Tuesday, January 20, 2009

Islamic Banking

Within the GCC most countries run a dual banking system, using both the western and Islamic banking systems side by side. Bahrain has the largest number of Islamic banking headquarters (at least 24 + 11 Islamic insurance companies), whilst Oman currently bans Islamic Banking.

Islamic banking takes its rules and strategies directly from the relevant verses in the Koran (a key verse being: 2:279) and in general attempts to work with borrowers, to the benefit of all relevant parties (the lender, the borrower and the bank).

The 4 Tenets of Islamic Banking
In Islamic banking, four basic tenets must be followed:
1. Interest, either for the borrower or the lender, is forbidden.
2. The lender shares in the profits and the losses made by any enterprise it lends money to
3. Excessive uncertainty, risk and speculation [GHar-rrarr] is forbidden
4. No business should support products forbidden in the Qur'an, e.g. alcohol, gambling, vice and pork. In Islam these products are forbidden and known as halal [haa-lal] {see wgaw blog archieve: halal or haram}

In addition to the four rules above, Islamic banking attempts to encourage investments benefiting the community at large ~but that would be an opinion or point of view not shared by everyone~

Image taken from: http://thetakaful.wordpress.com/2008/04/15/islamic-finance-manages-over-500b-assets/

1. Interest or Usury; riba [ribb-bah]
In Islamic banking only one kind of loan is allowed, a 'good loan’ or qard-el-hassan [KHaard-al-Ha-saan]. With a qard-el-hassan the lender can not charge the borrower any interest, or any additional fee because money has been lent.

On hearing this, many people want to know how the lender makes money. In Islamic banking the lender takes a share of the profits rahter than a monthly interest payment. You could say waiting for the profits from a business is very similar to waiting for interest, however the difference comes from there being a pre-determined profit-sharing ratio, rather than a specific monthly rate of return.

Interest, or riba, is written about in four different places in the Koran and I have quoted these references so you can feel the strength of dislike, in the Qur'an for the concept of ursury/ interest/ riba:

1. Al Baqarah, 2:275,
“Those that live on usury shall rise up before God like men whom Satan has demented by his touch, for they claim that trading is not different from usury. But God has permitted trading and made usury unlawful.”

2. Al Baqarah, 2:276-279,
“God has laid his curse on usury and blessed almsgiving with increase. God bears no love for the impious and the sinful. Those that have faith and do good works, attend to their prayers and render the alms levy will be rewarded by their Lord and will have nothing to fear or to regret. Believers have fear of God and waive what is still due to you from usury, if your faith be true; or war shall be declared against you by God and His apostle. If you repent, you may retain your principal, suffering no loss and causing loss to none.”

3. The Imrans, 3:130-2,
“Believers, do not live on usury, doubling your wealth many times over. Have fear of God that you may prosper. And then it goes on to say (Al Nisa, 4:161), “Because time after time they have debarred others from the path of God; because they practice usury - although they were forbidden it - and cheat others of their possession.”

4. Al Rum, 30:39,
“That which you seek to increase by usury will not be blessed by God; but the alms you give for His sake shall be repaid to you many times over.”

2. Profit & Loss Sharing
In Islamic banking the lender will share the profits and suffer the losses made by the business to which it lent money. That is, the investor becomes a business partner or in western banking terms, a 'sleeping partner'.

3. Excessive Uncertainty, Risk or Speculation [gha-rrarr] is Forbidden
Every single transaction carried out by an Islamic bank must be free from uncertainty, risk and speculation and all parties involved (1. the bank, 2. the depositor of money and 3. the business/person being lent money) must know what they will gain from the financial transaction. However a guaranteed profit is not allowed.

This forbidding of risk means the options and futures trading, as well as forward foreign exchange transactions, are considered un-Islamic because the rates are determined by interest differentials.

4. The Selling of Haram Products Should not be Supported
Before investing in any business, Islamic banks check to make sure the business does support nor trade in products forbidden by the Koran (i.e. alcohol, gambling, vice, or pork and their dirivatives) {see wgaw blog archive: haram} and does not invest in any business which supports these activities or industries.

This means the preferred long term investments for Islamic banks is often in areas such as real estate and manufacturing.

Image taken from: www.ameinfo.com/179388.html

Problems for Investors with this System
As an investor, Islamic banking limits the number of options for investing your money. In reality you will need to choose between the following two options:
1. invest with risk; that is, invest in a business, or
2. keep your money idle; and slowly loose your capital through devaluation.

Although most Islamic banks do offer deposit accounts for investors, the return on investment is very small (maybe ½ or 1%, per annum). This means your 'rainy day fund' or 'retirement pot' is highly likely to devalue over the years. Your money will be safe but the ammount of capital you own, in real terms, will slowly become smaller as inflation eats into your capital.

Additional Information
For far more detailed information on the intracies, the benefits and the problems with Islamic banking try:


aaliyah said...

Forbidden produts such as alcohol are called "haram" and not halal. Halal is something that is allowed. Really enjoy your blog :)

wgaw said...

Yes, you're right ... thanks for that. Quite a typo that one :-/