Understanding Islamic Finance

Introduction

Have you ever wondered why some banks offer ‘Islamic banking’ or ‘Sharia-compliant’ financial products? Or perhaps you’ve heard the term “usury” but aren’t quite sure what it means? Let’s dive into the fascinating world of different credit systems and understand how they work in our modern financial landscape.

The Differences Between Sharia Compliant and Traditional Credit

At its core, traditional credit (often associated with usury) is based on lending money and charging interest. When you open a conventional loan, you borrow a sum of money and agree to pay it back plus interest. The lender makes money from the interest and fees charged on the borrowed amount.

Sharia-compliant lending, on the other hand, takes a completely different approach. Islamic law (‘Shariah’) prohibits charging interest, which is known as ‘Riba’ in Arabic. As it is considered exploitative.

Instead, Sharia-compliant financing uses various alternative structures that allow both the lender and borrower to engage in ethical financial transactions, without interest.

How Do Both Forms of Credit Actually Work?

Let’s say you want to buy a car worth  USD 30,000. Here’s how each approach to vehicle finance would typically handle it:

Traditional Credit:

  • The bank lends you USD 30,000
  • You pay back the principal plus interest (let’s say 5% APR) over 5 years
  • The bank profits from the interest payments and any associated fees

Sharia-compliant Finance:

  • The bank buys the car for USD 30,000
  • The bank sells it to you for USD 33,000 (the cost plus the agreed-upon profit)
  • You pay USD 33,000 in fixed monthly instalments
  • The bank profits from the markup, not interest

While the end result might look similar financially, the structure completely changes how the transaction works from a religious and ethical standpoint.

The Application Process

Despite their fundamental differences, applying for either type of credit shares many common elements:

  1. Credit Assessment: Both systems need to verify your ability to repay
  2. Documentation: The borrower needs to prove their income and identity
  3. Collateral Requirements: Both may require security for larger loans

The main difference lies in the additional Sharia-compliance checks for Islamic financing. The bank needs to ensure that:

  • The asset being financed is permissible under Islamic law
  • The transaction structure meets religious requirements
  • All documentation uses Sharia-compliant terms and concepts

How Large is the Islamic Finance Market?

Islamic finance has grown remarkably in recent decades. As of 2023, the global Islamic finance industry is estimated to be worth over USD 2.7 trillion, representing about 1.5% of global financial assets. While this might seem small, Islamic finance is growing at a faster rate than conventional finance in many regions.

The highest concentration of Islamic finance can be found in:

  • Gulf Cooperation Council (GCC) countries (Saudi Arabia, UAE, Kuwait, Qatar, Bahrin and Oman)
  • Southeast Asian nations (Malaysia, Indonesia)
  • Some parts of North Africa

Even traditional Western banks are getting in on the action. Major global financial institutions such as HSBC and Standard Chartered have now set-up standalone Islamic banking subsidiaries which provide Islamic banking products in many markets.

Why Select One Over the Other?

The choice of which financing model to use often comes down to personal beliefs and circumstances:

Religious Adherence

For practicing Muslims, Sharia-compliant products provide a way to access financing while adhering to religious principles. It is not just about avoiding interest; it is also about ensuring money is used in ethically sound ways according to Islamic teachings.

Risk Sharing

Sharia finance emphasises partnership and shared risk between the lender and borrower. Some people prefer this more equitable approach over traditional lending which has a more hierarchical structure.

Available Options

In some regions, one form of credit might be more readily available than the other. While traditional credit dominates globally, Sharia-compliant finance might be the primary option in certain Muslim-majority countries.

Pricing

Despite different structures, competitive markets often drive similar total costs between the two credit granting systems. However, Sharia-compliant products might sometimes cost more due to their more complex structuring requirements.

Summary

What is particularly interesting is how these different approaches to credit are influencing each other. Traditional banks are learning from the ethical financing principles of Islamic banking, while Islamic banks are adopting modern financial technologies to become more efficient.

Some innovative recent developments include:

  • Green Sukuk (Islamic bonds) for environmental projects
  • Digital Islamic banking platforms
  • Hybrid products that appeal to both traditional and Islamic banking customers

As our global financial system becomes more interconnected, understanding different approaches to credit becomes increasingly important. Whether you choose traditional credit or Sharia-compliant, often depends on your personal beliefs, location, and specific financial needs.

What matters is that both systems continue to evolve and provide viable options for people to access the financing they need in ways that align with their values.

In the next article, we will take a deeper dive into the specific challenges and opportunities these different approaches to credit granting present. This will be from a risk management perspective, exploring how modern technology is helping bridge the gaps between traditional credit and Islamic finance.

About the Author

Jarrod McElhinney is the Chief Experience Officer at ADEPT Decisions and has been with ADEPT Decisions since 2017, playing a key role in designing and managing the platform, and ensuring that all subscribers realise direct business benefits from our solutions.

About ADEPT Decisions

We disrupt the status quo in the lending industry by providing clients with customer decisioning, credit risk consulting and training, predictive modelling and advanced analytics to level the playing field, promote financial inclusion and support a new generation of financial products.