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.