Over the past few months, Islamic financial institutions have been reporting significant pick up in business.

Such institutions increasingly appeal to Muslim and non-Muslim customers alike.

To me, this shows that Adam Smith's invisible hand is alive and well, notwithstanding reports of its demise.

But why are Islamic institutions doing well? For that answer, let us focus on two main reasons behind the global credit crunch.

The first cause was the immense increase in the availability and active trading of derivatives.

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In many cases, the paper held was not only highly leveraged but also unlikely to be secured by physical assets directly but by more paper.

As a result, banks increasingly held securities that were far removed from their core activities, with a corresponding increase in risk.

The second cause of the credit crunch was the lack of liquidity.

Up until September 2008, banks were quite content to lend to each other in the global interbank market. Almost overnight, the bankruptcy of the New York based bulge bracket investment bank Lehman Brothers - caused in no small measure by its overexposure to some of the complex derivative instruments - put an end to this in the middle of September 2008.

The resulting lack of liquidity in the interbank market, based on the extreme risk aversion of global banks that could no longer trust each other's balance sheets, had the unwanted outcome of also stopping the global economy in its tracks.

Islamic finance is based on a number of fundamental principles. One is that making money from money, ie receiving interest, is prohibited.

A corollary of this is that banks are only allowed to lend against physical collateral.

Any type of derivative, including collateralized debt obligations that caused much of the initial damage to investors worldwide, is regarded as paper securities with no physical backing, and are therefore off limits for Shariah complaint investors.

On a more general level, Islamic institutions operate on the partnership principle.

Their inability to assess the requirements of the borrowers has kept them away from the problem cases of the subprime mortgages in the United States. To some, it was too obvious that these mortgages only benefit the arrangers rather than share the risk among all parties involved in the deal.

The prohibition of the use of interest when lending money barred Islamic banks from participating in the interbank market, thus leaving their liquidity situation unchanged and not affecting their normal operations.

Islamic financial institutions are therefore not exposed to the liquidity crunch other banks found themselves trapped in through their reliance on the interbank market.

The overall result is that institutions run on Islamic principles have so far weathered the crisis well and are in much better shape than their conventional cousins.

Depositors, Muslim or not, are beginning to see the advantages of this approach and are attracted to putting their assets with these banks.

If you are interested in finding out more about Islamic Finance, the Institute of Professional Education & Knowledge, or PEAK, a member of the Vocational Training Council, continues to run a seminar series that covers all the basic elements of Islamic banking, finance, insurance and law.

Rudi Prenzlin is the chief financial officer of the Hong Kong Islamic Index

e-mail:cfo@hkislamicindex.com