Islamic finance has expanded significantly in recent years. In 2016, Islamic financial institutions total assets totaled more than S$3 trillion. In this article, we explore the implications for investors and borrowers.
Islamic finance describes financial activities conducted in accordance with Shari’ah Islamic law. This includes Islamic banking, funds, bonds (“sukuk”) and insurance (“takaful”) and other financial institutions.
The emergence of Islamic banks and other financial institutions has provided financial inclusion for large populations that have traditionally been underserved by conventional banking. It has also garnered a significant amount of interest, making it worth exploring in some depth.
How does Islamic Finance Work?
There are a few important rules that govern Islamic finance. First, Islamic finance does not engage with businesses that are involved with alcohol, gambling, sex or pornography. Additionally, it does not permit transactions that are associated with undue risk, speculation or excessive interest costs.
In order to avoid these potentially harmful risks while providing essential financing, Islamic financing utilises profit sharing contracts (“mudarabah”), partnership and joint stock ownership (“musharakah”). These methods align the interests of investors and borrowers and spread risks among the two parties.
Islamic banks offer many of the same services as conventional banks, including personal deposit accounts, car and home financing and business financing.
However, unlike conventional banks, Islamic banks tend not to offer loanswithout specified uses like personal loans or general purpose business loans; instead, these banks offer loans are centered around the purchase of a specific asset.
Does Islamic Finance Offer Good Returns?
Investors will naturally question the returns of any alternative investment. However, historical data indicates that Shari’ah compliant businesses have performed very similarly to the market as a whole over the past 10 years. For example, the Dow Jones Islamic Market Index (DJIM) has performed quite similarly to the S&P Global BMI over the past decade.
Dow Jones Islamic Market Index vs S&P Global BMI
Not only that, Islamic finance also outlaws risky financial behavior such as short sales or excessive use of leverage because it is designed to support real economic activity rather than speculation and interest income. For these reasons, Islamic finance may be an attractive investment opportunity even for non-Muslims because it provides less risk than other investment mechanisms.
In fact, an IMF study found evidence indicating that Islamic banks contributed to financial and economic stability during the first years of the 2007-2008 Global Financial Crisis because their profitability was impacted less compared to conventional banks due to their more risk averse profile.
Additionally, individuals may be interested in Islamic financial institutions because they consciously avoid certain industries that are viewed as harmful to society, including alcohol, pornography and gambling.
Islamic Finance in Singapore
Islamic finance has a growing presence in Singapore. A few large banks have Shari’ah compliant lending arms. Examples include Maybank and CIMB.
There are also several Islamic fund managers. Additionally, a few of the new crowdfunding platforms in Singapore offer Shari’ah compliant loans. For example, KapitalBoost offers individuals the opportunity to invest and help small business purchase assets they need to grow, while Ethis Crowd allows individuals to invest in international real estate projects.
The rapid development of Islamic finance has expanded access to financial services for individuals and businesses, globally. It also provides ethical selectivity that may reduce risk compared to traditional financial activities, making it a valuable alternative in Singapore as well as internationally.
In this sense, it’s certainly developing as a legitimate option for both investors and potential borrowers to consider regardless of their religious beliefs.
This was first published at Value Penguin’s website, “The Rise of Islamic Finance: What Does it Mean for Consumers?“.