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In defense of Islamic banking

  • Published at 07:37 pm June 9th, 2018
  • Last updated at 07:56 am June 10th, 2018
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What exactly is Islamic banking?

We’re told that we should have better laws to regulate Islamic banking in Bangladesh. This is entirely correct, we should. It’s not a great surprise that a conference called “Islamic Banking Operations of Banks” should come to this conclusion, but they’re still correct. 

The important thing here, though, isn’t really about the Islam part, it’s about the banking part.

Banking is an inherently risky business. The major function the banks themselves, the sector as a whole has, in our economy is “maturity transformation.” We want to be able to save our money safely, perhaps even invest it. Other people, ourselves at other times of life, want to be able to borrow money as well, often to invest it. 

The financial sector exists to be the middleman here, to collect in those savings and to parcel them out as lending and investment.

The banking -- as opposed to other forms of such intermediation -- sector specifically performs one more thing. We tend to want to save our money for fairly short periods of time. At one limit, perhaps just a couple of weeks. 

We get paid at the beginning of the month, we pay the major bills, then we only take out what we need for a few days or the weeks. So, we might be saving 20% of our wages for a couple of weeks each month. 

This is true even if at the end of the month we’ve spent everything we earned. However, people tend to want to borrow for much longer periods.

If we could only borrow for the amount of time an individual wanted to save, then there’d be a horrible shortage of long-term loans. Many of us want a 30-year mortgage. Very few people want to save money -- as opposed to investing in a pension say -- for 30 years. 

Banks transmute those short-term savings into long-term loans. This is known as borrowing short and lending long -- according to the American economist Brad Delong, this is the definition of banking. If you do this, transform maturity, then you’re a bank, if you don’t, you’re not.

The problem here is that if we all arrive demanding our savings back today, the bank doesn’t actually have them. They’re out in those long-term loans. This is what happens in a bank run. Given time, everyone could be paid but people aren’t willing to allow the time. Thus the bank goes bankrupt through illiquidity.

This is a risk of banking that we just cannot abolish, and still get that maturity transformation. Thus there’s good reason for the government to regulate banks, to insist that one has a licence, is supervised, and so on.

It’s entirely true that Islamic banking runs by slightly different rules, but it’s still subject to this same problem. Abjuring interest doesn’t change the possibilities of runs nor the benefits of the transformation. 

So, yes, we should indeed have good and strong regulation which takes account of the differences of Islamic banking and yet still covers those basic public duties which the government has.

That’s not all though. Islam is, quite famously, a religion which doesn’t have the one centralized authority. There is no pope who can, as within Catholicism, tell us all what is the one and only way to do things. 

We have the Qur’an, of course, the hadith, and we most certainly have the general principles by which Islamic banking should run. No interest, any return coming from a sharing in the risks and also the profits of a venture, and so on. The precise and exact details of how this may or might work tend to differ a little, dependent upon which authority we consult upon the subject.

At which point, we have another requirement for strong laws on Islamic banking. That is, from the definitional side, we want to know exactly what it is. Which processes and methods are haram, which are not, and so on. We also want the widest possible agreement upon these. For that’s the manner in which the sector as a whole can expand.

Note that we’re not particularly worried about whether investment is done in a proper manner here. As economists that is, we’re not very worried. Islamic banking mobilizes the savings of people just as more normal banking does, to the benefit of investment in the wider economy. While such things as interest are prohibited, the economic equivalent is achievable within the religious rules -- note that “economic” there. We can still get the job done. 

But we would like to mobilize the savings of those strong in their religious convictions, strong enough that they insist upon banking, saving, only in Islamic style. Thus, we want good and strong rules on what actually is allowable, what is religiously allowed, so that we can indeed use those finds, savings, and capital, to get on with investing in building the economy.

That is, we want good laws, good regulations, upon what is Islamic banking as well as good and strong laws on how bankers may undertake it.

It’s worth noting again that Islamic banking still faces that potential problem of illiquidity and thus needs to be, deserves, to be state regulated. But then, that’s also the flip side of the insistence that Islamic banking, while different in form, is still largely economically equivalent to the more normal kind of banking. 

Near everything -- every economic outcome and set of risk sharing -- that we can do with traditional forms is also available in Islamic banking. Which is why the two types of banking offer us the same systemic risks of course.

But note what that also means. If the two forms are economically equivalent then we, thinking purely as economists, don’t mind which type people prefer. All we do care about is that people get which type they do prefer. 

Firstly, because that’s the general aim of an economy that more people get more of what they prefer to have. If that’s banking of a particular structure, then that’s fine. 

Secondly, because if the religious gain access to a banking system which accords with their views and desires, then we’ll mobilize more savings to invest -- we’ll all be richer as a result.

Thus, yes, we do want good and proper regulation of Islamic banking, not because it’s a good thing in itself. For us as economists, just because it will aid us in achieving our goal as economists, the very reason for having an economy. It’ll make people richer.

Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.

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