AS the US sub-prime credit turmoil unfolded and the banking sector paid the price for careless lending, another financial system was expanding at an unprecedented annual rate of 15 per cent in the past three years, according to Moody's.
In the past decade, Islamic banking has boomed in contrast to the slump in interest-based financial markets, with consulting firm Mckinsey & Co estimating the Islamic finance industry to be worth an estimated US$1 trillion by 2010.
It seems the idea of linking faith with finance has taken off with Muslims and non-Muslims alike, spreading from the Gulf region to Asia, America, Europe and Africa.
In South-east Asia, full-fledged Islamic banks that conduct themselves in accordance with syariah, or Islamic law, exist alongside numerous international banks such as UBS and Citigroup that provide Islamic 'windows' within their modern banking structures.
But despite rosy headline numbers and increased accessibility of Islamic financial services, the overall level of awareness of them remains lower among Singaporeans compared with people in neighbouring Malaysia and Indonesia.
Key concepts
Islamic financial institutions conform to the teachings and interpretation of the Quran, and thus invest solely in syariah-compliant products and services. Activities that are said to be unlawful, or haraam, are forbidden on ethical grounds. Examples include businesses that deal with alcohol, tobacco, pornography and gambling.
Money, in this context of Islamic finance, is viewed as a unit of account or means of exchange, instead of an asset in itself. Thus, a loan cannot generate profit because it is not a product or commodity. As such, Islamic finance forbids riba, or usury, unlike interest-based banking principles. Therefore, no income can be received or provided from the loaning of funds alone.
Instead, in its place, a cost-plus concept known as murabaha is implemented when domestic customers approach an Islamic bank with the intention of taking a loan to buy a car, house or some other commodity.
The bank participates by purchasing the commodity on behalf of the customers and reselling it to them at an agreed marked-up price. The premium, or profit from the transaction, is used to offset the cost of services and amount of risk taken by the bank. Technically, the bank does not benefit from the monetary loan, which can be repaid in instalments or a lump sum.
This approach to lending is starkly different from that of modern banks, which essentially provide customers with money upfront, then benefit from the loan through regular and compounding interest payments.
With regard to funding smaller-scale corporate activity, a profit-and-loss sharing system known as mudarabah is carried out between an Islamic bank and a customer, with the former providing capital and latter offering expertise and management.
In the event a profit is made from the business, a proportional payout from the profits will be made according to an agreed ratio. But if the investment operates at a deficit, the bank will bear the loss, and the arrangement will be void when the loan is repaid.
As such, the Islamic focus on risk-sharing is beneficial to entrepreneurs and new business developers who would have to otherwise bear all the risks as well as interest payments if they took a loan from a modern bank.
As for the financing of larger-scale businesses under a profit-and-loss sharing scheme known as musharaka, a full partnership or joint venture is held between a bank and a group of individuals or corporations.
Partners may or may not choose to oversee the operation and management of the investment, and can provide either capital or expertise, or both. Each partner will receive profits or bear losses according to their ratio of contribution, unlike the structure of interest-based modern banking which requires partners to pay regular and pre-determined interest, regardless of the outcome of the business.
Challenges ahead
Like any other financial solution or instrument, Islamic banking has been plagued by obstacles and pitfalls, the most pressing of which is the lack of standardised and accessible guidelines on the parameters and definitions of Islamic banking concepts.
Cracks are starting to show as experts from different regions begin to voice their opinions on the inconsistent interpretation and implementation of Islamic banking principles.
Last month, United Arab Emirates-based Yasaar Ltd's chief executive Majid Dawood created a stir when he was quoted as saying that many Islamic products in the market fail to meet syariah standards because of their debt-based nature.
Despite efforts by the Islamic Financial Services Board to clarify the parameters and concepts of Islamic banking through publishing guidelines, no single model or body has jurisdiction to regulate and implement standards.
And to further aggravate the situation, the industry faces an acute lack of scholars and experts in the field of Islamic finance. Since each Islamic bank or institution requires a syariah committee for supervisory and consultative purposes, the demand for well-trained and knowledgeable mentors far outweighs the supply.
Finally, Islamic banks face obstacles when conducting inter-bank borrowing and lending. This is because the interest-based agreements that modern banks subscribe to are prohibited in Islamic finance.
So, there is still some way to go before these differences can be ironed out or worked around if Islamic and modern banks should choose to enter into financial agreements with one another. For now, Islamic banks will just have to rely solely on the Mudharabah Interbank Investment (MII) mechanism which brings together a deficit Islamic bank (investee bank) and a surplus Islamic bank (investor bank) based on the mudharaba scheme.
