Book Review for Islamic Banking, How Is It Different from Conventional Banking? By Professor Muhammad Ali Shaikh by Camille Paldi
This book provides a hands down approach to explaining the difference between Islamic and Conventional Banking. In a clear, methodological, straightforward approach, the author delves into a practical exploration of the key differences between Islamic and conventional banking while simultaneously pointing out the opportunities Islamic Banking has to offer the world at this moment in time. In an innovative narrative, the author illuminates the Islamic and Conventional Banking framework, systems, operations, products, risks, financial reporting methods, and Shari’ah governance framework and answers key questions such as how a debt-ridden society transfers resources from the poor to the rich through interest financing.
The author points out that in the United States as of 2007, the top 1% of households owned 34.6% of all privately held wealth, and the next 19% had 50.5%, which means that just 20% of the people owned a remarkable 85% leaving only 15% of the wealth for the bottom 80% (wage and salary workers). The author purports that Islamic economics can cure this inequality by redistributing wealth, turning the average person into a business partner with the bank and financial institutions in Islamic finance and takaful (Islamic insurance) and an asset owner through the Islamic bond or sukuk. The author explains all of the different modes of Islamic finance and shows how each structure evades interest finance and redistributes wealth to the business partner of the bank (the average citizen). It is no longer a creditor/debtor relationship, however, the banking relationship becomes one of business partners or investor/fund manager where surplus and loss are shared on a profit- and- loss sharing (PLS) method. The author explains that in the Islamic economic system, financing through the sale of goods or the profit- and- loss sharing method in real business activities promotes the creation of real assets in the economy. The author says, ‘The Islamic system encourages supply and moderation in consumption and spending surplus on others, which promotes balance and distributive justice and ensures savings and investment.’
The author emphasizes the injustice of interest-based financing. The author says that, ‘In an interest-based loan, the financier’s return is ensured, while the return of the borrower depends on the actual results of the business. In case of loss, the borrower gets nothing, but still pays interest and in case of huge profits, he retains major part of the profit leaving the financier to take a fixed rate of return, which may be far less than what he would have gotten on the basis of profit-sharing in a joint-venture. This is unfair to both.’
The author points out that money is not a commodity as is so treated in the conventional financial system. The author says that, ‘We have assumed that like commodities, money can also be sold for a price higher than its face value or lent against interest.’ The author says this is incorrect because: (1) Money has no intrinsic utility, while a commodity has intrinsic utility; (b) Commodities have different qualities, while money has no quality; (c) Money has no value except which is assigned to it. In case of commodities, it is the actual worth of the goods depending on their type and quality.’ The author explains that ‘Therefore, money of the same denomination cannot be the subject-matter of a sale, like other commodities. Its basic purpose is to act as a medium of exchange and a measure of value.’ The author points out that conventional banks make money by the pricing and time-value of money.
Furthermore, the author reveals that Interest-financing and the creation of money by the banks causes a mismatch between the supply of money and the production of goods and services, which fuels inflation. The money creation is far in excess of 90% of the total money supply and therefore causes over 90% of our inflation.
The author explains that there are two permissible financing methods in Islamic finance: fixed- income methods and investment and profit- and- loss sharing methods. The author says that fixed- income methods include trade modes, leasing modes, and diminishing ownership of assets or diminishing lease musharakah. The investment or profit and loss sharing modes are based on musharakah and mudarabah. The author explains in detail in the book each mode of Islamic finance often using real-world examples of how each modes of Islamic finance operates in the Islamic financial system. Next, the author explores Islamic financial contracts and how they are utilized in each mode of finance. In terms of Islamic bank deposits, the author points out that the relationship between bank and client is that of investor/manager or buyer/seller rather than the conventional creditor/lender relationship.
In order to have a valid sale contract, there must be offer and acceptance, parties capacity to contract, the contract should be instant and absolute i.e. not for a future date and non-contingent, delivery must be certain, and the sale must be without any void condition. The author explores each aspect of a valid sale contract and then goes onto to describe sale contracts commonly used by Islamic banks including bai muajjal or credit sale, murabahah, murabahah muajjal, musuwama, salam, and istisna’a contracts. Next, the author discusses trade-based financing products including murabahah, musuwamah, salam, and istisna’a contracts. This discussion is followed by an explanation of financing based on Ijarah. The author then goes on to explain partnership-based financing products including musharakah, mudarabah, and diminishing musharakah (for home finance). The author also includes discussion on import financing, export financing, financing through mudarabah funds, and profit- and- loss sharing methods and fixed-income methods of finance. The author sheds light on the fact that Islamic banks tend to avoid musharakah and mudarabah modes of finance due to high risk and expense for Islamic banks and that this should be changed.
The author then explores equity investments and capital markets. The author begins with an explanation of Shari’ah stock screening, a process, which is required to ensure the Shari’ah compliance of equity investments. The author then moves on to discuss Islamic capital markets and sukuk or Islamic bonds. The author states that, ‘Sukuk is one of the major emerging instruments, which is used as a financing and risk management tool. During the period 2001-2005, there were 18 sovereign ijarah sukuk issues amounting to USD 5.6 billion and 10 corporate ijarah sukuk issues amounting to USD 1.599 billion. Ijarah sukuk is the major one. Other sukuk structures include musharakah, murabahah, and Istisna’a.’
The author continues with an exploration of deposit takings by Islamic and conventional banks. The author says that ‘Islamic Banks raise deposits through a mudarabah contract whereby the relationship between the bank and the depositor is that of an investor and fund manager. These funds are used to provide financing to individuals and businesses using Shari’ah compliant methods such as musharakah or mudarabah (investment modes) or murabahah, salam, and istisna’a (trade modes) and Ijarah (leasing modes). The income so realized is not based on interest, but is either a trading profit or rent or an actual return on the investments made by the bank as manager of these funds. This income earned by the deposit pool is shared between the bank as manager of the funds and depositors who are treated as investors.’ In a conventional bank, the relationship between the bank and customer is that of creditor/lender. The income earned is based on interest. Thus, in Islamic banking, the depositors receive a rate based on actual profits rather than a fixed rate of interest on deposits as in conventional banking.
The author also emphasizes the need to create a unique system of financial reporting for Islamic banks due to the many differences with conventional banking. The author points out that International accounting standards are meant for interest-based transactions and cannot be used by Islamic banks. The author recommends adopting a financial reporting mechanism based on AAOIFI standards.
I recommend this book for students, academics, Islamic finance practitioners, and practitioners of conventional finance who want to obtain an understanding between the main differences between conventional and Islamic banking.