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How is Islamic Finance different from Conventional Banking?

An Islamic bank, on the other hand, could structure a service-based Ijarah to lease out the university’s credit hours

Tuesday July 2, 2019 2:37 PM, ummid.com News Network

Islamic Bank

What do President Obasanjo of Nigeria, Nick the UK homebuyer, and Faisal, an American college student, all have in common? They’re all trying to pay off loans that seem to increase every single day.

What started off with a seemingly small interest rate ballooned into something completely unattainable. We’ll look at each of their examples a little later.

First, let’s answer the big question on everyone’s mind: How is Islamic finance different from conventional finance? It looks the same. The result is often the same. What’s the difference?

Well, the best way to find out is with a simple, real-world comparison. Let’s take $10,000, for instance. And let's compare what a conventional bank can do with this $10,000 and what an Islamic bank can do.

First, The Conventional Bank

The conventional bank finds a credit worthy customer and lends at 5% interest. The bank is not particularly concerned about what happens to this money other than that it gets repaid. The customer, on the other hand, has already found a borrower willing to pay 7%. This borrower runs a small credit co-op for students and lends at 10%. One of these students is enterprising enough to lend to his unemployed brother at 15%. Who has just discovered the power of compounding interest and now lends to street vendors at 25%. We could go on. But you get the idea.

As we speak, there are poor people paying upwards of 40%...per month!

Now obviously we can’t blame conventional banks for everything that happens after they’ve made the initial loan. But we can blame the power of compounded interest.”

Compound Interest

Interest, and the fact that you don’t need actual cash to lend money means that the original $10,000 could keep passing hands until we pump out over $100,000 of artificial wealth. Artificial is right.

How much actual cash is there? Only $10,000. With interest, we managed to turn $10,000 into much more.

Now what happens if the street vendors go out of business? Or the unemployed brother doesn’t find his job? Or the credit co-op goes bankrupt?

That’s right. Loans don’t get repaid. And if enough people can’t repay their loans, lenders get into all sorts of trouble. This vicious cycle sets off a domino effect of defaults.

And imagine that instead of a $10,000 personal loan, it’s a million dollar business loan, or a billion dollar World Bank loan. Compounding interest grows so fast that borrowers are often unable to repay. People, economies, and the environment pay the price as we grow more desperate to meet rising debts.

Let’s Take The Example Of An Islamic Bank

With this $10,000 the Islamic bank only invests in actual assets and services. It might buy machinery, lease out a car, or invest in a small business. But, throughout, the transaction is always tied to a real asset or service.

And this is the central point: we can’t simply “compound” assets and services like we can compound interest-based loans. An asset or service can only have one buyer and one seller at any given time.

Interest, on the other hand, allows cash to circulate and grow into enormous sums. That’s the difference between Islamic finance and conventional finance: the difference between buying and selling something real and borrowing and lending something fleeting.

Global Financial Downturn

In recent years we’ve witnessed the most dramatic global financial downturn seen in decades. What began as a housing bubble soon became a sub-prime credit crisis. And what many thought would remain a credit crisis soon spread into a global financial meltdown. It devastated every corner of the world.

And while these events affected most of us negatively, there was one silver lining: people finally gave a serious look at alternative forms of finance. And many people stopped believing that interest could solve all problems.

Understanding what caused these events serves as our starting point for understanding Islamic finance, and how it differs from conventional finance.

What conventional finance enables is the ability to sell money when there is no money. To sell assets before there are any underlying assets. And to allow debts to grow unchecked while borrowers become more desperate.

Interest creates an artificial money supply that isn’t backed by real assets. The result? Increased inflation, heightened volatility, richer rich, and poorer poor.

Let’s look at 3 practical examples that show just how Islamic finance is different from, and better than, conventional finance. And while Islamic finance parts ways with conventional finance on more than just being interest-free, we’ll focus on interest in this talk.

We’ll look at 3 people in 3 very different, real-world situations: the first is the leader of a developing country: President Obasanjo of Nigeria; the second is Nick, a homebuyer in the UK, and the third is Faisal, an American college student.

Debt-Laden Country: Nigeria

We begin by quoting President Obasanjo who said these words after the G8 summit in Okinawa in 2000: "All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors' interest rates. If you ask me what is the worst thing in the world, I will say it is compound interest."

It seems unbelievable but, sadly, it’s typical. Developing countries start off with relatively small loans and remain saddled with huge amounts of growing debt for generations. And remember, this could be Nigeria, or any other poor country. To give just one other example, during the years leading up to the 1997 Asian collapse, Indonesia’s foreign debt as a percentage of GDP was over 60%. So Nigeria is certainly not an isolated example. There are countless more.

Nick The Homebuyer

Nick has lost his job, his house, and all the money he had spent paying off his mortgage. The property bubble that triggered the global financial meltdown could not have happened if the properties had been financed Islamically. Why? Because a conventional bank merely lends out cash.

Legally, it can keep lending this cash over and over. Well above its actual cash reserves.

An Islamic bank, on the other hand, has to take direct ownership of an actual asset. Whether for a longer period in a lease or partnership, or a shorter period in a sale or trade, Islamic finance always limits the institution to an actual asset.

The next time anyone wonders whether Islamic banking is just dressed up conventional banking, ask them to show you a single major consumer bank that co-owns actual properties with their customers.

Conventional Banking

Of course, there’s no excuse for Islamic banks that are Islamic in name only. But if the transaction complies with internationally recognized standards like AAOIFI, for instance, then there’s no reason for it to have the many side effects associated with interest-based banking.

To provide just one example of how Islamic banks get directly involved in asset purchases, let’s look at how a Diminishing Musharakah works. The word Musharakah refers to a partnership in Islamic finance.

And it’s called a Diminishing Musharakah because the banks equity keeps decreasing throughout the tenure of the financing, while the client’s ownership keeps increasing through a series of equity purchases. Eventually, the client becomes the sole owner.

If Nick had lost his job with a Diminishing Musharakah, at the very least he would still have an equity stake in an actual property that he could monetize.

Pay close attention to this example because this is something you may want to suggest to your own local bank. There’s no reason why they can’t do it.

Faisal The Student

Now our final example. Talking about indebted countries and property bubbles may seem removed from our immediate predicament.

What are we talking about? That’s right: personal debt. In the US alone, credit card holders have amassed over $1 trillion of personal debt. And that’s just credit cards.

Let's take Faisal’s student loan for example.

His education cost him about $30,000 a year for four years. That's $120,000. And Faisal had no savings to start off with. He got an interest rate of 10%, which is fairly typical for many students, and he began borrowing $30,000 at the beginning of each year. Three years after graduation he began paying off his student loans at the rate of $20,000 per year.

Can you guess how long it took Faisal to pay off his entire loan? That’s right. It’ll take him over 25 years to pay off his loan.

And in the end he spends over $400,000 to pay for his $120,000 education. And that’s assuming Faisal keeps his well-paying job. If he’s unemployed, the debt just gets bigger.

An Islamic bank, on the other hand, could structure a service-based Ijarah to lease out the university’s credit hours. Faisal ends up paying about 20% or 30% more; but with the interest-based loan, he pays about 400% more. Islamic finance never can, and never will be able to grow Faisal’s debt once it’s fixed.

[The above article is abridged version of the transcript of a video talk by an expert on Islamic Banking associated with Ethica Institute of Islamic Finance. The Dubai-based institute has trained and certified professionals in over 160 financial institutions across 64 countries.]

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