Islamic finance

By: Iliyas Ismail

Before discussing Islamic finance, its best to discuss Islamic economics as a more comprehensive field before delving specifically into Islamic finance. Going into Islamic economics would serve a better understanding of Islamic finance and its banking operations and provides a more holistic basis to the idea.

Introduction

Islamic economics and the subsequent Islamic finance were shaped into a separate form of discipline with its own doctrine rather recently in the 1970s. Prior to that, classical Muslim scholars have contributed to shaping this doctrine, with Ibn Khaldun contributing the most to this thought, and all this is grounded on the outlines of the teachings of the Qur’an and Sunnah 1,400 years ago.

In 1976, the first international Islamic conference on economics was held in Mecca and this is seen as the birth of Islamic economics as a doctrine and especially as a science with its many theories. Roger Arnold (2008) stated that theory in itself is an abstraction of reality, and science itself can be described as a home of theories. The interesting thing with developing Islamic economics is to find the source of knowledge for contribution to it, whether from a rationalist perspective or empiricist perspective. Logical positivism, which is closely related to empiricism, states that truth must be logical, evidence-based or based on logical analysis. This would mean that Islamic economists, in attempting to produce Islamic finance products, should conduct a logical analysis on how such a product would produce benefits for mankind.

Arnold (2008) talks about the development of Islamic economics, which started off as a separate discipline on the outcome of the Mecca 1976 “International conference in Islamic economics”. Initially, Islamic economics developed as a response to the many conventional practices dominating the Islamic world then. For instance, the British set up their own Ottoman Imperial Bank on formerly Ottoman territories that practiced riba (interest), but this did not augur well with the Muslims.

The establishment of riba-based banking systems and finance were a problem in other parts of the Muslim world too, including Pakistan and Malaysia. All this led to the resurgence of the need for implementation of an Islamic system that came in the form of the 1976 conference. It paved the way for Islamic banking systems to be developed much later on. However, there were several diverging schools of thought on the issue of riba itself that ensued after the conference. 

The first is the Usury-riba school, which allowed for interest as long it does not amount to usury, or excessive interest. As anathema as it may sound now, this view has been adopted at some point in history in the Islamic world. For instance, Mehmet Effendi the Ottoman grand mufti (d. 1574), once issued a fatwa permitting interest-based lending on Islamic waqf (Khan, 2015). Indeed, during the early days o the introduction of Islamic banks, several scholars allowed interest-based lending in their respective countries, for instance Rashid Ridha in Egypt, and Sir Syed Ahmad Khan and Fazlur Rahman in India (Siddiqi, 2004). 

However, this view did not gain wide acceptance in the Muslim world.

These scholars, view interest as a lubricant for the economy and stated that the actual riba that was prohibited was actually riba al-jahiliah that was practiced at the time of the Prophet. That type of riba would charge double interest to lenders who would make late payments and seemed highly oppressive in nature. The dominant view of riba however states that the interest should be avoided altogether and not merely usury and it is this view that prevailed until today.

Islamic economists agree that mudarabah financing (profit sharing based on the relationship between entrepreneur and financier, with a pre-agreed ratio) is the best type of Islamic financing to be used and it should be the ideal form used widely by Islamic banks. However, it eventually became apparent that murabahah (mark-up price) was the form that dominated instead, and it still is leading in popularity up to this day. Indeed, Harran (1995) estimated that murabahah financing comprised around 80-90% of financial instruments in the Islamic world between 1970 to 1990. A few years after, Ahmed (1993) stated that murabahah is “declining in the overall financing operations of the Islamic banks”, however almost three decades later, murabahah financing is still the preferred choice for many.

Many countries tried to implement Islamic finance in the system, but they faced many challenges and were not entirely successful. Interest-based banking systems were not able to be abolished. Some of the reasons for this was the difficulty of implementing Islamic finance on public and external debt and monetary policy (Omar and Haqq 1996). Two schools emerged on how to deal with this situation for Islamic economics, the aspiration oriented and the reality-oriented school, the former taking a more rigid approach, and striving for the complete replacement of the current economic system with a sharia-based approach, while the latter accepts the current situation of Islamic finance and succumbs to the dominance of Murabahah. This paper will touch more on this idea.

Mohsin Khan (1987), belongs to the aspiration-oriented school and is of the view that Islamic institutions that uses a two-tier mudaraba system would have a quicker recovery rate of their balance sheets at the time of recession, compared to conventional ones. This is due to the former combining assets and liabilities together, as opposed to conventional ones. He then argues about the rapid growth of Islamic finance, and presented opinions by scholars on the impermissibility of tawarruq and the reasons for that impermissibility (including the fact that it closely mimics conventional financing with riba’).

In averring for Islamic economics, many Muslim scholars tend to be more comfortable discussing issues among other Muslim scholars in their own conferences. This is presented as a disadvantage by some, since the idea of Islamic economics seems not to branch out and gain input from conventional economists. While it is true to state that more discussions should be done with conventional economists to gain and learn from them, focus should be done on the products of Islamic finance and to gain a distinct differentiation from conventional products as well as practices that is also at the same time more superior.

Islamic economy as a thought, is developing in the Muslim world, but presenting it to the those of other faiths to be accepted as this superior model is still a challenge. More and more non-Muslims have a better understanding of Islamic economics and Islamic finance nowadays compared to before, and will be readily accepting of the concept, but they would choose it as an alternative at times, rather than a better choice, if indeed it is taken to be such.

Islamic banks

Islamic banking is an alternative concept to the dominant banking system which lacks the moral and societal aspects, especially those existing within the framework of Western and secular economic system. The first Islamic banks were established in Egypt in 1963, and since then there have been many countries that have established Islamic banks and adopted the Islamic financial system as a mainstream system in their countries, including having a regulatory body and naturally, a specific, separate regulations for the system. Islamic banks differentiate themselves from conventional ones by their abiding of the Sharia and rest on the concept of avoiding riba, gharar and maysir.

In line with the above, Islamic banks differ from conventional ones in that it does not offer interest bearing deposit accounts but offers a profit-sharing and loss-bearing scheme. At least this is what the Islamic banks strive for, however as mentioned their products include debt-based as well. The annual growth of the Islamic banks portrays a promising prospect ahead, with a 15% worldwide growth for the past 10 years, and it even outpaced the growth of conventional banking and currently has an asset amounting to US$300 billion. This is among others due to the growing awareness of Muslims to abide by the principle of avoiding riba, as its explicit prohibition is expressed in the Qur’an, as well as the overall attractiveness of using Islamic products to identify with their faith.

The global Islamic market has also seen an increase with an average annual growth rate of 10-20% for the past decade, witnessing the growth of Islamic equity, Islamic financial asset, Islamic money market and as well as takaful. 

Facing the financial crisis

When facing the financial crisis, there are many papers that discuss about how Islamic banks are more resilient and are able to withhold the crisis at hand ((Mohamed and Muhammed, 2017, Hassan and Dridi, 2011, Beck et al, 2013). During the 2008 financial crisis for instance, conventional banks were facing major effects on their businesses as the crisis has mostly to do with the riba’ financial system. The Islamic financial system on the other hand, could provide an alternative scenario for this whereby the financial crisis could have been contained. Indeed, during the crisis itself, Islamic banks were spared the full brunt of the impact.

Whereas it was the conventional banks that felt the major waves, Islamic banks encountered the effects of mostly ripples, and that of which as a result of being a part of the global financial system. It should be noted that any major impact on conventional banks will indefinitely result in some kind of impact on Islamic banks, although various papers have shown that the effects on Islamic banks were much less adverse compared to their conventional counterparts

The resilience of Islamic banks can be attributed to the higher levels of capitalizations compared to conventional banks which relies more on debt (Beck et al, 2013). Baber (2018) noted on the resilience of Islamic banks but suggest re-evaluations by those who consider derivatives and short selling as “Islamic”.  Korbi and Bougatef (2017) noted that Islamic banks are less stable compared to conventional banks in terms of regulatory capital. Werner (2015) argues against regulating capital adequacy of banks as there are insufficient evidences to show that it could avert a financial crisis, bringing an example of Credit Suisse. Werner (2014) attempts to empirically test the theory of banking and posits that there are evidences to back up the credit creation theory of banking and that many banks were engaging in creating money out of nothing which exacerbated the crisis.

The crisis is also described as a crisis of morality (Siddiqi, 2008), failed morality is seen as leading to corrupt practices, greed and exploitation. The failure is further demonstrated in the lack of information by the loan providers about the potential risk involved in the transactions. Islamic banking that champions ethical practices should be transparent about lending risks as well as assessing lenders capabilities of repayment.

However, not all agree on this straightforward view of the dominance that Islamic banks would have with regards to facing a financial crisis. Of course, at the end of the day, the people constituting the Islamic banks are still humans, are will be tempted to fall into corrupt or lax practices. But beyond that, there are reasons to believe that even if with better individuals, Islamic banks could face a similar conundrum come a financial crisis.

Ahmed (2009) postulated that Islamic banks could end up in just a similar, if not the same situation as conventional banks, having the circumstances surrounding, in favour of such an occurrence. Accoding to him, this is due to the current nature of Islamic finance, which offers similar products as, and more often than not mimics, those of conventional products. Many criticisms have been levelled in this regard by Islamic economists and the need to distinguish themselves is considered pressing. To offset this, it is important for Islamic banks to continue to depart from conventional based financing and move to a more independent direction.

The current structure

To discuss the structure of the Islamic banks as contrasted with conventional banks, this could mean their organizational structure or it could refer to the products that they are offering. With regards to organizational structure, overall there are not very significant differences between conventional and Islamic. The company could have a chief executive officer at its helm with a board of directors as well as departmental heads to run the operations. This is a generic structure applied to most business organizations, but for Islamic banks there is an added Shariah supervisory board made up of a group of Sharia committee to ensure that the banks activities are run according to the Sharia guideline.

For the product offerings and how the conduct their business, the current structure of Islamic banks is mostly based on a profit and loss sharing system and is interest-free. The basic form of financing comes in the form of the three well known structure namely mudarabah, musyrakah and murabahah.

Khan (2016) notes that most Islamic banks’ practices still closely mimics conventional financing and is actively engaged in “duping observant Muslims” by presenting their activities as though it is sharia compliant as well as charging higher than conventional banking.

Challenges

As mentioned, there are still hurdles to provide musharakah and mudarabah financing on a large scale, as it is murabahah financing that is still dominating the Islamic banking industry. Abdul Rahman and Mohd. Nor (2016) interviewed two Malaysian Islamic banks and found that high risk of loss and difficulty of choosing a partner to be among the challenges, this in particular to the mode of mudarabah. Archer (2009) stated that the Islamic banks concept of non-guaranteed returns serves as a problem in some countries, for instance in the United Kingdom, as it does not meet the definition of deposit and results in problems in regulatory framework of the country.

Any returns from depository funds should not be in the form of a guarantee of the nominal value of deposits, but only in the form of profit and this has structure has certain advantages due to it being less rigid (Khan 1986). Alam (2013) avers that Islamic banks’ efficiency is positively influenced by the regulations related to the Basel II components, stating that Islamic banks’ technical efficiency is actually better in stricter regulatory conditions. Many Islamic banks has a mudarabah Profit-Sharing Investment Account (PSIA) which certain scholars such as Visser (2009) contends, could actually encourage Islamic banks’ managers to take more risks and to invest in risky projects, thus can cause Islamic banks to engage in excessive risk-taking. This possibility of excessive risk taking should be averted by having tighter requirements by the Sharia supervisory board.   

Under the PSIA contract, profits are shared between Islamic banks and the PSIA holders according to a predetermined ratio, the PSIA holder will bear the loss solely except if there is negligence on the part of the banks. As mentioned, however, many banks lack this PSIA, in terms of utilization. In Malaysia, Islamic banks are largely financed by non-PLS modes of financing, with PLS constituting only of the total financing offered by Islamic banks (Chang and Liu, 2009). Grasa (2016) found that even though PLS as practiced in the GCC countries leads to lower probability of insolvency, it is not the case for the PSIA and non-PSIA structure, where both could contribute to higher risk of insolvency.

Islamic banking should emphasis more on the attributes of ethics. The overall risk taken by Islamic banks is considerably lower with the avoidance of gharar and maysir, as well as Islamic banks are better able to pass negative shocks to the assets through the profit-sharing arrangements (Mollah et al, 2016). Some studies shows that ethics have a considerable effect on Islamic banks profitability as well as the level of capital (Toumi, 2019). It is hoped that Islamic banking can emphasize on this not just in words, but also in deeds and practices.