Monday, December 26, 2005


Islamic Banking

A previous section on Islamic prohibition of usury made mention of the rejection by Islam of financial interest or riba, largely on the grounds of its negative distributive justice and equity effects (Khan, 1986). Out of this prohibition has developed perhaps the most sophisticated and complete theoretical systems of interest-free political economy in the world (Chouhury & Malik, 1992).

The specific methods for implementing Islamic banking have centered around financial equity based approaches, most notably Mudarabah - a joint venture between the bank and a 'partner' with both contributing to the capital of the project and sharing the profit or loss - and Musharakah - in which all the capital for an investment is provided by the bank in return for a predetermined share of the profit or loss of the business undertaking (Kahn & Mirakhor, 1986).

The first modern Islamic bank was established in the 1960s in Egypt (The Banker, 1989) and in the ensuing three decades, Islamic banking has grown into an industry with $80 billion in deposits and 100 banks and finance houses (Khalaf, 1995). Much of this growth has been as a result of the comprehensive attempts by Iran, Pakistan and Sudan over past 10 years to restructure their national banking systems to bring them into accordance with Islamic law of the Shari'ah (Aftab, 1986; The Economist, 1992a). In addition, increasing numbers of banks outside these countries, including in Western countries, have begun to offer parallel Islamic banking services (O'Brien & Palmer, 1993). As recently as 1996, the UK joined these latter ranks, with Flemmings Merchant Bank (1996) offering the first Islamic banking service, the Oasis Fund, to British customers.

The claimed advantages of the Islamic banking approach to finance are that it results in: more just and equitable distribution of resources; more responsible and profitable lending due to the necessarily closer bank-client relationship; less volatile business cycles; and more stable banking systems (Taylor & Evans, 1987); as well as "the relative efficiency of the interest-free money system over the alternative interest-based system" (Darrat, 1988). On the other hand, the Islamic banking industry has been criticized on a number of counts too: for its lack of uniformity and standardization of products, accounting systems and endorsements by different Sharia boards (Khalaf op.cit); various bad-debt complications (Shreeve, 1988); the information-gathering burden on potential consumers and banks themselves to ensure the security and profitability of their funds, as well the lack of an interest-rate mechanism to use as a macro-economic tool (The Economist, 1992b). However, these limitations must be viewed against the backdrop of Islamic banking as a young and innovative growth market.