Principles and concepts of Islamic finance and its impact on global financial system

By S.A. Azeez

Islamic finance is a financial system that operates according to Islamic legal principles. Just like conventional financial systems, Islamic finance includes banks, capital markets, fund managers, investment firms, and insurance companies. However, these entities are governed both by Islamic principles and the rules and regulations that apply to their conventional counterparts.

In many Muslim countries, Islamic banking assets have been growing faster than conventional banking assets. There has also been a surge of interest in Islamic finance from non-Muslim countries such as the UK, France, Luxembourg, Hong Kong and. South Africa. Islamic finance is becoming an integral and inevitable part of world financial system. 

With annual growth of 10-12% over the past 10 years and a projected worth of $3.5 trillion by 2020, the rise of Islamic finance has been undeniable.

Major financial markets are finding solid evidence that Islamic finance has already been mainstreamed within the global financial system including in non-Muslim countries. It promotes risk sharing and connects the financial sector with the real economy.

Awareness of Islamic banking and finance is rising and there is a universal demand for a fair and just system that is socially responsible and sustainable.Millions of people lost their homes due to the 2008 global financial crisis.Billions were lost in the financialcrash of 2010. Many countries in the world are currently facing an unprecedented debt crisis. 

Currently there are over 622 institutions providing Islamicfinance worldwide, with 109 such institutions existing in Europe alone. “International leadingbanks such as HSBC, Deutsche Bank, Citi Bank and Barclays started Islamic finance products and have witnessed significant growth in the segment.

Systemically important in Asia and the Middle East

The International Monetary Fund has called Islamic finance ‘systemically important in Asia and the Middle East’, and highlighted the internationalisation of the Sukuk market (the Islamic equivalent of bonds) with issuances being made across the Middle East as well as in countries such as the United Kingdom and Hong Kong.

The World Bank has also recognised the growth of the industry and in 2015 signed a memorandum of understanding with the General Council for Islamic Banks and Financial Institutions in a bid to help foster the development of Islamic finance around the world and expand its use as an effective development tool globally.

The World Bank states: “Islamic finance is equity-based, asset-backed, ethical, sustainable, environmentally and socially responsible finance. It promotes risk sharing, connects the financial sector with the real economy and emphasises financial inclusion, and social welfare.”

Asian Development Bank (ADB) acknowledges Islamic finance as a key source of investment finance in both advanced and developing countries as well as a means for diversified funding and broadening risk exposure at institutional and macroeconomic level.

How to manage wealth in a way that promotes justice

Islam allows for a free-market economy where supply and demand are decided in the market, but at the same time, Islam directs the function of the market mechanism by imposing specificlaws and ethics that promote social justice. Therefore, social justice is a key concept of the Islamic finance industry.

Islam doesn’t allow for a society in which a small number of people enjoy most of the wealth while many people have very little. Economically speaking, ‘social justice’ is the distribution of wealth in a way that helps correct such an imbalance. 

Based on the core concepts of Islamic economics, Islamic finance institutions (IFI) adhere to certain principles that distinguish them from conventional finance. 

Prohibiting interest 

IFI avoid interest based transactions. In aninterest-based transaction, the owner of the wealth gets return without making any effort and bears no risk. The person receiving the loan, on the other hand, assumes all the risk and bears the responsibility of returning to the lender both the capital and the interest no matter what the outcome of the economic activity. From the Islamic point of view, in aninterest based transaction, the lender ignores the misfortune of the borrower in acquiring wealth, which is unjust in Islam.

Steering clear of uncertainty-based transactions 

IFI have to avoid to transactions that are uncertain or ambiguous.

When two parties enter a contract and one party lacks complete information: For example, a party purposely withholds some information in order to wield greater control over the transaction.

When both parties lack control over the underlying transaction: For example, two parties enter a contract related to the sale of fish that haven’t yet been caught. Both parties lack control over that transaction because outside forces (such as weather or overfishing) may prevent the delivery of all the fish expected per the contract.

Avoiding gambling

In Islamic finance, both the acquisition of wealth by chance (not by effort) and games of chance are prohibited because one person gains at the expense of loss for many.

Avoiding investment in prohibited industries

Islam prohibits industries that it considers harmful to society and a threat to social responsibility. These industries include alcohol, tobacco, and illegal drugs. By prohibiting certain industries, Islam also prohibits profiting from them in any way. Therefore, an Islamic financial institution can’t finance a project or asset that is prohibited.

Some of the typical transaction structures

There are a number of principal techniques that have evolved over the years. It may also be possible for other conventional facilities (for example, guarantee facilities) to be offered, provided they are not isolated but are linked to an underlying Islamic structure characterising the agreement.

Murabaha

The ‘Murabaha’ contract involves short to medium term financing for working capital requirements and for purchase of goods/assets. The service provider will inform the customer regarding the cost breakdown and the profit in the sale price.

The transfer of the asset under a Murabaha contract must be immediate (although the price payable by the purchaser is generally deferred). A financial institution would typically acquire an asset from a vendor and immediately sell the asset on to the clientwith a profit mark up. 

Ijara

‘Ijara’ involves the act of leasing in which the owner of the asset transfers itsuse and enjoyment to another person to use for an agreed period and for an agreed rent. The subject of the lease should be valuable, identifiable and quantifiable. As title to the leased asset remains in the financier or lessor’s ownership, the lessor must bear all liabilities arising from its ownership. 

Upon the satisfactory payment of the contract, the ownership of the item is transferred to the customer

Mudaraba

This arrangement involves two parties:

The managing trustee 

The beneficial owner 

The Islamic Financial Institution (IFI) can either put up all the funds itself and undertake responsibility for investing them, or it can provide funds to the customer who then acts as ‘Managing Trustee’. The funds provided will usually be those of its investors rather than the IFI, with the IFI acting as trustee for those investors and assuming fiduciary responsibilities. The rewards are split as follows:

The client retains a fixed percentage of the profits.

The IFI’s reward is a fixed share in the balance of the revenue generated by the investments.

The remainder goes to the investors.

There is no guarantee that the IFI’s investment will be returned or that a profit will be generated.

Sukuk

Along with the typical transaction structures, the ‘sukuk’ is an important instrument in Islamic finance.

Sukuk isdefinedas certificates of equal value representing undivided shares in the ownership of:

Tangible assets, right to use a property and services.

The assets of particular projects or special investment activity.

Sukuk are often referred to as ‘Islamic bonds’ but unlike conventional bonds, sukuk are not debt obligations but represent a beneficial ownership interest in the underlying asset or activities which generate cashflows. Sukuk are financial instruments which sit above a Sharia compliant underlying structure which generates revenue on behalf of the holder of the instrument.

The Islamic finance industry is constantly evolving and this article only provides an overview of some of the key concepts and principles of Islamic finance and the major developments in the Islamic finance industry over the recentdecade.The momentum of the world’s Islamic finance industry, backed by impressive statistics and growing popularity, the ambition and drive of its main players continues to make Islamic finance the most exciting story in the world of banking and finance.