The role of Islamic finance in economic stability and social justice

One of the most outstanding times for the Islamic home finance industry in the US began in February 2007. The Federal Home Loan Mortgage Corporation (Freddie Mac) issued a press release announcing that it would no longer buy the riskiest subprime mortgages and mortgage-backed securities. Two months after the announcement, a leading subprime mortgage lender filed for Chapter 11 bankruptcy protection. Three months after that bankruptcy filing, nationwide financial institutions warned of “difficult conditions.” Manifestations of such difficult conditions appeared on the financial market horizon as once-well-established mortgage companies suddenly began filing for Chapter 11. Similar circumstances reached the UK when the Bank of England approved the provision of liquidity support to Northern Rock, the country’s fifth largest mortgage lender. Five months later Treasury of the United Kingdom became the owner of Northern Rock.

Up to this point, the seriousness of these “difficult conditions” had not been fully understood by the majority of the population. In late 2008, the Federal Reserve Bank of New York was authorized to lend AIG $85 billion. This was the beginning of the deepest recession in the United States since the Great Depression. What followed was a chain reaction that led to an unprecedented global financial crisis as the world suffered from soaring unemployment, rampant foreclosures and widespread skepticism about financial instruments.

This led to a renewed spotlight on an unknown market segment that seemed comparatively more stable and, importantly, much more ethical: the Islamic finance sector. From financial hubs in Malaysia to the Middle East spanning more than seventy countries, US Islamic finance has grown from US$5 billion in the 1980s to US$1 trillion in 2010. This phenomenal growth was exciting caught the attention of global investors who wanted to protect their currency investments through more ethical and reliable financial instruments. As financial sector professionals realized that these Sharia-compliant instruments prevented many of the worst effects of the global financial crisis, they became an attractive investment vehicle to support a more diversified portfolio. The Shariah-compliant financial sector has avoided investing in predatory lending firms and overly leveraged financial instruments due to the strict ethical nature of the Shariah governance system. News and media started covering this old but unknown industry, hoping to learn from the mistakes of the conventional banking sector.

The concept of the modern Islamic financial services industry is rooted in the principles of Islamic jurisprudence dealing with financial transactions, a branch of Islamic jurisprudence called Fiqh Al Muamalat. Fiqh Al Muamalat is an Islamic legal framework that charts the conduct of Muslims in commercial or economic endeavors. Islamic financial products and judgments are based on certain injunctions from the Qur’an that prohibit certain features of financial transaction models and related economic activities.

The Koran forbids interest, also called usury or riba. The underlying reasoning is that Islam regards lending as a charitable act to help another member of society in his/her need – hence benefiting from another’s need is strictly forbidden. In the traditional banking system, when interest is charged on a loan, the risk of that transaction is transferred to the borrower, while the lender benefits from the interest-based transaction. There is no compensation for the hardships the borrower suffers should he suffer losses from the transaction.

By its very nature, Sharia law prohibits unethical financial practices. It also promotes the distribution of wealth among all people to reduce poverty and inequality. This is manifested in the prohibitions on activities such as excessive speculation, gambling and investing in products that are harmful to society according to Islamic law (alcohol, pornography, etc.). The structure of Islamic financial products and services, particularly the ban on speculative transactions, has helped the industry escape most of the negative impacts of the global financial crisis. The governance model of Islamic financial institutions has been hailed as an ethical alternative by institutions such as the International Monetary Fund and the World Bank. Economic experts have suggested that Islamic finance principles can be used to promote financial inclusion, which improves the quality of life in developing countries. Islamic financial principles can also contribute to financial stability and economic development around the world.