Islamic banking drawing attention

Hasanuzzaman

The ongoing global financial crisis is far from being over. The G20, which together accounts for almost 90 percent of the world economy, met in London in April with the primary objective of reshaping the financial architecture. The final result was an attractive commitment worth $1.1 trillion to revitalise the stagnated global demand. The lion share of this amount (nearly 70 percent) has been allocated towards strengthening the IMF's role in assisting countries that are falling prey to the silent tsunami in the global financial system.

Nevertheless, many critics have pointed out that the G20 did not do enough to streamline the global financial architecture and more critically, they failed to grasp the ongoing global financial crisis by its horns, for example re-regulating the world financial system. According to a news report, the same day that the G20 Summit was aiming to boost the IMF, the latter suspended lending to Latvia (one of the countries it has recently extended emergency crisis loans to) "until it sees more progress in cutting public spending". Such signals indicated the reluctance of developing countries to approach the IMF.

The optimists ought to be informed that that there are more dark days ahead. Freddie Mac, short for Federal Home Loan Mortgage Corporation which together with Fannie Mae own about half of the $12 trillion of the US mortgage market, once again reported a loss of nearly $10 billion in the first three months of 2009 and said it would ask for a further $6.1 billion in state aid to help compensate for the losses. This is the third request for more federal help from the respective firm since it was taken over by regulators in September last year and its latest request is likely to accumulate to a total of $51 billion.

Amid the strong turbulence being felt in the global financial system, Islamic banking system has been attracting much attention. In general, Islam forbids all forms of economic activity, which it perceives to be morally or socially degrading or harmful to others. The fundamental rule of Islamic finance is the prohibition of charging interest. According to the Sharia law, one is not allowed to make money from money, for example earnings (or payment) of interest, speculation, contractual uncertainty and transactions that prove to be advantageous to one party at the expense of another are not permitted. In accordance with Islamic principles, investments in companies, which are involved with alcohol, gambling, tobacco and pornography, are also prohibited. In short, wealth is to be generated only through legitimate trade and investment in assets.

In synchronisation with welfare economics, Sharia law can be conceptualised to possess many in-built mechanisms that aim to preserve a Pareto efficient allocation of profits in this case. In other words, its endeavour is to sustain a situation where an individual cannot be made better off without making some other party worse off. Sharia law aspires to minimise speculative types of behaviour by ensuring an equitable distribution of profits. So how does one make profit in a Sharia compliant banking system? To illustrate, in the West when an individual wants to borrow money to buy a house, he or she would go to a bank and agree a loan. Following the bank's approval of the loan, the customer would be required to make regular repayments, which include interests accrued on the loan. On the other hand, in the Sharia-compliant banking system, the bank would buy the house itself and sell it to the customer at a mark-up price. The bank and the people, who put their money in it, have a share in any profit, loss or from investments.

The one Islamic financing mechanism, which is attracting much attention in recent times, is the Sukuk, which are asset-backed, Sharia-compliant trust certificates. For the traditional banker and customer, they can conceptualise this as a bond. Then again, a bond generates interest income, which is prohibited under Sharia law. Sukuks tend to be used in parallel with an Ijara structure where the lease rental income provides a profit for the Sukuk holder. The proprietor also has the fiduciary responsibilities for the maintenance of the asset and this is the most striking difference between the conventional bond system and the Islamic one.

This is not to affirm that the Islamic banking system is not without any flaws. One of the inherent flaws is the lack of regulatory framework within the sector, implying that Sharia managers have the discretion to differ over what constitutes Sharia-compliance. Proponents of Islamic finance tend to refute this point by arguing that the built-in adherence to Islamic law makes this system fairer and hence, more morally acceptable.

To conclude, notwithstanding the fact that Islamic banks have been able to shield themselves from the spillover effects of the global economic recession, no one can predict the extent to which the Islamic finance's principles will serve to protect it from the looming financial storms. Whilst some have pointed out that it is already entwined with the mainstream finance whereby its future is as risky as any other part of the global financial industry, experts in Islamic finance believe that their way of carrying out finance-related activities has shielded them from the global credit crisis and hence, the model stands on its own merit. London, the financial heartthrob of the world, is emerging as a major financial centre for Islamic finance. Reputed banks like the UK's HSBC and Citi of the US have already set up Islamic banking subsidiaries that are flourishing.

Time and events are going to be the most crucial factors in deciding whether such a system remains a complement to the existing financial system or it evolves to such an extent that it replaces the conventional ways of doing business under a capitalist system.