Why Is Islamic Banking Controversial?

As the #Islamicfinance industry continues to grow, we can’t ignore the controversies surrounding some segments, namely #Islamicbanking. We can fairly say that it is the most criticized segment in the industry. But why?

Before we get into more details, you should note that Islamic banking is not one. The labeling might be the same (with some countries like Turkey and Morocco choosing to call it Participative Banking), but the practices differ greatly from one jurisdiction to another and from one bank to another, depending on various factors such as local laws and how developed they are, standards and fatwas adopted, the tax treatment of Islamic banking operations, and market maturity.

To understand why Islamic banking is controversial, we must first comprehend how a traditional bank operates.

The classic belief people have, and is still found in some economics textbooks, is that banks lend out existing money, which is clients’ deposits. However, the reality is that they use deposits only as records of how much money the bank owes its clients and create new money when lending.

When someone takes out a loan from a bank, the bank creates a new deposit in their account, which is new money that didn't exist before. For example, if someone takes out a $10,000 loan, the bank would create a new deposit of $10,000 in their account. This is new money that didn't exist before, and the bank created it out of thin air by simply crediting the borrower's account. The borrower can then spend that $10,000, and the money will circulate through the economy. (Check out this link for more in-depth reading).

This money creation process has significant implications for economic growth, inflation, wealth distribution, and financial stability.

Being part of this global system, policymakers in the Islamic finance industry had to come up with a solution. Enacting a whole new system is not an overnight process nor a realistic option. It needs time, political will, and sovereign independence. So, in order to meet the pressing market demand, the industry prioritized offering shariah-compliant financing alternatives within the existing system that their countries had in place.

The main challenge with banks is that the moment you set up an institution called a “bank”, you must comply with numerous legal shackles, from local banking laws to global standards, such as Basel requirements. Hence when an Islamic bank seeks to introduce contracts involving sale, ownership transfer, or equity, the financing risk increases dramatically. Plus, interest is legally tax-deductible, but profit is not, which results in double taxation for Islamic banks. That explains why Islamic banking products are always more expensive except in countries that have introduced exceptions or specific regulations to level the playing field with conventional banking.

Despite these challenges, scholars and policymakers have made significant efforts in setting rules and standards to ensure that Shariah-compliant alternatives are not just some conventional products disguised under Arabic terms.

Remember that when we say “Islamic” finance or banking, it does not mean that it’s perfect or flawless. It only means that it operates in accordance with Islam’s principles and rules to the best knowledge and ijtihad of scholars and policymakers. How it’s implemented in practice is another story.

In fact, many Islamic banks limited their offers to the minimum needed for their products to be Shariah-compliant. That led to a lack of innovation in the industry and reinforced the market perception that Islamic banking products are not different except in names.

Maybe it could work better if we can create a new type of deposit-taking institution that is not a bank, but offers banking, financing, and investment services, and segregates between the management of deposits and the management of savings and investment accounts. This way, banking restrictions won't apply to the new institution type, and there will be more authentic Shariah-based financing products.

It's important to remember that during the Quran revelation, Riba (interest/usury) was not prohibited in one shot, but rather in four stages over more than 10 years. Structural changes take time and come gradually.

Islamic banking is not perfect or ideal as it is today, but the industry has come a long way, and there remains more work to do before having a comprehensive Islamic financial system in place, where wealth is justly created, circulated, and distributed.