Islamic Finance

Free «Islamic Finance» Essay Sample


During the crisis, Islamic finance has attracted the attention of investors. Despite the extensive availability of information on the subject of Islamic banking, today the majority of experts in finances do not have a common idea about a concept of Islamic banking. People often think that Islamic banking looks like something antique or is the financial base for terrorists. The most significant difference is that Islamic banks strictly adhere to the norms of Islam, according to which loans with lending rate are forbidden. The construction of all Islamic financial instruments is done in a way to meet this condition and, at the same time, to make a profit from its activities. Islamic banking is relatively young. The starting point for the development of Islamic banking was in 1975, when the Islamic Development Bank and Dubai Islamic Bank were created (Hassan and Lewis 13). Recently, Islamic banks have emerged in the USA and Europe, where a vast percentage of population is anxiously relating to Sharia law. While looking for new customers, the major traditional European banks are offering specific products. Among them, for example, is the French bank “Societe Generale” (J. F.). The research paper aims to evaluate the issues of Islamic finance, its history, and investigates the perspective of development of Islamic banking, as an alternative to international finance system.

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The Understanding of Islamic Finance

Often, very little is known about the Islamic financial institutions that reduced to ban profit by obtaining bank interests and taking excessive risks, including the ones through the use of derivative financial instruments. The modern Islamic bank is an independent financial institution with the purpose of customer satisfaction and aiming to ensure the growth of shareholder’s value. Naturally, in essence, the economy cannot be Islamic, Christian or Buddhist. Nevertheless, the confessional basis determines the system and mechanism of doing business, performing a kind of code of honor for the executives. Traditional bank, in fact, is buying and selling funds to benefit from the loan interest. The Islamic Bank transfers credit based on financial business investment (Maghrebi, Mirakhor and Iqbal 288). The cornerstone principle of Islamic finance is the prohibition of interest on loans (riba) of any kind (Hassan and Lewis 43). Thus, any tools based on debt find themselves outside the law of Sharia. This issue means that a client cannot put money in the bank, in order to receive interest from the sum. Moreover, credit issued for any fixed or floating rate is also impossible. The bank opens accounts that accumulate depositors’ funds (Hassan and Lewis 43). By these means, it finances the business. However, instead of the common percentage, the entrepreneur shares profits with a bank, and it turns to the depositor (Hassan and Lewis 43).

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However, the first principle states that the bank or investor fee does not initially require certification, and emerges as a derivative of business profits. Thus, from an economic perspective, the eliminated basis of the dominant banking system is an interest loan (Ayub 47). The general principle of Islamic bank is that, since the money is not a commodity, they cannot grow just because they are issued in the form of loans (Maghrebi, Mirakhor and Iqbal 19). Therefore, the creditor may rely on income only if the investment in the economy has created a real benefit.

Instead of traditional banking and investment, products in the Islamic world have particular forms. “Musharaka” is the joint implementation of the project and the banks employer (Alawode and Iqbal). As a part of this operation, the bank lends to an outlined project. In fact, it is a form of project financing. The roots of these procedures go into the caravan trade when some merchants provide the goods, while others bring them to the destination with an aim to sell. This type of Islamic finance characterizes the deeds when the bank provides financing that is not related to the collection of a certain percentage and participates in the profits (Alawode and Iqbal). Profit distribution is as follows – a certain percentage is allocated to the partner in return for labor; management experience or otherwise participate in the transaction or the project (Alawode and Iqbal). The remainder distributes the partner and the bank that provided financing in a ratio that is proportionate to the contribution of each participant. When there are losses, they are distributed proportionally to the loss of participation in financing (Alawode and Iqbal).

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Murabaha” is the process of commercial transactions in a kind of contract of sale (Kettell 43). The bank acquires certain goods for resale. Such an activity does not contradict the Sharia because trade involves personal involvement and efforts (Kettell 43). The bank undertakes the sales organization, storage, transportation, etc. (Kettell 43). For example, the bank takes on its behalf and, at their expense, some items on the customer’s order. The bank assumes the entire risk of trade (Kettell 44). Subsequently, it sells the goods to the client at a price that includes the margin that was specified in the agreement. The bank’s income comes because of this markup (Kettell 44).

Mudaraba” is an agreement under which a customer’s bank transfers money to the bank for future investment of these resources in a certain project or activity (Lewis, Ariff and Mohamad 26). Profits derived from the project are divided in the agreed proportion. This operation is analogous to passive banking facilities, which aim to attract money (Lewis, Ariff and Mohamad 27). Islamic uniqueness lies in the fact that the customer knows where his/her money is going. The bank may not invest in any prohibited activities, such as production and sale of alcohol, the organization of gambling houses and brothels (Lewis, Ariff and Mohamad 27). Moreover, “mudaraba” excludes receipts of interest in pure form (Lewis, Ariff and Mohamad 28). Noteworthy is the fact of the so-called “sukuk” (interest-free Islamic bonds), which issue by certain tangible assets, where the issuer is its equity owner (Kettell 83). The yield depends on the “sukuk” profit on the underlying asset, and the client gives the investor an irrevocable right to purchase the asset at a fixed price (Kettell 83). The advantage of this type of bond is in low volatility, and the tendency of investors to hold these securities to maturity (Kettell 83).

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The History of Islamic Finance

For the first time, Islamic banks operations, based on Islamic law, were established in the 80s of the XX century (Ayub 29). However, the first attempts to organize such a bank have been going on for 60 years of the last century, when the economist Ahmad al Najjar in the Egyptian town of Mit Ghamr created a bank in Egypt (Ayub 29). That institution performed the operations for saving and accumulating funds of individuals and carried out the investment share of accumulated resources in conditions excluding usury. The interest on cash transactions is excluded, but it provides for the participation in profits from the carried out operations. Direction of the bank was to attract the funds of small investors and capital formation for the use consistent with the principles of Sharia. However, in the wake of the struggle against Islamic radical organizations, the bank was closed in 1967 (Ayub 29). Nevertheless, even after failures in the creation of Islamic banks that have befallen Ahmad al Najjar in Egypt, he believed that financial institutions established based on a single faith could count on success (Ayub 29). He moved from Saudi Arabia to Egypt, where his cooperation with the problems of Islamic economy continued (Ayub 29).

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In the early 70s of the XX century, oil prices have gone up and the suppliers to the world market, which are the Gulf countries (Ayub 201). Foreign exchange reserves of the Middle East have increased an average of 5 times; there was a need to create a new financial structure that was different from the world banking practice and was based on Islamic ethics and principles. The familiar geography of Islamic banking institutions in the Arab East and Africa began to expand with the release on Australian continent, attracting its supporters in the USA, Canada, Russia, Sri Lanka, the UK, etc. (Ayub 201). A trend line started to stand out particularly noticeably. Islamic service banks increasingly resort not only to Muslims, but also to large Western companies (IBM, General Motors, Daewoo), and the leading western banks open at Islamic divisions (Ayub 461). Among them, there are Deutsche Bank, IAG, ABN Amro, Citibank Chase Manhattan, Hong Kong & Shanghai Banking Corporation, JP Morgan and others (Ayub 461).

The Perspective of Using Islamic Finance

The crisis began in the credit system, but started with the mortgage. This fact indicates that the well established world’s credit system was now untenable. If the person looks into the essence of lending, it is evident that its principle is a material gain from usury. All the entrepreneurs, regardless of their religion, can use Islamic financial instruments (Irfan). According to analysts, the Islamic finance market, which is actively developing for the last several decades, is one of the most promising. Most Western operations of commercial banks create two principal groups. The first one characterizes credit operations (raising funds, mainly in the form of deposits, loans from other financial institutions, issuing loans or buying securities) (Hassan and Lewis 320). The second group includes the operations, which the bank carries out on behalf of a client for a commission (money transfers, documentary credit operations, foreign exchange) (Ayub 375). Most of the bank’s ordinary profits are the income from difference between the interest rates at which it is to borrow and the rate at which it gives out the loans. Moreover, it can make a profit from operations and the financial market securities and currencies, as well as income from commission payments to customers. Originally appearing in the Muslim world, the principles of Islamic banking have to overcome the national boundaries. There is currently an evident growth of Islamic banking in the world. There are about 300 existing Islamic banks with total assets, according to some estimates, more than $650 billion dollars, the growth rate of which is 10-15% on average per year (Alawode and Iqbal).

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The global financial crisis has greatly influenced international economy. Islamic banking is an alternative form of financial intermediation. It is now demonstrating its competitiveness, together with the property to withstand the external problems. The businesses are ready to cooperate with Islamic finance, while changing their demands. The main reason for rapid development of Islamic banking is a significant inflow of oil dollars in Muslim countries. It provides a large number of temporary free liquidity that is not redirected to finance investment projects in these countries, as well as the rapid development of financial infrastructure in the creation of congruent centers in Saudi Arabia, Kuwait, the United Arab Emirates and Malaysia (Lewis, Ariff and Mohamad 310). Factors, such as the quality of liquidity growth and financial infrastructure in these countries stimulate the investment of free resources in projects that enhanced the liquidity crisis in the US and Europe (Hassan and Lewis 350). In the current environment, when only hearing about billions of losses of US and European banks, the liquidity crisis in many developed countries, the scientists can expect a significant increase in the role of banking institutions, operating under Islamic model.

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Activities of Islamic finance actively interact in various countries in the implementation of infrastructure projects. The members of Islamic banking are providing them with financial assistance in addressing economic and social development. Moreover, the Islamic finance contributes to the development of international trade among member states. It creates insurance funds, as well as special funds for financial support of Muslim communities in various countries. In the agricultural sector, the projects financed by Islamic banking are focused on the development of agriculture, crop protection, soil protection, animal husbandry, agriculture, and land reclamation (Lewis, Ariff and Mohamad 130). Programs in the industrial sector include industrial management and operations, associated with process improvement, support for industrial enterprises, reconstruction of premises, and the use of non-performing capacity. During the tax and financial reform, the preference goes to projects, related to banking practices and management of internal and external commitments. In the sphere of infrastructure, it is the development of transport communications, telecommunication, telecommunications and utilities. In the field of science and technology, the priority gain projects for the development of national and regional science, and technology policy and strategy. The Islamic banking support science and technology research and education, as well as technical assistance, use of the latest technologies for priority sectors – agriculture, health, transport, etc.

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In particular cases, it may finance private sector projects. Participation in the share capital, when renting/leasing Islamic banking is investing in various projects in the public and private departments, including the construction and reconstruction of buildings, the supply of machinery and equipment for industrial, agro-industrial, transport and other enterprises. When renting, the system usually finances the total cost of machinery and equipment, including their transportation, assembly and installation. The use of the installment sale is a medium-term financing method, Islamic banking entered into force in 1984 (Hassan and Lewis 79). This process makes it possible to obtain from the beneficiary of bank machines and equipment, which the bank bought, and only then make a payment, using the possibility of making a postponement. In contrast to the lease, ownership of assets is transferred to the buyer, provided immediately after the delivery of property; the purchase price is paid by the buyer in installments.

The recent crisis has led to significant changes in the international financial system. The aim of reforms was to improve the stability of international financial system to prevent a similar crisis in future. The crisis also has an increased interest in Islamic finance, as a form of investment that promotes the maintenance of financial stability. The steadiness, shown by institutions, offering Islamic financial services, provides an insight into the viability of financing, based on the rules of Sharia. In particular, this is caused by the presence of the stable connection between the financial services and the real sector of the economy, the implementation of the ban on speculative trading, as well as the promotion of ethical business practices. Moreover, Islamic finance does not use derivatives.

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If, at the same time, to take into account the global spread of Islamic finance, there will be a need to interpret automatically sharia norms both in form and in content, according to local (non-Islamic) laws and traditions. It also entails particular difficulties. The parallel existence of a state of conventional and Islamic financial services by itself is the source of risk (Spangler). For example, in binary systems, the financial account in the first place should give to eliminating opportunities for arbitrage, the reason for which may be inconsistencies between Islamic and conventional products. In this regard, the development of the legal framework, governing Islamic financial services, should be based on the principle of neutrality in providing taxation procedure, establishing and functioning of the legal environment standards identical to that in the traditional financial institutions.

Over the past few years, some indicators of the Islamic banks have been able to overtake the classic financial and credit institutions. It happens because Islamic banks accumulate work experience, including foreign partners’ relations. Today, Islamic banks virtually operate all the traditional banking – deposit, credit, letter of credit, accounting and stocktaking of bills, other calculated and payment operations, the funds invested in the industry, the agricultural sector, the trade lending, services, and finance social projects (Hassan and Lewis 167). Both accounting and reporting by the banks comply with the existing standards and have their individual character. Experts say that in the near future, Islamic banks will influence the position of Western banking institutions in the Arab countries. It will create the objective conditions for a more sustained transfer of the foundations of Islamic banking in other regions of the Islamic world and beyond. Against the background of permanent scandals with European banks and the crisis of the American banking system, triumphal procession of the powerful new force in the face of Islamic banks does not remain without attention of multinational companies and the world’s largest commercial banks. They do not only anxiously monitor the situation, but also resort to cooperate. Leading western banks open at Islamic division, such as Chase Manhattan, Goldman Sachs, Ai-En-Ji, Nomura Securities, JP Morgan, and others (Hassan and Lewis 119). US Bank named Citibank has long been cooperating with the Islamic banking institutions, investing about $1 billion in Islamic specialized funds (Lewis, Ariff and Mohamad 181).

The concept of Islamic finance and banking has sufficiently established in the developed countries. Perhaps, the secret of success of Islamic banking lies in the fact that, unlike the Western colleagues, it rejects soulless economic feasibility. Any activity, including financial, should be consistent with the moral attitudes. In our unpredictable world, it is a valuable thing. Therefore, over the past three decades, Islamic banks have found their niche in the global financial system. At least in the medium term, this trend will continue due to continued growth in energy prices, the development of the financial markets of the Muslim countries, as well as the competition between the major Western companies for capital accumulated in Muslim countries.

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