By: Jacinta Sherris

What is it and what can it tell us about our own financial system?

Islamic finance refers to financial activities and institutions that conform to Islamic, or Sharia law. Islam is one of the world’s most politically oriented religions and thus there is much religious law that governs a variety of different aspects of daily life, such as business and even finance. For most people, the workings of Islamic finance remain a mystery. Studying this fascinating sector of finance can introduce us to different cultural interpretations of money and even demonstrate how profitable conscious capitalism can be realized.

The Islamic banking industry came into existence in the mid-1970’s as a result of specific political and economic conditions, but primarily by the quadrupling in the price of oil The driving force behind the growth of Islamic finance is attributed to this supply of funds rather than the demand for Sharia compliant financing by business in the region. With enormous global reliance on oil, the Muslim world witnessed rapid economic growth. As newly wealthy Islamic conservatives began searching for investment opportunities outside of the Western financial system, they created their own financial markets in compliance with Sharia law.

Since its inception, the Islamic banking industry has had many ups and downs. Nonetheless, its growth is still considerable. As of 2015, Sharia compliant financial assets, mostly held in the form of bank deposits, bonds, investment funds, and insurance, were worth approximately US$2 trillion worldwide. Countries that dominate Islamic banking include Iran, Saudi Arabia, Malaysia, Kuwait, and the United Arab Emirates. The United Kingdom, Singapore, and Hong Kong are among some of the global financial hubs that have expressed interest in this growing niche of a financial market.

Still, most individuals do not know exactly how Islamic banking differs from conventional banking. Aside from prohibiting any transactions with entities involved with things that are banned in Islam, (including pork, alcohol, and pornography), one of the main tenets of Islamic finance is its ban on charging interest. Such a practice is incredibly remarkable for banks since in conventional finance, interest is at the core of financial markets and economies.

Interest is banned in today’s Islamic banks because of the idea that charging interest on a loan is an act of sin. The banning of interest did not originate with Islam and was in fact practiced by early Jewish and Christian societies. What is striking about considering interest sinful is that it stems from an alternative view of the nature of money. Many religions do not view money as a commodity that can be bought and sold like food or furniture. It is the idea that money has no intrinsic value and is merely a means to achieve an objective and not the objective itself. Such an idea has enormous implications on the ethics of financial markets.

Thus in modern Islamic finance, monetary transactions must be tied to some concrete economic activity and be able to contribute to the real economy in order to be deemed moral and permitted. As you can imagine, such a practice stands in enormous contrast to conventional financial markets. Swapping (essentially exchanging one cash flow for another) and trading in high complex financial assets whose values are derived from other assets to which the trader has no legal title, are common examples of transactions where value has been created despite no real economic activity. Islamic finance is often considered by its proponents to be more in alignment with conscious capitalism because of its insistence of profit being tied to production.

So the question remains as to how Islamic financial institutions can generate profit without charging interest. In order to do so, the Islamic financial system functions on partnerships between the depositors and borrowers based on sharing profits as well as losses (mudaraba).

One such example is that of an Islamic bond, known as sukuk. A traditional bond is essentially a claim on debt to be repaid at a set time in the future, along with interest. An Islamic bond is not a claim on debt but instead represents partial ownership of whatever enterprise the money was spent on and a partial claim on the profit generated by that asset (Lumpur, 2014). An Islamic mortgage, also, would not consist of a customer borrowing money to buy a house. Instead, the bank would buy the house and the mortgagor would pay monthly installments to the bank along with rent until the mortgage is paid in full. Wealth savings generally work in a similar fashion. Usually depositors will pay a premium to hold their funds with a bank and then the bank will pay them in the form of profit shares instead of interest.

It is important to acknowledge that the Islamic financial industry has had many difficulties maintaining growth and staying competitive in global markets since its inception. It has had to remodel itself numerous times and there is constantly much debate among Islamic scholars whether certain transactions are becoming too resembling of charging interest.

Another difficulty for Islamic banks is the problem of moral hazard. In economics, moral hazard is the risk that comes when one partner in a transaction has an incentive to undertake additional risks that negatively impact the other partner. Parties seeking funds from Islamic financial institutions are more inclined to use their debts in more risky ways because they are not subjected to predetermined interest payments in the same way conventional banks charge customers. The amount the borrowers owe the financial institutions is dependent upon the profits and losses of their enterprises, and subsequently if their enterprises are not successful, it is the bank that suffers the greater loss. Islamic banks are thus under an enormous disadvantage as medium or long-term loans are especially risky for them. Indeed, much of the financing in Islamic financial markets has been focused on the short-term.

Another issue for Islamic banks is that they incur high monitoring costs. They need to be actively involved with the enterprises they work with in order to ensure the proper allocation of risk and to make sure the enterprise is not manipulating its profits and losses at the expense of the bank. Fundamentally, Islamic banks face much more limitations than conventional banks in terms of raising revenue and reducing risk.

Despite its shortcomings, Islamic finance is becoming more prevalent globally. Many argue that this growth is driven by the availability of Islamic capital and the distrust towards Western institutions in the Muslim world, though this is growth nonetheless. Its financial system is also an interesting one to consider especially when trying to understand some of the challenges the modern American financial system faces.

Interest rates on student loans are one of the biggest obstacles younger generations are facing in paying off their university debts and subsequently being able to invest in their futures. Perhaps we should consider how viable it would be for students to share percentages of their future incomes with their creditors instead of paying enormous interest rates on their loans. In light of the 2008 crisis, could we conceive of financial markets being less risky if people were more aware of the underlying assets behind their securities? The growing Islamic financial system is one to watch in order to understand the realities of incorporating ethical practices into mainstream finance, without compromising economic growth and innovation.

Works Cited

Alawode. A. A. (2015, March 31). Islamic Finance. The World Bank. Retrieved from http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance

Henry, C. M. (2004). The Politics of Islamic Finance. Edinburgh: Edinburgh University Press.

Irfan, H. (2015, May 15). The Nature of Money: Islamic Banking and Conscious Capitalism. The Foreign Affairs. Retrieved from https://www.foreignaffairs.com/articles/2015-05-15/nature-money

Lumpur, K. (2014, September 13). Big Interest, No Interest. The Economist. Retrieved from https://www.economist.com/news/finance-and-economics/21617014-market-islamic-financial-products-growing-fast-big-interest-no-interest

Warde, I. (2010). Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press.

Investopedia Staff. Interest. Retrieved from http://www.investopedia.com/terms/i/interest.asp

Investopedia Staff. Moral Hazard. Retrieved from  http://www.investopedia.com/terms/m/moralhazard.asp