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Islamic finance: the future of banking?

15 April Apr 2016 1119 15 April 2016
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Since 2008 Islamic banking has been growing at an estimated annual rate of 10-15% in no Muslim countries, such as the USA, Britain and France, amongst others, as an ethical and sustainable alternative to the conventional, profit-driven banking system.

Recent banking scandals that outrage citizens, has increased interest in “ethical finance,” which seems to have benefited Islamic banks.

Literally defined, Islamic banking is a system consistent with the principle of Islamic finance which is with Sharia (Islamic Law), sourced from the Quran and the Sunnah. The most common hurdle for Islamic finance is the prohibition for investors to collect interest on loans. Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. The basic principle of Islamic banking is based on risk-sharing, between the bank and the customer, rather than risk-transfer as is seen in conventional banking. For instance, when a customer wants to buy a house, the bank buys it outright and then sells it back to the client at a fixed higher price. They both share the risk and any profit made by the bank is deemed reward for the shared risk taking.

Today, Islamic banking is getting wider attention, including among non-Muslims, especially in the aftermath of the financial crash of 2008 that rocked the foundations of the global economy. Banks went bust. Standard and Poor's reports that in 2009, while many of the world's financial systems were deleveraging, assets of the top 500 Islamic banks expanded by 28.6 per cent to total $822 billion. This led many researchers to reexamine the efficiency of Islamic banks, which is risk-averse and anti-speculation, compared to conventional ones and to study their capacity to resist to the financial crisis. The results say that, generally, Islamic banks' efficiency is better than conventional banks only during a crisis period.

In some aspects, the ethical principles on which Islamic finance is based may represent a more morally appealing alternative to conventional banks, which is exclusively interest based. In addition to prohibition of riba (interest), there are several other important provisions which may affect financial transactions. These include the prohibition of ‘gharar’ (uncertainty or asymmetrical information) ‘maysir’ (gambling, speculation), as well as trading in prohibited commodities (for example, pork and alcohol). This makes the use of all conventional derivative instruments as perceived in the Western world, such as forwards, futures and options, impossible in Islamic banking system.

According to World Bank, Islamic finance has emerged as an effective tool for financing development worldwide, including in non-Muslim countries. “It has the potential to help address the challenges of ending extreme poverty and boosting shared prosperity”. However, a recent study, "How Ethical is Islamic Banking in the Light of the Objectives of Islamic Law?" released from Journal of Religious Ethics, found that the word ethical is used as a label, but evidence shows that this is not the case. Even if one sector operates according to a different set of religious (or other) constraints, it still must be able to meet with reasonable economic efficiency the basic requirements of both the commercial enterprise and the investors who supply its financial requirements. The study examines the extent to which Islamic banking is ethical and concludes that the practice of Islamic banking misrepresents Islam and does not contribute to solving social problems. “Whereas a completely Sha’ri’ah based banking is only possible when the whole of the Economy is Sha’ri’ah based”, the report said.

However others argue that Islamic and cooperative banks, such as credit unions, are broadly similar in that they share a similar ideology: namely, that finance is meant to serve society and should not involve exploitation of individuals. In a recent series of working papers, the International Monetary Fund, IMF, stated that there are important differences in practice, but it seems that an institution with ownership and governance according to cooperative bank and especially credit union principles could operate according to Islamic principles, and there may be advantages in doing so: a mutualist structure would be very much in keeping with Islamic precepts about inclusiveness and risksharing.

What is clear is that they are among those financial institutions that are generally more distant from “speculative” financial markets, and that they survived the crisis with comparatively little strain. So they are all worth considering as alternatives to conventional commercial banks.

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