gif Islamic Finance
many small productive projects can take place in the market, creating many new job opportunities. In contrast, the interest-based system is ‘security-ori- ented’ rather than ‘growth-oriented’. This attitude deprives many potential entrepreneurs of the opportunity to get the required funding, because they lack sufficient security to satisfy the banks’ criteria of creditworthiness.
• In the profit-sharing system, the sup- ply of money is not allowed to overstep the supply of goods and services. In any case in which the enterprise suf- fers losses, any capital that is to be re- paid to the bank will be diminished by the amount of the loss. This eventually curbs inflationary pressure within the economy.
Moreover, some economists have been more specific in discussing the economic benefits of the Islamic banking system. Their argument relates particularly to developing economies: theoretically, the level of moral hazard within any economy will be reduced where immoral and unethical conduct is eliminated by Islamic banking principles; fur- ther, the absence of the limitations normally imposed by the debt leads to an improve- ment in profits, which eventually encourages an increased level of investment. All of these conditions, in theory, are therefore ideal for the growth of a developing economy. Addi- tionally, some economists have argued that the financial services market constantly needs new products.
The products that have historically fuelled the development of the market have now be- come ‘commodities’, which means that they have become increasingly low profit, if not unprofitable. The industry therefore needs to reinvent itself in order to continue to pros- per in the which, in one way or another, of- fers a new set of different financial products. In practice, having a zero rate of interest in a banking system is not an impossible ideal. Some of the biggest economies at a global level have kept their interest at a near-zero or zero rate for a few years. Due to certain economic circumstances, the Central Bank of Japan, for example, decided to maintain a ‘zero or near zero interest rate policy’.
The zero-rate call has lasted for almost five years and the economists’ expectation is that the interest rates will remain under 1 percent for a very long time. This shows that interest is not always a positive component in the economy and that eliminating interest from banking transactions could become, at some point, a way out of many economic problems. In the last few months, the Bank of England has implemented certain cuts
68 Global Islamic Finance May 2012
in the interest rate in order to cope with the pressure of the current financial crisis. Finally, it has been argued that the prohibi- tion of interest would substantially prevent individuals from becoming over-indebted. It has been suggested that those who con- trol individuals’ access to credit (that is, the regulators and the banks) do not place individuals’ interests at the top of their pri- orities list. On the one hand, regulators are mainly concerned with the well-being of the whole economic system rather than that of individuals.
They may therefore allow certain transac- tions that can be hazardous to individuals, but beneficial to the economic system as a whole. On the other hand, bankers are main- ly concerned with their own interests rather than with those of their clients or the whole economic system. Thus they would make a large amount of credit available to individu- als to borrow if there were a prospect of high profits in the long term, which can be re- flected in their balances and remuneration. The current banking crisis is a good example of the consequences of bankers’ careless lending policies.
Conclusion Prohibition of Riba is central to Islamic fi- nancial ethics and law. All transactions and contracts must be free from elements of Riba. Moreover, Islamic banking is not based on creditor-debtor relationship, but on the principles of PSL between the bank and its customer under different financing arrangements and other trading and leasing contracts.
Whilst, non-Islamic banks rely primarily on the interest rate instrument, Islamic banks use a variety of contracts and instruments that have been developed in compliance with Shariah laws. Moreover, in Islamic fi- nance, the nexus between financial assets and real assets is crucial. Indeed, they con- nect bank resources in financing real assets rather than investing in derivatives.
In this article, we introduced the foundation for Islamic banking practices and we dis- cussed the governance concepts important in the conduct of Islamic banking. The main differences between Islamic and non-Islam- ic banks were identified as well. According to the literature, Islamic banks outperform non-Islamic banks especially during the last financial crisis. The question left is what role should Islamic banks play in order to contrib- ute to the financial stability?
gif References and Further Reading
• Abdul Rahman (2007). Islamic Microfi- nance: A Missing Component in Islamic Banking. Kyoto Bulletin of Islamic Area Studies, 1-2, pp. 38-53 • Aggarwal, R; K and T. Yousef (2000). Is- lamic Bank and Investment Financing. Journal of Money, Credit and Banking, 32(1): pp. 93–120 • Akerlof, G. A. and P. M. Romer (1993). Looting: The Economic Underworld of Bankruptcy for Profit. Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24 (1993-2), pp. 1-74. • Ali, S. S. (2007). Financial Distress and Bank Failure: Lessons from Closure of Ihlas Finans in Turkey. Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006 & Jan. 2007 • Al-Jarhi, M. A. (2003). Islamic Finance: An Efficient & Equitable Option. Islamic Re- search and training Institute. • Al-Tamimi, Y. (1995). Practice Require- ments for Establishing an Islamic Bank. in M. Fahim Khan (ed), Islamic Financial In- stitutions, Seminar Proceedings Series No 27, Jeddah: Islamic Research and Train- ing Institute, Islamic Development Bank, pp. 49. • Drucker (1999) ‘Innovate or Die’, The Economist, 25 September, pp. 26. • Ed Stevens (2001) ‘Beyond Zero: Transpar- ency in the Bank of Japan’s Monetary Pol- icy’, Federal Reserve Bank of Cleveland, Economic Commentary, 15 March, p 1, available online at
http://clevelandfed.org/ research/commentary/2001/031501. pdf [accessed 17/06/08]. • El-Gamal, M. A. (2001). An Economic Ex- plication of the Prohibition of Riba in Clas- sical Islamic Jurisprudence. 2 May, p 55, available online at
http://www.ruf.rice. edu/˜elgamal/files/riba.pdf [accessed 24/11/09]. • Ghannadian, F. F and G. Goswami (2004). Developing Economy Banking: The Case of Islamic Banks. International Journal of Social Economics, 31(8): pp.742-748. • Gower, L. C. B and P. L. Davies (2003). The Principles of Modern Company Law, 7th edn, London: Sweet & Maxwell. • Kaletsky, A. (2006) ‘Why Japan Will Keep Rates Ultra Low’, The Times, 12 June, avail- able online at http://business.timeson-
line.co.uk/article/0,,13133-2221438,00. html [accessed 20/06/08]. • Mishkin, F. S. (2003). Policy Remedies for Conflicts of Interest in the Financial Sys- tem. Conference:
www.bankofcanada.ca/ fr/conference/2003/remedies.pdf • Morris, S. and H. S. Shin (2010). Conta- gious Adverse Selection. Economic Theory Center Working Paper No. 001 • Venardos, A. M. (2005). Islamic Banking and Finance in South East Asia: Its Devel- opment and Future. London: World Scien-
tific, pp. 49.
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