Islamic Finance : The Alternative to the Conventional System?

From humble beginnings in the 1990’s, Islamic finance has become a trillion-dollar industry. The market consensus is that Islamic finance has a bright future, owing to favorable demographics and rising incomes in Muslim communities. Despite scepticism regarding accommodation between Islamic and global finance, leading banks are buying Islamic bonds and forming subsidiaries specifically to conduct Islamic finance. Special laws have been enacted in non-Muslim financial centers (like London, Tokyo, Zurich, Sydney, and Hong Kong) to facilitate the operation of Islamic banks and associated financial institutions, as well as amending laws to open up to non-resident Islamic investors.

An Islamic bank is distinguishable from its conventional counterpart by some basic principles :

1.       Riba (interest)-free Transactions

While riba literally means “increase”, it generally refers to when the borrower compensates the lender an interest payment for the use of capital over a period of time. Riba includes usury and commercial interest.

Interestingly, the best economic rationale for a zero-interest-rate system is provided in John Maynard Keynes’s General Theory :

“Provisions against usury are amongst the most ancient economic practices of which we have record….In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.”

 Keynes suggested that only a very low or zero interest rate could ensure continuous full employment and distributional equity. Keynes’s endorsement of such a policy does not necessarily make it right, but his analysis does suggest that it should be regarded as a serious proposition.

       2.   Risk Sharing

All banking is debt, equity, trade or lease-based. Islamic banking also includes all these components except debt. The concept of risk-sharing makes transactions more equitable, e.g. an Islamic bank intermediates a purchase and assumes some risk through equitable risk distribution. Also, a silent partner receives no more profit than is proportionate to their investment, while the working partners may enjoy more profit, reflecting an emphasis for reward on work than merely possessing  capital.

Importantly, although interest is prohibited under Islamic finance, profit is not; the latter is derived from various arrangements that combine finance and enterprise. In essence, this is a profit-sharing and risk-sharing system that is based entirely on equity finance.

Islamic finance thus contrasts with the current dominant system based on interest-bearing debt, in which risks are theoretically transferred to debt holders, but in practice are socialized during crises. Other things being equal, most economists will agree that debt finance leads to greater instability than equity finance.

       3.   Asset and Service Assurance

The teachings of Islam in finance forbids treating money as a commodity, hence its transactions are backed by an asset or service. This ensures real assets and inventories are created, rather than pyramidial money-lending schemes where money simply creates money and volatility continues unchecked.

        4.  Contractual Certainty

The uncertainty of fulfilling contractual responsibility is unlawful according to the Syariah (Islamic Sacred Law), which is present in conventional insurance, futures and options. However, uncertainty in commercial contracts is acceptable as the risks are underpinned by assets (property, factory, equipment) and / or services (labor, expertise).

Still, the similarities between Islamic and conventional banks outnumber their dissimilarities, since the basic principles of finance remain the same. Companies still raise cash in only one of two ways, by issuing equity or stocks through the sales of shares in a company, and by raising bonds, which obligate the company to repay the holder some fixed income at some given maturity. Like conventional banking, Islamic banking allows the profit-motive but it seeks to foster the spirit of transparency and corporate responsibility, and ultimately seeks to promote shareholder value.

The impact from the equity-based Islamic banking versus the interest-based conventional banking can be seen at three levels :

Profit Impact : Check the performance of bonds, small stocks, large stocks and treasury bills in the US for the last 50 years. Equity is not only historically more profitable but in the long-term safer as well. Even risk-adjusted returns are higher for equity than for debt.

Economic Impact : The primary objective for most commercial banks is to increase profits by extending loans to creditworthy individuals at the highest possible rate while undertaking the least amount of risk. But this objective focuses the borrower and lender on the repayment, not profit. Typically, the lender has little interest in the borrower’s business, only in his ability to repay. Equity focuses on profit and loss since the lender (principal) has an equity share in the business. Knowing that there is a possibility of loss, the lender makes effort to ensure the borrower (agent) succeeds.

In a debt transaction, the borrower loses everything if the business fails, and is still left to repay the loan. While in an equity transaction, the agent loses time and effort but has nothing to repay. Furthermore, debt inhibits innovation by putting undue stress into repayment schedules while equity promotes innovation by focusing on the business itself. Small, growing businesses need to invest in time and money to innovate before becoming profitable, a task made difficult by even the most lenient repayment schedule. In an equity transaction, the principal and the agent work in concord to make more money. Debt tends to centralize the capital into larger corporations that are more able to match with stable cash flows with repayment schedules. Equity, on the other hand, favors smaller companies that provide a greater profit potential. Speculative debt-based borrowing, including borrowing to finance equity purchases, triggered almost every major financial disaster in the modern capital market era. Debt also affects the collective consciousness of the business community, creating a demeaning, disempowered “borrower culture” rather than a vibrant and productive “investment culture”.

Social Impact : Regarding wine and gambling, “In them is great sin, and some profit for men; but the sin is greater than the profit.” (Quran 2:219) Like other evils, interest has its short-term advantages but comes at a price of a broader social impact.

The IMF and World Bank have aggressively disbursed loans for decades in the name of economic rehabilitation and poverty alleviation. Now their recipients are deeper in debt due to compounding interest which have now ballooned the principal amount. In the commercial sector, interest-based lending centralizes capital into fewer hands. The common man’s lower disposable income requires him to continuously borrow capital for consumption purposes, like financing a car, house or education. They have become further entrenched in debt for generations to come.

 

The global trend points to equity as being the investment of choice. Debt continues to be a corporate mainstay as a cheaper form of financing, particularly among large stable borrowers who are able to match expected cash flows with future debt repayments. But to choose debt over equity has severe implications, not just for the business itself but society as a whole.

But, whether any particular system is efficient in avoiding moral hazard is a matter of practice, rather than of theory. If the universal ethical values in Islamic finance – grounded in the religious Syariah law – can further deter moral hazard and the abuse of fiduciary duties by financial institutions, Islamic finance could prove to be a serious alternative to current models of derivative finance.

Moreover, the basic tenets of Islamic finance force us to re-think the ethical basis of modern monetary arrangements, which have evolved into a global reserve-currency system founded on fiat money. In the past, gold had been the anchor of monetary stability and financial discipline, even if it was deflationary.

"The test of any alternative financial system depends ultimately on whether it is – or can be – more efficient, ethical, stable and adaptable than the prevailing system. For now, there is no Islamic global reserve currency and no lender of last resort. But the Islamic world is the custodian of huge natural resources that back its trading and financial activities."

As the Islamic world grows in stature and influence, Islamic finance will become a formidable competitor to the current conventional financial system. The world would have much to gain if an alternative system can compete fairly and constructively to meet sophisticated needs for different types of finance.