Advantage and Disadvantage of Islamic Banking and Finance

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Islamic banking and finance are based on the principles of Shari’ah. These principles are applied through Islamic economics and are characterized by the principles of Mudarabah, Wadiah, Musharaka, Murabahah, and Ijara. Islamic banking and finance is a multipurpose financial service. However, it comes with some risks.

Islamic Banking and Finance Principles of Shari’ah

Islamic banking and finance is governed by principles of Shari’ah, or Islamic law. These principles include the prohibition of interest and other types of unjust enrichment. Specifically, these principles prohibit the use of interest, or Riba, in the provision of financial services. Riba is defined as any unjust increase in the value of the capital invested. Another prohibition is Riba al fadl, which refers to sales disguised as loans.

Islamic banking and finance products avoid gambling, speculation, and uncertainty. They also prohibit interest and exploitation. In addition, the Islamic financial system stresses the sanctity of contracts. These are fundamental values for any financial institution. It is also important to recognize that the financial system has evolved a lot since it was first established in 1963 in Egypt.

Shari’ah scholars generally agree on the principles of Islamic banking. However, there are differences in opinion on detail, procedure, and substance. These differences are often found among judges of law throughout the world. The principle of proportionality also means that a bigger loss cannot be prescribed in exchange for a smaller benefit. The bigger benefit is preferred.

Principles of Shari’ah in Islam-compliant finance and banking are closely related to the principles of Islam. Islamic banking is a component of the development of an Islamic economic order, which ensures social justice and prohibits all forms of unjust economic activity. It also ensures the ownership of legitimately acquired wealth. By restricting the use of interest, Islamic banking and finance seeks to avoid the accumulation of wealth in a few hands.

Islamic banking is a rapidly growing system of financial services that follows Islamic law. Its success in the Muslim world has led western economists to study its impact and potential as a profitable alternative to the established norms.

Multi-purpose nature

In addition to its interest-free operations, Islamic banking involves trade and equity financing. Although this is risky, Islamic finance deals with risk differently from conventional banking, and the banks involved take pains to spread their eggs over many baskets. As a result, they maintain reserve funds based on profits generated in previous years.

Islamic banks also offer a wide range of payment services. Unlike conventional banks, they do not charge service fees for safekeeping deposits. Furthermore, many Islamic banks operate alongside conventional banks. This allows them to circumvent central bank control of interest rates. However, they do not offer credit cards.

While there are advantages to Islamic banking and finance, it has limitations as well. The main disadvantage is that they are unable to offer longer-term financing. In addition, Islamic banks often focus on short-term trade finance because this is the least risky type of financing. In addition, the Islamic banking system in Iran uses only half of its resources for credit to the private sector, which is mainly short-term in nature. The main reason for the slower rate of conversion is the shortage of staff trained in long-term financing. However, this has not adversely affected the effectiveness of monetary policy.

Another advantage of Islamic banking and finance is its multi-purpose nature. Unlike conventional finance, in Islamic finance, money is not used for interest payments, but as a measure of value of goods. This allows for banks to earn money without charging interest on loans. Therefore, it is important to understand that Islamic finance is different from conventional finance.

In addition, Islamic banking is profitable in hostile environments. According to Nienhaus (1988), the profitability of Islamic banks in Islamic countries was partially due to the property boom. The subsequent property crash resulted in huge losses for Islamic banks.


In the current global financial environment, financial institutions are increasingly offering Islamic financial contracts. However, this growth has also brought about a number of unique risks. These include credit risk, operational risk, market risk, liquidity risk, and Shariah law risk. To mitigate these risks, financial institutions should develop risk management strategies based on shariah principles.

Credit risk arises when a financial institution expects payment from a counterparty. The Islamic finance industry emphasizes lending, leasing, and other financial products that require credit to be backed by assets and investment based on business performance. However, the risks of credit exposure are higher for Islamic banks than for conventional banks.

Islamic banks face many challenges and opportunities, which make risk management strategies critical to the health of these financial institutions. This book explores different management strategies that arise in Islamic banking and provides valuable insights for those working in the Islamic market. It is an excellent resource for anyone looking to understand how to effectively manage the risks that their institutions face.

As the world’s Islamic financial industry grows, countries need to adapt their regulatory, supervisory, and consumer protection frameworks to accommodate the unique needs of this market. In addition, they need to take steps to develop Shariah-compliant monetary instruments and financial markets, and improve their international architecture to facilitate cross-border transactions.

Islamic banks are constrained in managing their risks because of their limited access to hedging instruments and government securities markets. Moreover, they are not allowed to incur interest or fees on transactions. To minimize risk, IBs should carefully consider contracts with clear details and disclosure of all terms. However, minor uncertainties are allowed when they are necessary.


The current financial crisis has provided numerous opportunities for Islamic banking and finance institutions, including targeting a new client base of high net worth individuals (HNWs). The reversion to more ethical investments is another opportunity, as Islamic banking institutions can benefit from the shift in consumer preferences that has occurred in the current recession. As the Islamic faith prohibits investment in businesses that engage in haram, Islamic financial institutions are well-placed to benefit from this shift.

A study by Keith G. Carr-Lee and colleagues compared Islamic and non-Islamic banking sectors in more than 26 OIC states. He found that Islamic financial institutions had higher growth rates and greater financial depth in countries that had existing Islamic banking sectors. The research also found a positive correlation between fund size and performance among young and old funds, as the former outperformed older funds.

Islamic finance has grown beyond the Muslim world and into western economies. While the motivation for converting the banking system is often religious, socio-economic, and political, many questions still remain. This includes concerns about integrating Islamic financial instruments into existing juridical frameworks. This study addresses these questions by developing a testable theoretical framework for evaluating the feasibility of Islamic financial institutions.

Potential of Islamic Banking

The Islamic finance model has great potential to promote financial sector development and broaden financial access. By emphasizing partnership style financing, it can enhance access to finance for small businesses and agricultural enterprises. In addition, it can help improve food security by ensuring that more people can access financing. The principles of Islamic finance are also compatible with modern portfolio theory.

Although Islamic financial institutions are still a small percentage of global finance, they have significant potential for growth. Some countries have established systemic Islamic banking sectors, and the internationalization of Sukuk has increased cross-border financial flows. Furthermore, a number of countries have seen Islamic finance as a way to increase financial inclusion and invest in public infrastructure.


The Islamic banking and finance industry has seen remarkable growth over the past decade, averaging 10-12% growth annually. Global assets in Islamic banking and finance are estimated to be over US$2 trillion, encompassing bank and non-bank financial institutions, money markets, and Takaful. In many majority Muslim countries, Islamic banking and finance assets have outpaced conventional banking assets. In recent years, non-Muslim countries have also shown interest in Islamic banking and finance.

Although Islamic banks often report lower ratios than conventional banks, these differences are not statistically significant. A p-value of 0.05 is considered significant. Nonetheless, this growth in Islamic finance and banking is not limited to Muslims; non-Muslims are also welcomed to use this form of finance.

The sustainable development of Islamic finance translates into shared prosperity, reducing poverty, and fostering economic growth. As a result, Islamic finance encourages the creation and maintenance of productive enterprise through profit and loss-sharing arrangements. Furthermore, a focus on tangible assets ensures that financial transactions have a real purpose, and discourages financial speculation.

Roots of Islamic Banking

Islamic banking has its roots in businesspeople from the Middle East in the Medieval era. During this period, Middle Eastern businesspeople had begun interacting with Europeans, using similar financial principles. Western countries took notice and began to establish local branches in the Middle East. These new branches adopted local financial practices, including the no-interest financial system and the profit-and-loss-sharing method. These institutions served the needs of local Muslim businesspeople.

Islamic banks must make sure they have adequate liquidity to meet the needs of their clients. Having too much liquid cash can increase costs and negatively affect the bank’s profitability. In addition to the profitability of transactions, Islamic banks must ensure that they are able to meet Shari’ah regulations. Liquidity risk management is a central concern in the Islamic banking and finance industry.

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