There is another reason that explains Islamic banks’ general aversion to equity investment. As Aaron Maclean writes, “Those involved in the first wave of Islamic banks realized that equity financing does not make for a stable banking sector, and, after a series of shocks and bad investments, they became very conservative. It was a race to the loopholes—a search for means of sharia compliance less risky than straight-out equity investing” (Maclean, 2007).
A study done by Abdul Gafoor in 1995 sums up well the problems Islamic banks face in involving themselves in PLS contracts:
PLS basis […] involves time-consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have developed the latter and they seem to be averse to the former.
There are no commonly accepted criteria for project evaluation based on PLS partnerships. Each single case has to be treated separately with utmost care and each has to be assessed and negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very long periods, unlike in conventional banking where the capital is recovered in regular installments almost right from the beginning, and the uncertainty and risk are that much higher, b) the longer the maturity of the project the longer it takes to realize the returns and the banks therefore cannot pay a return to their depositors as quick[ly] as the conventional banks can. Thus it is no wonder that the banks are averse to such investments.
Al-Muharrami and Hardy observe:
By sharing also upside risk with depositors, moral hazard may be reduced: bank management has less incentive than under conventional banking to make investments with relatively good chances of making very high returns and also a good chance of doing poorly.
But management of an Islamic bank may have less incentive than management of a conventional bank to reduce downside risk, which too is shared with depositors. Owners and thus managers have less at stake, less “skin in the game,” and may therefore make less effort to choose and monitor investments carefully.
At the other extreme, small-scale enterprises find it much harder to obtain finance from Islamic banks on the PLS basis than their larger counterparts, as banks consider holding equity stakes with small enterprises extremely risky. Working capital loans, critical to many small businesses, are rare.
In murabaha financing, the bank is to first buy the goods from the seller and possess them for a period, thus assuming liability, as in a normal trade, and then sell them back to the buyer who wanted the goods with a profit margin on the price.
However, in practice, the bank does not take possession of the goods and there is virtually no holding period involved. Thus the loan advanced by the bank is much like a normal loan of a conventional bank and the profit margin, in an annualized form, is akin to interest.
In the case of another popular instrument used, ijara financing, the bank collects rent with a profit on the property leased out to the buyer of, say, a vehicle or a house or some durable equipment. Let us say, the bank enters into a partnership with a person who wants to buy a house.
The bank pays, say, 80 percent of the house price and the individual 20 percent. The bank rents its share of the house back to the individual until it is fully paid for, collecting rent with profit over the interregnum period. The profit collected, on an annualized basis, is little different from conventional mortgage interest. The name change does not alter the essential nature of the charge.
“Whether the product is dressed up in Arabic terminology, such as Mudarabah, or Ijarah, if it looks and feels like a mortgage, it is a mortgage and to say anything else is semantics” (Foster, 2009).
Murabaha contracts such as bai salam and istisna that involve time and credit elements on which the bank makes a profit agreeable to the bank and the buyer also involve interest in essence.
Islamic banks cannot just issue bonds (sukuk), a debt instrument, in return for a promise of a fixed rate of return. But they have found a way around the problem. For a bond to qualify as shariah-compliant, there must be an underlying asset backing it. However, the extent to which such bonds are really asset-based is a question mark.
“To be Islamic in nature, the securities that look like bonds must represent fractions of an equity asset, rather than fractions of a loan” (Maclean, 2007). In Iran, for example, banks use a fixed rate of return for inter-bank financial transactions and those with government departments and public enterprises with little direct relation to actual profits on the ground of borrowing entities (Gafoor, 1995, Section 4.3).
Also, state-owned companies and municipalities can issue sukuk in foreign capital markets with prior approval of Bank Markazi (Iran’s central bank) and Ministry of Finance. Islamic banks are currently making roaring business in low-risk sukuk.
Another observer observes, “Islamic banking, in its current form, will go down in history as a mighty deceit based on an operational principle that is simply unfeasible. Islamic banks give and take interest as a matter of course, though under the guise of commissions, fees, penalties or profit shares. The holder of a “halal” credit card pays a penalty on unpaid balances; this penalty is proportionate to the size of the balance, which makes it equivalent to interest.”
The Turkish-American professor at Duke University Timur Kuran, who is considered a leading authority on Islamic economics, is a strong critic of Islamic finance. He “argues that Islamic finance is a faith-based fabrication that sits awkwardly in a modern business school.”
For the most part of their businesses, Islamic banks thus largely fail to get rid of interest. This is not a bad thing, after all. As we have seen above, Islam does not really ban interest that has come to play a very vital role in the modern economy.
Islamic banks are broadly similar to conventional co-operative banks or credit unions that are prevalent in the United States and European countries in that they both share some risk with the depositors. However, while the member-depositors of co-operative banks are also their owners, this is not the case with Islamic banks.
A new 2010 IMF study finds that “Islamic banks, on average, showed stronger resilience during the global financial crisis. But the study also finds that Islamic banks faced larger losses than their conventional peers when the crisis hit the real economy.” Also note, however, that the key trigger for the financial crisis was the housing bubble that developed in the United States due to heavy involvement in sub-prime mortgage investments by some banks, notably Lehman Brothers.
Muslim countries were largely immune to this crisis as their property market has been in a sound condition. Conventional banks would have performed as well as Islamic banks in this regard, if there were sufficient financial regulation and oversight by the Central Bank.
Although Islamic banks have weathered the recent financial crisis relatively well, their overt non-embracing of the interest instrument makes them suffer from a number of serious drawbacks:
They are deprived of a powerful tool to appraise projects on sound economic lines;
Because they are much too risk-averse, they have ignored longer-term projects as well as small and medium sized industrial projects (SMEs) that are critical to economic development;
These banks have difficulty also in providing working capital for existing financed projects, since it is hard to apply the principle that such capital funds cannot relate to real assets on the ground;
They provide many of the banking services by mimicking those of conventional banks, but with the approval from one or more Muslim legal experts they hire. This practice as well as the roundabout ways they adopt to market their products lead to additional transaction costs or efficiency losses for these banks; Such banks also explicitly make use of conventional banks’ products such as benchmark interest rates such as LIBOR (London Interbank Offer Rate) as a reference rate for the opportunity cost of finance (Curiously, contemporary Muslim jurists do not condemn such benchmark rates as unIslamic);
They also hurt depositors by making them vulnerable to risks that are usually borne by conventional banks; and
In view of this risk-sharing feature, Islamic banks have less incentive to operate on behalf of depositors to engage in operations that can yield high returns or to reduce downside risks.
Overall, Islamic banks appear to be less efficient and growth-friendly than conventional banks. “Khalid Ikram, who headed the World Bank’s operations in Egypt in the late 1990s, [and] looked into the performance of Faisal Islamic Bank of Egypt (FIBE) back during the early boom days, says of Islamic banking, ‘it hasn’t had a lot to do with development.’” Rice University professor Mahmoud El-Gamal “condemns those who confer Islamic legitimacy to a trade simply on account of the transaction’s formal adherence to the requirements of Islamic law without respecting the goal of promoting fair pricing, a practice he calls ‘shari’a arbitrage.’”
He further suggests that adherence to such formal requirements increases Islamic banks’ transaction costs and leads to efficiency losses. He comments, “[D]espite the good intentions of its pioneers, Islamic finance has placed excessive emphasis on contract forms, thus becoming a primary target for rent-seeking legal arbitrageurs. In every aspect of finance – from personal loans to investment banking, and from market structure to corporate governance of financial institutions – Islamic finance aims to replicate in Islamic forms the substantive functions of contemporary financial instruments, markets, and institutions.”
IV. SOME CONCLUDING REMARKS
Interest has become an unavoidable, integral part of the modern economy. It plays a very powerful role as an economic development and monetary policy instrument and as an essential device for efficient allocation of productive resources. Islamic banks do not really avoid interest except in mudaraba and musharaka financing, but this financing mode is not much used. That is because of real problems of implementation or because a heavy reliance on such financing does not assure good returns to them. Islamic banks use a reference rate that is called a profit rate. But this is essentially interest in nature. But their overt non-embracing of interest deprives the Muslim economies of a very powerful tool that can help promote economic development, assure price stability, and strengthen banking, capital markets, and stock exchanges.
According to Maclean, the unprecedented economic boom in Europe over the last five hundred years was made possible, in part, by a codification made in the Christian tradition in the twelfth century of a distinction between usury and interest. It’s time Islamic tradition also embraces this distinction and Islamic banks come clean about their operations and openly embrace interest as a legitimate, integral part of their business.