Islamic loan Vs Conventional loan

My last post attempted to make a fundamental comparison between riba and al-bay. So on this post I seek to differentiate the concept of loan from the Conventional and Islamic banking prospective.  

In order to explain the differences between the Islamic and conventional loan, first the general concept of loan needs to be addressed, from both conventional and Islamic prospective in terms of banking.  From the conventional point of view loan is a type of debt which involves two parties’ lender and borrower.  In a loan the borrower receives a certain amount of money from the lender which here is the bank; this borrowed money is called the principal amount, which needs to be paid back by the borrower at a later period through installment and these terms are enforced by legal contract.  Now the bank requires the borrower to pay back the principal at a cost which is the interest that is the incentive for lender (bank) to engage in providing loan. Similarly Islamic loan (qard) are also form of debt where there is transfer of ownership of fungible wealth (loans in terms of Islamic banking does not necessarily be money it can be any tangible asset) to a person on whom it is binding to return wealth similar to it¹.   

From the above we can say that both Islamic and Convention loans are form of debt.  So what really is the difference here? The prime difference lies in the incentive aspect. Interest is the dominated aspect of Conventional loans which is excess amount paid over the principal. In contrast Islamic banks cannot charge excess over the principal as interest constitutes riba which is prohibited in Shariah (Islamic Law).  “Allah permitted al-bay (trading) and prohibited riba  (Al-Baqarah: 225); Quran refused to accept the contract of interest-bearing loan as fair business trade. Hence loan for Islamic banks has no monetary gain in comparison to conventional banking where loan is their prime profit generating tool. 

Taking profit from interest-bearing loan is unjust from an Islamic prospective therefore loan is not a profit generating tool in Islamic banking. However it is permitted for banks to charge for services rendered, that is the operational cost involved in issuance of the loan any excess amount is prohibited. Therefore it is mandatory for the loan contract to clearly state the operational cost of the service.  Islamic Banks do issue Qard Hassan (benevolent loan) to fulfill part of its social responsibility; it’s given to employees of the banks or to students in many cases.  

 From here we can conclude that loan is not a mechanism for generating profit for Islamic banks compared to conventional banks. Trade contracts (al-bay) are used to earn profit they involve buying and selling of assets. (the next few posts will talk about the trading contract that drive Islamic banks and financial institutions)

Al-bay vs Riba

My previous post talked about Islamic world view as the driver for all Islamic economic activities now financing those activities is imperative, without financing economic activities will not take place; this is where banks and financial institutions come in. Islamic banks need to adhere to the notion of the Islamic world view as well, so let me try and make a fundamental comparison between Islamic banking and Conventional banking.  

Conventional Banks are financial intermediaries that hold capital, borrow from depositors the surplus sector then give out loans to the deficit sector, where these loans are based on interest when doing this bank bares financial risk. Here households, businesses and government bodies makeup both the deficit and surplus sectors. In a conventional bank the market for Deposits that is the demand for deposits and its supply as well as the market for loans which is the demand for loans and its supply are both based on interest rates, meaning that banks pays interest to depositors for borrowing their money and receiving interest from the loans that they give out.  

Like the Conventional banks, Islamic banks are also financial intermediaries, that take deposits from surplus sector and extend financing towards the deficit sector but unlike Conventional banks Islamic banks cannot take or receive interest as it is not permissible according to Shariah (Islamic Law). So if the prime factor that generates profits for conventional banks is interest the question to ask is how Islamic banks and financial institutions make profit? Certainly an Islamic bank is not a charitable organization, in order to answer this question one needs to understand the concept of al-Bay in comparison to riba (interest).  

First what is Riba?  It is predetermined surplus over and above the loan.  Also three conditions must be fulfilled for transaction to constitute Riba 

1.   excess or surplus over and above the loan capital to be returned to the lender;
2.  determination of this surplus in relation to time with definite date of redemption;
3.  stipulation of this surplus in a loan agreement. ¹

From this one can easily conclude that Interest constitutes Riba. Its stated in Quran “O ye who believe do not consume riba with continued redoubling and protect yourselves from God, perchance you may be blissful” (Al-Baqarah:130). In the conventional banking system depositors are promised a guaranteed sum of principle and interest payments. Likewise a bank charges interest with serious legal implications when loan is defaulted. 

This seems all good however, when small businessmen and those who aspire to expand operations but lack the credentials of giant corporations, conventional banks usually close their doors to these group of businessmen, taking them as business partners is taboo in banking. Is causes income disparity².  Its stated in Quran “wealth must not circulate only among the rich ones among you” (Sura 59:7) 

Now that we have established that interest constitutes riba and its implications we can go back to our initial question; what is the alternative that Islamic banks use to generate profits. What then is the key factor that drives deposit market and financing market for Islamic banks? The answer is al bay 

What is al-bay? It means trade which is money exchanged for goods and services meaning that the key principle here is profit sharing and loss sharing in financial terms risk sharing. (I will talk about the concept of risk sharing in detail in my next post). Therefore in Islamic banking, banks are agents (mudarib) and depositors as investors, the banks manage the deposited funds.  So the deposit and financing markets for Islamic banks is based on Trade contracts and not based on lending and borrowing contracts in comparison to how conventional banking is structured.  This means that Islamic banks are faced with business risk, where as Conventional banks are faced with financial risk this another element that differentiates Islamic banks from the conventional. This is because conventional banks face capital loss due to credit default and interest rate volatilities where as Islamic banks faces capital loss due to adverse price movement. (In the next few posts I will talk about risk as it is an important aspect for Banking and financial institutions). 

¹ Murat Cizakca ‘Islamic capitalism and finance’ Page 74-75

² Saiful Azhar Rosly ‘Critical Issues on Islamic Banking and financial Markets’ Page 37-38

Islamic Finance based on Islamic World view

According to a recent KPMG international  report Islamic financial industry is estimated to grow between 15-20 percent annually, but some institutions have reported faster growth. Of current, the sector has estimated assets under management of US$500 billion. Rapid emergence of new markets like  Syria, Lebanon, UK, Turkey and Canada are evident to the growth of this sector. Also some conventional banks and financial institutions are embarking to the process of conversion for example in 2006 Kuwait Real Estate Bank converted to a licensed fully fledged Islamic Banks. 

      

The question to ask is ...what is this animal called Islamic finance and how is it any different from conventional finance?  According to Mabid Ali Al-Jarhi, Islamic banking and finance can be described as a system through which finance is provided in the form of money in return for either equity or rights to share in future business profits, or in the form of goods and services delivered in return for a commitment to repay their value at a future date. Islamic Finance is not a new concept it is actually fifteen centuries old. The origins of Islamic finance can be traced to the birth of Islamic and even earlier pre- Islamic era. There were sophisticated trade contracts that laid  foundation to the modern Islamic financial system.(will discuss those contracts in my later posts). A lot of institutional borrowing occurred during medieval times. (for a better and elaborate overview on origins Islamic finance and cross institutional borrowing read Dr Murat Cizakca's book called Islamic capitalism and finance).    

 We know that economic activities gives rise to financial institutions that provide capital to fund enterprises. Now to understand the framework of economic activities we need to look into that particular system's "World view". World views reflect a society's social vision and thus defining its social norm therefore it exerts significant influence on its economic discussions. One now asks this question- what actually is the Islamic world view and what has it to do with Islamic financial markets? According to al- Attas, an Islamic world view is the vision of reality and truth that appears before our mind's eye, revealing what existence is all about. The world view of Islam encompasses both al - dunya (Life) and al-akhirah (After life), In which dunya aspects must be related in a profound and inseparable way to the akhirah aspect. Such world view requires one to acquire knowledge about the concept of: 

•         Din (religion)
•         God 
•         Man
•         Universe 
•         Prophethood 

In other words Islamic world view is an holistic view that combines reason and divine revelation. The Holy Quran says "By time, man is in loss, except those who believe and do good works and exhort one another to truth and to patience" (Al-Asr:1-3). This shows that for muslims Islamic world view is a basic need without which they will be in utter loss and confusion. With Islamic world view, Islamic banks and financial institutions are able to pursue transactions manifesting the Quranic conception of trading and commerce (al bay) as an alternative to conventional transactions which are based on conventional world view that is only based on reasoning alone. (This was a very brief note on world view for a clear understand about the Islamic world view in comparison to the conventional refer to the IDB lecture by Dr Mohammad Umar Chapra  http://bev.berkeley.edu/ipe/readings/IslamicEconomics.pdf )

Having talked briefly about the world view lets now highlight the fundamental principles  

• The prohibition or taking or receiving interest at exorbitant rates (Riba), but this does not preclude a rate of return on investment. (My next post will be about riba I will discuss why riba is an impediment)
• Risk in any transaction must be shared between at least two parties so that the provider of capital and the entrepreneur share the business risk in return for a share in profit.
• The prohibition of speculative behavior (Gharar) is not allowed, meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited and thus contractual obligations and disclosure of information are a sacred duty. This also restricts traditional derivatives.
• Investments that violate the rules of Shariah (Islamic Law), advised against by Shariah boards, and are generally non-ethical meaning that investment in businesses related to alcohol, pork related products, entertainment (gambling and casinos, pornography). In addition, some Shariah boards recommend against tobacco, weapons and defense. An example of index restriction can be seen on Page 5 of The Dow Jones Islamic Market Index Rulebook.

Finally I would like to mention to those who have been saying that Islamic finance faces identity crisis-- No Islamic finance has clear and defined identity based on its principles, on the practice side as Islamic finance is not a matured industry it faces challenges that most developing industries do. regardless its not having identity crisis in fact this is not something to even debate about.. all one has to do is it to understand Islamic world view that serves as framework for its economic activities.