How does Islamic finance differ from conventional finance?

How does Islamic finance differ from conventional finance?

The main difference between Islamic and conventional finance is the treatment of risk, and how risk is shared.

In this article, we examine what these differences can teach us about risk and risk management in conventional banking and financial markets.

What types of Islamic finance are there?

The two main forms of Islamic finance are bank finance and issuing Islamic securities (called sukuk).

In conventional terminology, you might think of these as debt – bank loans and bond issues respectively, but that is inaccurate. Those categories cannot be applied to pure Islamic finance.

In Islamic finance, interest is prohibited. If an enterprise is financed by debt with an obligation to pay interest, the risk of the business is not being shared fairly.

Profit and loss sharing

Instead, Islamic finance requires that finance be provided on the principle of profit and loss sharing. Under sharia law, finance can be provided through several types of contracts. Each type specifies how risk is shared between the enterprise and the supplier of finance.

Mudarabah

One such contract is a mudarabah. This specifies in advance how profits and losses are to be shared between the financier and the entrepreneur.

Profits are shared in a predetermined ratio, so the financier’s return fluctuates according to business profitability. Losses, except those caused by the entrepreneur’s fraud or negligence, are to be borne entirely by the financier.

Contrast that with a conventional loan where the financier has a contractual right to receive interest (and capital repayment) irrespective of the condition of the borrowers’ business.

Does Islamic finance operate with pure profit and loss sharing?

Islamic banks and sukuk are currently based on contracts that formally match what is required by shariah law.

But many scholars argue that the way they operate is not based on Islamic profit and loss sharing. A buyer of a sukuk, for example, expects to receive an assured yield comparable to an interest-bearing bond.

Owners of bank deposits expect capital certainty comparable to deposits in a conventional bank. Islamic banks smooth fluctuations in profits to provide this capital certainty.

And they channel most of their lending through shariah-compliant methods that, unlike mudarabah, do not involve participating in enterprise risk.

Therefore, a number of scholars observe that most Islamic finance is not different in substance from conventional finance.

How do Islamic banks manage risk?

A pure Islamic bank would share risks – profits and losses – with its customers. The ethical code underlying shariah does not seek to abolish risk: it recognises that business enterprise is desirable but is inherently risky. Therefore banks need to manage risks to keep them below undesirable levels.

Islamic banks also need to ensure their risk management does not involve purely speculative risk-taking, which is prohibited under shariah. As you will see next week, conventional investment banks can appear to be betting on exchange rate changes or on the prices of financial assets.

What methods are available to manage risk?

Islamic banks can use some of the methods available to conventional banks. To minimize the risk of default they can investigate and monitor the businesses they finance. In fact, profit and loss sharing might create an additional reason for monitoring the enterprise.

Challenges in risk management

However, Islamic banks face particular challenges in risk management. Some instruments that conventional banks use are not available. This includes conventional financial derivatives.

A financial derivative is an instrument whose value is determined by another financial instrument. This directly contravenes the principle of materiality: materiality means finance must be tied to real economic activity. Shariah-compliant derivative markets have not developed.

As you can see, Islamic finance is based on ethical principles including sharing risk; profit and loss sharing; and real activity.