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Islamic finance offers alternative solutions

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islamic finance

Manzar Naqvi

Islamic finance offers alternative solutions to conventional finance that comply with the principles of Shari’ah. Islamic jurisprudence strives to promote moral and ethical values in establishing an economic system that outlaws the payment and receipt of interest, excessive uncertainty in business transactions and investment in prohibited industries.
Initially, the operations of Islamic banks were underpinned by the principle of a two-tier Mudaraba. In this model, funds are acquired from investors on a profit and loss sharing basis (tier one). These funds are then channeled to an entrepreneur to invest in productive activity (tier two). Any profits generated from the business venture would be shared in a pre-agreed ratio between all parties, whereas losses would be incurred by the investors alone. This principal-agent relationship, however, proved to be slightly problematic in that considerable discretionary power was provided to the entrepreneur to invest funds. The separation between management and ownership at times resulted in the best interest of the venture and the investor not being considered. The return provided to participants is also dependent on the profitability of the venture, and inadequate oversight and decision-making increased the risk of financial loss. This principle is moving towards limited use as Islamic banks do not undertake liability for any losses. Another drawback with this system was that the return provided to depositors proved to be volatile.
As financial systems became more complex, Islamic finance structures began developing further. The two-tier Mudaraba model is being gradually phased out and the industry is moving toward Murabaha modes of financing. These are contracts entered into between banks and clients at a price incorporating an agreed upon profit margin. Murabaha has become one of the most frequently used modes of financing among Islamic financial institutions globally. Over the past few decades, Islamic finance has progressed significantly, and many different products have been introduced. Currently, the industry comprises three sectors: Islamic banking, Takaful and the Islamic capital market. There remains huge potential for growth as the industry remains untapped locally and within continents, and the challenge lies in exploring new avenues to tackle existing problems. Islamic finance can act as the catalyst in mobilizing funding into countries thereby resulting in economic growth and sustainable development.
As per Economic Outlook, the continent’s growth is expected to progress to up to 13- 16% in the upcoming year. This is driven by increased domestic demand, developments in the private sector and strong trade relations with developed and developing economies. Although the Islamic financial services industry is currently dominated by the banking and Sukuk segments, growth potential remains in the asset management and Takaful spheres.
Globally, the Islamic finance sector is expected to surpass the US$2 trillion mark by the end of 2017. Islamic law based on the teachings of the Qur’an and Prophet Muhammad (May Peace Be upon Him), prohibition of gambling, alcohol, entertainment, arms manufacturing, tobacco and certain food manufacturing industries are the basic pillars of Islamic finance and banking. These pillars are proving helpful in creating world environment based on healthy traditions.