What is Islamic Finance and What Can It Do?

M. Kabir Hassana –
Department of Economics
and Finance,
University of New Orleans,
USA

Ashraf Khanb – Department of Economics and
Statistics,
University of Udine, Udine,
Italy

Introduction

A well-established financial system plays a vital role in the growth and development of an economy. The Global Financial Crisis of 2008 raised serious concerns about the operations of the conventional financial system. Consequently, Islamic Finance emerged as an alternative— presenting itself as not only resilient enough to absorb shocks but also capable of providing fair and efficient ways of financial intermediation. Islamic finance represents a fundamental departure from conventional interest-based and speculative practices, as it relies completely on real economic transactions such as trade, investment based on profit-sharing, and other ways of conducting business. Unlike the conventional financial system where money is commonly considered a commodity, under Islamic finance the sole purpose of money is to measure the value of goods and commodities. One of the major differences between the conventional and Islamic financial systems is that the latter does not allow activities based on interest payments.

Historically, there has never been a financial system based on Judeo-Christian principles, even though interest is forbidden in their religions. Similar to Islam, Kennedy (1995) also considers interest as unjust and epitomized it as a cancer in the social and economic body of a country. Similarly, there is significant overlap between Islamic principles and socially responsible investment (SRI), given that Islam preaches social justice, ecology, kindness, and what is nowadays called sustainability. Furthermore, Islamic finance has the ability to foster financial inclusion by supporting the poor segment of society through asset-based and risk-sharing financing, thus ultimately reducing systematic risk and making the economy more stable (Kammer et al. 2015). 

Islamic finance was initially started for Muslims in Muslim populated countries, but in recent times its rules of business have spread all over the world, including Europe and America. It works parallel to the conventional financial system, encompassing all activities through its unique banking system, capital and money markets, and insurance services. The recent worldwide shift towards sustainable development goals and infrastructure financing has opened up another avenue for the Islamic finance industry to make further inroads in the global financial system  (Ahmed, et al., 2015). The main purpose of this article is to give an overview of Islamic finance, its role towards sustainable development goals and infrastructure financing.

What is Islamic Finance?

Islamic finance refers to a system which follows the laws of Islamic jurisprudence. Under Islamic jurisprudence, Islamic financial institutions (IFIs) are not allowed to be involved in interest-based transactions or activities forbidden in the religion (e.g., alcohol). IFIs are encouraged to be involved in financial intermediation based on risk-sharing, but transactions involving speculation and uncertainty are forbidden (Hassan, Kayed, and Oseni, 2013; Hassan, Khan, and Paltrinieri, 2019). In this model, risk is divided into two categories: legitimate risk and illegitimate risk. Legitimate risk is when one buys a commodity in order to sell it for profit, relying on the market. This risk is necessary for merchants and is embedded in the nature of business and trade. Illegitimate risk entails taking on excessive risk of losing everything in the pursuit of higher profits, as witnessed during the Global Financial Crisis (GFC) when the market observed a large decline in housing prices and put the overall economy into recession.

Profit is permitted in Islam, but usury is prohibited. A rate of return based on the work done is permitted, but speculation is discouraged. According to Islam, investments should neither be too safe nor too risky. Such contracts will have positive externalities on the economy and promote the entrepreneurial spirit by linking effort with returns. Profit-loss sharing contracts in Islamic finance align managers’ interests with those of investors, in contrast to debt-financing. As a result, such contracts create positive externalities for the economy. Having no ambiguity in contracts eliminates exposure to excessive risk for investors. Transparency in Islamic financial contracts and the absence of gharar (uncertainty) eliminate adverse selection and moral hazard by discouraging speculative activities.

Islamic finance products are broadly classified into two categories: Equity-based products and debt-based products

Equity-based Products

Equity-based products are the core essence of Islamic finance and are directly connected to real economic transactions which promote the culture of risk-sharing and reduce income inequalities. There are mainly two types of equity-based products:

Musharakah refers to a pure form of partnership where all parties are required to provide capital and are involved actively in the management of the business/project. The profit and loss will be shared on a pro rata basis.

Mudarabah refers to a modern form of venture capital where one party provides the capital and the other party (entrepreneur) provides the skill.  The profit is shared at a pre-agreed ratio while the loss is borne by the capital provider, except in the event of a proven breach of contract, negligence, or misconduct.

Debt-based Products

IFIs mainly rely on debt-based products that are commonly used for working capital financing and asset rentals.

Murabaha is a sale contract where IFIs buy goods and sell them to their customers in installments to be paid at pre-agreed future dates. The price of the goods and profit margin must be clearly known at the time of contract. Once the contract is signed, the price of the goods or profit margin cannot be increased. Furthermore, all financial institutions charge a penalty for late payments. Under Islamic finance, the impact of this penalty is beneficial for society. Instead of making these penalties a part of their profit, a common practice in conventional financial institutions, IFIs create a charity account and spend it for the welfare of society.

Ijara is a rental/lease-based contract where IFIs sell the rights to use an asset to their customers for a specific period of time. The leased asset remains in the ownership of the IFIs and can be repossessed by IFIs in case of non-payment. Generally, once the lease contract is completed, the leased asset is sold back to the customer through a separate independent sale contract.

Salam refers to a forward sale contract where full payment is made at the time of contract and delivery of commodity will be made at a specified future date. Salam is usually used in agricultural financing where small farmers do not have sufficient investment for farming their lands. The commodity type, price, quantity, quality, and place of delivery must be mentioned in the contract.

Istasna is also a forward sale contract, but the price of the required products can be paid as per agreement between both parties, unlike salam where full payment must be paid at the time of contract.

Facts and Figures of Islamic Finance

The journey of the modern Islamic finance industry started in the 1960s when the first commercial Islamic bank was established in Egypt. The last three decades have witnessed the tremendous growth of the Islamic financial industry and the development of more than 1,000 IFIs working in 50 Muslim and 40 non-Muslim countries, including the UK, U.S., Australia, and Canada. The global Islamic financial industry is growing at a rate of 8.3%, with total assets of 2.05 trillion dollars in 2017 (IFSB, 2018) and over 1,300 financial institutions in 50 Organization of Islamic Cooperation (OIC) countries. Iran and Sudan each have a banking and finance industry that is fully Islamic. Table 1 breaks down the assets of the global Islamic financial industry in terms of sectors and regions.

Islamic banking is the main sector of Islamic finance, having a share of 76% of the total global Islamic financial assets, followed by the Sukuk market with a 19.5% share, Islamic funds with 3.3%, and finally Takaful assets with 1.3%. Sukuk is an Islamic bond which is defined as “certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity” (AAOIFI, 2003: pp. 298) whereas Takaful is an alternative to conventional form of insurance which is defined as “Islamic Insurance is a process of agreement among a group of persons to handle the injuries resulting from specific risks to which all of them are vulnerable. A process, thus initiated, involves payment of contributions as donations, and leads to the establishment of an insurance fund that enjoys the status of a legal entity and has independent financial liability” (AAIOFI, 2015).

The Islamic finance industry is mainly concentrated in Gulf cooperation Council (GCC), Middle East and North Africa (MENA), and Asian countries. Recently, Islamic finance has also commenced in Suriname. This gives Islamic finance a presence in all six continents.

The growth of the Islamic finance industry does not depend solely on Islamic banking, other financial institutions, such as fund management companies, microfinance, credit unions, leasing companies, and cooperatives also play their roles and are performing competitively with their counterparts in the conventional finance industry, at times even outperforming them.

 

 

Sustainable Development Goals and Islamic Finance

The United Nations’ paradigm shift towards Sustainable Development Goals (SDGs) has called for the shared responsibility of all stakeholders in improving living standards and empowering all mankind, which will require huge amounts of investment in capacity-building assets (El-Maghrabi et al., 2018). There is an estimated yearly gap of 2.5 trillion dollars between the annual investment needs of the SDGs and current actual annual investments (UNCTAD, 2014). The need for SDG investment is further intensified by the challenges posed by climate and environmental issues, urbanization, and social imbalances.

 

 

An ideal Islamic economic system promotes the concept of a welfare state, supports development-related activities, ensures financial inclusion through equal distribution of wealth, and protects the overall environmental and ecological system.  In this regard, Islamic finance has the potential to contribute to the SDG goals, which overlap with the basic objectives of an ideal Islamic economy. There is growing investor interest in providing funds to businesses, non-profits, and financial institutions that utilize sustainable business practices and provide a benefit to society. Islamic finance aims to provide social justice, fairness, and an equal distribution of resources through providing social protection to the less privileged in society. Islamic banking and finance can provide the support and guidance necessary for borrowers to succeed in their business ventures. Risk-sharing is used to ensure that both financiers and borrowers work together with aligned interests and mutual benefits. Poverty alleviation is a focus in Islamic microfinance that the industry addresses head-on through providing loans that stimulate growth while not burdening the borrower with excessive debt from incurring interest. Islamic finance prides itself on encouraging entrepreneurship and sharing risk to support entrepreneurial endeavors. Therefore, the Islamic financial objective goes beyond profit maximization and is instead focused on achieving societal prosperity.

 

 

Infrastructure Financing and Islamic Finance

A recent survey by Pew Research (2017) projects the world population to increase by 32% in the coming decades. The current total population of Muslims is 1.8 billion, with 1.6 billion living in OIC countries. With the forecasted growth in population, the global economy will need more than 50 trillion dollars in infrastructure financing for projects such as urbanization, well-organized transport systems, water and sanitation projects, energy systems, and information and technology-related projects. The recent financial crises, along with other economic issues such as volatility in oil and commodity markets coupled with energy crises in some emerging countries, have increased fiscal deficits, especially in terms of infrastructure financing, which deters economic development in these countries. Due to limited public financing, governments look to the private sector to invest in building infrastructure for sustained economic development.

Over the last decade, Islamic finance has played a critical role in financing a wide variety of infrastructure projects both in Islamic and non-Islamic countries. The conventional sources of financing are largely debt-based and consist basically of risk-shifting financial products that increase systematic risk in the world economy and cause frequent financial crisis. Islamic finance, on the other hand, is based on risk-sharing principles that require a high degree of transparency and create incentives for all stakeholders to monitor projects, thus making the overall infrastructure more sustainable. Infrastructure financing can be arranged through the Islamic mode of financing through private-public-partnerships (PPP). 

Conclusion

Islamic finance is one of the fastest growing industry segments in global finance. It has much potential for growth in both Muslim and non-Muslim countries because its core business principles regarding interest, uncertainty, harmful activities, and risk-sharing have universal appeal (Kayed and Hassan, 2011).  Islamic finance has a strong potential to play a decisive role in supporting the implementation of the Sustainable Development Goals (SDGs) and infrastructure financing.

References

AAOIFI, 2003. Shari’ah Standards, Accounting and Auditing Organization for Islamic Financial Institutions. Manama: AAIOFI.

Ahmed, H., Mohieldin, M., Verbeek, J. & Aboulmagd, F., 2015. On the Sustainable Development Goals and the Role of Islamic Finance, s.l.: World Bank Group.

Ashraf, D., 2013. Performance evaluation of Islamic mutual funds relative to conventional funds: Empirical evidence from Saudi Arabia. International Journal of Islamic and Middle Eastern Finance and Management, Volume 6, pp. 105-121.

El-Maghrabi, M. H., Gable, S., Rodarte, I. O. & Verbeek, J., 2018. Sustainable Development Goals Diagnostics: An Application of Network Theory and Complexity Measures to Set Country Priorities, s.l.: World Bank Group.

Hassan, M. K., Khan, A. & Paltrinieri, A., 2019. Liquidity risk, credit risk and stability in Islamic and conventional banks. Research in International Business and Finance, Volume 48, pp. 17-31.

Hassan, M. Kabir, Paltrinieri Andrea, Alberto Dreassi, Stefano Miani and Alex Sclip (2018), “The determinants of co-movement dynamics between sukuk and conventional bonds,” Quarterly Review of Economics and Finance, 68: 73-84

Hassan, M. Kabir, Rasem N. Kayed and Umar A. Oseni, Islamic Finance, Pearson Publishing Company, May 2013: 436 pages

IFSB, 2018. Islamic Financial Services Industary Stability Report, Kuala Lumpur, Malaysia: Islamic Financial Services Board.

IIFM, 2018. IIFM Annual Sukuk Report, Kuala Lumpur, Malaysia: International Islamic Financial Market .

Kammer, A. et al., 2015. Islamic Finance: Opportunities, Challenges, and Policy Options , Washington,D.C. USA.: INTERNATIONAL MONETARY FUND.

Kayed, Rasem and M. Kabir Hassan,  “The Global Financial Crisis and Islamic Finance,” Thunderbird International Business Review,  Volume 53, Issue 5 (September/October, 2011) : 551-564

Kennedy, M., 1995. Interest and Inflation Free Money: Creating an Exchange Medium That Works for Everybody and Protects the Earth.. Okemos,MI: Seva International.

Kusuma, K. A. & Silva , A. C., 2014. Sukuk Markets: A Proposed Approach for Development, Washington DC: The World Bank.

Mahyar Amouzegar
Research Feature Editor

Updated: March 18, 2019 — 10:49 am

Leave a Reply