Islamic Banking and Global Financial Market: Signs of Economic Growth

Introduction

The topic of my present research work is “Islamic Banking and global financial market” and how they are interrelated to lead to the sustainable growth of economic development. Islamic finance is closely related to Islam’s vision of economic development, which gives primary importance to the realization of socioeconomic justice and the well-being.
The subject of Islam and economic development raises a number of 
questions, one of which is about the relevance of the subject to a 
discussion forum on Islamic finance. This question is not difficult to 
answer because finance and development are very closely interrelated. 
Finance is not an end in itself; it is one of the essential means to 
development, which in turn leads to a rise in financial resources for 
accelerating development. The juxtaposition of Islam and economic 
development in the title also raises some other questions. One of these 
is whether Islam is an asset or a liability for development and whether 
Islam and development can coexist without hurting each other. If Islam 
is capable of promoting development then the second and third questions 
are about the kind of development that Islam visualizes, and the 
reasons for the failure of Muslim countries to realize development of 
this kind.

As the economic crisis deepens throughout the world, global financial institutions have set about to re evaluate the various systems and business models in place. It is no exaggeration to say that practically every mainstream and conventional banking institution has been affected by the global financial crisis. In contrast, the Islamic banking system has largely escaped the fallout from the financial crisis, thanks to rules that forbid the sort of risky business ventures that infected mainstream institutions.

There is no doubt that the current global financial crisis has presented the Islamic finance industry with an excellent opportunity to expand its appeal beyond Muslim investors as a safe haven from the speculative excesses. The message may have particular resonance in the West after the crumbling of the US 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. Investors traumatized by the credit crisis are seeking assurances and security. The stricter rules imposed on lending by Islamic laws provide these assurances and security. Many of the speculative and highly risky structures and financing methods that have proven to be the nemesis of the western financial industry are forbidden under Islamic laws. Islamic finance practices are undoubtedly fiscally more conservative, requiring direct participation by investors in plans that do not involve esoteric strategies such as parking assets in off-balance-sheet vehicles.

While Islamic banking is no longer a novelty in the international financial world, the United States is yet to embrace this model. While some US financial institutions are venturing into this market, they are few and far between. According to some experts and financial gurus, the United States is almost a decade behind the European and Asian financial counterparts as far as the adoption and implementation of Islamic banking is concerned.

What Is Islamic Finance?

In order for one to understand how Islamic banks have virtually escaped unscathed from this financial crisis, it is essential to have a grasp of the basic fundamentals of Islamic finance. Islamic finance is based on shariah, or Islamic law, which in essence requires that gains be derived from ethical and socially responsible investments and discourages interest-based banking and investments. Islamic finance is fundamentally different from the conventional banking models as it is based on a profit and loss structure (PLS) and the prohibition of riba’ (interest). This structure requires that the financial institution invest with the client in order to finance the client’s transaction rather than lend money to the client. Due to the inherent risk involved in any investment, the financial institution is entitled to profit from the financial transaction. This is a stark contrast to modern finance in which interest is one of the key methods by which banks make money through their products, such as mortgages and personal loans.

Another fundamental distinction of an Islamic bank is the absence of insurance protecting client deposits found in conventional banks. While the PLS structure permits receipt of money by depositors when deposits invested have earned a profit, they must incur losses when deposit investments incur losses to comply with shariah mandates. Deposit insurance, such as the protection provided by the Federal Deposit Insurance Corporation, defeats the very purpose of the PLS model, as the depositor does not incur any risk. The deposit insurance is an integral part of the western banking regulations but is in direct conflict to the basic concepts of Islamic banking. The issue of deposit insurance has proven to be a major hurdle for western, primarily European, banks that wanted and have chosen to provide shariah-compliant products. European banks overcame this hurdle of deposit insurance by informing clients that the insurance was not shariah-compliant.[1]

Islamic banks have been marketing their services aggressively in the West. The conventional commercial banks have in direct competition with the purely Islamic banks begun offering Islamically structured products to their clients through “Islamic banking windows’. However, confusion exists about Islamic banking. In many minds, the prohibition of interest is the defining characteristic of Islamic banking, but it can be distinguished from conventional banking by its concern with spiritual values and social justice.

The fact that interest is prohibited does not mean capital is costless. Islam is not opposed to a return on capital. What it prohibits is the predetermined pricing of capital. The owners of capital have no right to ask for additional payment without sharing risk. Thus in lieu of fixed interest which is prohibited, the lender will be a participant in the enterprise. [2]

Islam and Banking

A. The Prohibition of Riba (interest): legal connotations

The Qur’an, or holy book of Islam, is the primary Islamic authority and it prohibits riba. The prohibition appears in several passages in the Qur’an. One passage states that God does not view interest as true wealth because it represents unearned income. Another passage condemns Jews for not obeying the Torah’s prohibition of interest.  A third passage condemns the compounding of interest upon default by stating “O believers, take not doubled and redoubled interest, and fear God so that you may prosper. Fear the fire which has been prepared for those who reject the faith . . . .” A final condemnation warns that those who receive riba are waging war with God and shall be “inhabitants of the fire and abide there forever.” Scholars have noted that the taking of riba is on par with repeated adultery and deemed more sinful than maternal incest–two crimes in Islamic criminal law that are punishable by death.

The riba prohibition reflects the Islamic view that accumulating wealth through collecting riba is not a legitimate mode of “work”. Islam values capital when it is the product of labour and risk-taking. When a lender charges interest for capital, he receives a reward without adding his labour and without regard to the success or failure of the borrower’s venture. The benefit of the loan to the lender is certain while the benefit of the capital to the borrower is uncertain. Islam views these transactions as necessarily including unfair allocations of risk and justifying reward for a passively acquired return on capital. Riba is thus exploitive vies-a-vies the borrower and its prohibition limits the extent to which one party may be disadvantaged by the other party in financial transactions.

Prohibiting economic exploitation is important in Islam because Allah wills his followers to accumulate wealth in a manner that achieves social justice. Social justice, however, should not be mistaken to mean that Allah wanted people to be equal in wealth. Muslims believe that God “deliberately created disparities in the distribution of goods in this world.” Rather, social justice supported by legitimate work means that “no one may claim more than he has earned” and may not use wealth to disparage others. This thought, when applied to conventional banking, means that investments cannot be viewed solely through the lens of achieving the highest profit margin. Instead, Islam places accession to wealth in relation to spiritual costs to the individual and social costs to the community.

Outside of social justice, Islamic scholars have also offered economic critiques of interest that support its prohibition. Scholars have argued that the unjust allocation of risk between borrower and lender creates a “penalty upon entrepreneurial initiative.” In a truly competitive market, Islamic scholars believe it to be unlikely that an investment could result in gross profits that also cover the interest. Since capital would be unproductive without entrepreneurial input, the disincentive to create wealth hinders economic growth.[3]

Ideological issues involved in Islamic Banking mechanism

Twenty years ago, Islamic banks were unknown; today, they number in the hundreds worldwide and hold more than U.S. 0 billion in assets. In the world of global finance, this is not a large amount, but its growth rate is