As the ex-masters of the financial universe struggle to emerge from a perfect storm of bad loans, bad debts and a deep recession, an alternative approach to business transactions is having a moment in the sun: Islamic finance – based on the teachings from the Qur’an.
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Sharia- the Islamic law and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba, usury) for specific terms and investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden).
These principles were used as the basis for a flourishing economy in earlier times. It is only in the late 20th century that a number of Islamic banks were established to practise these principles to private or semi-private commercial institutions within the Muslim community.
Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah. The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). The term Riba basically means surplus value without counterpart.
In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).
The best thing about Islamic banking is that while lending money to companies, it pegs its interest rate to the company’s profits. The bank’s profit on the loan is equal to a percentage of the company’s profit. Even for entrepreneurs, the bank provides funding, whereas the entrepreneur provides labour, resulting in a balanced risk sharing. Approaches like these result in a balanced distribution of income and not allowing monopolies to form.
The classic Islamic banking was developed between the 8th and 12th centuries. It started off as a vigorous “Islamic capitalism” monetary economy. It was based on the expanding levels of circulation of a stable high currency (the dinar) and the integration of monetary areas that were previously independent. Early Islamic banking introduced bills of exchange, limited partnerships, capital accumulation, cheques, promissory notes, and a lot of financial tools used widely nowadays. Many of these capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.
The modern Islamic banking started in Egypt with the formation of Islamic Development Banking 1975. The first modern commercial Islamic bank also opened in 1975 as Dubai Islamic Bank. In the early years, the products focused on conventional banking but during the last few years, the product development has been strong.
Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, plus an additional 250 mutual funds that comply with the Islamic principles. The relative stability of Islamic banking institutions in current recession has gained attention. Even The Vatican has said that banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. Conservative estimates suggest that over US$500 billion of assets are managed according to Islamic investment principles.
The World Islamic Banking Conference held annually in Bahrain since 1994 is internationally recognized as the largest and most significant gathering of Islamic banking and finance leaders in the world.
Islamic banks have expanded recently in the Muslim world but contribute a very small share of the global banking system. In Canada, Standard and Poor’s recently founded a Shariah-compliant index that has already led to the proposed creation of the first Islamic ETF in the country. As the Islamic finance movement begins to set in motion, a tug-of-war has broken out amongst the prospective players of this emerging religious market.
Sources report that there are about half a dozen applications sitting at the Department of Finance in Canada. These are mostly from organizations hoping to be the first Canadian institution to set up a licensed Islamic focused bank. The prolonged Canadian Government’s silence is making them impatient, since a normal application takes about 12 months, but the Islamic applications have been sitting for two to three years.
In other parts of the world, for instance,London has picked a more proactive approach by trying to become “center of excellence” in Islamic finance.
“This is the next big shift in retail banking for Muslim community, looking to the future, this is going to be great for banks.” says Steve Watt, a partner with KPMG (a Canadian limited liability partnership established under the laws of Ontario, is the Canadian member firm affiliated with KPMG International, a global network of professional firms providing Audit, Tax, and Advisory services) in Toronto.
Watt also says that Islamic finance is one of the fastest-growing sectors in financial services. The reason being that products offered under Islamic banking are not that unconventional; they are similar to ones used at credit unions, in private equity and venture capital.
Islamic finance proponents argue that if the principles were followed, the big crash could have been avoided. It provokes the idea among westerners that they would hopefully benefit from the Islamic system. “You don’t have to be Muslim to enjoy the benefits. How many Canadians might want that – invest ethically in a system that isn’t debt-based?” says Watt.
The fact that several applications for Islamic banking are still sitting at the Canadian Government does not seem to bother Omar Khlair. He is the president and CEO of UM Financial Inc., a financial company that offers Islamic mortgages and more recently, a “prepaid” (interest free) Islamic credit card. He likes to see more of these developments in the market before a fully operational Islamic bank could be opened. This way, there would be greater familiarity with Islamic products among the public.
Nevertheless, the rest of the world is moving fast, and accepting the Islamic system. Due to its enlightened rational approach, the new system might also appeal to non-Muslims, since it is about investing “ethically in a system that is not debt-based.”
Those in the world of Islamic finance believe that now is the time to strike. In the western world, the 25-year expansions in the consumer credit lead to the current meltdown. Deregulation, cultural positive attitudes towards debt and easy credit policies all led to a sharp rise in debt holdings by individuals. As formerly non-creditworthy people were offered mortgages, demand in the economy was artificially expanded as well. It worked like a charm for a while, but as the credit bubble began to inflate, crisis quickly followed.
Countries like Canada have developed an understanding of Islam and its recurring benefits over time. It is a pity that Pakistan being a Muslim country has not utilized the benefits, which is obvious by the presence of majority of banks being debt-based in Pakistan. Before the rest of the world converts into the Islamic banking saga, it is hoped that our own Muslim brothers and sisters can reap the benefits well before them.