Salman Ahmed Shaikh
Keeping aside the technical debates and unsettled issues regarding the legitimacy of some of the Islamic banking operations, in this article, we try to highlight if there are any key elements of economic merit in this system of banking.
Often, in commercial financing, huge financing is required for different projects that take time to be completed. For instance, construction of plant, highways and dams. The firm providing services to undertake and execute such projects may have expertise, but lack funds to undertake such projects. Financial intermediation can bring necessary financing, liquidity and risk mitigation that enables the unknown counterparties to undertake such projects.
There is often need of making payments for resource supplies before production is complete. To keep the production cycle going, Istisna can be used to ensure resource supplies availability and production.
Often, it is desirable to keep low levels of inventory and improve turnover ratios. Keeping huge inventory all the time will require inventory maintenance cost and may result in underemployment of assets at times. It will dampen liquidity and turnover ratios and hence affect the stock price of companies. Using Murabaha and Istisna right when financing is needed for new projects can reduce operational and financial inefficiencies.
To take another example, construction and engineering companies enter into big-volume, but customized contracts with institutional clients. Keeping inventory beforehand is neither financially possible nor it is operationally appropriate. Hence, financing the project requirements after project deal is signed can enable firms to work with less cash tied up.
From the risk and profitability perspective, Islamic modes of financing keep the Islamic financial system liquid and less prone to risk due to asset backing. Islamic financial intermediary enables credit availability to ensure that productive transactions are executed and also, it reduces the transaction and monitoring costs which result in more productive transactions happening in the economy.
Often, the investors with bank (the deposit holders) are risk averse and want consistent returns. But, small savers do not have enough funds to finance big volume projects directly. But, using investors’ pool of funds to provide financing, the investors are able to share in benefit of such economic activities.
Financing big projects without financial intermediation will be a very difficult task. Equity financing is also costly in some ways because of high floatation cost, risk of under subscription and inflexibility in modifying capital structure when needed. But, using investors’ pool of funds to provide financing, the banks can effectively finance such big projects that have positive benefits to direct parties involved as well as positive externalities enjoyed by masses in the society.
However, one can argue that such economic benefits also accrue whether banking is done via conventional or through Islamic banking. Some can also validly point that conventional banking could be less costly. Thus, Islamic banks also need to work on making their distinct identity beyond fulfilling some documentary changes in the way banking in general is done. Currently, Islamic banking can not be used by individuals who want finance for health and education. Also, their contribution in micro finance is dismally lower than desired. Going forward, it is hoped that Islamic banking will become more involved in socially important segments and sectors.