Until a while ago, there was one approach to banking referred to as “conventional banking”. The concept was introduced as the main form to lend and borrow money whether the transaction was between the bank and an individual or the bank and a corporation. A new approach, or a field of study, was introduced in the Far East as well as the Middle East which was called “Islamic banking”. Because there should be a need for a new intervention to be introduced into the market, the need here was that the way lending transactions are processed in conventional banking is forbidden and rejected by Islam as a religion. That did not stop people from accepting conventional banking as the default way of banking for a very long time, just like it made many accept and adopt the new Islamic banking. When the latter was introduced, its core principle was that lending transactions, other than investments, had to be backed up with an asset. In other words, the bank buys something and sells it to you, and then you buy it and pay through timely installments.
So allow me to explain with an example. When a person decides to buy a car, they head to the bank and apply for car finance. The bank asks for a few documents; including a salary certificate if the salary was not being credited in it, and then the transaction is processed. The bank, since it got the cash, buys the car then sells it back to you with a rate and a number of years agreed upon earlier. The difference here is that the transaction is considered a sales one before being a banking one, and that the rate quoted by the bank is multiplied by the number of years to decide on the profit rate which the bank shares openly with you. In conventional banking, the interested rate is usually compounded over the number of years where you keep paying the interest off in the first few years of the loan lifetime. Also, in Islamic banking, part of the profit that the bank made is actually given back to the customer if an early settlement was made. The same banking concept is applied to different products, but liquidity was always an issue if cash, not a product, was required.
For that, banks that apply Islamic banking came up with “Tadawul Finance”. When customers require immediate cash, banks apply the same sales and financing transactions, “Murabaha”, but with stocks. And since liquidity was a problem, this made life easier without the worry of breaking the main rule in Islamic banking. In many Far East countries, Islamic banking has lost its core value as assets are no longer traded in the transaction to safe guard the bank’s interest neither is there a risk borne by both parties under the concept of “Mudaraba”; which is mainly a partnership between the bank and the customer in a new venture. Since the bank is a money-providing partner and the borrower provides management and expertise; this is fine as both share the risk of a start-up. The concepts introduced earlier are the two main ways of doing Islamic banking to finance products and ideas. As the field is new, new products are always being developed, approved, and then introduced as long as no direct financing occurs in the transactions.
Due to excessive hedging and selling of bad loans prior to the financial crisis, continuous defaults resulted in banks and financial institutions having no way of claiming their investments back. As opposed to Islamic or as many refer to it currently as asset-backed banking, there was nothing solid to hold on to and say: “here is where I have invested my money”. What’s on papers have resulted in investors tracking their money back to houses that were already undervalued when the real estate bubble burst as defaults on mortgage increased, with many financial institutions seeking reimbursement of whatever amount. Since markets are very well connected nowadays, the problem escalated and affected institutions and economies worldwide. When banks realized what went wrong, they moved towards short-term lending including credit cards, with salaries credited being somewhat the asset mentioned earlier. Eventually, if people getting laid off because of the last crisis are more than those hired; a new crisis shall emerge.