Is Islamic Finance The Panacea?

Image Courtesy: 123rf

The principle of Islamic finance (Non-Interest Finance) focuses more on transparency of dealings, social responsibility through proper equitable distribution of wealth. The crisis in the Euro for the past couple of years with the conventional banks struggling to weather the storm looks promising for the Non- interest financing.

'Musharaka' which I largely believe is the major significant argument for Islamic finance is a financial activity where the bank or investor provides the fund for an enterprise but also participate in the managing of the firm. Profits earned on the venture will be shared between the parties based on the agreed ratio and the losses will be shared based on their capital contribution.

For instance, If conventional banks were required to share the profits and losses of their clients like the 'Musharaka', whether on business investments or mortgages which led to sub-prime crisis in 2008 they would be much more careful. This is because their financial returns would depend more on the performance of the projects that they finance. Interest-based lending substantially divorces financial institution from their customers risks and focuses only on the interest to be earned on the loan deal. In many cases, the banker who brings in the loan deal has already collected his or her bonus and sometimes retired by the time the deal goes bad and eventually causes problem for the entrepreneur and the bank.  

Budding entrepreneur with great business idea without collateral often fail to attract finance under the conventional system because of the interest based finance but Islamic finance has bridged this gap through profits and loss sharing.

Despite the prospect of Islamic finance, challenges abound as well. Some school of thought argued that Islamic finance instruments are only an hybrid version of the conventional instrument and that there is no significant difference. There is also shortage of qualified professional who specializes in Islamic instruments and also diversity in the laws and procedure in different countries where it's been practice. I believe if these challenges are eliminated, non interest finance can be the panacea for the financial crisis.

Islamic Finance - My Understanding

Image courtesy: Capital Business

A friend once asked me is Islamic Finance and banking for only Muslim? This prod me to write this short piece based on my understanding. Many people believed that since the name says 'Islamic' it simply has to do with Muslims. It is a financial system that allows all and sundry to participate irrespective of their religious beliefs.

Islamic finance and banking  sometimes called Non- Interest Finance can be said to be financial activities which is based on Islamic principles that forbids interest 'Riba' and financial speculation. It focuses more on risk and profit sharing which is the basic principle.

The major principles :

Non-Interest (Riba) : The conventional banking focuses on taking and giving interest  but in Islamic finance, it prohibits any payment above the actual amount of principal been borrowed.

Risk Sharing: It is financial system that focuses on profit, loss and risk sharing as well as participation of parties involved the transaction.

Investment in gambling and dealings in alcohol is prohibited.

Market prices are determined based on the forces of demand and supply and not on speculation.

Finally, non -Interest finance as I like to call it is centred on fair, transparency and risk sharing in all dealings. I will follow up this short piece with my personal opinion on Islamic finance and the financial crisis.