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 By Malika Akhatova

       The recurring financial and banking crises in recent decades have stimulated intense discussion and scholarly inquiries not only in the root causes of the crises but also in mechanisms to avert similar crises in the future.   In addressing these inquiries, Muslim economists and scholars are quick in pinpointing to the inherent weakness and instability of the conventional financial system and in suggesting the Islamic banking system as a solution.  Indeed, some even argue that the recent Global Financial crisis, which has its root in the banking system, could have been avoided if the principles of Islamic banking and finance are adhered to.   With the rapid progress of Islamic banking even during periods of financial hardships, the call for Islamic banking as an alternative banking system seems to receive increasing attention.   Still, the crux of the issue is: Is Islamic banking system a viable alternative?

      Like the conventional banks, Islamic banks perform a function of intermediating funds from a surplus unit to a deficit unit of an economy.  However, the Islamic bank operations are based on principles distinct from the interest-based banks.  In Islamic banks, the practice of charging interest rates of any form in the process of intermediation is strictly prohibited.  This conforms to the teaching of Islam which prohibits interest rate, the intensity of which is reflected by the declaration of war by Allah swt on those who are involved with interest rate – based transactions.  In place of the interest rate, the Islamic bank transactions are tied in a fundamental way to tangible assets or the real sector either in the forms of mark-up pricing, leasing or partnerships.  Apart from the principle of interest-free transactions, it is required that Islamic banks be involved in only activities permissible by Islam.  Thus, activities relating to alcoholic beverages, gambling and the like are totally absent in the financing of Islamic banks.  Adding to this, the Islamic banking takes the social welfare to be of the utmost concern and above the individual interest.

      On the basis of these principles, the Islamic banking system is viewed to be relatively stable and less susceptible to adverse shocks as compared to the conventional banking system.  Interest rates are speculative in nature, which is well reflected even in the early and classic writing of Keynes.  According to Keynes, interest rates are a basis of speculative motive in economic agents’ monetary holdings.  Minsky further advances a hypothesis of financial instability inherent in the present financial system based on interest rates.  Indeed, abundance of evidence suggesting the vulnerability of an economy or a firm relying on interest rate-based debt instruments can be cited.  The Islamic banking system eliminates the interest rates from the system and strengthens the tie between its operations and the real sector.  Hence, theoretically, the Islamic banking system should bring stability to the financial system in general and to the banking system in specific.

      While it is acknowledged in theory that the Islamic banking system is relatively more stable, whether it is true in practices remains unclear.  A glance through the literature in recent years will likely suggest mixed supports for the relative stability of Islamic banks.  Principally, there are at least three pieces of evidence that tend to cast doubt on the ability of Islamic banks to contribute to financial and economic stability.

     First, it has been raised in scholarly discussion and popular debate that the operations of Islamic banks simply mimic those of the conventional banks particularly in a country with a dual-banking system (i.e. interest-based banks and Islamic banks coexist and operate side by side).  This view is based on the observation that Islamic financing is predominantly based on mark-up pricing, known as murabahah financing.  The financing based on profit-and-loss sharing, purported to be the core element of Islamic financing and be tied directly to the real sector, is however minimal.  Being in direct competition with and small relative to conventional banks, Islamic banks are likely to align their mark-up pricing to interest rates charged by conventional banks.  The convergence of mark-up pricing and interest rate seems to be apparent in light of the well-noted business displacement risk or rate of return risk faced by Islamic banks in a dual banking system.  Hence, despite the absence of Interest rates in the Islamic banking practices, Islamic banks in a dual banking system are still subject to variations in the interest rates.

      Second, while it is noted rightfully that Islamic banks have better asset quality, are better capitalized, and have higher intermediation ratios as compared to interest-based banks, Islamic banks tend to incur higher intermediation costs.  This means that in channelling a given amount of funds from the surplus unit to the deficit unit, the costs incurred by Islamic banks are higher as compared to conventional banks.  Adding to this, some have advanced evidence that there is no difference between the two banking systems in their distance to risk.  This evidence tends to reaffirm the similarity between Islamic banks and conventional banks as pointed above.  In essence, the view that Islamic banks contribute to financial stability has to some extent been undermined.  

      Third, despite evidence noting the resiliency of Islamic banks to the recent Global financial crisis, the Islamic banks are not totally immune from the real consequences of the crisis.  In a recent work by the IMF evaluating the performance of Islamic and conventional banks during the sub-prime crisis, the performance of Islamic banks are noted to be less affected by the financial crisis.  However, the financial crisis is not a sectorial crisis contained only within the financial sector.  It propagates and aggravates the real sector.  Indeed, the link between the financial and real sectors is well established in the literature.  In the same work, it has been documented that the performance of Islamic banks is more adversely affected after the financial crisis permeates into the real sector.  Based on this evidence, the Islamic banks may not be resilient to the adverse consequences of the financial crisis.   It can be further argued that the relative resiliency of Islamic banks may be due to the fact that they have not been tested.  Namely, they are not exposed in the same magnitudes, e.g. to international transactions, as the conventional banks are.

        On the basis of the foregoing discussion: Is Islamic banking system a viable alternative?  While there is no doubt that in theory the Islamic banking system is a viable alternative and, indeed, the only viable system, still much work is needed in practices to demonstrate the purported viability of the Islamic banking system.  More specifically, the main focus should be on narrowing the gap between theory and practices.  In addition, attention should also be given to cost minimization and to better risk management practices.  Unless and until these are done, there would be no affirmative answer to the question: Is Islamic banking system a viable alternative?

Source: http://www.inceif.org/research-bulletin/islamic-banking-system-viable-alternative/

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