Banking Religiously


The new wave of “sharia-compliant” banks go to a lot of trouble to neither charge nor pay interest.


Listener: 27 June, 2013


Keywords: Macroeconomics & Money;


‘No risk, no return” is a summary of Islamic financial principles. So their system has to work without interest.


Muslims are not opposed to business – Muhammad was a merchant before he began teaching Islam – but the Koran prohibits gambling.


By conventional standards, Islamic financiers go to considerable trouble to avoid paying interest. Instead, depositors in their banks get a share of the profits. Banks do not charge interest, either; they charge borrowers in other ways. This allows Islamic banks to carry out the conventional banking role of collecting and pooling others’ savings and advancing them for productive purposes.


Sophisticated Islamic “sharia-compliant” banking is a relatively recent phenomenon (sharia is Islamic law derived from the Koran and the teachings of Muhammad). Once, many Muslims kept their financial savings “under their beds” because suitable banks did not exist. One Islamic scholar I spoke with, on my Asia New Zealand Foundation-sponsored study tour, said hiding one’s savings this way was un-Islamic because they were not being utilised. (It is also risky and unrewarding.) So, Islamic financial institutions were developed; some of the earliest were conventional banks with sharia “windows” offering sharia-compliant services.


However, there was a concern that ordinary banks would mix their depositors’ funds together, lending them at interest, and that they might invest them in Islamic-prohibited areas, such as gambling and alcohol. Islam also imposes charity obligations and encourages people to settle their debts to those having real difficulties.


What is a permissible investment for a proper Islamic bank? Consider the routine trading problem in which goods are paid for some time after they are sold. The conventional arrangement involves providing the future cash at a discount – in effect an interest payment. Instead, an Islamic bank buys the goods and sells them at a higher price later, so the seller gets the cash immediately and the bank manages the risk associated with the ownership of the asset and credit-worthiness of the end buyer.


As an alternative to bonds, Islamic financiers issue “sukuk” financial certificates in which the holder owns a share of the physical investment. In a case explained to me, the sukuk holder ended up owning a share of the plane that the cash was financing. Importantly, there are increasingly secondary markets for sukuks, so investors can sell them if they need the cash, just as they can with bonds.


As the transactions get increasingly complicated, each Islamic bank has to establish the appropriate mechanism to consult sharia advisers to ensure its innovative transactions are compliant. In Malaysia, ultimate decisions reside within the Shariah Advisory Council of the Bank Negara Malaysia. (The central bank’s feisty governor, Zeti Akhtar Aziz, is proof that Islam need not oppress women.) Malaysia aims to position itself as the international centre of Islamic finance, which amounts to only 1% of the world’s financial system.


Sharia-compliant finance has to be much closer than much conventional finance to real economic transactions and productive activities. Islamic finance prohibits the higher “derivatives of derivatives” that collapsed the world into the global financial crisis, leading one to ponder whether sharia-compliance has some relevance to our search for a banking system whose collapse does not undermine the payments system.


That does not mean sharia-compliant banks are totally safe. Like our trading banks, which also avoid higher derivatives, they can make bad investments and can hire fraudulent employees. Risk is a reality of any financial system.


Sharia-compliance is unlikely to be a handicap when the Reserve Bank is faced with registering an Islamic bank in New Zealand. Rather, our 40,000-odd Muslim population is not big enough to attract one. If we do get one, some non-Muslims might like to entrust it with their savings, attracted to its style of financial arrangements and its more ethical investing.


For an earlier column on Islamic finance: 11, 2004)