Islamic versus Traditional Banking: Financial Innovation in Egypt

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Islamic versus Traditional Banking: Financial Innovation in Egypt, by Elias G. Kazarian. Boulder, San Francisco, and Oxford:

Westview Press, 1993. xv + 233 pages. Gloss. to p. 236. Interviews to p. 239. Bibl. to p. 252. Index to p. 260. $32.50 paper.

Reviewed by Sohrab Behdad Kazarian's book is a study of the theoretical basis of Islamic banking and a review of the performance of Islamic banks in Egypt in the 1980s. Islamic banks may not engage in activities that are forbidden by the shari'a (Islamic law), including interest bearing transactions (riba), speculation (gharar), and financing activities prohibited by Islam (e.g., production of intoxicants). Islamist economists assert that Islamic banking enhances the economic welfare of the community (umma) by promoting economic development and social welfare. It may be asked, then, if Islamic banking is a feasible alternative to traditional (non-Islamic) banking in a modern capitalist economy, or if Islamic banks can replace traditional banks while remaining true to their Islamic nature.

Chapters 1-5 of Kazarian's book examine the theoretical issues in Islamic banking. Elimination of interest is the most important consideration. Islam prohibits a return on monetary capital unless the return comes from direct investment which is subject to market risks. Therefore, lenders cannot expect a fixed rate of return on their loans, but can participate in profit-loss sharing contracts with borrowers. Mudaraba (trustee financing) and musharaka (equity participation) are two possible forms of such contracts. In mudaraba contracts, a financier provides funds to an entrepreneur. Profits are shared between the two parties at a predetermined rate. If losses occur, the financier loses part or all of the capital, and the entrepreneur loses the work effort. There is no obligation by the entrepreneur to repay any of the lost capital.

Islamist economists maintain that mudaraba is a socially desirable arrangement since it enables innovative entrepreneurs with little means and no substantial collateral to gain access to capital. This may indeed have been true in small medieval economies, when mudaraba contracts were formulated and lenders had an intimate knowledge of the business practices of a borrower. But in a modem capitalist economy, as Kazarian argues, such arrangements are subject to "adverse selection" and "moral hazard." That is, only entrepreneurs with little means and with risky projects seek mudaraba contracts, and these contracts encourage inefficiency and a high cost of operation. Besides, determination of the real rate of profit of thousands of borrowers is a formidable task for any bank. Therefore, it is very unlikely that banks would find mudaraba a practical (and profitable) arrangement.

On the other hand, musharaka is a more practical arrangement. Buying stocks of companies the "shares" of which are available on the market may be a possible form of musharaka. The extent of this activity, however, depends on the size and viability of the stock market, which is quite limited in most developing countries. The musharaka activity of banks is very similar to that of mutual fund companies. Other forms of legitimate transaction for an Islamic bank are murabaha (mark-up) and ijara (leasing), where the bank finances the purchase of an asset and expects a predetermined fixed rate of return. In these cases, the rate of return is similar to interest. These arrangements are similar to the short-term lending of traditional banks for merchandise trading, only the terminology is different.

Therefore, an Islamic bank functions as an intermediary between the owners of funds (savers) and the users of the funds (borrowers). …