COMPARISON OF ISLAMIC AND CONVENTIONAL FINANCE

1. INTRODUCTION

Islamic finance has started to grow in international finance across the globe, with some concentration in few countries. Nearly 20 percent annual growth of Islamic finance in recent years seems to point to its resilience and broad appeal, partly owing to principles that govern Islamic financial activities, including equity, participation, and ownership. In theory, Islamic finance is resilient to shocks because of its emphasis on risk sharing, limits on excessive risk taking, and strong link to real activities. Empirical evidence on the stability of Islamic banks, however, is so far mixed. While these banks face similar risks as conventional banks do, they are also exposed to idiosyncratic risks, necessitating a tailoring of current risk management practices. The macroeconomic policy implications of the rapid expansion of Islamic finance are far reaching and need careful considerations.
Islamic finance is growing within international finance. In its modern form, Islamic banking started with pioneering experiments in the early 1960s in Egypt. The Mit-Ghamr Islamic Saving Associations (MGISA) mobilized the savings of Muslim investors, providing them with returns that did not transgress the laws of the Shari'ah. 2 The MGISA attracted a flurry of deposits, which grew at the rate of more than 100 percent per year in the first three years of operations. Later, the Pilgrims Fund Corporation (PFC) enabled Malaysian Muslims to save gradually and invest in Shari’ah-compliant instruments, with the purpose of supporting their expenditures during the Hajj period (pilgrimage). In 2012, the PFC had eight million account holders and deposits of more than $12 billion. Formally, Islamic banking started in the late 1970s with a handful of institutions and negligible amounts, but it has increasingly grown over the past two decades, with total assets reaching about $2 trillion at end-2014.
The establishment of the Islamic Development Bank (IsDB) in 1975 was a watershed moment for Islamic banking, coming just after the establishment of the first major Islamic commercial bank—the Dubai Islamic Bank—in the United Arab Emirates. The success of the latter led to the establishment of a series of similar banks, including Faisal Islamic Bank (Sudan) and Kuwait Finance House (Kuwait)—both in 1977.

As early as the late 1970s, steps were taken in Pakistan for making the financial system compliant with Shari’ah principles. The legal framework was then amended in 1980 to allow for the operation of Shari’ahcompliant profit-sharing financing companies, and to initiate bank finance through Islamic instruments. Similarly, Iran enacted a new banking law in August 1983 to replace conventional banking with interest-free banking. The law gave banks a window of three years for their operations to become compliant with Islamic principles. Sudan’s efforts to align its entire banking system with Shari’ah principles began in 1984.

2-Three Principles Islamic Finance

Principle of equity: Scholars generally invoke this principle as the rationale for the prohibition of predetermined payments (riba), with a view to protecting the weaker contracting party in a financial transaction. The term riba, which means “hump” or “elevation” in Arabic, is an increase in wealth that is not related to engaging in a productive activity. The principle of equity is also the basis for prohibiting excessive uncertainty (gharar) as manifested by contract ambiguity or elusiveness of payoff. Transacting parties have a moral duty to disclose information before engaging in a contract, thereby reducing information asymmetry; otherwise the presence of gharar would nullify the contract. The principle of equity and wealth distribution is also the basis of a 2.5 percent levy on cash or in-kind wealth (zakat), imposed by Shari’ah on all Muslims who meet specific minimum levels of income and wealth to assist the less fortunate and foster social solidarity. Principle of participation: Although commonly known as interest-free financing, the prohibition of riba does not imply that capital is not to be rewarded. According to a key Shari’ah ruling that “reward (that is, profit) comes with risk taking,” investment return has to be earned in tandem with risk-taking and not with the mere passage of time, which is also the basis of prohibiting riba. Thus, return on capital is legitimized by risk-taking and determined ex post based on asset performance or project productivity, thereby ensuring a link between financing activities and real activities. The principle of participation lies at the heart of Islamic finance, ensuring that increases in wealth accrue from productive activities. Principle of ownership: The rulings of “do not sell what you do not own” (for example, short-selling) and “you cannot be dispossessed of a property except on the basis of right” mandate asset ownership before transacting. Islamic finance has, thus, come to be known as asset-based financing, forging a robust link between finance and the real economy. It also requires preservation and respect for property rights, as well as upholding contractual obligations by underscoring the sanctity of contracts.