Islamic Banking and Finance Contributions to Economic Development of a Country

Islam prohibits riba because riba deprives justice and discourage people from undertaking real economic activities. Riba makes people putting hopes for reward rather than putting efforts to earn it. People with excess funds keep the money in the bank and earn interests. Banks lend the money they receive from depositors (surplus people) to borrowers (deficit people) and earn interests. Banks and surplus people, by having money excess money and lend it to the deficit people, are able to grow their money because of interest. The situation of the money grows from money through interest is the main core of conventional banking and finance systems. There is no additional increase of production in the economy. Although the system itself is growing (because of the payment of interest plus the principle amount), but the real economic activity actually did not take place.

The core proposition of Islamic finance draws from its inherent features and the values that it brings to the economy, and the tremendous potential that it offers in supporting sustainable economic growth and in safeguarding financial stability. These core propositions are derived from the Shariah, which dictates that Islamic financial transactions must be supported by underlying productive activities. This Shariah ruling ensures a close link between financial transactions and the real economy of a country.

Islamic banking and finance is strongly against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy of the country.

This decade has witnessed a dramatic transformation of the Islamic financial landscape. It has been marked by sustained rapid growth and the widening of its geographical reach, resulting in more diverse Islamic financial institutions and the generation of a wide spectrum of innovative products, particularly in the high-growth segment of the sukuk market. In this decade, Islamic finance has also evolved from being domestic-centric to become increasingly internationalised. In this dynamic environment, the scope of the Islamic finance business has expanded from simple retail and trade financing to include private equity, project finance, sukuk origination and issuance, as well as fund and wealth management products. This demonstrates that Islamic banking and finance has moved up its roles from a financial intermediary and financial market to be part of financial system of the country.

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth.

In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

The developments in Islamic finance have gained greater prominence in terms of their potential to improve financial stability outcomes, and most notably by the vital contribution that they make towards restoring the foundations for finance that supports sustainable economic growth, and bringing with it immense benefits to the real economic development and to the well-being of society of the country.

References:

1. Saiful Azhar Rosly (2005), Critical Issues on Islamic Banking and Financial Markets, Kuala Lumpur, Dinamas Publishing.
2. Abdul Ghafar Ismail (2010), Money, Islamic Banks and the Real Economy, Singapore, Cengage Learning.
3. Governor Zetty Akhtar Aziz's Speech at the Islamic Development Bank (IDB) Regional Lecture Series on Islamic Economics, Finance and Banking: “Finance and the Real Economy: Fostering Sustainability”, (2002), Jakarta.