Islamic Alternative to Conventional Finance

Introduction

The last few decades have been characterized by heated debates and scholarly questions that seek to find answers concerning the persistent predicament witnessed in the financial sector and more so the prevailing conventional banking frameworks. The inquiries not only seek explanations about the root of the crises but also the possible strategies or options that can be implemented to restore the situation while at the same time preventing any similar future scenario in the financial industry. Interested Muslim stakeholders and bankers have come out to identify some of the current flaws that have led to the unsteadiness of conventional banking structures, including the catastrophic impacts that such gaps have had on the existing conservative financial frameworks, specifically the unrelenting crises.

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Regarding some of the possible and sustainable measures that can be adopted, Muslim scholars have gone ahead to single out the Islamic financing approach as the only viable alternative that can help to address issues that have been linked to the conventional banking framework. Hence, it is crucial to investigate various aspects that Islamic finance may have adopted to qualify as an alternative to conventional banking systems. In addition, based on the methods investigated, this study also responds to whether such Islamic-based systems should be viewed as viable, sustainable, and secure alternatives to conventional banking frameworks.

How Islamic Finance May be Considered an Alternative to Conventional Finance

Interest Prohibition

Regardless of how other conventional financial agencies are hard-hit by recessions, the apparent express advancement of many Islamic banking systems during times of crises has heightened the demand by stakeholders to have Islamic finance be adopted as an alternative to other conservative frameworks. According to Jreisat et al., although Islamic and conservative financial systems serve an analogous function of supplying monetary resources from their reserves to individuals or areas that have a shortage of funds, it is crucial to point out that the process followed by the former (Islamic financial agencies) is founded on strong principles, which seek to safeguard customers’ welfare (437). For instance, whenever funds are transferred from the conventional banking system to the respective destination, the repayment plan requires the beneficiary to part with additional costs, namely, interest fees, which Islamic banks have banned in their operations.

According to Abou-Zaid and Leonce, although interest charging is a mechanism deployed when supplying repayable funds to individuals or organizations, the Quran regards such a move as unethical because it translates into customer abuse and extortion (219). Nonetheless, conventional financial systems take advantage of the period that passes to justify why the client needs to pay an additional amount in the form of interest fees, a move that many customers have not been considering fair. As Abou-Zaid and Leonce reveal, “Because Islam does not make a distinction between charging interest to a Muslim or non-Muslim, it also makes it unlawful and forbidden to receive or pay interest” (224).

Important to note, one of the major reasons why many clients may have defaulted their loans during the infamous global financial predicament of 2007 and 2008 entailed the huge accrued interests, which they were unable to pay regardless of the corresponding security. In other words, conventional banks have always risked losing clients because of the huge interests they charge to the extent that customers may be required to pay almost double the principal amount after a specific period. The amount of assets, which can be procured with the amount paid when interest charges are included, raises ethical questions, especially bearing in mind that such materials goods end up being more valuable compared to what the client purchased with the initial smaller amount.

The above disparity paves the way for a consideration of an alternative financing mechanism whereby customers do not incur unreasonable expenses whenever they need a particular asset to be financed. Here, Islamic banking may be the appropriate choice because it addresses this issue to the client’s satisfaction (Abou-Zaid and Leonce 225). Surprisingly, during the well-known worldwide financial predicament, some financial agencies recorded substantial losses to the extent of re-examining and even adjusting some of the policies that governed loan repayment with the hope that clients would reduce their debt levels. For instance, a study by Liu et al. reveals how a big number of conventional financial agencies had to borrow an alternative strategy of waving almost all accumulated interest charges to woo clients to pay back the principal amounts (2). It is crucial to point out that this strategy is characteristic of Islamic finance where customers are not subjected to unwarranted extra costs whenever they borrow money from interest-free financial organizations. Hence, the above interest-prohibition strategy can be viewed as one of the possible ways that may make Islamic finance qualify as an alternative to conventional banking systems.

Asset-Backed Financing

According to Jreisat et al., the worldwide financial predicament whose impact, for instance, the loss of billions of the U.S. dollars, was felt for almost seven years, beginning from 2007, was solely linked to major gaps in conventional banking structures, for instance, the lack of an asset-backed financing mechanism (438). Consequently, as the authors reveal, many scholars present such gaps as arguably part of the forces that drove many countries, for instance, the UAE, towards adopting Islamic banking practices, which were characterized by an increased customer share for the Dubai Islamic Bank (Jreisat et al. 438). Such a transformation may be indicative of clients’ and stakeholders’ awareness that Islamic finance may be an alternative to the current crisis-bound conventional banking structures. In other words, another way that can be used to classify Islamic finance as an alternative to the conventional monetary system is its asset-secured financing aspect.

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Under the conservative financing framework, operations in all monetary agencies entail the exclusive use of cash and monetary papers. However, this conventional approach to financing has been retrogressive, owing to the insecurity linked to it. Important to note, a bigger percentage of nations around the globe have banned this counterproductive and outdated financing strategy. According to Pani and Holman, asset-backed financing entails giving out credit that is secured for a specified period through other existent or material goods (214). To demonstrate how the use of conventional monetary papers alone is losing grounds, financial agencies that embrace the concept have been warned never to buy and sell merchandise in the majority of nations around the globe (Pani and Holman 214). In other words, Islamic banking is applauded for its asset-backed approach to financing, owing to its stringent measures of disallowing or recognizing monetary papers in any business operations, unless under extraordinary and permissible conditions.

During the global recession of 2007 and 2008, monetary agencies, especially those that embraced conventional financial approaches, as opposed to Islamic finance, experienced the worst case of the highest number of borrowers who could not repay their loans because of the lack of commercial papers. According to Garg, the situation may be attributed to the lack of securitization whereby “The cash flow arising from the securitized assets could be utilized to make periodical payments either to the bank or the respective investors” (47).

It is possible that the situation would have been manageable if the asset-backed Islamic financing concept had been adopted, owing to the above advantage. Riba-prohibited monetary organizations believe that money lacks any inherent worth and that it is unethical to expect some profit when doing money-money, as opposed to money-asset transactions. Such profit amounts to riba, which is strictly proscribed in Islamic finance. In this case, riba is an Islamic aspect that denotes the interest charged on the principal amount. Consequently, according to Ayub, contrary to what is practiced under conservative financing structures, Islamic banking encourages the adoption of illiquid assets that result in actual property and inventory (13). Hence, Islamic finance may be regarded as an alternative to conformist banking mechanisms.

The Prohibition of Speculative Investments

One of the key reasons why many Islamic banking organizations did not experience the full force of the infamous global financial predicament of 2007 and 2008 is that they shunned any form of speculative investment. Contrary to what conventional financing embraces, the extent of liability transfer or provisional deals under Islamic finance cannot exceed the actual worth of an asset. Islamic finance discourages speculative investments, for instance, derivatives. Scholars around the globe claim that derivatives fuelled the worldwide monetary catastrophe, which left many conventional financial agencies bankrupt following huge and unrecoverable debts (Liu et al. 4). In other words, adopting this strategy of prohibiting speculative transactions may be regarded as an alternative that conventional banking stakeholders can adopt as part of their operations in their attempt to recover from the impact of the infamous global financial predicament.

Borrowing from Islamic finance as an alternative, conservative banks stand a better position to reinforce their standing in the global commercial zone because shareholders and business people are looking for unconventional means of financing. According to Nagy and Benyovszki, unforeseen devastating negative impacts of allowing speculative investments triggered the fall of many conventional financial organizations during the global economic disaster (7). Ayub introduces another element of ethics concerning speculative transactions and hence a substantiation of why Islamic finance does not tolerate the plan, despite its wide adoption under the conventional approach to banking (12). Specifically, the authors reveal the presence of “elements of al-maisir (gambling), al-gharar (uncertainty), malpractice, unethical activities, and unearned income in speculative stock market transactions; matters that are patently undeniable” (Salamon et al. 372).

From the above observation, it is apparent that no well-informed client or organization can opt for a financing approach that is characterized by malpractices and other immoral deeds because such actions create avenues for the insecurity of finances (Ayub 12). In other words, the failure to regulate the extent of the tolerability of speculative investments may have catastrophic consequences to local and even global financing and banking operations as witnessed during the 1930s Great Depression. As a result, since Islamic finance has been proactive in ensuring that customers and stakeholders are not subjected to such repercussions of speculative investments, it suffices to regard it as an alternative to conventional finance.

Why Islamic Finance is a Viable Alternative to the Conventional Financial System

From the issues mentioned in the above section, it is crucial to substantiate why Islamic finance is a viable alternative to conventional banking frameworks. Over the last few years, the world has experienced an array of crises in the financial and banking sectors, thereby calling for the identification of solutions that would bolster the overall economic stability. A considerable number of scholars in the areas of finance and banking identify the Islamic financial system as one with the potential means of saving global economies from the weakness and instability of conventional banks (Hassan et al. 36). Particularly, Islamic banking upholds several principles that enhance its viability as a substitute for the orthodox banking system. As earlier mentioned, some of the principles that make the Islamic banking system stable include the prohibition of riba and gharar, the sharing of profit and risk, and asset-backing (Hassan et al. 36). Gharar or al-gharar is used to refer to ambiguity or dishonesty. In this light, the adoption of the proposed banking system has the potential of lessening economic recessions triggered by the conventional banking arrangement.

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Similar to the approach of orthodox banks, Islamic financial institutions also offer a transitional funds transfer mechanism from a superfluous unit to an economy’s deficit component. Hence, in addition to other benefits, this provision makes it a viable option. To substantiate this claim, financial institutions that follow Islamic principles approach the function of intermediation of funds from a different angle. Particularly, the prohibition of riba bars Islamic banks from imposing interest rates of any form when conducting the process of intermediating funds. Instead, Islamic financial agencies connect financial transactions to tangible assets or the actual industry, thus avoiding subjecting the affected parties to interest rates. Some of the notable forms in which the Islamic banking system attracts interest charges include the engagement in partnerships, leasing, and mark-up pricing (Hassan et al. 40). In this respect, the abolition of interest rates in the system facilitates economic growth and development by encouraging private investments through partnerships among other ventures.

The prohibition of interest rate transactions in the Islamic banking system makes it a viable alternative over mainstream banking since it mitigates the crowding-out effect arising from deficit spending. Important to note, economies that need to recover from a recession engage in deficit spending as a way of accelerating growth and development. The financial institutions lending funds to governments to facilitate their deficit budgets usually impose huge interest rates that discourage private investments. Consequently, the crowding-out effect emerges since the interest rates arising from the debt weaken the initial improvements in total expenditure. Nonetheless, if financiers of government loans employed the Islamic principle of riba, the crowding-out effect would be mitigated, thus resulting in hastened economic recovery and growth, especially through private investment (Rosman et al. 80). Therefore, in addition to offering stability against the development of a recession, the Islamic banking system has the potential of boosting economic recovery and growth in the event of an economic slowdown, a situation that makes it a viable substitute to the orthodox banking system.

In Islamic banking, asset-backed transactions between lenders and borrowers foster the flexibility of economies by discouraging speculation or debt transfers, also known as swaps unlike the case of traditional banking (Jawadi et al. 78). In this view, Islamic banks support transactions that take into consideration the factual worth of assets, a concept that is not embraced in transactions that involve speculations and swaps. The asset-backed approach to financial transactions seeks to address issues surrounding excessive credit expansions in an economy. Furthermore, the asset-backed principle makes Islamic finance a viable option because it has the potential of mitigating recessions induced by speculative trading activities in the banking sector (Rosman et al. 82). In this light, according to Liu et al., the Islamic banking system offers a solution to issues brought about by the speculation of transactions involving various forms of derivatives in the traditional banking arrangement (4).

The asset-backed approach adopted by Islamic banks addresses the issue of interest rate risk (IRR), a significant problem that faces the orthodox banking system (Imam and Kpodar 115). Notably, the asset-backed trading approach discourages repricing mismatches, a leading trigger of IRR in the conventional banking structure. Instead, Islamic banking applies mark-up pricing or murabahah to bolster the realization of equality in the valuation of assets. Murabahah refers to the profit (mark-up) made when an individual sells a particular product at a price bigger compared to the cost of buying it. Mark-up pricing also mitigates the occurrence of repricing inconsistencies that lead to the upsurge of operational costs that prompt the fluctuation of interest rates experienced by conventional commercial banks. As a result, the asset-backed principle is viable because it discourages the development risks that usually face traditional banks.

The risk and profit-sharing aspect of the Islamic banking system also fosters resilience. Traditional banking systems do not uphold the essence of sharing the prospects and benefits offered by various investments. In this sense, the borrower and the financing agency share any risks or profits realized from asset-backed transactions. Conversely, traditional banks disregard the essence of distributing risks and returns to the borrower because they usually focus on profits (Jawadi et al. 75). The Islamic banking system values the welfare of customers more by ensuring that they take minimized business risks while at the same time gaining a share of returns attained by financial institutions that observe the principle of gharar. In other words, Islamic finance offers a worthwhile alternative to the traditional banking scheme by focusing on the financial well-being of the borrower rather than concentrating solely on the realization of substantial profits.

Conclusion

The Islamic banking structure is a sensible alternative to the conventional banking arrangement. The asset-backing feature functions as a self-protection tool that prevents speculative trading activities that may prompt excessive credit expansions. Importantly, tying financial transactions to tangible and recognizable assets minimizes the likelihood of Islamic banks becoming bankrupt amid the emergence of an economic contraction since financiers share losses with borrowers. For this reason, Islamic banks demonstrate more resilience and sustainability compared to conventional banks. Riba and gharar injunctions also play a considerable role in protecting the well-being of borrowers, an approach that is not prevalent in the traditional banking system.

Importantly, riba safeguards borrowers’ financial well-being by ensuring that they secure loans to finance private investments or other purposes at an insignificant cost, thereby bolstering economic growth and development. The gharar ban is essential in safeguarding a country from speculative transactions that may lead to an economic slowdown, a common issue triggered by conventional banks. The distribution of risk and benefits in the Islamic financial system is also advantageous since it protects the interests of both the lender and the borrower. In addition, sharing risks under Islamic finance allows the lender and the borrower to have a portion of the underlying benefits or losses as a way of enhancing the fairness of transactions.

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Works Cited

Abou-Zaid, Ahmed, and, Tesa Leonce. “Religious Pluralism, yet a Homogenous Stance on Interest Rate: The Case of Judaism, Christianity, and Islam.” Contemporary Economics, vol. 8, no. 2, 2014, pp. 219-29.

Ayub, Muhammad. Understanding Islamic Finance. John Wiley & Sons, 2007.

Garg, Nikhil. “Understanding Credit Risk in Securitization and Measures to Build Effective Securitization Markets.” IUP Journal of Financial Risk Management, vol. 14, no. 4, 2017, pp. 45-59.

Hassan, Kabir, et al. Introduction to Islamic Banking and Finance: Principles and Practice. Pearson Education Limited, 2013.

Imam, Patrick, and Kangni Kpodar. “Islamic Banking: How has it Expanded?” Emerging Markets Finance and Trade, vol. 49, no. 6, 2013, pp. 112-137.

Jawadi, Fredj, et al. “Conventional and Islamic Stock Price Performance: An Empirical Investigation.” International Economics, vol. 137, 2014, pp. 73-87.

Jreisat, Ammar, et al. “Global Financial Crisis and Productivity Changes of Banks in UAE: A DEA-MPI Analysis.” International Journal of Business & Society, vol. 18, 2017, pp. 437-448.

Liu, Ming-Hua, et al. “The Global Financial Crisis and Retail Interest Rate Pass-Through in Australia.” Review of Pacific Basin Financial Markets & Policies, vol. 19, no. 4, 2016, pp. 1-32.

Nagy, Ágnes, and Annamária Benyovszki. “The Global Crisis: Challenges to the Banking System.” Theoretical & Applied Economics, vol. 20, no. 4, 2013, pp. 7-26.

Pani, Erica, and Nancy Holman. “A Fetish and Fiction of Finance: Unraveling the Subprime Crisis.” Economic Geography, vol. 90, no. 2, 2014, pp. 213-235.

Rosman, Romzie, et al. “Efficiency of Islamic banks During the Financial Crisis: An Analysis of Middle Eastern and Asian Countries.” Pacific-Basin Finance Journal, vol. 28, 2014, pp. 76-90.

Salamon, Hussin Bin, et al. “Speculation: The Islamic Perspective; A Study on Al-Maisir (Gambling).” Mediterranean Journal of Social Sciences, vol. 6, no. 1, 2015, pp. 371-378.

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