ISLAMIC BANKING

Islamic Banking: Strengths, Weakness, and Areas of Growth

Amirsaleh Azadinamin, MBA

Doctorate of Finance Student Swiss Management Center (SMC) University

March 1, 2012

Electronic copy available at: http://ssrn.com/abstract=2007818

ISLAMIC BANKING Abstract The purpose of this article is to identify and explore major challenges, opportunities, weaknesses, and threats of Banking in Iran, and hence, the system of Islamic banking. First, the paper looks upon the concept of Islamic banking and how it has been shaped based on the theoretical frameworks mentioned in Quran, the holy book of Islam. Then, the paper mentions the opportunities of growth where the Islamic banking market is in high demands, where there has been no or few services offered. The paper also reviews how Islamic banking has benefited in terms growth by the recent financial crisis where most conventional banks had to take a step back and recapitalize. Islamic banking did not need to go through the same path as they were never as leveraged as conventional banks. The system that prohibits making profit on money without being fully asset backed will eradicate a substantial degree of risk and immunes it against the fragility that conventional banks are prone to.

Electronic copy available at: http://ssrn.com/abstract=2007818

ISLAMIC BANKING Theoretical Framework of Islamic Banking Even though banking is not a new concept and it has always existed in the human history, whether in preliminary forms or todays form of banking, the formations of Central Banks are fairly a new phenomenon and they have not been around more than 100 years. The Iranian Central Bank is no exception and it was established around 50 years ago, and as an Islamic country after the Iranian revolution it has followed the Islamic banking laws known as sharia. The emergence of Islamic banking has been driven by the increasing number of Muslims who wish to lead their lives according to the shariah, the legal code of Islam (AbdulMajid et al., 2010, p. 25). As for following the Islamic banking regulations are concerned, Iran is no different story. At the core of the Islamic banking is the prohibition of riba, which is the interest on money without having been fully backed by assets. Some argue that this may be reason that Islamic banking has shown more resilience to the current crisis of credit and it has received a lot of interest due to the insignificant damage that it had sustained from the crisis

(Noreen et al., 2011). Many economists have contributed this resilience to the key concept at the core of Islamic banking, the elimination of interest in financial dealings. Noreen et al., (2011) mention that a key tenet of Islamic banking is the elimination of interest (Riba) in financial dealings which is also prohibited in four major religions: Christianity, Judaism, Islam, and Hinduism. According to basic Islamic perception about money that it has no built-in value, money cannot be earned out of money directly. Anti-shariat principle selling a debt against a debt has made credit crisis technically improbable in Islamic financial market. This paper uses terms of credit crisis, financial crisis, subprime mortgage crisis, credit crunch and economic turmoil interchangeably (p. 193).

ISLAMIC BANKING One cannot talk about banking in Iran without illuminating the system that is shariacompliant at its core. And hence, Islamic and Iranian banking are one and same and they cannot be distinguished from one another. So, one can only explain banking in Iran by shedding light

on Islamic banking. This trend has even been mortified by Muslims who try to blend the Islamic law in their lives. As Azarian (2011) mentions, by the late 1970s political developments in Pakistan and Iran had let to governmental attempts at transforming these countries whole financial system into an Islamic one, which helped the trend tremendously. Iran has been no exception. Islamic Banking and Its Structural and Cultural Context Azarian (2011) explains the Islamic bankings institutional matrix, mentioning the issue of Riba (interest) and the prohibition against it as it has been mentioned in several places in Quran. Riba literally means addition, excess, expansion or increase, and it is a religious-legal term in which the widest interpretation covers both usury and interest. In another word, it is any unjustifiable increase of capital whether in loans or sales. As far as sales on credit are concerned the prohibition is considered as a measure to forestall riba from creeping into the economy through the back door, and includes any exchange of commodities without giving an equivalent counter-value in return to the other party, whether this is arranged through variations in the amount of commodities being exchange or through exchange of commodities of equal value but with differences in time of delivery. Furthermore, with its obvious significance for the moulding of the Islamic financial system, this prohibition refers to any increment gained through lending money. More technically, it covers any cost levied on the principal of a loan to be paid to the borrower along with the principal amount at a pre-determined rate tied to the

ISLAMIC BANKING maturity and the amount of the principal as a condition for the loan or for its extension on its maturity (p. 261). Growth Opportunity and Limitations One can clearly realize that there are fundamental differences between conventional banking in Western countries and that of Islamic banking. Many instruments, of which speculative tools are the main ones, are not allowed in Islamic banking, and thus, one can conclude that Islamic banking is constrained within a more conservative framework. This will safeguard the system against shaky grounds in more turbulent times, while it may limit its exponential growth. However, this may be a more long-term pragmatic approach as the Islamic banking will continue its steady growth while other banks face major obstacles and setbacks. With the global financial markets experiencing extreme unrest due to existing credit crunch, the world Islamic banking sector has been progressing at the uniform pace. According to Financial Times (2008), the Islamic banking has gained a growth more

than five folds by hitting $900bn from $15bn during the time period of 1990 to 2008 and prospering at the yearly pace of 15%-20%.As for most recent statistics revealed by Financial Times of November 2008, the global Islamic banking assets worth $800bn from around 50 countries accelerated at 27.6% over the past year (Ismail et al., 2011, p. 194). Nonetheless, the asset amount owned by Islamic banking may be relatively small compared to assets of global conventional banks, but with the world markets struggling hard to make their existence after the financial recession, Islamic banks have been moving on with their steady pace of growth, and their escape from global recession may be solely due to a more ethical and less risk bearing investment approach than conventional banks (p. 195). The

ISLAMIC BANKING advantage that Islamic banking has over conventional banking may showcase itself not in times of good economic times, but the exact contrary, in times of economic contraction, and studies can attest to that. When the performance of top 10 conventional banks is compared with the top 10 Islamic banks, Ismail et al., (2011) conclude the followings: 1- During the time period December 2006 to May 2009, the main starting point of the current economic crisis, the Islamic banks suffered a decrease of 8.5% of market capitalization in comparison to 42.8% of conventional banks. 2- During the same period the reserves of conventional banks grew at 36%, while that of the Islamic banks grew at 55% reaching $ 147 billion from $ 94. Similarly, during this

period an increase in total equity for conventional banks and Islamic banks was 24% and 36% respectively (p. 195). 3- Smaller leverage ratios of Islamic banks helped them scape the crisis. The leverage ratio of conventional banks was 16.6 times in 2006 that increased further in 2008 to 18.2 times, which was three times the leverage ratios of Islamic banks that increased from 5.8 to 6.6 times. As a result, while five out of top ten conventional banks gained financial assistance, it is worth mentioning that none of the Islamic banks required any governmental rescue support. Emphasizing on conservative moves by Islamic banking and how it has safeguarded these banks from sinking in the turmoil, Martin (2008) mentions that Islamic banks have been excluded from groups where the concerning banks had to face up to periods of retrenchment and cutbacks. Some conventional banks are well placed to take advantage of their rivals' weaknesses, while the Islamic banking sector could emerge to play a more central role in the financing market (p. 1). Also, the structure of the bailout packages will limit them from

ISLAMIC BANKING expanding as well as their ability to do business in many markets. For instance, according to the terms of the liquidity injection for UK banks, those that access government funding will be forced to concentrate on their home markets. The banks involved include Royal Bank of Scotland (RBS) and Lloyds TSB, which are looking for 20bn ($35bn) and 17bn respectively from the UK government (p. 1). Martin (2008) adds that when compared to the conventional banks which have failed in the face of the recent financial crisis, Islamic banking has benefited from the crisis, and they are being brought into deals now more than ever due to their sufficient capitalization. This holds true even though the restrictions on Islamic banks have traditionally made them more expensive to be used and they have played a limited role in the past; however, in the face of the current crisis the situation has changed. This is mainly due to their more conservative and less speculative manner which helped them maintain a strong capital position. Given the restrictions on the kind of assets in which they can invest, sharia-compliant institutions have avoided many of the products that led to the credit crunch in the first place, such as collateralised debt obligations. As such, they are well placed to expand in today's difficult climate (Martin, 2008, p. 1). Martin (2008) also highlights yet another point of strength of the Islamic banking system. [T] he strength of Islamic banks' balance sheets puts them in a strong position compared with major conventional banks and companies that are trying to reduce the amount of debt they hold, known as deleveraging (p. 1). In the era of deleveraging and recapitalization, where Islamic banks are well capitalized and not very leveraged, Islamic banks are positioned one step ahead in compared to conventional banks.

ISLAMIC BANKING Even though Sharia-compliant banks have been less affected by the credit crunch and its negative consequences, and they are seeing growth opportunities while conventional banks are facing liquidity issues, there are weaknesses as well. Martin (2008) mentions that the relatively small size of Islamic banks could still prevent them from playing a major part in various regional deals in which their small size may come as a disadvantage and the banks would be looked over. The article Islamic banking: Three opportunities amid a shaky recovery (2010) illuminates the untapped resources within the Muslim population as a great opportunity for growth. The resource is the large Muslim population itself, and the opportunity is in providing large-scale Islamic banking for those who believe in the Sharia law. The long-term growth prospect is where the domestic demand is strong. The large and growing consumer demand is where the opportunity for profit and expansion lies. Many of these countries not only have large and unsatisfied people with the banking system, but also a population with a high growth population rate. Looking only at those regions where there is large a Muslim population, we prefer Saudi Arabia and Egypt in the Middle East, Turkey in Europe, and India and Indonesia in Asia (p. 19). In addition there are various European countries with Muslim population, where the Islamic banking service has not been provided. In developed markets with large Muslim populations, the UK has been a pioneer due to its status as a European financial hub, but it does not have the largest Muslim population. France and Germany both had 4mn Muslim citizens (in 2009), according to Pew Research Center, compared with 2mn in the UK and 2mn in the US. However, Germany in particular seems to be coming round to the idea of Islamic finance. (p. 19).

ISLAMIC BANKING As the strength for growth is laid in places where lack of Islamic banking services is seen, the contrary may also be true: the market for Islamic banking is not very expansive as it is contained by geographical borders, namely Middle East and some Muslim Asian countries. As Volk and Pudelko (2011) mention, the determinants of Islamic banking are demand, supply, social and regulatory conditions, and these determinants can clearly explain why Islamic banking could grow in some European countries and not in some other. Lack of supply, and apt regulatory and social conditions play an essential role in the growth if the demand condition exists. This demand could also increase considering the growing Muslim population in Europe. A recent survey among German Muslims revealed that only 4 per cent of the respondents used Islamic financial products or services and 55 per cent of the respondents identified the lack of supply as the major reason for the low prevalence of Islamic finance in Germany. Lack of experience among local banks is certainly an important reason for this shortage (Volk and Pudelko, 2011, p. 196). Concluding Remarks Since Iran follows the same sharia-compliant laws that go into Islamic banking, it was rather logical to turn the argument to a broader concept and system: the Islamic banking. Islamic banking has many limitations which in many cases have worked to its advantage. Islamic banking is fairly new and it has not been put to the test as much as the conventional system of banking. The recent financial crisis was probably the very first major test that Islamic banking was put through and the results were nothing less than satisfactory. The damage that Islamic banks sustained during the 2006 - 2009 era was far less than those of the conventional banks. Islamic banks are better capitalized and that makes them stronger in absorbing external

shocks. One can surely point to numerous weak points of Islamic banking, like many limitations

ISLAMIC BANKING

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on its financial instruments, but these limitations have also helped the system engage in a lesser speculative financial activities, which at the end played as the winning card of Islamic banking. The paper highlighted points of strength and weaknesses of Islamic banking; however, there are also many scholars on the other side of the argument who do not have much trust in Islamic banking and consider it nothing more than being unrealistic. They also argue that the core concepts of Islamic banking are not very well defined. [T]here is a lot of confusion on the main topics of Islamic economics. Muslim thinkers are not yet able to define the term riba (interest) which is the foundation of Islamic Economics; prevailing concept of riba is completely baseless. No solid arguments can be presented in the favour of private ownership of land. Interest free banking is not more than deception. It is the need of time that Muslim thinkers take a deep critical analysis of their views and try to find out the basic mistakes which they are doing in interpretation of Islamic economic teachings. According to Quran there teachings can never be friendly to elite class, but now-a-days situation is quite reverse which clearly required an operation clean up in this regard (Aziz et al., 2011, p. 772). What was just mentioned above by Aziz et al., (2011) is a great topic for discussion to ponder on even though it is outside the framework of this paper, but it remains a strong point for discussion.

ISLAMIC BANKING References Abdul-Majid, M., Saal, D. S., & Battisti, G. (2010). Efficiency in Islamic and conventional banking: an international comparison. Journal Of Productivity Analysis, 34(1), 25-43. doi:10.1007/s11123-009-0165-3

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Alam, H., Noreen, H., Karamat, M., & Ilyas, M. (2011). Islamic banking: Insulation against US credit crisis. International Journal Of Business & Social Science, 2(10), 193-201. Azarian, R. (2011). Outline of an economic sociology of Islamic banking. International Journal Of Business & Social Science, 2(17), 258-268. Aziz, F., Abbas, H., Zia, S., & Anjum, M. (2011). An Analytical & Critical Analysis of Different Aspects of Islamic Economics. Interdisciplinary Journal Of Contemporary Research In Business, 3(3), 766-772. Ibrahim, W., Ismail, A., & Zabaria, W. (2011). Disclosure, risk and performance in Islamic banking: A panel data analysis. International Research Journal Of Finance & Economics, (72), 100-114. Islamic Banking: Three Opportunities amid a shaky recovery. (cover story). (2010). Emerging Markets Monitor, 16(7), 19. Martin, M. (2008). Credit crunch winners emerge. MEED: Middle East Economic Digest, 52(43), 24-25. Volk, S., & Pudelko, M. (2010). Challenges and opportunities for Islamic retail banking in the European context: Lessons to be learnt from a British-German comparison. Journal Of Financial Services Marketing, 15(3), 191-202. doi:10.1057/fsm.2010.16