Distinctions between Islamic Finance Regulation and Conventional Financing of Commercial Credit - Essay Example

Distinctions between Islamic Finance Regulation and Conventional Financing of Commercial Credit By IntroductionThe 2008 global financial crisis has generated doubts about the safety of conventional banking and has increased interest in whether or not Islamic banking is perhaps a safer alternative.1 Islamic banking is distinguished from conventional banking in three main areas: a prohibition against interest (riba), risk sharing2 and asset-backed credit.3 An additional feature of Islamic banking is that all products and services are required to be Sharia compliant.4 In general Islamic banks operate with a higher level of discipline and under a tighter regulatory framework than conventional banking.5 Islamic financing was first introduced in the UK in 1990 and has since developed to such an extent that the UK hosts the largest share of Islamic assets (valued at US$18 billion) among all Western countries and is eight worldwide.6 As of 2008, there were five “stand-alone” Islamic banks in the UK and more than 20 conventional banks offering Islamic products.7 This paper provides a critical analysis of the distinctions between Islamic finance regulation and conventional financing of commercial credit. Islamic Banking: Background and Overview The modernized form of Islamic finance began in Egypt during 1963 when the Mitt Ghamr savings system was introduced as a “social banking initiative”.8 By 1975 the first commercial Islamic banks were established: Islamic Development Bank and the Dubai Islamic Bank. The Islamic banking sector grew at a steady pace and by the 1990s there was a growing demand for Islamic financial products in investments and loans. In more recent years, the growth in demand and supply of Islamic financial products has been more expansive. Between 2006 and 2008, Islamic financial assets experienced a growth rate of 30%. As a result, Sharia compliant banking products have been described as the worlds “fastest growing financial sector”.9 There are at least 614 “registered Islamic finance institutions” in 47 countries with Islamic assets increasing from US$150 billion during the 1990s to approximately US$700 billion by 2007.10 The growth and expansion of Islamic banking and financial products have been impressive. Holden reports that over the last thirty years or so, Muslims all over the world have demonstrated a propensity for withdrawing billions of dollars from conventional banking systems and transferring them to Islamic banking and financial systems. In addition, conventional banks have shown an increasing willingness to offer Islamic banking and financial products and services.11 Islamic Banking Theory and Philosophy Islamic banking is defined as a “system of banking” of banking activities that comply with “Islamic law Sharia principles” and are at the same time “guided by Islamic economics”.12 Sharia principles dictate how Muslims should conduct themselves in the course of their daily activities and this would necessarily include how they deal with financial matters.13 In this regard, Sharia principles require that all Muslims conduct their daily lives in accordance with social justice. This means that all social and financial matters are required to be carried out in ways that fair to all participants and are further required to comply with the standards established in the Holy Koran and by the teachings of Muhammad (Sunnah).14 In complying with the Holy Koran and the teachings of Muhammad, it is believed that riba (interest) is one of the main catalysts of capitalism and is directly linked to inflation, unemployment and all other economic problems that are nothing more than a manifestation of social injustice. 15 As a result credit or financing on interest is forbidding.16 Based on this theory, Sharia compliant banks offer interest free products and this is usually compensated for by virtue of risk-sharing and profit sharing structured financial products.17 The profit and risk-sharing philosophy originates from an antiquated tribal belief called “takaful”.18 Takaful is founded on the shared belief of “protecting one another” from the threat of “common dangers”.19 This shared belief is manifested in Islamic banking theory in which Islamic banking and financial products are based on shared risks and profits and thus reflect the takaful philosophy.20 The prohibition on interest is also consistent with takaful since takaful is based on the perception of mutuality. The prohibition on interest likewise reflects mutuality since it speaks out against a practice or policy that would confer a benefit on one part at the cost to another.21 Moreover, if interest was permitted it would be tantamount to a social injustice as it would represent “unjust enrichment”.22 Islamic Banking Explained The philosophy of mutuality and social justice translate over to banking practices that do not offer interest and are averse to risk-taking (gharar).23 Together the prohibition against riba and the containment of gharar are methods used by Islamic banks and financial systems to safeguard against unjust accumulations of wealth via credit facilities or investments or savings.24 The prohibition against gharar will apply to any financial or banking product that is characterized as risky or comes with uncertainty. It is believed that banks and financial institutions are trustees are required to ensure that the weak are protected from exploitation.25 Ideally, all parties to a financial or banking product should be in a position to know with a high degree of certainty, exactly what the outcome of the transaction will be.26 This is obviously the working of the prohibition against gharar. The prohibition against riba similarly ensures that all banking or financial products are fixed positively.27Riba is perceived as an “usury” and is regarded as an instrument of inequity and as such is inconsistent with concepts of social justice.28 Social justice is achieved when lender and borrower are both required to profit at a rate that is proportionate. Moreover capital must be distributed in a fair manner reflecting the parties’ input which should be shared equitably.29 What this means is that in Islamic credit facilities, both lender and borrower equally share the risks and the profits. As a result when lenders provide credit facilities or loans, a profit will only be gained when the loan or credit facilities are performing positively.30 In practice, the prohibitions against riba and gharar are reflected in the fact that Islamic banking and financial products will not offer debt leveraging and solely debt securities.31 It would therefore appear that Islamic banking systems and financial services err on the side of caution in the protection of the weak, the sharing of profits and risks in giving expression to the prohibition against riba and gharar. Disadvantages of Islamic Banking and Financial Services and Products As Iqbal and Mirakhor argue, the prohibition against riba can have a negative impact on cash capital. With no interest attached to loans and savings, this can compromise equilibrium between credit demand and supply. This can be especially discouraging to persons who would otherwise be compelled to deposit their funds in a bank for the purpose of accumulating savings. These persons may withdraw funds more often than they would have if they were accumulating interest rates on their savings. Some may even decide not to save at all. This could hurt savings as well as investment incentives and could stifle growth in the accumulation of cash capital.32 In addition, the prohibition against riba dispenses with the need for monetary regulations and policies. This is because interest rates are not determined. Moreover, it is not inconceivable that where conventional banks that do pay interest may end up taking business from Islamic banks where there is no interest. Obviously, individuals may be more inclined toward a banking and financial service that applies interest to their savings and investments.33 However, despite these concerns, we have already established that Muslims are withdrawing their funds from conventional banks and transferring those funds to Islamic banking systems. Regardless scholars and academics argue that interest plays a crucial role in regulating prudential systems. Interest rates are necessary for controlling and influencing exchanges in circumstances where there is purchasing power and where there are credit facilities. In this regard, interest rates can discourage borrowing and encourage savings where borrowing is excessive and savings are down.34 It would also appear that Islamic banking and financial practices and policies rely on profit and risk-sharing. This could be detrimental to the lending institution in circumstances where a project for which a loan is obtained is performing well and the borrower decides that he or she does not want to share their profits with the lending institution and therefore decides to deposit his or her profits elsewhere or use them without the lender’s knowledge. Unless the borrower shares the social justice values and the Sharia principles with the lender, there is real risk that borrowers can take advantage of the lender in this way. The ban on gharar is equally problematic. Although it may not be a problem for Muslims or clients that can tolerate excessive state control over private property, it will certainly be a problem for individuals who are not amenable to excessive state control over private property. The ban on gharar means that banks and financial institutions that are Sharia compliant cannot offer speculative and/or ambiguous financial products and services.35 In complying the ban on gharar, Sharia compliant banks and financial institutions must ensure that products and services offered, particularly credit facilities are productive and are also compliant with Sharia principles.36 As a result, financial and banking services and products cannot be speculative and low in value or such that it is tantamount to rolling the dice.37 This means that each and every party to a banking or financial product or service must be equally apprised of the value, prognosis and expected risks attached to or likely to be attached to the product of service. 38 This can be problematic because where there is a ban on speculative banking and financial products and services, the state is permitted to control how property owners use and invest their funds. Citizens in Western democracies are accustomed to total autonomy over their private property and enjoy the freedom to invest in risky financial products if they want to take the risk. As Nizami argues, the prohibition against gharar allows the government to exercise excessive control over what individual private property owners can do with their private property and what they cannot do with their private property.39 The ban against gharar can also operate against both the interest of the borrower and the lender. This is because, gharar does not allow taking account of unanticipated circumstances that could affect future losses and profits because everyone must be in a position to know exactly what to expect in the future prior to engaging in a financial or banking transaction. Therefore, should circumstances arise necessitating a restructuring of the original agreement for credit, the agreement cannot be changed. This may be particularly difficult when inflation changes everything for both the borrower and the lender.40 The irony is that gharar is calculated to protect the weak from exploitation by the stronger party. However, in reality, gharar can function to facilitate the exploitation of the weak by the stronger party. For example, where the parties are bound by the original agreement for a loan and a inflation compromises the weaker party’s ability to discharge the loan on the original terms and conditions, gharar binds him or her to the original agreement despite his or her weakened position and circumstances. Advantages of Islamic Banking and Financial Services and Products The approach taken to loans and savings under Sharia compliant banks and financial institutions is arguably safer and more efficient than conventional banking systems. Under Sharia complaint banks and financial institutions, profits and risks are shared. In this regard, when a borrower obtains a loan for a specific project, the borrower can expect that if he or she suffers a loss, the lender will share that loss as well. Likewise, should the borrower realize a profit, the lender will likewise share in that profit. As a result, a borrower will only qualify for a loan if the project is perceived to be profitable and productive. According to Siddiqi, this is an entirely efficient banking policy and practice.41 According to Kuran the prohibition against riba and gharar translates into to a practice of capital venture products in Islamic banking and financial services. By virtue of capital venture products, the ban on interest and excessive risk taking translates over to the distribution of risks and profits between those providing the capital and those using the capital and capital is only distributed where ideas or projects are feasible rather than on the basis of reputation and collateral or security.42 This is one of the main distinguishing features between Islamic banking systems and conventional banking systems. Conventional banking systems are more prone to take risks which often results in loans that either underperform or go into foreclosure.43 It can also be argued that in conventional banking systems, borrowers confronted with the prospect of repaying both the principle and the interest are not motivated to satisfy a loan when if the reasons for which the loan was obtained is underperforming. According to Herring and Santomero banks are important players in regulating the economy. How banks carry on business impacts the wider economy since banks inject capital into the general economy via the provision of credit facilities over time and in different areas of the economy.44 Herring and Santomero go farther to note that banks and financial institutions supply payments services and provide other products and services that aid businesses and individuals so that they can deal with uncertain economic conditions.45 Banks and financial institutions are therefore in a unique position to mitigate risks and costs linked to production, trade and commerce and therefore significantly contribute to “improving” the standard of “living.46 Taking this view of the role of banks in the wider economy, it can be argued that the ban on riba and ghara by Islamic banks and financial institutions is consistent with the role of banks in the economy. This is because Islamic banks not only approve loans on the basis of profitability, but also on the basis that the project funded is productive. This means that Islamic banks and financial institutions encourage individuals to be innovative and realistic and this can generate productivity and profitability and will also safeguard against the potential for bad loans which can only be bad for the general economy. While this is not a flawless system, no banking system is flawless. If anything, the Islamic banking and financial system is hardwired to safeguard against risks and excessive risk-taking is the primary catalyst for the recent global financial crisis.47 Islamic Banks vs. Conventional Banks Islamic banking and financial products and services are obviously constructed around the Sharia ideologies relative to social justice. According to Rahman, Sharia ideologies and concepts pertaining to social justice emanate from the theory of zakah. Zakah comprises the fight pillar of Islam and represents the first pillar of Islamic economic ideology.48 There are three underlying principles tied to Zakah. The three underlying principles are theologically, legally and linguistically constructed. Based on the linguistic construction of Zakah, social justice involves “cleansing” or purifying “something from dirt or filth”.49 Taken a bit further, from a linguistic perspective, zakah contemplates praising, growing and increasing.50 Theologically, zakah contemplates the practice of philanthropic sharing with a view to spiritually purifying the self and other.51 From a legal perspective, zakah contemplates sharing one’s wealth with others in appropriate circumstances and situations. Collectively, zakah commences with the belief that no property is owned by individuals. All property belongs to Allah and mortals are no more than trustees of Allah’s property.52 Thus, Allah’s property is intended to be distributed fairly and judiciously in way that Allah intended. It therefore follows that under the auspices of zakah, those holding more wealth than others, should share that wealth with those less fortunate. To refuse to share excessive wealth is regarded as selfish and greedy and inconsistent the zakah. Thus, a banking or financial product or service that would only ensure that the poor get poorer is banned. In Islamic banking and financial institutions, the primary belief is that debt is the main contributing factor to poverty.53 Zakah is therefore the primary motivating factor for the prohibition against riba and gharar. Taken as a whole, Islamic banks and financial institutions are not permitted to conduct practices and policies that involve the provision of loans and credit facilities to individual who may not be able to satisfy the terms and conditions of the loans and credit facilities. This means that attention is paid to the proposed project and the likelihood that the project will not realize a profit and thus put the borrower into debt.54 Thus in Islamic banking and financial institutions, the focus appears to be on the client rather than the bank’s interest. While conventional banks are required to determine whether or not a client is credit worthy, the primary focus is on profitability for the bank or the financial institution. In Islamic banks and financial institutions, the primary focus is on profitability for the client. In other words, conventional banks are focused on profitability for the bank and assess the customer’s creditworthiness in this way. In Islamic banks and financial institutions, a client’s credit worthiness is tested by reference to the profitability for the client. According to Friedman and Friedman, conventional banking and financial institutions operate on an ideology that is capitalist in nature. This ideology encourages aggressive pursuit of “self-interest” based on the perception that an open and free market economy should not be tightly regulated.55 In this regard, directors, executives, bankers, politicians, regulators, auditors, accountants and other professionals impacting the financial sector act as “watchmen” who would rather pursue their own interests and leave the public to their own devices.56 This is not entirely true of all so-called watchmen. Many of these watchmen are fully aware that they cannot achieve their own personal goals if the public interest is not served. Many of these watchmen are fully aware that if the public is unhappy, it could compromise their pursuit of their own interest. It can therefore be argued that regardless of the different ideologies that guide the financial regulation of Islamic banks and conventional banks, it is obvious that both sets of institutions are equally committed to safeguarding against bank failure. Although conventional banks are more prone to take risks and Islamic banks are more prone to avoid risks, both approaches can be detrimental to the banks’ stability and can be beneficial. As Adhikari and Oh point out, an institution is just as vulnerable to failure if it take too many risks and if operates risk free.57 Conclusion The prohibition against riba and gharar has not acted as an impediment to Islamic banking and financial institutions. Conversely, the prohibition against riba and gharar has served the Islamic banking and financial institutions well over the year as evidenced by its growth and expansion. Likewise, the inclusion of interest and the tendency to take more risks than Islamic banks and financial institutions has likewise served conventional banks well. While conventional banks and their risk taking have been attributed to the recent global financial crisis, it must be remembered that conventional banks have been around for a much longer time than Islamic banks and have proven to be resilient. If conventional banks were not resilient they would not have survived the latest global financial crisis and they would not have survived as long as they have. In the final analysis, conventional banks serve a specific sector and Islamic banks serve a specific sector. Muslims would not be satisfied with conventional banking systems since conventional banks take risks and offer interest rates, both of which offend against Sharia principles and the tenets of zakah. Non-Muslims however are amenable to Islamic banking and financial services and products. Whether non-Muslims would be satisfied with a purely Sharia compliant banking and financial product is another matter entirely. Non-Muslims may find the credit facilities particularly appealing since they are interest-free. However, it is doubtful that a non-Muslim would find it convenient to save their money in non-interest bearing Islamic bank account. It would therefore appear that both conventional and Islamic banks and financial institutions have their strengths and weaknesses. From the perspective of Muslims, the conventional banking product is inappropriate and inconsistent with their beliefs and practices. From the perspective of the non-Muslim, particularly non-Muslims in Western democracies, the Islamic banking product and services is too conservative and reflects far too much state control over private property. Bibliography Textbooks Ariff, M. and Iabal, M. The Foundations of Islamic Banking: Theory, Practice and Education. (Glos. 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