Monday, July 16, 2007

Islamic Banking, or, the separation of Bank and State

Banking practices are not the same everywhere. Since the 60s there has been an increase in "Islamic Banking" throughout the Mesopotamian regions. The largest Mid-Eastern economy, Turkey, also has a separate sector for a small but expanding “participation banking” sector, which is not backed by the Central Bank. This participation banking movement is essentially Islamic Banking in Turkey. Practices such as charging interest rates on loans are considered 'making money from money', and this is forbidden in Sha'ria Law and the Hadith. Islamic banking in theory is full-reserve banking, where all the money deposited into a bank is held in the bank. Profits come from transaction costs, service fees and gains from defaulted loans (such as possessed capital or collateral) not increasing prices on loans. Dubai Islamic Bank had been acquiring smaller banks mostly in Central and Eastern Turkey, such as MNG. Turkiye Finans, another participation bank, in fact hires HSBC to evaluate offers from potential foreign partners.

The mix between Islamic and fractional-reserve banking is becoming more integrated. Islamic subsidiaries of Citigroup or HSBC are playing a large role in create a market for financing and financiers with Qur'anic laws forbidding holding fractional reserves, or sponsoring un-Islamic activities such as gambling or smoking. Citigroup's Bahrain-based Citi Islamic subsidiary was first into the market in 1996, and now leads the pack with deposits of more than $6 billion. Citi and at least 10 other Western majors dwarf the biggest locally owned rival, Al Baraka of Bahrain, worth a little more than half a billion.

Westerners are drawn to these banks by oil money. Muslims are drawn to Western banks in part by distrust of their own banks. Prominent failures, such as the 2001 collapse of Turkey's Ilhas Finance dented depositors' faith. In Turkey, the Islamic world's largest economy, the fledgling Islamic-banking sector is lobbying the state to guarantee deposits. In Malaysia, where more than 11 percent of deposits are now Sharia-compliant, local houses like Bank Muamalat are working to gain on the multinationals.

According to Islamic Banking and Finance magazine, there are $265 billion in deposits that comply with Sharia, finances included. Since 1996 Dow Jones has offered indexes of stocks vetted by Sharia scholars. Now there are more than 40 Islamic indexes, and last year Islamic stocks on average outperformed the market by 5 percent.

A generation ago, an Islamic bank was just a simple investment house that, instead of paying interest on deposits, created dividends by buying and renting out property. Sharia does of course allow you to rent and trade. Western banks are using that template to pioneer Islamic credit cards, Islamic mortgages and Islamic bonds (known as sukuks) that during the past year have financed everything from a $1 billion upgrade of Dubai airport to Pakistani government debt. As growth picks up in the Middle East, more and more Muslim-run corporations find they need sophisticated services, from bond issues to derivatives, which so far only Western banks provide. The Western banks go so far as to gain Islamic credibility by hiring Sharia scholars to sit on their boards.

There is another reason why Western banks practicing Sha’ria law are successful in Muslim nations. Small Islamic banks are less profitable and do not have reserves large enough to deal with several problems that large, profitable banks can. Rich banks can invest in a riskier banking style, but only if they have less risky banks elsewhere. For example, the Islamic banks have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis.

They face the same problem in financing consumer loans and government deficits, which is unclear what counts as collateral. The risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions (such as “participatory banking” which sounds more secular in Turkey.) It also is important that the Islamic banks do not have the legal support of central banks, as a lender of last resort, in their respective countries (except in Pakistan and Iran), which exposes them to great risks. To date there is no international Islamic lender of last resort.

As more international banks like Societe Generale, BNP Paribas, Deutsche Bank and Standard Chartered enter the Islamic banking business, more interest and controversy will be raised over this issue. In the end, while this practice faces several difficult and fundamental problems, only two governments in the world, Pakistan and Iran, continue to use these banks to finance serious government projects. It is a growing practice in Turkey, but I am doubtful as to its becoming an important banking trend. Much support for the reforms since 2001 have been recognized by the Turkish population as being useful. And these reforms are connected much more in the public perception to secularism than to Islamist politicians in government.


WeeZie said...

well explained!!!

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