Sharia banking provides universal alternative

Muhammad Akhyar Adnan, Yogyakarta

During four decades, the banking industry has been enlivened by the emergence of new types of bank, known as Islamic or sharia banks. These have been set up, not only in countries where Muslims are in the majority like Indonesia, Malaysia, Egypt, Saudi Arabia, Iran, Pakistan and so forth, but also where Muslims constitute a minority, as in the United States, Britain, Russia and Switzerland.

In Indonesia a sharia bank began to operate in the early 1990s, much later than its neighbor Malaysia, which started in the 1980s.

The most important reason for establishing a sharia bank, particularly in countries where Muslims account for the bulk of their population, is simply that Islamic teachings prohibit the practice of riba (usury), as stated frequently in the Koran.

But it is interesting to note that, the prohibition of riba (such as bank interest) is not merely the monopoly of Islam, as it is also clearly condemned by Christianity and Judaism. Even the great philosophers like Plato and Socrates were against usury because it led to unfair or unjust transactions.

There are, in essence, special types of transaction or products/services a sharia bank can enter into. Among these are the murabaha (trading transaction). For example, a customer who wishes to buy a car (or any other commodity) can go to a sharia bank. The bank will propose to the customer that it will buy the car at a specified cost, but will sell it again to the customer at an agreed margin or profit. Hence, instead of selling money as a commodity, as practiced by conventional banks, the bank sells the car at an agreed profit and payment procedure within a certain period of time. This is one of the ways that conform to sharia principles, by which a sharia bank earns its income.

Another product that might be offered by the sharia bank is a partnership contract. The most common ones are the musharaka and mudharaba.

The musharaka is broadly similar to what is known by the conventional finance industry or Western practice as venture capital. In this regard, two parties (a bank and a customer) participate in a particular project by putting up capital and, perhaps, skill. The profit and loss resulting from the project will be shared proportionately by both parties.

Experience in many developed countries in Europe and the United States has shown that many international corporations that have now become giant companies were launched in collaboration with venture capitalists. Bill Gates with his Microsoft Corp. is perhaps one of the best examples of how a small firm can be helped and finally transformed into a giant corporation through the venture capital system or musharaka.

Unlike musharaka, in a mudharaba contract, one party will be the capital supplier, and the other will act as the provider of expertise and, at the same time, operate or manage the business. The manager is known as the mudharib and the capital provider sohibul maal. Again, the income generated by the project is shared between the capital provider and project manager, based on an agreed split. However, if normal losses (caused by honest mistakes) are incurred, they will be borne by the capital owner, while the manager will bear only nonfinancial losses, such as his labor or managerial expertise. But any loss inflicted by the manager's negligence is entirely his responsibility.

A sharia bank may also provide other fee-based services such as hiwalah (money transfers), kafalah (financial guarantees), wakalah (representation or deputyship), ijarah (leasing) and so on.

These are some illustrations of the way a sharia bank earns its revenue and income. It is also interesting to note that the variety of products and services a sharia bank can offer is basically much broader than what conventional banks can provide. A sharia bank will share its income with its depositors on a proportionate basis. Hence, the more profitable a bank, the greater the income that accrues to depositors.

Unlike conventional banks, a sharia bank will not provide fixed income or pre-determined interest revenue, meaning that a sharia bank shares its risks with depositors and customers.

Within the organizational context a sharia bank should also have a special, independent unit in charge of supervising the bank and seeing to it that the bank always holds to the principles of sharia.

This unit is called the Sharia Supervisory Board (SSB). While the board of commissioners in a conventional bank is in charge of ensuring that the bank fulfills prudential regulations and all other rules imposed by the central bank on the banking industry, the SSB oversees that a sharia bank's operations are fully in compliance with sharia principles.

Given its role and responsibilities, the SSB must comprise people who have both competence or knowledge about Islamic teachings/rules on economic activities and skills in business management and auditing.

Many have acknowledged that sharia banks are much stronger and more flexible than conventional ones, particularly at times of economic crisis, such as the one that hit Indonesia in 1997. While most major conventional banks collapsed during the crisis, none of the sharia banks went bankrupt. The reason is obvious -- sharia banks do not have the negative spread of their conventional counterparts.

The growth of sharia banks, both in terms of individuals or aggregates, is really remarkable. Sharia banks have so far successfully attracted many depositors, not only from Muslims but also the non-Muslim community. They have also been very successful in efficiently allocating their funds to the market. If the loan-to-deposit ratio (LDR) of conventional banks in Indonesia now averages only about 40 percent, the finance-to-deposit ratio (FDR, the sharia bank equivalent of LDR) averages about 80 percent, much closer to the standard set by the central bank.

In recent years many conventional banks have expressed interest or announced plans to open sharia bank branches (as permitted and regulated by the central bank), or even to convert themselves fully to the sharia bank model.

Despite some weaknesses, many depositors and customers have testified they are fully satisfied with the performance of their sharia banks, not only because they generate just and fair transactions, but also rates of return that are mostly higher than the interest provided by conventional banks.

The writer is a senior lecturer in the department of accounting of the school of economics at Universitas Islam Indonesia, Yogyakarta.