4 Things You Need to Know about Islamic Finance (IMF)

1-Islamic finance is based on Islamic law.

This means that interest can neither be paid nor received; nor can the financial activities be used to finance activities which are forbidden by Islam, including gambling and alcohol.

But does this mean that Islamic financial institutions can’t lend?

No.

In the conventional world, a bank may be providing funding for a more mortgager to finance a house, the more mortgager repays the loan with interest over the lifetime of the loan, and the bank pays the interest to its depositors.

But an Islamic bank provides a funding in a slightly different form. It uses the funds that are provided by its depositors to purchase the house.

And the borrower then pays a rental for the use of that house over the lifetime of the loan, plus an amount which repays the loan over its lifetime and the bank then pays a share of its profits to its depositors.

Sukuk is very similar to Islamic banking insofar as the lender provides funding to purchase an asset, a road, a bridge, a hospital… and the borrower pays a rental income which is then transferred back to the lender.

So the two key aspects of Islamic finance are:

1. It’s asset-based

2. There is risk sharing

2- Islamic finance is growing fast

Islamic finance is growing rapidly but still remains concentrated in a number of jurisdictions.

Its strong growth reflects a very strong interest on the part of Muslim populations, who have previously been underserved, but also the very strong growth in a number of jurisdictions, where Islamic finance that already existed.

But Islamic finance isn’t growing just in the Muslim world, there’s strong interest on the part of advanced economies.

We see particularly Sukuk as an opportunity to tap the large pool of savings an interest in Shariah-compliant instruments.

3- Islamic finance offers possible economic benefits

Well, in the stability front, the Islamic finance has the advantage of being asset backed, which makes it inherently less risky than conventional finance.

And in terms of growth, it serves growth in two dimensions:

First, it provides greater access to banking to the Muslim population, who have previously been underserved by conventional banks.

And by tapping a larger pool of savings, this unleashes greater potential for funding of growth-enhancing investment

4- Islamic Finance still faces many challenges

Islamic finance holds great promise for promoting macroeconomic stability and financial stability.

But to fulfill these promises, three prerequisites really need to be filled:

1. While standards and codes for the application of Islamic finance have been defined, these need to be deepened and applied in more consistent manner, both nationally and internationally. And this becomes much more important as Islamic finance and Islamic institutions become more important and more systemic

2. It’s essential for Shariah-compliant money markets to be developed. This will allow Islamic banks to manage their liquidity in a more effective way and free up resources for them to invest in growth-enhancing projects.

3. There is a vital need for institutional reforms in the areas of tax policy, legal reforms, and capital market development, which will be needed for Islamic finance to fulfill its promise.

This video is originally produced by IMF. It is transcribed by Reading Islam team.

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