Islamic Banking:

Is it a System or a Beginning of a Change? Where is it Heading?

Once upon a time, when the movement of Islamic banking started in the 1970s there were professional economists who saw in it a totally new economic system that does not only restructure the economy but the whole society as well. Some writings envisaged Islamic banking as a different system of motivation for saving and investment as well as a dreamed solution of bridging the gap caused by the saving/investment dichotomy. The biggest blow to these writings came from the fact that Islamic banks came to blend and co-exist within a conventional system of banking, making no economic revolution and upsetting nothing in the prevalent economic equations. Islamic banks, whether commercial or investment, actually took the same shape and approach that are adopted by their interest-based counterpart, to the extend that they can be loaded with the same criticism addressed to conventional banks, ‘they give the umbrella when it is shining and take it back when it rains or the give the cake to the rich and nothing to the poor.’ In fact, there are professionals, within the ranks of Islamic economists, who still argue that the experiment of Mit Ghamr was not merely an attempt of an early version of “banks for the poor, the Islamic way” but it was the true form of Islamic banking that was brought to an end by the conspiracy and conspirators!

Another frustration was the outcome of a large gap between theory and practice. Is it a disobedient practice or a misguided theory? The problem of Islamic banks is that they were born in a milieu of two extremely polaristic paradigms: the reality of interest-based conventional banks that came to take its present shape after more than four centuries of natural development, growth and boundary expansion and the idealistic fictitious theorization that imagined a framework of Islamic banking on the basis of a simplistic Mudarabah and two tier Mudarabah. Writings in Islamic banking preceded the actual establishment of the first such bank by nearly two decades.² Throughout this period, most of our emphasis was on Mudarabah as the “Islamic” trademark of banking, Ju’alah and Wakalah were also presented by some writers, but when the early Islamic banks were born they had to wait for two years to start any banking business until the “Murabahah to the purchase orderer” was invented!³ Is it only a case of mismatch? Did Islamic banks go astray and deviated from their presumed course? Or was the theory wrong?

Until today, many Islamic economists insist on their Mudarabah theory and pray to God that Islamic banks come back to their lap! They will not. . . It is not a case of miscarriage or birth defect but of an erroneous unrealistic pre-nuptial theory that was formulated in isolation of banking experience. Islamic theory was born before Islamic banks and delivered by non-specialized idealists. The first reference to the inadequacy of Mudarabah in fund utilization came with the survey of Saudi small businesses that indicated a preference for Murabahah; and Islamic economists started recognizing the risk of Mudarabah and its stringy institutional requirement only in the late nineties and the new century with the rise of concern about risk analysis in Islamic banks! This is inspite of the tremendous success Mudarabah encountered in funds mobilization.

This brings us close to the controversy of whether the Islamic banks are mere financial intermediaries or direct actors in the real (physical) market. Although many Islamic economists started to incline toward the intermediary idea, most Islamic bankers argue for larger authority. The nature of Islamic financing requires Islamic banks to make transactions in physical goods and services, but while many of us like to see them done only on initiatives from businesses that need financing, Islamic bankers cling to holding larger authority.⁴ I think Islamic banks have to be restricted to an financial intermediary role only, otherwise the conditions of competitiveness in the market should be reconsidered and a signorage charge has to assessed for the right to accept deposits and issue credit.

We also find professional writings in Islamic economics that load Islamic banks with a social philanthropic role that uniquely singles them out from among all the economic units. While all economic units are expected to participate in philanthropy, and they actually do whether for altruistic or public relations reasons, charging the Islamic banks with a unique social role that is not required from their conventional counterpart nor from other businesses puts them in an uncompetitive position. In fact, the actual practice of Islamic banks indicates that the majority of them do not interfere even in the payment of the obligatory Zakah for their shareholders let alone the depositors, and the amount of charitable and other donations they give is very trivial compared with their revenues, net profit or assets.

There are also writings that want to deprive the Islamic banks from the right to issue credit through the process of demand deposits creation caused by the partial reserve system. They argue that the demand deposits in Islamic banks should take the legal form of ‘Wadi’ah’ as known in the Fiqh with a slight change that is implied in physically putting all deposits in one vault and using checks and transfers to manipulate them. Some writings reinforce their view by the argument that since the Shari’ah calls for monopolizing the issuance of currency (minting gold and silver coins) in the hand of the government, money creation in all forms including the creation of credit as demand deposits should be strictly held in the hands of the government through a 100% reserve system.

Once more, to the dismay of these writings, the short history of Islamic banks and the development of Fiqh positions on demand deposits took a completely different direction: Demand deposits are treated as loans in order to justify the 100% guarantee for the principal of deposits’ and loans do not require preserving a physical presence of lent assets. On the other hand, central banks apply the same rules of partial reserves to Islamic conventional banks alike. Additionally, the theoretical argument for full reserves is itself borrowed from conventional economics; it is controversial, socially costly and anti the trend of Fitra (that has been the actual real-life basis on which the creation of credit relied) that is growing now toward creating electronic credit in the form of means of payment.

Then comes the latest frustration in the form of the recently prevalent Tawarruq. Regardless of whether it is permissible or not and regardless of what conditions the Shari’ah compatibility may impose on it, Tawarruq brings the whole Islamic banking theory to square 1. The Essential virtue of Islamic banking that is so much elevated by

the most liberal Islamic economists is that Islamic Financing has to be stick to the real market transactions and it does not allow for the provision of cash. Now, this new Tawarruq, domestic and international, provides cash at a higher cost than interest.

The last two points that I want to raise about Islamic banking are related to justice between share holders on one hand and the depositors on the other hand; and the effect of globalization. While the present system of Islamic banks runs Shari’ah compatible contracts, it leaves out in the air the effect of the negotiation power on the final products of such contracts. In fact, banks in general and Islamic banks in particular have, much more negotiation power than their contractors under normal circumstances This is one of the theoretical reasons for regulating the banking industry. Islamic banks are left alone to determine the share of profit distribution between depositors and share holders and reap, alone too, the profit that is generated from the investment of demand deposits. Additionally, although owners of Mudarabah deposits share the risk with the bank they are left up in the cold when it comes to the management of the bank. These elements together have created a clear disparity between the rate of profit of distributed to share holders and that given to depositors.

To face any potential side effects of Globalization, Islamic banks were expected to integrate and consolidate. The reality over the last three years indicates that although the total number and aggregate size of Islamic banks increased, there average size remained virtually stagnant. There are indications of deepening their markets and improving the services they provide especially in countries that have more than one Islamic bank. But it seems that merger and unification are not taking their toll in the Islamic banking industry!

All the above requires a revision of the theory of Islamic banking to reassess its functioning and whether it is really distinct from the conventional theory!