Why Islamic Banking?

By Sajjad, Rabia | Economic Review, February 2010 | Go to article overview

Why Islamic Banking?


Sajjad, Rabia, Economic Review


Islamic banking is based on Sharia that prohibits 'riba'. According to religious scholars it means both usury and interest, and 'gharar', that signifies ambiguity, uncertainty, or lack of specificity in terms of a financial contract,

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These financial transactions within the Islamic banking are based on a culturally distinct, ethical and moral principle as investments/trading involving alcohol, gambling, pork etc. are prohibited. In 1975, the world's first full-fledged Islamic bank was formed in Dubai.

A review of the literature on Islamic banks reveals that these promote greater business stability as this system matches the payment obligations of the entrepreneur with the revenues that he acquires from his transactions. This is made possible when the obligation to pay back the funds acquired from the banker and the profit is related to the realization of profits in the project in which funds are invested.

Islamic banking is more efficient in that it allocates funds capable of being invested on the basis of productivity of projects rather than on the creditworthiness of those who own the projects, as is the case in conventional banking.

Islamic banking is less prone to inflation and much less vulnerable to speculation. The increasing prevalence of inflation and speculation in today's business environment cannot be ignored particularly when banks are using debt instruments as money substitutes, making speculation on debt instruments inevitable. And Islamic banking is been as the only flexible alternative in the face of global recession. Islamic banks are prudent when it conies to leveraging their assets to invest in capital too.

The typical leverage ratio of assets to capital was over 20:1 in the US (Lehman's leveraged around 30:1 before bankruptcy) and over 30:1 in Europe compared to below 10:1 in the Middle East and North Africa. This practice has enabled Islamic banks to recapitalize their operations in the wake of financial turbulence.

Another such example is Ireland's Blue Ocean Wireless which supplies wireless communications for merchant shipping. When the company got a $25 million loan in December 2008, it came from what might seem an unusual source: the Bank of London and the Middle East, or BLME, which strictly follows Sharia rather than conventional western banking practices.

While recognizing the benefits of the Islamic banking, its disadvantages in the modern era cannot be ignored.

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