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The difference Islamic finance makes

It brings people into the financial system who would not take part in conventional finance for religious reasons. It should also discourage borrowing for accelerated consumption.

Summary

Posted 13 February 2018

People new to Islamic finance are often surprised to find that its economics are essentially the same as the economics of conventional finance.

Many start off assuming that banking without interest must mean loans are free! The more sophisticated expect widespread use of profit sharing financial contracts, and are surprised to find that fixed return contracts predominate in Islamic finance. See my page "Why fixed return contracts predominate in Islamic banking."

Since the economics are basically identical, when I give presentations on Islamic finance, I am often asked "What difference does it make?"

In my view there are two key ways in which Islamic finance genuinely makes the world a better place.

  1. It brings people into the financial system (banking, insurance and asset management) who would otherwise not participate in it due to their religious beliefs.
  2. Islamic finance should emphasise the provision of finance for business activities, rather than for accelerated consumption.

I made this the theme of my October 2017 "Letter from Amin" column in Islamic Finance News. You can read it below.

"How Islamic finance helps humanity"

I am often asked whether Islamic finance genuinely makes any difference to the world compared with conventional finance. I believe that it does, in two main ways.

Firstly, while many Muslims have no fundamental objection to using conventional finance (as demonstrated by the significant market share for conventional finance in countries where Muslims have a free choice between conventional finance and Islamic finance), some Muslims absolutely refuse to engage in conventional finance. If the only bank accounts offered are conventional ones, those Muslims will keep their savings in cash or gold, rather than putting them into a bank or indeed purchasing other conventional financial investments such as interest-bearing bonds or quoted shares.

The consequence is that such savings are effectively “sterile” and do nothing to contribute to the total level of investment in that economy. When you buy and store gold (or keep cash in a safe deposit box), nobody else can use that money to build a factory.

The provision of Islamic finance brings such savings into economic circulation. It means that the individual with the savings is able to earn an economic return which will vary with the level of risk that he or she takes on, for example by putting money into an Islamic bank or alternatively buying shares in a Shariah compliant equity investment fund.

Even more importantly, that individual’s savings are no longer sterile. The Islamic bank will use the money the individual has put into it to make Shariah compliant advances to businesses. The effect is that the total level of investment in that economy will be greater than if the savings had remained sterile. The overall effect is to make that society richer.

The second way that Islamic finance helps humanity, or perhaps more accurately should help humanity, is by promoting attitudinal change. Conventional finance sees borrowing merely as a form of discretionary time-shifting of income. “Borrow £1.000 to go on holiday now, and pay back £1,100 out of your future income, if you prefer to have the holiday now rather than in the future.”

For religious and also practical reasons, I have always considered this attitude wrong. Instead I believe that you should always aim to spend less than your income. Borrowing should only be undertaken to purchase major capital items (such as a house or a car) or for genuine revenue investment such as paying for a training course that will enhance your future employability. Otherwise, you should not borrow.

Islamic finance should help to propagate and reinforce this attitude, since Islamic financiers regularly make the point that the advances they make should only be used for “investment in the real economy.” The greater the proportion of finance in an economy that is Islamic, the lower should be the proportion of borrowing that is used for consumption expenditure.

Sadly, in this case, I am not convinced that action always matches the rhetoric when I see Islamic banks promoting financial services such as Shariah compliant credit cards.

 

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