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Islamic banking: Panacea for global financial crisis (II)
(Continued from last week)
This is a contract whereby a person (principal) asks another party to act on his behalf (as his agent) for a specific task. The person who takes on the task is an agent who will be paid a fee for his services.
A customer asks a bank to pay someone under certain terms. The bank is, therefore, the agent for carrying out the financial transaction and the bank will be paid a fee for its services.
Qard (lnterest-free loan)
Under this arrangement, a loan is given for a fixed period on a goodwill basis and the borrower is only required to repay the amount borrowed. However, the borrower may, if he so wishes, pay an extra amount (without promising it) as a way to thank the lender.
Islamic Banking: A credible alternative
My message may have particular resonance in the West after the crumbling of the U.S. mortgage market left banks holding hundreds of billions of dollars of nearly worthless credit instruments tied to home loans by a web of complex structures. There are many analyses of financial crises and a long list of their causes, but surprisingly, there are two wldely common denominators to all of them: debt contracts that are by nature unrelated to the income flows that the underlying productive and capital assets of these entities can generate; and sheer greed on the part of banking professionals and to a small extent, the customers.
While the financial innovations of the last decade have led to mobilisation of financial resources in astronomical proportions, they have also led to the equally impressive growth of debt contracts and instruments. Comparing the huge corporate and sovereign debts, (including consumer debt in industrial countries) to the production and capital base of the global economy reveals that an inverted pyramid of huge debt piled up on a narrow production base that is supposed to generate the income flows that are meant to service these debts. In other words, this growth in debt has nearly severed the relationship between finance and production.
An Islamic financial system has the potential to redress this serious threat to global financial stability because of its fundamental operating principle of a close link between financial and productive flows and because of its basic but core requirement of risk sharing.
Let me use a somewhat lengthy illustration to drive home my point. The main source of profit for the banks is from the interest they charge and from other ancillary services. The bank relies on their client to pay back the borrowed money with interest. As a precautionary measure, the bank obtains collateral against the loan. The primary interest of the bank is to make a profit from the interest and not from reclaiming collateral.
The borrower believes that by leveraging the commodity/collateral, he will make more money than interest paid to the bank. For example: If you buy a Nl,000,000 house with a 20 per cent downpayment, and sell the house after two years for Nl,l00,000 your profit is 50 per cent.
That is, on your initial downpayment of N200, 000. The interest you paid on the borrowed money was the rent you would have paid if you had lived elsewhere.
The transaction occurs on mutual confidence - the bank being confident of his client’s ability to make interest and principal payments on regular basis. The client being confident of making more money o.n his product against which he has borrowed money.
The payment of interest from one party to another is unrelated to the value of the house. You may put down 10 per cent (instead of 20 per cent) in order to make more profit and the bank will be willing to lend you more in the hope of receiving more interest. These types of transactions ultimately create fear, greed and corruption.
In Islamic financing, the purchaser of the house and the “lender” both become partners in the equity of the house in proportion to their contributions say, 20 per cent and 80 per cent as in the above example. Here the “Islamic banker” either rents him the house till the price is paid off or sells him the house outright with an agreed-upon long term payment contract.
Can you see the difference in both systems? In the present banking system, one party gains at the expense of the other without due regard to the price paid for the home. In Islamic finance, the arrangement is based on equity participation, called Murabaha. The focus in this type of financing is the individual, the product and the society. Islam has no objection to wealth creation; however this must be based on partnership and fairness. The Islamic bank providing the equity to finance the house will share in the loss as well as in the profit as earlier agreed upon when the product is sold. The whole society ultimately benefits from such transactions.
In the case of businesses that require capital or that need venture capital, the Islamic system providing finances is called Mudarabha. Here, the bank or the individual provides the financing and the person receiving the fund provides his entrepreneurial skills. Profit or loss from the business is shared on an agreed basis.
Arrangements regarding leasing are called Ijara and could apply to car leasing and/or home mortgage. This system is more or less same as the Western banking system and in the case of car lease, the option to buy the leased car is called Ijara Wa Iqtiana. The recent development of “Bonds” transaction, called Suku-based on equity participation-is gaining popularity in some Middle East countries. As we can see, the process requires Socially Responsible Investment (SRI) in worthy causes and especially those that would benefit the society.
The major premise of the present “free market” banking system is to loan money on interest to any individual able to repay principal and interest. This is irrespective of whether he makes profit or loss and irrespective of whether society is a beneficiary or not. Profit is the ultimate motive and the individual is the focus rather than goods or the society. We do not have to look far to see the results of such actions. The debacle of major institutions like Merrill Lynch, Lehman Brothers, Fannie Mae, Freddie Mac, Bear Steams, WaMu, AIG, Northern Rock.......and the other ‘fallen soldiers’ are well-known. Countries were not spared either; the US, UK, Iceland, Greece and the list goes on. And Africa was no exception. Even the Nigerian financial sector continues to record its casualties as we speak.
Islamic banks have not been affected by the mortgage/credit crisis that afflicted the international financial markets and are largely immune against such crisis, thanks to inherent factors within the tenets of Islamic banking. The most important of these factors are the prohibition of debt trading and predatory lending, taking precautions against money laundering, as well as the official and professional restraints upon which banks are based such as caution against embarking upon projects that entail financial difficulties and risks. Islamic banking is also distinguished by a commitment to uphold integrity, restrict investments in certain prohibited industries involving alcohol, pork, gambling et cetera and its obvious scorn for risky projects.
Even in a worst-case scenario, only the profits of Islamic banks could be affected in severe downturns, and not the capital which is procted.
At the product level, Islamic banks have several alternatives to conventional banking instruments, including but not limited to, Ijarah Bitamlik (a renting contract that ends in owncrship), Murabaha, Mudharabah and Musyarakah (similar to private equity/venture capital), et cetera which demonstrate that Islamic banking is a sound and systematic alternative banking system that others could emulate. I would argue that these basic instruments can be spanned into a wide, varied, and variegated menu of financial instruments. Based on the spanning theory of the 1980s which asserts that a basic financial instrument can be spanned into an infinite number of instruments, Islamic banking may consider engaging financial experts who, under very strict risk management, and Shariah laws, can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of various investors on a global scale.
Mrs Bello is of the ING Investment Management, Atlanta Georgia, United States of America.