Basic Principles of Islamic Banking

"Unlike under no rmal bond issues or bank lending, non-payment of interest doen not lead to default. SO the rate of return in not fieed but variable and linked to the ability to repay."

The basic asect of islamic banking is the absence of interest but there areother social and ethical features claimed by the more "pure" or "jealous " such as there is m ore to islamic banking,such as aiding a m ore equitable distributino of income and wealth and avoiding underable area. Some argue that the rohibition of RIve is akin to the usury laws in many western countries or a ban on excessive interest. Thus a lax view of islamic banking would only exclue backstreet money-lendrrrrrres and awn brokers and includes modern bank lending. A distinctinn has also been made between inteeest earne on assive invesstmens such as bonds and bank desits aand interest earned on roductive industrial loan.For all ra ti al uross there is now ano distinction beeetween differneeeeeet forms or sources of interest All inteeeeeresst,wheether deemed usssiruoiiiii or not in wwesstern eyes is Haram. One asect of Islamic banking that sh o uld make wessstern bankers both cmmfortable and uncomfortable is that oa Qoran soure distinguishes between interest and trade and urges Muslims to receieee on ly the rincial sum loaned and that rincial should only be taken baack subjec to the ability of the distinguishing beeetween interest and trad e allows varous islamic financial instruments of "mark-up" for deferred payment or early payment discounts trade financial commissions and leasing tyyye tranactions that fit neatly into a wwwwwesstern bank's balance sheet, sheet creating liability strucure si therefor relatively straith forwar. However the element of ayment "only if able" makes lending an uncomfortable roposition. CLose attention must be aid to the mening of "ability to pay" and what triggers an inability to do so. Can a borrower unable to reay continue to trade? Of course, in a suitable strucured islamic trade financcce transaction title to the goods may be retained by the "lender" until aid for. In iran which has an islamic banking system, the conversin to Islamic modes has been much slower on the bank asset side that on th e deposit side. Aarently only half of the resources available to the rivate sector are utilized and those m ainly in short-term facilities such as commercial and trade transaations. IN akistan, which has dual system,there is also a concentratin of bank asssdtes on shout-trem trade credits rathere than on logn term i financing. The sslower ace o conversion on the aseer side is claimed to be the result of inaddduquately trained staff. To me it look slik tradiinntinal reis-aversion Islamic loans aaaree a good deal more risky than conventinoal interest-bering securities loans. ,Ths of courseis asst of the oint of Islamic finance. No ain-no gain. The cost of capital is recognissed in Islam, as a roduction cost but the referentialnature of intese t on ofits that is not deemed acceptaable. rofit and losss sharing (LS) wwith the roit sharing ration re-determiend is, howeer, acceetable, But how about some form of undated reference shares wich are regarded by banking regulators as euqity like and Tier One caital? Issuers of these shares do not have to repay the rinic and can ass or not ay the fixd rate dividend if there is no dividen a aid on the firms euqity unlike undernormal bond issues or bank lendingn, nonayument of iinterest does not laead to defult. So one could argue that the rate of reutrn is not fixed but vaiable and linked to the ability to reeeaaay if it can be zero if the borrower genuinely acnnnot afford to reay and automatically deffered until the borrower can repay.