Islamic Banking and Finance – Social Failurezulkiflihasan
Quoted from the New Horizon by Dr Mehmet Asutay
The phenomenal growth of the Islamic banking and finance (IBF) industry has been remarkable since it came into existence just over thirty years ago. However, a closer reading of this positive development indicates that IBF does not necessarily share the aspirations or the foundational claims of Islamic moral economy (IME), an authentic value system for human-centred economic development and social justice. Despite its contribution in expanding the financial base in Muslim countries and overcoming financial exclusion through product diversification, IBF, in responding to the realities of the international financial system has converged towards the conventional notion of managing wealth, resulting in tensions with the foundational axioms upon which an Islamo-ethical financial system was intended to be built. In such transformation, the identity of IBF is reduced to the mere removal of riba and conducting financial activity in contractual norms derived from the Shari’ah. The result, therefore, has been the divergence between the aspirations of IME and IBF as an instrument of that system.
Philosophical sources of Islamic finance: utopia
IME, in its modern usage, came into existence in the early 1970s mainly as a critique of economic development strategies that ignored the importance of societal well-being. Therefore, it aimed at formulating a human-centric development strategy by providing the following foundational base through which financial and economic activity could be conducted:
* Tawhid (unity) indicates the vertical dimension of the Islamic ethical system in terms of equality in front of God;
* Al-’adl wa’l-ihsan (justice and equilibrium) provides for the horizontal dimension of equity in terms of equality between individuals;
* Ikhtiyar (free will), provides individual opportunities in the economic system to choose between various options;
* Fard (responsibility) implies that individuals and society need to uphold the public good;
* Rububiyyah indicates divine arrangements for nourishment, sustenance and directing things towards their perfection;
* Tazkiyah calls for growth with purification to incorporate the good of the others and be conducted with ethical and moral considerations;
* Khilafah indicating an individual’s role as God’s vicegerent on earth.
Within this framework, maqasid al-Shari’ah, or the objectives of Shari’ah, is interpreted to suggest that economic and financial activity must lead to ‘human well-being’. Being the institutional aspect of this IME, IBF institutions are expected to operate within this framework to produce a social and environmentally acceptable optimum.
From utopia to reality
In responding to this moral economy strategy, the initial experience of IBF in Egypt in late 1960s was structured as a socially-oriented institution, aimed to provide credit to peasants, small businesses, and workers to overcome financial exclusion and expand the ownership base of society. However, despite such a novel origin, with the internationalisation and unprecedented growth in their assets base and financing since 1980s, the lives of Muslim individuals have not been significantly affected by such development of IBF, as the social dimension is limited to zakat and other non-systematic charitable activities, which negates systematic economic development.
It might be useful, therefore, to compare the realities against the aspirational worldview by deconstructing the practices of IBF through values the practitioners attach to IBF against the foundational values mentioned above. Speaking at the Islamic Finance Seminar held in London last year, Iqbal Khan, a leading contributor to the development of the sector, suggested the following values among the aims of IBF:
* Profit-and-loss (PLS) sharing and risk- sharing is preferred alongside creating more value addition to the economy;
* Community banking: serving communities, not markets;
* Responsible finance, as it builds systematic checks on financial providers; and restrains consumer indebtedness; ethical investment, and corporate social responsibility (CSR) initiatives;
* Alternative paradigm in terms of stability from linking financial services to the productive, real economy; and also it provides moral compass for capitalism;
* Fulfils aspirations in the sense it widens ownership base of society, and offers ‘success with authenticity’.
It is clear that these values fit into the aspirational values of IME as well. A critical examination of these objectives, however, indicates that the reality is far from fulfilling these objectives.Regarding preference towards equity-based PLS and risk-sharing financing over debt financing, data analysis, for instance, in the Malaysian IBF case depicts that the percentage share of musharakah declined from 1.4 per cent in 2000 to 0.2 per cent in 2006, while major modes of Islamic financing remain to be bai bithaman ajil (sale of goods on a deferred payment basis; another term used for such sales is bai mu’ajjal) and ijara wa iqtina (leasing and subsequent purchase) with 55.9 per cent and 25.2 per cent respectively in 2006. In addition, from 1984 to 2006, murabaha constituted 88.1 per cent of the mode of financing for Bank Islam Malaysia Berhad, and 67.3 per cent for Dubai Islamic Bank, while mudarabah and musharakah was about 1.7 per cent and 9.3 per cent respectively.
Moreover, in relation to social lending, the percentage of qard hasan (an interest-free loan for welfare purposes/short-term funding requirements) is at a negligible level in IBF sector. Taking into account that IME aims for equity financing for creating value addition in economic activity, the change towards debt-financing is rather meaningful, which indicates that IBF institutions have deviated from the economic development and social welfare objectives of IME. Thus, the promise of Islamic finance in relation to its performance failed to be realised in providing socio-economic development for the larger parts of the Muslim world and communities.
Data analysis also shows that long-term financing is not the norm, as most of the financing focuses on projects with maturities lasting less than a year. In addition, while developmental financing necessitates financing sectors such as agriculture and manufacturing, the majority of IBF is related to retail or trade financing. For instance, after the initial years, Islamic banks in the Sudan moved away from financing agriculture and industry using PLS schemes. Furthermore, instead of investing in value-added economic activity in the Muslim countries, there has been a tendency to invest the funds abroad. As a result, the value addition of IBF to the local economy has further declined, and the contribution of IBF for economic development through real economy has been rather elusive.
Regarding the community banking objective, experience shows that IBF has done little to contribute to capacity building in the communities. On the contrary, IBF has aimed at becoming part of the international financial markets and, despite the social expectations, IBF claims that it is not a charity, and that firms have to work under difficult competitive conditions. Clearly, this indicates profit maximisation as the aim, which negates the importance of societal responsibility.
As regards to responsible finance, there is no universally accepted regulatory body that systematically checks Islamic financial providers. The initiatives by AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) in Bahrain and IFSB (Islamic Financial Services Board) in Malaysia remain weak and are not generally adopted. To evidence this, a recent study demonstrates that a large number of Saudi Islamic finance practitioners, accountants and auditors, are largely unaware of AAOIFI standards.
Pertaining to fulfilling aspirations, IBF has not positively affected social capacity building and contributed to widening ownership, which could have been possible through venture capital or PLS type of investments. However, as discussed previously, these do not seem to be preferred by IBF. As part of restraining consumer indebtedness, the data indicates that IBF institutions prefer to involve themselves in transactions, which are debt-financing oriented, as they are more profitable. Thus, this aim remains unfulfilled.
Concerning ethical investments, restraining the investment areas does not necessarily make IBF ethical. Rather, it only implies that IBF fulfils its legal expectations, as screening of Islamic investment is part of Shari’ah. However, considering that ethicality includes being pro-active in regards to IBF, there is little indication that the industry is entirely ethical. This, again, refers to the CSR, as recent studies on these initiatives of IBF demonstrate they have not pro-actively developed such an understanding. Their perceptions of CSR remain within the framework of zakat distribution and other non-systemic charitable activities rather than working towards capacity building for developing communities.
In terms of real economy consequences, the claim that IBF links financial services to the economy’s productive side is not convincing, since IBF does not exhibit macroeconomic consequences. Particularly so, when considering the most preferred financing is debt financing as opposed to equity financing. It is, therefore, difficult to argue that IBF is related to the real economy beyond financing the retail markets. In addition, further involvement of IBF sector in debt-like financing, including tawaruq products (sale of a commodity to the customer by a bank on deferred payment at cost plus profit), clearly undermines the ‘productive economic activity’ discourse in Islamic economics.
The realities of financial markets, which prioritise economic incentives rather than religious behavioural norms, has thus forced IBF to become part of the international financial system by adopting the commercial banking model. In that predicament, IBF is described as heterogeneous financial products deprived of their value system as expected by IME. Under such circumstances, it is difficult to argue that IBF acts as a moral compass for capitalism, either. On the contrary, recent studies show that IBF has much to learn from conventional finance in terms of ethical and CSR financing issues.
As to locating the principles governing IBF in the Quran, indeed it reveals the importance of authenticity. Yet, the characteristics of IBF do not necessarily reflect the Quranic economic meaning of authenticity or, for that matter, Shari’ah-based principles as formulated in the aspirational notions of IME. Instead, religion serves to provide justification for IBF’s current operations by claiming legitimacy in the form of ethicality and social responsibility as shaped by Islam.
The discussion so far should not be considered to undermine the progress of IBF, as its contribution in terms of bringing economic growth through expansion of the financial base in Islamic commercial banking is self-evidenced with the developments in the sector. Also, provision of alterative products in compliance with Shari’ah overcomes financial exclusion. However, against this ‘commercial’ nature, social aspects of IBF, in terms of economic development and as described in IME need to be addressed, which constitutes the gap between promised expectations and performance.
It can, therefore, be suggested that IBF has failed to internalise the social dimension and social justice into its own operational function, as the distinguishing characteristics of IBF has been reduced to a technicality in which the value system is referred to only in describing the Quranic prohibition of riba. As a consequence, a solution to overcome social failure requires new models of institutional developments beyond commercial IBF, by going back to the Islamic construction. In this new modelling or reorienting social banking, community banking, ethical and social investment, community development-oriented projects and microfinance have to be endogenised and addressed as objectives.
In reorienting towards social banking, Professor Mahmoud El-Gamal, a renowned contributor to academic discourse in the field, in his recent books states that ‘the “Islamic” in “Islamic finance” should relate to the social and economic ends of financial transactions, rather than the contract mechanics through which financial ends are achieved’.
The difficult state of economic affairs in the developing world requires such a transformation. In this effort, the evolutionary financial experience in the West can be taken as an example in developing Islamic community development banks and Islamic social banks alongside commercial IBF. Such an institutional solution aiming at correcting and moderating the social failure of IBF will contribute to the development of individual lives by focusing on societies’ micro-dynamics rather than affecting the financial equilibrium by extending financial involvement to embrace larger society in this economic dynamics. This fits into the new development paradigm, which has shifted focus from macroeconomic development to micro dynamics.
Thus, a move towards goals and policy rather than the mechanistic and legal structure of IBF will serve human well-being much better, as suggested by Professor Nejatullah Siddiqi, a leading scholar in the field. This will help to establish optimality between venal behaviour and sacrificial behaviour, and the choice between the two will be determined by the values of the participants in the sector and the interest of the larger environment. However, Islamic social and community banking can provide this balance, and the new brand in compliance with ethical religious norms of IME regarding economic and financial activity for achieving prosperity (falah) in this world and in hereafter through purification and perfection of individuals and institutions for growth and development, as tazkiyah suggests.