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The Effect of Debt on Islamic Banking - ASHARQ AL-AWSAT English Archive
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Riyadh, Asharq Al-Awsat- One cannot read a book or research paper dealing with Islamic Banking and its operational model – whether it is written by an Arab or Westerner – without hearing Islamic Banking described as a system built upon participation, to the extent that in a country like Turkey for example, Islamic banks are called participation banks.

This should mean that most transactions taking place in Islamic banks should be participation [i.e. contribution] rather than the accumulation of debt. But the reality is quite the reverse and the majority of Islamic banking operations – whether by Islamic banks or Islamic windows in conventional banks – are predominately transactions that create debt once they have been concluded, especially all forms of Murabaha, such as sale-on-credit, [paying by] instalment, and tawwaruq. Murabaha transactions constitute around 70 – 80 percent of Islamic Banking operations, and so Islamic Banking has become a system of debt accumulation rather one of contribution. Perhaps the reason for this is the simplicity of Murabaha transactions, and its limited credit risk, along with its similarity to taking out a loan from a conventional bank, all of this has made it an accepted practice amongst those working in the [Islamic] banking sector. However the dominance of Murabaha transactions over Islamic banking assets in particular, poses a number of dangers to Islamic banks including;

– Reduces the ability of these banks to manage their liquidity efficiently, as they are unable to convert non-negotiable non-liquid assets to liquid negotiable assets when needed, such as via securitization [structured finance process of pooling and re-packaging financial assets into securities which will then be sold onto investors]. This is because the selling of debt is forbidden under Islamic Shariaa Law, except under strict conditions which make this extremely difficult, if not impossible.

– Increases the financial burdens on Islamic banks in comparison to conventional banks in terms of providing sufficient capital as stated by the Basel II Accord. This is because the predominance of debt in comparison to [liquid] assets in Islamic banks limits their ability to securitize these assets, which in turn limits their ability to grant funding in contrast to conventional banks that are able to securitize their assets from loans.

– Limits the ability of Islamic banks to manage risk. The predominance of debt in comparison to assets makes it extremely hard for these banks to pool this risk via securitization. Therefore the risk to Islamic banks is greater than that faced by conventional banks who are able to pool this risk via securitization. Here we see that what as a blessing in the beginning – as we mentioned above among the reasons for the prevalence of Murabaha transactions in Islamic banking is its limited risk – has become a curse for [Islamic] banks at an institutional level.

– The accumulation of debt by Islamic banks limits this industry’s ability to manage market risk resulting from a change in the interest rate, as well as limiting the management of credit risk in the event of clients defaulting on payment. This is because once debt payment has been agreed upon it is legally prohibited for the original amount of debt to be increased [after payment has been defaulted] as this would be viewed as an act of usury which is forbidden under Islamic Shariaa Law.

And so Islamic Banking is vulnerable to having its profits eroded, and indeed incurring loses, when interest rates rise, or when bank deposits exceed the Murabaha funding granted to clients, or when the client delays or even defaults on the debt, especially when Islamic deposits are drawn on the basis of short-term Murabaha transactions, rather than speculation.

And so we can see how important it is that debt does not dominate [liquid] assets in Islamic banks, therefore it is up the regulatory bodies to impose limits on financing via Islamic financial services [in this manner], as well as to monitor the extent of the commitment of Islamic banks in fulfilling their obligations. These regulatory bodies should also encourage Islamic banks to diversify their products by contributing to their innovation and development, enacting laws and regulations that are in harmony with the [Islamic Banking] system, and setting up institutional structures that reduce the risk in Islamic Banking.

Here one can cite the experience of the US government when it wanted to encourage banks to broaden their operations in the real estate market. The government established the Freddie Mac [Federal Home Loan Mortgage Corporation; FHLMC] and Fannie Mae [Federal National Mortgage Association; FNMA] institutions. This is a good example of what regulatory bodies can accomplish and one that cannot be repeated. I believe that the experiences of the Freddie Mac and Fannie Mae were unique, although marred by a number of mistakes and errors.

Asharq Al-Awsat

Asharq Al-Awsat

Asharq Al-Awsat is the world’s premier pan-Arab daily newspaper, printed simultaneously each day on four continents in 14 cities. Launched in London in 1978, Asharq Al-Awsat has established itself as the decisive publication on pan-Arab and international affairs, offering its readers in-depth analysis and exclusive editorials, as well as the most comprehensive coverage of the entire Arab world.

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