What is Islamic Finance?

Islamic Finance and Banking 101

First Published Date : November 24, 2010 ADawnJournal.com

When we think of banking, we think of the United States, Europe and Japan, along with China, as examples of what banking is. However, in the Islamic world, there is a term called Islamic finance, or Islamic banking, which is very important to understand, especially to anyone doing banking work with the Middle East.

Islamic banking, or finance, refers to banking that works on the principles of Islamic law, while developing Islamic economies. Under the Sharia, which is Islamic law, the payment or even the acceptance of interest fees for loans is completely forbidden. In the 20th century, several Islamic banks have applied the principles to private and semi-private institutions within the Muslim world.

The concept of Islamic finance came about during the Islamic Golden Age, when early forms of free markets were present and a market economy was just beginning during the 8th to 12th centuries. A monetary economy was created on the expanding levels of the currency, which was very stable and highly valued.

Several concepts and techniques were applied to Islamic finance, including partnerships, limited partnerships, capital, cheques, promissory notes and bills of exchange, all of which would become commonplace in future centuries.

One concept created in Islamic finance was Riba, which means excess. This was applied to prevent excess compensation without due consideration, which we would know as high interest rates. Therefore, applying interest under Islamic finance law was not something commonly done, but there were cases where it was.

Currencies that were based on guarantees by government, or based on materials such as base metals, were allowed to have interest applied ot them.

Interest-free banking, the most common trait of Islamic finance, continued into the 20th century, however several Islamic banks saw interest as a necessary evil that could be used in a banking system based on profit and loss sharing. In the early 1970s, several Islamic institutions got involved in the concept of Islamic finance. The Conference of the Finance Ministers of Islamic Countries in 1970, a study done in Egypt in 1972, the First International Conference on Islamic Economics in 1976, the International Economic Conference in London in 1977 and more helped to determine if Islamic finance could work in the 20th century. Through all of this, the Islamic Development Bank, which is a bank that covers many Islamic governments, was created in 1975.

In the past 20 years, interest free banking has gained a lot of praise and attention, especially in Pakistan where several young Muslim economists praised it.

Egypt attempted to use Islamic banking, beginning in 1963 by forming a savings bank that was based on profit-sharing. This experiment lasted until 1967, at which point nine banks were created within Egypt.

Over the years, more and more banks opened up that worked on the concept of Islamic finance. One such bank was the Dubai Islamic Bank, which opened in 1975.

Currently, Islamic banking, or Islamic finance, is growing at roughly 10 to 15 per cent per year, and there is no sign that it is going to be slowing down. Currently, Islamic banks have more than 300 banks spread across 51 countries, including the United States. They also have an addition 250 mutual funds that work on Islamic finance concepts. Roughly $822 billion in assets are managed by Islamic finance concepts. This is about .5 per cent of the world’s total assets. Islamic finance is also the fastest growing segment of global finance in the world, and sales of Islamic bonds have risen by 24 per cent, to $25 billion, by this year alone.

According to Standard & Poor’s Rating Services, the potential market of $4 trillion existed for Islamic financing and banking.

The countries of Iran, Saudi Arabia and Malaysia are the biggest Islamic bank compliant countries on Earth, with Iranian banks accounting for 40 per cent of the total assets of the world’s top 100 Islamic banks. The Bank Melli Iran had the most assets with $45.5 billion, followed by Al Rajhi in Saudi Arabia with $39.7 billion. Iran also has the most Islamic finance assets valued at roughy $235.3 billion.

So, how does Islamic banking work if there is no interest? Since that is where many banks make most of their money. In an Islamic mortgage, instead of loaning money to the homebuyer to buy the house, a bank will buy the item itself from the home seller, and then re-sell it to the buyer at a profit. The buyer can pay in installments, however the bank cannot make profit explicitly, otherwise it will face fines, so it cannot have penalties for late payment. In order to make sure that the buyer does not default on the transaction, a Murabaha arrangement is made, which is similar to real estate leasing.

Some banks will use a Musharaka al-Mutanaqisa approach, which involves a floating rate which works like a rental. The bank and individual borrowing will form a partnership, with both putting in capital and agreeing on a percentage for buying the property. The partnership rents out the property to the borrower, and the borrower is charged rent. While this is happening, the borrower slowly buys the bank’s portion of the property from them over agreed payments over a set period of time until the partnership ends.

As would be expected, Islamic banking does not just forbid the use of interest, but also works on other principles of Islam. Islamic banking restricts transactions that involve pork, gambling and alcohol as well. This makes it a form of ethical investing, which makes it very popular with some Western World investors. Islamic finance and banking is sometimes called a full-reserve banking method, where banks have a 100 per cent reserve ratio, at least in theory.

Islamic finance is a unique concept that is very popular in the Muslim world, and could become popular here as more banks use the methods of Islamic banking to help people get loans that are easier to repay, meaning the risk of default is less.