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Insights and News /

15 October 2018

Islamic banks – an ethical form of banking?

Justin Beese

Justin Beese
Analyst | Financial services | London

Islamic banking has been dubbed an ‘ethical’ alternative to conventional western banking systems. The Economist reported that despite accounting for only 2% of global banking assets, Islamic Banking is expected to grow by 19.7% in 2018. With a reported two billion people still unbanked, a significant portion of whom are located in the predominately Muslim North African and Middle Eastern region, Islamic banking has also been lauded by the World Bank as a key mechanism to promote financial inclusion and economic development.

Based on Sharia law, the rules and guidelines of which are derived from both the Quran (the Holy book of Islam), and the Hadith (the reported sayings and actions of the Prophet Muhammad), Islamic banking follows four ‘guiding principles’:

  1. Promotion of inclusive growth
  2. Equitable risk sharing
  3. Social justice
  4. Fair distribution of wealth.

It differs to conventional banking in several ways:

  • No charging or receipt of interest
  • All transactions must have ‘material finality’ – rooted in something tangible
  • No charging for late payment
  • No involvement in ‘forbidden’ industries, such as pornography, pork or alcohol
  • No transactions involving ambiguity or speculation
  • Compulsory sharing in the risk of financial arrangements, such as profit sharing.

These principles have resulted in some significant contrasts from the conventional western banking system.
The most notable take away is that of resilience. During the 2008 financial crisis, Islamic banks were protected partly due to their higher asset qualities – a direct result of the requirement for transactions to be grounded in the ‘tangible’. In addition, Islamic banks did not borrow on interbank markets, thus reducing their exposure and interdependence. Finally, given the obligation to return all deposits, Islamic Banks tend to hold higher capital reserves.

Secondly, the practice of profitable risk sharing, whereby both the bank and the customer share in the risk and profits of any joint venture, also helps resilience but could be explored in its own right. The Islamic bank shares in the profit (or loss) the customer makes. This business model fosters trust and the alignment of mutual interest between customers and their financiers.

Finally, Islamic banking promotes greater transparency as they are supervised by an independent Sharia Supervisory Board whose role is to ensure the bank is compliant with Sharia law - removing ambiguity from contracts and acting to give customers peace of mind. Conventional banks could learn from this – this transparency builds trust in the system and oversight over crucial financial institutions. This could be done by a refreshing banks’ attitudes to regulation compliance – perhaps even having independent in-house oversight teams.

Therefore, if conventional banks wish to increase their resilience, trustworthiness and transparency, they could do worse than consider some basic tenets of Islamic Banking:

        A. Limiting transactions based on derivatives, shares, and other ‘non-material’ activities
        B. Limiting of banks borrowing on inter-bank capital markets
        C. Ensuring adequate capital reserves, over and above regulatory minimum levels
        D. Bring in more products based on a mutual sharing of risk basis.
 

Islamic banking is growing at a speed which will one day make it a significant player in the world of international finance. While Islamic banking may have its challenges, there are many learnings to be taken from its principles, from rebranding the image of banking towards something ethical, to enhancing the structural resilience of the banking industry itself.