 What Is Islamic Finance:

Islamic banking has been defined as banking in consonance with the ethos and value

system of Islam and governed, in addition to the conventional good governance and risk

management rules, by the principles laid down by Islamic Shariah. Interest free banking

is a narrow concept denoting a number of banking instruments or operations, which avoid

interest. Islamic banking, the more general term is expected not only to avoid interest-

based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices

and participate actively in achieving the goals and objectives of an Islamic economy.

 Islamic finance features banks, capital markets, fund managers, investment firms, and

insurance companies. However, these entities are governed both by Islamic law and the

finance industry rules and regulations that apply to their conventional counterparts.

 Importance/ Significance of Islamic Finance:

 Islamic Finance as a field has received steadily growing attention over the last 30 years

or so. Initially, the study of Islamic Finance was restricted to the religious realm, with

the promise of creating a viable faith-based finance system applicable in modern secular

economies. The main point of focus for Islamic Finance theorists was the banking arena,

and the concept of Islamic Banking was born. The significance of Islamic banking for

the Muslim community lay in its potential to deliver them from the charging and paying

of usury, which is strongly forbidden in Islam. The power of Islamic Finance to raise

capital from Muslim countries, with particular focus on petro-dollars, as well as captive

local markets, led to financial institutions outside of Muslim countries focusing on

Islamic Finance and the development of Islamic Finance products. Indeed, the

development of Islamic Finance products has dominated the Islamic Finance landscape.

But, what comes after that?

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 The ideas inherent in Islamic finance, and the alternative techniques present in Islamic

finance to achieve the goals of society cause it to be a fertile body of knowledge for

innovation and new methodologies in conventional finance. Indeed, there are Islamic

finance concepts that can be adapted and implemented to change the characteristics of

the conventional financial system, and can find application in banking, personal finance,

business capitalisation, and many others.

 The development of products essentially revolved around three key areas: banking

products, primarily credit products, investment products, primarily equity funds and

insurance products. In light of the global financial crisis, however, it would seem that

Islamic Finance has the potential to become increasingly significant for various other

reasons, especially for the insights that can be gained from the underlying philosophy

and different financial architecture inherent in the Islamic financial system. The

architecture of the Islamic financial system is not debt-based, but rather based on

partnership. This has implications for the manner in which capital is pooled and

disseminated through society. Fractional reserve banking would therefore have no place

in an Islamic financial system, but rather a full reserve banking system would apply. In

order to earn a return on capital, it will have to be invested as equity into a business

venture or fund – thus, when people merely wanted to store money and transactional

capability, they would deposit it into a full reserve bank. When people wanted to earn a

return, they would make an equity investment. Thus, they would know exactly the risk

that they were undertaking. This can be contrasted to the current conventional banking

system, where the objectives of safe keeping and earning a return are intertwined in a

fractional reserve system, and the risk assumed is not entirely clear. Even when one

deposits money into a transaction or no interest account, they are assuming credit risk

and liquidity risk, when all that was wanted was a means of storing money and effecting

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 payments. Perhaps in light of the global credit crisis, there can be a two tiered banking

system – one geared for risk and reward, the other purely for transactions and safe

keeping – certainly, Islamic Finance can offer important principles pertaining to

separation and awareness of risk.

 The concept of profit and loss sharing (“PLS”) can also find expression in the

conventional financial system. In a global financial system rocked by the liquidity crisis

and losses of deposits, the concept of depositors sharing in losses in a “lending” bank

may add stability to a fractional reserve banking system. This would work well in

conjunction with a parallel full reserve banking system. The restriction on trading in

intangible assets in Islamic finance may find increased application in a financial world

reeling from the trading of debt obligations and various derivative instruments going

wrong.

 In terms of personal finance, the over-indebtedness of consumers is a topic of concern

and is further underscored by the introduction of legislation to control the granting of

credit to consumers. In terms of Islamic finance principles, the abhorrence of debt and

the focus on living well within one’s means and becoming more productive in order to

consume more (rather than merely borrowing out of anticipated future earnings)could go

a long way towards increasing the net savings rate of households and increasing

productivity in the economy. In terms of the capital structure of businesses, the use of

equity instruments to sculpt different return profiles provides the effect of leverage

without the obligations of debt. Thus, in times of economic instability, the principles of

Islamic finance can be applied to achieve leverage through the use of equity only, thus

enabling the enterprise to have a higher survival threshold due to the absence of debt

repayments.

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