Islamic Finance, regarded as a powerful alternative to the traditional model, is currently the juggernaut in the world of finance. Despite being a modern phenomenon, the roots of this burgeoning field of finance trace back 1400 years, when Islamic principles were established in the Quran. It enlists a way of carrying out commercial transactions and banking services, in accordance with Sharia or Islamic law. Unlike conventional finance, Islamic finance has a multitude of dimensions such as religious, social, and ethical, in addition to the economic aspect of transactions. Modern monetary instruments such as letters of credit and cheques have been adopted from the tenets of Islamic Finance. Although Islamic finance originated in the seventh century, it became popular after the late 1960s. This was driven by the booming oil profits, in the Middle-East, which fueled the demand for Sharia-compliant products and practices. Islamic Finance, which hardly existed three decades ago, is a $2.2 trillion strong industry today, widespread across more than 60 countries. Islamic banks are the biggest stakeholders in the industry and account for $1.5 trillion in assets. According to Reuters, this sub-branch of finance is expected to grow to $3.5 trillion by 2021. With an annual growth rate of 10-12%, Islamic finance is not limited to Islamic countries and has transcended borders to establish a strong foothold in several Western countries including the UK and France.
The concept of risk sharing and socio-economic upliftment is integral to the working of Islamic finance. The most famous tenet of this branch is the ban on usury, which is the practice of lending money at unreasonably high rates of interest. Riba (interest) and Gharar (deception and/or obscurity) are proscribed by the Sharia. These practices are considered exploitative in nature, which favours one side of the transaction, i.e. either the lender or the borrower, over the other. Ban on usury implies that lenders and borrowers are forbidden from charging or paying interest amounts. Consequently, banks which comply with Sharia, do not issue interest-based loans. A prominent question that arises is how do these profit-making entities function in the absence of interest rates. The simple answer is that the creditors become investors who lend funds to clients. As investors, they become entitled to have a share in the business profits, as compensation for the lending risk they bear. Losses are a collective phenomenon, implying that both sides do not benefit. Simply put, investments have an upper hand in making profits for Islamic banks rather than interests. Sometimes, a proportion of the deposited money is used to buy assets that are leased or resold at higher market value. The difference is accrued as profits to these banks. This is Sharia’s way of ensuring economic and social justice so that everyone gets what is due to them.
Another concept that is barred in the Sharia law is that of ‘gharar’. In a financial context, gharar refers to the ambiguity and deception that accompanies the purchase of items with uncertain existence. Examples of gharar would be insurance premiums purchased to insure against something that may or may not occur, and derivatives which are used for hedging purposes. In short, investors must have all relevant information about potential risks and should not participate in the exchange of instruments that one doesn’t own. Moreover, as Sharia forbids any form of unethical investment, an individual cannot base his ownership over assets acquired from speculative activities, known as ‘maisir’. In addition, any kind of financial transaction which is considered immoral or illicit by the Quran is termed ‘haram’ in the field. Possible examples include gambling and investment in alcohol production. In due course of time, a couple of financial instruments were developed which were compliant with the Sharia. These contracts follow strict principles and have a complex set of rules and codes. Financing tools in Islamic finance consist of equity-like and debt-like instruments. The word ‘like’ indicates that these tools are not exactly similar to their conventional counterparts.
For example, a Sukuk is an asset-backed trust certificate, which is an equivalent of a bond in the traditional model. However, these two instruments are notably different. While a Sukuk indicates ownership of an asset, a conventional bond is a debt obligation. Moreover, a Sukuk can increase in value when the underlying asset increases in value but profits accruing from bonds correspond to a fixed rate of interest. Equity instruments include Profit & Loss sharing contracts such as ‘mudarabah’ and ‘musharakah’. In a Mudarabah or a P&L partnership contract, one partner (financier or rabb ul maal) provides the capital to another partner (labour provider or mudarib), who is responsible for operations and management of the business. The profits are shared by both parties in accordance with pre-agreed terms. On a similar note, Musharakah is a P&L Joint Venture contract. All partners pool in capital resources and share profits in a proportionate manner. Islamic Finance is expanding at a remarkable pace. The market perception about this model being insulated to economic shocks and being driven by strict ethical codes of conduct has led to greater inclination towards it. Lack of financial stability in the conventional field has called for better alternatives and reforms, bringing Islamic Finance to the table. As the United Kingdom became the first non-muslim country to adopt this Sharia practice, other countries are not far behind. The system has also appealed to countries like India, which believe that the adoption of Islamic Finance will make them a lucrative destination for Islamic investments. This intriguing interplay between faith and finance is yet to be uncovered fully. Time will tell how this emerges.