Islamic banking restrains bankruptcy

 

The fall of giants in the world financial sector like Lehman Brothers in the aftermath of the US sub-prime mortgage crisis, we need to be strict about credit rating system to restrain chances of any further bankruptcy. Interestingly, since Islamic banking adheres to strict credit rating system and disallows indebted economic agents to avail more debt finance, it could save our financial and economic enterprises from bankruptcy.

 

Interest is strictly prohibited in Islamic banking and principles of equity finance disallow financing the indebted enterprises, the chances of bankruptcy considerably decline. Under Islamic banking since equity finance need pre-rating analysis of projects after reviewing cost yield analysis, it tends to reject the economically weaker. Islamic banking principles thus reduces the throat cut competition in financial sector to get more credit shares and tends to provide stability in the financial market.

 

Since principle of Islamic equity finance allows the banks to recover the assets by right of ownerships, it would be fairer on the part of financial institutions to recover assets in case of any bankruptcy or crisis, which may not be found in interest-based lending by SCBs and financial institutions because in later case the lender have no right over assets financed to debtors.  Thus to strengthen the stability in financial sector and avoid chances of bankruptcy, the system of Islamic equity finance should be promoted through Islamic banking instead of raising scope for throat cut competition among banks and financial institutions by compromising lending rates to attract more credit shares.

 

It would be interesting in part of the financial sector reform to evaluate the credit rating system adopted by our conventional credit rating agencies and the practices adopted by Islamic bankers and financial institutions in the international financial market. It would certainly help us improvise our rating system to prevent any bankruptcy in future.

 

10 Responses to "Islamic banking restrains bankruptcy"

  1. Guest   September 28, 2008 at 7:44 pm

    HUH?

  2. A accidental reader   September 29, 2008 at 1:12 am

    Dear Author,The article assumes that the existing practice does not allow the bank to take over assets. But as per my understanding the current crisis arose not because the bank could not take over asset but the value of the asset dropped so much that the bank even if they could take over they could not sell it at the value they wanted. In such a case, the Islamic banking as suggested will not make any difference. Kindly correct if this is a wrong notion.ThanksA accidental reader

  3. Syed Zahid Ahmad   September 29, 2008 at 7:22 am

    It is not that existing practice does not allow the banks to take over assets, but there are some limitations by regulators and the more importatntly the throat cut competition to grab more share in credit market spoils the market.

  4. Rohit   October 2, 2008 at 6:34 am

    Author,Dont you feel that Islamic Banking tends to ignore the weaker section of the society by lack of access to credit?

  5. Syed Zahid Ahmad   October 2, 2008 at 2:01 pm

    Islamic banking interestingly supports the weaker and even the weakest section of the society to avail cost free credit. But it has definitely reservation to allow flow of credit for projects with low economic viability. This definitely encourages the entrepreneurship skill development within the society and thus promotes economic development as well. Because the motivating force for flow of credit in Islamic banking is not assured fixed and compulsory interest return over credits, but is driven by economies of credit management through more economically rational and profitable venture with share in equity returns. Thus it helps to find more profitable and ventures for credit flow under equity finance as compared to debt finance.Since credit rating under debt finance depends on asset value, it may crash the credit market with fall in asset value. Under Islamic finance, since a return on equity is not related to asset value, but on profitability of the business, it has nothing to do with rise or fall of asset value. Thus the credit market under Islamic finance is related to real market trend, instead of up and down in asset value. Thus the credit under Islamic finance is safe from any manipulations in real estate market.The credit rating under Islamic banking and finance is directly related to real term business potential and growth trends, instead of manipulated price levels which has caused recent huge damages to the credit market.

    • Nab   October 12, 2008 at 11:32 pm

      Sir,In the booming real estate market, Islamic Banks also competing to provide real estate finance through number of products. Existing Islamic Real Estate finance among Islamic Banks are depending on asset value.According to my understanding, if the Real Estae market of Gulf countries fall Islamic Banks in the region also will taste the bitterness of credidt crisis.Pleae correct me, if I am not correct.

  6. Anonymous   October 3, 2008 at 9:07 am

    hello sirsorry for my english, my mother langages are arabic, french and spanish. i think the article of Syed Zahid Ahmad is interesting, but it fails in the most important point: islam refuse strictly all kind of credit à interêt. Which we call in arabic Ribaa. ribaa is totaly forbiden as to someone who pretend to be muslim. the credit crisis which is a confidence crisis as it is a liquidity crisis shows the killing effects of the ribbaa on the economy. i presume that what we see on wall street is a pure and simple demonstration of the islamic axioma. virtual credit debt economy is nothing less than debt economy. debt economy shouldn’t be allowed and that’s the error of the (credit-debt) developped countries. they have gone from being productive developped countries to consumer leveraraged (by debt) countries.Allah help us all

  7. Syed Zahid Ahmad   October 4, 2008 at 4:45 am

    Even Equity finance is a sort of credit and not necessarily be considered as a debt. And for credit under equity finance also, we need credit rating system because no Islamic bank will approve equity finance of equity credit under assuring sound credit grade. Appraisal of the project financed under Islamic banking will cover strict credit rating system by evaluating all dimensions without special focus on price value of assets. So, by no way we are talking about debt credit under Islamic banking. Islamic banking off course rule out interest (Ribaa) but focus on scope of profitability and sustainability. The economic rationality of the project to be financed under Islamic banking would certainly need stronger credit rating system. Here by credit rating system, we stand to rate all sort of credits, debts and equities. If Islamic bankers would neglect credit rating system, no one could save them from their bankruptcy.Islamic banking has just the unique advantage to shoulder the financial risks upon the investors instead of credit borrower because the borrower is supposed to be weaker (in comparison to investors) to bear the financial risk. This justified allocation of financial risk also need credit rating system for optimal utilization and security of funds. That why we advocate that credit rating system must be genuine and strong enough to stabilize the market.

  8. Dzuljastri   October 18, 2008 at 10:45 pm

    Salam,In order to practice Islamic finance in the real sense, we should not use interest to benchmark the cost of finance. What is happening in the financial turmoil is that the financial sector is growing faster than the real economy. Hence when the property market dropped, the outstanding balance owed to banks are higher than the actual(real)value of the property resulting in negative equity. To avoid this, banks should practice the home share ownership (equity) finance whereby bench mark is based on the rental(real) value of property instead of interest rate. Secondly, profit sharing in equity ensures fair distribution of wealth between the bank and customer.