Islamic Finance: The Sustainable Alternative
Islamic Finance: The Sustainable Alternative
Nooreddin Bazbaz
Javeriar Laskar
In a world run by an unstable and speculative financial system, is there an alternative that prioritizes the needs of all people while still generating profits for investors?
Basic Principles
Overview
Islamic finance refers to a financial framework that is compliant with Sharia, or Islamic Law. It promotes an overall operating and investing mechanism that is morally, culturally, and ethically responsible. It prohibits dealing with interest (Riba) in transactions due to its harmful impact on the public.
It aims to create a just and equitable financial and economic ecosystem that accommodates everyone while mitigating forms of harm and encouraging fair prosperity. As of 2018, Islamic Finance was worth approximately $2.5 trillion.
Prohibition of Interest
Charging interest is forbidden in Islam. To promote fairness and discourage exploitation, Islamic finance utilizes profit-sharing models in which the investor and entrepreneur fairly share the probabilities of risk and reward and have equal profits or losses in a transaction. The goal is to lessen the income inequalities existing in society and create a balanced economy, all while incentivizing the deployment of capital.
Ethical Investments
Investing in sectors such as gambling, alcohol, and pork is prohibited. Instead, Islamic finance encourages investing into projects which benefit the community and raise overall social welfare. This includes the building of community centers, schools, mosques, hospitals, lawful (Halal) food production, green projects, and interest-free microfinancing.
A prominent example of microfinancing following the principles of Islamic finance is Bangladesh’s Grameen Bank’s Struggling (Beggar) Member Loan, created by Nobel Economic Laureate and current Chief Adviser of Bangladesh, Dr. Muhammed Yunus, where all loans are interest-free and are insured without any premium. In the event of death, a borrower’s outstanding payments are paid off from an insurance fund.
Profit and Loss Sharing
Mudarabah is a partnership in which one party provides capital, and the other party provides expertise and management. For instance, a bank funds a business project, and the entrepreneur oversees the operations. The profits generated are shared based on a pre-determined split.
In the event of a loss, the burden is shouldered by the capital provider, while the party providing expertise only loses their effort and time invested. This system is designed to ensure responsible fund management and the utmost care of both parties. When there are profits, both parties gain, but when there are losses, the financier incurs them.
Musharakah is a joint venture in which both parties contribute capital and share profits or losses based on contributions. As an example, two companies join to develop a real estate project where each contributes capital, and any profits or losses are divided based on their shares, investments, interests, and dealings in a transparent manner.
Capital invested using both systems provides much-needed funds to businesses and projects, thereby supporting legitimate industries instead of simply idling or circulating without benefit.
Asset-Backed Financing
In asset-backed financing, every financial transaction must be linked to a legitimate economic activity and have a direct connection to real goods, services, and property in the economy. This prevents money generation from commodities or money itself and serves to avoid ambiguity (Gharar) and speculation (Maysir), both of which are prohibited in Islam. This creates real growth in the value of goods and ensures a balanced financial system that is ethical and equitable.
In Ijara, banks buy assets and lease them to a customer who gets to benefit from the asset without paying the full amount upfront, instead making payments over time. Once the lease term ends, the customer has the option to purchase the asset outright. This creates a direct relationship between financing and using the asset accordingly.
Meanwhile, in Murabaha, banks buy tangible assets and sell them at a slight profit to the customer (cost-plus), where the profit margin is pre-determined, and the customer repays the money in interest-free installments. This profit generated is directly from the product at hand, and not from money on money.
Sustainability
Safety
By prohibiting speculative investments and emphasizing asset-backed financing, Islamic finance fosters a safer financial environment. Products such as Murabaha and Ijara are structured to ensure that investments are based on tangible assets, thus reducing the risks associated with non-performing loans and financial instability.
Additionally, the risk-sharing nature of Islamic finance creates a buffer against economic downturns, as financial institutions and clients jointly bear the consequences of any economic shocks. This builds a more resilient system and enhances overall market stability by discouraging excessive leverage and bubbles.
Wealth Distribution
Islamic finance boasts social welfare mechanisms, which integrate wealth redistribution through mandatory almsgiving (Zakat) and voluntary endowments (Waqf). These mechanisms are directed towards societal welfare, assisting the needy, funding community projects, and improving access to essentials.
Ethical Governance
Islamic financial institutions are bound by strict ethical codes, focusing on transparency in transactions and accountability to stakeholders. Sharia-compliant governance requires disclosure of financial activities to ensure that investments align with ethical standards, building trust and integrity within the financial system.
Any institution that wishes to be labeled as Islamic must have a Sharia board comprised of several specialized directors. They must conduct periodic audits and reviews of the company’s products and compliance with standards.
Conventional Differences
Speculation
Conventional finance often relies on interest to generate profit, which can encourage speculative lending practices. Interest-based systems prioritize short-term gains, potentially leading to excessive borrowing and unsustainable debt accumulation, which contributed to past financial crises.
The 2008 Financial Crisis provides a clear example of how interest-based lending contributed to economic collapse. Banks issued high-interest subprime mortgages to individuals with low credit scores, maximizing short-term profits. When interest rates on these loans reset to higher levels, many borrowers defaulted, leading to a chain reaction of foreclosures and the collapse of mortgage-backed securities, which destabilized the global financial system.
Ethical Gaps
Conventional finance often prioritizes profit maximization, sometimes at the expense of social and environmental impacts. This focus on financial returns can lead to investment in sectors that may harm society or the environment (e.g., fossil fuels, arms manufacturing). Conventional finance lacks a framework that inherently aligns with justice and sustainability.
Challenges
Regulatory Differences
Interpretations of Sharia are different across nations, meaning scholars can have different conclusions on permissibility. Although the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) sets standards, they cannot mandate them as not all Islamic financial institutions follow the same interpretations. There is not a single regulatory standard that everyone can follow, causing a lack of accountability in the system.
This challenge creates operational complexities as financial institutions need to adjust their products and practices to meet local interpretations, increasing costs to operate and reducing scalability.
Limited Public Awareness
Islamic finance encourages principles contrary to conventional finance, which makes them seem unorthodox and complicated to some. There is a shortage of Islamic institutions involved in schools and universities to increase education.
Additionally, the media sometimes portrays the concept as ‘extreme’ and ‘discriminatory’, common misconceptions due to lack of awareness. There should be greater efforts to educate the public on the main tenets, such as risk-sharing, profit-sharing, asset-backing, and ethical investments.
Recommendations
Establish Competency Centers in Universities
Universities globally should create dedicated Islamic finance centers and think tanks to provide specialized programs, research, and certifications. This could include partnerships with Islamic financial institutions to ensure practical learning. The outcome is that awareness increases, biases decrease, skill gaps get filled, and growth is enhanced.
Create Unified Regulatory Standards
Currently, organizations like the AAOIFI set voluntary standards, but without a single, enforceable system, inconsistencies arise in the interpretation and application of Sharia principles globally. A unified standard would provide a consistent foundation for Islamic finance practices, addressing the fragmentation caused by regional differences.
Create a Global Islamic Finance Database
To provide customers and investors with a clear understanding of available services, a global database of approved companies should be established. Additionally, a data portal should also be created to track Islamic finance transactions, products, standards, and trends, as they are continually updated. This will facilitate better regulation, create more transparency, and drive smarter decision-making.
Integrate Sustainability with Sharia
Islamic finance companies should blend environmental, social, and governance standards with Sharia principles, creating more opportunities for the industry to align with global sustainability goals. This will attract environmentally conscious investors and position Islamic finance as a leader in ethical finance in a world increasingly aware and concerned about its footprint.
