Keeping the faith

Islamic finance is an important part of global banking. We explain what it is and why it will be more influential in the future

Islamic finance is an important part of global banking. Hannah Langworth explains what it is, how it works, and why it will be more influential in the future.

What is Islamic finance?

"Islamic finance" refers to financial transactions deemed to comply with sharia, law derived from the Qu'ran (the text Muslims believe to be a divine revelation made to the prophet Muhammad) and the sunna (his deeds and utterances) and various secondary sources. Sharia regulates many areas of social interaction, for example, family law and criminal justice as well as finance.

In the realm of finance, sharia's most well-known principle is the prohibition on the receipt of riba (broadly speaking, interest on a loan) but there are also rules against speculation, contracts deemed to be uncertain, unjust enrichment and unfair exploitation, and investment in products deemed to be haraam (forbidden) such as pork and alcohol.

Because of these prohibitions, under Islamic law many financial transactions, including lending with interest, some derivatives, conventional insurance, many investment funds and conventional project financing are all forbidden. So the Islamic finance industry steps in, providing alternative solutions certified by an Islamic scholar as sharia compliant.

Some common techniques used to create sharia compliant products which satisfy the same needs as prohibited conventional ones include using sale and leaseback structures (ijara) to replace secured lending, or profit-sharing agreements (mudaraba) to facilitate various kinds of investments. Just as with conventional financing, the way in which Islamic compliant deals are structured can be extremely complex, and new techniques are constantly being developed. For example, a relatively recent innovation in the Islamic finance market is the sukuk, a product which has similar functions to a fixed income bond.

Why is its significance increasing?

Islamic finance has grown rapidly from the origins of its modern form in the years following the Second World War, although, of course, the influence of the Islamic religion on the mercantile practices of its followers has a much longer history. The sector is now worth around $500 billion dollars and is growing at the rate of more than 15 per cent annually, claim M. Fahim Khan and Mario Porzio in their book on the topic published this year.

Its rise has been attributed to a variety of interacting factors, including the oil wealth of the Middle East, the resurgence of religion as a political force, patterns of migration from the Muslim world to Europe and America, and an increased attention to social responsibility in business in recent years. Most recently, the relatively small effect that the 2007-2008 financial crisis had on Islamic banking has led to a surge of interest in the application of its principles and methods.

In the City today, any investment banks or law firms with clients in the Middle East or Asia will work on deals involving Islamic finance because parties from these parts of the world will often require their transactions to be sharia compliant. Many City institutions have strong offerings in this area and/or close connections with Middle Eastern or Asian firms with extensive expertise. Historically, Islamic financing techniques have been used most in the financing of large infrastructure projects in the Muslim world, but they are now increasingly being applied to many other banking and corporate transactions.

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