Have you ever looked at something, and imagined what it would be like if it were… different? Say, what would the education system look like without the written word, or arithmetic without the concept of zero? Or what would the financial system be without interest? Many centuries ago, in Europe and all the Christian world, collecting interest was forbidden by the Church on the grounds of immorality, being universally recognized as a sin – the sin of Usury.
Nowadays, the official stance of most western nations with respect to interest is significantly different – not only is it not condemned, but is actually regarded as a vital part of our economies. And it definitely is. It is impossible to imagine how our current financial system would ever work without this tool. Interest is a crucial part of loan taking, house buying, and savings. Politicians talk about it, economists worry about it, investors use it to generate returns. The concept of interest is inseparable from the concept of money itself. In most of the world, at least.
Like the Catholic Church once did, some still consider interest to be immoral, or simply impossible to reconcile with their religious beliefs. Such is the case of the Islamic Faith.
THE ISLAMIC VIEW
Before we look at how this financial system is different from the main one, it is worth spending some time understanding its foundations.
A member of the Islamic community is supposed to comply with certain rules and guidelines, living their lives according to the teachings of the Faith in order to lead a moral life. To this code of conduct, we call Sharia (or Shari’ah) Law. Sharia is a complex subject. It requires interpretation of the will of God, something that has divided humankind for millennia. We are not likely to solve it in 1400 words. It is not the purpose of this article to explore the religious and legal complexities of Muslim-majority countries. Sharia law exists, and millions of people in the world follow it. Our focus is on how Sharia, and by extension the individuals that try to guide their actions by it, think of financial transactions.
The Institute of Islamic Banking and Insurance states the objectives of Islamic Financial Transactions (i.e. Sharia compliant financial transactions) as follows:
- To be true to the Sharia principles of equity and justice;
- Should be free from unjust enrichment;
- Must be based on true consent of all parties;
- Must be an integral part of a real trade or economic activity such as a sale, lease, manufacture or partnership.
The first three points can be considered more or less subjective – what constitutes equity, injustice or true consent are open for debate. Interesting as that debate may be, it falls out of our scope today. Let us then look at the fourth point.
Sale, lease, manufacture and partnerships are no strangers in the traditional financial system. The key is the one missing – can you spot it? That’s right – debt! Debt-based instruments, so common in traditional financing, don’t have the same centrality in its Sharia compliant counterpart. Why is that? Well, we’ve stated the reasoning before: the Islamic Financial System absolutely prohibits paying/receiving “any predetermined, guaranteed rate of return”, that is, interest.
But why does the Islam forbid someone to be compensated for departing from their capital for a period? Doesn’t it recognize the Time Value of Money (the notion that having money right now is more valuable than the promise of the having money in the future)? As a matter of fact, it does! The difference is in understanding what constitutes capital. Ask any non-Islamic banker, investor or economist, and they will almost surely tell you that money is capital – a production factor, something that can be used to create more wealth. Islamic thinking draws a line: money is only seen as potential capital. It is only considered actual capital when it is employed in an actual productive activity together with other resources. Simply put, money sitting still is not productive, so you are not entitled to any compensation for lending it to someone who will actually put it to use.
PRINCIPLES AND INSTRUMENTS
So, what can actually be done inside this system? Well, any activity that complies with some basic principles:
As previously discussed, interest (riba) is forbidden. It is regarded as an “unjustifiable increase of capital whether in loans or sales”. This is the central principle ruling mutual dealings. Borrowers and lenders should equally share the profits and risks – profits are a symbol of a successful enterprise, while interest is a cost independent of success, only on the side of the borrower. A supplier of funds is not a creditor, but an investor. Since money has no purpose unless tied to a real asset, speculation and gambling (maysir) are forbidden. Uncertainty or asymmetrical information (when one of the intervenients possesses information that the other one has no access to) are also prohibited in any transaction – contracts are sacred, and agents have a duty to disclose all relevant information beforehand. Hoarding is also not permitted, as well as trade in forbidden commodities (pork, alcohol, dealings with casinos, etc.).
Many instruments that are present in the traditional financial system are also used by the Islamic Financial System. The most basic ones, which can then be combined to create more complex products, are cost-plus financing, profit-sharing, leasing, partnership and forward sale.
As you can see, Islamic Financing is no more than a selection of the financial instruments and products that comply with certain religious and, especially, moral principles. If you think about it, it is not so different from how a food restriction works – if you and your friends go to dinner, the vegan friend will order something with no meat, the one with a seafood allergy will probably not get the shrimp, and some may choose to get water instead of wine or other alcoholic drink. And, of course, you are perfectly free to order a salad if you’re not vegan, or to ask for no peanuts in your dessert even if you have no allergy. And you are equally free to partake in a Sharia-compliant financial transaction, whether you are a Muslim or not!
People can invest in an Islamic Financial Product regardless of their faith
Islamic finance has been growing, and not only inside the Muslim Community. Its principles appeal to many, and it does have some advantages over the traditional system: as interest is forbidden, predatory loans can’t happen at all; income and wealth are more equally distributed, as every intervenient receives a part of the profits, regardless of how much capital they had at the beginning of the enterprise; speculation is forbidden, meaning the system is not so exposed to market bubbles (goodbye, 2008-like financial crisis!); and it is significantly more transparent and accessible. Many argue that it can help lift many out of poverty, especially if combined with ideas like Microfinancing. These characteristics indicate that Islamic Finance may be better equipped for sustainable development, a point that may prove to be of great importance in the years to come.
Of course, it has some significant disadvantages too: it does not provide funds for all businesses (religious prohibitions prevent it from dealing with pork, alcohol and gambling firms) and, for all its efficiency in allocating resources to businesses with a greater chance of success and encouraging money to be fueled into real and productive activities, it can be argued that it does not maximizes investment profits (as interest is not charged).
There is another detail that is worth pointing out: Islamic Finance comes with a moral compass (or at least a baseline). Whether this is a positive thing or not will probably depend on the degree to which you agree with the moral principles it is rooted in, but it is, undoubtedly, a point of difference between this system and the traditional one.
The islamic Financial System serves millions of people worldwide
It is easy for some to look at the presented characteristics and to regard this system as limiting. We cannot argue it may not be limiting, but it is so in order to provide an option that answers the needs of millions of people, who do not wish to compromise their faith in exchange for a piece of wealth. Different cultures have different approaches, and we live in a wonderfully differentiated world. Imagine how boring it would be otherwise.
Sources: Institute of Islamic Banking and Insurance, Corporate Finance Institute, Investopedia, World Bank, Blossom Finance, Wikipedia