Is Islamic banking any different from conventional finance?

Dr Nagib A Omar

The common practices of Islamic finance and banking came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance occurred only in the 20th century and ever since, the recent statistics show that Islamic Finance sector continues to grow exponentially at 15-25 per cent per year, while Islamic financial institutions oversee over $2 trillion.

With such growth, many are asking whether Islamic Banking and Finance is really a viable alternative to the traditional interest-based (conventional) banking and whether it is sustainable for all parties involved in these Islamic ways (contracts) of doing trade or banking, not only for Muslims but humanity at large.

Indeed, most participants in the global financial markets have realised that most financial institutions were affected by the global financial crunch, except for the Islamic financial institutions that specifically carried out non-speculative and ethical forms of financing.

It is therefore imperative to understand that Islamic finance places emphasis on asset-based or equity-based financing. For any form of financing, there has to be an underlying asset to back the facility approved as Shari’ah-based product. It is also good to note that when we look at banking operations, it is all debt, equity, trade or lease-based. Thus, the Islamic way of equity-based financing has created no room for speculation hence created not only a positive impact on the profitability of a business but also improving the welfare of the society, as compared to the negative effects evident through interest-based products.

Many scholars in the field of Islamic finance and banking have always tried to demystify the concept of Islamic finance and tried to show the key differences to conventional banking, which comes down to the basic understanding of the “banking process” that distinguishes a bank as “Shari’ah-compliant” compared to the traditional conventional banking.

Islamic finance is a type of financing activity that must comply with Shari’ah (Islamic Law). The concept can also refer to the investments that are permissible under Shari’ah. On the other hand, an Islamic bank is a financial intermediary or institution that brings together two parties namely, the providers and the users of capital, in accordance with the principles of the Shari’ah. Thus, some of the banking practices and principles that are used in conventional finance are not permissible under the Shari’ah laws.

Contemporary Islamic finance is based on a number of prohibitions that are not always illegal in the countries where Islamic financial institutions are operating such as (1) charging interest on loans or paying interest on deposits, (2) prohibition of speculation (maysir), (3) participating in contracts with excessive risks and uncertainty (gharar) and (4) investing or engaging in business that are considered haram or forbidden in Islam, such as producing and selling alcohol or pork.

Islamic finance is also based on two other crucial principles. One is that the “material finality” or the “subject matter” of any transaction must be based to a real underlying asset for it to be permissible; and secondly, the aspect of profit or loss sharing where, parties entering into the contracts in Islamic finance share profit or loss and the risks associated with any transaction. It should be noted that no one should benefit from the transaction more than the other party.

Shari’ah financial institutions are thus unique in their core activities that are regulated by rules derived from the Qur’an, Sunnah (Prophetic practices) and Fiqh (Islamic jurisprudence) rulings.

[Dr Nagub Omar is Assistant Professor, Business Management (Investments, Finance and Islamic Banking), Programme Manager, Certified Islamic Finance Executive, Majan University College. Email: nagib.omar@majancollege.om]