Why Islamic banking?

Islamic banking is based on Sharia that prohibits ‘riba’. According to religious scholars it means both usury and interest, and ‘gharar’, that signifies ambiguity, uncertainty, or lack of specificity in terms of a financial contract.

These financial transactions within the Islamic banking are based on a culturally-distinct, ethical and moral principles as investments/trading involving alcohol, gambling, pork etc. are prohibited. In 1975, the world’s first full-fledged Islamic bank was formed in Dubai.

A review of the literature on Islamic banks reveals that these promote greater business stability as this system matches the payment obligations of the entrepreneur with the revenues that he acquires from his transactions. This is made possible when the obligation to pay back the funds acquired from the banker and the profit is related to the realisation of profits in the project in which funds are invested.

Islamic banking is more efficient in that it allocates funds capable of being invested on the basis of productivity of projects rather than on the creditworthiness of those who own the projects, as is the case in conventional banking.

Islamic banking is less prone to inflation and much less vulnerable to speculation. The increasing prevalence of inflation and speculation in today’s business environment cannot be ignored particularly when banks are using debt instruments as money substitutes, making speculation on debt instruments inevitable. And Islamic banking is been as the only flexible alternative in the face of global recession. Islamic banks are prudent when it comes to leveraging their assets to invest in capital too.

The typical leverage ratio of assets to capital was over 20:1 in the US (Lehman’s leveraged around 30:1 before bankruptcy) and over 30:1 in Europe compared to below 10:1 in the Middle East and North Africa. This practice has enabled Islamic banks to recapitalise their operations in the wake of financial turbulence.

Another such example is Ireland’s Blue Ocean Wireless which supplies wireless communications for merchant shipping. When the company got a $25 million loan in December 2008, it came from what might seem an unusual source: the Bank of London and the Middle East, or BLME, which strictly follows Sharia rather than conventional western banking practices.

While recognising the benefits of the Islamic banking, its disadvantages in the modern era cannot be ignored. First, the profit-and-loss sharing (PLS) modes of financing are not the dominant part of Islamic banking as in the case of other forms of conventional banking, the difference between these two types of banking is largely illusory.

This is demonstrated by the fact that commercial banking and company laws appropriate for the enforcement of Islamic banking and financial contracts do not exist in many countries. Second, in PLS modes of finance, there exist potentially exorbitant costs of continuing auditing of the enormous number of PLS partnerships. In contrast to Islamic banks, the costs associated with assessing the creditworthiness of a few borrowers paying a fixed interest rate in conventional banks are low.

If creditworthiness is not of a concern for Islamic banks then the question arises as to how they will decide between two diverse customers with varying but still significant financial needs as, for instance, between lending to an old client who wants to pay for his daughter’s wedding and lending to a new client who wants to fund his child’s education.

Islamic banks have over 60 per cent excess liquid funds which cannot be properly utilised due to non-availability of Sharia-compliant products and services. A committee of Muslim scholars called the “Sharia Committee” usually determines whether a product or practice complies with Islamic law. This requirement applies to western competitors wishing to enter Islamic banking, too. It is a challenge though, since Sharia banking scholars are in short supply.

Despite the hurdles faced by Islamic banks and their clients, Islamic banking is growing and drawing attention of institutions the world over. One of the main driving forces being the income Arab countries are obtaining from the exploitation of the abundant oil resources. Nowadays, major establishments such as Al Rajhi Bank of Saudi Arabia, the Kuwait Finance House, and Malaysia’s Maybank Islamic compete with western financial institutions such as Barclays, HSBC and Deutsche Bank.

Several banks have set up separate Islamic financial services departments in their home markets as well. For instance, in the UK, the Financial Services Authority has introduced regulatory standards for Islamic financial products and has a separate department dealing with Islamic financial institutions. Surprisingly, non-Muslims make up as much as half of Islamic bank customers in some cases. There is a huge potential for Islamic banking.

Article originally published in the Daily Dawn.