Is Islamic finance a solution?

Even the Christian world is embracing Islamic banking and finance as a response to the international economic crisis. The Vatican has endorsed the values of Islamic finance as a solution to the problems in the world of conventional, interest-based finance. It has stated that Western banks should carefully examine Islamic financial regulations in order to restore confidence among their clients.

“They are experiencing divine punishment. We are happy over that. The more they become unhappy, the happier we get,” proclaimed Ahmad Jannati, senior Shia cleric and secretary of the Guardian Council, to a crowd at the Tehran University in Iran.

His Sunni counterpart Yusuf al-Qaradawi was less dramatic: “The collapse of the capitalist system, which is based on usury and securities rather than commodities in markets, shows us that it is undergoing a crisis and that our integrated Islamic philosophy — if properly understood and applied — can replace the Western capitalism.”

The conventional banking system is built on a foundation of “Riba”, usually interpreted as usury or interest, which is firmly forbidden in Islam. The collapse of leading Western financial institutions amid the global financial crises has encouraged economists worldwide to consider alternative financial solutions and new approaches to banking and finance.

According to Joseph DiVanna, finance expert for The Banker publication, sharia-compliant banks were performing better than conventional banks. He said more Islamic banks and financial products have been launched worldwide since late 2008, despite the banking crisis that restricted conventional banks from doing so.

A Financial Times article published early in June 2009 cites evidence that suggests “what happens in the world of conventional finance affects the Islamic financial world with a time lag”. But Daud Vicary Abdullah, expert at consulting firm Deloitte, expects double-digit growth in global Islamic finance over the next few years. “Countries like Japan, South Korea and Singapore are showing more interest in the Islamic finance because of the value of the products offered and also the transparency of the transaction.”

Another finance expert, Professor Rodney Wilson of Durham University, claims that in the current crisis no Islamic bank has failed, and in contrast to conventional banks, none have needed government funds to save them from collapsing.

Some claim that Islamic banking provides a viable alternative to conventional banking. The spread of Islamic finance into Western markets shows that it is being treated seriously by government and finance authorities. While the Islamic financial system is being increasingly sold as the best alternative, it is widely recognised that the Islamic system itself has been largely modelled on its interest-based Western counterpart. Both share the same material goals and adopt the same institutional structures, with the result that the products promoted by the Islamic finance industry are sometimes indistinguishable from those of interest-based institutions. These similarities have led some to claim that the Islamic banking and finance industry has failed to properly implement Islamic ideals.

The soundness of Islamic banks is perhaps accounted for by the fact that they use a classical banking model, with financing derived from customer deposits. Islamic banks are less susceptible to economic downturns, instead of paying interest to depositors, those with investment (mudaraba) accounts share in the bank’s profits. This profit-sharing reduces risk for the banks and means they are less likely to become insolvent.

Muslims scholars are claiming that had the requirements of sharia been properly implemented, a financial crisis of the present kind would not have occurred. For example, if commercial banks were required to share the risks as well as the profits and losses of their clients they would be more careful when choosing which deals to finance.

However, the fact that Islamic finance has copied the Western template of finance raises serious questions around its ability to point to a viable alternative. Besides the fact that Islamic investment funds tend to invest in better performing companies by avoiding investing in companies that are heavily indebted with interest-based loans, a closer look at the industry might explain why the Islamic finance industry is performing better. Islamic banking benefits from oil revenues (primarily in the Gulf where it is predominately based) and is relatively smaller than its interest-based counterpart. These characteristics allow the industry to deal with problems quicker and without huge public-bailout packages.

Leading critics of the Islamic finance industry argue that the Islamic banking and finance industry is partially just a soft version of the secular system. According to them, if the Islamic finance industry continues to develop in the manner that is has, it will suffer from the same systemic problems as the conventional system. They call for a total reconsideration of the objectives, frameworks and methodologies of the modern Islamic banking and finance industry before it is presented as a viable alternative.

Muslims firmly believe that Islam has the solutions to the world’s problems and now is the ideal time to start demonstrating thus.