David Cameron has announced plans to issue a Sharia law bond in the UK, making it the first non-Muslim country to do so.
But Bishop Nazir-Ali warned against the move, saying dabbling with Sharia law could lead to “unforeseen consequences” for the Government.
The Prime Minister set out proposals to issue the £200 million bond at the World Islamic Economic Forum last week.
To comply with Sharia law, the bond is a form of debt which charges no interest.
Mr Cameron also announced plans for a new Islamic index on the London Stock Exchange.
He said: “I don’t just want London to be a great capital of Islamic finance in the Western world, I want London to stand alongside Dubai as one of the great capitals of Islamic finance anywhere in the world”.
Bishop Nazir-Ali raised concerns about the effects of the proposals.
He said: “This means that the Government itself will be subject to sharia in its dealings on these bonds.”
He added: “At the moment the issue is pretty modest, but how much will it grow?”
The Bishop said it may lead to a situation where a “major part” of the financial system is governed by “sharia-compliant considerations”.
The treasury is expected to launch the bond next year, and will bring in a fixed return from a tangible asset or service, without charging interest.