Islamic Banking and Finance: Shock Resistant and Socially Responsible?

*Alexandros Dimitriou is a 3rd year Finance student at the University of Macedonia. His main research interests include macroeconomics, banking, global markets and monetary policy.

Abstract:

The term Islamic Banking and Finance is used when financial institutions abide by the law of Sharia, as described in the book of Quran. Charging interest is prohibited, as well as speculating and selling items not directly in one’s possession. The result is an alternative paradigm to conventional banking, in which common practices in the financial world like day trading and short selling are banned, and can possibly lead to a more socially responsible financial culture, as well as an increased resistance to economic shocks. This was demonstrated in the Great Financial Crisis of 2008, where Islamic banks steered clear of the moral hazard in their organizational culture that led conventional banks to their collapse, as well as a markedly better financial performance as long as the crisis had not seeped in the real economy.

Main Body

The origin of Islamic Banking and Finance can be traced to the dawn of Islam and to the book of Quran, while its modern manifestation was established in the 1960’s, in Egypt. Today it is a $2.5 trillion industry with hundreds of institutions located in more than 80 countries. According to a 2019 State of Global Islamic Economy report, total sharia-compliant assets are expected to grow to $3.5 trillion by 2024 (Domat, 2020). The theoretical framework around Islamic banks commands for adherence to the principles of the law of Sharia, leading to certain prohibitions quite unusual for the world of conventional banking and finance.

The four main points that differentiate the two are the following: Investing in the industries of tobacco, gambling, alcohol and entertainment is forbidden, as they are considered haram or unacceptable by religious terms. Selling items that are not directly in one’s possession is not allowed, so short-selling is out of the question, as well as excessive speculation -gambling. However, the most crucial prohibition is that of interest (Riba), which constitutes a fundamental mechanism of the Western financial system.

The normative approach towards explaining the ban on riba is that it drives poor people deeper into poverty while creating more wealth for the lenders who do not have to  carry the risk of carrying out an activity, for instance starting a business endeavor or purchasing a home. This of course makes economic inequality soar, fracturing societal cohesion. In Islam, as well as in Christianity and Judaism, this type of inequality is considered sinful, as all are equal in front of God.

There have also been attempts at citing economic reasons. For example, interest, as a predetermined cost of production, tends to prevent full employment (Khan l968; Ahmad n.d.; Mannan l970). In the same vein, the institution of interest has been pointed at as the cause of international financial crises, as well as the cause of economic cycles. (Ahmad l952; Su’ud n.d.). However, both studies did not succeed demonstrating a causal relation between interest on one hand, and unemployment or economic cycles on the other (Ariff, 1988).

Sometimes in the research literature, the “unearned income” aspect of interest is cited as a reason for its prohibition. On first sight, rent on a property and riba look similar, but rent differs in the regard that the benefit to the tenant is certain while the productivity of borrowed capital is not. Also, property is the subject of wear and tear in contrast with a loan that is not, so the owner must be reimbursed.

The prohibition of interest in Islamic Banking and Finance (henceforth IBF) does not completely remove the cost of capital, as it is recognized as a factor of production. What is not allowed is an a priori claim on the added value, inviting the question of what could be a replacement mechanism. Profit and Loss Sharing (henceforth PLS) has partly filled in the role of riba. The reason PLS is acceptable or halal is because the rate of return for the lender is not predetermined and in fact losses incurred are also shared. One large advantage of the PLS institution is that unlike conventional banking, it forces the Islamic banks to do their due diligence on the viability and profitability of the project, while the importance of collateral takes a back seat. Through this way economic development can be significantly stimulated as projects with potential can be financed despite the lack of collateral. However, in practice, focus is shifted toward short-term finance which carries fewer risks (Ariff, 1988).

Not all financing needs, however, can be met through equity and PLS, debt has been an essential mechanism of Islamic finance. Nevertheless, important differences remain between conventional lending and IBF. Goods being sold must be legally possessed (ruling out any kind of short selling) and financial intermediation must be based on asset purchases and lease transactions, thus expanding in line with the real economy, limiting credit creation.

There are a number of financial instruments used in IBF, similar in some ways with those of conventional finance but also with key differences, in order to conduct financial intermediation while abiding to the law of Sharia. They can be summarized as such (Clews, 2016):

Ø  Istisna’a: A procurement contract whereby payment is made by a buyer for goods to be delivered at a later date. An Istisna’a structure is used to finance the construction period of a project. The Islamic financiers appoint the borrower as their agent to procure the specific project assets.

Ø  Ijara: A lease contract whereby a party is given a ‘right of use’ in return for a rental payment. The Ijara structure is usually used for the operational phase of a project financing in conjunction with an Istisna’s structure during the construction phase

Ø  Wakala: An agency contract whereby the Wakil acts in an agency capacity on behalf of the financier

Ø  Sukuk: The Islamic equivalent of a bond, although rather than a debt claim the investor owns a share in the underlying asset.

Ø  Murabaha: A credit sale agreement pursuant to which an agreed profit between a financier and a client is specified in a sale and purchase contract.

Ø  Musharaka: a joint partnership arrangement in which profits and losses are shared, according to a predetermined ratio.

 One basic function of a bank, the deposits, also theoretically abides to different rules in IBF. Depositors get their due from conventional banks irrespectively of the bank’s profit or loss, while an Islamic bank is expected to share the realized profit or loss with account owners. This of course carries a high withdrawal risk for Islamic banks and in practice they tend to deviate from the PLS model, securing for depositors a competitive return regardless of profits or losses. While this may seem inefficient, Islamic banks are expected to be concerned about religious beliefs and taking into account the positive correlation between religiosity and risk aversion of an individual, Islamic institutions may face less risk than conventional banks (Abedifar et. Al, 2013)

Despite the aforementioned advantages of IBF, the industry is relatively young, especially when compared to conventional banking, and as a result there is major ongoing debate regarding the compliance of many financial products offered by Islamic banks with the law of Sharia. Sheikh Muhammad Taqi Usmani, of the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI), a Bahrain-based regulatory institution that sets standards for the global industry, said that 85% of Sukuk, or Islamic bonds, were un-Islamic. Because Sukuk underpin the modern-day Islamic financial system, and Usmani is a pioneer and maybe the most important scholar of IBF at this moment, one of its pre-eminent proponents arguing that the epicentre of the system was flawed sent shockwaves through the industry.  Also many critics see Islamic finance as an industry more driven by cultural identity than practical problem solving, as many Islamic financial institutions use the same strategies and products as conventional banks, altered on a surface level in order to preserve the form over the function.

Islamic Banking and Finance in correlation with the Global Financial Crisis of 2008

The crisis of 2008 caused catastrophic consequences, shaving an estimated $4 trillion from the world economy as direct losses (Seidu,2009). The aftermath, however, both in developing and advanced economies is still hard to comprehend. The report of the Financial Crisis Inquiry Commission proposes that major causes of the Global Financial Crisis (henceforth GFC) were discrimination, moral failure, weak governance, easy money policy, imprudent lending, excessive debt and leverage, and regulation and supervision failure. Despite the downturn, IBF continued its superior growth compared to the conventional financial sector. Islamic banking scholars Kayed and Hassan (2011) claim that Islamic banks survived the initial outburst of GFC because most of the causes and practices that led to the crisis are not permissible under Islamic finance principles, including ethical practices, the prohibition of interest (riba), and multi-level supervision mechanisms (Alqahtani,2016). It ought to be noted that no Islamic bank went bankrupt though the crisis of 2008 or needed a bailout with taxpayer money.

As mentioned above, Islamic finance is asset-based. In contrast, the conventional system is based on debt and when applying for a loan, the client has to pledge assets to secure the loan from the bank. This is called a collateralized or secured loan and if the client defaults on his debts the bank has the right to sell the collateral to recover its losses. In the Islamic banking system, money is not disbursed to the client, the bank purchases the asset and ownership remains with the bank until the client completes his payments, while allowing the use of the asset. The bank has a stake and a vested interest in the viability of the project, discouraging excessive speculation (Gharar) and greed, manifested in the GFC as banking institutions knowingly issuing loans to homebuyers who could not afford to repay them, asking for low or even no documentation to confirm the credit rating and income of potential homebuyers, the now infamous subprime loans.

IBF institutes, according to their profit and loss sharing principle, harvest extra profits but also must bear unexpected losses, as such they must take project scrutinizing very seriously. Islamic banks did not have the ability to get rid of the risk the subprime loans carried through securitization and hedging. Hedging is only allowed in the case that is backed by tangible goods and does not exceed the amount of their value, like the case of an export where foreign currency is needed. Derivatives like CDOs and CDS are considered  gambling and are forbidden, resulting in the minimizing of risk and speculation (LSE, Introduction to Islamic Finance, 2014), as well as the metathesis of risk.

Excessive leverage was one of the main triggers of the global financial crisis and the basis for many sovereign debt crises that shake many countries around the globe to this day. Total debts of developed countries have reached a point between 300 and 600 % of their accumulated GDP. The asset-based or asset-backed Islamic finance culture, through the usage of Musharaka or Murabaha instruments, does not purchase or sell any debt and as such steered clear of Option ARMs and securitized loan derivatives that were dependent on subprime loans and triggered the collapse of 2008 (Baber, 2018).

Other common practices of the conventional financial systems that carry excessive risk and contributed to the GFC are prohibited in IBF. Margin trading for instance, the use of borrowed capital to purchase stocks or other financial instruments, is not allowed because the institution of interest on the borrowed money is involved, as well as a much greater risk than non-margin trading because losses incurred can be greater than the capital borrowed. Day trading, the very short-term buying and selling of financial instruments, has been called unislamic because of the very short period of ownership. Day traders must pay interest and furthermore it is believed they do not truly own the object of their trade, something considered haram and is the same principle that prohibits short selling (DeLorenzo et Al, 2017).

A toxic asset is defined as a financial instrument whose value has fallen significantly and there is no longer a functioning market, therefore cannot be sold at a price satisfactory to the holder. Junk bonds, CDOs and other derivatives during the crisis of 2008 were being “marked to market” daily as their value could not be reliably estimated, tanking the balance sheets of financial institutions who had invested heavily on such assets. Islamic banks, due to the partnership nature of their dealings, give emphasis on the success of the project they get involved and their tendency for “debtlessness” in the way they conduct business safeguarded their liquidity and solvency.

Islamic banks performed better than their conventional counterparts during the beginning of the GFC in a number of financial indicators including growth, liquidity, leverage, riskiness, capital adequacy and asset quality. However, in the post-crisis phase when the real economy started to suffer, those indicators were also majorly affected (Baber, 2018).


References

1. October 20 and 2020 Author: Chloe Domat, “Global Finance Magazine – What Is Islamic Finance And How Does It Work?” Global Finance Magazine, accessed May 6, 2021,

2. Mohamed Ariff, University of Malaya, Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

3. Mohamed Ariff, University of Malaya, Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

4. R.J. Clews, in Project Finance for the International Petroleum Industry, 2016

5. Pejman Abedifar, Philip Molyneux, Amine Tarazi, Risk in Islamic Banking, Review of Finance, Volume 17, Issue 6, November 2013, Pages 2035–2096, https://doi.org/10.1093/rof/rfs041

6. Alqahtani, Faisal. (2016). Islamic Banking and the Global Financial Crisis. 10.13140/RG.2.1.2997.0163.

7. The rise of Islamic finance – Knowledge Works,(University of South Australia, 2013)

8. LSE, Introduction to Islamic Finance: Concepts and Structures, 2014.

9.Hasnan Baber, (2018) “How crisis-proof is Islamic finance?: A comparative study of Islamic finance and conventional finance during and post financial crisis”, Qualitative Research in Financial Markets

10. DeLorenzo, Yusuf Talal. “Day Trading in Stocks vs. Investment”. muslim-inestor.com. Retrieved 18 May 2017

11. Hasnan Baber, (2018) “How crisis-proof is Islamic finance?: A comparative study of Islamic finance and conventional finance during and post financial crisis”, Qualitative Research in Financial Markets

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