Can Islamic finance save the banking sector?

Islamic finance has grown and expanded rapidly in recent years. It was recently announced that, following in the footsteps of some of its European neighbours, Germany will soon have its first Islamic bank — which is ironic if you think about the history of the country.

Ireland, a country of arguably staunch Catholics, is also making a bid to be a global hub for Islamic finance.

The global growth of Islamic finance in recent years is, in part, a response to the demand for a more ethical financial system. But is Islamic finance just an ethical “spin” on “conventional” finance? Or can it offer more tangible solutions beyond the Muslim community?

What is Islamic finance?

Just like ethical investment in the standard financial sector, Islamic finance prohibits the use of funds for certain purposes. For example, no investment in activities that deal with alcohol, pornography, gambling and so forth.

The basis for Islamic finance’s code of ethics comes from religious texts and is less arbitrary than secular ethical investment. Admittedly, these texts have to be interpreted, and this can lead to vigorous debates and disagreements. But compared to standard ethical investment, the religious texts serve as a relatively more permanent anchor to guide behaviour.

Islamic finance goes much further than standard ethical investment. Not only does Islamic finance prohibit funding for “unethical” activities, it also bans transactions where people share risks and uncertainty in a disproportionate manner. This is why the use of interest is prohibited.

As you know, if you borrow money from a “standard” bank to run a business, the bank is guaranteed a return (the interest) while you, the borrower, will bear all the risks of making or losing money from the business operation. Islamic finance prohibits such arrangements. Instead of an interest-based banking system, Islamic finance prefers a system where profits and losses are shared. So, instead of lending money in return for interest payments, Islamic banks would lend money in return for an eventual share of the profits or loss generated from the business.

No speculation

The standard financial system permits speculative activity. In fact, this is encouraged as a way to keep the market “efficient”. Unfortunately, speculative activity can also have unwelcome effects, such as when financial bubbles are created and then burst.

Unlike the standard financial system, Islamic finance prohibits financial transactions that involve speculation. According to Islamic texts, financial transactions must have a clear link to an underlying “real” activity. So, you can buy and sell financial assets if you have a genuine interest in its underlying value, not because you want to gamble on changes in its price. [See the paper (paywalled) by Shahnaz and Tony Naughton for a clear and detailed discussion on this point.]

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