Islamic banking – A play on words?

Credit has been a basic need of human race since the beginning of civilization. In Assyria and Babylonia, farmers and traders used to take grain as a form of loan when they travelled between cities. The history of banking world can be traced back to thousands of years but the modern global interest based banking system traces its origins to Florence in the 14th century. In the Arab and Muslim world, despite early innovations, such as establishing banking standards like the checking account during the Abbasid era (circa 10th century), little innovation had taken place within the world of Islamic finance until the early 70s of the 20th century.

Islamic finance resides at the nexus of a unique philosophy and religious belief system.  It is a twist on the conventional banking system. Its services have the potential to appeal to a broad based of consumers – not just Muslims. To better understand Islamic banking, one has to first understand the philosophical root of which the banking practices are based upon: Sharia, a body of moral and religious law derived from Islamic, as opposed to human legislation. The law is practiced among Muslims and covers all spheres of one’s life ranging from diet, prayer, marriage, politics, trade regulations, and of course economics activities such as banking.

So what does sharia-compliance really mean?

First and foremost, Islamic banking must operate within the framework of the religion and perform islamically-acceptable transactions, which exclude underlying assets involving alcohol, pork and gambling and other transactions at odds with Islamic principles.

Secondly, Sharia prohibits acceptance of interest or fees for loans of money (known as riba, or usury). According to the Sharia, money can’t become more valuable simply because time is passing. Rather, the value of money can increase if it’s invested in a project that itself is increasing in value. Effort and taking risk yielding returns, rather than returns being obtained through the possession of capital.  There is no concept of a risk free rate of return in Sharia.

If earning interest through loan sanctions is not sharia-compliant, how can banks make money? To be compliant, banks need to adopt a profit-risk sharing model which allows banks to earn profit by co-investing in their clients’ goods and businesses. The example of home financing explains how it works.

  • If one wants to finance a small flat in Dubai marina with Dubai Islamic Bank (DIB), the bank will not directly lend money to me. Rather, DIB will buy the flat itself. One can either buy it back from the DIB at a higher price paid in instalments (murabahah), or make monthly payments to the bank both a repayment of the purchase price and rent until th person becomes the property owner outright (ijara)

Thus, Islamic financing is largely asset-backed financing. It prevents the banks from making huge profits from the transaction, and the borrower from losing too much. Islamic banks have become hugely profitable in the past decade due to product innovation.

For example, although Sharia has prohibited interest-bearing bonds, banks have come up with innovative solutions such as Sukuk (the Arabic name for financial certificates). Sukuk owners will be given partial ownership of a property built by the investment company. The Sukuk owner will collect the profit as a form of rent.

This innovation is not without controversy.  Conservative scholars argued that Sukuk identical to a conventional bond. The growth of the Sukuk market has allowed investors to diversify their portfolio and invest in credit that they would not otherwise have access to. One school of thought has predicted that “The future of the Sukuk market is one of innovation, where new assets, structures and markets continue to create new opportunities for investors.”

Banking serves human needs, it caters to mankind’s financial needs. The growth in Islamic finance demonstrates that mankind’s needs are more than financial.  To be truly customer centric all banks must understand these needs and adapt their operating models to suit their customer – no matter the religious affiliation of the bank or the customer.

Author: Shuyao Kong

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