Economics / Finance / International Business / Organizational Strategy

What is Islamic Banking? And Why Does it Appeal to More than Just Muslims?

Considering the economic conditions of the Arab world, one wouldn’t expect that financial practices in the Middle East would be imitated. However, elements of Islamic Banking appeal to individuals everywhere, and it is starting to pick up steam outside of Muslim regions.

The size of Islamic banking worldwide has grown 17.6% from 2009-2013, according to Ernst & Young, who also project an average growth rate of 19.7% through 2018. There are also a growing number of major traditional banks worldwide that offer Islamic branches.

Islamic banking was born out of Sharia Law, the moral code of Islam, which applies special rules regarding finance. Some of the most basic practices in finance worldwide violate Sharia Law. For example, charging interest is immoral under Sharia Law. Islamic Banking was born mostly out of this principle; it answers this dilemma with alternatives to traditional products. For example it replaces bonds with sukuk, and insurance with takaful. Islamic Banking also prohibits investment in areas deemed immoral by Islam, such as alcohol, pork, gambling, and pornography.

Sukuk differs from bonds because it actually gives the bond owner partial ownership in the asset that the capital is being used for, as opposed to a bond, which simply provides capital for the bond issuer and then charges interest. In a sukuk issuance, an agreement is usually made that the certificate will be sold back at a certain maturity date, similar to stock maturity dates.

In the risk management system of takaful, participants make “donations” to a group fund to spread out risk. It differs from insurance in that the surplus at the end of a certain period in the fund belongs to the participants, rather than a company. Takaful funds usually have managers that invest certain percentages of the fund in Sharia-compliant ventures. These managers usually make some sort of fee, salary, or commission, depending on the type of fund.

Notice that in both of these types of commodities agreements, no profit is being made off of the risk of others, which violates Sharia Law. In sukuk issuances, the investor shares risk with the issuer, and in takaful funds, there is no company making profit off of the donations.

These two Islamic financial products only scratch the surface of Islamic products. To learn more about the basics of Islamic finance I recommend the YouTube channel, Marifa Academy.

Since Islamic banks cannot charge interest, the venture or asset they are financing must succeed in order for the bank to make a profit. This gives Islamic banks the reputation of being more transparent and safer, since it is logical for users to assume that the success of the bank is tied to their own success. This differs vastly from traditional banking. Since traditional banks make the majority of their profits by charging interest, they do not have to be as heavily invested in the success of their customers. Schemes of making profit like this were contributors to credit bubbles that caused both the 1929 crash and the Great Recession of 2008. With the latter fresh in our minds, it is not difficult to understand growing preference for Islamic finance.

Mark Mulkeen

Sources:

http://www.economist.com/news/finance-and-economics/21617014-market-islamic-financial-products-growing-fast-big-interest-no-interest

http://www.dummies.com/how-to/content/how-sukuk-islamic-bonds-differ-from-conventional-b.html

https://www.youtube.com/watch?v=hd9jBdgocMY

http://www.bbc.com/news/business-28365639

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