Sharia: Definition, How It Affects Investments, and Example

What Is Sharia?

The term sharia refers to a set of Islamic religious law that governs aspects of day-to-day life for Muslims in addition to religious rituals. Sharia law also provides religious followers with a set of principles and guidelines to help them make important decisions in their lives, such as finances and investments. Islamic banking and finance outline where many can be invested and rules about interest. There is some variation in how Sharia is interpreted and implemented, especially in the financial industry.

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

The word Sharia literally translates to "the way," and is often also spelled as Shariah or Shari'a. As mentioned above, the law outlines how Muslims should conduct themselves in various aspects of their lives, including their personal lives, their responsibilities to society, their religious beliefs, as well as their finances.

Interest is a key part of everyday finance. But it is haram under Sharia law, which means it is prohibited for interest to be paid between borrowers and lenders. This includes 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.

Business activities are also very relevant. Investors who adhere to Sharia law are prohibited from investing or working with companies that engage in the following:

  • Brewing and the production of alcohol
  • Producers and distributors of pornography
  • Creators of pork products, such as ham and bacon
  • Manufacturers of weapons and related armaments
  • Producers of tobacco and tobacco-related products
  • Casinos and other gambling-related companies

The various tenants of Sharia law mean investment strategies to 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-compliant finance, which is also often called Islamic banking or Islamic finance, is an area of modern finance that is and will continue to grow. Western financial services firms now offer Sharia-compliant investment vehicles that neither pay interest to the investor 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.

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

Special Considerations

Sharia-based financial vehicles vary the same way they do in traditional finances. For instance, Mudarabah refers to a profit-and-loss sharing partnership while Musharakah is a profit-and-loss sharing joint venture.

There are Sharia-compliant funds that adhere to the restrictions of the faith. A Sharia board consisting of Islamic scholars must be established that follows Sharia principles. Board members are responsible for evaluating a fund's investment decisions, including the businesses in which they invest.

Sukuk is the Arabic name for financial certificates. It refers to Sharia-compliant bonds. 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 India and Pakistan
  • 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. A special purpose vehicle (SPV) created for the purpose of issuing certificates in capital markets. Proceeds are used to purchase an asset using the principles of Ijarah.

An intermediate entity buys the asset and leases it back to the SPV. The SPV has an option (the right, but not the obligation) to buy the leased asset before its term expires. Proceeds from the original sale may alternatively be invested using principles outlined in a Wakala transaction. In this type of transaction, the investment is temporary and executed using a special agent, known as Wakeel, for the purpose.

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