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How Do Islamic Financial Services Work?

Principles, Models, and Objectives

Islamic finance is exponentially growing in asset base, outreach, and product lines in both UK and around the world. Globally, Islamic finance presents in over 50 countries, growing at 10-12% annually from the last two decades. The current size of the global Islamic finance market is nearly USD 2 trillion with expectations of market size to be USD 3.4 trillion by end of 2018, covering bank and non-bank financial institutions, capital markets, money markets and insurance.

This growth creates great business and career opportunities particularly, in Asia, Middle East, and key financial hubs of Europe. There seems to be two key factors contributing to this growth. Firstly, Muslim population is growing around the globe and aims to access financial services which are compliant to Islamic law (shariah). Secondly, Islamic financial institutions offer asset backed and based services and claimed these to be less risky.

There is, however, a need to understand the principles, models, and objectives of the Islamic financial services. As we understand, conventional financial services operate on loan models, where a financial institution borrow money from the surplus saving units and lend the same to deficit saving units in the economy. This way, the deposits work as liabilities of the financial instituions and wearers finances work as assets of the financial institutions. Financial institutions making profits through payment and charge of different interest rates.

Islamic financial services are, however, quite different from conventional financial services mainly because of the use of unique partnership, sale, agency, and other socially responsible models instead of conventional loan models. This is because payment and charge of interest is prohibited in shariah. These models work as alternatives to conventional loan models to enable financial services which are compliant to shariah. In various variants of partnerships, such as in capital & skill partnership model called mudarbah, Islamic banks create saving and investment services. Where the depositors provide investments and banks provide skills to earn and share the profits. Similarly, in a diminishing partnership called diminishing musharikah, a bank invests in a house partnership and gradually decreases its share to ultimately transfer the house to customer, thus create an alternative to conventional house financing. For the duration in which the house remains in the ownership of bank and customer jointly, the bank charges rentals from the customer for its part in the house being in the use of customer.

Islamic financial institutions also get involve in different sale (bai) types with customers. In such models, instead of providing loans banks purchase and then sell goods to customers to earn a profit on the goods sold. Sale models are more popular in financing the running assets of firms. In other models, such as lease (ijarah), financial institutions provide durable assets on rent to customers. In agency (wikalah), Islamic financial institutions provide agency services. All these models and others are used in different combinations by Islamic financial institutions to develop various service packages.

These Islamic financial models or sometimes called contracts and bases on the shariah principles and objectives. The shariah principles include piety (taqwa), equality (masawath), brotherhood (akhowath), justice (adl), benevolence (ihsan), and cooperation (taawon). These principles, inherently, bring in unification and integration among various stakeholders of the Islamic financial services and society. These shariah principles also affect the theorists and practitioners to develop financial contracts to be applied in practice, to achieve the shariah’s socially oriented objectives. Islamic financial services are therefore sometime discussed as socially responsible and ethical finance.

The shariah objectives include safeguarding faith, self, intellect, family, and property to frame a balanced social system. The shariah principles and objectives make Islamic financial services to base on real assets and avoid conventional financial practices, such as avoiding charge and payment of interest on principal amount and going into transactions which involve greater uncertainty, which are believed to be constraining the achievements of shariah objectives.

In our book, Understanding Islamic Financial Services, published by Kogan Page, London, we discuss in detail the background of Islamic financial services, shariah its sources, the principles of Islamic financial service, key shariah prohibitions, such as interest (riba) and excessive uncertainty (gharar), and ethics in Islamic finance. The Book also presents a comprehensive review of current Islamic financial models, their applications, and unification for the effective Islamic financial services development.