How Islamic banks compare to other financial institutions
In their article for Business Daily, Christos Alexakis, Vasileios Pappas & Athina Petropoulou explain, among others, why Islamic finance may be important to Greece.
What are Islamic banks? In western banking the interest rate reflects the remuneration that the depositor is entitled to and the price that the borrower would pay for utilising extra funds. Whether fixed or floating, interest rate is indirectly linked to the economy and the estimated economic performance of the financed venture. Within a financing situation the entrepreneur bears the business risk; he should ensure that cash flows meet the interest payments.
Collateral requirements and the contract itself are the bank’s cushions against business risk. Depositors normally do not bear any business risk as their remuneration is fixed too. Risk and reward are severed. Islamic banking adopts practices that are commensurate with the Islamic law. Perhaps the most well-known prohibition is that of interest; Islamic banks are neither allowed to charge nor receive it.
Instead to mobilise funds their financial products are either equity-based, where the bank and an entrepreneur enter a joint profit-sharing venture, or fee-based, where cost-plus-profit sales and leasing agreements are typical. Equity-based financing is perhaps the most distinctive feature compared to conventional banks, as it allows the sharing of risk and reward. For using funds beyond their means, the entrepreneurs commit to a profit-share ratio with the bank. Contrary to the interest rate case where the entrepreneur is always liable, here the remuneration is tied to the economic performance; hence the entrepreneur repays when the venture is profitable. No profits in a certain period (e.g., due to Covid-19); no repayment to the bank.
Such contracts are more demanding at the design stage, with solid business plans, stress-testing and reliable forecasting typically required. This heightens the importance of due diligence and monitoring, while it requires highly skilled personnel. Since profits are shared, the bank has strong incentives to ensure non-performing investments are minimal.
Equity-based contracts are also in place with the depositors, which are now quasi-investors. They receive a profit share ratio too, which is tied to the bank’s performance. If the bank is profitable, their reward is higher. If the bank’s investments turn sour then the remuneration to the depositors is reduced, or even zeroed. This is an effective mechanism to exert control on the bank. Depositors have the flexibility to withdraw their deposits from a mismanaged bank and place them with a profitable institution in search of higher reward. In fear of such behavior bank managers have more incentives to work closely with the entrepreneur to ensure their investments remain profitable.