Consider the plight of a poor farmer or a small businessman who borrows money to run his regular business operations and has to pay back even more after the due period. These high rates of interest oblige them to borrow even more money for paying the interest and brings them in a vicious circle of borrowings and interest called debt trap. Islamic Financial System has a different concept regarding this. Let’s get to know more about this system.

The Islamic Financial System is based on Sharia law and guided by Islamic economics, which aims to strike a balance between profitability and economic and social justice. We often confuse Islamic Finance with Islamic banking. Describing it as Islamic banking does not provide the real picture of the Islamic financial system. Rights and duties of an individual, the inheritance of property, equitable distribution of wealth, the obligation of both the parties to honour the contract and most importantly risk-sharing highlight the key features of the Islamic financial system. This system is much more than just banking. It enables capital formation, covers the insurance sector, serves as a financial intermediary and encourages a moral and ethical system while operating in the capital market.

Let’s learn more about the features of this system, starting with the nucleus: the banking system. Islamic banking works on the fundamental principles of sharing of profit and loss, and the prohibition of the collection interest, “riba”, by the lenders or payment of interest by the investors. Islamic banks account for $1.5 trillion in assets standing as the largest players in the Islamic financial industry. Financial transactions in this system forbid the investments involving alcohol, pork and gambling, making it a form of socially responsible investing. But, how do these banks earn if they do not charge interest? Here comes the second feature of this system. The creditors become investors and get a share in the business profits as a reward for bearing the risks. In other words, they contribute to the equity of a business, which means if a bank loans money to a firm, it need not pay any interest but a share in its profits. It is an appropriation of profits and not a charge on the firm. No one benefits at the time of losses. This is also the reason this system is called for ensuring economic justice as everybody gets what is due to them. It does not put pressure on the business in case of loses. Since Sharia forbids unethical investment, one cannot base his ownership of assets as a result of any speculative activity.

In the light of above features, we can say that the Islamic financial system is very different from the conventional financial system. While the traditional model only inculcates the economic and financial aspect of any transaction, on the flip side, the Islamic financial system covers different dimensions be it social, ethical, religious as much as it covers the economic aspect. Even more, instruments such as bonds, options, and derivatives that are used in the conventional system are not appreciated in its Islamic counterpart. The primary investment vehicles in Islamic finance are Equities and Fixed Income Instruments. As mentioned above, conventional instruments are prohibited, but there is a parallel to bonds know as Sukuk aka Sharia-compliant bonds, representing partial ownership in an asset.

This system is spreading across the globe at a remarkable pace. In recent times, we have witnessed a shift from the conventional financial system to the Islamic financial system as with this the market perception is affirmative of more tranquil conditions and is backed by a better regulatory framework. A new concept of Islamic Windows has been brought into light with conventional banks functioning on the principles of Islam. For example, in Oman, there are two Islamic banks, Bank Nizwa and Al Izz Islamic Bank. Six of the seven commercial banks in the country also offer Islamic banking services through dedicated windows or sections. The value of sovereign Sukuk, or Islamic bonds, issued outside the Middle East and Southeast Asia by non-Muslim countries reached $2.25 billion. This system has also appealed to India because India believes that complying with the laws of Sharia will make her an attractive destination for Islamic investments. Expansions have also reached the United Kingdom and London witnessing enormous growth in the Islamic Financial sector domestically and internationally.

Islamic finance promotes entrepreneurship and risk-sharing, and its expansion to the poor could be an effective development tool in various countries. It can be extended at the microfinance level, and the resulting social benefits are evident since the poor currently are often exploited by lenders charging usurious rates.

After understanding the Islamic financial system, can we state that the Islamic financial system has greater resilience to the financial crisis or the 2008 crisis wouldn’t have happened if all institutions followed the principles of this system? Well, the pillar of this system is justice. There is risk-sharing between the borrower and financer, which results in a more careful assessment of risk by the financial institutions. They monitor the use of funds by the borrower more effectively. The double assessment of risks by both the financier and the borrower should help inject greater discipline into the financial system, and go a long way in reducing excessive lending and making the financial system healthier. Secondly, Islamic law condemns the practice of making money from speculation and prefers to deal with instruments backed by real money or grounded in the real economy. Because they do not trade in toxic and volatile assets, when the world was struggling in the great depression, the Islamic banks were not hit hard by the blow.

Moreover, the secondary market is superficial and the money markets hardly have any volume. Hence, the burden of risk cannot be transferred. But many reports say that even though this system has better immunity to a crisis than the conventional system, the Islamic banks suffered greater losses and were impacted more in the post-crisis period.

No system comes without limitations. If we flip the coin, we see a lot of challenges this system faces. The most significant one is the lack of standardisation in the system. Interpretation of Sharia principles is subjective and thus varies from institution to institution. This means the same instrument may be accepted by one party and rejected by the other or maybe permissible in one country and not in the other. Until now, the Islamic financial markets function in isolation with the international markets. Standardisation, as in the case of the conventional system, will sync the two markets. Moreover, there is a need to develop a uniform regulatory framework to increase the support and adaptability of the Islamic financial system. The system lacks innovation in the sense that for many years it has been catering to short and medium-term maturities and is not facilitated by robust instruments to handle extreme maturities or public debt financing. The players in the market are exposed to risks such as highly volatile currency and commodities. This calls for a system that provides instruments to hedge against these risks and make prudent financial decisions.

The future growth of the Islamic financial system is directly proportional to the innovations in the market. The need of the hour is that human and financial resources work to intensify the secondary market and alongside introduce public finance instruments which are not usual to this system. As a result, the liquidity position of the assets will also improve.

All the nations are realising the benefits of this system and are slowing moving towards it. The intensity of recent financial instability highlights the need for reforms in the conventional system and working along Islamic principles may be the appropriate path in the quest for stability.

By Somya Yadav