Islamic Banking

During the Islamic Golden Age, which spanned approximately 500 years, between the 8th and 13th centuries, some early forms of capitalism and freemarkets existed. The dinar brought together previously economically independent regions. Before Islam, the city of Mecca was already a center of trade in Arabia, a place where not only goods but also ideas were exchanged. Islamic civilization grew thanks to its merchant economy. It was commerce, not holy war, that expanded the Muslim faith to Asia.

Islamic banking is based on the teachings of Prophet Mohammed, himself a merchant. During its heyday, shariah was the world’s most vibrant body of commercial law, its contracts recognized from the Arabian peninsula to the Iberian peninsula. The shariah issued fatwas or opinions on which transactions were Islamically acceptable and which were forbidden. Shariah prohibits the payment or acceptance of interest fees for loans of money, a principle as old as money itself and basic to Western banking. However, charging high interest rates to lend money is repeatedly condemned in the Bible, Aristotle denounced it, the Romans limited it, and it was prohibited by the early Christian church.

Back in the days of Mohammed, the reasons for rejecting interest were pretty obvious: loan-sharking was common and not paying a loan could result in slavery. By outlawing interest, Islam encouraged an economy based on risk-sharing, fair dealing, and equity. The reason for prohibiting interest is to keep everybody spending according to his limit, so inevitably this system involves more prudent lending. Western consumerism society is the result of a banking system that encourages buying today and paying tomorrow. For advocates of Islamic banking, Western capitalism is synonymous with speculation, volatility, inequality, large corporations and usury. Not that they are entirely wrong.

In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. There are no additional penalties for late payment. To protect itself against default, the bank requires a strict collateral. Some transactions, look a lot like interest, but any late fees must be donated to charity, and the bank cannot penalize a borrower who is genuinely broke. Financiers share borrowers’ risks and depositors are treated more like shareholders, earning a portion of profits. Financing deals resemble lease-to-own arrangements, layaway plans, joint purchase and sale agreements, or partnerships.

Interest-free banking as a financial concept is pretty recent. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in the 40’s. But it wasn’t until the oil boom of the 1970s that it became a movement. Nostalgia for the lost golden era of Muslim power, when Islamic economy covered half the world, has been a strong impetus for Islamic banking. The region’s millenium-long material decline has been blamed both on moral decay and on colonialism, which imposed Western-style banking, a cause for resentment still today. However, the only countries that have officially Islamicized their entire banking systems, are Iran, Pakistan, and Sudan.

After the collapse of Wall Street institutions and a global recession, Islamic banking is seriously being considered a possible alternative to conventional banking. The biggest support has surprisingly come from the Vatican itself, which has been very critical of the destructive excesses of the interest-based conventional financial system. Two authors of L’Osservatore Romano, the Vatican’s official newspaper, have said that the ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark financial services. After all, the Bible denounces that “the love of money is a root of all kinds of evil” (1 Timothy 6:10).

Islamic Banking experiences a healthy growth of 10-15% per year. According to The Economist there are over US$822 billion shariah-compliant assets worldwide. Most international big banks now (JP Morgan, Deutsche Bank)  have Islamic banking operations and they employ shariah scholars, expert in both scriptures and in financial theory. These scholars are so rare, many have to sit on several boards. Ancient texts don’t address specific matters like derivatives, bonds, futures, warrants, stock options or day trading, so a delicate and very sophisticated form of extrapolation ensures transactions comply with the spirit of the writings in holy books.

Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. If a company makes 2% of its money from selling pork rinds, an investor must give away 2% of his dividends to charity, a process known as “portfolio purification.” Buying and selling stock is fine, because it represents real assets, and they can be traded safely today using the Dow Jones Islamic Index.

Islamic banking is not entirely free of guilt or suspicion, of course. With 60% of Muslims living in poverty, Islamic banking is perceived by some to be of little benefit to the general population. It has had its share of scandals too, like one Malaysian bank who apparently invested the majority of its Islamic funds in the gaming industry, something totally unethical and prohibited under Islamic principles. Goldman Sachs’ $2 billion Islamic bond program came under scrutiny after it was discovered that the scholars who were supposed to approve the operations had not even seen the prospectus. Islamic banking has also been accused of serving as a channel for financing terrorists. However it does seem that Islamic banking has important ethical principles well worth imitating, and proponents of Islamic banking say any socially conscious investor can agree with most limits, standards and criteria of Islamic banking, whether they are Muslim or not. 

-Still want more? Here’s an article in Fortune magazine

-The photographs of the Al-Quran and the Astrolabe were taken from this blog

To read my article in its original PDF form, go to: Islamic Banking

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