Islamic Banking: What it Can Teach the West

Can the Islamic banking system teach the Western world how to create an interest-free system for banking? David Williams investigates.

Imagine a banking system that doesn't rely on interest. It takes some effort for anyone trained in western finance to conceive of such a system. But, as the world starts to rebuild its financial institutions, the interest-free, more consensual approach of Islamic finance is offering a challenge to established assumptions.

The profile of Islamic finance has been growing sharply in recent years as the world's estimated 1.2 billion Muslims have become more concerned with placing their money in institutions and accounts that comply with Shariah law. Driven by the wealth of the Gulf States and by regulatory innovation in Malaysia, new Islamic financial institutions are continually being established to serve this growing market.

For the same reason, conventional western banks have also been offering Shariah-compliant accounts and products such as mortgages for several years now. Some estimates predict that the volume of the world economy managed under the Islamic financial system will shortly reach a quite significant four percent.

Islamic finance takes centre stage

The collapse of Western financial institutions and a general crisis of confidence in Western regulatory regimes has created an upsurge of interest in Islamic finance. While many in the West have long advocated that the financial sector adopts approaches such as more sustainable practices, ethical investment and non-predatory lending, Islamic finance is an example of how such a system might work in practice.

Assistant Treasurer of Australia, Nick Sherry, opening a conference on Islamic finance at La Trobe University, Melbourne in July 2009, said: “The conventional financial system would do well to learn what it can from Islamic finance's avoidance of exposure to the US sub-prime market and associated complex financial instruments.”

At the same time, half way across the world, the UK's University of Leicester School of Management was holding a conference with the explicit aim of considering potential lessons for the West from the Islamic banking and finance sector.

“Islamic banking has a lot to offer in terms of generating ideas to overcome the current recession the world is facing,” says Dr Ibrahim Umar, the organiser of the Leicester Conference. “Perhaps the most important thing that anyone new to the topic should realise is that Islamic banking is not only for Muslims. Malaysia is now leading the world in this area, and what has been found there is that many non-Muslims have been going to Islamic banks, not for religious reasons but because they find that those banks offer products and services that they appreciate and that have commercial viability.”

Dis-interest

Although Shariah-compliant banking has many different practices, it is perhaps best known for the way it prohibits the charging of interest (“riba” or usury). In order to avoid interest, what characterises Islamic banks is the arrangement in which both bank and client share a proportion of the risk and the profit. Known as “musharakah” (joint venturing), business loans are therefore made on the viability of the opportunity rather than being based on some more or less rigorous assessment of the credit worthiness of the borrower. Other products such as mortgages are organised through various leasing arrangements in which the bank buys the property and sells it back to the client over the term of the mortgage.

“Islamic banking offers the Western system a number of new perspectives,” says Dr Umar. “It is very difficult for some people to imagine running a system that isn't based on interest. So the creation of Islamic products or institutions helps conventional financial organisations with their product development. It makes them look at the world differently by showing them that it is possible to create something viable and to continue to do business through arrangements that are not based on charging interest.

“Secondly, the continuing discussion about whether or not a product is legitimately Islamic can be seen as a healthy element of the system. The act of challenging a product creates transparency because it allows customers to understand the process of validation and reveals to the client the strengths and weakness of a product.”

Ethical advantage

However, for Dr Umar, it is the ethical principles at the heart of Islamic banking rather than the products themselves that provide the most important element for the non-Islamic financial system to reflect upon.

“What fundamentally distinguishes Islamic banking and finance from conventional systems is the way the Islamic system embeds some moral judgement into its decision-making process,” he explains. “It looks not only at satisfying the profit motive but at the underling fairness of the arrangement and at how it will affect all the stakeholders. It is completely different because the bank goes into a relationship with its clients that is based on partnership. This factor is distinctive and is likely to be the one that leads Islamic banking to provide steady, sustainable levels of growth as compared to the quick growth and sudden bust we see in the West. This is hypothetical, but it may be the crisis could not have got to this level if the Islamic system had been in use.”

Intellectual advantage

Abdulrazzak Al Wafi has an MBA from the UK's Heriot-Watt University where he is continuing his doctoral studies. He also attended the Leicester conference and believes the Islamic approach has benefits for corporate governance as well. “If you look at Western corporate governance, you can see there is a fault in the system,” he explains. “It emphasises short- rather than long-term viability and only examines the benefit of a transaction to a narrow segment of the stake holders. Because the Islamic approach emphasises ethics, it looks at whether the transaction is good for the society, for the economy and for everyone involved. I am not saying the Islamic system solves everything, because it cannot be applied independently of the moral teaching of Islam. However, MBA students who understand the Islamic approach would obviously have an advantage over their peers in areas of the world where the system is being used. On top of this they would have the intellectual benefit of being able to consider a radically different approach to finance.”

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