Imagine a world where profit margin is disclosed to the buyer. They know exactly what it costs and how much more they would be paying for something, and are delighted to take the deal. In this world, money can’t just sit there to make more money. Instead, it must be tied to an economic activity, such as a good sold or service provided. People would enter nothing short of a clear-cut contract with one another. That means no deception or ambiguous fine print. Consider yourself warned. This world exists.
History of Islamic Banking
During the 20th century, banks began to expand their size and geographic reach as a result of new technology in communications and computing. As these banks made their way into Muslim countries, there was just one major problem – interest. Banks operate based on interest. They make money by paying lower interest rates on deposits while lending at higher rates to customers. But this is against Islamic law (Sharia) which prohibits the acceptance or charging of interest or riba. As a result, the Mit Ghamr Savings Bank was set up in Egypt in 1963 and became the first Sharia-compliant bank to serve communities that want adherence to the religious law.
According to the International Trade Centre, being Sharia-compliant means that banks must also not engage in haraam activity, such as those involving pork, gambling, alcohol, tobacco, and adult entertainment. They can’t invest in a business that produces wine or lease a poker table to a gaming company. Another responsibility is to minimize ambiguity or gharar in transactions by stating price, quantity, quality, and time of delivery on sale and lease contracts. In compliance with gharar, one cannot sell the fish in the water, for instance.
Over the last 30 years, Islamic banks have sprung up around the globe, especially in the Middle East and Asia where there is a large demand from Muslim populations. Bahrain, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates are particularly active in the Middle East. Asian countries with Islamic banks include Brunei Darussalam, Indonesia, Malaysia, Pakistan, the Philippines, and Thailand.
Based on a report last fall by the Kuwait Finance House Research, there are currently over 600 Islamic financial institutions operating in 75 countries. Over the last decade, the Islamic finance industry registered a 15 to 20 percent annual growth, as if recession was in a whole other universe. Assets were estimated to be USD 1.6 trillion in 2012 and the sector is expected to continue growing in 2013.
Conventional banks want in on the pie. UBS, Paribas, HSBC, and Citibank are among a growing list of financial institutions who have launched Islamic banking windows. Others offer limited Islamic banking services. While they primarily serve customers in the Middle East and Asia, they also have clients from Europe, Canada, and the United States. Another growing trend is that clients are increasingly non-Muslims who have opted for Islamic banking services.
Islamic Banking Services
If Islamic banks don’t use money to make more money, what do they do? How would the banks survive? Although Islamic banks don’t trade money, they can nonetheless use a number of instruments to organize economic activity with customers and generate profit in three basic ways: sale, lease, and partnership.
Among all the instruments, sales contracts are most commonly used by Islamic banks. In a cost-plus contract or Murabahah, the bank buys an asset and sells it to a client. Rather than exchanging money for money, an asset is traded for money so it complies with Sharia. In Murabahah, the bank would state the cost of the asset as well as the markup so as to make the profit known to the buyer. Some banks may use a sales contract in which only the sales price is disclosed, called Musawamah. In this case, buyers are able to negotiate until an agreement is reached.
The bank may allow the buyer to pay for an asset in installments. Because the price is fixed in a contract and that riba is prohibited, banks cannot impose additional fees on late payments. To protect against default, the bank would ask for strict collateral or a high down payment.
For assets that don’t already exist, such as uncultivated agricultural produce, a forward sale contract called Salam is used. Banks would purchase the uncultivated product from farmers as start-up capital and once the product is delivered, the banks would sell it. Although Salam is widely used in Sudan, it is not particularly popular with Islamic banks in general. Salam is used for generic goods, whereas Istisna is used to finance non-generic goods, such as infrastructure projects.
Instead of selling, banks may also lease an asset to a client. Ijarah is the name for a lease. Usually, leases are set up as operating leases so that clients do not own the asset at the end of the lease, but ownership is possible at the end of maturity through a sale or gift.
Evidently, conventional banks organize activity around risk transferring, whereas Islamic banks organize activity around risk sharing. Central to the ideology of risk sharing are partnership contracts.
There are two types that differ depending on the bank’s involvement: Musharakah and Mudarabah. Musharakah is a joint venture where both the bank and client contributes capital to the business. They divide up profits and losses based on pre-agreed ratios. The bank could choose to or choose not to play a strategic role in the business.
On the other hand, Mudarabah is where only the bank provides the capital and only the client runs the business. The bank assumes the risk of losses while the client does not take home a salary. Profits are shared between the two parties.
Significance of Islamic Banking
Experts are increasingly drawing parallels between Islamic finance and social finance. Both treat money as a means to create value for society. They seek to build win-win situations and discourage hoarding, excessive consumption, and monopolistic activity. While Islamic finance avoids investments in businesses involving alcohol, gambling, and weaponry, social finance supports investments in businesses creating positive social and environmental outcomes.
Given the similarities between the two options and the rapid growth of Islamic banking, social ventures have at their disposal the choice to seek Islamic financing – especially since impact investors are reluctant to invest in many early-stage ventures. Australia-based Solar Guys recently raised $500 million to build five solar-powered stations across the Indonesian islands, all through an Islamic bond called Sukuk issued in Malaysia.
Malaysia is a pioneering example of a country having a dual-banking system that includes commercial banks and investment banks running alongside Islamic banks. They have an Islamic stock market and regulatory framework that spell out the responsibilities of management, the board, and the Sharia committee – professionals that banks appoint to ensure operations comply with Sharia principles.
However, even for a system as developed as Malaysia’s, industry players still hope for more refinement to shape a healthy sector. Concerns over banks lacking strict adherence to Sharia, having little tolerance for risk, and investing in the gaming industry have risen in the past. Similar to some microfinance institutions deviating from its original idea to the point where Nobel laureate Muhammad Yunus once said it should no longer be called microfinance, there are questions over whether or not Islamic banking is in fact Islamic.
This could lead to frustration for the consumer. “Sharia is sometimes subject to interpretation,” said professor Sudin Haron, President of Kuala Lumpur Business School and a renowned scholar in Islamic finance, in an email exchange, “There is a possibility that products at certain Islamic banks are not allowed at other Islamic banks.”
CIMB Islamic Bank Berhad CEO Badlisyah Abdul Ghani told the StarBizWeek that he hopes financial regulators see regulating Islamic finance as an act of regulating commercial transactions, rather than regulating religion. The model could prove vital for other countries. Last November, the Reserve Bank of India stated “legal problems” as reason the country ruled out Islamic banking.
Badlisyah added that Islamic finance can enhance and promote global financial stability if its ethics are codified in a country’s banking and financial regulatory framework.
“We have a lot of untapped market in both Muslim and non-Muslim communities,” said Haron. “Each country has its own set of banking law. Some, for political, social, and economical reasons, will find ways to ensure that Islamic banks can be operated in their country.”
Come what may, assets continue to pile up in the sector.
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