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From just a handful of institutions in the Arab countries in the 1960s, Islamic banking has found a public and is growing four times faster than conventional banking. Mohamed Ariff explains why.
Banking has seen one of the more interesting side skirmishes in the ‘clash of civilisations’ between Islam and the West. As Western banking rubs up against the religious points of difference proffered by Islamic banking, industry bastions from England to Switzerland are seeing their Islamic counterparts enjoy growth figures four times their own.
Ever since the first modern experiment with Islamic banking in the Egyptian town of Mit Ghamr in 1963, Islamic banks have evolved into specialised, complex entities such as Islamic mutual funds, Islamic index funds, the Islamic Development Bank and Islamic or takaful insurance. Like conventional Western banking, modern Islamic banking provides three main functions: an efficient payment system, a channel for funnelling household savings to businesses and government and financial products like mortgages.
However, in addition to standard banking and prudential laws, an Islamic bank is supervised by a shari’ah board that bans the payment of interest, the financing of anything not in the long-term interest of society and high-risk financial products. The sector is supervised by a number of institutions: the Accounting and Auditing Standards Organisation for Islamic Financial Institutions (AASOIFI) standardises accounting treatments and the General Council for Islamic Banks and Financial Institutions (GCIBFI) promotes homogenisation.
Ancient world religious practice considered profit from trade in goods and services as acceptable but not from money. The first recorded use of the word ‘interest’ appeared in Babylon in 2400 BC. Traditionally, Islam frowned on usury or interest (riba) and Muslim jurists, lay scholars and a long line of commentators from Aristotle to Benjamin Franklin have argued about what is interest and what level of interest payment is too much. Catholicism took a dim view of interest in the Middle Ages until it entered the banking business itself. The upshot of all this is that today’s Islamic bank replaces interest income with a pre-agreed profit-share formula conditional on the outcome of the end-result of a loan. For example, on an Islamic mortgage transaction, instead of lending money to purchase property, the Islamic bank may buy the item itself from the seller and re-sell it to the buyer at a profit, who pays back the bank in instalments. To protect itself against default, the bank enters into an arrangement called murabaha, which is a contract of sale between the bank and its client for the price of goods plus an agreed profit margin for the bank. 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).
An Islamic bank will not engage in financing activities considered illegal (haram) for an adherent to Islam; hence, an Islamic bank will not finance activities considered anti-social such as alcohol or prostitution. According to the Dow Jones Islamic Index, 40 per cent of US companies fail this test.
Under the third principle, financial products that carry a high level of risk (garar) for the customer (that border on gambling) are not permissible. This arises from the mandate in Qur’anic law that requires contracted parties to avoid extreme risk. However, there have been several new products that have been introduced inside more innovative bank circles including truly risk-sharing instruments.
From just a handful of institutions, mostly in the Arab countries in the 1960s, Islamic banking’s revisionism has slowly but surely found a public and today is growing at 15 per cent per annum, about four times faster than conventional banking. Importantly, it has innovated itself to be accepted by venerable institutions with HSBC, UBS, Dresdner Bank and ABN-Amro developing Islamic compliant products.
Today there are about 400 Islamic banks with total assets estimated at US$7 trillion (A$8.9 trillion) and an equity capital base of US$400 billion. Pakistan, Saudi Arabia and Sudan have adapted their domestic banks to become full Islamic banks with foreign banks operating as conventional banks for international transactions. In other countries, Islamic banks exist side-by-side with conventional banks, some of which offer Islamic financial products as well - examples include Indonesia, the Persian Gulf countries, Malaysia and Thailand.
Despite this, at this early stage of the market growth, Islamic banks will not account for more than 1 to 2 per cent of the total assets of all banks. If full potential is reached in the future, it will be about a quarter, however, business is picking up fast as more of the world’s resource-rich banking groups get involved. This is partly because it not only appeals to Muslims but also non-Muslims. Plus, broader indicators of financial performance show that the banks studied enjoy a good return on assets, equity and other measures. Studies of production efficiency show that the banks have positive total factor productivity scores, although the size of the scores is small because of the lack of scale economies in such banks, given their infancy.
With the exception of Indonesia, Malaysia and the Islamic Development Bank, the provision of Islamic finance expertise training in banking, finance and insurance has been inadequate. In 2006, the establishment of the International Centre for Education in Islamic Finance (INCEIF) represented an investment in human capital to support the global development of Islamic banking. About 20 institutions and some universities, mostly in the Arab region as well as Malaysia, Indonesia, the UK, Switzerland and Singapore, provided small-scale introduction to the specialisation. It is expected that there will be a boom in this subject area as the market grows in coming decades.
Existing products can be simply classified by looking at what is the core of a conventional bank and how conventional banking items have different meanings in light of shari’ah regulations. What a bank is as a business is represented by the balance sheet on Chart 1).
On the left are assets with loans marked A that deliver conventional interest income and profit-share income to an Islamic bank; those marked B are fixed assets. While a conventional bank would call a loan an earning asset from making loans, an Islamic bank would call it financing or profit-share agreements to avoid any connotation of interest being attached. Together these add up to the total assets of any bank and are classified according to relevant accounting standards.
Item C is deposits from the public. In a conventional bank, deposits earn interest but an Islamic bank pays a profit share at the end of each month. If the deposit is a cheque account, then an Islamic bank ensures its safekeeping and return, but does not pay any interest; however, it may make ex gratia payments. Item D is capital. In conventional banking this consists of interest-based borrowed capital; in an Islamic bank this will be the same borrowed capital but based on profit sharing. A major part of item D is in fact the share capital (musharaka), which is exactly the same in both conventional and Islamic banks. In that case, in a conventional bank, a time deposit will earn a small interest pre-agreed with the depositor while, in an Islamic bank, the depositor receives a profit share declared at the end of each month on the basis of profits made on the deposits by the bank depending on whether the loan is a profit-share basis or joint venture. A point to remember here is that by engaging in profit-sharing funding/financing agreements, funds provided by Islamic banks become an ‘investment’, unlike a conventional bank.
For the purpose of illustration, terms of a conventional bank are used to drive the point that Islamic banking is a variation of this. In reality, the actual terms an Islamic bank uses are peculiar to them. For example, an Islamic bank profit and loss statement may have an entry mudaraba financing which is a loan based on a profit-share agreement or musaraka financing which is a loan contract also based on a profit share agreement but with joint ownership.
A conventional bank reports net income on loans net of interest paid to depositors and loan capital providers. An Islamic bank does not accept or pay interest but reports net income from profit-share agreements and fee incomes from sale-like or banking services fees. Profit-share income may be from different forms of lending activities such as profit shares (mudaraba) or joint venture (musaraka) or some specialised form of lending. Or it may be from services fees for safekeeping (wadiah), cost plus services (murabaha) and leasing of assets (ijarah).
Of the other items in Panel A, all are similar, but for the noted exception that the entire report is conditional on income reporting without interest, financing projects that are not in the long-term interest of society and prohibitions of financial products with extreme risk. An Islamic bank would have the same type of entries as Panel B but consistent with the three principles discussed earlier. For example, a bank may hold a bond, but it is called a sukuk bond as it is issued with no pre-agreed coupons as in conventional bonds. There are finer points to consider here. The issuer of sukuk (say, a central bank) has some real assets, providing rental incomes, which provide investor returns in a sukuk bond. Similarly, the equity may be referred to as the musaraka fund but it means exactly the same as equity.
Islamic banking is yet another specialised bank offering new products just like investment banking when it started to offer opportunities for securitisation of assets some decades ago. Islamic banks provide clients the secular satisfaction that their financial activities are carried out in a manner consistent with their beliefs and the nature of profits therefore takes a different form from the pre-agreed, pre-fixed, non-risk-shared rewards. Historically, banks have sought profits by distancing their monitoring function by going from fixed to variable interest, and from engaging in monitoring aggressively to securitising their risky products and taking such products off the balance sheet. The result is firms with bank loans relaxing their management or in some famous cases engaging in outright fraud. These modern innovations have seen banks become less socially responsible and more profit-focused without considering the end-use to which humanity’s accumulated scarce capital is being deployed.
Although this article may give an impression that the contemporary Islamic banks have the flavour of a true prototype, Islamic banking at this early stage is considered by some to be merely an approximation bordering on a legal fiction (hiyal) of what they should truly be. Further, there have been several new products introduced inside more innovative bank circles, and truly risk-sharing instruments are being designed and offered.
MBR subscribers: To view the full academic paper email mbr@buseco.monash.edu.au.
Public access: www.mbr.monash.edu/full-papers.php (six months embargo applies).
Mohamed Ariff holds a Chair in Finance, Monash University and also a Renong Chair Visiting Chair at Universiti Putra Malaysia. After 11 years in industry, he has spent 22 years teaching, researching and consulting in banking and finance. His interest in Islamic banking arose from research and advocacy needs to incorporate modern banking and finance theories/concepts into this new form of banking-finance-insurance.
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URL: http://www.austlii.edu.au/au/journals/MonashBusRw/2007/2.html