The official law of Islam is called Sharia. It is based mostly on the Quran, but on other holy Islamic texts as well. Sharia covers a wide range of topics, from religious rituals to courtroom proceedings to food preparation. Among other things, Sharia law prohibits some very common financial practices, including excessive uncertainty and the charging of interest. These rules can make it very difficult for conventional banks to operate in regions that strictly follow Sharia law.

Islamic Finance/Microfinance Principles

Bankers in Islamic countries have developed a series of practices in order to adjust modern banking with Islamic law. These principles and practices were developed in the 1960s and 1970s and have collectively come to be known as Islamic finance. Though the practices can be different, some of the most important postulates are:

  • Profit-sharing. The bank and the borrower each own shares of an enterprise. If the enterprise succeeds, the borrower pays the bank a predetermined portion of the earnings. If it fails, the bank shares in the loss.
  • Leasing: The bank purchases an asset and leases it to a customer. The customer agrees to pay off the asset plus a certain amount of profit to the bank. These payments are not considered and defined as interest on a loan, but payments on a physical object, which is allowed.
  • Asset-based bonds: These are similar products to bonds, except instead of earning interest on an investment, the borrower owns part of an asset. If the asset increases or decreases in value, so does the sukuk.

Advantages and Disadvantages of Islamic Finance

Surprisingly, Islamic finance has recently caught on across the world, including non-Muslim countries. The value of asset-based bonds issued in non-Muslim countries reached $2.25 billion in 2017. The biggest Islamic finance institution in Britain, Al Rayan Bank, says that about a third of its customers are not Muslim. There are several reasons for the popularity of Islamic finance in non-Muslim countries. Many people are starting to realize that it has the potential to reduce poverty and increase equality around the world.

As of 2008, as much as 72 percent of people in Muslim-majority countries did not use conventional banks and as much as 40 percent of the same population said they refused to use microfinance institutions because Sharia law bans interests. Small and medium enterprises (SMEs) in Muslim countries face a similar issue. Around 35 percent of SMEs in these countries do not have access to credit because they insist on using Sharia-compliant lenders. Since SMEs are widely considered to be major drivers of a country’s economy, a lack of access to credit among SMEs can do damage to the whole country’s financial success.

Consequently, the expansion of Islamic finance institutions around the world can make it easier for many people to gain access to credit, which will allow them to start or expand businesses, buy homes and engage in other forms of economic activity.

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Islamic Finance/Microfinance Reduces Exploitation

Like other religious traditions around the world, Islam requires its adherents to behave justly. Sharia does not only include laws about interest payments. It also has laws requiring the protection of the poor and less fortunate. Because Islamic financial institutions are explicitly organized along religious lines, they are technically required to consider principles of justice when making decisions. Of course, the people who run Islamic finance institutions are not saints, and they make decisions to benefit themselves just as the leaders of Western banks do, but there are some systems in place that make justice-oriented lending more likely.

Since Islamic finance institutions are required to share risk with borrowers, they have an incentive to help borrowers succeed. These institutions are also required to have a Sharia board consisting of Muslim scholars to ensure that the institution’s decisions comply with Sharia law.

Some institutions have taken even more direct steps to use the financial system to improve people’s lives. For instance, Kazanah Nasional in Malaysia has issued a “social impact sukuk” worth around $280 million. Assets in the sukuk are intended to support affordable housing, renewable energy and other initiatives.

Islamic Finance/Microfinance and Stability

Because Sharia forbids “excessive uncertainty” and trading in debt, some scholars think Islamic finance is resistant to the kind of mismanagement that caused the 2008 financial crisis. Islamic finance institutions also performed better than conventional banks in the wake of the global economic crisis, in part because they tend to make safer investments.

The relative stability of these institutions explains some of the appeals among non-Muslims in them after 2008. Discouraging risky investments and increasing stability also protects the most vulnerable people around the world who suffer most from predatory lending practices and also from economic crises that come from such practices.

Nobody thinks Islamic finance is the solution to all the world’s economic problems. As the practice of Islamic banking spreads, more research is emerging about its drawbacks as well as its promises. But when it comes to increasing access to credit in some of the poorest areas of the world, organizing finance on principles of justice and preventing instability, Islamic finance is emerging as one popular and relatively effective solution.