3
$\begingroup$

Under Islamic law (Sharia), any interest is considered usury and is prohibited. This makes banking in Islamic ruled countries difficult as the normal way for banks to create profit is through lending money at a rate of interest. Rather, Islamic banks work by profit sharing or buy-sell method (e.g. when asking for a mortgage, the bank buys a house and sells back to the borrower at a higher price).

My question is: how successful is this model of Islamic banking? Does it make more money? Are there any advantages that this model gives not present in the regular banking doctrine?

$\endgroup$
4
$\begingroup$

In Ernst & Young 2016 Report we read (p. 17) that for the period 2010-2014 the Average Return on Equity for "Participation Banks" (this is the secular name of Banks under Sharia) was $12.6$% compared to $14.5$% of the "comparable conventional" banking. Although the ROE is lower, it is not that lower.

We also read that in the same period (p. 10), the assets of International Participation Banks grew by $16$% yearly on average.

It looks like a profitable way of doing business with strong growth.

From a philosophical point of view one should ask: how bankers in Participation banks view what they do?

Are they viewing their business model as essentially a way to cheat the religious doctrine-turned secular law, and everything they do they "translate" it into "what was the interest earned" or, after accepting the constraint that they won't do banking business in the traditional way, they explore different ways of making available funds earn a return?

The two examples offered by the OP are very useful: first, "profit sharing" makes a Participation bank more like a joint venture enterprise -and it reminds us of Ancient Greek bankers (they were the first bankers), whose bulk of business consisted of funding ships to travel and trade around the Mediterranean Sea, for a share of the profits.

Second, when a Participation Bank, instead of loaning an amount of money for a house-buy against a mortgage, buys the house and sells it to the interested party at a higher price (to be paid gradually through installments), it may appear as just a trick to avoid calling it "loan with interest", but a large construction firm that constructs houses and then sells them with a long-term payment plan, does nothing different.

So it appears that Participation banks use very standard ways to do business, only, they are ways that we usually associate with other sectors of the economy, and this is why they may appear "strange" for the banking sector.

As regards the pros and cons of Islamic Banking, there are many studies, for example

Beck, T., Demirgüç-Kunt, A., & Merrouche, O. (2010). Islamic vs. conventional banking: Business model, efficiency and stability. The World Bank.

where the abstract reads

This paper discusses Islamic banking products and interprets them in the context of financial intermediation theory. Anecdotal evidence shows that many of the conventional products can be redrafted as Sharia compliant products, so that the differences are smaller than expected. Comparing conventional and Islamic banks and controlling for other bank and country characteristics, the authors find few significant differences in business orientation, efficiency, asset quality, or stability. While Islamic banks seem more cost-effective than conventional banks in a broad cross-country sample, this finding reverses in a sample of countries with both Islamic and conventional banks. However, conventional banks that operate in countries with a higher market share of Islamic banks are more cost-effective but less stable. There is also consistent evidence of higher capitalization of Islamic banks and this capital cushion plus higher liquidity reserves explains the relatively better performance of Islamic banks during the recent crisis.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.