Being a staff in the KL Islamic Finance Forum 2011 (KLIFF 2011) is truly a blessing. I have learnt quite a lot from the discussions among the policy makers of Islamic finance from around the world. Most importantly how does the Islamic finance system differ from the conventional system.

For the ordinary layman, the difference between the Islamic finance and conventional  finance systems are not really obvious. In fact, many see Islamic finance profit rates (or interest rates) higher than the conventional system and things like no benefit given to early settlements of loans also make it not as attractive as the conventional banking system. Well, I don’t blame people that see Islamic finance unattractive, because it’s not entirely their fault. Islamic finance has been directly compared to the conventional system purely on an implementation level ; how profit rates are calculated, how much money you get back in return etc. Bankers have done little to explain why Islamic financial products are structured the way they are. But then again, do the consumers bother to listen if they tried to explain?

That’s why in this post, I would like to share some points I acquired during my duty at KLIFF 2011 not too long ago. Apparently, there is a big difference in terms of point of view when you are at the policy making  level then when you are at the implementation level (bankers and consumers).

Islam and loans

In Islam, any form of interest or profiteering from money lent to other people is prohibited. The concept of lending money in Islam has to be sincerely to help the person in need, not to take advantage of his/her misfortune. Interest is seen as a form of oppression to the poor because if interest is allowed, what is stopping the money lender to put ludicrous amount of interest, just like the ah longs of Bukit Beruntung. The prohibition is to stop ah long mentality to flourish in the society.

However, while interest is prohibited, trade is encouraged. So what the Islamic Banks do to avoid interest is to buy the item the the customer wants to buy and sell it to a higher price to the customer. For example, you want to buy a car and apply a so called “loan” with an Islamic bank. What actually happens is the bank will buy the car, add a profit margin to the price of the car and sell it to you by instalments. Interestingly enough, some of the contracts are structured as a rent contract. This means you rent the car for the a certain term (5, 7 or 9 years) at a agreed rate and at the end of the term, the bank will give you the car as a gift.

How this differs from a conventional loan is the clear ownership terms. The car is the property of the bank and the customer is renting the car. So, if the customer defaults on his payment, the bank has all the right to take the car as it is the banks property.

On the other hand, in a conventional load, you borrow the money to buy the car. So, isn’t it strange that when one default on his/her payment, the bank will repossess the car? A car that basically is yours. You borrowed the money so the car should be yours, not the bank. I know that they have a contract and laws etc, but if you look at it from a logical  perspective. This “vagueness” is what Islamic finance wants to avoid.

Loans

Speaking of loans, did you know conventional banks can lend out 10 times the value of their assets? (some say 20 times and some say more). Meaning if their asset value is RM10 million, they can lend out RM100 million worth of loans. This is called leverage or what some call lending money into existence. Lending out money that they don’t have (which are actually just numbers in the banks accounts). What happens when a loan is made is the bank will issue money or “borrow the money” from the system, so to speak. Only when the customer pays back the loan, then only the money “officially exists” in the banks balance sheets. It’s a super fast way for the banks to get rich but the problem happens when people default on their loans. This means the debt will be on the bank. If it is only 1 default, maybe the banks capital/assets can cover the losses, if there are many defaulters and the debt is much more that the total value of the banks assets (which is most likely because they can lend out 10 times the value of their assets), the the bank will go bust.

In Islamic Banking, banks can only loan what they have. Each loan must be backed by something material (assets or bank accounts), not just numbers in the banks accounts. So, if a default happens, the debt will never surpass the total asset value of the bank.

While this might not seem significant to the layman, it is exactly this kind of thing that caused the credit crisis in the US back in 2008.

Another example can be found in insurance vs takaful. What’s the difference you may ask? It’s fundamentally different. Insurance works on the basis of “transfer of risk” and takaful works on the basis of shared risk.

Transfer of Risk

In insurance the client will pay a premium to the insurance company and in return the company will compensate the client if something happens to what the client has insured, be it a car, his house or his life. So this means the risk of something happening to the insured item has been transferred from the client to the insurance company.  This premium will be put in the insurance companies account to be used for whatever the company wants to do with it, for all they know it’s companies money.

But on a moral level, one young chap who never has not made a insurance claim since taking insurance for 5 years might complain and wondering why they are paying for the premium when nothing is happening to him. In a way it’s like gambling. If something happens to the client, the insurance company looses. If nothing happens to the client, the insurance company takes the premium.

Sharing of risk

In takaful, on the other hand, the takaful participants premium will be put into a pool of money with the goal of helping out any of the participants in need. In other words risk is shared among the participants. The Takaful company will act as a fund manager and invest the money in halal investments to increase the size of pool of money and of course, the company will take cut of the investment profit as a service charge.

On a moral level, as the participants join on the basis of helping each other out, nobody complains about paying the premium. This reminds me of the movie “Sicko” where a Canadian was asked on why people should agree on paying taxes for socialized medical care in Canada after he had an medical emergency and treated in a Canadian hospital (or in other words, why should people pay taxes for medical care for other people?). By the way, Canada has a socialized medical care system, very similar with the takaful concept. His answer was simply, “because he would do the same for other people.” Which is exactly what takaful wants to achieve.

The Freedom of Choice

In short, Islamic finance and the conventional system is a choice between a stable, but less profitable system and a highly profitable but fragile system. But above all the Islamic Finance system gives the privilege of an option for consumers to choose between two types of banking systems with two totally different concepts. One may choose either one they feel is right for them. At least we have a choice, unlike the Americans.