The Future of Islamic Finance in the Global Economy
Islamic banks do not have a long history. The first bank started its operations in 1963 in Egypt. The main centres worldwide are in Iran, Saudi Arabia, Malaysia, Europe, Great Britain and Switzerland. Islamic banking and religion are correlated (shock!). However preposterous it may sound, it is a bank that does not charge you interest.
Consider that you want to start a manufacturing plant. A conventional bank will provide you with the money and charge interest on it: the concept of ‘multiplying’ money. On the contrary, Islamic banks are forbidden from charging interest. Instead, they will offer to be partners in your business and share profits and losses. This strengthens the economy by reducing the burden from the promoter’s shoulders and sharing it with financial institutions. In fact, their peculiar business model helped Islamic banks largely avert the adverse impact of the 2008 crisis. In particular, it was investment portfolios that were smaller in size, partially deleveraged, and adherence to Shariah principles which prevented Islamic banks from putting money in the kind of instruments that affected their conventional competitors and helped limit the impact of the crisis on them.
A characteristic feature of Islamic banking is the role of the bank. The basic mission is, surprisingly, not to generate profit for the bank or multiply the income for customers but to support local development and entrepreneurship. Everything in the Islamic banking system is made according to Shariah law. The things which are allowed in Islam are called ‘halal’ and the things which are forbidden are ‘haram’. So, the bank is not able to invest any of their money in the products or services forbidden in Islam. For example, in production or trade of alcohol, nicotine, drugs, or in sectors related to pornography, the defence sector, casino, and nightclubs. So, a customer of the Islamic bank can be well assured that his money would not be invested in anything inconsistent with Islam. The rule of ‘Money makes Money’ does not exist in Islam because money has no value in itself and cannot be multiplied just by rotating it.
There are two key aspects of Islamic finance. First, it has the advantage of being asset-backed which makes it inherently less risky than conventional finance. Second, a prevalent risk-reward sharing arrangement exists. Apart from this, there are some rules which guide such institutions. For example, retaining surplus profit is unfair in this system, it is strictly related to usury - ‘Reba’. Reba is one of the most important rules in the Islamic banking system. The second rule is gharar, which is related to risky or hazardous sales and the fact that gambling is prohibited in the Islamic world. For instance, you cannot sell the goods or services which are not yet produced. It can be traded upon only once it comes into existence. Moreover, nothing can be sold unless you acquire it. This essentially eliminates the risk of not possessing the goods. All products offered in Islamic banks have to be observed and accepted by the Council for Islamic Banks (by their lawyers and clergy). The most popular transaction in Islamic banking is ‘Murabaha’- a cost-plus financing structure where the client and the bank agree on the markup or “cost-plus” price for the item being sold. In essence, the bank purchases the item on behalf of the client and retains its ownership rights until the client pays back the amount (which is the cost-plus profit on the item) to the bank.
Islamic finance is growing rapidly but remains concentrated on a few jurisdictions. Its strong growth reflects a tremendous interest on the part of the Muslim population who have previously been underserved by the banking industry. For the past two decades, many Islamic banks have witnessed double-digit growth rates, surpassing their conventional peers. The industry’s total worth, across its three main sectors (banking, capital markets, and Takaful), was estimated to be $2.05 trillion in 2017. At a mere glance, all seems well for the Islamic banking industry. However, several potential markets with a considerable quantum of the Muslim population remain largely unbreached, including India and the Commonwealth of Independent States countries, made up of the former Soviet republics.
Islamic finance holds great promise for promoting macroeconomic and financial stability but to fulfil these promises three prerequisites really need to be met: first, a further deepening of the standard and codes for the application of Islamic finance and their consistent application globally. Secondly, it is essential for Shariah-compliant money markets to be developed. This will allow Islamic banks to manage their liquidity in a more effective way and free up resources for them to invest in growth-enhancing projects. The Islamic financial market is now facing increased competition due to the establishment of other Islamic financial institutions and conventional banks who have established Islamic subsidiaries or windows. Islamic banks also suffer from an overhang of bad loans, and they lag behind their Western counterparts in technology and expertise. The religious dimension adds an extra layer of problems with respect to introducing new products that need to cater to both the Islamic law and the needs of the general public. Lastly, there is a vital need for institutional reforms in the areas of tax policy and capital markets development, which will be needed for Islamic finance to fulfil its promise.
Critics consider Islamic banking similar to having a boiled ice cream-cream, it cannot exist in real life without trickling down our confidence. For instance, if you need a loan for purchasing a house, Islamic Banks will not charge you interest on this money. Instead, they will buy the house for you and sell it back to you at a higher price, demanding this amount from you in, say, 15 years, of course, interest-free. This is a backdoor policy of interest collection. In other words, it is interest-collection in all but name.
When it comes to India, which will soon be the home to most Muslims in the world, there has been a long-standing debate on Islamic banking. Currently, the rules don’t allow it. Critics say it’s a bad idea because it goes against India’s secular fabric. Is India ready for it? Will it open a Pandora’s Box? Should we look at it through a religious prism? The opinions are sharply divided. The Reserve Bank of India Act, 1934 and the Banking Regulations Act, 1949 both prohibit the setting up of an Islamic banking system. Only an act of Parliament can set up one.
In recent years, growth has sparked optimism about the future of Islamic finance. However, as competition intensifies, Islamic financial banks are still left with work to do. Most Islamic banks need to function more efficiently along the entire value chain, regardless of whether the strategy is aimed at entering a niche market, at competing with traditional banks or at both. They need to scrutinise strategic choices and focus on operational basics to grab unused market opportunities and overcome the changing dynamics of the industry. In all, Islamic finance is still at a nascent stage which is yet to meet its full potential.
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