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Can Islamic Finance Help Our Economy?

Who is to blame for the recent financial crisis, the worst since the Great Depression? Majority would say that it’s the banks that are at fault. And although the reasons behind the recession are still being researched and it will be long before we know the exact answer to this question (if at all), it is difficult to ignore the role that banks, especially investment ones, have played in crippling our economy. As a result, everyone, no matter the opinion on the topic (perhaps with the exception of bankers themselves) has called for governments to take action and heavily regulate financial institutions. However, for the first time (at least on such a big scale), many have called not to just regulate the banks once again, but to change the way we think about global finance altogether. There are, of course, many ideas on how to achieve that. Still, not many have been actually tested and, therefore, it might be difficult to introduce them instead of keeping the status quo. However, one has been used for quite a while already and has been discussed as a possible solution. Is Islamic finance a solution to our economic problems?

So what is Islamic finance? The underlying idea behind it is to satisfy the tenets of Sharia, a framework with guidelines and laws for many aspects of Muslims’ everyday lives. In the context of finance, the most important rule is the absence of interest rates or riba, as profiting from lending money is forbidden. Furthermore, profiting from areas of the economy that stand against Islam, such as alcohol or tobacco, is not allowed either. This sounds rather simple, but for us, the FEB students, lack of interest rates stands in a total opposition to what we’ve been learning in each of our classes. In fact, at first you would probably ask yourself: how do banking and finance even work without interest rates? First of all, the ban on interest rates is not a new idea or one that is specific to Islam alone. For most of the medieval ages, the Catholic Church banned charging interest on loans. As a result, most of the banking in Europe was done by the Jewish communities. However, with the Church’s change of policy on financing and the creation of the first big banks, such as those of Medici and Fugger families, interest rates have become a natural part of banking across the European continent and later the world. To the extent that, again, we cannot imagine finance without them. And yet, it works. With no interest, Islamic banks deal only in real (tangible) assets and not in highly speculative financial instruments. Therefore,  you could compare an Islamic bank to a trade intermediary. Ok, but without interest how do Islamic financial institutions stay afloat? They do so through several types of transactions, based on trade and lease agreements and risk-sharing between the “lender” and the “borrower”. So rather than lend you the money to buy a new car, an Islamic bank will buy the car and transfer its ownership to you with each installment you pay. It is through those installments (with a margin above costs), rather than interest rates, that Islamic financial institutions earn money. In case of investments, two parties agree on the amounts they will commit and the proportion of returns each of them will receive. Again, with no interest rates.

So where can you find Islamic financial institutions? Other than in predominantly Muslim countries, Islamic banking is, among others, present in European countries and in the United States. An example would be Al Rayan Bank in the United Kingdom, which has operated there since 2004. Also, in March this year, Russia witnessed the opening of its first Islamic bank. Still, the biggest Islamic banks are, not surprisingly, located in predominantly Muslim countries, especially the Persian Gulf states. In 2015, the largest one  was Al-Rajhi Bank from Saudi Arabia, followed by financial institutions from Kuwait and United Arab Emirates.

So is Islamic finance the answer to the problems of our financial system? Not necessarily. There are certainly some aspects from which we could learn. For example, one could argue that one of the causes of our problems is the obsession with profits that drives bankers and financiers to find new and new ways of squeezing out more money. Lack of interest rates and not dealing in speculative assets could (at least in theory) limit the negative effects that greed has on our economy. However, Islamic financial instruments are not that much different from conventional banks. Yes, there are no interest rates, but Islamic banks still make profit by charging installment payments with margins above the costs or increasing their shares of returns. In fact, according to research, payments that Islamic banks charge are strongly correlated with prevailing interest rates. Therefore, in the end, Islamic finance offers the same or very similar instruments, albeit in a slightly different form. However, it shows that financial systems other than the one on which our economy is built are possible and that they can and do work. Maybe we should finally sit down and talk about how to incorporate new ideas into old institutions and make everyone (perhaps with the exception of those who benefit the most from the status quo) better off?


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