Contributions of Islamic Finance to financial markets

image of newspaper with finances

Ever since the global financial turmoil of 2008, experts have been looking for different ways to firm-up the economic conditions of the global market. The need being a viable financial system that is devoid of ‘weak links’ that contributed to the first major financial crisis of the millennium.

While experts around the world are exploring different options to identify a viable alternative, some of them believe that a financial system, which does not promote short-selling or speculation could address the issue. Islamic finance, which is based on religious principles of Islam (Shariah law), offers scope for such a system. Though the principles are as old as the religion itself, Islamic finance as a business came into the market only in the 1970s.

How does Islamic finance work?

For starters, one of the basic differences between Islamic finance and conventional finance is that the former prohibits the component of interest/usury. This is because Islamic doctrine bans the trade of money as a commodity. All transactions in Islamic finance are asset backed, meaning there is no creation of money from thin air. Musharakah, a widely promoted concept of Islamic finance takes the conventional lender-borrower arrangement into one that is based on partnership. Unlike the conventional system, which burdens the borrower with risks, Musharakah requires the sharing of profit/loss proportionally by both the lender and the borrower.

At Guidance Residential, our home financing program is based on this model, which makes the management of risks in homeownership a lot easier for the customer. To make it even better, Guidance Residential does not claim a share in the increase of the home’s equity, which may accrue over a period of time.

Why is it a promising option?

As it involves the proportional sharing of profit/loss, by the lender and borrower, there is a greater scope for managing risks. This will ensure the stability of financial institutions and limit the onset of lending booms and real estate bubbles that paved the way for the global financial crisis of 2008. Another major advantage of Islamic finance is that it improves financial inclusion. A large number of people who stayed away from banking due to religious reasons can now make use of this model for banking purposes. This provides access to a larger pool of savings, which can be used for growth and development.

The way ahead

The growth of Islamic banking has been upward over the past decade and it forms nearly 15% of the banking system in around the world. With initiatives from governments, international financial organizations and companies already involved in Islamic finance, the potential for this industry’s growth is massive. This will bring in the much needed stability to financial markets at the global level, to a certain extent.