Oeconomicus Volume VII 2004 2005 Islamic Financing Impacts on Development and Equality By Andrew Barenberg University of Missouri Kansas City So called Islamic Banking has expanded into 60 countries with over 250 billion in reserves since the presentation of a plan to reform banking to foreign ministers at the Third Islamic Conference in 1972 Siddiqi 2002 1 and Kazarian 1993 2 According to its proponents this new type of banking that in principle rejects interest riba not only observes the religious laws Shariah but also obeys the Islamic injunction for socioeconomic justice and facilitates economic growth In this study we examine the success of this system compared to traditional interest based banks in achieving these goals In order to do this we will examine the success of Islamic banking in allocating funds to areas that assist development Before turning to the empirical data we will discuss the underlying principles of Islamic Banking as laid out in Islamic Economics examine its functions and then construct theories of how the instrument will function By comparing the theories to the empirical data we will draw some conclusions on the role of Islamic banking in economic development and its sociological role in class relations History and Principles Islamic Economics is a recent innovation created by Pakistani economist Sayyid Abul A la Maududi in the 1940s as an attempt to reclaim Islamic authority and defend Muslim society from the encroachment of western systems Kuran 1995 168 By that time virtually all finance systems in Muslim countries had western banking as part of their colonial legacy The combined radical political Islamic awakening of the 1960s and the failure of western banking methods to transform oil wealth into meaningful development helped push Islamic economics from an esoteric field to a policy initiative The early successes of using Islamic Profit Loss Sharing in rural Egyptian villages to create new investments led to a 1972 proposal of reform at the Islamic Conference Egypt created a state sponsored Islamic bank in 1977 while wealthy Saudi ideologues helped fund other banks throughout the 1970s Kazarian 1993 144 The 1980s saw complete reform of banking in Sudan Iran and Pakistan to the Islamic Model while in other countries Islamic banks competing with traditional banks saw deposits increase at a rate of 10 15 annually Aggarwal and Yousef 2000 1 Since then Islamic banking has grown into a major subsystem of worldwide banking The defining characteristic of Islamic Economics is a rejection of lending money at interest but that is not the only requirement Islamic Economics forbids all speculation and time value of money instead agents are to be rewarded solely for effort or by assuming risk Although the Qur an endorses trade as permissible Hallal profit maximization is not the goal of agents in Islamic Economics who are required to balance spiritual maximization through acting in ways that benefit society Kavoossi 2000 74 and 17 Andrew Barenberg Kazarian 1993 51 Hence some potentially profitable ventures are prohibited because they violate Islamic norms or are considered to be destructive to society for example selling alcohol guns pornography and unhealthy foods Kazarian 1993 48 On the other hand there is a requirement for investments to aid society in funding projects that contribute to the social good The social good is considered to include job creation housing projects medical services and or projects that assist in the development of the nation Kazarian 1993 4 and 53 While it is expected that achievement of these goals is somewhat dependent on the ability of the agents to make moral decisions the instruments used are said to aid in bringing about socially beneficial results The main instrument is Mudaraba a system of profit loss sharing Generally in Mudaraba the financiers create a contract with an entrepreneur to provide the capital for the entrepreneur s project and then the financiers receive a share of the profits Kazarian 1993 62 As risk and or effort are required to receive Islamically condoned returns the financiers should not demand collateral In the system of Mudaraba the banks risk their funds and the entrepreneurs risk losing their time and effort Kazarian 1993 63 Mudaraba profit loss sharing defines not only the contract between the bank and borrowers but also the agreement between the bank and its depositors A deposit at the Islamic bank will be used for the investments and the depositor is subject to risk If the bank is profitable the depositors receive the appropriate portion of the profits minus overhead Kazarian 1993 63 Murabaha mark up pricing and Ijara rent to own are two other instruments that are used although many theologians argue that their use should be limited so as not to become a hidden interest Aggarwal and Yousef 2000 1 Both Murabaha and Ijara use a system of payments whose total is higher than the original This system allows a set predetermined rate of return with little risk hence the debate over its appropriateness Even less proper arrangements include penalties for late payment creating little difference between this system and one of interest Models of Mudaraba Profit Loss Sharing Islamic economists argue that the Mudaraba contract in itself not assuming a higher moral responsibility of the agents is superior to traditional interest based loans in allocating funds to investment The major shortcomings of the traditional system in developing countries especially oil rich countries with possibilities for rent seeking behavior is the failure to provide long term high risk loans find new entrepreneurs and profitable investments and an especially important failure for development purposes to fund agricultural and industrial projects Sikorski 1996 2 and Studart 1995 69 In all criteria its proponents expect Mudaraba to outperform traditional banks Without collateral requirements virtually any entrepreneur even one who is risk averse and without wealth should be able to receive financing Kazarian 1993 98 With the bank exposed to financial risk ideally it should try to minimize its vulnerability by 18 Oeconomicus Volume VII 2004 2005 investing in a large number of investments in a diversified portfolio guided by project viability not speculation Given the developing countries lack of functioning stock markets and the high concentration of capital such a measure could increase both the number of investments and the number of
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