RegionsMiddle EastIslamic Banking: Better Banking?

Islamic Banking: Better Banking?

How often have we really seen innovation in banking products? Despite modern banking’s 400-year history, innovation has been fairly thin on the ground. Recent electronic delivery channels that are unable to replicate the old-fashioned bank manager, and rampant originality in finding obscure ways to charge customers are examples of change of course, but if we leave aside derivatives, exotics and the like, we see precious little difference in the products themselves. How and what we lend and, crucially, how profits are made, are roughly the same as they always have been.

But as the 21st century gets underway, we’re seeing the increasing popularity of new markets and customer bases. Global finance has led most western financial institutions to consider the world’s 1.6 billion Muslims – a group growing at 3% every year (50% faster than the total population) that has given birth to Islamic banking.

What Have Banks Ever Done for Us?

Banks struggle to be allowed just to get on and make money. The public somehow expect banks to be benevolent institutions – they trust banks with their money but in their hearts, they dislike them.

Despite banks getting on and doing what they are there to do, they get short shrift from their customers. Customers dislike banks making money, ‘just’ for safeguarding their hard-earned cash. There is resentment against banks despite the banks providing the infrastructure and tools to allow customers such basics as the ability to buy things in shops, even allowing them to buy things when they don’t even have the money! Banks are resented despite putting a roof over their customers’ heads, getting their cars on the road, financing their business or providing for their rainy days. Making money out of lending money seems to be a loveless occupation.

It’s Not Enough – Morality Too, Please!

The public wants more: morality. For example, in the UK, ethical consumerism, of which ethical finance accounts for 40%, is a growth industry whose annual sales of ethical goods at £29.3bn outstrip sales of ‘unethical’ tobacco and alcohol at £28.0bn combined. Conventional, ethical finance is itself growing at 9% per year.1

Yet the biggest ethical financial phenomenon – Islamic finance and investment (Islamic banking) – is unregarded by most because it uses words that sound strange to some people – murabaha, musharaka, mudaraba, etc. Yet they have attractions. For example, in Malaysia, more than half of HSBC’s 2004 Islamic mortgages were taken up non-Muslim customers.2 Indeed, almost one-quarter of all ‘Islamic’ business done in Malaysia is being transacted by non-Muslims.

What is So Attractive About Islamic Banking?

As readers of gtnews will know, Islamic banking is based on a few religious principles. Avoid usury. Tie finance to its underlying trade. Share risk. Do not invest in unethical activities. Spurn gambling. These ethics also appeal to many non-Muslims.

The damage done to conventional banks by their apparent greed is un-estimated but the demutualisation of the relatively much-loved building societies, the panic over LTCM,3 the lack of sympathy for the NatWest three, the opprobrium heaped on HBoS for wanting their money back from Fairpak, mis-selling scandals, the pensions deficit and even the Enron and WorldCom backlashes are all laid at the love-hate door of high finance.

However, Islamic principles are pretty close to what is advocated as modern business best practice. For example, gharar, the avoidance of uncertainty, embraces accountability and transparency, both prominent in corporate and regulatory ideals today.

What is Hard About Being an Islamic Bank?

Islamic banking products have to fit in with the purity and ethics laid down in Shariah rulings, which vary. A notable example is when the Islamic Bank of Britain launched in the UK in 2003. There was much correspondence between the FSA and individual banks to try to make the Shariah-compliant products (especially deposits) acceptable, with the systems of course having to flex in their wake.

Key initiatives, such as Basel II and IAS 39, were drafted without real regard for how to interpret Islamic financial instruments. And some inherent difficulties persist – the Islamic equivalent of mortgages is an example. If the bank owns the house, who gets the value of its price rise? Who pays the capital gains tax?

The factor holding back Islamic banks most is getting the right people with the right commitment. Expertise is thin on the ground, slowing growth so that some banks can initially support only a small Islamic ‘window’.

What About Technology?

Here is the challenge. It’s tough enough getting an effective handle on computer systems and IT in any bank, but Islamic financial institutions have to deal with different interpretations of financial products at each bank and country. This adds a huge level of complication to system design for packages – and surely no-one these days advocates building custom systems any more?

It is best if the unethical concepts are simply not present in the system – interest, for example – is built right into the heart of most banking package user interfaces. Changing this is no small custom enhancement.

Islamic banking transactions also depend on a lot more process control. Activities must happen in a certain order. For example, the bank must be able to show it owns the goods before passing them on. So workflow linked to the accounting entries is critical.

What Happens Next?

The bottom line is, if you don’t brand a product Islamic, but just advertise pool-based profit bearing accounts, shared risk insurance, mutual property savings schemes and client-selectable ethical funds, you have a superb source of innovative (or, in many cases, rediscovered) banking products for everyone. Once the systems can handle these products, the computer doesn’t ask how they are marketed.

Also, performance need not be impaired by these ethical limitations. A recent study showed that “the behaviour of Islamic mutual funds does not differ from that of other conventional funds… there is not any statistically significant risk-adjusted abnormal reward or penalty associated with investing in Sharia compliant mutual funds and thus with following one’s belief.”4

With the right systems support, Islamic banking is poised not just to continue its rising trend as a growing industrial phenomenon, but could also be used to radical effect in a reassessment of conventional banking products.

12006 Ethical Consumerism Report, Co-operative Bank.

2Business Week – 8 August 2005.

3Long-Term Capital Management, see “When Genius Failed: The Rise and Fall of Long-Term Capital Management,” Roger Lowenstein.

4“Performance of Islamic Mutual Funds”, Said Elfakhani and M. Kabir Hassan, Economic Research Forum, December 2005.

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