Islamic Finance: Stereotypes and Reality

16 March


We are continuing to get acquainted with peculiarities of Islamic banking. Today we are going to focus on the most popular stereotypes that have been around Islamic finance for years and figure out which of them are true and which of them are fiction.


1. The Islamic Financial System will Replace the Western System and Dominate the World


This statement is greatly exaggerated: Islamic finance is a supplement to the traditional structure of the global financial market and is officially recognized by the World Bank. The Islamic financial system is not diametrically opposed to the current Western system. Its fundamental difference is that as a socially oriented system, it is addressed to society. It has certain moral messages, and this is exactly how it differs from existing business practice.


As for investments, they are channeled into the real economy in the Islamic financial system. However, there is a ban on interest as a fee for providing a service for the use of financial resources. Provider of financial resources must bear adequate risks along with the one who will use these resources. In addition to it, there are certain requirements for social charity. And besides, investments are not directed to socially harmful economy sectors, such as alcohol or tobacco production and gambling.


2. Islamic Finance is a kind of Charity


This is also a stereotype because the Islamic financial system is a future-oriented business. This type of financing is actually material aid on a repayable basis, which can be provided to organizations, regions or individuals. For instance, money can be given to individuals for educational purposes, for marriage, or to firms in financial difficulty.


3. Global Financial Crisis do not Affect the Islamic Financial System


This was the case until the 2008 crisis, when the Islamic financial system the traditional Western financial system became interlinked. In total the assets of Islamic banks amount to about 1% of the world’s total assets. About 300 banks deal with Islamic finance and over 23 thousand – with conventional finance. The crisis forced a number of Muslim countries to review regulations and develop a structured and effective regulatory framework for Islamic banking. Their activities are aimed at the three main directions:


- Allowing foreign banks to set up new Islamic banks:
- Allowing conventional banks to open “Islamic windows”;
- Allowing conventional banks to establish separate Islamic banking units.


4. Only Muslims can be Customers of Islamic Banks


Half of all the customers of Islamic banks in the world are non-Muslims, and people often deal with these institutions for purely economic reasons. The main purpose of Islamic banks is to avoid transactions prohibited by the Quran (for instance, usury). Instead of lending the customer money at interest, as in the classical Western banking model, in this case a transaction takes place. When the Islamic bank approves this transaction, it first of all considers the credibility of the borrower. Religious affiliation is not important in considering the application. 


5. Methods Used in the Islamic Financial System are Primitive


This view is based on the fundamental misunderstanding of the basics of Islamic financing.


The main instruments of Shariah-compliant finance include the following:


- Murabahah – resale with a trade mark-up;
- Musharakah – joint enterprise;
- Ijara – leasing;
- Istisna – forward dealing;
- Mudarabah – profit and loss sharing.


Thus, the essence of Islamic financing is to serve those for whom the instruments were directly created, not the governing entities.


6. There are more Risks in the Islamic Financial System than in a Traditional kind of Financial Systems


In fact, there is no riskier area in the world than a banking system. But unlike the “secular” system, the Islamic system relies on, so-called, “risk management”, in which investments are made with one’s own funds rather than those of others.


7. In the Islamic Financial System, Financing Costs are Higher than in Traditional Types of Financial Systems


Islamic financial institutions are located predominately in countries of the Middle East and South East Asia (with Bahrain and Malaysia being the largest centres), but are also being established in Europe and the USA. Their total global assets are estimated to exceed US $250 billion, growing at around 15% a year. However, despite this rapid growth, Islamic banking remains rather limited in most countries and its scale is small compared to the global financial system.


8. The Islamic Financial System Offers no Guarantees


In the Islamic system, the danger of insolvency rises for economic entities only if their revenue items prove insufficient for their out-of-pocket costs and liabilities. This kind of situation can only rise due to poor management or external economic factors, but is not intrinsic to this financial system.


9. Islamic Banks allegedly Finance Terrorism


Of course, this is not true. In more than 50 years of history, the Islamic bank has never been caught funding terrorist organizations. The system of Islamic banking experiences the same image problems as the religion as a whole. This is due to narrow-mindedness of many people who equate terrorism with religion. Islamic banking operates in the same system as all commercial structures: it is accountable to Central Banks of their countries, cooperates with the IMF, and internal control there is even stricter than in conventional banking. So, for instance, it is impossible to raise funds through the Islamic bank for alcohol production.


10. The Islamic Bank Offers more Favorable Terms to Borrowers


This is not as straightforward as it appears at first glance. On the one hand, the Islamic bank positions itself as a softer and more “human” structure. In the event that the customer is unable to pay the debt, the bank will work out a compromise. In the conventional bank, if the customer misses a payment, the interest will go up, but this is not the case here. On the other hand, this does not mean that there are no penalties for overdue loans – they can be used for charitable purposes. Islamic banks prefer to finance business, but in a conventional way – by giving funds. Traditional Islamic banking, where the bank gives money on a non-repayable basis and in return enters into a share of a business, is gradually dying out; it is difficult for bankers to calculate business risks and almost impossible to send their representative to a company’s board of directors every time.


11. There are no Set Rules in the Islamic Financial System


The negative impression is due to a certain fragmentation in the Islamic financial market, which resembles unhealthy competition, which should be addressed by the common regulatory body. There is a lack of specialists, Shariah experts with financial experience. Thus, for instance, a number of Islamic financial products popular in Malaysia are disapproved in the Middle East because of disagreements over the interpretation of the services offered by Islamic financial institutions.


But problems of this level are also typical of “secular” banks. Islam does not remain silent about them, but actively solve these problems. The existing fundamental constraints in Islamic banking make it possible to claim that these are the highest standards to date. If it was not true, the Japan Bank for International Cooperation would not have chosen aforementioned Malaysia (52% of Muslims), which is gradually becoming a kind of trendsetter in Islamic finance and claims to be a leader in such financial segment as sukuk, Islamic bonds not only in Asia, but in the world too. Today Malaysia has set the bar high on standards of the Islamic financial system, which is under control of the National Shariah Council, single governance structure. Their decisions are interpreted by religious authorities of individual banks, which makes the financial system more transparent and predictable. At the same time, Islamic banks openly compete here with conventional financial institutions, which can also be licensed to operate with Islamic financial products.



Ilmira Gafiyatullina

Photo: Creative Commons