The main difference between Western and Islamic economics is debt-based financing versus asset-based financing. In the Western concept, the financier (usually a bank) lends money as credit and collects that money plus interest due to the debt that was taken from the borrower and then repaid. In the Islamic concept, the financier (sometimes a bank, but often an investment house) actually becomes a co-owner of a particular asset, property, or equipment and then either charges “rent” to the borrower until the borrower pays off the remaining shares of ownership or re-sells the asset to the borrower at a markup of the spot price.
Now the payment plan of each concepts appears similar to outsiders, which is why there are many accusations that Islamic Financing is just regular interest-based financing but with different names in the contract. There is some truth to this claim, as we shall see in this paper. However, there are some redeeming qualities that should be further developed to realize actual social and economic justice. For one thing, with asset-based financing, the product itself must be sound and worth buying and reselling or renting, so this puts incentive on the Islamic Bank to do a more thorough investigation into the product and the buyer. This by itself means there are fewer cases of defaults and write-offs because of more stringent requirements before financing can be agreed upon.
The purpose of Islamic Law is to promote common good and prevent harm. The Islamic injunction against riba is to protect people from the worst outcomes of debt-based financing. However, formalistic prohibition of the form of riba instead of the substance of riba will not further the goal of economic justice. Islamic finance as it exists today has been shown to reduce economic efficiency by increasing transaction costs, without providing any substantial economic value to its customers.[1] True Islamic financing should espouse substance over form.
[1] (El-Gamal 2006, 190)
