Benefits of Islamic Banking and Finance:
We are all aware that the global finance market is dominated by the conventional banking system. However, due to the advantages of Islamic banking, the industry has expanded rapidly over the last decade, growing at the rate of 15%. Due to the growing benefits of Islamic banking, many international and local banks have stepped into the Shariah-compliant financial industry by establishing Islamic units and wings in their existing banking system. Islamic banking, initiated around 40 years ago was first limited to Middle Eastern countries. But over the years, Islamic banking and finance has become an effective tool for finance development worldwide including in non-Muslim countries by becoming a more than $4 trillion market at the global level. This alternative financial system operates based on the principles of Shariah law, which prohibits charging or paying interest, investing in unethical businesses, and engaging in excessive risk-taking.
14 Key Advantages of Islamic Banking and Finance
Let’s explore the significant advantages and exceptional benefits brought about by the practice of Islamic banking and finance.
1. Promotes Financial Justice:
Financial justice is the main principle of the Islamic model. Islamic banking creates a balance for the net profit or loss between the lender and the beneficiary rather than throwing it all on the entrepreneur. If an Islamic bank finances a project, the output of the project will be equally distributed amongst both parties. If the financier expects to receive profits for a certain project, he should also agree to carry a share of the loss.
2. Financial Inclusion:
Muslims refrain from banking through the conventional banking system since it is based on paying/receiving interest which the Shariah Law strictly prohibits. Almost three-quarters of the world’s Muslims remain unbanked. Islamic banking removes these barriers and allows Muslims to benefit from the financial system.
3. Reduces the Impact of Harmful Products and Practices:
Islamic banking restricts the goods and services that are restricted in Islam such as alcoholic beverages, tobacco, gambling, pornography, etc. irrespective of whether they are legal or not in a given country.
4. Strengthens Financial Stability:
In Islamic finance, investments are approached cautiously and the decision-making process is carried out thoroughly unlike the conventional banking system. The companies that appear risky are usually kept away from financial institutes. This is why during the global 2008 financial crisis and during the Covid-19 pandemic; the Islamic financial institutes remained untouched. With careful audits and analysis, the Islamic Finance Institute lessens the occurrence of risk and enhances financial stability.
5. Moral Values:
The moral values within the system are one of the key advantages of Islamic banking and finance. This plays an important role in promoting socially desirable investments and better individual/corporate relationships as well as behavior.
6. Ethical Investments
Islamic banks only invest in ethical sectors, excluding industries such as alcohol, gambling, and pork products, among others. This ethically responsible approach ensures that investments contribute to the betterment of society. For instance, funds may be directed towards sustainable energy projects or healthcare innovations.
7. Risk-Sharing
In contrast to conventional finance, Islamic finance operates on a risk-sharing principle where both the lender and borrower share the risk of any investment. This creates a more just system, for example, if a business financed by an Islamic bank fails, the loss is distributed between the bank and the client.
8. Prohibition of Interest
Islamic banking forbids the charging and paying of interest (Riba), which is deemed exploitative. For example, in Islamic home financing, the bank and client jointly purchase the property, with the client gradually buying the bank’s share over time.
9. Asset-Backed Financing
All monetary transactions in Islamic banking must be backed by a tangible asset or service. This prevents the creation of debt through speculative transactions, reducing the risk of financial crises.
10. Economic Stability
With its risk-sharing and asset-backed principles, Islamic banking contributes to greater economic stability. It discourages reckless speculation and promotes sustainable growth.
11. Transparency
Islamic banking systems prioritize transparency and mutual consent, ensuring all parties understand the terms of the contract. This transparency safeguards clients’ rights and promotes trust in the financial sector.
12. Support for Entrepreneurship
Islamic banking encourages entrepreneurship by offering profit-sharing investments. Startups and small businesses, for example, can secure funding without the pressure of interest-based repayments.
13. Financial Inclusion
By offering a banking system aligned with their faith, Islamic banking extends financial services to those who might otherwise be excluded due to religious reasons.
14. Inflation Protection
An inherent advantage of Islamic banking lies in its unique products such as Ijarah (leasing), which offer protection against inflation. Under the stipulations of an Ijarah contract, the rental payments are linked to inflation rates, safeguarding the preservation of money’s value.
15. Promoting Welfare
Islamic banking aims at promoting welfare and reducing poverty. Zakat (charitable giving) is one of the five pillars of Islam, and Islamic banks often facilitate this giving, contributing to societal well-being and wealth redistribution.
16. Opportunities for New Professionals
As the contrast between Islamic and conventional banking continues to pique market interest, Shariah-based banking proves to be a versatile solution, serving both Muslims and non-Muslims alike. The Institute of Islamic Finance and Banking is an excellent platform for those interested in advancing their knowledge in this unique financial sector. The demand for professionals in this niche is projected to skyrocket, with a need for over 75,000 experts anticipated in the upcoming five years. Given this, online courses in Islamic banking can be a strategic career move. For those aiming for the pinnacle, an affordable MBA in Islamic Finance and Banking or an Islamic Finance Expert Certification could present a prime opportunity. In essence, this could be your chance to be at the forefront of this rapidly growing field.
Disadvantages of Islamic Banking and Finance
Despite the many advantages of Islamic banking and finance, there are also potential disadvantages that one must consider before fully committing to this banking and financial system.
1. Limited Range of Products:
Islamic banking, being comparatively younger, does not offer as wide a variety of Islamic financial products as conventional banking. For instance, there are fewer options when it comes to long-term financing or retirement plans, which may limit possibilities for certain customers.
2. Complexity in Operations:
Due to the intricate nature of Sharia law compliance, Islamic banking procedures can often be more complex than those of conventional banking. For example, instead of simply lending money and accruing interest, Islamic banks must engage in a series of transactions such as leasing or purchasing and re-selling to ensure Sharia law compliance.
3. Higher Costs:
In some instances, the cost of Islamic banking services can be higher than conventional banking due to the additional overheads involved in ensuring that the products are Sharia-compliant. This might include costs related to the advisory board of Islamic scholars who verify compliance.
4. Uncertainty and Ambiguity:
There can be uncertainty in Islamic banking contracts as they are based on tangible assets and their performance. For example, if a business venture funded by a Mudaraba contract fails, the customer may lose their entire investment.
5. Lack of Standardization:
Islamic banking and finance lack a unified global standard, which could lead to inconsistency in practices and products. For instance, a financial product considered Sharia-compliant in one country might be viewed differently in another. This could create confusion for customers and hinder the growth of Islamic finance on a global scale.
Challenges for Islamic Financial Institutions:
Central banks frequently place Islamic banks on an equal footing with their traditional counterparts. However, the nature of products offered by Islamic banks distinguishes them significantly from conventional debt-generating alternatives, potentially stalling monetary inflation. Islamic banking’s approach to money creation is inextricably linked to real-sector wealth generation, accentuating one of the prominent advantages of Islamic banking. Unlike traditional banks, Islamic financial institutions face challenges when attempting to liquidate assets, necessitating a larger cash reserve in their vaults to satisfy withdrawal obligations. This characteristic further highlights the advantageous uniqueness of Islamic banking in comparison to conventional financial systems.
1. The Practice of Islamic Banking Institutions:
AN ARGUMENT:
Islamic modes of financing did not result in monetary expansion.
ANSWER:
Islamic banks do not allow overdrafts, so they don’t directly create money. Investment accounts in Islamic banks differ from conventional savings. The need for keeping a reserve against any deposit arises essentially, and the return of that deposit to the depositor is guaranteed. In the case of an investment account, an Islamic bank owes the depositor according to their investment.
2. Nature of Investment Accounts:
- To resolve this controversy, it is necessary to understand what money is. How it is created? and what should be the appropriate reserve requirements for Islamic banks to operate?
- Money is a means of payment. Whenever a new checking account comes into being, money is created. That results in monetary expansion because of this fact.
3. Premium Payment and Profit Distribution Mechanism:
Investment accounts in Islamic banks have close similarities to savings and time deposits in conventional banks. COIs of Islamic banks and TDR of Conventional Banks are similar. Nevertheless, the Premium Policies and Profit Distribution mechanism are different.
PREMATURE ENCAHSMENT:
Islamic banks allow investment account holders, to withdraw full money from their accounts. This is in contrast to conventional banks which do not pay the full principal, at premature encashment.
EXPANSION THROUGH ISLAMIC BANKS:
Let us see how the Islamic modes of finance may contribute to monetary expansion:
- Funds accumulated in Islamic banks’ investment accounts are invested in industry, trade, or agriculture in partnership with businessmen.
- These funds are received by people as salaries, wages, prices for raw materials, rents, etc. Some of it finds its way back to banks, and are distributed between current and investment accounts. Anyway, the investment based on Musharkah or Mudarbah results in new bank deposits.
Differences between Debt Finance and Participatory Finance:
Number 1: All profit-sharing investments are based on a potential for additional production. This does not necessarily apply to debt finance, in which the borrower’s ability to repay takes precedence over the project’s expected profitability.
Number 2: In case the business runs into losses, lesser profits are earned by Islamic banks. So, Islamic banks debit the amount of the loss, pro rata to the investment accounts.