Key Principles of Islamic Finance

Islamic Finance is a fast growing financial services sector within which transactions are required to be compliant with Shari’a – a body of jurisprudence derived from the Qur’an and secondary sources known as the ‘Hadith’.

Key characteristics include finance based on trade transactions in order to remove the basis of making money from money, often interpreted as interest. The trade transaction will typically involve an underlying asset. As such Islamic banks do not lend money, they enter into trade transactions based on leasing, partnerships and trading with transactions being structured based on a number of well known contract formats.

A key feature of shari’a compliant finance is the pooling of risk between the investor and the customer. Related to this are ethical values which under pin shari’a compatible transactions giving the customer more rights that he or she would have in conventional finance in the event of a default. For example default or penalty interest is not permitted in the case of a missed or delayed payment. In the event of a default on a house purchase the customer would be entitled to the equity in the house which they have already paid.

History

Modern banks began offering sharia-compliant products in the mid-1970s, though Islamic finance is as old as the religion itself with its principles primarily derived from the Quran, which was revealed some 1400 years ago. Some principles of Islamic finance stem from prior Abrahamic traditions.

Islamic Finance values are Universal and for All Mankind Irrespective of Faith

Turkish Deputy Prime Minister Ali Babacan speaking at an IMF discussion in May 2015 emphasised the universality of Islamic finance for all of man-kind irrespective if the customer is Muslim or not.

Mr Ali Babacan stated Islam is not the monopoly of any single country and that Islamic finance techniques are now universally accepted and practised. He added that he was happy to see the United Kingdom and Luxembourg issue sovereign sukuk because Turkey has long been emphasising equity and asset based financing and was a founding member of the IFSB from which global standards for Shari’a compliant financing are set.

Whilst big ticket Islamic financing projects such as sovereign sukuk, and funding of the Shard and the Olympic Village in the United Kingdom make the headlines, at its heart Islamic finance is about social good and creating economic activity, a point wonderfully illustrated in the following video from Sudan.

Size of Market and Growth

Islamic finance assets are heavily concentrated in the Middle East and Asia, and the biggest component of the market is Islamic Banking which constitutes assets worth $1.46 Trillion according to data compiled by the IFSB. Sukuk which represents investment banking in the form of issuance of certificates of trust (commonly referred to as Islamic Bonds) has assets worth $294 Billion. Takaful and Funds make up the remaining components giving the industry total assets as of end of 2014 of $1.87 Trillion.

The market has over the past decade demonstrated strong growth with Ernst & Young, estimating Islamic banking assets grew at an annual rate of 17.6% between 2009 and 2013, and will grow by an average of 19.7% a year to 2018.

Other related sectors include law and education which have grown in depth and expertise as the industry has developed.

Islamic financial commerce co-exists within the wider economy and as such is not a safe haven bubble despite often being labelled as such. During the global financial crisis of 2008, initially the market was not effected as the ‘toxic assets’ built up on the balance sheets of American banks were not shari’a compliant hence Islamic banks were not impacted. However following the collapse of Lehman Brothers Islamic institutions were impacted from drops in valuation of real estate and private equity as these sectors tend to be heavily invested by Islamic firms.