Author links open overlay panel Feisal Khan

https://doi.org/10.1016/j.jebo.2010.09.015Get rights and content

Abstract

Islamic Banks hold well over US $700 billion in assets and are growing at over 15% p.a. Islamic Banking and Finance (IBF) involves wider ethical and moral issues than simply ‘interest-free’ transactions. Its advocates argue that these make it more economically efficient than conventional banking and promote greater economic equity and justice. To what extent, then, do actual Islamic Banking practices live up to the ideal, and how different are they from conventional banking? A preliminary investigation shows that, three decades after its introduction, there remain substantial divergences between IBF’s ideals and its practices, and much of IBF still remains functionally indistinguishable from conventional banking. This runs counter to claims by IBF advocates that it would rapidly differentiate itself from conventional banking. However, despite not providing an alternative to conventional banking and finance, IBF does strengthen a distinctly Islamic identity by providing the appropriate Islamic terminology for de facto conventional financial transactions.

Introduction

Commonly synonymous with ‘interest-free’ banking, Islamic Banking has become a growing force in global financial circles over the past three decades, with Islamic Banks found in over 70 countries worldwide (Warde, 2000, p. 1). In 2008 the value of the world’s “Islamic assets” was about US $700 billion (Economist, 2008) and in the 10 years preceding 2005, the growth rate of Islamic Banking assets had been ∼15% p.a. (Benaissa et al., 2005, p. 1). In 1999 Dow Jones created ‘Islamic Indexes’ to offer Sharī‘a-compliant investment portfolios to cash-flush pious Muslims. Several major Western banks, e.g., Citibank, ABN Amro, Bank of America, HSBC, Standard Chartered, and the Union Bank of Switzerland, either have Islamic Banking subsidiaries or offer Islamic financial products to their customers. Clearly Islamic Banking and Finance (IBF) has transformed itself from an obscure financial experiment to a major factor in global finance.

By some (optimistic) estimates, Islamic Banks could account for 50% of all savings in the Muslim world by 2010 (Zaher and Hassan, 2001, p. 167). There is no doubt that Islamic Banking assets are growing rapidly: in Bahrain, the Muslim world’s money center, between 1998 and 2005, Islamic Bank assets grew at 111% annually versus only a 6% average annual growth rate for conventional bank assets (Bahrain Monetary Agency, 2006). Unsurprisingly, the increase in crude oil prices in the last few years has increased the growth rate of Islamic Bank assets in the Middle East. Although still insignificant compared to conventional banking – the US’s 10 largest banks alone hold over US $4.3 trillion in assets (Mishkin, 2007, p. 262) – the growth of Islamic Banks demonstrates their importance to, and the growing financial clout of, the world’s billion-plus Muslims.

Contemporary IBF practices have not been without their critics (e.g., El Gamal, 2006, Kuran, 2004, Zaman, 2002; see Nomani, 2006 for an excellent summary of the debate) who often charge that IBF is merely a change of terminology (e.g., substituting ‘profit rate’ or ‘markup rate’ for ‘interest rate’) in what is essentially a standard debt contract; this gives a de jure distinction that is without a de facto difference.

Kuran, 2004, Kuran, 1993, in his voluminous work¹ on the subject, has argued that in its 20th century incarnation IBF arose in colonial India and was part of a broader movement designed to replace Western (i.e., Christian) leadership and structures in all areas of Muslim life; the aim of Islamic economics was not to provide a viable alternative to conventional economics but to strengthen a threatened Islamic identity. This is what I term the Kuran Thesis. Thus “Islamic economics was primarily a vehicle for reasserting the primacy of Islam and secondarily a vehicle for radical economic change” (Kuran, 2004, p. 5), and “Islamic economics” would help counter the danger that “Westernization was weakening the control that religion [Islam] exerted on personal worldviews and interpersonal relationships” (Kuran, 2004, p. 88).

The current secured, interest-based debt contract that is the basis of conventional banking evolved over centuries of operation in an asymmetric information environment. Therefore Islamic Banks, which also operate in an asymmetric information environment, would inevitably be “sticking so closely to the techniques of conventional banking” that they would be indistinguishable from the latter (Kuran, 1993, p. 311). Since in this case form does follow function, there should be nothing surprising in Islamic Banking being virtually indistinguishable from conventional banking once one accounts for the completely different, Classical Arabic, terminology favored by IBF advocates.

A counter to the Kuran Thesis was offered by Ahmad (1993, p. 59), a leading IBF advocate, who argued that the apparent similarities between conventional and Islamic Banking was simply a phase in the transition away from conventional banking as IBF’s clients had to be offered products they were immediately familiar with and that “evidence suggests that the significance of murabaha is declining in the overall financing operations of Islamic Banks.”² Ahmad (1993) was writing a decade-plus after the establishment of major Islamic Banks in many parts of the world (e.g., United Arab Emirates 1975, Saudi Arabia 1978, Pakistan 1981, and Iran and Malaysia 1983) but many still viewed IBF as being a relatively new financial innovation.

A decade after Ahmad, IBF’s advocates were still defending it from the same charges. Yousef (2004, pp. 63–64) while conceding the “predominance” of what he terms the “murabaha syndrome,” i.e., Islamic Banks closely mimicking conventional banking practices, holds that this does not provide valid grounds for arguing against IBF as an alternative to conventional finance since this criticism has been severely overplayed and merely serves as a convenient tool to unfairly condemn all of IBF outright.

So which is it? Is the Kuran Thesis a valid criticism of Islamic Banking and Finance, or is Ahmad correct in arguing that Islamic Banks are transitioning away from mimicking conventional banks? A legitimate question to ask, therefore, is what are the desired characteristics of an Islamic Banking system and do actual IBF practices differ from their desired characteristics to the extent that contemporary IBF is functionally indistinguishable from conventional banking? This paper will attempt to answer this question by looking at both the ideal and the actual form that IBF takes.

As I shall show, three decades after IBF was first introduced as a major financial innovation, the Kuran Thesis is still a valid characterization of IBF, current IBF practice conforms in almost all key respects to the conventional banking norm, and IBF practice does not resemble what its advocates say IBF is supposed to be. Thus three decades after IBF’s introduction, Ahmad’s (1993) defense of IBF is increasingly untenable and unconvincing, and even some of IBF’s staunchest advocates condemn how it is currently practiced. Consequently the “murabaha syndrome” is a valid charge to levy against IBF.

Section snippets

General principles

The Qur’ān, Islam’s Holy Book, and the hadīth³ lay down general guidelines for what are and are not Islamically permissible forms of economic activity. Over the centuries, the ūlamā (scholars of the various schools of Islamic law, fiqh) have concluded that, along with ribā (usually translated as

Profit and loss sharing via direct equity participation

At its most basic, there are only two ways to finance any commercial venture if one’s own resources are insufficient for the task: take on a partner or borrow money. The advocates of IBF contend that equity finance is preferable to interest-based debt finance because if the venture fails, the borrower does not bear the entire cost alone or lose the collateral. If the venture succeeds, the financial investor receives a larger return than a predetermined interest rate would allow (e.g., see 

Non-participatory financing as the norm

Given the extensive critique by IBF advocates of the debt-based/interest-based financing that constitutes the overwhelming majority of conventional finance, one would expect equity-participation/direct-investing to dominate Islamic financial transactions. Unsurprisingly, this is not the case. Murabāha and ijāra (leasing) operations predominate.

A typical murabāha banking transaction would be structured as follows. A firm in need of upgrading its existing machinery would approach an Islamic Bank

The prevalence of information asymmetry, moral hazard and adverse selection

There is a long-established consensus in conventional economics on how best to resolve the debt-finance versus equity-finance question in the presence of non-trivial information asymmetry and hence costly state verification: the standard debt contract is superior to equity financing.¹⁶ Therefore, Islamic Bankers’ preference for non-PLS financing is an eminently rational response to the information asymmetry problems

Avoiding true equity participation in home purchases

Clearly a mudāraba is PLS financing: one partner contributes capital and another contributes expertise/managerial skill. Mushāraka financing should also be PLS since there is supposed to be a direct equity stake taken by the financier, but this is frequently simply misleading terminology. Often when an Islamic Bank seemingly has taken a direct equity stake, it has actually done nothing of the sort.

For example, one common way of structuring an Islamic residential mortgage is as a ‘declining 

Basics of Islamic bonds and the size of the market

A sukk (plural sukūk) is a generic term for an Islamic financial certificate,¹⁸ an ‘Islamic bonds.’ Most sukūk are corporate or public debt instruments, usually with a variable rate of return tied to a commonly accepted market indicator rate (usually EURIBOR or LIBOR) and must have an underlying ‘real’ transaction basis to be Sharī‘a-compliant. The Bahrain-based Accounting and

Islamic derivatives?

A derivative is, of course, an instrument which derives its worth (price) from that of an underlying financial asset. Derivatives are invaluable in risk hedging for firms (e.g., foreign currency options to hedge exchange-rate transactions for importers/exporters) but are now used mainly for speculating on the direction of future price movements since the notional value of derivative contracts is many multiples of the actual underlying economic transaction. Thus derivatives fail both the

Performance on El Hawary fourfold taxonomy

El Hawary et al. (2004, p. 5) gave the four defining characteristics of IBF as (a) risk-sharing, (b) materiality, (c) no exploitation, and (d) no financing of sinful activities. How well has contemporary IBF practice lived up to this?

• a.Given the overwhelming use of non-PLS financing modes, IBF cannot be said to be risk-sharing in any meaningful sense. IBF transactions mimic conventional, collateralized debt contracts very closely, often right down to actually using current market interest rates

Conclusion

Consequently a vicious cycle is set up. Pious Muslims try to avoid ribā by avoiding the standard debt-contract, but this is not possible in most situations. Major banks wish to cash in on this desire but cannot provide truly Sharī‘a-compliant vehicles. Therefore they look for scholars willing to certify de facto conventional instruments as Sharī‘a-compliant. Conservative ūlamā regularly denounce much of contemporary IBF as being un-Islamic and even the industry’s own standards-setting body, the 

Acknowledgements

I would like to thank the anonymous journal referees and Prof. J. Barkley Rosser (the editor), Jennifer Tessendorf and participants at the 2007 Association for the Study of Religion, Economics and Culture conference (in Tampa, FL), and the Middle East and Central Asia: Politics, Economics, and Society Conference (at the University of Utah) for comments on earlier drafts of this paper. I am particularly grateful for one set of anonymous comments that helped me to better conceptualize and situate 

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