Electronic copy available at: http://ssrn.com/abstract=2007818

ISLAMIC BANKING 1

Islamic Banking: Strengths, Weakness, and

Areas of Growth

Amirsaleh Azadinamin, MBA

Doctorate of Finance Student

Swiss Management Center (SMC) University

March 1, 2012

Electronic copy available at: http://ssrn.com/abstract=2007818

ISLAMIC BANKING 2

Abstract

The purpose of this article is to identify and explore major challenges, opportunities,

weaknesses, and threats of Banking in Iran, and hence, the system of Islamic banking. First, the

paper looks upon the concept of Islamic banking and how it has been shaped based on the

theoretical frameworks mentioned in Quran, the holy book of Islam. Then, the paper mentions

the opportunities of growth where the Islamic banking market is in high demands, where there

has been no or few services offered. The paper also reviews how Islamic banking has benefited

in terms growth by the recent financial crisis where most conventional banks had to take a step

back and recapitalize. Islamic banking did not need to go through the same path as they were

never as leveraged as conventional banks. The system that prohibits making profit on money

without being fully asset backed will eradicate a substantial degree of risk and immunes it

against the fragility that conventional banks are prone to.

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Theoretical Framework of Islamic Banking

Even though banking is not a new concept and it has always existed in the human

history, whether in preliminary forms or today’s form of banking, the formations of Central

Banks are fairly a new phenomenon and they have not been around more than 100 years. The

Iranian Central Bank is no exception and it was established around 50 years ago, and as an

Islamic country after the Iranian revolution it has followed the Islamic banking laws known as

sharia. “The emergence of Islamic banking has been driven by the increasing number of

Muslims who wish to lead their lives according to the shariah, the legal code of Islam” (Abdul-

Majid et al., 2010, p. 25). As for following the Islamic banking regulations are concerned, Iran

is no different story. At the core of the Islamic banking is the prohibition of riba, which is the

interest on money without having been fully backed by assets. Some argue that this may be

reason that Islamic banking has shown more resilience to the current crisis of credit and it has

received a lot of interest due to the insignificant damage that it had sustained from the crisis

(Noreen et al., 2011). Many economists have contributed this resilience to the key concept at the

core of Islamic banking, the elimination of interest in financial dealings. Noreen et al., (2011)

mention that a key tenet of Islamic banking is the elimination of interest (Riba) in financial

dealings which is also prohibited in four major religions: Christianity, Judaism, Islam, and

Hinduism.

According to basic Islamic perception about money that it has no built-in value, money

cannot be earned out of money directly. Anti-sharia’t principle “selling a debt against a

debt” has made credit crisis technically improbable in Islamic financial market. This

paper uses terms of credit crisis, financial crisis, subprime mortgage crisis, credit crunch

and economic turmoil interchangeably (p. 193).

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One cannot talk about banking in Iran without illuminating the system that is sharia-

compliant at its core. And hence, Islamic and Iranian banking are one and same and they cannot

be distinguished from one another. So, one can only explain banking in Iran by shedding light

on Islamic banking. This trend has even been mortified by Muslims who try to blend the Islamic

law in their lives. As Azarian (2011) mentions, by the late 1970s political developments in

Pakistan and Iran had let to governmental attempts at transforming these countries’ whole

financial system into an Islamic one, which helped the trend tremendously. Iran has been no

exception.

Islamic Banking and Its Structural and Cultural Context

Azarian (2011) explains the Islamic banking’s institutional matrix, mentioning the issue

of Riba (interest) and the prohibition against it as it has been mentioned in several places in

Quran. Riba literally means addition, excess, expansion or increase, and it is a religious-legal

term in which the widest interpretation covers both usury and interest. In another word, it is any

unjustifiable increase of capital whether in loans or sales.

As far as sales on credit are concerned the prohibition is considered as a measure to

forestall riba from creeping into the economy through the back door, and includes any

exchange of commodities without giving an equivalent counter-value in return to the

other party, whether this is arranged through variations in the amount of commodities

being exchange or through exchange of commodities of equal value but with differences

in time of delivery. Furthermore, with its obvious significance for the moulding of the

Islamic financial system, this prohibition refers to any increment gained through lending

money. More technically, it covers any cost levied on the principal of a loan to be paid

to the borrower along with the principal amount at a pre-determined rate tied to the

ISLAMIC BANKING 5

maturity and the amount of the principal as a condition for the loan or for its extension

on its maturity (p. 261).

Growth Opportunity and Limitations

One can clearly realize that there are fundamental differences between conventional

banking in Western countries and that of Islamic banking. Many instruments, of which

speculative tools are the main ones, are not allowed in Islamic banking, and thus, one can

conclude that Islamic banking is constrained within a more conservative framework. This will

safeguard the system against shaky grounds in more turbulent times, while it may limit its

exponential growth. However, this may be a more long-term pragmatic approach as the Islamic

banking will continue its steady growth while other banks face major obstacles and setbacks.

With the global financial markets experiencing extreme unrest due to existing credit

crunch, the world Islamic banking sector has been progressing at the uniform pace.

According to Financial Times (2008), the Islamic banking has gained a growth more

than five folds by hitting $900bn from $15bn during the time period of 1990 to 2008 and

prospering at the yearly pace of 15%-20%.As for most recent statistics revealed by

Financial Times of November 2008, the global Islamic banking assets worth $800bn

from around 50 countries accelerated at 27.6% over the past year (Ismail et al., 2011, p.

194).

Nonetheless, the asset amount owned by Islamic banking may be relatively small

compared to assets of global conventional banks, but with the world markets struggling hard to

make their existence after the financial recession, Islamic banks have been moving on with their

steady pace of growth, and their escape from global recession may be solely due to a “more

ethical and less risk bearing investment approach than conventional banks” (p. 195). The

ISLAMIC BANKING 6

advantage that Islamic banking has over conventional banking may showcase itself not in times

of good economic times, but the exact contrary, in times of economic contraction, and studies

can attest to that. When the performance of top 10 conventional banks is compared with the top

10 Islamic banks, Ismail et al., (2011) conclude the followings:

1- During the time period December 2006 to May 2009, the main starting point of the

current economic crisis, the Islamic banks suffered a decrease of 8.5% of market

capitalization in comparison to 42.8% of conventional banks.

2- During the same period the reserves of conventional banks grew at 36%, while that of

the Islamic banks grew at 55% reaching $ 147 billion from $ 94. “Similarly, during this

period an increase in total equity for conventional banks and Islamic banks was 24% and

36% respectively” (p. 195).

3- Smaller leverage ratios of Islamic banks helped them scape the crisis. The leverage ratio

of conventional banks was 16.6 times in 2006 that increased further in 2008 to 18.2

times, which was three times the leverage ratios of Islamic banks that increased from 5.8

to 6.6 times. As a result, while five out of top ten conventional banks gained financial

assistance, it is worth mentioning that none of the Islamic banks required any

governmental rescue support.

Emphasizing on conservative moves by Islamic banking and how it has safeguarded

these banks from sinking in the turmoil, Martin (2008) mentions that Islamic banks have been

excluded from groups where the concerning banks had to face up to periods of retrenchment and

cutbacks. “Some conventional banks are well placed to take advantage of their rivals'

weaknesses, while the Islamic banking sector could emerge to play a more central role in the

financing market” (p. 1). Also, the structure of the bailout packages will limit them from

ISLAMIC BANKING 7

expanding as well as their ability to do business in many markets. For instance, according to the

terms of the liquidity injection for UK banks, “those that access government funding will be

forced to concentrate on their home markets. The banks involved include Royal Bank of

Scotland (RBS) and Lloyds TSB, which are looking for £20bn ($35bn) and £17bn respectively

from the UK government” (p. 1).

Martin (2008) adds that when compared to the conventional banks which have failed in

the face of the recent financial crisis, Islamic banking has benefited from the crisis, and they are

being brought into deals now more than ever due to their sufficient capitalization. This holds

true even though the restrictions on Islamic banks have traditionally made them more expensive

to be used and they have played a limited role in the past; however, in the face of the current

crisis the situation has changed. This is mainly due to their more conservative and less

speculative manner which helped them maintain a strong capital position.

Given the restrictions on the kind of assets in which they can invest, sharia-compliant

institutions have avoided many of the products that led to the credit crunch in the first

place, such as collateralised debt obligations. As such, they are well placed to expand in

today's difficult climate (Martin, 2008, p. 1).

Martin (2008) also highlights yet another point of strength of the Islamic banking

system. “[T] he strength of Islamic banks' balance sheets puts them in a strong position

compared with major conventional banks and companies that are trying to reduce the amount of

debt they hold, known as deleveraging” (p. 1). In the era of deleveraging and recapitalization,

where Islamic banks are well capitalized and not very leveraged, Islamic banks are positioned

one step ahead in compared to conventional banks.

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Even though Sharia-compliant banks have been less affected by the credit crunch and its

negative consequences, and they are seeing growth opportunities while conventional banks are

facing liquidity issues, there are weaknesses as well. Martin (2008) mentions that the relatively

small size of Islamic banks could still prevent them from playing a major part in various

regional deals in which their small size may come as a disadvantage and the banks would be

looked over.

The article ‘Islamic banking: Three opportunities amid a shaky recovery’ (2010)

illuminates the untapped resources within the Muslim population as a great opportunity for

growth. The resource is the large Muslim population itself, and the opportunity is in providing

large-scale Islamic banking for those who believe in the Sharia law. The long-term growth

prospect is where the domestic demand is strong. The large and growing consumer demand is

where the opportunity for profit and expansion lies. Many of these countries not only have large

and unsatisfied people with the banking system, but also a population with a high growth

population rate. “Looking only at those regions where there is large a Muslim population, we

prefer Saudi Arabia and Egypt in the Middle East, Turkey in Europe, and India and Indonesia in

Asia” (p. 19). In addition there are various European countries with Muslim population, where

the Islamic banking service has not been provided.

In developed markets with large Muslim populations, the UK has been a pioneer due to

its status as a European financial hub, but it does not have the largest Muslim

population. France and Germany both had 4mn Muslim citizens (in 2009), according to

Pew Research Center, compared with 2mn in the UK and 2mn in the US. However,

Germany in particular seems to be coming round to the idea of Islamic finance. (p. 19).

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As the strength for growth is laid in places where lack of Islamic banking services is

seen, the contrary may also be true: the market for Islamic banking is not very expansive as it is

contained by geographical borders, namely Middle East and some Muslim Asian countries. As

Volk and Pudelko (2011) mention, the determinants of Islamic banking are demand, supply,

social and regulatory conditions, and these determinants can clearly explain why Islamic

banking could grow in some European countries and not in some other. Lack of supply, and apt

regulatory and social conditions play an essential role in the growth if the demand condition

exists. This demand could also increase considering the growing Muslim population in Europe.

A recent survey among German Muslims revealed that only 4 per cent of the

respondents used Islamic financial products or services and 55 per cent of the

respondents identified the lack of supply as the major reason for the low prevalence of

Islamic finance in Germany. Lack of experience among local banks is certainly an

important reason for this shortage (Volk and Pudelko, 2011, p. 196).

Concluding Remarks

Since Iran follows the same sharia-compliant laws that go into Islamic banking, it was

rather logical to turn the argument to a broader concept and system: the Islamic banking.

Islamic banking has many limitations which in many cases have worked to its advantage.

Islamic banking is fairly new and it has not been put to the test as much as the conventional

system of banking. The recent financial crisis was probably the very first major test that Islamic

banking was put through and the results were nothing less than satisfactory. The damage that

Islamic banks sustained during the 2006 - 2009 era was far less than those of the conventional

banks. Islamic banks are better capitalized and that makes them stronger in absorbing external

shocks. One can surely point to numerous weak points of Islamic banking, like many limitations

ISLAMIC BANKING 10

on its financial instruments, but these limitations have also helped the system engage in a lesser

speculative financial activities, which at the end played as the winning card of Islamic banking.

The paper highlighted points of strength and weaknesses of Islamic banking; however,

there are also many scholars on the other side of the argument who do not have much trust in

Islamic banking and consider it nothing more than being unrealistic. They also argue that the

core concepts of Islamic banking are not very well defined.

[T]here is a lot of confusion on the main topics of Islamic economics. Muslim thinkers

are not yet able to define the term riba (interest) which is the foundation of Islamic

Economics; prevailing concept of riba is completely baseless. No solid arguments can

be presented in the favour of private ownership of land. Interest free banking is not more

than deception…. It is the need of time that Muslim thinkers take a deep critical analysis

of their views and try to find out the basic mistakes which they are doing in

interpretation of Islamic economic teachings. According to Qur’an there teachings can

never be friendly to elite class, but now-a-days situation is quite reverse which clearly

required an operation clean up in this regard (Aziz et al., 2011, p. 772).

What was just mentioned above by Aziz et al., (2011) is a great topic for discussion to

ponder on even though it is outside the framework of this paper, but it remains a strong point for

discussion.

ISLAMIC BANKING 11

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