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Islamic banks as financial intermediaries

In the last 20 years, commercial banks share of US financial assets has declined to 24.5% from nearly 40%. New technologies of communication and computerized financial transaction made it possible for many savers to bypass commercial banks and directly reach out to users of funds. This diminishing role of banking is, effectively compensated for by growth of financial markets (money and capital markets). As their ability to make their own credit judgment improves, more and more savers prefer to eliminate the “middleman” , by directly taking the risk of borrowers, than the risk of banks. This is exactly the idea of Islamic banking. An Islamic bank is a financial intermediary. However, its operation is not based on a “borrower-lender” relationship with savers. Alternatively, it functions as an agent procuring investment opportunities to its depositors, where they directly take the investment risk. To prevent adverse selection and generate incentive compatibility, this agent does not get fixed fees for its fund-management. rather it is compensated on the basis of actual profits of these investments.

The model of Islamic banking is built on what is called in Islamic jurisprudence “Mudarabah”. Mudarabah is a principal-agent contract. It is based on trust, where assets remain the ownership of the principal (the saver in this case) managed by the agent (the Islamic bank).

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Islamic banking raison d’être is prohibition of usurious transactions. Because usury arise in loans, a financial intermediary established on the idea of borrower lender relationship is not compatible with the Islamic system.

Both being essentially financial intermediaries, the differences between an Islamic bank and a conventional bank are basically that of operation. These differences can be summarized in two main points:

  • that an Islamic bank advances are, effectively, off-balance sheet assets, and
  • that value can pass from the bank to its clients either in the form of goods and services sold on deferred payments or in the form of money. In the latter case risks and returns are shared between the bank and the users of funds.

It is not too difficult to see, therefore, that there is “common ground” between the two models of banking. Many conventional banks are discovering that Islamic banking is not as intricate as the name may sound. Responding to increasing demand from its clients, numerous conventional banks started offering interest-free banking products in the last 5 years. Most popular of these products is the Murabahah, where the bank takes constructive possession of assets and then re-sell on deferred payment with a mark-up. Murabaha, which is in vogue nowadays in automobile and housing finance, is not very dissimilar to bank lending, and actually creates comparable bank assets. The mark-up, however, is not compounded and if penalties are charged in the case of delayed payments, they should be deposed off to charity and not constitute an income to the bank.

Murabaha is the mainstay mode of finance in Islamic banking. Because the prohibition of interest is very serious in Islam, pressure to innovate new banking products is very strong. This is one area where Islamic banks are quite distinguished.

Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.