Under the notion Islamic Finance fall financial services based on Shari’ah principles (Islamic law). Major principles of Shari’ah that are applicable to finance and that differ from conventional finance are the ban on interest (riba), the ban on (excessive) uncertainty (gharar), the prescription that losses and profits are shared between borrower and lender, the request to back each financial transaction with an tangible, underlying asset as well as the necessity to invest only in industries that enhance society (products/services that are not forbidden or discouraged by Qur’an).
Instruments and extension
Modern Islamic finance has existed internationally since the 1970s and represents a small but rapidly growing segment of the global finance industry. There is currently over 800 billion US Dollar worth of deposits and investments lodged in Islamic banks, mutual funds, insurance schemes (takaful), and Islamic branches of conventional banks, with growth rates of 10% to 15% annually over the past ten years. The Persian Gulf and Southeast Asia historically have been and continue to be the major centres of Islamic finance. Following Iran, the largest Islamic finance markets in 2007 were Saudi Arabia, Malaysia, Kuwait, and the United Arab Emirates (UAE). Yet, even large conventional banks in the United States and Europe have opened so called “Islamic windows” or subsidiaries in order to participate in this growing market.
The most common types of Islamic Finance are Mudharaba (profit sharing), Wadia (safekeeping), Musharaka (joint venture), Murabaha (cost plus financing), and Ijara (leasing). Murabaha, Ijara and diminishing Musharaka are structures that provide an Islamic alternative to conventional mortgages.
Murabaha is an arrangement whereby instead of loaning the buyer money to purchase the house, a bank buys the house itself from the seller, and re-sells it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral; thus the house is registered to the name of the bank from the start of the transaction.
In Ijara the financial institution buys the property and lets it to the client over a fixed period of time at an agreed rent. The customer may reimburse the mortgage in one lump-sum when the rent period expires or from the outset by additional payments that reduce the intital term of mortgage.
The concept of diminishing Musharaka is an innovative concept that allows for a floating rate in form of rental. The customer and the bank participate in the joint ownership of the property. Each one has a number of units. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the customer can purchase the bank’s share on the property gradually from it, thereby reducing the rental price proportionally.
In general, a sound, well-functioning Islamic financial system might foster the regional integration and the social and economic development of the countries involved by financing the economic infrastructure and creating job opportunities. Yet, it may also contribute in Europe or the United States to the wealth creation of the Muslim minority. The rapid growth of the Islamic Finance industry shows the high potential of this concept and indicates the high demand for corresponding products. This is also true for Islamic mortgages. Yet, Islamic mortgage products are priced higher than conventional mortgage products with customers expected to find a higher deposit. This is due to the nature of the transaction: institutions have added cost implications and, technically, the property has been bought and sold twice so stamp duty is charged on each transaction if regulation is not adapted to Islamic finance practices.
In general, Islamic finance faces many challenges, including recent regulatory changes, illiquidity issues, liquidity risk management concerns, need for harmonised regulation, regulatory disparity amongst national supervisors, and a potentially unlevel playing field with the conventional financial industry. Furthermore, the Shari’ah principles predispose the system to hold substantial liquid assets and excess reserves; in theory, it has to be a full-reserve banking system.
These critical issues have to be addressed for a sound future market and industry development. Yet, the ensuing financial innovation process in tandem with favourable regulatory developments at domestic and international levels indicate that the long-term prospects look promising for Islamic finance.
Islamic Finance in times of financial and real estate crises
Islamic banking has so far been spared from a serious financial crisis, with the exception of a few small cases.
Since the summer of 2007, the global financial system has undergone a period of dramatic turbulence, which has caused a widespread reassessment of risk in both developed and emerging economies. Internationally, Islamic banks appear to be more resilient to the global economic downturn and the international financial crisis than conventional banks. They tend to avoid the speculative investments, such as derivatives, that many analysts believe led to the financial crisis affecting conventional banks. However, as Islamic banks operate within a global financial system, they have not been completely insulated from the recent economic and financial shocks. For instance, on the one hand, the Islamic financial industry is considered by many to be less risky because financial transactions are backed by physical assets. On the other hand, Islamic banks may be more vulnerable to fluctuations in the mortgage market, given their high activity in the real estate sector compared to conventional banks. The recent slowdown in real estate activity in the Gulf economies raises concerns about some Islamic banks’ financial positions. In December 2009, Nakheel, a Dubai-located real estate developer, could only repay its maturing Islamic bonds with the help of a 10 billion USD aid. However, Nakheel still faces severe problems.
Yet, the jury is still out how Islamic finance will be affected in the short-run by the repercussions of the global financial crisis.
 In the following cp.: Shayerah, Ilias: Islamic Finance: Overview and Policy Concerns, s.l. 2009, pp. 1-2. In the following: Shayerah, Islamic Finance.
 In the following cp.: Boulif, Mohamed: Islamic mortgages – European growth potentials, in: Mortgage Finance Gazette, 2006, pp. 23-24.
 In the follwoing cp.: El Qorchi, Mohammed: Islamic Finance Gears Up, in: Finance and Development, Volume 42, Nr. 4, Washington 2005, p. 6.
 In the following cp.: O’Hara, Mary: Double stamp duty abolished on Islamic mortgages, in: The Guardian, 10 April, 2003, p. 11.
 In the following cp.: Hesse, Heiko/ Jobst, Andreas/ Solé, Juan: Quo vadis Islamic finance?, s.l. 2008.
 In the following cp.: Shayera, Islamic Finance, pp. 2-4.
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Is Islamic Finance a sustainable and less crisis-prone alternative to the conventional banking system?
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