How Islamic finance can prevent financial crises

The collapse of financial institutions such as the recent Silicon Valley Bank highlights the fragility of the conventional financial system, which is built on debt and leveraged investments. Islamic finance offers an alternative.

The principles of Islamic finance are based on ethical behavior, risk sharing, transparency, and accountability. They create a natural limit to arbitrary lending – and are less prone to financial crises. You can learn about the key principles and how Islamic financial instruments behave under changing market conditions in this article.

Prohibition of Interest and Securing with Real Assets

A key difference between conventional and Islamic finance lies in how banks provide money. In Islamic finance, the collection of interest is prohibited. Therefore, banks cannot lend money with interest.

Instead, they share profits and losses with their customers through profit and loss sharing contracts. This means that the bank has a vested interest in the success of its customers. At the same time, it avoids giving money to customers who cannot repay their loans.

Another principle of Islamic finance: transactions must be secured by real assets, and speculative activities must be avoided. This ensures that banks do not engage in risky investments or promote unnecessary consumption through easy credit. This principle also prevents the creation of financial instruments that are detached from the real economy – such as the complex derivatives that were a significant factor in the 2008 financial crisis.

Reducing Risk, Transparency, and Social Responsibility

Moreover, Islamic finance calls for risk sharing and risk mitigation. This leads banks to diversify their portfolios and invest in a variety of different assets to spread risks. The likelihood of a bank collapse due to the failure of a single asset or investment is reduced.

Finally, Islamic finance principles require transparency and accountability with a focus on ethical behavior and social responsibility. Banks must pay more attention to the impacts on society and avoid activities that could harm their customers or the broader economy.

Islamic Finance: Not Completely Immune, but More Stable and Resilient

The emphasis on ethical behavior, risk sharing, transparency, and real asset backing in Islamic finance reduces the risk of bank collapses, liquidity shortages, or bank runs. While no system is completely immune to financial shocks, Islamic finance creates a financial system that is more stable, resilient, and less prone to the types of financial crises that have occurred in conventional finance. It protects investors and society at large and can serve as a model for a more sustainable and equitable financial system.

How Do Various Islamic Financial Instruments Behave?

Islamic finance operates with various financial instruments, including Sukuk bonds. They are similar to conventional bonds but comply with Shariah law, which prohibits interest-based transactions. There are different types of Sukuk bonds, differing in their structures and cash flows. Sukuk bonds are influenced by market conditions, and their behavior can impact the underlying assets. An overview:

1. Ijarah Sukuk: These are based on the leasing of assets. Investors in these Sukuk bonds receive regular rental payments. They are relatively stable in behavior and offer predictable cash flows, making them attractive to risk-averse investors. Under changing market conditions, the underlying assets can be affected by factors such as changes in rental prices or the value of the asset.
2. Murabaha Sukuk: These are based on the sale of assets with a markup. Investors receive a return in the form of the markup. Murabaha Sukuk are also relatively stable in behavior and offer predictable cash flows. Under changing market conditions, the underlying assets can be affected by factors such as changes in the cost of the asset or the markup.
3. Musharakah Sukuk: These are based on partnerships. Investors receive a share of the profits from the underlying assets. Musharakah Sukuk are more volatile in behavior than Ijarah and Murabaha Sukuk because their returns are tied to the performance of the underlying business or project. Under changing market conditions, the underlying assets can be affected by factors such as changes in market demand or the operating costs of the business.
4. Mudarabah Sukuk: Similar to Musharakah Sukuk, these are based on a specific project or investment. Investors in Mudarabah Sukuk provide the capital, while the other party (the Mudarib) provides expertise and management. Mudarabah Sukuk are also more volatile in behavior than Ijarah and Murabaha Sukuk because their returns are tied to the success of the specific project or investment. Under changing market conditions, the performance of the underlying assets can vary.
5. Hybrid Structures: These combine various Sukuk structures to achieve specific goals. For example, a Sukuk can combine Ijarah and Murabaha structures to create a hybrid Sukuk that offers both predictable cash flows and potential capital gains. The behavior of hybrid Sukuk depends on the underlying structures and the market conditions affecting each element.

In summary: Ijarah and Murabaha Sukuk are relatively stable and offer predictable cash flows, while Musharakah and Mudarabah Sukuk are more volatile and depend on the success of the underlying business or project. Hybrid Sukuk combine different structures.