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Islamic banking and conventional banking have only minor economic differences

The economic differences being minor is indisputable. Whether there is a religious difference is not covered in this short article.

Posted 10 January 2023

Many believe that there is a fundamental economic difference between Islamic banking and conventional banking. In my experience, this belief is most common amongst people who are not familiar with Islamic banking.

Accordingly when presenting or writing I often make the point that Islamic banking is just banking done in a Shariah compliant way. I chose this as the topic for my November 2022 column in the magazine "Islamic Finance News."

You can read it below, along with my sad explanation of why I was a "no show" amongst the speakers at a conference for the first time I can remember.

Islamic banking is banking – with Shariah compliant contracts

I was recently asked to speak at a conference with the theme: “The Role of Islamic Banking Towards Establishment of Socio-Economic Welfare: Potential, Challenges, Development & Future Prospects.” An Islamic finance acquaintance had recommended me based on my article “Governments should stop privileging debt over equity” in the 1 June 2022 issue of Islamic Finance News.

My 15-minute presentation will have the title “Why companies prefer debt finance (whether conventional or Islamic) to equity finance. What could change this?”

The tax reasons were covered in my article mentioned above.

However, there is a more fundamental point. As suggested by the conference title, many expect Islamic banking to produce different economic results to conventional banking. In my experience they are regularly disappointed when it doesn’t.

The early thinking about Islamic banking in the 1950’s came from individuals with a religious background but limited understanding of economics. In my view, that is why “Islamic economics” has gone nowhere as a subject.

While being a Muslim should influence the way you see the world and your attitudes to fairness and justice, intellectually there is no more logic in talking about “Islamic economics” than “Islamic civil engineering.”

Over six years ago, my “A Letter from Amin” in the 10 August 2016 issue of Islamic Finance News explained why fixed return contracts predominate in Islamic banking.

People who put money into banks want to be able to get it back – in full.

That is what regulators seek to ensure when setting the rules under which banks operate. In turn, that is why conventional banks make interest-bearing loans rather than equity investments, and why Islamic banks finance customers with fixed-return contracts rather than participating contracts such as mudarabah.

Poor people who put money into banks simply cannot afford to lose it. That money may represent their only savings. Rich people can afford to lose money when investing, and often invest in equities and other risky investments.

However, even rich people have some practical need to be able to hold money in a bank which they can rely upon recovering in full. (They balance their equity investments’ risks by holding some safe investments such as bank deposits.)

The very purpose of a bank is to hold customers’ money and return it to them in full. In between, that money is used to finance customers, but keeping the risks low so that any credit losses do not impair the ability of the bank to repay its customers in full.

In some countries, Islamic banks do engage in genuine participatory finance by operating mudarabah funds.

However, these are typically well segregated from their mainstream fixed-return financing, and funded by profit-sharing investment accounts where the customer is fully aware that they are taking on genuine business risk and may lose part or all of their money. (Sadly, sometimes the disclosure may not be as good as it should be!)

However, even when done by banks, such participatory financing activity is fundamentally different from mainstream fixed-return banking, just as conventional banks sometimes engage in operating equity investment funds for clients.

These distinctions between the mainstream banking operations and the running of equity-related investment funds apply equally strongly whether the bank concerned is conventional, using interest-based contracts, or Islamic using Shariah compliant contracts.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.

The conference“The Role of Islamic Banking Towards Establishment of Socio-Economic Welfare: Potential, Challenges, Development & Future Prospects.”

The full 6½ recording of the conference organised by the Institute of Business Management in Karachi, Pakistan can be watched below. I was due to appear via Zoom to give my presentation "Why companies prefer debt finance (whether conventional or Islamic) to equity finance. What could change this?"

Sadly you will not find me in the video, as I failed to turn up. I have learned to think about international time zones since I started working with US clients at Arthur Andersen in 1977 .

Despite that long experience, when entering the appointment in my diary (after having carefully used a time zone converter to ensure that I got the time difference right), I made a mistake. I entered the Pakistan time I was due to speak, 14:15, in the UK time zone field of the converter, and then recorded the output 19:15 shown in the Pakistan time zone field into my UK based diary.

I have no idea how I failed to notice the mistake, since the UK time number must always be earlier than the Pakistan time number, not later.

Once you have made the mistake, you never notice anything is wrong afterwards. I only realised with horror what had happend while I was having an early dinner on the conference day while thinking about getting ready for the Zoom talk. Suddenly I realised that I had recorded the wrong time since by then it was nearly midnight in Pakistan.

Hopefully this catastrophe will remain unique in my life. Obviously I apologised profusely to the organisers afterwards!

Video of 6th International Conference on Islamic Banking & Finance [ICIBF 2022]


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