Islamic Finance

In what ways could Islamic finance be seen as an innovative way that could substantively redefine finance or do you rather think that it is more of the same as conventional finance? Discuss why Islamic finance is substantively different or similar to conventional finance.

In the last decade, the concept of “Islamic bank” has firmly entrenched in the lexicon of financiers in many developed countries. This financial institution typical for Muslim states gradually begins to play an increasingly important role in the traditional financial system. In such countries as the United Kingdom and the United States, where the number of citizens who practice Islam and refuse to use the services of traditional banks has grown by many times, it is no longer possible to ignore Islamic institutions. Therefore, the study of Islamic banks is quite a relevant topic in the global economic literature and is of practical interest for the economic agents all over the world. The aim of the paper is to describe the basic principles of the functioning of the Islamic financial system as well as discuss its differences and similarities with the traditional banking system.

To a large extent, Islamic banking differs from the traditional system adopted in most countries. It has certain peculiarities typical only to it. The first of them consists in the prohibition on interest rates. The Islamic financial system forbids “riba” (surplus), which means any unjustified increment of capital at a loan or in the exercise of a trade transaction (Ayub 448). In other words, any predetermined rate depending on the timing and amount of the loan and not depending on the success of investment is called riba and is prohibited (Khan 413). This interdiction is justified by the notions of social justice, equality, and property rights. Islam encourages yielding gains (Khan 413). However, this religion condemns the use of interest rate for generating a profit. It is associated with the fact that these activities do not lead to the creation of the product and cannot increase the welfare of the society (Khan 414). Social justice requires that borrowers and lenders receive compensation or damages on a parity basis and that the processes of money accumulation and wealth creation in the economy reflect a real contribution of economic agents into economic development.

Risk-sharing is another principle of Islamic banking (Ayub 450). Because of the prohibition of charging interest, those who offer money in debt become investors rather than creditors. The owner of financial capital and the entrepreneur share the risks to share the benefits. Money is regarded as “potential” capital (Ayub 450). It means that they become real money only when invested in productive activities.

The Islamic financial system does not approve the accumulation of money and prohibits activities characterized by great uncertainty, for instance, gambling (Ayub 451). In such a way, propagation of derivative financial instruments is highly difficult in the Islamic financial system. Islam preaches the discharge of contractual obligations as an important duty of transaction parties. These requirements are intended to reduce the risks associated with the asymmetry of information and moral hazard. Additionally, Islam condemns receiving of unilateral gains by a more informed party of the contract. In this regard, a ban on a deliberate risk that goes beyond the inevitable accident is imposed. Generally, this concept excludes any speculative operations.

Islamic banks are the most important element of Islamic financial system. They perform the same functions as the traditional ones:  provide operations of the national payment system and act as financial intermediaries. Besides, in the part of the payment conduction Islamic bank is not different from the traditional one in the principle of its work; however, in regard to the financial intermediary function, there is a fundamental difference.

A key moment, in which Islamic banks are different from western financial institutions, is that they do not get the award in the form of interest payments in their practice (Hassan and Lewis 96). However, as it was already noted, Islam does not blame an attempt of yielding gains. The ban is imposed only on a fixed profit, which is not dependent on the results of the activities. In other words, a fee to the owner of the capital must not take the form of payment of a sum established beforehand regardless of the profitability of the enterprise as in the case of charging interest. According to the norms of Islamic ethics, only that wealth can be righteousness, which is a source of work and entrepreneurial efforts of the owner as well as the inheritance or a gift (Hassan and Lewis 97). In addition, the profit is the reward for the risks associated with any business venture.

A bank may receive income without charging interest if it is a member of the project (Hassan and Lewis 97). In this scenario, it must fully share both gains and risks with the enterprise. In addition, the bank may engage in trade and make a profit from the margin between the cost of acquisition of the goods and the cost of its implementation. In this case, only the actual results of operations will affect the financial institution’s yields.

Thus, the principles of Islamic banks do not contradict the principles of operation of the market economy. In the book Financial Markets and Institutions in the Arab Economy, it is stated that “The Islamic banks offered most of the banking services, which are offered by conventional banks with some exceptions” (Sabri 84). Abandoning the collection of interest rates, they do not seek to work on the charitable basis. It is worth noting that in the world, there are both individual financial institutions operating on the basis of the principles of Islamic religious ethics in the ordinary course of the financial system and the whole countries, the financial systems of which are based on the norms and laws of Sharia.

In addition, each Islamic financial institution necessarily has religious advisers constituting the Sharia Supervisory Board (Ayub 457). The functions of this body include admissible certification of financial instruments, calculation and payment of the decline, checking of bank transactions for compliance with Sharia, and the development of recommendations on the distribution of income and expenses between the investor and the financial institution.

The main differences and similarities between Islamic and traditional banks are concluded in some points. Guaranteed payments on demand deposits are offered in both kinds of institutions (Iqbal and Mirakhor 101). However, in contrast to the traditional banking system, there are no guaranteed payments on investment deposits in Islamic banks as the interest rate on deposits is not defined in them (Iqbal and Mirakhor 101). It is determined and guaranteed by traditional banks (Iqbal and Mirakhor 102). The mechanism of defining the interest rates on deposits does not depend on the financial institution’s profitability in the traditional system. In contrast to this, in the Islamic banking system, the rate of interest on deposits is determined using the profitability of the bank and income investments in the system (Iqbal and Mirakhor 104). Another difference consists in the fact that in Islamic financial institutions, there is an active participation of investors in the profit and loss account of the bank. However, it is not typical for a traditional banking system. With the participation of investors in the profit and loss statement of the Islamic bank, it often does not discriminate against clients depending on their existing pledge (Iqbal and Mirakhor 104). However, the traditional financial institution always has the right to make a decision on whether to grant a loan depending on the financial position of the client.

Islamic financial institutions are widely spread in the world. It is obvious that the current trends in the development of Islamic banks will persist in the future. It creates conditions for a thorough examination of their functioning and their differences and similarities with the traditional financial markets. Consideration of the principles of Islamic financial institutions has showed that the characteristics of the majority of Islamic financial contracts are not economic but associated with the need for their conformity to Islam.

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