The ROI in Islamic Banking

Islamic Economic System

Islamic Economic System The Islamic economic system is concerned with social justice to ensure that none of the parties involved in a transaction is being exploited without at the same time inhibiting individual enterprise. Extended to the Islamic financial system, this means that the funds individuals and/or companies put at risk share the profits or losses resulting from the enterprise. Islamic banking encourages better resources management, in particular as outright speculation is not permitted by Shariah, ie Islamic law.

As this is a trend not only applicable to the Muslim world, the emerging Islamic banks are increasingly being accepted by non-Muslims who do not wish to invest in, or even deposit their savings with companies engaged in unethical and socially harmful activities, such as dealing in alcohol, gambling, pornography and tobacco.

In Islamic housing finance the risks involved are shared between the borrower and the bank, rather than transferring all the risk to the latter. The most commonly used contract is the diminishing musharaka (partnership) contract. In this case the borrower and the bank form a partnership, with the bank providing up to 95 percent of the purchase price, and the borrower 5 percent.

The borrower buys out the ownership share of the bank which makes its profit from the rent paid by the client for the share the bank owns. This happens over a period of, usually, 15 to 30 years.

To recap, one of the basic principles of Islamic banking is the prohibition of riba (usury or interest). Up until the 1980s riba was generally interpreted to only apply to usury but it is now accepted practice to refer to all interest.

Should the borrower default on a principal or rental repayment, the bank may advance the borrower an interest-free loan to enable him to continue their payments in anticipation that he will pay in full when he is able to. The good news is that during this period of distress, the borrower retains his home rather than face eviction.

Islamic banking is also by no means a recent phenomenon. The other crucial element was the accompanying search for ethical values in managing their financial affairs, something many of the traditionally western financial organisations could not provide. As this is a trend not only applicable to the Muslim world, the emerging Islamic banks are increasingly being accepted by non-Muslims who do not wish to invest in, or even deposit their savings with companies engaged in unethical and socially harmful activities, such as dealing in alcohol, gambling, pornography and tobacco.

Having said this, Islamic banks still appraise credit risk, and indeed are more cautious about who they finance than conventional banks.

In a previous article I presented the argument that Islamic banking institutions were weathering the present financial crisis comparatively well as they were, or certainly should be, insulated from the disasters in the interbank market and the mess in the derivatives markets. A number of readers raised the logical question of how Islamic banks manage to stay in business without charging interest.

Islamic financial solutions generally have Arabic names thus intimidating many potential buyers into saying it is all too complicated. At their core, most of these products are essentially the same as their conventional equivalents. The main differences are the absence of interest and often complicated procedures to ensure compliance with Shariah law.

A young man makes his career choice and decides to become a successful banker, just like his father. It is a shame that many of today’s bankers either never received this sound advice, or ignored it!

Extended to the Islamic financial system, this means that the funds individuals and/or companies put at risk share the profits or losses resulting from the enterprise. Islamic banking encourages better resources management, in particular as outright speculation is not permitted by Shariah, ie Islamic law. Islamic financial solutions generally have Arabic names thus intimidating many potential buyers into saying it is all too complicated. In Islamic housing finance the risks involved are shared between the borrower and the bank, rather than transferring all the risk to the latter.

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