This essay will provide a comparison between Islamic Finance and conventional Finance principles. In order to do this, firstly it is necessary to determine the scope and establish some of the fundemental concepts that define Islamic Finance, or "Sharia compliant banking" as it is often referred to. After this, it will be possible to discuss some of the advantages that Islamic Finance institutions have over the typical conventional banks.
As of 2014, Islamic Financial institutions represented around 1% of the total assets throughout the world, with an estimated value of around $2 trillion. There exist in the region of around 300 institutions throughout the world that adopt a financial approach dictated by the principles of Islam. This number has been growing as a result of the financial crash in 2008 where many conventional banks faced liquidity issues; investors disillusioned with the performance and practices of ...view middle of the document...
First and foremost, Islamic banking must operate within the framework of the religion, based on Qura'n and Sunna. Hence only Halal activities are allowed. This holds ethics paramount and, consequently those activities forbidden to Muslims, i.e. gambling, liquor, hoarding and usury based lending are strictly avoided. The Bank does not, for example finance liquor manufacturing, transportation, storage or distribution companies. Scholars trained in Islamic law (Islamic Jurisprudence) screen the suitability of investments on an ongoing basis and provide guidance on products to the Bank's management. By investing in ethical businesses and corporations the Islamic Bank will miss out on some very lucrative investment opportunities.
Interest, known as Reba in Islam is forbidden. Hence, all banking activities must avoid interest. Instead of interest, the Bank earns profit (mark-up) and fees on financing facilities it extends to customers. Also, depositors earn a share of the Bank's profit as opposed to interest. One of the criticisms of this "mark-up" is that in fact it is also a form of interest, yet disguised by the use of complex banking terminology. However, it is clear that it does comply with the Islamic canons and it is necessary for the bank to maintain profitable and competitive.
Rather than charge interest, Islamic banks work by forming a partnership and sharing the risks. This means that an Islamic bank has to ensure that it only lends money to individuals and corporations that they deem to be non-risky. If they believe that their client poses a liquidity risk, then it follows that they should not take on this risk and extend the loan. Another principle of Islamic finance is based on profit sharing partnership between the parties involved in a transaction. Usually, this profit sharing is based upon the risk that the bank takes on when it extends liquidity to a client, if this risk is very large then they will claim a large share of the profit and vice-versa.