Islamic banking gets the inspiration from the religion which strictly prohibits interest but allows business on the PLS. The basic distinguishing characteristic of Islamic banking system is the absence of the payment or receipt of any predeter- mined interest rate riba. There is consensus among Muslim scholars that any form of predetermined return on the use of money is unacceptable. Instead of such a pre- determined interest rate, the principles of Islamic banking proposes the PLS which effectively transforms Islamic banks into equity–based firms. In the PLS, depositors of an Islamic bank become a shareholder and are offered simply a share of whatever profit or loss the bank earns. The funds obtained on the PLS basis are invested on the basis of PLS again. Whatever the bank gains/loses from such businesses will be again distributed according to a pre–agreed formula 30.
There is a deep divide between the opponents and proponents’ views on the idealism of Islamic banking. The proponents of Islamic banking basically defend Islamic banking from its positive impact on financial stability and economic growth. The arguments of the advocates of Islamic banking raise Islamic banks as the vi- able alternatives of conventional banks to promote economic growth and to absorb macro–financial shocks (Hasan and Dridi, 2011; Ebrahim and Safadi, 1995).
30Besides its own capital, there are two kinds of deposit accounts in an Islamic bank which are
the main sources of funds for the bank: transaction accounts and, investment accounts. Transaction accounts are equivalent to regular (non–interest bearing) checking accounts in conventional banks. Deposits in such accounts are the funds that are ready for immediate withdrawal. Consequently, the bank cannot use these funds in any short– or long–term investment project since they could be withdrawn by the depositor any time. By depositing funds in current accounts, the depositor gets services in the form of safety, convenience and the use of checks instead of cash. For these services, the bank then can charge the depositor full fees in return for the bank’s cost to produce such services. The investment accounts represent the major source of funds for lending portfolio. Investment accounts in Islamic banks do not guarantee fixed and predetermined interest rate. The contractual agreement between the depositor and the bank solely contain the ratio by which the profit (or loss) is to be distributed.
From financial stability point of view, the advocates of Islamic banking argue that the practice of fixed interest rate based banking is a major cause for many banks to fail during a crisis. Khan (1986) claims that fixed interest rate based banking prevents conventional banks from instantaneous adjustments to financial shocks. The author defines Islamic banks simply as the institutions which do not receive predetermined interest, using a neoclassical model and shows that Islamic banks show resilience to financial shocks. Islamic banks in the model demonstrate balanced assets and liabilities, but conventional banks can not escape huge balance sheet imbalances.
The advocates of Islamic banking further argue that the contribution of Islamic banks to general economy is higher than conventional banks. Accordingly, con- ventional banks are exposed to agency problems more than Islamic banks. Siddiqi (1981) posits that the conventional banks are prone to adverse selection problems, because they lend to borrowers who have sufficient collaterals, and give only sec- ondary attention to the soundness of the projects. On the contrary, Islamic banks have an incentive to finance those more promising investment projects, since the profitability of the project will be shared between the lender and the borrower. The relationship between creditor and debtor is harmonised under Islamic banking since both sides have a mutual interest in the success of the project.
The criticism toward Islamic banking originates mainly from their actual prac- tices which diverge in significant ways from religious doctrines and have significant resemblance with conventional banking practices. The actual practices show that the majority of Islamic banking operations are not based on PLS, but rather on the use of the murabaha contract, an instrument which is akin to the standard debt contract in conventional banking 31. Yousef (2004) names it ”murabaha syndrome”
31A murabaha contract works as following: for instance a firm which upgrades its machinery
equipment applies an Islamic Bank to buy the machinery on its behalf, with an agreement to purchase the machinery on a marked–up basis from the bank. If the bank’s purchase price is, say £100,000, it might resell the machinery to the firm for, £110,000 payable in 12 equal monthly instalments. The bank retains ownership until the last instalment is paid and so the bank’s position is fully secured. This is accepted as Sharia-compliant because the agreement is based on a real transaction and the rate of mark–up is (theoretically) not a function of the time, i.e. time value of money. This kind of transaction is permissible since the bank owns the machinery and bear
and argues that this kind of financing mimics conventional banking. Several other studies also give support for ”murabaha syndrome” and claim that Islamic banking replicates conventional banking practices. Khan (2010), for instance, claims that ”profit rate” or ”mark–up rate” is just a variant of ”interest rate” without having a fundamental difference (see El-Gamal, 2006; Kuran, 2004; Sohrab Behdad and Nomani, 2006, for further debates).
The intense use of debt contracts in Islamic banking is at odds with the expecta- tions of an equity–based Islamic model which PLS principle suggests. Kuran (2004) complains that the exercise of PLS mechanism is rather limited in Islamic banking. He points out that Islamic financial services are not very different from those of- fered by their conventional counterparts. Touching upon the agency problems and adverse selection problems, Kuran (1993) argues that Islamic banks are not dis- tinguishable from conventional banks, since the informational asymmetry does not positively discriminate Islamic banks from conventional banks.
When financial stability is concerned, the opponents claim that Islamic banks cannot act differently from conventional banks. Islamic banks have the same suscep- tibility to financial shocks, since they are exposed to standard moral hazard prob- lems. As Warde (2010) argues, Islamic banking faces severe moral hazard problems associated with ex–post information asymmetry in PLS instruments. For example, the borrower who borrows over a Shariah–compliant financial product has an in- centive to under–declare profits and/or undertake high–risk projects since it is the main principle that profit/loss will be incurred on a pre–defined rate.
Despite significant controversies, Islamic banks’ contribution to financial inclu- sion is significant. Financial inclusion, in a broad sense, refers to provision of fi- nancial services to each and every member of an economy. There can be several barriers to financial services, e.g. poor, disadvantaged people, geographical segrega- tion, societal groups and individuals, the elders etc. (Simpson and Buckland, 2009;
some risk; whereas an equivalent loan for £100,000 at 10% interest, secured by the machinery, is not (for more contract-related details, see Khan, 2010). Although the mark–up rates are selected in accordance with the on–going market rates, e.g. London Interbank offer rate (LIBOR), London Interbank offer rate (EURIBOR), swap rates.
Chakravarty and Pal, 2013). In the context of Islamic banking, financial inclusion concerns the spread of banking services among interest–sensitive conservative peo- ple. In countries where Muslim population is the considerable part of the whole population, Islamic banks provide banking services to interest–sensitive customers who would be otherwise excluded from the banking system (Aysan et al., 2013c).
In many developing and developed countries, policymakers devise several poli- cies to maintain financial inclusion (Chakravarty and Pal, 2013). Cheap credits to target customers, for instance, designed to attract those who find banking services expensive. Whilst financial exclusion can be removed via reducing the cost of finan- cial services to target customers, in the case of Islamic banking, removing financial exclusion can bring extra costs. Since the exclusion does not stem from any in- ability to access finance but from the sensitivity of the potential customers, Islamic bank customers are ready to bear a higher cost once the products are sterilised from interest items. The provision of interest free financial products can significantly re- move financial inclusion while increasing profitability and market power of Islamic banks. Increasing market power might also fuel the cost of financial services via ”monopoly premium” by a secondary effect (Freixas and Rochet, 2008). Since the customers of Islamic banks are ready to pay additional cost to reduce their fear of participating in interest–based transaction, Islamic financial institutions may keep generating excessive profits. A serious question that needs to be examined then is whether or not Islamic banks exploit their status by proving Shariah licenses. If this concern is proved to be true, then Islamic banks may impose their market power to earn monopoly profits which is detrimental to consumer utility (Freixas and Rochet, 2008). This study mostly discusses Turkish Islamic banking on this ground.