 Islamic finance is a unique system of financial management that is rooted in the principles of Islamic law, also known as Shariah. It is a rapidly growing and dynamic sector of the global financial industry, with an estimated total global assets of over $2 trillion as of 2022. Islamic banking finance has gained significant attention in recent years due to its ethical and socially responsible approach to financial transactions, which are guided by the teachings of Islam.
History of Islamic Finance
Islamic finance has its roots in the early Islamic period, with principles that were established over 1,400 years ago. The principles of Islamic finance are based on the teachings of the Holy Quran, and the Hadith, which is the collection of sayings and actions of the Holy Prophet. These teachings emphasize ethical conduct, economic justice and the prohibition of interest (Riba) and excessive uncertainty (Gharar).
Riba, or usury, refers to the charging or receiving of interest on loans or debts. In Islamic teachings, Riba is generally considered Haram (forbidden) based on the Holy Book and Hadith, which are the primary sources of guidance for Muslims. Let’s explore this in more detail:
References:Â There are Ayats: For example, in the Second Surah (2:275), The Almighty says, “Those who consume interest cannot stand [on the Day of Resurrection] except as one stand who is being beaten by Satan into insanity. That is because they say, ‘Trade is [just] like interest.’ But He has permitted trade and has forbidden interest.” This verse highlights that while trade is permissible in Islam, interest (Riba) is not.
Hadith references: Hadith, which are the sayings and actions of the Holy Prophet, also emphasize the prohibition of Riba. He said, as narrated by Abu Hurairah, that “He cursed the one who consumes Riba, the one who gives it to others, the one who writes it down and the two who witness it.” (Sunan Ibn Majah)
Principles of Islamic Finance
Islamic finance is based on a set of principles that guide its operations. These principles are:
Prohibition of Interest (Riba): Islamic finance prohibits charging or paying interest on loans. Instead, it promotes risk-sharing and profit-sharing arrangements between parties.
Prohibition of Speculation (Gharar): Islamic finance discourages excessive uncertainty or speculation in financial transactions. Contracts must be based on clear terms and conditions, and parties should have full knowledge of the underlying assets and risks involved.
Ethical and Socially Responsible Investments: Islamic finance encourages investment in businesses that are socially responsible and morally ethical, such as those involved in healthcare, education, renewable energy, and infrastructure development. It prohibits investment in businesses related to alcohol, tobacco, gambling, and other haram activities.
Asset-backed transactions:Â Islamic finance promotes asset-backed transactions, where financing is tied to real assets, such as property, equipment, or commodities. This promotes real economic activities and discourages speculative transactions.
Sharing of profits and losses: Islamic finance emphasizes the sharing of profits and losses between parties in a transaction. This encourages a sense of partnership and accountability, as parties share the risks and rewards of an investment or business venture.
Avoidance of excessive debt: Islamic finance discourages excessive debt and promotes responsible borrowing and lending practices. It emphasizes the importance of living within one’s means and avoiding over-indebtedness.
Practices of Islamic Finance
Islamic finance offers various financial products and services that comply with the principles of Shariah. Some of the commonly used practices in Islamic finance include:
Islamic banking:Â Islamic banks operate based on Shariah principles and offer a range of products, such as current accounts, savings accounts, and investment accounts. Instead of charging or paying interest, Islamic banks use profit-sharing arrangements, rental agreements, or trade-based transactions to generate income.
Sukuk (Islamic bonds):Â Sukuk are financial instruments that represent ownership of a tangible asset or project. Sukuk are structured to comply with Shariah principles and are commonly used to raise capital for infrastructure projects, real estate developments, and other investments.
Takaful (Islamic insurance):Â Takaful is an alternative to conventional insurance that is based on the principles of mutual cooperation and shared responsibility. Participants pool their contributions to form a fund that is used to compensate for any losses incurred by the members of the group.
Islamic investment funds:Â Islamic investment funds offer investment opportunities that comply with Shariah principles. These funds invest in assets that are Halal, such as real estate, commodities, and socially responsible businesses.
Fintech and Islamic Finance:Â Financial technology (fintech) is playing a significant role in shaping the Islamic finance industry. There is an increasing focus on leveraging technology to enhance customer experience, improve efficiency, and provide innovative solutions that comply with Shariah principles. Fintech companies are developing Islamic finance-focused platforms for areas such as digital banking, crowdfunding, peer-to-peer financing, and robo-advisory services.
Sustainable and ethical finance: There is a growing emphasis on incorporating sustainability and ethical considerations into Islamic finance. This includes the development of Islamic financial products that promote responsible investment, green financing, and social impact initiatives. There is also a focus on aligning Islamic finance with the United Nations’ Sustainable Development Goals (SDGs) to address global social and environmental challenges.
Cross-border collaboration: Islamic finance is expanding beyond traditional Islamic finance markets, such as the Middle East and Southeast Asia, into other regions around the world. This has led to increased cross-border collaboration and partnerships between Islamic finance institutions, international financial institutions, and global market participants. This trend is expected to continue as Islamic finance gains traction in new markets and jurisdictions.
Innovation in risk management:Â Risk management is a critical aspect of financial services, including Islamic finance. There is a growing focus on developing innovative risk management tools and techniques that comply with Shariah principles. This includes the use of Takaful (Islamic insurance), Waqf (Islamic endowment), and other risk-sharing mechanisms to manage risks in a Shariah-compliant manner.
Regulatory developments:Â Regulatory frameworks for Islamic finance are evolving and adapting to the changing landscape of the industry. Many jurisdictions with significant Islamic finance markets are introducing or enhancing their regulatory frameworks to provide clearer guidelines and promote standardization in areas such as product development, disclosure requirements and governance.
Reasons for popularity
Growing Muslim population: The global Muslim population is estimated to be over 1.9 billion, making up about a quarter of the world’s population. As the Muslim population grows, there is an increasing demand for financial products and services that comply with Islamic principles, including Islamic finance. This has led to the expansion of Islamic finance in Muslim-majority countries as well as in non-Muslim-majority countries with significant Muslim populations.
Ethical and socially responsible investing: Islamic finance promotes ethical and socially responsible investing, which aligns with the values and preferences of many individuals and institutions seeking to invest their money in a socially responsible manner. Islamic finance prohibits investment in businesses involved in haram activities, such as alcohol, tobacco, gambling, and other unethical industries, and encourages investment in businesses that contribute positively to society, such as healthcare, education, and renewable energy. This has appealed to a wide range of investors who are looking for sustainable and responsible investment options.
Global recognition and standardization:Â Over the years, Islamic finance has gained global recognition and standardization, with the establishment of regulatory bodies, industry associations, and standard-setting organizations that oversee and promote the development of Islamic finance. This has created a conducive environment for the growth of Islamic finance, providing clarity and transparency in terms of regulatory frameworks, product standards, and dispute-resolution mechanisms. The standardization of Islamic financial products and services has also facilitated their integration into the mainstream financial system, making them more accessible to a wider range of investors and customers.
Innovation and diversification of products:Â Islamic finance has seen significant innovation and diversification of products and services in recent years, catering to a broader range of customer needs. This has helped expand the appeal of Islamic finance beyond traditional banking and investment products and into areas such as Islamic microfinance, Islamic fintech, and green Sukuk (Islamic bonds issued to finance environmentally friendly projects). The innovation and diversification of products in Islamic finance have contributed to its rapid growth and increasing popularity among investors and customers.
Stability and resilience: Islamic finance has demonstrated stability and resilience during times of financial crisis, which has boosted its reputation as a viable and sustainable alternative to conventional finance. Islamic finance’s emphasis on risk-sharing, asset-backed transactions, and avoidance of speculative activities has been seen as a more prudent and stable approach to finance, which can help mitigate the risks associated with excessive leverage and speculation that often contribute to financial crises. This has led to increased interest and adoption of Islamic finance by investors and customers seeking stability and resilience in their financial dealings.
Islamic banks and banks with Islamic banking window
There are five full-fledged Islamic banks in Pakistan and several conventional banks that also have Islamic banking windows. The five full-fledged Islamic banks in Pakistan are:
- Meezan Bank Limited
- Bank Islami Pakistan Limited
- Al Baraka Bank (Pakistan) Limited
- Dubai Islamic Bank Pakistan Limited
- Burj Bank Limited (Now merged with Al Baraka Bank (Pakistan) Limited)
In addition to these full-fledged Islamic banks, several conventional banks in Pakistan also offer Islamic banking services through designated Islamic banking windows. These conventional banks with Islamic banking windows in Pakistan include:
- National Bank of Pakistan (NBP)
- Habib Bank Limited (HBL)
- United Bank Limited (UBL)
- Askari Bank Limited
- Faysal Bank Limited
- Bank Alfalah Limited
- Allied Bank Limited (ABL)
- Standard Chartered Bank Pakistan Limited
- Soneri Bank Limited
- Habib Metropolitan Bank Limited
- JS Bank Limited
Countries adopted Islamic Finance models
Several countries have successfully adopted Islamic finance models and have established thriving Islamic finance industries. Some of the countries that are considered successful in adopting Islamic finance models include:
Malaysia has been a pioneer in Islamic finance and has developed a comprehensive and well-regulated Islamic finance ecosystem. It has implemented a range of regulatory and legal frameworks to support Islamic finance, including the establishment of the Securities Commission Malaysia and the Labuan International Business and Financial Centre. Malaysia has also developed a wide range of Islamic financial products and services, including Islamic banking, Takaful (Islamic insurance), and Sukuk (Islamic bonds).
The government of Malaysia has actively promoted Islamic finance as part of its economic diversification strategy and has provided incentives to attract investment in the sector. Malaysia’s success in Islamic finance can be attributed to its supportive regulatory framework, robust infrastructure, and active promotion of Islamic finance at the national level.
United Arab Emirates (UAE), particularly Dubai and Abu Dhabi, has emerged as a global hub for Islamic finance. The country has established specialized regulatory bodies, such as the Dubai Islamic Economy Development Centre and the Abu Dhabi Global Market, which provide regulatory oversight and support for the development of Islamic finance. The UAE has also attracted significant investment in the Islamic finance sector, particularly in areas such as Sukuk issuance and Islamic asset management. The success of the UAE in Islamic finance can be attributed to its strategic location, strong infrastructure, and proactive efforts to attract investment and promote Islamic finance as part of its economic diversification strategy.
Bahrain has a long history of Islamic finance and has been a pioneer in the development of Islamic financial products and services. The Central Bank of Bahrain has implemented a comprehensive regulatory framework for Islamic finance, including the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic International Rating Agency (IIRA). Bahrain has also established the Bahrain International Islamic Financial Centre (BIIFC) to promote and facilitate Islamic finance activities. Bahrain’s success in Islamic finance can be attributed to its supportive regulatory environment, strong infrastructure, and early adoption of Islamic finance principles.
Indonesia has a large Muslim population and has been actively promoting Islamic finance as part of its efforts to develop a more inclusive financial system. The country has implemented various regulatory reforms to support Islamic finance, including the establishment of the Islamic Financial Services Authority (OJK Syariah) and the issuance of Sukuk by the government. Indonesia has also developed a wide range of Islamic financial products and services, including Islamic banking, Takaful, and Islamic capital markets. The success of Indonesia in Islamic finance can be attributed to its large Muslim population, supportive regulatory reforms, and efforts to develop a more inclusive financial system.
Saudi Arabia has a deep-rooted Islamic finance industry, and the country has been actively promoting Islamic finance as part of its efforts to diversify its economy. The Saudi Arabian Monetary Authority (SAMA) has implemented a comprehensive regulatory framework for Islamic finance, including the issuance of Sukuk and the establishment of the Saudi Stock Exchange (Tadawul) as a platform for trading Islamic financial products.
Saudi Arabia has also launched initiatives such as the Islamic Development Bank, the Islamic Corporation for the Development of the Private Sector, and the Fintech Saudi initiative to support the development of Islamic finance. The success of Saudi Arabia in Islamic finance can be attributed to its strong commitment to Islamic finance principles, supportive regulatory framework, and efforts to diversify its economy.
The success of these countries in adopting Islamic finance models can be attributed to various factors, including supportive regulatory frameworks, robust infrastructure, and proactive efforts to attract investment and promote Islamic finance, large Muslim populations, and a commitment to Islamic finance principles. These countries have established comprehensive regulatory frameworks, developed diverse and innovative Islamic financials.
The author, Mr. Nazir Ahmed Shaikh is freelance writer, columnist, blogger and motivational speaker. He write articles on diversified topics. Mr. Shaikh could be contacted at nazir_shaikh86@hotmail.com.