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."
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 today:
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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).
