The Rewards and Risks of Islamic Finance

As the global economy grapples with climate change and economic instability, Islam offers a financial model built on principles of fairness, shared risk, and social responsibility. The unique prohibition of interest, an emphasis on ethical investments, and a commitment to social justice are characteristics of a financial system fairer and more equitable than other models.

Islamic finance has its roots in early Islam, dating back to the seventh century CE and the time of the Prophet Muhammad. The Quran and Hadith (sayings and actions of the Prophet) laid the foundation for the financial system, with key prohibitions such as riba (interest) and gharar (excessive uncertainty) that prevent exploitation and ensure financial justice for all parties involved.

For centuries, trade and commerce in the Muslim world operated under these principles, with a focus on equity-based contracts and asset-backed transactions. However, with the rise of colonialism and the spread of Western banking practices, many traditional Islamic financial practices were sidelined. The revival of modern Islamic finance began in the mid-20th century. As Imtiaz A. Pervez describes, the first modern Islamic bank, Mit Ghamr Savings Bank, was established in Egypt in 1963; other institutions across the Muslim world soon followed. Since then, Islamic finance has grown into a global industry, encompassing insurance companies (takaful), banks, and investment funds, with assets predicted to exceed $6.5 trillion globally within a few years.

One of the most compelling features of Islamic finance today is its natural alignment with climate goals and sustainability initiatives. Islamic finance mandates that all investments adhere to principles of social responsibility and avoid activities harmful to society or the environment. This also conforms to the modern environmental, social, and governance (ESG) criteria used by investors worldwide. For instance, Islamic finance prohibits investment in industries such as alcohol, gambling, and weapons production, which can be seen as ethically questionable or harmful to societal well-being.

Islamic finance also requires that financial transactions be tied to real, tangible assets, which helps deter speculative practices that can lead to economic crises, such as the 2008 global financial collapse. By focusing on real economic activities, Islamic banking and investment systems reduce the risk of unsustainable practices and encourages investment in sectors that contribute to long-term development, including infrastructure, energy, and healthcare.

Ensuring investments are backed by real assets dovetails with the growing global focus on green and sustainable finance. For example, sukuk (Islamic bonds) have been used to finance green projects, such as renewable energy plants and eco-friendly infrastructure. These bonds, known as green sukuk, have seen significant growth, particularly in countries like Malaysia, where they’re used to fund environmental sustainability projects. Indeed, Malaysia has deliberately positioned itself as a transnational hub for Islamic finance, writes Daromir Rudnyckyj, capitalizing on its rapid growth in the twenty-first century.

In addition to promoting sustainability, Islamic economics offer a more stable and resilient financial system. The prohibition on interest payments encourages a focus on equity-based and risk-sharing contracts, such as mudarabah (short-term loans) and musharakah (long-term ventures). These contracts require both parties to share the profits and risks of a business, creating a more equitable balance of power and reducing the likelihood of unsustainable debt accumulation. By avoiding interest-based loans, Islamic finance mitigates the risk of financial crises driven by over-leverage and excessive borrowing, explain Islamic finance law scholars Sherin Kunhibava and Balachandran Shanmugam. Additionally, the prohibition on gharar (excessive uncertainty) encourages transparency and careful assessment of risks, further enhancing the stability of financial institutions and markets.

There have been plenty of calls to expand the principles of Islamic finance to the broader global financial system, with suggestions that it could aid in the mitigation of pressing issues like climate change and economic instability. Its proliferation may not be simple, however. Some, including Lena Rethel, scholar of finance, development, and Islamic economies, have suggested that the growth of Islamic finance has led to emerging governance structures that simply emulate and reproduce the existing global financial order. Others, explains Islamic finance researcher Younes Soualhi, have raised concerns over juristic disputes, particularly between its two largest markets of Southeast Asia and the Middle East, which have become known as “Shari’ah Risk.”

Despite these barriers, Islamic finance, with its principles of fairness, transparency, and risk-sharing, may provide a useful blueprint for a more sustainable and stable financial future.

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