Understanding the Increasingly Popular Concept of ‘Islamic Finance’
As the Middle East has become an increasingly important hub for global trade, and one that, due to its oil reserves, has a profound impact on economies around the world, it has also had to find ways to create financial structures that can operate within a Muslim framework. That has meant the steady growth of "Islamic finance" or Islamic banking, financial institutions that are compliant with Islamic law. Given that Islam is the world’s fastest-growing religion, and one of its largest, we here at the Daily Lounge thought it might be useful to try to understand how the world’s Muslims (and their entrepreneurial pursuits) get the financial support that they need.
What makes Islamic finance specifically "Islamic" is that it is consistent with sharia, or Islamic law. Traditional banks loan money on the guarantee of a fee in return, usually in the form of some kind of interest rate. We’re all familiar with this from the use of credit cards: Essentially, the credit card company is lending us money on the agreement that we’ll pay back that money with some percentage of interest. (Actually, one could argue that putting your money in a savings account that earns interest is basically the same thing; you’re lending money to the bank and they’re giving you a return.) This is known as usury, and it’s outlawed in sharia as a sinful practice; as an interesting historical side note, it was also outlawed for Christians to practice usury in the Middle Ages, and thus created an opportunity for non-Christian Europeans (i.e. those of the Jewish faith) to become medieval moneylenders and resulted in a slew of negative stereotypes that persist to this day.
The ban on usury puts Islamic lenders and borrowers in a quandary. A borrower needs money to make a purchase or investment, but doesn’t have the capital himself. The lender, meanwhile, needs to find a way to ensure that the loan is safe from default and that he can profit from the transaction. Without the lender taking an interest fee, how can the two work out a deal?
One way that Islamic banking institutions get around this is through a process of purchase and resale, with the bank acting as an intermediary between the borrower and his investment. In this structure, the bank will actually make the initial investment, and then resell it to the borrower at a higher price, allowing him to pay in installments. In another model, the lender and the borrower will make a joint investment, with the borrower paying the bank back for its share over a fixed period of time. In this model, the bank also charges a rent or a service fee for the duration that it is invested.
The other central characteristic of Islamic finance are restrictions on what kind of investments Islamic financial institutions can make. Such institutions are prohibited from putting up money for purposes or endeavors that are considered to run contrary to Islamic law; for example, as Muslims are not allowed to drink alcohol, an Islamic bank could not lend to a borrower who hoped to open a bar or to import and export wine.
Currently, Islamic banking only represents a fraction of the world’s financial sector. But as the Middle East becomes an increasingly important region in the world’s economy and as the world’s Muslim population continues to grow, it stands to become an increasingly influential and important side of international financial service.
[Pic via Flickr - Sarah Joy]
