Islamic finance has grown and expanded rapidly in recent years. It was recently announced that, following in the footsteps of some of its European neighbours, Germany will soon have its first Islamic bank — which is ironic if you think about the history of the country. Ireland, a country of arguably staunch Catholics, is also making a bid to be a global hub for Islamic finance.

The global growth of Islamic finance in recent years is, in part, a response to the demand for a more ethical financial system. But is Islamic finance just an ethical “spin” on “conventional” finance? Or can it offer more tangible solutions beyond the Muslim community?

What is Islamic finance?

Just like ethical investment in the standard financial sector, Islamic finance prohibits the use of funds for certain purposes. For example, no investment in activities that deal with alcohol, pornography, gambling and so forth.

The basis for Islamic finance’s code of ethics comes from religious texts and is less arbitrary than secular ethical investment. Admittedly, these texts have to be interpreted, and this can lead to vigorous debates and disagreements. But compared to standard ethical investment, the religious texts serve as a relatively more permanent anchor to guide behaviour.

Islamic finance goes much further than standard ethical investment. Not only does Islamic finance prohibit funding for “unethical” activities, it also bans transactions where people share risks and uncertainty in a disproportionate manner. This is why the use of interest is prohibited.

As you know, if you borrow money from a “standard” bank to run a business, the bank is guaranteed a return (the interest) while you, the borrower, will bear all the risks of making or losing money from the business operation. Islamic finance prohibits such arrangements. Instead of an interest-based banking system, Islamic finance prefers a system where profits and losses are shared. So, instead of lending money in return for interest payments, Islamic banks would lend money in return for an eventual share of the profits or loss generated from the business.

No speculation

The standard financial system permits speculative activity. In fact, this is encouraged as a way to keep the market “efficient”. Unfortunately, speculative activity can also have unwelcome effects, such as when financial bubbles are created and then burst.

Unlike the standard financial system, Islamic finance prohibits financial transactions that involve speculation. According to Islamic texts, financial transactions must have a clear link to an underlying “real” activity. So, you can buy and sell financial assets if you have a genuine interest in its underlying value, not because you want to gamble on changes in its price. [See the paper (paywalled) by Shahnaz and Tony Naughton for a clear and detailed discussion on this point.]

As such, Islamic finance is about more than just ethical investment. It challenges the increasing “gap” that has emerged since the 1990s between the financial sector and what economists call the “real” economy: the part of the economy that is concerned with producing goods and services, as opposed to the financial sector which is less tangible. It seeks to take us back to the days when the role of the financial sector was to serve the “real” economy.

In emphasising the need for financial transactions to have a link to a “real” activity, Islamic finance limits the amount of debt in the system, creates fewer opportunities for speculation and, as a result, minimises the chances of the financial system becoming unstable. Islamic finance would have prohibited the type of products that contributed to instability in the American financial system in 2007.

By prohibiting the use of interest while encouraging the sharing of profit and loss, the approach adopted by Islamic finance will shift some of the risks shouldered by consumers on to financial institutions. Supporters of Islamic finance argue that it offers a safer and more equitable approach to the organisation of finance than the standard system.

A way to a more equitable financial system?

In practice, Islamic finance has so far not been able to perfectly follow what it preaches. Even though interest is prohibited and banks should share in profits and losses, Islamic banks tend to intentionally structure the products they sell so that they achieve outcomes that are very similar to interest-based products. As a result, Islamic financial institutions get more certain outcomes instead of bearing the risks profit and loss-sharing arrangements.

Until now, supporters of Islamic finance have argued that these choices have been necessary in order to compete with the “standard” sector, and that they would be abandoned once Islamic finance becomes more established and sophisticated. But, in mimicking the “standard” financial sector, Islamic finance risks betraying its roots. Such an approach undermines its claims to offer an important and substantially different system.

Despite these criticisms, Islamic finance can still reframe the debate about the role of the financial sector in modern society. It forces us to question our current relationship with finance: should finance be used for speculation, or should it only be used to fund “real” activities?

Given the global financial crisis and the debate about reforming financial sectors, the approach of Islamic finance offers us one way to think about how the financial sector might be reformed to better serve society’s needs.