THE MIDEAST IN THE NEWS

Everything You’ve Always Wanted to Know About Islamic Banking

The size of this banking industry globally was close to $820 billion at end-2008. Iranian banks, for example, are fully covered under Islamic finance framework. In other Muslim countries such banks co-exist with conventional banks, a substantial portion of them situated in the Gulf Cooperation Council (GCC) countries, Pakistan, Sudan, Malaysia, and elsewhere.

The rapid diffusion of such institutions coincides with rising oil prices during the 1970s and after 9/11. The spread is also due, in part, to a recent resurgence of traditionalist Islam. However, such institutions are yet to make much headway in terms of credit supplied in many of these countries. Such banking is dwarfed by conventional banks even in countries like Malaysia, where Islamic banking is well developed.

Islamic banks are founded on the principle that they offer only interest-free products. They are envisioned to work as private equity or venture capital firms. The core principle required to be used is a participatory, profit and loss sharing (PLS) basis called mudaraba and musharaka contracting.

Non-participatory financing should be only for miscellaneous services for which banks should charge fees, not interest. However, in actual practice, the PLS or equity financing principle is found to be the least used. Most of the Islamic banks’ investment consists of credit extended on non-PLS basis to profit-making businesses. Some 75 percent goes to markup or cost-plus (murabaha) lending and another about 10 percent goes to leasing (ijara) financing.

The reason is clear. The banks lack needed expertise in project selection and evaluation and requisite business experience for equity investment. That means that information that the concerned parties have about the PLS projects is asymmetrical, which necessarily makes Islamic banks more averse to financing such operations as involve risk and uncertainty than short-term trade or other businesses that assure certain returns. By using data for six Islamic banks of Bahrain for the period 1991-2001, Abdus Samad finds that only 0.9 percent of such banks’ total credit went into long-term PLS (mudaraba and musharaka) projects.

At the other extreme, small-scale enterprises find it much harder to obtain finance from Islamic banks on the PLS basis than their larger counterparts, as banks consider holding equity stakes with small enterprises extremely risky. Working capital loans, critical to many small businesses, are rare. Aaron Maclean writes: “Those involved in the first wave of Islamic banks realized that equity financing does not make for a stable banking sector, and, after a series of shocks and bad investments, they became very conservative. It was a race to the loopholes—a search for means of sharia compliance less risky than straight-out equity investing.”

In murabaha financing, the bank is to first buy the goods from the seller and possess them for a period, thus assuming liability, as in a normal trade, and then sell them back to the buyer who wanted the goods with a profit margin on the price. However, in practice, the bank does not take possession of the goods and there is virtually no holding period involved.

Thus the loan advanced by the bank is much like a normal loan of a conventional bank and the profit margin, in an annualized form, is akin to interest.

In the case of another popular instrument used, ijara financing, the bank collects rent with a profit on the property leased out to the buyer of, say, a vehicle or a house or some durable equipment. The bank enters into a partnership with a person who wants to buy a house. The bank pays, let’s say, 80 percent of the house price and the individual 20 percent. The bank rents its share of the house back to the individual until it is fully paid for, collecting rent with profit over the interregnum period. The profit collected, on an annualized basis, is little different from conventional mortgage interest. The name change does not alter the essential nature of the charge.

“Whether the product is dressed up in Arabic terminology, such as Mudarabah, or Ijarah, if it looks and feels like a mortgage, it is a mortgage and to say anything else is semantics,” writes John Foster.

The contracts such as deferred delivery sales (bay salam) and sales on deferred payment basis (bay muazzal) also involve time and credit elements on which the bank makes a profit agreeable to the bank and the buyer. But these contracts are very much in the nature of murabaha financing, involving interest in essence.

Islamic banks cannot just issue bonds (sukuk), a debt instrument, in return of a promise for a fixed rate of return. But they have found a way around the problem. For a bond to qualify as sharia-compliant, there must be an underlying asset backing it. However, the extent to which such bonds are really asset-based is a question mark. In Iran, for example, banks use a fixed rate of return for inter-bank financial transactions and those with government departments and public enterprises with little direct relation to actual profits on the ground of borrowing entities. Also, state-owned companies and municipalities can issue sukuk in foreign capital markets with prior approval of Bank Markazi (Iran’s central bank) and Ministry of Finance. Islamic banks are currently making roaring business in bonds.

For the most part, Islamic banks thus fail to get rid of interest. This is not a bad thing, after all. Islam does not really ban interest that has come to play a very vital role in the modern economy. Islam bans interest that is exploitative, as in pre-Islamic days, which is referred to in the Quran as doubling and redoubling of usury in times of default (3:130).

This modern Islamic view on interest is best represented by noted Pakistani-American scholar late Fazlur Rahman (Rahman, 1963). I also make a similar point. Interest-free lending, which the Quran calls qarza-hasana or beautiful lending (2:245; 57:11, 18; 64:17; 5:12; 73:20), should be meant for individuals or entities that deserve humanitarian treatment.

The needy must be helped with grants (sadaqa), not loans.

By Abdur Rab, a retired economist and author of Exploring Islam in a New Light: A View from the Quranic Perspective, 2010.

*Photo Credit: Wikimedia Commons

Add comment

We only welcome and encourage constructive and respectful comments. Please avoid slurs, hate speech, general abuse against other participants, or any incitement of violence.
We reserve the right to delete your comments and block your participation with continued abuse.

Name (required)

E-mail (required, but will not display)

Notify me of follow-up comments

Refresh

Send

Cancel

Comments   

 

0 # malick elias 2012-07-03 04:39

AA, So what are the ranges of financial contracts that are not deemed to be forbidden, which has a measure of 'non-exploitati ve intrredt connectef tp it? Moreover, what is the Islamic justification for this?

Reply | Reply with quote | Quote

 

 

0 # ISRAR HASAN 2012-07-19 03:54

Abdur Rab deserves commendation for his views on Islamic Banking. He is right when he says, "Islam bans interest that is exploitative, as in pre-Islamic days, which is referred to in the Quran as doubling and redoubling of usury in times of default (3:130)." The Qur'an in 2:275 differentiates between 'rib'a' (Eng. usury) and 'bai'y' (Eng. trade). In the post and pre-Islam Arab traditions, the one was used for personal loan which was exploitative and the other, for trading and commerce. The former was forbidden and later was permitted.

Reply | Reply with quote | Quote

 

 

0 # Small Business Loans 2013-01-28 10:21

This is really innovative and a new idea, I like this concept and the way it is carried out in so light and cool manner. I concur with your conclusions and will eagerly look forward to your future updates I’ve been meaning to read this and just never received a chance. It’s an issue that I’m quite interested in, I just started reading and I’m glad I did. You’re a excellent blogger, one of the greatest that I’ve seen. This blog unquestionably has some details on subject that I just wasn’t aware of. Thanks for bringing this things to light.
small Business Loans

Reply | Reply with quote | Quote

 

 

0 # Celina Smith 2013-01-31 14:35

Your web page ideal for my needs. It contains useful and beneficial content. It features very beneficial subjects for many individuals to obtain a lot from it.Incredible news on this website. Business loans for bad credit

Reply | Reply with quote | Quote

 

Refresh comments list
RSS feed for comments to this post

JComments