1. OVERVIEW
Since the inception of Islamic banking about 30 years ago, the number and reach of Islamic financial institutions worldwide has risen from the one bank in Iran in 1975 to more than 300 institutions operating in more than 75 countries.
Banking systems of Sudan and Iran are based on Islamic finance principles. They are also niche players in the United States and Europe, with non-Muslims also finding it sensible and competitive (Oakley, 2008). With assets of around $800 billion as of 2008, the Islamic finance sector is expected to reach $1 trillion by 2010, according to McKinsey & Co.
The Pope Benedict XVI has also noted that the ethical foundations of not collecting "Riba" or excess, on which Islamic Banking is based, bodes well to the ailing financial institutions and markets today. An article in the Vatican's official newspaper also suggests that "Western banks could use tools such as the Islamic bonds, known as sukuk, as collateral" (Loretta Napoleoni).
Islamic banking has been witnessing robust growth in the recent past and has achieved maturity in several Middle-Eastern markets, as indicated through significant market shares in terms of assets as a percentage of total assets. Kuwait and Saudi Arabia are among the largest markets with over 25% of the proportion of assets belonging to Islamic banks (Celent report, 2008).
2. PRINCIPLES OF ISLAMIC BANKING
The basic Islamic principles that this form of banking is based on includes risk-sharing and profit-sharing.
Risk-sharing
Indexation of the principal can yield negative, positive or no returns on the principal in money terms. There is inherent uncertainty in this method, as opposed to earning a pre-determined rate of interest on loans which inevitably is positive in money term. Interest on loan is thus a “gain without risk” and accordingly, prohibited in Islam.
Profit-sharing
There are primarily two ratios of profit-sharing. One is between the depositors and the bank, which is determined based on the incentive needed for sustainable supply of investible funds. The other ratio between banks and entrepreneurs is based on the expected rate of profit in the economy. The expected rate of profit plays the allocative role, which is performed by the rate of interest in the modern economy.
3. RISK MANAGEMENT
In the McKinsey Quarterly article “Risk: Seeing around the corners,” various risk triggers are listed as Inflation, Financial Markets, Economic Growth, Commodity Prices, Demographics and others (Figure 1 - Source: McKinsey Quarterly). With the Islamic Banking model, these triggers are accounted for in the following manner (please see diagram on top).
Inflation
Because the profit-sharing ratios depend on the expected rate of profit in the economy, with higher inflation, the profitability of the enterprise is directly affected and this reflects in the expected rate of profit. For enterprises that are able to pass on the rising input costs to their consumers, the profitability might remain the same or improve, whereas for some firms, the profitability might be negatively affected. This provides an efficient means of keeping the demand under check, as opposed to the pre-determined rate of interest, which usually lags the inflation and is policy-determined rather than market-determined.
Financial Markets
Islamic banking avoids the concept of debt, instead preferring to take equity when lending cash to borrowers for financing their asset purchase or enterprise activities. Thus the risk is not handed solely to the financier but split between the two. Default in debt markets, as witnessed in the recent credit crisis, can lead to bankruptcy, whereas in the case of equity, there are little chances of insolvency. The bank therefore has an incentive to not only assess the borrower at the outset, but also after extending the finance.
There is thus a tendency to seek out and support low leverage projects. Typical leverage ratios were 10:1 in Middle East (Sullivan, 2008). While providing a stabilizing effect, this can potentially detract from further growth opportunities.
Economic Growth
The success of Islamic Banking is closely related to the rapid growth of “oil dollar” capital (Kanoksilp, 2007). South East Asian (SEA) countries have strong trading relationships with the Middle East, and prefer banking based on Shariah law. Accordingly, Islamic Banking has filled in the gap by providing a trade path to the Gulf. SEA is witnessing strong economic growth riding on 24% CAGR in SEA-Gulf trade.
The growth effect can also be seen in Europe.
Commodity Prices
To an extent, the success of Islamic banking depends on the boom in oil production and real estate in the Middle East. Of late, the decline in oil prices and the slowdown in property developments in Middle East have affected its growth. Due to widespread nature of the sources of capital, in European and SEA countries, this risk is however considerably mitigated.
Demographics
The Muslim community is one of the fastest going communities in the world today. Riding on the back of oil exports and foreign trade in manufactured goods, the community is amassing wealth that finds an appropriate channel for further reinvestment through Islamic banking.
The Indian Finance Minister is discussing the feasibility of Islamic banking system in India, citing the fact that 40% of Malaysia’s and 20% of Britain’s Islamic banks are non-Muslims (Ghafour, 2009). The growth effect can also be seen in Europe.
Customers and Competition
Customers and Competition lie at the heart of Islamic Banking with its success depending on the profit sharing ratios as determined through supply and demand conditions.
4. INSURANCE
Islamic banking laws do not permit commodity hedging or dealing with futures contracts since these deals are not rooted in a real asset. This has potential drawbacks in the case of sudden shocks (Sullivan, 2008), hence insurance is a critical component of Islamic banking.
Islamic insurance, or Takaful, is perceived as community insurance, where the risk is shared among the community. Losses are divided and paid, with no surpluses remaining with an insurance provider, as in the case of traditional insurance.This helps the Muslims deal with risks to life, property and health.
5. DEALING WITH CREDIT RISK
Islamic Bonds
Islamic Bonds, or Sukuks, valued at around $107 Billion globally (Brown, 2009), are a rough equivalent of the debt of the Western markets. The difference lies in that the Sukuk owner owns a stake in the asset. Islamic banking doesn’t consider money as an asset, hence the underlying asset has to be real and capable of producing a rent. A pre-determined rent, benchmarked to LIBOR, is collected in lieu of the credit, which might border on the western concept of “interest,” but the difference lies in the held-to-maturity and lack of developed secondary market for trading these bonds.
Thus, Sukuks, through their principled discouragement of conventional loan lending and credit cards, can alleviate the ailments of developed markets. The United States is witnessing stunted growth because of highly liberal regulatory policies regarding housing credit extension which led to inflated assets and negative rate of savings. Sukuks, based on partial ownership of the business, asset or project, and a continuous return on investment in the asset thus holds promise for Western capital markets.
Shariah or Islamic Law also entails the concept of “public benefit” and considers the possibility of “hedging” of avoidable business risks.
Credit or Lending of cash
Islamic banking doesn’t allow for lending cash in its conventional sense, in return for a sum higher by the time value of money. The lending for (say) an asset purchase is carried out thus:
- The bank purchases the asset to be financed for the asset price and thus assumes ownership.
- It then receives a payment from the borrower that is higher than the asset purchase amount.
- This is the profit that it pockets, in lieu of the risk of ownership and non-payment of asset price.
The financier has an obvious incentive to minimize the risk of non-payment, thus stabilizing the lending (Arab News).
6. CONCLUSION
Islamic banking, based on ethical foundations and inbuilt risk management features, can provide recourse to the ailing financial markets today.
However, forces of globalization are posing important challenges to the model, particularly related to innovations in financial instruments and efficient risk management. While its concepts and instruments can potentially benefit today’s troubled markets, the model has its own gaps.
There is a lack of scholars which holds back the Islamic banking sector. The perception of Islamic banks among the non-Muslim community can also hinder its global expansion. The financier’s risk of ownership involved in lending activities needs to be mitigated through appropriate regulatory frameworks.
With resemblance to venture capital and private equity in its investment philosophy, Islamic banking believes in enabling rapid growth through interest-free credit and shared risk. Ongoing discussions among scholars related to hedging of business risks and derivatives need to end conclusively with development of regulatory and operational framework that can provide further stability to the rapidly expanding Islamic banking phenomena.
