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Backgrounder: Islamic Banking and Financial Instruments

Around the mid-19th century, a new model of banking emerged and developed in parts of the Middle East and North Africa known as Islamic Finance. It is one of the fastest growing sectors in banking, with more than 428 Islamic banks that hold an estimated $2 trillion in assets in 2019, providing competition to conventional banks as a substitute product. Islamic finance, also known as sharia-compliant finance, includes all financial or banking activities that are compliant with Islamic law (Sharia). The Sharia requires that all transactions comply with a set of rules known as fiqh al-muamalat, which are in turn derived from the Quran, the teachings of Prophet Muhammad, and scholarly rulings called fatwas. The unique character of these rules creates significant differences in the practice of Islamic finance compared to the conventional model.

The fundamental difference between the Islamic and conventional model comes down to the concept of money. While conventional banking strictly deals with money, Islam merely regards money as a medium of exchange with no intrinsic value. Profits cannot be made on the trade of money itself, leaving that, instead to real assets and inventories. Because of this, Islam prohibits several financial activities that conventional banking depends on. The first of these prohibitions is on the collection and payment of interest (riba) under the assumption that interest is unfair to either the borrower or the lender. For example, if a loan is taken out to be used in a business only for that to result in a loss, the borrower despite incurring losses must pay the lender back the loan plus interest. The inverse can happen to lenders, who mostly consist of small savers, often have their money used by the bank to loan out to larger companies that could earn more profits than the interest they pay back to the bank, resulting in relatively poor returns for the savers whose funds were used in the first place. The last argument often called upon is that the availability of credit on interest has created an unstable economy of debts and promises, aggravating the business cycle’s booms and busts.

In addition to restricting riba, the Islamic model also prohibits the concept of gharar, which refers to conditions in contracts that the implications of which are uncertain to either or both parties, akin to asymmetric information. Because Islam encourages openness and transparency in business deals, a classic example of gharar invoked by Muslim scholars is selling the unborn child of a camel or any other livestock since the gener of the child is unknown. A more modern example is derivative or speculative transactions, which include activities such as short-selling, fronts, options, and so on due to the future uncertainty of delivering the asset. Of course, some cases of uncertainty are tolerated and classified as gharar yasir (trivial uncertainty) such as a buyer having to trust a built house seller about the construction materials since the house cannot be torn down to check. Lastly, Islam prohibits all forms of gambling and games of chance (maysir) because wealth is not created from the individual’s productivity.

Entrepreneurship and insurance are the only exceptions as there is a natural risk to these processes, but gambling and other unnecessary ‘games’ add no value to society and pose no risk to the non-participant. Naturally, since gambling is banned in Islam, this rule extends to the idea that banks cannot offer loans to a business that goes against the principles of Islam such as gambling, tobacco, or alcohol. Ultimately, one can surmise that Islamic finance is a culture-specific form of ethical investing that claims a moral high ground over the profit-minded conventional model of banking. That then leads to two important questions: how do Islamic banks generate returns and do they sacrifice efficiency for ethics? The second question will be answered later whereas the first is not too complicated.

For these banks to function without interest, capital and enterprise are not considered factors of production since every investor, naturally fearing loss, is entitled to a profit share proportional to the investment. Thus, Islamic banks use an equity participation system, meaning if a loan is issued to a business, the business would pay the bank with a share of the profits made without an interest rate. The banks will then use the money collected to conduct investments assuming that said activities are sharia-compliant. If profits are not made, an Islamic bank will not benefit from the loan, which forces them to verify the risks of a potential loan. This makes an Islamic bank more risk-averse when offering loans and more likely to avoid investing in an economic bubble.

Outside these primary differences, the Islamic banking framework is divided into several structures and terms, most of which will be discussed below:

  • Musharakah: A joint enterprise to run a business where profit is shared at an agreed-to ratio and loss according to contributions made. Musharakah is established between more than one party through a mutual contract that can be terminated either by a partner leaving, which allows the remaining parties to purchase the share of the departing partner or through the completion of a specific project. It is a substitute for interest-based financing as that is already prohibited, mitigating the inherent risk of investing and enhances productivity. A recent development has also created a subtype to this model known as Diminishing Musharakah.

  • Mudarabah: Another type of partnership where one party acts as the investor (rab al maal), providing funds and capital to the other to use their expertise in managing a business (mudarib). The profits made will then be shared between the two sides at an agreed-to ratio. Any incurred losses are the responsibility of the investor alone unless the mudarib was found to be negligent. In most cases, the investor is unable to interfere in the management of the business, but conditions can be specified in a restricted contract to guarantee better use of the investor’s funds.

  • Murabahah: A form of sale where the bank purchases the item for the customer after the exact price is specified. The customer then usually makes deferred payments in installments back to the bank, which also adds an agreed-to profit margin. Although it has attracted criticism for its similarity to interest-based payments (riba), it nevertheless remains the traditional method of Islamic finance, used by 70% of all Islamic banks

  • Ijarah: A lease agreement where the bank purchases an item to lease it to the customer over a specified period. The duration of the lease and the rental fee is set in the contract, and until the contract is terminated, the asset is owned by the bank and the customer has the right to use it. Once the contract expires, the right to use the asset reverts solely to the bank.

  • Wadiah: Meaning deposit, it is defined as the deposit of money or assets between a customer and an Islamic bank, in addition to a fee charged by the bank for the safekeeping of the deposit known as an accounts maintenance fee.

Development of Islamic Banking:

Since the early days of Islamic history, Muslims were able to adopt the tenets of Islamic finance and avoid the payment of interest, fully codifying even during the reign of Caliph Umar (634-644 CE). This framework continued for centuries afterward, but as the center of commerce began to shift to the West, the Islamic tradition was phased out in favor of the dominant financial institutions of Europe. In most cases, interest was indirectly employed through technicalities, an example of which was the opinion that although interest cannot be applied to gold or silver currencies, it can apply to fiat money. The Industrial Revolution changed that with the introduction of commercial banking, which combined with the European colonization of the Middle East, led Muslim scholars to call for an alternative means of financial intermediation.

Some theoretical experiments in Islamic banking were conducted through the Egyptian branch of the Ottoman Bank that was established in 1867, the first modern bank in the Middle East. Under colonial rule and poor economic growth, however, the majority simply accepted interest and speculation as essential components of the modern economy. Once the Muslim World gained its independence shortly after WWII, experiments with interest-free finance began to take shape. For example, one of these experiments was done from 1963 until 1967 in Mit Ghamar, Egypt using small savings from the rural sector. Of course, no interest was paid to the account holders, but they were offered small interest-free loans as a production incentive. It wasn’t until 1971 when the first Sharia-compliant bank, the Nasser Social Bank, was established, and although its goals simply involved loans for the needy, scholarships, and other micro-credits, the fact that a government was willing to support an interest-free institution fascinated businessmen with funds to spare. One of these groups would establish the Dubai Islamic Bank in 1975, the first Islamic bank to be made for private sector initiatives.

However, the spotlight that year was stolen by the Islamic Development Bank (IDB), an international multilateral financial institution founded in Jeddah after a series of OIC meetings led by the finance ministers of several Muslim countries and King Faisal of Saudi Arabia.

The establishment of the IDB opened a period from 1975 to 1990 where the Islamic finance industry evolved into an alternative form of financial intermediation, gaining recognition from the IMF and World Bank as a viable product. A multitude of sharia-compliant financial products and institutions were created, and most notably, several multinational banks have started to offer these products through their own Islamic windows, and countries such as Iran and Pakistan have pledged to fully eliminate interest-based banking from their economies. Although the Middle East’s economic and political instability hampers financial development, the Islamic banking sector has secured its growth primarily through activities in the GCC Countries, which contribute to 85% of the sector’s assets at a CAGR of 6% since 2012. Therefore, Islamic banking is being recognized as not only a regional alternative but a rapidly-growing financial sector with products that appeal to a sizable market.

Performance of Islamic Banks & Challenges:

Comparative Analyses of Islamic and conventional banks in the Middle East point to the former being a rapidly growing industry that has grown past being an experiment in ethical finance. The period between 1990 and 2002 in the top twelve regional banks of each category, for example, shows that growth rates in equity, investments, and assets are consistently higher for Islamic banks than their conventional counterparts. Although the growth rates are shown to decline, this can naturally be attributed to a combination of immobilized funds from Muslim clients being freed and the fact that conventional banks started offering Islamic products as well. A proposed disadvantage in previous sources was that Islamic banks suffered from excess liquidity due to avoiding investment avenues that conflict with religious values, but the ratio in that period for Islamic banks (17.28%) is lower than that of the peer group (30.60%). Combined with a lower cost-to-income ratio of 55.28% as compared to 64.81%, Islamic banks seem to mobilize their resources better even with the limit that interest rates impose, likely a product of the guaranteed stability that Islamic banking offers even in financial downturns. However, the Islamic model faces several operational challenges that are reflective of its lack of maturity when placed beside conventional banking.

Although the sector looks promising, Islamic finance faces theoretical issues in its development. Most of these stem from the constraints of Islamic fiqh (jurisprudence), which prevents new products and reforms from being implemented unless clearance has been acquired from Sharia scholars. For example, long-term finance is mainly performed by long-term bonds and equities in sectors such as the securities market, a trend that is limited by disagreements in jurisprudence. Equity investments are permissible under certain parameters, but those parameters have not yet been specified by scholars. While most groups agree with conditions such as equity investments not going to prohibited businesses or that interest income earned be negligible, the Islamic Fiqh Academy has no unifying ruling on the matter. This problem extends to situations such as penalties and risk management concepts, which tend to carry different opinions from the different sects and schools of Islam.

Some practical considerations also exist to limit the development of Islamic banking. The first of these is a requirement for governments to create special laws for the practice of Islamic banking and the enforcement of its contracts, a notion limited by the fact that most countries (even some Arab countries) use commercial and banking laws that mimic those supporting conventional banking. These laws also extend to the management of central banks, which often supervise Islamic banks on an equal footing to their conventional counterparts. This treatment does not hold since Islamic banks cannot participate in many of the benefits a central bank provides. They cannot receive interest on deposits, take loans in a liquidity crunch, maintain legal reserves, nor conduct open market operations. These examples serve as evidence that additional regulatory frameworks need to be created to support Islamic banking, which countries such as Pakistan and Iran have begun to experiment with by creating new applications of the profit-sharing model.

The final barrier to the sector is its lack of maturity and development, and as a result, a sizable number of institutions raise several questions about their compliance with Sharia laws. For example, Islamic scholar Taqi Usmani argues that Musharakah (profit sharing) is often ignored in favor of Murabahah (cost-plus) because the latter uses a fixed markup mode that resembles an interest payment. This creates confusion for some banks since interest and Murabahahcan be substituted for all intents and purposes, which then leads to contradictions such as requiring deferred payments for overhead expenses when no commodity was purchased or using buy-back procedures even if the Sharia prohibits the use of such instruments. The substitution of conventional terminology is supported by economist Mohammad Siddiqui, who attacked the tendency to substitute the term sukuk for ‘bonds’ only to leave out the part where they are meant to be Sharia-compliant as well. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) stated in 2007 that approximately 85% of sukuk bonds are non-compliant. By trying to create alternatives to instruments used in conventional finance, many of the systems currently employed by Islamic banks closely mimic those in the West.

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