October 15, 2024
Financial Assets

What Is Islamic Finance And How Does It Work?


The first of five parts of a Global Finance FAQ web series on Islamic finance.

In just a few decades, Islamic finance has established itself as a significant player in global finance. Today, with thousands of institutions around the world, this sector is no longer limited to the devout clientele of Muslim countries in the Middle East and Southeast Asia. It has successfully gained market share in Europe, Asia, Africa, and North America, where a diverse clientele is drawn to the Sharia-compliant principles of risk-sharing and social responsibility. As global investors increasingly prioritize sustainability and ethics, Islamic banking’s alignment with these values positions it as a key player in the burgeoning sustainable finance movement.

Islamic banking has also proven resilience in turbulent economic times. By prohibiting speculation and leveraging risk-sharing mechanisms, Islamic banks have demonstrated their ability to withstand crises, sometimes better than the conventional sector, a strength particularly relevant for investors in today’s uncertain economic climate. With a host of new financial innovations and robust regulatory backing, Islamic banking is poised for a bright future.

What Is Islamic Finance?

Islamic finance is a way of doing financial transactions and banking while respecting Islamic law or sharia. Islamic finance hardly existed 30 years ago yet today is a $3.96 trillion industry with over 1,650 specialized institutions located all around the world. Islamic banks are by far the biggest players in the Islamic finance industry and account for $2,7 trillion or 70% of total assets. According to a 2023 State of Global Islamic Economy report, total sharia-compliant assets are expected to grow to $5.95 trillion by 2026.

Islamic finance only represents about 1% of global financial assets but with a compound annual growth rate of 9%, it is expanding quicker than conventional finance. In some geographies like the Gulf Cooperation Council (GCC) or Sub-Saharan Africa, Islamic banks now compete directly with Western banks to attract Muslim clients.

So what is behind the success of Islamic finance? What makes Islamic finance special? Why is it growing rapidly?


Interest-Free Lending

The most famous rule in Islamic finance is the ban on usury. In economic terms, this means lender and borrowers are forbidden from charging or paying interest or riba. Sharia-compliant banks don’t issue interest-based loans.

The obvious question then becomes: how do Islamic banks make money? Instead of lending money to their clients at a profit, they buy the underlying product—the house, the car, the refrigerator—and then lease it or re-sell it on installment to the client for a fixed price typically higher than the initial market value. The key notion here is risk sharing—the banks make a profit on the transaction as a reward for the risk they took with the customer. Instead of thriving off of interest rates, Islamic banks use their customers’ money to acquire assets such as property or businesses and profit when the loan is successfully repaid.

All Islamic finance investments, acquisitions, and transactions must reflect Islamic values. Dealing with anything illicit (haram) like alcohol production, pork breeding, arms manufacturing, or gambling is strictly forbidden. It is interesting to note that similar initiatives exist in other faiths—the STOXX Index for example only selects companies that respect Christian values.

Avoiding Interest Pays Off

This ethically-driven approach to business partly explains the success of Islamic banks at a time when many customers lack trust in the financial system. Moreover, sharia-compliant entities have proven themselves in times of crisis.

Because Islamic law holds that making money from money is wrong, sharia-compliant institutions tend to refrain from engaging in speculation. They traditionally avoid derivative instruments such as futures or options and prefer to have assets grounded in the real economy.

This substantially protected Islamic banks from the 2008 financial crisis. Unlike their conventional counterparts, sharia-compliant banks were not involved with toxic assets and resisted the shock better.

“Adherence to Shariah principles—which precluded Islamic banks from financing or investing in the kind of instruments that have adversely affected their conventional competitors—helped contain the impact of the crisis on Islamic banks”concluded a 2010 IMF report.

This is a major reason why Islamic finance now has a serious, stable and trustworthy image around the world.



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