Islamic Banking and Finance in a Global Economy - Assignment Example

International Banking paper Islamic banking: a comparative perspective and its potential in avoiding future financial crises Islamic banking differs from conventional banking as practiced in the West in present times in some fundamental ways. This paper explores the key differences between the two systems, especially with respect to how risk is managed and how money and other material rewards are made. In so doing, the Islamic principles of risk management and profit sharing are explained to help understand how Islamic banking functions without involving interest. It also examines the possibility of applying Islamic banking principles in Western economies to safeguard against future financial crises. Studying the prospects and challenges for Islamic banking could reveal useful lessons for a reorientation of Western conventional banking. A key feature of the conventional banking system as practiced today is that it is based on interest. This is an amount of money that is paid on deposits at banks and levied on the loans they provide. This system is designed to benefit money lenders whereas borrowers are made to bear the risks entirely. Consequently, this system facilitates exploitation and many borrowers become burdened by rising values of their debts. Occasionally the problems become so extensive that financial crises occur. The Islamic financial system is characterized by the strict prohibition of riba, which is the charging, paying and receiving of interest on money loaned. The Quranic injunction is in chapter 2, verse 275, which states, “Allah has allowed the sale and has prohibited interest”. The prohibition extends to both the lending and taking of money involving interest or partaking in any other way in an interest based transaction. The justification is that the charging of interest results in an imbalance and it therefore promotes exploitation whereas the Islamic system is designed to ensure balance, fairness and justice (‘adl) in all financial dealings. Actually, Islamic finance is not unique in its prohibition of interest but it has perhaps developed the most sophisticated system to help implement interest-free banking. As Lewis (2007) noted, usury was prohibited in all the major religions but people then made it acceptable. For example, it is also prohibited in Exodus (22:25). In addition, the shariah (Islamic law) advises to avoid gharar (uncertainty), qimar (speculation) and greed. In short, shariah compliant financial products and services do not involve any interest and speculation and uncertainty is minimised as far as possible. Instead, the Islamic system of finance is based on the principle of shirakah, which means sharing or ‘joint participation’ in the risks and rewards by both sides (‘Abdur Rahman, 1984). It also means partnership (shirkah) because under the shariah, financial ventures, including loan dealings, are seen as based on relationships in which all sides share in the risks and rewards. In Islamic banks therefore, the bankers are motivated by the potential profit sharing whilst the customers are protected from being treated unfairly. Moreover, the potential return for an investor or lender under the Islamic financial system is “the rate of return of real activities” and this determines how the financial resources are allocated (Iqbal & Mirakhor, 1987). Consequently, the financial and real rates of return tend to correspond more closely than under conventional banking and the financial resources tend to be allocated much more efficiently. The Islamic banking system uses three main instruments to provide their customers with finance products based on the principle of sharing. These are called musharakah, murabahah and mudarabah. Under a musharakah arrangement, the bank and the depositor are both partners and share in either the profits or losses from the joint enterprise after a portion is set aside for managerial remuneration. The proportion of the share is usually according to the proportion of the investment made by each partner although it could be different as mutually agreed. The murabahah is a fiduciary sale in which the buyer’s role is non-participatory. The item sold can be bought back as per a predetermined price differential. This instrument is commonly used for selling large assets such as cars and property where the cost is known. For customers, it usually involves making fixed monthly payments comprising of the purchase price by the bank, and a mark-up in place of interest as in a conventional mortgage or installment plan. The mark-up or profit, as the case may be, is also known to the purchaser beforehand so there is no uncertainty in the sale (Albaraka, 2009). It has been shown that the murabahah arrangement for financing mortgages is a very cost effective method for banks, especially if they are located far away from where the property is located although the customers are not always any better off financially than if they had obtained a mortgage under the conventional banking system (Gamal, 2006). Like the musharakah, the mudarabah instrument also allows for greater participation. However, one partner mainly provides the financial backing while the handling of the business venture or enterprise is entrusted to the other. The profits (or losses) are still shared between the partners in the proportions as agreed. In addition to the above three instruments are a variety of special financing products and services for specific purposes such as ijara wa iqtina (lease and purchase), istisna (deferred delivery) and musharakah mutanaqisah (diminishing partnership). However, they are all based on the same fundamental principles described earlier. In a comparative summary of the two systems, the conventional banking arrangement is heavily debt-based whereas Islamic banking is equity based (Khan & Bhatti, 2008). Interest is central to conventional banking but it is totally absent and forbidden in Islamic banking. Conventional banking is largely one sided as far as reaping the benefits of added value is concerned whereas the Islamic system allows for sharing by all participants. In the case of loans, the lender benefits at the expense of the borrower under the conventional system which is exploitative. Essentially, the system of Islamic finance frowns upon the ”making [of] excessive profits at the expense of their customers or the local community at large” (Dasuki & Dar, 2005, p.396). In short, the Islamic system is much fairer and promotes justice and a more equitable distribution of wealth, which in turn promotes the well-being of society in general. Islamic banking therefore has not only financial goals but also social obligations (IAIB, 1996). Another major area of difference between the two systems is the way in which the financing is backed. Islam requires a strict backing by assets with intrinsic value (Usmani, 2002). For this purpose, gold and silver are used for the traditional currency comprising of the dinar and dirham respectively. There is no scope therefore, for lenders to give money beyond their means or cash reserves, as during the process of credit creation without regard to the amounts they hold in fixed assets. This prevents money being treated as a commodity as under the conventional system. As it is also possible to share in the losses instead of profits, the Islamic system tends to encourage more responsible financing. Investment and lending decisions are made more carefully. In contrast, if for example, a debtor incurs a loss under conventional financing, the creditor would still claim a certain amount of return, i.e. the interest on that loan. This practice is considered unjust in Islam. The Islamic system thus encourages all sides to be motivated and dedicated to ensuring the success of the venture rather than taking advantage of the other person or organisation’s misfortunes as in the conventional system. The principle of sharing of the risks stimulates the lenders to be equally responsible to ensure financial success. Similarly, if a large amount of profit is gained, as becomes more likely to be the case given the greater support, it is fair that both sides should enjoy the benefits. The detrimental nature of interest is best seen in the impact it has in creating financial crises as in the recent global financial crisis during 2008 and 2009 which resulted from problems with the subprime mortgage debt, initially in the US housing market. The problem mainly stemmed from engaging in trading money without any backing with valuable assets. Allah had already warned nations of the consequences of running interest based financial systems (Holy Quran, 2:279). Karim (2010) noted that the recent global financial crises have demonstrated the discredited nature and invalidation of interest-based monetary management. Islamic modes of finance have the potential to help avoid such crises in future because the above described conditions would simply not be possible under the Islamic system. The shariah prohibits selling debts against debts (Sinnakkannu & Bhatt, 2008) so it does not become possible for the markets to become stretched beyond the level that the economy is able to bear (OIC, 2009). Moreover, as Seetharaman (2008) observed, under the Islamic system, there is a tangible purpose for financial activity and this helps to ensure that liquidity management remains sound. The more fundamental problem with the present system is its being based on greed, exploitation and lack of transparency and accountability rather than being motivated for the greater good of society. Greater risk sharing can help people to become more conscious of the needs of others and make them more mutually supportive of each other. As far as the banks are concerned, under an Islamic system, they would be much more responsible in ensuring their borrowers’ successes because the performance of their assets would determine the worth of their liabilities. The ability of Islamic finance to provide for greater stability in the economy has been shown in several studies. For example, Darrat (1988) compared interest-free and interest bearing money and showed the former to be more stable. In 1993, Hassan & Aldayel conducted a large scale study spanning 15 economies. They compared the two systems by examining the stability in monetary demand. It was found that interest-free banking systems tend to have a lower velocity of money and variance than interest-bearing banking systems. Furthermore, during the recent global financial crisis, Hasan (2010) showed that Islamic banks generally demonstrated greater resilience than the conventional banks. The study involved analyzing the performance of 120 banks globally between 2007 and 2010. The implementation of Islamic banking and its principles in Western economies however, is not without its complications because of the need to adjust the existing laws and to overcome social barriers and prejudices. For example, in the UK, the murabahah arrangement for mortgages proved to be costly for the bank’s customers. This was because of the legal requirement to pay double stamp duty, registry and other fees given that the Islamic scheme involves transfers of property twice. The property is first bought from the original owner by the bank and eventually it is bought by the customer from the bank. Furthermore, it becomes a costly method if the need arises to sell before the end of the loan period or if the loan period needs to be extended and securitization cannot be done because of the prohibition of interest (Visser, 2009). There is also the disadvantage for homebuyers from being unable to deduct interest payments on mortgages for income tax purposes because Islamic finance does not involve any interest. In recognition of these problems, double stamp duty was eliminated in 2003 by the Finance Act and the Stamp Duty Land Tax now permits property to be transferred in stages (Masood et al., 2009). The more recent Finance Act 2006 specifically stated the purpose was to remove tax impediments in relation to shariah compliant Islamic finance products (Ahmad, 2010). However, further accommodations in terms of legislative and institutional support would be necessary to facilitate people to avail themselves of Islamic sources of finance under Western laws in a beneficial way. Another issue with Islamic finance has been the perception of its inability to fund short-term loans but this problem is eroding as more Islamic banks are being established globally and the investment pool is growing (EY, 2010). The social barriers are lack of awareness, ignorance, misunderstandings, prejudices and biases against Islam in general in the Western world let alone the Islamic banking system (Hussein, 2010). More difficult problems are the erroneous association of Islamic finance with the funding of so called terrorism, religious intolerances and media distortions which lead to perceiving Islamic banks as a threat and promotes irrational fear. On the other hand, the longer term situation could be favourable as awareness and knowledge of Islamic finance grows and Islamic banks are allowed to demonstrate their potential (Wilson, 2007). The performance of specific Islamic financial products such as the sukuk bonds are also proving to be popular and helping to promote Islamic finance (IFR, 2008). However, in the Western context, Islamic banking could perhaps be better promoted if it is perceived instead as a form of humanitarian and ethical banking which is descriptive of its nature. References ‘Abdur Rahman I Doi. 1984. Shari‘ah: The Islamic Law. Ta Ha Publishers. London. Ahmad, Abu Umar Faruq. 2010. Theory and practice of modern Islamic finance: the case analysis from Australia. 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Hasan, Maher. 2010. “The effects of the global crisis on Islamic and conventional banks: a comparative study.” International Monetary Fund. Available at: http://www.imf.org/external/pubs/cat/longres.cfm?sk=24183.0 [Accessed September 2011]. Hassan, M. Kabir & Aldayel, Adnan Q. 1993. “Stability of money demand under interest-free versus interest-based banking system.” Humanomics, Vol. 14, Issue 4, pp. 166-185. Hussein, Madzian Mohamed. 2010. “Demystifying Islamic finance: correcting misconceptions, advancing value propositions.” Lawyers Weekly. Available at: http://www.lawyersweekly.com.au/blogs/top_stories/archive/2010/06/09/islamic-finance-not-jihad.aspx [Accessed September 2011]. IAIB. In Al-Omar & Abdel-Haq. 1996. IFR. 2008. “Halal finance.” International Financing Review. Available at: http://www.ifre.com/halal-finance/565773.article [Accessed September 2011]. Iqbal, Zubair & Mirakhor, Abbas. 1987. “Islamic banking.” Occasional paper – International Monetary Fund, Vol. 49. 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An introduction to Islamic finance. BRILL publishers. Visser, Hans. 2009. Islamic finance: principles and practice. Edward Elgar Publishing. Wilson, Rodney. 2007. “Islamic banking in the West.” In Hassan, M. Kabir & Lewis, Mervyn K. 2007. Handbook of Islamic banking. Edward Elgar, UK. Read More