The Islamic banking system - Not conductive to the start-up of young, innovative business firms

TABLE OF CONTENT:

1.  Introduction  1

2.  The Problem of the Prohibition of Interest (riba) and Alternatives  2

3.  The Meaning of the Higher Supervisory Religious Board for Young Enterprises  4

4.  PLS Concepts: Mudaraba and Musharaka  

  And Why Banks Shy Away From These Concepts  5

4.1.  Mudaraba “Sleeping Partnership  5

4.2.  Musharaka “Sharing  9

5.  Other Forms of Loans in Islamic and their Limited Applicability for Young,  

Innovative  Enterprises  13

5.1.  Qard Hasan “Credit Without Interest Not Available for Business Financing  13

5.2.  Ijara “Leasing / Ijara wa-Iktina “Hire-Purchase  

  Just Suitable in Exceptional Cases  14

5.3.  Murabaha “Trade Financing Feasible Just for a Minority of Entrepreneurs  

  and at the Cost of Deriviation from the Original “Halal Concept  15

6.  Conclusion and Proposals for Improvements Inherent to the System  17

  Notes  19

  Bibliography  23

Appendix A:  The Three Main Principles of Islamic Economics  

Appendix B:  Institutions in Islamic Economy  

Appendix C:  The Islamic Banking System  

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1. Introduction

The contemporary Islamic banking system, a relatively young institution, gains influence not only in the Islamic world but also in non-Muslim countries with big Muslim communities. The first Islamic bank, Dubai Islamic Bank, was erected in 1975. Today about 265 Islamic finance institutions operate in more than 70 countries, and their assets have increased more than 40-fold since 1982 to exceed $230 billion. More and more western banks erect Islamic branches; the first was Citibank in 1996. 1

We have to raise the question, what influence this banking system has on the start-up of young, innovative businesses, inside and outside of Muslim countries. A negative influence would hinder these businesses to develop - if not counterbalanced by other measures like state involvement, e.g. by providing special funds for these businesses. In non-Muslim countries, it would constrain religious Muslims from participating in the contemporary economical changes, determined by an opening-up of markets and privatisation, which require the start-up of new businesses.

The Islamic banking system operates according to Islamic law; hence several Islamic restrictions, the most important of which is the prohibition of riba=interest, limit its freedom to develop suitable financing instruments for the support of young, innovative businesses. These restrictions enlarge the risk of the bank, especially when financing these businesses, so the bank either avoids these businesses or tries to bend the Islamic law and tries to operatede facto - like a conventional bank. In this case, however, the bank will face problems with the Religious Supervisory Board, an integral part of every Islamic bank, which may declare the bank to be in opposition of Islamic law (Sharia) and shut down its operations.

The Islamic banking system is a relatively young concept and the scholars can be divided into three main camps. The first consists of Muslim scholars, like Chapra ² , Siddiqi ³ or Ahmad ⁴ , who support the concept of Islamic banking and are concerned mainly with the theoretical and ideological aspect, but lack an analytical research. The second group analyzes Islamic Banking from a theoretical point of view, like Mirakhor ⁵ , Khan ⁶ or El-Ashker ⁷ . The third group comprises Western scholars, like Wilson ⁸ , Nienhaus ⁹ , Kuran ¹⁰ and Kazarian ¹¹ , although this topic was largely neglected by Western scholars for many years. Kazarian provided an interesting analysis of Islamic versus traditional banking. But also Muslim scholars like Al-Omar/ Abdel-Haq ¹² provide us with studies and analysis from a practical point of view.

This paper will not discuss the ways a government can balance these negative impacts of Islamic banking, e.g. by setting up public development institutions which provide special funds for young, innovative entrepreneurs. It is also not my aim to discuss whether the Islamic values create a better society, even at the cost of reduced development of innovative businesses. It is my aim instead to focus on the influence of Islamic banking on the financing of young, innovative businesses in the start-up phase.

In order to analyze these influences, I will first briefly describe the most important element that determines the religious framework of Islamic banks: The prohibition of riba, and the absence of interest-based financial instruments. I will prove that the institution of a Higher Supervisory Religious Board has a negative influence on planning reliability, both for banks and entrepreneurs, and increases transaction costs.

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Next, I will look at the interest-free financing instruments of Islamic Banking suitable for the start-up of young, innovative enterprises:

1) Musharaka (partnership) and mudaraba (silent partnership). I will analyze these Profit-loss Sharing (PLS) concepts and identify the factors that make them unattractive for banks, especially when financing young, innovative business, leading banks to avoid such financing.

2) Murahaba (Trade Financing) and ijara/ijara al-waktina (Leasing). I will analyze these mark-up activities and identify why these concepts - preferred by banks - are suitable only for financing very special cases of young businesses, and are not an option for the majority of young entrepreneurs.

Finally I will present ideas on how to improve the system without violating Islamic law, but also show the limits of this system.

2. The Problem of the Prohibition of Interest (riba) and the Alternatives

Literally translated riba means ‘usury’ and not ‘interest.’ ¹³ Other authors claim that riba literally means increase, addition, expansion or growth. ¹⁴ The ban of riba is one of the most important pillars of Islamic Economy. It is mentioned in many verses in the Quran and reduces the forms of loans available for young, innovative enterprises to PLS concepts, which bear a high risk for the bank in case the enterprise fails. 15

Originally this prohibition arose from the days of Mohammed. During that period it was common to double and redouble debts when the debtor could not pay back in time. This procedure led to effective enslavement of a substantial number of people; hence the purpose of the Quran was to ban this ancient Arabic practice of riba. ¹⁶ It did not differentiate between consumer credits and investment credits. 17

Today the prohibition of riba means predominantly a prohibition of interests and not a prohibition of usury. Other forms of usury, for instance overpriced sale of commodities, are not forbidden by the prohibition of riba. ¹⁸ In the early days of Islam, however, it was not clear if riba means all kinds of interest or just usury. ¹⁹ Islamic Economists today tend to include all kinds of interest in the prohibition of riba ²⁰ , led by the general conviction that interest promotes all kinds of egoistic behaviour, opposed to what a good Muslim society should be like. Financial institutes, who lend out money to a higher rate than offered for depositors are regarded by one scholar as “abominable creatures who fatten on the labour of others.” 21

It could be argued, regarding the problem of inflation that did not exist when the Quran was written, that the prohibition of riba applies to real interest, not to nominal interest.

The prohibition of riba has one main advantage for the bank: The Sharia-conform operation of the bank will attract Muslims that are not allowed to use other banks. Hence, advocators of this prohibition argue, as seen above, only in religious and ethical ways. But opinions about the main goal of an Islamic bank differ. We see these contradicting goals i.e. in the official purposes of the Jordan Islamic Bank, which claims that its goals are to make profit, but also to keep the laws of the Sharia. 22

From a purely economical point of view, however, this system causes several problems. The bank has to develop loans without interest, which are nevertheless profitable for the bank. These concepts are Islamic-conform Profit-Loss-Sharing concepts or mark-up activities. For the latter, the banks are only allowed to demand a “service fee”, which is not allowed to be

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connected to the amount of money given as a loan but only to the service provided, so it can only cover, if at all, short-time loans of a low value. 23

The prohibition of riba does not only cover interests for regular forms of loans, but also forbids the bank to pay interest on bank deposits, which are de facto credits given to the bank. Hence the prohibition of riba influences the financing by banks as well as the refinancing of banks.

Regarding the lending-out of money, a conventional form for innovative, young business to finance the start-up, the A.L.M. Abdul Gafoor claims: “… these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this is also from where the investment account holders are expected to derive their profits from.” 24

Schumpeter takes a common point of view, when he claims that conventional bank credit is necessary for industrial development. ²⁵ The director of the Pakistan Institute of Development Economics, Syed Nawab Haider Naqvi doubts that an interest-less economy will invest optimally and claims that state intervention is necessary for the optimal allocation of resources. ²⁶ Optimally allocation of resources means, as seen above, the promotion of young, innovative businesses, which are necessary for economical growth. The role of innovative entrepreneurs for economical development is a common point of view, as stated in the principles of the Gründerforum, a German institute for furthering young entrepreneurs: “Innovative entrepreneurs, however, are the root of economical growth, because an economy can only develop by regularly innovations”. 27

The predominantly opinion in Islamic economical thought, however, is, that PLS concepts are an efficient alternative to interest ²⁸ , some authors, like Khan, even claim they are superior to conventional banking. 29

Many scholars, however doubt this opinion, stressing that in the PLS-concept of mudaraba: ”the financial risk is borne entirely by the bank” ³⁰ and in case of the other predominant PLS concept, musharaka they claim “…this seems to make investment in general less attractive.” ³¹ Kuran claims, that though PLS concepts:”in many markets and for various types of lenders, borrowers, savers and investors…is the preferred mechanism for allocating returns even when interest is a legal alternative” and accents that PLS is integrated in the arab culture and “…has been practiced since long before Islam, it hardly follows, though, that it is reasonable to make profit sharing the basis of all productive ventures. 32

When we take a closer look at the PLS-concepts of musharaka and mudaraba, we will see that these concepts are not suitable for young, innovative enterprises, because these businesses are too risky for the bank. Hence, the bank will consider them not feasible. Hildebrandt confirms this, claiming that Islamic banks:”…concentrate on conventional businesses instead of realising new, innovative concepts.” ³³ In paragraph 5 we will analyse the PLS concepts of mudaraba and musharaka regarding its deficits and the problems deriving out of the fact that banks tend to avoid these financing in general and especially for young, innovative businesses.

But first we will take a closer look at the meaning of the Higher Supervisory Religious Board and its meaning for young, innovative enterprises.

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3. The Meaning of the Higher Supervisory Religious Board for Young Enterprises

Islamic banks have different boards of trustees than western banks. On the one hand there is a religious board of trustees working for the business firm and on the other hand the Higher Supervisory Religious Board (HSRB), which supervises the banks; it is responsible for ensuring that the Islamic banks works strictly according to the requirements of the Sharia in their policies and day-to-day operations. This board has the authority to make decisions and issue decrees (fatwa).The existence of a Higher Supervisory Religious Board is the precondition for a bank in order to be accepted as a member of the IAIB (International Association of Islamic Banks) and the adherence of a bank to the decisions of the board is the precondition to be allowed to claim that it is operating within the principles of Sharia.

In order to develop a central regulation board, that is setting standards for the Islamic banking system and for the regulation of this system as well as for the development of new ways of management, many Islamic states founded in November 2002 in cooperation with the IMF (International Monetary Fund) and the Islamic Development Bank the Islamic Financial Service Board (IFSB). This Service Board holds conferences and workshops in order to reach a common standard, but does not replace the HSRB of the banks. 34

We have different reports of how many persons this board contains. Mengers, Assistant Director of the Institute of Islamic Banking and Insurance in London, claims the Higher Supervisory Religious Board has to contain not less than thirteen Islamic scholars. ³⁵ But when we look at other countries we see that the structure of Sharia supervision board in reality varies a lot. Comparing two banks, the BIB (Bahrain International Bank) and the FIBB (Faisal Islamic Bank of Bahrain), we see that the in the BIB the SSB (Sharia Supervision Board) contains 4 members, representing the main schools of thought, in addition the BIB employs a qualified religious supervisor, reporting both to SSB and to the general manager. The FIBB employs board members from five different countries, which means at least five members. 36

The existence if this board is often described, but little is said about the consequences of this board for economical development; maybe because it is a relatively young institution and still developing.

A big problem is the scarcity of scholars, who furthermore are mainly conservative. There is a lack of progressive scholars, able to confront with the economic problems. Makkawi, CEO of Dubai Bank, claims:”The biggest hurdle is scarcity of scholars and (Sharia) boards. We need to institutionalize the rulings, the standards and fatwas (religious edicts)," ³⁷ Experts, like Sheikh Nizam Yacoubi, who sits on the Sharia (Islamic law) boards of several Islamic banks and institutions, criticizes that Islamic finance has been adopting a highly conservative and cautious approach while pondering entry into new areas of investment, services and products: "Islamic banks have so far been cautious. We want them to become more aggressive ... we have plenty of investment opportunities in our countries, we should not remain at a standstill, we must develop ourselves within Sharia framework ... Like anything human, Islamic banking needs to be revised." ³⁸ New areas of investment, service and products, the areas of young, innovative businesses, suffer from the caution of Islamic banks to invest in their businesses.

Taha al-Tayeb, head of Islamic Banking at the Bahrain Institute of Banking and Finance, criticizes the complicated process Islamic banks have to follow: "The problem is that every

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standard must involve Sharia, accounting and banking considerations and must be approved by Sharia boards," ³⁹ This process increases the transaction costs, both for the bank and for the entrepreneur, because it lengthens the time until a project can start. In addition, we have the possibility that a contract is considered to be legal by the religious board of the enterprise but rejected by the bank, there is no possibility to foresee in advance what a religious board will decide and so the planning security suffers compared with a conventional bank. For less religious Muslims, who have conventional banks as an alternative, it is less attractive to deal with an Islamic bank because it is not possible to predict the decision of the board and this might make the company loose time (and money) if their project is turned down.

Especially for young, innovative businesses the conservative “Weltanschauung” causes a problem because a bank will prefer to invest in areas which are “halal”(not violating the Sharia) and shy away from new businesses, which need to be proven “halal” first. This increases the transaction costs because it might require a longer time until the decision of the HRSB is made.

4. PLS Concepts: mudaraba and musharaka - And Why Banks Shy Away From These Concepts

The Profit-Loss-Sharing concepts, mudaraba and musharaka are not only determined by the prohibition of riba, but also have to operate according to other Islamic principles. Mudaraba and musharaka are bound to the principle, that there should be no reward without risk bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, no reward for capital should be allowed unless it is exposed to business risks. Hence, these concepts bear a high risk for the investors/banks, especially in case of risky young, innovative businesses. Wilson accents the problem of the high risk of mudaraba for the bank, claiming:”for the bank’s point of view this arrangement is a great risk, although it also offers potential great returns.” ⁴⁰ Young, innovative businesses have a high failure rate. According to an internet paper for young entrepreneurs, published by the University of Essen, the success rate of start-ups is only 50% after a period of four years. ⁴¹ In the PLS concepts of Islamic banks the bank would loose all money invested in case of a failure. In case of a success, however, its profits are limited.

We will examine these principles in the next paragraph, when taking a closer look at the PLS concepts musharaka and mudaraba and analyse why they hinder Islamic banks from financing young, innovative enterprises.

4.1. Mudaraba - “Sleeping Partnership”

The concept of mudaraba describes a partnership between the bank and the borrower according to the profit-loss-sharing principle (PLS). The bank gives the money and the enterpriser gives his labour force and experience. Theoretical this concept means that the bank and the enterpriser set up an enterprise together and the bank is taking part as a sleeping partner. United Arab Emirates Civil Transaction Act No. 5 of 1985 defines mudaraba as follows:” A mudaraba is a contract whereby the person owning property puts in a capital and the mudarib puts in effort or work, with a view to making a profit.” ⁴² The enterpriser can use the money according to the conditions of the contract and the profit will later on be shared between the bank and the mudarib according to a quota previously fixed in a contract.

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