How does Islamic finance work?

How does Islamic finance work?


At the World Islamic Economic forum in London, David Cameron announced that the UK will become the first non-Muslim country banking rules of Shari'a and that bonds and Islamic index will be created on the London stock exchange. These steps are a recognition of the unique model of Islamic finance, and they play an important role they have to play in ensuring sustained economic growth.

To understand why the UK is so keen to promote these investments is to understand - what distinguishes Islamic finance from Western models of banking and finance.

The Islamic financial industry is on the threshold of great opportunities, but also face serious problems. In the last few years it has achieved significant successes. Since 2006 asset base increased by 150% and projected to reach $1.8 trillion. this year. If we consider the stability of the Islamic supply of banks and severe restrictions under which they operate, it is a great achievement.

Even more important is that this growth is accompanied by the promise of much greater stability than it can guarantee a regular financial sector. The reason for this are strict conditions for Islamic products.

Without risk 

To begin with the fact that the Islamic finance need to work on profit, and simply lending money to those who need it, is not considered work. Under Islamic law, the money can not be used to “make” more money. Instead, the bank must provide the services of “making” profit.

Thus, instead of the traditional accounts with predetermined interest rates, Islamic banks provide accounts that offer profit or loss. The Bank, in turn, acquires the assets of your money, which generate income of the bank. In particular, it is considered unfair and forbidden to charge high rates from the needy.

Secondly, is not allowed gharar - risky or hazardous sale and the transaction. Gharar, as a rule, prohibited by Islam, which prohibits transactions taking excessive risk due to the uncertainty. All risks must be identified by investors, and all relevant information is disclosed. Finance prohibit the sale of something which person does not have, as this represents the risk of its absence in the future.

This excludes investments in ordinary derivatives, which require speculation in the future, depending on excessive risks. This is also the main reason why Islamic banks have remained intact in 2007 (poor control of risk means that they remained vulnerable to falling real prices for the assets).

Thirdly, Islamic Finance requires invest only in projects with good intentions. It is not allowed to invest in anything unethical or socially irresponsible, from weapons to entertainment and gambling.

With a focus on equity and investments in the sector of the economy, the principles of Islamic finance provides a stable and efficient banking sector. Instead of providing a favorable financial alternative investment into the real sector of the economy, Islamic banking complements and enhances the last. This ensures that financial capital does not artificially inflated the prices of assets. On the contrary, it leads to a job in the real economy, on real projects.

The high costs

But the cost of Islamic institutions for this responsible version of the banking higher. For this reason, these banks were limited in the Middle East and some other Muslim countries for a long time.

International growth was also limited due to the lack of well-developed regulatory systems abroad, able to analyze and monitor the operation, including Islamic accounts, mortgages, bonds and insurance.

However, with the expansion of the product range, the rapid growth of Islamic banking has attracted increasing attention of leading financial markets, their main desire is to connect to the massive liquidity offered by these institutions. Also, this is a key reason why the UK government has announced the issue of bonds by Shariah (except the desire of London to strengthen its position as a leading financial market).

Now we are probably going to see more of the steps taken in other markets in order to adapt to Islamic banking.

Global competition

Expansion in the world's major financial markets makes it difficult for Islamic banks, while not compete against much larger and regular players, but many also allow them to standardize products and reduce costs to a level where they can compete on a par with conventional banks.

Islamic banks will make its way into new markets where regulators are more open to this financial model. Thus, they will attract a lot of customers from traditional banks. But in order to preserve them and make most of these opportunities, Islamic banks will have to develop a much more robust risk management than it is now. They will also need to invest heavily in the reorganization and improvement of human resources, on which they depend.

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