Thus, Islamic financial system is capable of minimising the severity and frequency of financial crises by getting rid of the major weaknesses of the conventional system. It introduces greater discipline into the financial system by requiring the financier to share in the risk. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses, and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully. (Iqbal, 2009) In addition, Islamic Banking can also reduce the problem of subprime borrowers by providing credit to them at affordable terms. This will save the billions that are spent after the crisis to bail out the rich bankers.
Because interest-based transactions are prohibited, Islam encourages business and trade activities that generate fair and legitimate profit. In Islamic Banking, there is therefore always a close link between financial flow and productivity. This intrinsic property of Islamic Banking contributes towards insulating it from the potential risks resulting from excess leverage and speculative financial activities which are part of the root causes of the current financial crisis.
Another fundamental principle of Islamic Banking is the risk and profit-sharing feature of Islamic Banking transactions (such as Mudarabah or Musyarakah contracts). It is this profit and risk-sharing feature of Islamic Banking transactions that requires a high level of disclosure and transparency in the Islamic Banking system. These disclosures allow the market to assign the appropriate risk premiums to companies, thereby enhancing the potential for market discipline to take effect. These features, which are required by Shariah (Islamic law) injunctions, provide built-in checks and balances which serve to ensure the financial stability of the Islamic Banking system.
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