The Financial Jihad

What with all this bedlam over global slowdown, financial crunch, recession and inflationary trends. Do we have any financial system in place to circumvent such cataclysms? The Islamic banking or the interest free banking can be a serious alternative….

The Islamic Banking is a system of banking which is consistent with the principles of sharia, this branch of economics sprang up in the Islamic Golden Age from 8^th-12^th A.D. It was an early form of mercantilism. Some of the most innovative concepts of present day financial setup like bills of exchange, partnerships, trusts, startup companies, loaning and ledgers owe it’s origin to this period. Islamic banking made a comeback in Egypt in 1963.

The inimitable feature of Islamic Banking is the zero interest policy. The payment or acceptance of interest fees for the lending and accepting of money respectively (called Riba), is treated as noxious (haram) or against the principles of Sharia. Islamic Banking believes in sharing of profit and loss between the borrower and the investor. So how do they sustain and make profit………

Suppose I want to loan a vehicle then the bank would buy it for me from the seller and instead of charging me interest on that loan would resell it to me at a higher price, the payment of which I have to pay in installments. To bulwark itself against defaults the bank asks for strict collateral. This avoids irresponsible behavior on the part of banks and significantly reduces bad loans thus help in avoiding 2008 like recessions. Sounds simple….right….

What about housing? The Islamic banking forms an entity in partnership with the borrower who would both provide capital for financing the purpose. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity.

So where does Islamic banking score? When an Islamic bank provides an entrepreneur with venture capital it forms an entity in partnership with him and the capital is provided to the entity at a floating rate of interest. The floating rate of interest is pegged at a companies individual rate of return. The bank’s profit on the loan is equal to a certain percentage of the companies profit, so profit and risk are shared. Such participatory arrangements reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.

Besides it solves the problem of hyper-inflation as no interest is paid. Let us understand how. In commercial banking procedure the deposit rate is always 5-6% lower than the lending rate which increases the cost of production and thus inflation, moreover these rates do not remain static and deposit rate tries to catch up with inflation which again results in an increase in the lending rate. Therefore in an interest based economy there is secular rise of prices which can be circumvented in the case of Islamic Banking. The Islamic banks have a 100% reserve ratio which avoids bank runs and thus reduces the risk of defaults.

Now let us do some number crunching. Islamic banking though in its embryonic stage is growing at a rate of 10-15% per year and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed and according to Standards & Poor's Ratings Services, the potential market is $4 trillion. A sharia compliant bank in India would have meant investments worth $300 billion from the Middle East and the huge potential of tapping the 150 million strong Indian Muslim population. In the wake of such exorbitant figures, why has the Kerela High Court decreed to stymie our tryst with sharia compliant Islamic bank……

But the High Court of Kerela thinks that having a community specific bank would tarnish India’s secularist credentials and would lead to similar demands by other communities. Besides Islamic banking violates the RBI guidelines set for the banks. Another issue is that Islamic banking does not support some economic activities as cigarette and liquor production, insurance firms, etc also they have limited number of financial instruments.

In spite of these shortcomings policies should be reviewed to incorporate Islamic banking because of the huge opportunities it opens and the alternative it provides to the ‘Casino-Banking’ system of the west.