Allah's Way to Finance (Part 2, Banking)

For those of you who have been impatiently waiting (just joking!), here is the second part on islamic finance!

This time I will be more specific and focus on banking, as a matter of fact banks, their regulations and structures, have a leading role in any financial system.

An overview of the history of islamic Banking:

An early market economy and an early form of mercantilism were developed between the 8th-12th centuries, which some refer to as "Islamic capitalism". The monetary economy of the period was based on the widely circulated currency the dinar, and it tied together regions that were previously economically independent.

A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, partnership (mufawada) such as limited partnerships (mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal), cheques, promissory notes, trusts (Waqf), transactional accounts, loaning, ledgers and assignments. Organizational enterprises independent of the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.

Many historians and economists have tried to understand why islamic finance came to an abrupt stop in Medieval times after such a period of flourishment. The most accredited hypothesis seems to point to islamic inheritance laws as the cause. In fact independent organizational enterprises never grew to a more financially and economically developed organization because muslim law prescribes that at the death of an individual at least two thirds of his wealth and assets should be equally distributed between all his relatives. Therefore also one's share in an independent organization and enterprise at one's death had to be distributed, bringing the amount of partners, in the time lapse of 2 generations, to an amount that was beyond the organizational abilities of the time.

Moreover, the prohibition of "Riba" has determined the refusal of the muslim world to follow the path that has led the western world, from the XIII century until now, to develop such a complex and lucrative financial industry. 

"Riba": The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial."

Modern Islamic banking

Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950. They have all recognised the need for commercial banks and their perceived "necessary evil," have proposed a banking system based on the concept of Mudarabha - profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first of these works is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. 

The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the results of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born from this process.

The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967, by which time there were nine such banks in country.

Islamic Banking is growing at a rate of 15% per year with signs of consistent future growth. Islamic banks have more than 600 institutions spread over 65 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 500 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed according to The Economist. This represents approximately 1% of total world estimated assets as of 2009. According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010. In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, currently, is still in business in Egypt. In 1975, the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services.

Islamic Banking today:

Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital. Because Islam forbids simply lending out money at interest (riba), Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to avoid this problem. The basic technique to avoid the prohibition is the sharing of profit and loss, via terms such as profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar).

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. This meaning that the banks take the risk to actually own the object until the final buyer, who is a client of the bank, does not have the money to buy it. However, the bank's 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 Murabahah. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. 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 innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments, until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.

All these different ways of managing money, as one can see, tend to guarantee a healthy limitations on loans emitted by a bank, as the bank either risks to share the losses or risks to get paid back in a non predefined amount of time. 

There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

... Is this the third way? Even the Vatican has argued that "the principles of Islamic finance may represent a possible cure for ailing markets."

Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing.

In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. 

Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank (the founder of which, Muhammad Yunus, in 2006, was awarded with the Nobel Peace prize) use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).