of the faith. A Sharia board consisting of Islamic scholars must be established in each fund that claims to adhere to Sharia principles and is responsible for evaluating every investment decision that it makes. Businesses that are deemed by this board as prejudicial against the principles 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 can result in followers of the faith who abide by Sharia not being able to engage in sizable portions of the market. In the West, Sharia-compliant investments are similar to socially responsible investments (SRIs).

Sharia in Practice

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 sizable Muslim population, such as Pakistan and India, and the U.S. and Europe, where the Muslim population is relatively small but has significantly more disposable wealth.

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 Sukuks 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 then used to purchase an asset using the 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 term 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.

Other types of Sharia financing include Mudarabah, which is a profit-and-loss sharing partnership, and Musharakah, which is a profit-and-loss sharing joint venture.