The role of Islamic Banks as Financial Intermediaries

As an entrepreneur, there is a high chance that you may need to borrow funds to invest in your business at some point in your entrepreneurial career. That’s exactly what a financial intermediary is; a financial institution such as a bank, insurance company, investment banks, pension fund, credit union, stock exchange, Brokerage Company or the likes which acts as a conduit for parties in a financial transaction.  It is basically a bank that ‘consolidates deposits and uses the funds to transform them into loans’. Aside from the avoidance of riba, promotion of social and economic growth whilst upholding Islamic moral values and rulings, Islamic banks also serve as a financial intermediary.

Financial intermediation was practiced in the early days of Islam. It originated from the principle of al-muḍārib udārib which translates into “the one who mobilizes funds, on profit-sharing basis, can extend these funds to the users on the same basis”. The intermediation took place when caravan traders which were financed by muḍārabah (trust financing) were permitted to sell them at higher prices and make surplus.

With regards to intermediation, Islamic banks are responsible for detecting suitable and reliable projects to finance and as well as supervise its development. However, as an intermediary, they should not participate in the management and policy-making section. By giving that responsibility to the entrepreneur, the bank can keep an objective view on the development of that project.

Islamic banks’ intermediate by mobilizing funds from their clients and delivering it to businessmen/entrepreneurs with a legit business plan looking for investors. The sharia laid down specific rules and restrictions of the economic activity in a community to promote a high degree of justice and equity in the production, exchange and distribution of wealth.

As a result, Islamic financial laws lay great emphasis on the social and economic justice which makes Islamic banks such a great choice for financial intermediary; they prioritize the client’s interest, the economy’s interest and the society’s interest before the bank’s interest as opposed to the conventional banks which only give precedence to their profit.

To ensure justice, Islamic banks abide by one of the fundamental principles of finance; profit and risk-sharing by obliging both the investor and the businessman to even-handedly split the profit or the loss. Due to this principle, Islamic financial institutions and their clients alike infuse regulation and order into the system because they equally have something to lose or win.

Another prerequisite for financial intermediation of Islamic banks states that once the broker, in this case, the bank, purchases the goods for sale or rent, financier bears the risk.  This ensures that the broker is also allotted a portion of the risk so it can get a share of the profit. It also upholds the sharia principle of ‘no risk no returns’.

These conditions are fixed to uphold Islam’s fundamental objective of promoting equity and development in all aspects of life through finance. The system is set to foster fairness, morality and coordination in society.

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