Islamic banking

I recently heard about Islamic banking, a form of banking that is consistent with Islamic Sharia law, and started learning a bit about it. Unlike conventional western banking, Sharia law explicitly forbids usury, the collection of interest on loans. Obviously Islamic banks need some kind of profit model, so when a business takes out a loan with an Islamic bank, rather than paying interest on the loan, the entrepreneur engages in a profit-sharing partnership with the bank. That is, the bank becomes a partner in the business and takes an agreed upon percentage of the profits. This type of agreement is consistent with the no-usury requirement in Islamic law.

Apparently Islamic banking is one of the fastest growing sectors of the international economy, catering for the world's enormous Muslim population who wish to bank in accordance with Islamic law. Interestingly, during the Asian financial meltdown, Malaysia's prime-minister Mahathir Mohamad refused IMF assistance, a move which shocked world markets, and instead invited the Islamic Development Bank to provide the necessary investment to revive Malaysia's economy. As it turns out Malaysia's economy recovered very quickly, unlike some of the other Asian economies which faltered despite IMF assistance.

In my mind, this model of banking offers some key advantages compared to conventional Western banking. Namely, risk is spread between the investor and the debtor - Islamic banks assume a share of the risk in the businesses in which they invest. This is unlike conventional banking where bankers have a cut-and-run approach - the banker's income is fixed and they are effectively insured against risk via collateral offered by the entrepreneur. This difference clearly changes the dynamics of business loans since the bank has a strong vested interest in ensuring the success of the business and is therefore likely to offer advisory support and other assistance to businesses along the way.

I'm interested to see how Islamic banking develops and whether it becomes more widespread. I'm particularly interested to see whether, influenced by this banking model, conventional banks might start to offer business loans under a profit-sharing model rather than an interest based model (perhaps some banks already do this, unbeknown to me). Islam aside, I'm sure there would be significant demand for this kind of banking model as it spreads risk rather than concentrating it all onto the entrepreneur.

11 thoughts on “Islamic banking”

  1. Good question Aggie. This was one of the first question I had too when I first learned about Islamic banking. The way personal loans works is as follows. Suppose you want to take out a loan to buy a car. Instead of borrowing the money from the bank and paying interest on the loan, the bank buys the car and then sells it to you in installments at a profit. So the bank is still charging you for the loan, but just in a different way. So for personal banking I actually don’t see that much of a difference between Islamic banking and conventional banking – they’re achieving the same thing in different ways. But for business loans things are quite different.

  2. Am I correct in assuming that part of the present meltdown of financial markets is due to the high risk taking of private equity and hedge funds? How would Islamic banking cope with this kind of exposure? Or would such kind of exposure be prevented altogether?

  3. Being a cynic – I’m not convinced that this really is an alternative or particularly novel idea. Indeed, diocesan banks have been around for some time to fulfil religious purposes such as the provision of favourable loans to educational institutions. However, in the example you describe there is one important question – who bears the burden of borrower defaults?

    The role of banks as financial intermediaries cannot be underestimated, indeed given the current liquidity crisis it is all too apparent that a ready supply of capital is a necessity for any economy. On the other hand, banks’ depositors (who provide that capital) are unable and unwilling to accept unsystematic risk. Thus, most of banks’ capital is balanced between providing funds to borrowers and providing a safe place for depositors’ funds. Then there are the interests of the banks’ owners – shareholders – who want a return on their investment.

    As far as Malaysia’s recovery after the Asian financial crisis is concerned, the suggestion that this particular model of banking decreased the length and depth of recession is highly questionable. I would suggest that significant capital inflows are likely to have contributed significantly more to this than any particular method of capital distribution.

    However, to deal with your closing question, I think it would be highly unlikely that traditional ‘Western’ banks will be looking to move their business models in such a direction anytime soon. The main reason is that there are already highly evolved systems for capital to be distributed and priced according to risk. Those who are willing to assume business risk are equity investors, those who cannot afford that risk should not be asked to pay for it.

    P.S. You’re back in the ‘dale? I wouldn’t mind catching up 🙂

  4. Hi Jonathan. I agree that conventional banks have highly evolved models for the assessment of risk/return tradeoffs. However, there is more than one model for risk distribution. Conventional banks offer just one such model and the ‘Islamic’ type model offers another, in which the bank assumes a larger share of the risk, and presumably expects more in return. Even in our ‘Western’ model for investment this type of risk distribution approach to investment already exists, in the form of shares. So I don’t think it’s a huge step for this model to be offered by banks for business investment. It’s really very similar to an IPO. I agree with you that one shouldn’t underestimate the value of our banking system, and I don’t want to undermine it by any means. I merely want to point out that there are different available models for distributing risk and return.

  5. Hi Peter and Wolgang

    Your understanding of profit sharing type of Islamic banking model is theoretical. Islamic banks still dispense credit rather than getting into equity type arrangement involving profit sharing structure. Islamic banks being banks need to comply with Basel II capital adequacy prudential guidelines which are prepared to regulate credit dispensers the whole wide world, inclusive of Islamic banks. Please take a look at annual report of Kuwait Finance House to come to your conclusion. Too much hype about Islamic banks being the torch of conscience in the international world of finance. Urge you to be less carried away with Islamic finance,which to most in the practice, is more form over substance. Have fun reading and being critical!

  6. Hi.

    Is there a blog I can read to understand about islamic banking in detail? A beginners’ blog – I don’t have a finance background but I feel it offers considerable advantages in construction projects.

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