Articles on Islamic Finance

Potential of Islamic Finance to Lead New Financial Architecture

Salman Ahmed Shaikh

The financial crisis of 2007-2009 and ongoing sovereign debt crisis in Europe has challenged the conventional wisdom. Massive levels of debt and consumption beyond means and speedy financial innovation with lax regulation has put major economies in a deep crisis.

In the US, the share of total corporate profits generated in the financial sector grew from 10% in the early 1980s to 40% in 2006. These earnings are transaction costs for the productive sector. Financial institutions that were just supposed to be playing a supportive role to the productive economy got much bigger and unregulated through shadow banking practices. Recently, Piketty in his book “Capital in the 21st Century” explains that the tendency of returns on capital to exceed the rate of economic growth today threatens to generate extreme inequalities.

Nevertheless, financial intermediation has a useful function to facilitate intertemporal consumption decision by households and investment decisions by firms to encourage capital formation. What is needed is a new paradigm that can put the focus back on productive enterprise, brings recovery with job creation, limit and regulate speculative financial instruments and improve corporate governance by influencing the incentives more deeply and proactively. Below, we analyze how Islamic finance principles and institutions can provide basis of new financial intermediation architecture.

During the last decade and half, the Islamic financial industry has seen tremendous growth even when the conventional financial institutions went into a deep crisis. Islamic finance is a fast growing industry all across the globe. Islamic banking assets with commercial banks globally crossed $1.7 trillion in 2013, suggesting an annual growth of 17.6% over the last four years.

The two most important problems identified in a post-financial crisis look back are perverse incentives and de-linking of financial sector growth and activities with the real sector of the economy. Islamic finance principles by basing all financial products with real assets fill the gap and this feature alone is a very important risk management tool inbuilt into the system.

In Islamic banking, there is inherent risk management technology. Floating rate rentals substitute the use of interest rate swaps. Credit Default Swaps (CDS) are not needed in most cases since almost all financial assets credit creation is backed by real assets and the bank has recourse to them. Delivery based trade contracts ensure that the transaction is not for speculative purposes only. Price hedging can be ensured through Salam and Murabaha already which are used for short term financing. In long term financing, the rentals are mostly floating.

However, to lead and sustain the growth momentum, Islamic banking has to overcome several challenges.

Islamic banks do not have complete product alternatives for all kinds of conventional finance solutions. According to the World Islamic Banking Competitiveness Report 2013, there are 38 million customers globally with Islamic banks with an average product holding of 2.1 which is significantly lower than the class leading average of 4.9. This represents untapped cross selling potential in Islamic banking with existing and growing customer base.

While it is indeed appreciable that not all conventional practices are replicated as is by Islamic banks, but such lacking in solutions and alternatives cannot completely be attributed to this factor alone. Distress financing, educational financing, health financing and micro finance are areas where if Islamic product alternatives can be developed and adequately marketed, it will increase the size and scope of Islamic banking. Furthermore, it will validate the position of Islamic banks as having solutions for all classes and stratum in economy and not just for the big corporations looking to expand.

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