Is Islamic Finance More Robust and Resilient Than Conventional Models? 

by Ammar Khairi & immedia | 10th December 2019


Are financial institutions paying enough attention to Islamic finance? Despite the strong growth of the Islamic finance sector, many financial institutions still do not realise the benefits Islamic finance can bring, not just to their companies, but to society as a whole. First, let’s refresh our basic understanding on Islamic Finance.

The basic concepts of Islamic finance

The fundamental features behind modern Islamic finance are the prohibition of riba (usury), maisir (speculation) and gharar (uncertainty) in accordance with Shariah law. Instead of charging interest, Islamic banks instead follow profit-sharing and asset-financing models.

Further, Islamic banks are themselves prohibited from investing in speculative instruments, making them, in many ways, more robust compared to conventional banks. This was demonstrated during the last global financial crisis, with the International Monetary Fund (IMF) noting that“Islamic banks, on average, showed stronger resilience”.

But these inbuilt limitations can do more than increase an institution’s resiliency. They can also benefit their reputations.

Islamic Finance – A return to a socially responsible reputation

Modern finance, rightly or wrongly, is seen to have become divorced from social responsibility.

Consider the question, what is the core purpose of banking?

Banks give people a safe place to deposit their money and support the economy as financial intermediaries. They connect borrowers and savers, allowing the economy to allocate resources more efficiently. Ultimately, banks exist to serve society.

But as finance becomes ever more abstract, many question whether banks have strayed from their core purpose in serving society and may, in fact, result in negative externalities. Since the global financial crisis, this view has become increasingly prevalent. This was perfectly captured by papers by the IMF and the Bank of International Settlements, titled ‘Too Much Finance?’ and  ‘Why does financial sector growth crowd out real economic growth?’.

Further, the excessive growth of the financial sector was also at least partly responsible for the global financial crisis. The effects of the real estate crash were amplified by complex financial instruments tied to the value of subprime mortgages. These exotic derivative instruments were far removed from the core purpose of banking.

Islamic banking mandates a return to this core purpose. Being bound by Shariah principles, Islamic banks are forbidden from investing or issuing such speculative instruments. This explicit prohibition, again, not only creates more resilient institutions but ensures Islamic banks stick to the core purpose of banking, and by extension, sticks to socially responsible goals.

Other than speculative instruments, Islamic banks are also prohibited from investing in so-called vice industries, which further adds to their reputation. The same investment prohibitions apply in other areas of Islamic finance such as Takaful (insurance), wealth management, and capital markets. On top of that, in Takaful, excess profits are distributed to policyholders instead of to the shareholders of the insurance company.

All of these differences mean Islamic finance is viewed as the socially responsible cousin of conventional finance and thus enjoys strong reputational benefits.

Islamic finance landscape deals with many challenges despite exhibiting resilience

Despite the higher resilience of Islamic financial institutions spoken about earlier, the industry is not without its challenges—namely growth. S&P estimates that global Islamic finance assets surpassed the US$2 trillion mark at the end of 2017 and will continue to grow in the lower single-digits over the next few years. While Islamic finance has historically grown at a faster rate compared to the conventional sector, 2018 marked the first time that Islamic banks, especially those in the Gulf Cooperation Council (GCC), grew slower than their conventional peers.

One of the main reasons for this is its difficulty in keeping up with the ever-evolving world of global finance. This has led ro criticisms that Islamic banking is merely trying to mimic conventional banking using more and more complicated financial structures which may follow the letter of Shariah law, but not its spirit.

As lecturers from the International Islamic University Malaysia said in a paper:

“The substance is the same .... Islamic banks in reality keep interest but just call it by another name, such as commissions or profits”

But Islamic finance's growth challenges can also be used as an opportunity. Islamic banks can do more than just being a limited version of conventional banks. They have a unique advantage that conventional banks don’t—the ability to enter into profit-sharing arrangements with businesses.

Profit-Sharing models – an untapped growth opportunity

Musharakah and mudarabah are the official terms to describe profit and loss sharing in an Islamic context. It is also considered the ideal form of Islamic financing. However, it is also an underexplored area in modern Islamic finance. For instance, a university paper on the most popular Islamic financing concepts in Malaysia, using Bank Islam as a case study, noted that ‘Musharakah was absent from bank’s financing in the last three years and Mudarabah was proportionately negligible throughout the five years period in which the study covered’.

This means there is still a huge untapped opportunity in true profit and loss sharing models. Mirroring the rise of fintech, Islamic fintech has seen a concurrent rise - one 2018 report identified almost 100 Islamic fintech companies globally. Growth in this ecosystem is also supported by supportive regulatory bodies such as the Malaysia Digital Economy Corporation and the Dubai International Finance Centre, with the latter having a USD100 million fintech-focused fund to that end.

Tapping into this opportunity not only has large growth potential, but it can also bring the whole industry closer toward more socially responsible principles and further add to its reputation.

A growing Islamic finance sector is good for both financial institutions and society

Muslims not only being the fastest growing religious demographic, they are also on average younger, more devout, and make up a higher percentage of the world’s unbanked. As such, a stronger pivot toward Islamic finance can allow financial institutions to enjoy both reputational and growth benefits while simultaneously fostering a socially responsible agenda.

It is truly a win-win situation, and that’s more than worth paying attention to.


Interested in learning more about Islamic finance? At the FAA, we provide a comprehensive list of accredited programmes to help equip you and your staff with the knowledge need to successfully operate in this space.


















Tuesday, December 10, 2019

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