Global Finance FAQ Series: Understanding Islamic Finance
Welcome to the first installment of our Global Finance FAQ web series, focusing on Islamic finance.
Islamic finance operates under Islamic law, or sharia, and has evolved significantly over the past few decades. Although it was a niche area 30 years ago, it has grown into a $2.5 trillion industry with numerous specialized institutions across more than 80 countries. Islamic banks are the largest players in this sector, holding $1.75 trillion, which represents about 70% of total Islamic finance assets. According to a 2019 report on the State of the Global Islamic Economy, sharia-compliant assets are projected to reach $3.5 trillion by 2024.
Despite representing only about 1% of global financial assets, Islamic finance has been expanding rapidly, with a growth rate of 11.4% in 2019. Although the COVID-19 pandemic is expected to slow this growth, the sector remains resilient. In regions like the Gulf Cooperation Council (GCC) and Sub-Saharan Africa, Islamic banks are increasingly competing with Western banks to serve Muslim clients.
Key Principles of Islamic Finance
A core principle of Islamic finance is the prohibition of riba, or interest. Unlike conventional banks, which generate revenue through interest on loans, Islamic banks avoid charging or paying interest. Instead, they adopt alternative methods for profit generation.
Islamic banks often acquire assets—such as real estate or vehicles—and then lease or sell them to clients at a profit. This profit comes from the sale or lease, not from interest. The idea is to share the risk with the client, where the bank earns a profit by taking on part of the risk associated with the transaction.
Ethical Considerations
Islamic finance is guided by ethical considerations and must comply with sharia principles. Investments in activities considered haram (forbidden), such as alcohol production, pork, arms manufacturing, or gambling, are strictly avoided. This ethical approach is somewhat similar to other faith-based investment initiatives, such as the STOXX Index, which includes only companies aligning with Christian values.
Resilience and Trust
The focus on ethical practices and avoidance of speculative financial instruments like derivatives have contributed to the stability of Islamic finance. During the 2008 financial crisis, Islamic banks were less affected because they did not engage in high-risk financial products. A 2010 IMF report noted that adherence to sharia principles helped Islamic banks mitigate the crisis’s impact compared to their conventional counterparts.
This commitment to ethical standards and financial prudence has helped Islamic finance build a reputation for stability and trustworthiness on the global stage.
