Articles on Islamic Economics

Realist and the Idealist Schools of Thought in Islamic Banking


Salman Ahmed Shaikh

Modern Islamic banking formally began in mid-70s. After four and a half decades, Islamic banking has spread in many countries in Asia, Africa and Europe. In many countries, Islamic banking share is more than 25%, such as in Brunei, Qatar, Saudi Arabia, Kuwait, Bahrain, and Malaysia, for instance.

In evaluating Islamic banking, people tend to have different thoughts. Some evaluate Islamic banking taking the banking and finance view where cash flows and their timing and values become the significant point of contrast. Some take other perspectives including legal, accounting, economics, and Shari’ah compliance. In the legal perspective, legal title to counterparties in various steps along with tax implications become the primary focus. In the accounting perspective, financial reporting becomes the significant point of distinction. In the economics perspective, return on investment and cost of financing become the distinguishing features.

In the Shari’ah compliance perspective, adherence to the detailed rules of sale, lease and economic exchange in Islamic jurisprudence are given most importance. In addition to Shari’ah compliance, in the Maqasid-e-Shari’ah perspective, broader concerns of welfare, equity and sustainability are given important consideration. Thus, when people evaluate Islamic banking, they take into account various perspectives.       

Realists hold the view that Islamic banks are commercial financial institutions. Their primary objective is to provide Shari’ah compliant financing and investment solutions to the saving deficient and saving surplus units in compliance with Shari’ah principles. Since Islamic banks are commercial institutions, they are also responsible for safeguarding the interest of shareholders and depositors who provide investment capital to the bank. They are expected to provide Halal returns in terms of profits to the shareholders and depositors. Hence, they would be expected to invest in commercially viable contracts in order to earn Halal profits for their major stakeholders, i.e. shareholders and depositors.

Islamic banks operate in a market where the leading firm or the group of firms practicing interest-based conventional banking hold scale and regulatory advantage. Islamic banks as new entrants with small market share and facing regulatory disadvantages cannot be price-setters and cost leaders in the beginning. Thus, what they can realistically achieve in the short term is to be competitive, liquid, and solvent and then penetrate slowly in the market to increase their share and efficiency without compromising the principles and boundaries of Islamic rules of trade and lease in which they engage as financial intermediaries.

The realists contend that the visionary objectives of equitable distribution of income will be taken care of in the long run by Islamic social finance institutions, such as Zakat and Waqf. Islamic banks as one part of Islamic finance ecosystem will continue to serve the short term financing requirements of clients and for which debt based Islamic modes of financing are the suitable options. There is some credence in this promise and approach. In Malaysia and Indonesia, Islamic microfinance, Zakat and Waqf institutions are used in social finance. The results have been effective to complement Islamic banking and bring more inclusivity in the Islamic finance ecosystem. In the case of Pakistan, Akhuwat has proved how Qard-e-Hasan can be used to help the poor people on a large scale.

Nonetheless, idealists view that since Islam prohibits Riba, Islamic banks are also perceived to make a distinct mark in their economic impact as compared to the economic impact of Riba based financial contracts. Early thinkers in Islamic finance literature built high expectations from Islamic banks to contribute to egalitarian income distribution, inclusive financial products and to achieve a reduction in poverty. The idealist scholars take the view that Islamic banking has to strive towards making a distinctive socio-economic impact in society. They also opine that since interest based banking is primarily criticized in economic terms for its exclusive focus on the richer segments of the society and thus creating asymmetric access to funds and concentration of wealth, the Islamic banks need to be different.

Inclusivity, equitable distribution of resources and socio-economic mobility do not determine Shari’ah compliance or validity. However, these visionary goals are the aspirations of many people in academics and public at large. Therefore, idealist scholars emphasize that Islamic banks need to focus more on equity based modes of financing which ensure inclusivity of both richer and poorer segments of society in access to funds and thereby lead to much more egalitarian distribution of income.

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