As the global economy experiences its first green shoots, one cannot forget the economic trauma precipitated by the global financial crisis of 2007-2008, one of the worst in living memory.
Following the crisis, many economists revisited the question of whether the seeds of the recurrent crises lie in systemic flaws in the financial system.
A number of studies have shown that Islamic banks did indeed weather the financial storm better than their conventional counterparts, exhibiting lower hazard rates.
This is mainly attributed to the higher levels of capital adequacy and liquidity of the banks prior to the crisis, laying the foundation for regulatory bodies such as the Basel Committee to proffer new amendments on additional capital adequacy requirements and stress-measured liquidity.
This remedy is akin to installing better airbags in a car rather than prevention of a crash. What else might we assimilate from Islamic finance for the benefit of the long term financial stability of our economy?
To answer this question, we need to examine the three prohibitions on which Islamic finance is premised upon: (i) interest, (ii) excessive speculation, and (iii) information asymmetry. The most conspicuous facet of Islamic finance is prohibition of interest.
Islamic finance experts argue that the mainstream finance industry falls short of addressing inequity and unfairness inherent in the interest-based financial model.
The exploitative nature of interest-based finance in favour of capital owners and the tenuous link between financial transactions and the real economy create dire conditions for our economic system.
How does Islamic finance work if it does not earn income from interest? Two main ways: (i) financing contracts comprising of sale or lease of tangible assets, and (ii) partnership financing.
While borrowers can incur debt from transacting via sale contracts, the debt is collateralised by a tangible asset and the profit margin is pre-determined and fixed, avoiding the spiralling costs to the borrower with the variance of time mitigating the likelihood of business insolvency.
In the case of partnership financing, the general format is profit and loss sharing (PLS). The common PLS structure creates more parity between those who own capital and those who employ knowledge and skill, normally the client, in a form of partnership where both profits and loss are shared.
Implicitly, capital owners partake in the risk of the client’s financed business. The dynamics of this structure embed firmer risk mitigation by virtue of the capital owner undertaking enhanced and constant due diligence commensurate with additional risk assumed.
In contrast to the normative models of finance constituted on profit maximisation proposition, Islamic finance is predicated on the achievement of socio-economic well-being of all segments of society.
It is therefore of no surprise that Islamic finance has created a number of innovations to serve the wider community for the furtherance of social goals such as endowment trusts and microfinance.
The Islamic endowment funds — which arguably inspired the development of endowment trusts in English law — have played a pivotal role in helping vulnerable and disadvantaged people and alleviating poverty in society.
The endowment trust model has been employed also to fund other communal initiatives such as universities, libraries and museums.
Islamic microfinance and SME financing has also been an inherent facet of Islamic finance offerings as it accomplishes the social responsibility of Islamic finance institutions despite their higher risk.
While Islamic finance does not claim to be a panacea for all of the ills of the financial system, it has the potential to answer the calls of some financial regulators who harken a return to basics banking to rebuild trust and greater social justice in the banking system.
Farrukh Raza is Managing Director, Islamic Finance Advisory and Assurance Services.