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What if I tell you that banking and religion are correlated. However preposterous it may sound,  this is the case with Islamic banking.

The spiralling growth in Islamic banking has gained much attention recently in economic literature. Islamic financial institutions now operate in over 70 countries across the globe with their worth increasing to $2.3 trillion in 2016 since its inception. The transactions that come under this are a distinct form of ethical investing i.e. these transactions are undertaken by the Islamic banks following the Shariah laws.

Where once – in the mid-seventies – Islamic banks were handful and easily identifiable, the spiralling growth in the banking industry has led to an increase in the number of Islamic financial instruments. Owing to this and the introduction of many concepts, techniques, and instruments of Islamic finance, which were successful, the concept of Islamic banking was also introduced to other parts of the globe.

The concept of Islamic banking is mainly woven around two principles- profit and loss sharing and interest-free banking. Both these concepts are based on the principle of Shariah, which simply prohibits the creation of “money out of money.” To explain this further, neither can Islamic banks charge interest on the money they lend nor do they have to pay interest on money deposited with them.

What stimulates curiosity is that even though interest forms the backbone of the western and conventional banking systems, Islamic banks function in the absence of collection and payment of interest.

This is primarily because of practices such as the Murabaha system and the profit-and-loss sharing mechanisms, which help Islamic banks to cover their costs and earn profits even without charging interests. Under the Murabaha system, the bank establishes a contract to purchase an item, for their client, at a cost lower than what it charges the client.  The difference in the prices is what the bank earns. Many argue that this is simply another method of charging interest.  However, the difference lies in the structure of the contract.  In the Murabaha system for sale, a set fee is charged rather than riba (interest), and hence this type of loan is legal in Islamic countries.

The other practice through which banks earn money is the profit and loss sharing mechanism. When seen from the lending side, the banks give out money to business houses, which they further invest in various areas. Rather than paying interest on these borrowings, such business houses pay back the banks a part of their profits accruing from the aforesaid sum. Same is the strategy that the banks employ when they deal with customers. The banks, instead of paying them interest, pay them a share of this profit that it gets from the business houses. The fixed percentage share to be given is usually left to the discretion of the institution and depends on its profitability.

Just like the system in the west, Islamic banks offer both current and saving Accounts. Current accounts, which offer depositors safe custody for precautionary and transaction purposes, are operated on the principles of al-wadia (safekeeping) and there is no return given on this deposit.  Savings accounts usually involve higher balances and a longer time commitment. While few banks promise a fixed interest(contrary to their principle) on these accounts, most of the other banks follow the profit and loss system mentioned above.

The Islamic banks have flourished enough since its inception to attract the foreign conventional institutions such as Citibank, to establish Islamic banking subsidiaries and Islamic windows not only in the Muslim world but also expand it to the global economy (mainly in the United States and countries of Europe) offering ‘Islamic products’ such as the Murabaha practice.

When modern Islamic finance came into existence, the oil bonanza complemented with the uniqueness of the concept allowed considerable latitude for experimentation. Ample funds were at the disposal of a handful of Islamic institutions, that were in a position to share a monopoly on the small, but growing niche of clients looking for Islamically-correct investments i.e. the investments that adhere to the Shariah laws. Many depositors did not seek any remuneration, thus providing banks with the cheapest possible funding. In those years, Islamic financial institutions could flaunt their religious character by offering unique financial products but now, pressure has increased upon them owing to the growth of the industry and increasing competition.

The Islamic financial market is now facing increased competition due to the establishment of other Islamic financial institutions and conventional banks who have established Islamic subsidiaries or windows. Islamic banks also suffer from an overhang of bad loans, and they lag behind their Western counterparts in technology and expertise. The religious dimension, adds an extra layer of problems with respect to introducing new products that cater to both the Islamic law and the needs of the general public.

The mechanisms by which conventional and Islamic banks make their strategic decisions differ. This creates problems for Islamic banks as conventional institutions proceed through trial and error: countless ideas are considered, innovation is promoted and new products are launched in short order. However, Islamic financial institutions cannot proceed in the same way, as they are obstructed by the religious constraints that require new products and new practices to be first be cleared by Shariah board to ensure adherence, of these products and practices, to the religion. Yet in a harsh competitive environment, it is crucial to be innovative and swift as the product cycle of banks is such that in the early stages, profit margins are high but later, as competition intensifies and as the product is commodified, fat margins disappear and change into mounting losses. Thus, prompt decision making and timely implementation of new plans is necessary to take advantage of opportunities in the current dynamic world.

The close association that this banking system has with the Islamic religion, though unique, poses numerous threats to its expansion.  For the past two decades, many Islamic banks have witnessed double-digit growth rates, surpassing their conventional peers. At a mere glance, all seems well for the Islamic banking industry. Several potential markets with a bulk of Muslim populations remain largely untapped, such as India and the Commonwealth of Independent States countries, made up of the former Soviet republics. However, when Islamic banking was proposed to the Reserve Bank of India, it rejected the proposal to pursue the concept of Islamic banking as it would have led to legal, technical and regulatory complexities and issues (that it went against the secular fabric of India.)



Any objective assessment of Islamic finance can only be mixed. On one hand Islamic banking has now become a $2.3 trillion industry but on the other hand, it has not fulfilled its promise of becoming an original system based on religion as it does not completely follow the Islamic laws completely. Indeed, profit-and-loss sharing (PLS) transactions, initially the most important reason for the existence of this industry, only account for about five per cent of the operations of Islamic financial institutions. Even the promise of interest-free finance has not been fulfilled since not only interest-like mechanisms have been devised in most of the Islamic financial institutions but also, interest is paid and collected by Islamic countries on foreign loans.

To conclude, Islamic banks will face a considerable disadvantage as conventional banks can do anything which an Islamic bank can do, whereas Islamic banks cannot do the same! Pressure is increasing and thus forcing Islamic banks to reconsider their strategy. If the Islamic banks want to expand their market to the untapped areas and increase their customer base, they will have to bring in more innovative products and new strategies to attract the new generation towards this unique banking system.



By Harshit Gourisaria

2nd year undergraduate student, Shri Ram College of Commerce

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