Challenges in Islamic finance are the difficulties in providing modern finance services without violation of sharia (Islamic law).
Islamic finance has faced criticism both from within its community and from external observers. A primary concern is that conventional Islamic financial institutions often fail to fully implement the core principle of profit and loss sharing (PLS) financing. Supporters contend that these institutions sometimes resort to hiyal, legalistic maneuvers considered ethically questionable in Islam, to circumvent the spirit of PLS.
The industry of Islamic banking and finance has developed around avoiding riba (unjust, exploitative gains made in trade or business) by avoiding interest.
The majority of Islamic banking clients are found in the Gulf states and in developed countries that are in the Muslim world. The challenges include that interest rate benchmarks have been used to set Islamic "profit" rates so that "the net result is not materially different from interest based transactions". giving the impression that Islamic banking is "nothing but a matter of twisting documents ....".
The religiously preferred mode of Islamic finance is profit and loss sharing (PLS) but this causes several issues including that it must wait for the project invested in to come to fruition before profits can be distributed and increases the risk and complexity for financial providers.
Reception The industry has been praised for turning a "theory" into an industry that has grown to about $2 trillion in size;Usmani, Introduction to Islamic Finance, 1998: p. 162-3 for attracting banking users whose religious objections have kept them away from conventional banking services, drawing non-Muslim bankers into the field,Munawar IQBAL and Philip Molyneux. Thirty Years of Islamic Banking: History, Performance and Prospects, [Palgrave, 2005], p.58 and (according to other supporters) introducing a more stable, less risky form of finance.
However, the industry has also been criticized for ignoring its "basic philosophy" and moved in the wrong direction over the decades—leading both outsiders and rank and file Muslims to question it.Usmani, Introduction to Islamic Finance, 1998: p. 166 This has happened first by the sidelining the original finance method advocated by promoters—risk-sharing finance—in favor of fixed-markup finance of purchases (particularly murabaha), and then by distorting the rules of that fixed-markup murabaha, effectively delivering conventional cash interest loans following conventional interest rates,Usmani, Introduction to Islamic Finance, 1998: p. 165-8 but disguised with "ruses and subterfuges"Khan, What Is Wrong with Islamic Economics?, 2013: p.xv-xvi and burdened with "higher costs, bigger risks".Khan, What Is Wrong with Islamic Economics?, 2013: p.400
Other issues/complaints raised include a lack of effort by the industry to help small traders and the poor; the question of how to deal with inflation, late payments, the lack of hedging of currencies and rates or sharia-compliant places to park short term funds for liquidity; the non-Muslim ownership of much of Islamic banking, and the concentration of what ownership is in Muslim hands.
Compliments and defense According to Muhammad Taqi Usmani, a leading scholar in contemporary Islamic finance, Islamic finance has turned a "theory" into "a reality", "asserting" Islam into international financial markets. It has "enriched" the Islamic legal system with shariah-compliant solutions developed in response to the practical business questions put to it by the industry. Abayomi A. Alawode, head of Islamic finance for the World Bank, praises it as "ethical, sustainable, environmentally- and socially-responsible", emphasizing "financial inclusion and social welfare". Its popularity has drawn conventional banks into Islamic finance in search of Muslim customers. Positive sum effect A study on the size and market share of Shariah-compliant Islamic banking in Muslim countries found "strong and consistent empirical evidence" that the development of Islamic banking leads to "higher banking sector development" rather than attracting money and existing customers away from conventional banking as measured by "the amount of private credit or bank deposits scaled to GDP." Stability Proponents (such as Zeti Akhtar Aziz, the head of the central bank of Malaysia) have argued that Islamic financial institutions are more stable than conventional banks because they forbid speculation and their two main types banking accounts—"current account" and mudarabah accounts—carry less risk to the bank. This is because in a current account the customer (in theory) earns no return and (in theory) the bank is not supposed to invest the account funds. The alleged stability in a mudarabah account comes from the smaller risk of loan defaults because that risk is shared with the depositor. If the borrower cannot pay back part or all of the money lent to them by the bank, the amount going to the depositor is cut by an equivalent amount, whereas in a conventional bank the depositor is given fixed interest payments whether or not the bank's earnings decline from loan defaults.Khan, What Is Wrong with Islamic Economics?, 2013: p.330 Ibrahim Warde credits the supervision of Shariah Boards for preventing Islamic banking from following the following conventional banks into the excesses that led to the 2008 financial crisis.
Defence While the industry has problems and challenges, these can be explained by the industry's relative youth and its position in the early stages of a "learning curve" that will solve the challenges over time;Usmani, Introduction to Islamic Finance, 1998: p.xviii (In 1993 Ausaf Ahmad defended the industry as early in its transition from conventional banking.) unless and until the industry operates in an Islamic society and environment it will be hindered by non-Islamic influences and won't "operate in its essence".Farooq, Riba-Interest Equation and Islam, 2005:p.36
Customers and the industry
The majority of Islamic banking clients are found in the Gulf states and in developed countries. Studies of Islamic banking customer in Malaysia and Pakistan found customer satisfaction was connected to service quality. A study of Islamic banking customers in Bangladesh found "most customers" between 25–35 years, "highly educated" and having a "durable relationship" with the bank, more knowledgeable about account than financing products.
In series of interviews conducted in 2008 and 2010 with Pakistani banking professionals (conventional and Islamic bankers, Shariah banking advisors, finance-using businessmen, and management consultants), economist Feisal Khan noted many Islamic bankers expressed "cynicism" over the difference or lack thereof between conventional and Islamic bank products,Khan, Islamic Banking in Pakistan, 2015: p. 138, 142 the lack of requirements for external Shariah-compliance audits of Islamic banks in Pakistan,Khan, Islamic Banking in Pakistan, 2015: p. 144 shariah boards lack of awareness of their banks' failure to follow shariah compliant practices in or their power to stop these practices.Khan, Islamic Banking in Pakistan, 2015: p. 138-9 However this did not deter patronage of the banks by the pious (one of whom explained that if his Islamic bank was not truly shariah compliant, "The sin is on their head now, not on mine! What I could do, I've done.")Khan, Islamic Banking in Pakistan, 2015: p. 146
One estimate of customer preference (given by a Pakistani banker) in the Pakistani banking industry, was that about 10% of customers were "strictly conventional banking clients", 20% were strictly Shariah-compliant banking clients, and 70% would prefer Shariah-compliant banking but would use conventional banking if "there was a significant pricing difference".Khan, Islamic Banking in Pakistan, 2015: pp.138 A survey of Islamic and conventional banking customers found Islamic banking customers were more observant (having attended hajj, observing salat, growing a beard, etc.), but also had higher savings account balances than conventional bank customers, were older, better educated, had traveled more overseas, and tended to have a second account at a conventional bank. Another study, using "official data" reported to State Bank of Pakistan, found that for lenders who had taken out both Islamic (Murabaha) financing and conventional loans, the default rate was more than twice as high on the conventional loans. Borrowers were "less likely to default during Ramadan and in big cities if the share of votes to religious-political parties increases, suggesting that religion—either through individual piousness or network effects—may play a role in determining loan default."Khan, Islamic Banking in Pakistan, 2015: p. 149-50
Challenges, industry view "Key challenges" to the Islamic finance industry as a whole—including sukuk—as of 2016 (according to the State of the Global Islamic Economy Report, 2015/16 and the IMF) include "Low levels" of awareness and understanding of Islamic finance products and services among the public, leading them to not patronize these products and services;“What customers want; Customer insights to inform growth strategies of Islamic banks in the Middle East”, PwC, October 2014 A need for "increased regulatory clarity and harmonization, better cooperation between Islamic and conventional financial standard-setters, and further improvement of supervisory tools", to deal with the "complex financial products and corporate structures" in some countries/jurisdictions brought about by "regulatory and supervisory frameworks" that do not "address the unique risks of the industry"; A "scarcity of Shariah-compliant monetary policy instruments" and a lack of understanding of "the monetary transmission mechanism";“Islamic Finance: Opportunities, Challenges, and Policy Options”, IMF, April 2015, p.6-7 "Underdeveloped" safety nets and resolution frameworks. A lack of complete Islamic deposit insurance systems where premiums are invested in Shariah-compliant assets, or Shariah-compliant "lenders-of-last-resort"; Regulators who "do not always have the capacity (or willingness) to ensure Shariah compliance."State of the Global Islamic Economy Report, 2015/16:70
Challenges, questions of shariah compliance Imitation of conventional finance A number of supporters (such as Taqi Usmani, D.M. Qureshi, Saleh Abdullah Kamel, Harris Irfan) and skeptics (Muhammad Akram Khan, Muhammad O. Farooq, Feisal Khan, Mahmoud El-Gama, Timur Kuran) of Islamic banking have examined the differences between Islamic and conventional banking and lamented their similarity.
Taqi Usmani argues Islamic banking has "totally" neglected its "basic philosophy",Usmani, Introduction to Islamic Finance, 1998: p. 165 first by ignoring modes of risk-sharing between the financer and the user of finance (Musharaka), in favor of the fixed markup mode of murabahah and ijarah, which in theory should only be used when risk-sharing is impractical. Then by ignoring the rules of murabahah and ijarah themselves, by, for example, using murabahah finance to borrow cash and not even purchasing a commodity in the process, (see also Ignoring required commodities below) or using ijarah (leasing) without the "lessor either assuming "the liability for his ownership" or offering "any usufruct to the lessee".Usmani, Introduction to Islamic Finance, 1998: p. 167
Interest rate benchmarks have been used to set Islamic "profit" rates so that "the net result is not materially different from interest based transactions". Ignoring basic principles such as these has weakened the case for Islamic Banking "before non-Muslims" and "before the masses especially", who Usmani believes, have now gotten the impression that Islamic banking is "nothing but a matter of twisting documents ...."
In March 2009, Usmani declared that 85% of Sukuk, or Islamic bonds, were "un-Islamic".