How Islamic Banking works


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Matt Smith:

Welcome to the La Trobe University podcast. I would be your host, Matt Smith, and I’m here today with Dr. Hayat Khan from the School of Economics and Finance at La Trobe University. Thank you for joining me Hayat.

Hayat Khan:

You’re welcome.

Matt Smith:

You’re here today to talk to me about Islamic banking. Can you tell me what is Islamic banking?

Hayat Khan:

Well in the simplest possible terms, Islamic banking basically refers to banking practices approved by Islamic law. The Arabic term that is frequently used to replace Islamic law is Shariah even though Shariah by itself is a broader term and Islamic law is a subset of it.That’s why Islamic banking sometimes is referred to as a Shariah compliant banking system.


Islamic law like any other legal system provides details of the do’s and don’ts of its ideals or the underlying principles. The two main sources of Islamic law are the Qur'an, which is the holy book of the Muslims, and the Sunnah, which is the established tradition of the prophet Muhammad (peace be upon him). There are some deeper issues involved but I would like to keep it as simple as I can.

In the context of Islamic banking and finance, there are three legally binding guiding principles. The first principle is that one should not engage in any economic activity that is prohibited by the Shariah, for example investing in immoral activities. For example, investment in pornography or dealing in alcohol and drugs unless it is for medical purposes, and gambling.

The second principle is that all business activities must be based on real transactions. In other words, all nominal activities must be legally tied to real transactions. In finance terminologies what this means is that all activities must be asset-based rather than debt-based.

And the third guiding principle is that participant should equitably share returns from the real economic activity where the Shariah clearly defines the principles of equitability under alternative scenarios.

Matt Smith:

What makes it different from traditional banking systems?

Hayat Khan:

Well, its one of the most frequently asked questions. The real world is a bit complex, but the simple way of defining it would be that some of the important implications of the principle that I just outlined includes the prohibition of bank interest and a ban on selling what isn’t physically or legally owned with some reasonable exceptions, which we know are the two cornerstone of the traditional banking system.

These prohibitions are clearly and loudly outlined in the Qur’an and the Sunnah, which are the two main sources of the Islamic law. Bank interest is prohibited because money exchanged from more money is a nominal transaction, which cuts it loose from any real economic activity.

Similarly, selling something with excessive uncertainty about its real delivery is equivalent to executing a nominal transaction without the real transaction. In Islam, money cannot earn money unless it is legally identified with a real economic activity. In which case, parties will equitably share the returns from that economic activity, for example on profit and loss sharing basis.

So, it’s the underlying asset and the way returns are distributed that are important here. A simple example would be -- in the conventional banking system you can borrow a hundred thousand at certain interest rate from a bank. You can do whatever you want to do with the money. You can lend it to someone else with an even higher interest rate. You can consume it all or you can invest it somewhere else in the real project.

But in respect of what you do with the money, you would have to pay back the principal plus the interest. The bank is not interested in whether you make profit or loss, you have to pay that bank. So, in case of the crisis, you bear all the losses and the bank will still make money. This is against the equitable norm that is hold dearer by Islam.

Now in an Islamic bank, you will have to show what is that you want to do with this money and you have to enter into a business partnership with the Islamic bank. The Islamic bank will not receive any interest on principal but a share in profit or loss.

One of the many possibilities is to enter into a Musharaka contract, which is basically a joint venture enterprise where both parties put money in the same business. The two parties can agree on any distribution of the profit in any proportion but their share in loss should be equal to their percentage share in equity.

This is what the equitable norm in this part of the contract – in Musharaka type contracts. In case of the crisis, the burden is the equitably shared among the two parties.

Matt Smith:

Does it really make any difference though because they look more or less similar from an individual point of view? Investors or banks won’t return whether this is from money on money or money from profits.

Hayat Khan:

Well, they do look similar from an individual point of view assuming that businesses or individuals who borrow money from conventional bank will necessarily invest that money in real projects and on profit more than the interest payment. But we know this assumption is not always true.

On the one hand, Islamic finance gets investors take their investment more serious then the traditional bank system, which requires a bit of an extra effort. But this in itself is an important behavioural change. But at the same time, the investment is real and relatively safer, which could give them a peace of mind.

At the macro level, which is more interesting, one of the major disadvantage of not legally binding nominal transactions with real transaction is that people start making money without any real economic activity. This opens it abuses like the subprime loans where loans are extended to people who are more likely not to be able to pay them back.

This is because they are unable to invest it in a genuine real economic activity, which could generate the income stream that could be used to repay. We know that there are bits and pieces like this in the system that could lead to bubbles and defaults, which ultimately leads to crisis.

So one of the explanations why a crisis might hit the system put forward by Muslim economists is that when they gap between nominal and real transaction increases, nature will intervene in the form of a crisis to cleanse the system that is to reduce to gap between real and nominal.

Matt Smith:

Are there any countries that mainly practice Islamic banking and what is the benefit to global community from adapting it?

Hayat Khan:

Actually, the idea of modern Islamic finance is relatively a new one and still has to go through some hot and cold to mature. The current supportive infrastructure is basically cut out to suit a system based on debt management and Islamic finance shifts the focus to asset management, which requires modification to the entire infrastructure of an economy and its management system.

This a huge challenging task. That’s why there isn’t any country where the entire banking system is shariah-compliant, keeping aside the lack of interest from policy makers for whatever reasons. There are, however, countries that adapted a dual banking system and encourages Islamic banking.

For example Pakistan, Malaysia, countries in the gulf like Saudi Arabia and Iran, and they are increasingly moving to Islamic banking and conventional banking is becoming less and less in proportion.

As for benefits to the global community from adapting the system, I’ll just mention a couple. What we have seen is a celebrated into some extent, exaggerated resilience of Islamic finance during the global financial crisis. It is definitely a relatively stable alternative where crisis are less likely to happen.

This is because there isn’t any gap in between the nominal and real activities. The narrower the gap between the nominal and real transactions, the less likely it is for crisis to hit. So this is not to argue that the crisis will never hit the system. It may but relatively less likely and the distribution of losses will be more equitable than in the conventional system.

If the crisis ever hits, it will be relatively less damaging than under the traditional system. So investing the Islamic finance could be a reasonable diversification that could add to stability of the system, which is also one of the reasons why Australia is intrusted in the area to basically diversify its portfolio. The other important aspect, which could be a postive contribution, would be the controled inflation.

One of the important implications of binding nominal activities with real activities is to reduce demand-push inflation and making prices more real and stable. This is because the real economic activity shifts the supply curve along with the demand curve, which keeps prices in control.

Matt Smith:

What are you doing at La Trobe University to educate on Islamic banking?

Hayat Khan:

Well, we know that the Islamic finance is just one of the fastest growing segments of the global financial world and at the same time, Australia intends to be a global financial center in the region and hub for Islamic finance.

The demand for trained professionals in the area is increasing globally and more importantly in our local market here in Australia. We believe there is a real need out there for professional trained in the area of conventional and Islamic finance. La Trobe University took the initiative to produce such professionals and introduce its masters in Islamic banking and finance two to three-semesters degree and a joint degree of masters of financial analysis and masters of Islamic banking and finance, which is basically a four to five semesters degree.

So La Trobe University is actually contributing to the events related to Islamic banking and finance in Australia. We organized a symposium last year which was very successful and this year we’re also going to organize another symposium in June together with Liquid learning, which basically would look into the challenges faced by Australia in integrating Islamic finance into the Australian system.

Matt Smith:

Dr. Hayat Khan thank you for your time today.

Hayat Khan:

You’re welcome, thank you.

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