THE SEVEN ADVANTAGES OF ISLAMIC FINANCE
Dr. Mabid Ali Al-Jarhi
mabid.al.jarhi@gmail.com
I.
efficiency
In a
system with positive rates of interest, people can increase their earnings by
depositing cash in the bank rather than use it for transactions. In order to carry the same volume of
transactions they must use real resources in place of money, which could have
been used to produce goods and services.
This means that the community output is less than the maximum. Such situation is considered by economists as
suboptimal and inefficient.
Islamic
finance provides opportunities to save and earn profit on savings. However, in this case savers present their
financial resources according to the Mudaraba or Wakala contracts. In both cases, there is a degree of risk
sharing. Therefore, the rate of profit
on “investment or Wakala deposits” will not automatically encourage the
inefficient substitution of real resources for cash. Therefore, the Islamic financial system is
more efficient at the macro level than the conventional financial system.
Conventional
finance allocates financial resources with paramount regard to borrower’s
ability to repay loan principal and interest.
In modes of Islamic finance that are based on equity and profit sharing,
focus would be on the profitability and rate of return of the concerned
investment. This has the potential of
directing financial resources to the most productive investments, thereby
increasing efficiency.
Modes of
Islamic finance that are based on mark-up finance the acquisition of goods and
services, including productive assets.
When conducted in an open market with sufficient competition, the cost
of finance, or mark-up, will depend on the relative value in use of each
commodity, whether in consumption or production. Resource allocation would again be optimal.
II. stability
A
conventional bank has on the one hand liabilities that include demand, time and
saving deposits, which the bank guarantees.
On the other hand, it has assets that are mostly composed of debt
instruments that are subject to the risk of default. Default on the asset side in significant
proportion would imply inability to meet the bank’s obligations to depositors. Such default can be expected at times of
crises, be it of macroeconomic nature or caused by circumstances specific to
the bank.
A bank
operating according to Islamic rules of finance has liabilities of different
nature. Only demand deposits are
guaranteed. Meanwhile, investment
deposits are placed on profit-and-loss-sharing basis. When such bank faces macroeconomic or bank-specific
crises, investment depositors automatically share the risk. The bank is less likely to fall and a bank
run is less probable. It can therefore
be said that an Islamic banking system is relatively more stable when compared
to conventional banking.
Conventional
finance has an integrated debt market.
Hundreds of billions of dollars of debt are traded daily. Bonds markets threaten the world economy with
the spread of instability that might start in one single debt market in a
fashion that economists have come to call “contagion.”
In
contrast, debt created in Islamic finance through selling goods and services on
credit is not readily tradable, implying a fully segmented debt market. There is no room for sudden and mass
movements of funds. Possibilities of
instability and contagion through the debt market would therefore be remote.
Individual
and institutional participants in financial
markets carry out huge speculative transactions, based on gambling contracts. More often than not, such transactions are
sources of instabilities. In contrast,
Islamic financial institutions are automatically prevented from carrying out
such gambling activities; destabilizing speculations would be significantly
curtailed in financial markets.
All
Islamic modes of finance involve money on the one end and goods and services on
the other. Monetary flows through
Islamic financial modes are tied directly to commodity flows. In other words, Islamic finance removes the
dichotomy between financial and real activities. Obviously, this leaves little room for
instability due to excessive credit expansion, as the finance extended is
automatically earmarked for specific uses.
III.
lower
risks of moral hazard and adverse selection
Islamic finance does not provide funds
directly to customers. Instead, it
finances the commodity and asset requirements of customers. This means that both the finance provider and
the finance user are fully and equally informed, and there is no information
asymmetry. Therefore, there are no risks
of moral hazard and adverse selection.
Conventional finance provides borrowers
with cash. Borrowers know more about the
use of the loans they obtain than banks do.
There is a great deal of information asymmetry, implying substantial risks
of moral hazard and adverse selection.
IV.
finance
and development
Islamic banks,
by financing both demand and supply simultaneously, put their financing
activities right in the center of the development process. Bankers in this case become both partners and
financiers of entrepreneurial efforts to develop the economy.
It is widely
accepted that economic development requires mobilization of vast financial
resources. Many Muslims, Christians,
Jews, Hindus and Buddhists abhor interest.
They hold their funds outside the banking and financial sector to avoid Reba.
Fewer funds would be directed to the
development process. Islamic finance would
automatically attract such funds that would be otherwise kept idle. In addition, it provides them with a way
through which they can participate in the development process without exceeding
their religious beliefs, instead of suffering from cultural exclusion.
V. system integrity
Conventional
finance can be likened to a spectator’s game where few skilled players
stay in the playground and a big crowd is watching from outside. Islamic finance, meanwhile, is similar to participatory
sports, where everyone is playing and no one is concerned with mere
watching. In addition, there is a moral
side to Islamic finance that seems to be in the back of mind of everyone.
We can
therefore notice that risk as well as decision-making is spread over a much
larger number and wider variety of concerned people. Risk sharing is balanced by sharing in
decision-making. This allows for wider
involvement in economic activities, so that people will eventually feel they
are partners rather than spectators.
The
economic system itself becomes more compact with wider involvement. The real and financial sector, banks and
savers, investors and fund owners are all strongly glued to each other. This finally leads to an economic system with
a high degree of integrity that can better withstand shocks.
VI.
equity
Islam
prescribes a tax-subsidy approach to reducing poverty. A levy called Zakah is paid out by the
wealthy to give to the poor. Zakah can
be collected by nongovernmental and governmental organizations. Islamic banks can help by acting as
custodians and in the disbursement of the proceeds. Islamic banks can use Zakah proceeds to
finance micro projects whose title could be eventually transferred to the poor.
Under conventional
lending, banks give their utmost attention to the ability to repay loans, depending
overwhelmingly on the provisions of collaterals and guarantees. Thus, those already rich would have most
access to finance. In contrast, Islamic
finance could provide the poor through sale finance (Murabaha, Bai' Bethaman
Ajel, Ijarah and Ijarah Muntahia Bittamleek) with consumers durables as well as
productive assets for installment payments that fall within their income. Goods financed will serve as collateral to
the bank until payments are all effected.
The poor will need only to verify his income through proper
documentation or depositing his receivables or salary with the bank.
In
addition, providing funds on equity or profit-sharing basis would be more concerned
with profitability and rates of return and less concerned about collateral as
the primary consideration. In both
cases, those who are not wealthy, but have worthy investment projects, would
have relatively more access to finance.
VII. sustainability
Conventional
debt places debtors in difficulties if circumstances do not allow them to repay
in time. Interest is usually calculated
on the outstanding balance, usually compounded annually and sometimes at
shorter intervals. Delinquent debtors
are subjected to penalty rates of interest, which are higher than regular
rates. It is not uncommon to find
borrowers who end up paying debt service that is many folds the original
principal they borrowed.
We can
therefore conclude that interest based financing lacks a great deal of
sustainability. Creditors have to stop
every few years to give debtors relief in terms of rescheduling and
forgiveness. Sometimes this also
includes floating low quality debt at lower market value and swapping it with
equity. The system has demonstrated unsustainability
several times.
Debt
created through Islamic finance has characteristics with which debt crises are
less likely to rise. Particularly, the
total value of debt, which includes the spot value of commodities purchased on
credit as well as an implicit mark-up, is set from the very beginning. The total value of debt can be repaid in
installments, without increase in its total value, as there is no compounded
interest to pay on outstanding balance.
When
debtors face unavoidable circumstances that would make them temporarily
insolvent, they are often granted grace periods to help them bring their
finances back to order. No penalty fees
can be levied in this case. In other
words, debt rescheduling, when justifiable, would be granted at no extra cost
to borrowers. Therefore, we can conclude
that Islamic finance is sustainable and less liable in itself to cause undue
hardship to debtors.
As Islamic
finance provided to finance investment is asset-based, i.e., it is used to acquire
real assets; it is much less likely to lead to debt crises. Such type of asset-based finance, directly
contributes to the ability of the economy to meet its internal and external
financial obligations. This is certainly
a welcome effect.
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