Question

In what ways could Islamic finance be considered an alternative to conventional finance? Is Islamic finance a viable alternative to conventional finance?

Answer 1

Financial services that meet the requirements of the Shariah, or Islamic law are called Islamic finance. While designed to meet the specific religious requirements of Muslim customers, Islamic banking is not restricted to Muslims: both the financial services provider and the customer can be non-Muslim, as well as Muslim. Shariah-compliant financing (SCF) constitutes financial practices that conform to Islamic law.8 Major principles of shariah law that are applicable to finance and that differ from conventional finance are: ● Ban on Interest (riba): In conventional forms of finance, a distinction is made between acceptable interest and usurious interest (i.e., excessive rates of interest). In contrast, under Islamic law, any level of interest is considered to be usurious and is prohibited. Some question how lenders can profit from financial transactions under Islamic law. Take for instance, in a real estate setting, SCF takes the form of leasing, as opposed to loans. Instead of borrowing money, the bank obtains the property and leases it to the shariah-compliant investor, who pays rent instead of interest. ● Ban on Uncertainty: Uncertainty in contractual terms and conditions is not allowed, unless all of the terms and conditions of the risks are clearly understood by all parties of a financial transaction. This condition may help eliminate most of the speculative transactions which involve gharar (excessive uncertainty).

Risk-sharing and Profit-sharing: Parties involved in a financial transaction must share both the associated risks and profits. Earnings from profits or returns from assets are permitted, so long as the business risks are shared by the lender and the borrower. This will help ensure that the seller (or lessor) also shares a part of the risks in order to be able to get a share of the returns. Once the seller (financier) acquires ownership and possession of the goods for sale or lease, he/she bears the risks. ● Ethical Investments That Enhance Society: Investment in industries that are prohibited by the Qur’an, such as alcohol, pornography, gambling, and pork based products, are discouraged. ● Asset-backing: Each financial transaction must be tied to a “tangible, identifiable underlying asset.”9 The debt cannot be sold, and thus the risk associated with it cannot be transferred to someone else; it must be borne by the creditor himself. According to this condition a transaction must be a genuine trade transaction, and the fact that the creditor cannot transfer the risk to someone else by selling off the debt, will also help eliminate speculative and derivative transactions, as well as prevent the debt from rising far above the size of the real economy.

Islamic Finance as an Alternative System: Islamic finance can act as an alternative to the conventional financial system. The major features of Islamic finance, like asset-backing, the bans on uncertainty (Gharar) and interest or usury (Riba), and risk and profit sharing seem to provide a more resilient financial system. Under Islamic banking, lending and borrowing are fully asset-backed and there is no scope for debt transfer (swaps) or speculative transactions beyond the real value.

The reason why Islamic banks have not felt the full brunt of the global credit crisis is that it is difficult to get loans from Islamic banks unless the loans are deemed prudent, growth promoting and beneficial to society. As a result of a strict discipline from religious as well as regulatory points of view introduced into the process of debt creation, the growth of SCF products can rise only in line with the growth of the real economy. The system thus provides a selfprotective device and curbs speculative transactions leading to excessive credit expansions. If economic growth fails to achieve the target or enters into a phase of contraction, Islamic financial institutions will suffer, but they are unlikely to go bankrupt as borrowers are treated as joint owners and are liable to incur losses (or profits at times of high growth). From an individual investor’s perspective, Islamic finance is usually considered a “low risk low gain” system which should satisfy the needs of those who subscribe to the basic principles of shariah law (which generally discourages greed and excessive wealth accumulation). The innocent and those who are not fully aware of the benefits (as well as of the associated risks) of financial investments are protected against any kind of fraudulent activities that may arise out of pure speculation. Internationally, Islamic banks appear to be more resilient against the global economic turndown and international financial crisis than conventional banks have been. As mentioned above, they tend to avoid speculative investments, such as derivatives, that many analysts believe led to the financial crisis affecting conventional banks. For many observers, Islamic finance serves as a vehicle for recovering from the international financial crisis. The Islamic banking industry may be able to strengthen its position in the international market as investors and companies seek alternate sources of financing.