Can Islamic banking help resolve our current financial crisis?
October 16th 2008 14:19
Islamic banking is a banking system based on the rules of Sharia, or Islamic law. The main differences between these banks and traditional banks is that Islamic banks cannot charge interest, and they must share in both the risk and rewards with the borrower. I won't go into it too much here, but for a better understanding, I would recommend visiting the wiki page, found here.
The way in which Islamic banks lend to businesses is what is of particular interest. The banks charges a floating interest rate, which is pegged to the borrower's rate of return, basically meaning that the bank's profit on the loan is equal to a percentage of the borrower's profits. This profit sharing continues until the principle amount of the loan is repaid.
How could this principle help western financial institutions? What we are seeing now is the seas of credit drying up, and fast. Banks are afraid to lend on anything but a short term basis, and even then only on the surest deals. However, if a bank's profits were directly linked to the rate of return that a borrowing company generated, then the financial system would once again be linked to the real economy. I also like the idea of banks sharing in the risk of the borrower, as it should help keep lending in check. What we have seen is a financial system that has grown beyond the real economy, into what has been described by Nobel laureate Muhammad Yunus as a "casino". Especially in the market for credit default swaps, finance had grown beyond an economic support mechanism, into a global gambling arena worth countless billions of dollars, until eventually everyone realized that, to again quote Mr. Yunus, "Castles were built in the sky, and suddenly people realized that these castles don’t exist at all."
Amidst global bailout packages, linking a banks profits to the growth rate of its customers should help prevent the reckless offerings of credit offered by banks that was the a major factor in the current crisis. After all, it would be awfully easy for these banks to hand out credit with little afterthought, especially those protected by their respective governments.
So really, I'm not saying that we should all give up pork and alcohol, but look critically at the Muslim take on finance. It has been around for quite some time and could provide some valuable lessons for their western counterparts.
The way in which Islamic banks lend to businesses is what is of particular interest. The banks charges a floating interest rate, which is pegged to the borrower's rate of return, basically meaning that the bank's profit on the loan is equal to a percentage of the borrower's profits. This profit sharing continues until the principle amount of the loan is repaid.
How could this principle help western financial institutions? What we are seeing now is the seas of credit drying up, and fast. Banks are afraid to lend on anything but a short term basis, and even then only on the surest deals. However, if a bank's profits were directly linked to the rate of return that a borrowing company generated, then the financial system would once again be linked to the real economy. I also like the idea of banks sharing in the risk of the borrower, as it should help keep lending in check. What we have seen is a financial system that has grown beyond the real economy, into what has been described by Nobel laureate Muhammad Yunus as a "casino". Especially in the market for credit default swaps, finance had grown beyond an economic support mechanism, into a global gambling arena worth countless billions of dollars, until eventually everyone realized that, to again quote Mr. Yunus, "Castles were built in the sky, and suddenly people realized that these castles don’t exist at all."
Amidst global bailout packages, linking a banks profits to the growth rate of its customers should help prevent the reckless offerings of credit offered by banks that was the a major factor in the current crisis. After all, it would be awfully easy for these banks to hand out credit with little afterthought, especially those protected by their respective governments.
So really, I'm not saying that we should all give up pork and alcohol, but look critically at the Muslim take on finance. It has been around for quite some time and could provide some valuable lessons for their western counterparts.
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