Islamic Finance is a system of banking that affects many Islamic countries around the world and that has some key differences to conventional banking.
Ibrahim Khan, [title], said that Islamic Finance holds several unique attributes around debt, ownership, and the types of assets or trading vehicles that are allowed or prohibited.
“The key thing in Islamic finance is that there are a few big no-nos,” said Khan. “Interest is not allowed. You’re not allowed to have excessive uncertainty in transactions. So, for example, gambling or spread betting would be problematic.”
He added that, given proscriptions against interest, gambling, and immoral activities, “Muslims have to think carefully and structure [a loan] in a way that makes it work.”
Khan spoke with David Lin, Anchor and Producer at Kitco News.
ZERO-INTEREST LOANS?
In Islamic finance, loans with interest are considered haram, or forbidden. Islamic loans are instead structured as equity contracts.
Khan gave the example of a borrower who only has $5, but needs to purchase a $10 pencil. An Islamic bank would lend the borrower the additional $5, in return for a 50 percent equity stake in the pencil.
There would then be rental payments instead of interest payments.
“I would actually rent [the bank’s] proportion of the pencil,” Khan explained. “Let’s say it’s $5 in rent over the course of the next year for [the bank’s] proportion, and I’ll buy it off [the bank].”
Over time, the borrower would pay “rent” on the 50 percent of the pencil the bank owns, while buying up the full equity in the pencil.
Khan admitted that rent, in this case, is similar to interest payments. However, he said that “from a risk perspective… [the bank] was actually taking an ownership risk in the pencil. If anything happened to the pencil, [the bank] would end up losing out.”
ISLAMIC BANKING
Central banks typically conduct monetary policy by buying or selling interest-bearing bonds, and by setting interest rates. In turn, they interact with retail banks, which create money through fractional-reserve lending. Such activities would be considered problematic in Islamic finance.
“We’ve never had a pure Islamic economy, certainly since the decoupling of gold from currency,” said Khan. “I think what would happen is you would have a public investment bank… This public investment bank would create new money, and put that into infrastructure projects and other projects that are needed. That would be the way that new money enters into the economy.”
Khan said that while the question is “theoretical,” an Islamic central bank could be modeled on this public investment bank framework.
“The base rate or the prime rate would be linked to the rate of money creation of this public investment fund,” he said. “That’s how you would control or dampen the issuance of money through the ecosystem.”
To find out which types of assets are permissible in Islamic finance, watch the video above
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