Banking with zero per cent interest

The U.S. Federal Reserve and the Bank of Japan have lowered interest rates to almost zero per cent. What is quite rare in conventional banking, however, is the norm in Islamic banks. But the Islamic Finance industry currently also finds itself hostage to the financial crisis.

'Fed cuts interest rates to near zero' - the latest headline triggered by the financial crisis triggered raised eye-brows throughout the world.

With one exception: In the Islamic world, banks working on the basis of Shariah aim to always operate without interest.

While conventional banks borrow at a lower interest rate than they lend out money to the public, Islamic banks aim to generate profit by establishing Profit-Sharing-Accounts, among other forms of financing.

Granting loans is haram in Islam, as is pooling credits and selling them to third-parties. By definition, an Islamic bank cannot hold hedge funds, sub-prime loans or junk bonds in its balance sheet.

Not immune to financial crisis

Is Islamic banking the solution to all the problems which came up in the financial crisis? Are they immune from default? 'Of course not', explains Fares Mourad, Head of Islamic Finance at Zurich-based Bank Sarasin.

'The entrepreneur who gets capital from the Islamic bank in a Mudharaba agreement can also fail, for whatever reason.'

Also, in reality, Islamic banks are unable to isolate themselves from the conventional world. Their size is still infinitely small compared to conventional finance houses.

The total volume of Islamic assets will soon reach $1 trillion, but US banks alone hold about $12.7 trillion. If a client of any Islamic Bank transfers money abroad to a conventional bank, the latter will charge interest. He will not find an Islamic bank in every market, although 500 banks in 75 countries offer banking according to Shariah.

The banking sectors of Sudan, Iran and Pakistan aim to be as close to an interest-free economy as possible. But again, if Pakistan is bailed out with a $5bn-loan granted by the IMF (as it happened on October 23 2008) the money will have to be paid back with interest, certainly.

Secondly, if risk-aversion is rising (as it is now), investors start hoarding cash instead of investing. This mentality affects the secondary Islamic market as well. Take the volume of Islamic Bonds (Sukuk); in 2008, it almost halved to $15.2bn. According to the IMF, the global market for structured finance suffered even more; it dipped by 80% to $387bn.

Saudi banking assets

Nevertheless, developments are also encouraging: Until 2010, $174bn, or half of Saudi-Arabia's banking assets, will be managed in line with Islamic law, according to Sarasin-Alpen, Dubai.

For the UAE and Malaysia, theses shares will be at 24% and a fifth, respectively. More and more non-Muslims are looking at Islamic finance as a non-interest, non-conventional, ethical-style of investment.

But Hari Bhambra, Senior Partner at Praesidum, a Dubai-based regulatory consultancy warns of a copy-and-paste mentality: 'The message of the financial crisis for Islamic banks is clear: Avoid placing conventional products in an Islamic dress with a 'halal'-label. A diluted Islamic finance industry will not only drive clients away, but also put Islamic banks in the same risk environment as conventional banks are.'
Source: ameinfo