How Islamic Finance Works

Posted by admin on March 24th, 2010 at 07:54am

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Such systems are a small but growing part of banking, including in the West. Lenders charge fees instead of interest and often share in risk; bondholders have no guarantee of repayment.

This is the VOA Special English Economics Report.

Dubai’s recent debt problems have brought attention to the growth of Islamic finance. A government-owned group of companies, Dubai World, has been seeking to restructure twenty-six billion dollars of debt. About six billion of it is in Islamic bonds, including a three and a half billion dollar bond set for repayment on Monday.

The biggest difference between Western and Islamic finance involves beliefs about charging interest on borrowed money. In Islam, the basic idea is that you should not make money from money itself.

Instead of interest, lenders charge fees. Ghiyath Nakshbendi at American University in Washington is an expert on Islamic financing.

GHIYATH NAKSHBENDI: “The bank will estimate its costs based on its fixed costs, variable costs, the cost of their employees, the rent and so on and so forth. And from that they estimate how much they are going to charge.”

But he points out that this system can make Islamic financing costly. The costs of the system are shared by the borrowers. The fewer the borrowers, the more each has to pay.

In many cases, Islamic financing requires the lender and borrower to share profits and losses. Ghiyath Nakshbendi explains what that means with Islamic bonds, called sukuk.

GHIYATH NAKSHBENDI: “When we talk about sukuk, we don’t guarantee a certain return.”

He says the bondholders are buying a share of a business or property. If business is good, then they could get back more than they expected. But if it fails, then there is no guarantee of repayment. Islamic bonds can be structured in different ways, but a major idea is shared profit and loss.

Professor Nakshbendi says Islamic lending practices are also supposed to be socially responsible.

In world banking, the total share of Islamic finance is less than one percent. But it is growing at a rate of fifteen to twenty percent a year. There is growing interest in Islamic banking in the West. London is becoming a center of Islamic finance. And France recently proposed changes in finance laws to protect Islamic bondholders.

Estimates differ, but as much as one and a half trillion dollars may be managed under Islamic rules.

Last year, the International Monetary Fund studied the financial security of Islamic banks. It found that their lack of complex products like futures and derivatives limits the ability to spread risk.

Professor Nakshbendi notes that Islamic finance does not appeal only to Muslims.

GHIYATH NAKSHENDI: “In Malaysia, the majority of customers in Islamic banks are non-Muslims.”

And that’s the VOA Special English Economics Report, written by Mario Ritter. Our reports are online at voaspecialenglish.com. I’m Steve Ember.

Tags: economics, Economy Report, finance

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