Basic Characteristics of Islamic Investment Modalities

In the process of applying Islamic investment modalities, some basic characteristics have emerged.

The alternative risk sharing modalities offered by Islamic banks in lieu of interest are characterised by flexibility. Banks, in conditions of free market, can choose the most suitable formula or formulae, set the suitable profit margin or profit sharing percentages (according to type of activity, location, clientele, pricing constraints etc.) design specific disbursement or repayment conditions to go with the formula etc. Thus the actual socio-economic costs of providing goods/services to the community is better reflected in Islamic financing. This has its implications for rational resource allocation for the whole community. The banking system can be made to act as a more potent resource allocater than the traditional one (albeit through concessionary interest rates) if the state so chooses in centrally managed or directed economics.

More specifically the variety of modalities used enables Islamic banking to offer more effectively their services to the society in these areas.

• Taxes and other fiscal resources - Banks ‘know better’ the profit margin realised by their partners. They may be asked to deduct taxes on behalf of the taxing authority at the source. This would certainly boost tax collection. A similar effect may happen when banks (in their capac ity as co-financiers) pay customs duties, excise duties etc. directly to the state on behalf of the ‘Musharaka’ operations — thereby lessening possibility of tax evasion.
• Adaptability to fiscal and monetary regimes by the state - Islamic banks can only trade in assets (goods and services). If these are regulated (e.g. rationed by import licenses) then Islamic banks can only extend finance to the available volume. Excess liquidity cannot go to finace speculative activities as the banks do not stand to gain from financing these activities through overdraft arrangements. Islamic banks can not offer normal overdraft. Equally if price controls are enforced, Islamic banks can help enforce observance — either when purchasing raw materials or selling the products. This can work more effecitvely if the whole system is Islamic since the breachers of the systems will be penalised by not having any finances extended to them. Compliance would be greater. An incomes and prices policy becomes more feasible to contemplate if the state machinery can have such an effective tool to check an unruly business community.
• Development - Because of their readiness to share risks, their emphasis on rewarding labour per se and the availability of modalities that require no down payment by would-be partners in addition to a relatively easier collateral policy, Islamic banks are in a better institutional standing than traditional banks in assisting development of their communities. This is especially so, for small industrial and agricultural sectors who are basically cut off from normal commercial financing.
• Resource mobilisation - Islamic banks’ trading activities and modalities avail them of higher profit margins especially if they were efficients in turning over their activities at a higher rate. This enables them to offer higher profits for their investment account holders (depositors) and enables them, therefore, to draw more of the public savings into investment accounts. This has been proven in the case of Sudan and Pakistan.
• Inflation - Islamic banking investments are given for financing specific operations in terms of types of activities, duration and value. Thus there is a direct trade off between money going out of the bank and goods and services coming into the bank’s hold (by way of participation and/ or sales contracts). As such, Islamic finance can not go to hoarding or monopolistic or market cornering activities. These activities are ‘Haram’ or prohibited.

Therefore, Islamic investment modalities work to lessen inflation in a very direct way.

Source: Islamic Banking, Abdur Rahim Hamdi. Republished with permission.