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Sunday, 20 January 2008

Shari'a Banking and the Financial Mainstream: An Outlook on Compatibility

By Nicholas Van Zandt
January 18, 2008 (AC)

Within the Western banking system, there has been a rise in the use of Islamic banking. The industry of banking and finance in the Arab and Muslim world has been doing it for years, but now there are shifts towards Shari´a-compliant banking from within North America and Europe. Some major banks like Citigroup, HSBC, Lloyds TSB and Deutsche Bank have already established departments devoted to this system. With all of the criticism that has surrounded this new trend, it is important to ask what is to gain and what is to lose with a full integration of Shari´a banking in the mainstream financial industry. While there are several complexities to the system of Islamic banking, or Shari´a compliant banking, it would probably be easiest to describe it by the prohibition of riba (interest) as it is considered usury. Instead of the standardized system of banking known to the West where interest is used as a way for money to make money onto itself, Islamic banking was established in a way to entirely avoid that method. The use of interest is seen as unethical and predatory. The Koran makes several references to the effect that the engagement in usury is something that only Satan has facilitated and should one engage in usury in order to gain from one´s wealth that they shall not gain anything from God. In a historical perspective, as stated through Koranic commentary, the practice of usury was one in which the pagan Meccans did so that they could acquire wealth in order to defeat the Muslims at the Battle of Uhud in 625. As a replacement to interest, it then becomes a system of reinvestment of assets—granted that the assets to be reinvested in are not haram (prohibited by Shari´a law). This would include businesses that engage in alcohol, pork, pornography or gambling. As the banking industry across the West jumps into this growing market, there is no doubt a great deal of concern as the executives and shareholders of these haram industries watch the gradual transition into Islamic banking. The principal reasoning for the Western banking industry´s desire to expand in Shari´a banking is not by means of appeasing ideological or moral appeals by the Muslim community, as some have claimed, but rather by the recognition of an undeniable and quickly growing financial market that until recently has been limited to countries within the Muslim world. At the start of it, Malaysia, for example, began to see their economic interests being diverted to China so in 2001, the government decided to build upon its Islamic financial sector in order to draw in trade and investment from the Middle East. After seeing the estimated $1.6 trillion in oil wealth floating around the Gulf, Malaysia, and soon after Britain, Japan, Europe, and the United States, found that by providing sukuk (Islamic bonds), they could break into the market and draw in the petrodollar investments. In order to draw in further investment, additional banking serviced were employed. As it was recognized that with over 1.5 billion Muslims in the world—granted not all strictly adhere to Shari´a finance laws—that it was time to open up the banking industry to those that did before the Gulf states cornered the market. Many Muslims were banking in conventional banking methods and when given the option to convert their savings and investments into a Shari´a-compliant system, they did. The system in itself has been found to be attractive to non-Muslims as well who in some Islamic banks make up as much as 50 percent of the depositors and borrowers. In the British perspective, it was soon found by many in the mainstream banking establishment that there are approximately 2 million Muslims and 100,000 Muslim businesses in the country and based on research conducted by Lloyds TSB, that three-quarters of them wanted to engage in banking according to their faith. So instead of watching this community send its money overseas to Islamic banks in the Gulf or engage in less than conventional forms of money management, these banks found that there was a service to provide. That, among the services conducted, there are personal savings accounts, home loans, and business loans that are all in compliance with Shari´a law. Every bank who has gone into Islamic banking employs an advisory board of Shari´a scholars. This board will supervise every step of the process of a transaction in order to ensure that it is within Shari´a compliance. For personal savings accounts, the depositor will not receive interest but rather shall receive returns from the bank´s investment. This runs along the principles of mudaraba, which is an equity partnership financing instead of a debt financing scheme. The contract between the bank and the depositor works by the risks and rewards being shared. Profits will be shared as agreed upon but in the case of loss, the investor will bear the loss of any capital. This scenario allows for the bank to take the deposit and redirect it into a halal (permissible by Shari´a) investment. The bank will then provide the depositor an agreed upon percentage of returns from that investment. Unlike with the payment of interest, which generally is a fixed percentage, the profit share can increase in Shari´a banking should the investment pay off at a greater rate. Typically, the percentage of profit sharing is lower than the standard interest rate and—in the United Kingdom—the payout of shared profit to the depositor is taxed as if it were a return on a standardized loan. Islamic home finance is of course dealt with in a different fashion as well. Instead of a mortgage loan paid over time with interest, the bank will purchase the property for the borrower and then rent it to them at an agreed upon payment scheme. The bank typically requires a minimum of 10 percent on the down payment and then allows the borrower to pay off the rest through rental payments. Over a period of up to 25 years, each rental payment acts as a purchase of shares over the property. In order for this to work to the lender´s advantage, the bank will typically buy and resell the property after a price increase. Many have advocated for this system over the conventional interest-based mortgage loaning system by stating that it provides security from fluctuating interest rates that could cause problems in repayment. The banks that offer this loan all state that the house will be repossessed should payments not be made. Within the interest-based mortgage system, there is a relative level of flexibility. Borrowers are able to refinance their mortgage or even take out second mortgages before they are forced into foreclosure. It has been argued that a more expansive Islamic banking system would have provided for an environment where crises like the sub-prime mortgage problem that afflicted the United States might not have happened. This crisis, which has been an ongoing financial problem, has caused a sharp rise in home foreclosures. It started in the Fall of 2006 and became a global financial crisis by July 2007. Many factors created the crisis, but the most immediate cause was a rising interest rate which caused people with adjustable rate mortgages to see significant increases in their mortgage payments. This left many home owners unable or unwilling to meet their financial commitments and lenders without a means to recover their losses.It has been stated that had the banking system been one under Shari´a compliance, this crisis would have never occurred. There would have been no system of interest, thus there would be nothing to raise the mortgage payment rates. At least in this aspect, Islamic banking would have been advantageous. The entire problem, however, would not be under control. In the United States, the Federal Reserve is the primary tool to manage inflation rates. Interest rates are raised to slow the level of economic growth so that inflation rates can decrease. Interest rates were raised which caused the sub-prime mortgage crisis but inflation rates were mitigated. Iran, for example, claims to have a 100 percent Islamic banking system. There is no interest based system to curb inflation that is as broad as the Federal Reserve. For this reason Iran holds a 16 percent inflation rate versus the 4.5 percent of the United States or the 2.3 percent of the United Kingdom. The area of entrepreneurship thus becomes an issue when looking at the principles of business investment loans by way of Shari´a banking. This process also goes along with the risk and profit sharing principle of mudaraba. As a means of avoiding the use of interest in loans, financiers will share with the borrowers risks as well as the profits. Instead of the borrower being the sole owner of whatever business they seek to start with a business loan, the financier then becomes a de facto co-owner, earning a share of the profits. Should the business fail, it is the investor that loses everything. If the business succeeds, the investors will gain far more than if they were collecting simple interest-based repayment. In principle, the process is the same as venture capitalism. The financier will engage in what is known to them as being high risk venture but only when the reward is worth it.
venture capitalist who is successful in staying in business, however, will not invest in every idea that comes to them; they will wait for a scenario where the risk is at a manageable level considering the level of profit. For many venture capitalists, they will likely hear hundreds, if not thousands, of proposals for investment every year and pick only but a handful. Experienced business owners with a proven track record of success are typically considered a safe investment whereas borrowers inexperienced in business administration aiming at a small-business ventures, will be considered higher-risk, lower-profit and will likely not be considered. In the interest-based banking system, the bank is not required to take such risks and these higher risk, small business ventures will have a greater chance of receiving the capital they need to start their business. When placed on the individual level, the small business owner still has the option to choose the loan available to them, Shari´a compliant or not. When placed on the macro scale, in a society like Iran where business loans that are interest based are largely unavailable, it worsens the plight of the entrepreneur. Starting a food shop in a high traffic area might be considered a safe investment and would likely have no problem. Riskier businesses proposals that are attempting to break into, or create a new market, might not be given a chance. This would then have an adverse affect on the entirety of the economic system of that country.It is through this concept that most directly impacts the small business start ups. While the conventional financial markets operate in the simple process of lending money after a credit history search and ensuring the borrower is able to repay the loan, the Islamic banking process requires a great deal more engagement with the borrowers intentions for investment on the part of the lender. Reliability and security are issues of significant concern when the bank considered who to provide their loan to. Lloyds TSB has provided the first Islamic Business and Corporate account at all of its 2,000 branches designed to cater to the 100,000 existing Muslim businesses in Britain and for new entrepreneurs. Out of all of these businesses, the bank recognized that there was a substantial market waiting to be tapped. This is the first Shari´a business banking account in mainstream banking today. Prior to its existence, Muslim business owners went to the regular accounts. Now that it exists it has become widely popular. It is a process in which the mainstream bank itself made Islamic banking popular—and seen as necessary—rather than the Muslim community.The question is, has the West benefited by expanding its commercial banking industry into the Muslim world to share in the wealth of oil profits or is the Muslim world benefiting more by introducing Islamic banking to the financial mainstream of the West? Is it a win-win scenario or are there serious drawbacks to come as this process evolves? Perhaps one result of Western interest in Islamic banking is that it provides a greater sense of legitimacy to the practice and then gives Middle Eastern banking systems the incentive to go ahead and provide full implementation. Only up until 2006, for example, the National Commercial Bank of Saudi Arabia, overhauled its entire retail business to make it Shari´a-compliant and only until this year did Tunisia and Morocco have Islamic banks. By the West making the decision to move into Islamic banking, it has given the Middle East the option to develop its Islamic banking system as well; an option that may not have been viable before the banking giants made the transition.It has been estimated that over $800 billion has been transferred out of the United States and Europe into other regions where Islamic banking is more prevalent—specifically within the Muslim world. As Islam has grown increasingly conservative over the past few years, matched with a greater wealth being invested into the Muslim world, there has been a reinforcing effect on both religion and economics within the region. It is in this economic revival—due to religious reasoning for halal banking—that an Islamic revival has been made possible. Now that the Western banking sector has become interested in getting involved in Islamic banking, it has given this revival a greater sense of legitimacy.The concluding question is with regard to how—if at all—Islamic banking can be a detrimental to economic development in the long run. The simple answer would be to state that the larger banks like HSBC and Citigroup, who are actively engaged in Shari´a banking, have done their cost/benefit analysis and found that the untapped market of Muslim investors who wish to adhere by their religious code of finance is worth the risks that go along with the system. There has been a great deal of debate on this matter and some have advocated that the introduction of Islamic banking is part of a larger ploy to Islamicize the West. Providing ammunition to these types of arguments are groups like Hizb ut-Tahrir, an organization in Britain that has publicly advocated for the totality of the West to be run by Shari´a law, that have in fact advocated on their website that events like the financial crisis in America under would have never happened under an Islamic system and that capitalism is the seed of the devil. In a brief analysis, however, it is not necessarily the society that is entirely at risk. Investors engaged in Shari´a banking are no longer protected and can incur greater loss but stand to gain a great deal more. Borrowers, in effect, may very well find it more challenging to acquire the capital they need if their investment plan is less than solid. It is a trade-off for both sides, as directed by the original principles of the Quran. For Muslims who wish to conduct their finance adhering to Islam with a less than attractive investment proposal, they will likely find it hard to launch their business whereas a conventional loan might be their saving grace. From the bank´s point of view, on the other hand, an attractive investment plan, one which looks to be of low-risk and high profit, could provide a far better rate of return than if it were the standard interest based loan. Investors in this case recognize a profitable opportunity and the fact that interest is not involved makes it no less capitalistic. The concern is not as much with the processes of Islamic banking but rather by the surge of interest by Western banks. It is highly unlikely that Shari´a banking will replace mainstream banking due to the requirement for a total economic reformation, but with every action brings a reaction within the financial industry. When the largest banks begin to implement Islamic banking practices at the international level, country based banking systems in the Muslim world will alter their systems to a greater degree towards Shari´a banking. In time, the problem this could present is a conflict in commercial trade and banking when mainstream banking cannot complete transactions with countries in the Middle East because they are not Shari´a compliant. As stated, the West will not and cannot make a full transition into the Islamic banking system due to the nature of change needed, but as their smaller scale integration provides legitimacy to the practice, thus bringing a revival in Islamic finance, it could provide for complicated trade and commercial dealings down the road.

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