Islamic Finance refers to a form of finance that is consistence with Islamic teachings on commercial or business transactions. It links finance with the real economy and maintains links at each point in time in a fair and transparent manner.
Fundamental teachings of Islam on business encompass avoidance of Riba (interest/usury), Gharar (excessive uncertainty in commercial contracts) and Maisir (gambling or game of chances). The principles promote profit and loss sharing through trade, partnerships and leasing. Besides, ethical business practices are at the center of Islamic economics and finance hence avoidance of sectors considered to be non-permissible.
Currently, Islamic finance sub-sectors include Islamic banks, Islamic insurance, Islamic capital markets, Islamic microfinance institutions, Islamic credit unions and Islamic pension funds, among others.
Researchers and scholars have highlighted five major areas of contribution of Islamic finance towards improving lives of the people and achieving sustainable growth and stable economies.
First, financial stability. Islamic finance is an ethical financial system bridging the gap between the financial sectors with the real sector and potentially contributing towards global financial stability.
One of the reason cited by economists and financial experts who analyzed causes of the2008 financial crisis, is called growing ‘financialization’ of the economy. According to Mike Collins, in his article titled ‘Wall Street and Financialization of the economy’, he quotes;
financialization- defined as the “growing scale and profitability of the finance sector at the expense of the rest of the economy and the shrinking regulation of its rules and returns.” The emphasis is no longer on making things – it is making money from money.
Maurice Obstfeld and Kenneth Rogof in their paper titled “Global Imbalances and the Financial Crisis: Products of Common Causes” have argued that due to various factors prevalent in 2000s led banks to innovate structured products such as Collateralized Debt Obligations (CDO) endowed with very high levels of systemic risk. (CDOs sales rose almost 10-fold from $30 billion in 2003 to $225 billion in 2006). This structured product is not in line with Shari’ah principles. Shari’ahprohibits selling debts (CDO), prohibits derivative products such as credit default swaps and prohibits short-selling.
Second, financial inclusion and shared prosperity. It is a well-known fact that one of the malaises of capitalist economies is the wider gap between the rich and the poor. The seriousness of the problem is highlighted by one striking fact: almost half of the world’s wealth is now owned by just 1 percent of the population (Working for the Few 2014).
Islamic finance through its core ethical principles such as fairness, justice, equitable distribution of income, risk-sharing instruments and asset-based financing, has a potential to contribute to growth and shared prosperity. However, inclusion and shared prosperity can only be achieved once there are policy interventions or improvements in policy effectiveness. Furthermore, Islamic banks should go beyond banking by embracing risk-sharing inter-mediation and increase the allocation of credit to the micro, small, and medium enterprises (MSME) sector.
Third, promoting the Non-bank Financial Institutions Sector (NBFI). Islamic finance through the concept of risk-sharing and asset-based instruments can fit well with the NBFI sector. Scholars are of the view that a good place to start is with Islamic insurance. Besides providing protection against risk and uncertainty, takāful could play a critical role in enhancing financial inclusion, reducing poverty, achieving inclusive economic growth, and boosting shared prosperity. For example, taking note that majority of the poor lives in rural areas depending on small scale farming, there is need to develop the micro-takāful industry to provide protection against uncertain events and loss of income.
Fourth, alleviating poverty and sharing prosperity through Islamic social finance. Islamic finance is not naive to the fact that some segments of our people require sustainable financial support for their well-being due to old age, disabilities and extreme environmental conditions. Bearing this fact in mind, the institutions and instruments of Islamic social finance can be put into use. Such instruments, involving qardhasan (benevolent loan),awqāf (Islamic endowments or trusts),zakat (mandatory alms giving), and ṣadaqāt (voluntary donations) can potentially address the basic needs of the extremely poor and the destitute and create a social safety net.
Last but not least, promote infrastructure development. Infrastructure deficit is a main challenge facing many countries. For developing countries, infrastructure gaps are estimated to be in the range of $1-1.5 trillion annually. Sukuk (Islamic capital market instruments) have successfully been used to finance large scale infrastructure projects all over the world and could be utilized to achieve sustainable development goals.
Sukuk funds when put in development projects can accelerate economic growth through creation of employment, increased revenue and providing opportunities for the poor to build assets.