The Theory Of Islamic Banking (4/5)

2. Viability of Islamic Banking

A good deal of literature on Islamic Banking is concerned with the viability of banking institutions which seek to operate on an interest free basis. Notice has been taken of a number of misgivings expressed about the viability of interest free banking and an effort made to dispel these misgivings [1]. The more important of such misgivings can be stated as follows:

a)   a) Because of commitment to share in losses also, Islamic banks working on the principle of profit/loss sharing will be exposed to huge losses leading to their failure and insolvency,

b)   b) Islamic banks will experience frequent defaults and loss in their earnings on account of concealment of correct income by their clients which will undermine their stability, and

Muslim writers have pointed out that the commitment of Islamic banks to share in losses will not necessarily involve them in huge losses leading to their failure and insolvency. Islamic banks are expected to operate on the basis of a diversified investment portfolio so that notwithstanding losses suffered in some individual cases the overall profitability can be maintained on account of the pooling of risks. Losses to banks arise mainly on account of defaults on the part of concerns to whom, finance is provided. There is no intrinsic reason why an Islamic bank should experience more defaults in the fulfillment of contractual obligations on the part of its clientele compared to other banks. There are three main elements which are germane to the possibility of defaults viz., the nature of the party to whom finance is provided, the purpose for which finance is provided, and the type of supervision exercised by the banks on the end-use of funds. These elements are essentially the same for an Islamic bank and a conventional bank, and if sufficient care is not exercised in regard to these elements, defaults would arise irrespective of whether the bank concerned follows the traditional banking practices or the principles of Islamic banking. Given prudent management, there is no reason to believe that the incidence of defaults would be greater in the case of Islamic banks compared to other banks. On the contrary one should expect that the incidence of defaults would be less because, on account of their having a direct stake in the profit of concerns to whom finance is provided, Islamic banks would be more vigilant in monitoring the end-use of funds as compared to the traditional banks which attach greater importance to the security pledged against the loans compared to the actual monitoring of the business dealings of their clientele.

The possibility of the stability of Islamic banking being undermined by a tendency on the part of users of bank funds to conceal their true profits has been the subject matter of extended discussion in recent literature. A study on the relative merits and demerits of interest based and PLS (profit/loss sharing) based banking attributes the dominance of interest based banking in the world at large to the problem of existence of the "moral hazard" in PLS based banking even though PLS based banking is superior to interest based banking in several other respects[2]. In other writings it is stressed that though the existence of the problem of moral hazard in PLS based banking cannot be denied, its risk potential should not be exaggerated. Even the study just now referred to acknowledges that over time the incentive to cheat would be reduced as loss of reputation would restrict future access to credit markets. Others have pointed out that:

Another misgiving about the feasibility of Islamic banking of which note has been taken by Muslim scholars is that Islamic banks cannot perform all their functions on non-interest basis in a world dominated by interest based banking. These scholars recognize that successful conduct of Islamic banking in an international environment which is permeated with interest is of course a big challenge. In the financing of multilateral trade transactions, Islamic banks have to deal with conventional banks. In a number of contributions it has been suggested that ways can be found for the dealings of Islamic banks with conventional banks to be founded on non-interest basis. It has been suggested, for example, that in establishing correspondent relationships with conventional banks, the following procedure could be adopted:

 (Continued)