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The Challenge of Islamic Finance

HONG KONG – With Britain now in talks to sell part of the government’s 82% stake in the Royal Bank of Scotland to Abu Dhabi sovereign-wealth funds, the Islamic world’s growing financial clout is once again on display. That clout also poses a systemic challenge to the dominant way that finance is now practiced around the world.

From humble beginnings in the 1990’s, Islamic finance has become a trillion-dollar industry. The market consensus is that Islamic finance has a bright future, owing to favorable demographics and rising incomes in Muslim communities.

Despite skepticism regarding accommodation between Islamic and global finance, leading banks are buying Islamic bonds and forming subsidiaries specifically to conduct Islamic finance. Special laws have been enacted in non-Muslim financial centers – London, Singapore, and Hong Kong – to facilitate the operation of Islamic banks and associated financial institutions.

How should these developments be viewed from the perspective of Western finance and mainstream economic analysis? Does Islamic finance really constitute a viable alternative financial system?

The very fact that such a question is asked nowadays is significant. Not so long ago, Islamic finance was superficially dubbed a zero-interest-rate system that would lead to inadequate and inefficient resource mobilization and utilization. Ironically, mainstream central bankers today routinely use precisely such policies when pursuing massive “quantitative easing.”

There are two central precepts of Islamic finance: absolute prohibition on charging interest on financial transactions, and high moral standards on the part of lenders and borrowers. Interestingly, the best economic rationale for a zero-interest-rate system is provided in John Maynard Keynes’s The General Theory:

Provisions against usury are amongst the most ancient economic practices of which we have record….In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.”

Keynes suggested that only a very low or zero interest rate could ensure continuous full employment and distributional equity. Keynes’s endorsement of such a policy does not necessarily make it right, but his analysis does suggest that it should be regarded as a serious proposition.

Importantly, although interest is prohibited under Islamic finance, profit is not; the latter is derived from various arrangements that combine finance and enterprise. In essence, this is a profit-sharing and risk-sharing system that is based entirely on equity finance.

Islamic finance thus contrasts with the current dominant system based on interest-bearing debt, in which risks are theoretically transferred to debt holders, but in practice are socialized during crises. Other things being equal, most economists will agree that debt finance leads to greater instability than equity finance.

It follows from the second major tenet of Islamic finance that if people adhered strictly to its ethical requirements, there would be fewer moral-hazard problems in Islamic banking. Moral hazard exists in all systems in which the state ultimately absorbs the risks of private citizens.

But, whether any particular system is efficient in avoiding moral hazard is a matter of practice, rather than of theory. Many would agree that, historically, Christian morality played an important role in the rise of Western capitalism. Secular capitalism, however, has experienced an erosion of values, whereby the financial sector has put its own interests above those of the rest of society.& If the ethical values in Islamic finance – grounded in sharia religious law – can further deter moral hazard and the abuse of fiduciary duties by financial institutions, Islamic finance could prove to be a serious alternative to current models of derivative finance.

Moreover, the basic tenets of Islamic finance force us to re-think the ethical basis of modern monetary arrangements, which have evolved into a global reserve-currency system founded on fiat money. In the past, gold had been the anchor of monetary stability and financial discipline, even if it was deflationary.

The test of any alternative financial system depends ultimately on whether it is – or can be – more efficient, ethical, stable, and adaptable than the prevailing system. For now, there is no Islamic global reserve currency and no lender of last resort. But the Islamic world is the custodian of huge natural resources that back its trading and financial activities.

As the Islamic world grows in stature and influence, Islamic finance will become a formidable competitor to the current financial system. The world would have much to gain if the two systems were to compete fairly and constructively to meet people’s needs for different types of finance.