IS CONVENTIONAL BANKING COMPLETELY HARAM?

Islamic Banking

Interest income and speculative trading of financial and other assets in any form and shape is strictly prohibited (haram) in Islam. Over the last 20 years of my banking/corporate finance career, many Muslims have asked me about the acceptability of current banking system in Islam. The intensity of such questions has increased in the last 10 years when I moved into Islamic banking.

There is a widespread misconception in innocent Muslim minds that everything related to banking within the conventional system is prohibited in Islam. This probably stems from a (a) lack of understanding and (b) genuine desire of common Muslims to stay away from even remotely prohibitive income. Since this assumption of blanket prohibition is erroneous, I wish to explain in as simple a language as possible that apart from dealing in interest and speculation (both categorically prohibited in Islam), there are many permissible (halal) functions that conventional banking institutions perform and make substantial profits from (For some top GCC banks, see box at the end).

In my view, Muslims may engage in such functions in the form of customers, employees, investors or advisers. Some of these functions are briefly explained below:

ASSET MANAGEMENT

– MUTUAL FUNDS (MFS)

Apart from interest income, banks derive a significant chunk of their revenue by managing multi billion dollar Mutual Funds. These funds are raised from public and invested in the equities (shares) of companies listed on stock markets through asset management arms of conventional banking institutions. Mutual Funds allocate their investment across fixed income securities (Income Funds), equities (Growth Funds) and a combination of both (Balanced Funds). Muslims need to stay away from both Income and Balanced Funds due to interest being their major source of income.

Since Islam prohibits certain products like liquor, gambling, pornography and conventional Banks that derive major income from interest, even within Growth Funds Muslims need to ensure that their portfolio consists of shari’ah compliant equities only. Over US$ eight trillion of equity funds are managed by various conventional financial institutions across the globe, which generate billions of dollars of income for them. This income does not seem to contradict with any shari’ah injunction provided Funds are not engaged in speculative trading.

– BROKERAGE

Another increasingly significant line of income for conventional banks is brokerage services. All publicly listed equities can be traded on stock markets only through companies authorized by the capital market regulators e.g. SEBI in India, CMA in Saudi Arabia and SEC in the US. Such brokerage companies are owned by all major banks. Since banking institutions have large clientele with surplus capital, these clients prefer to trade in equities with their known banks.

For providing this service, banks charge certain percentage of fee on the volume e.g. 0.5% on actual buying or actual selling (not speculative buying/selling) shares. In bullish capital markets this stream of income runs in billions. This brokerage income received from equities trading appears to be completely acceptable from the Islamic perspective. Here also, brokerage subsidiaries of conventional banks must refrain from speculative trades and sectors in the “negative list” indicated above and below.

INVESTMENT BANKING

– MANAGING PUBLIC AND RIGHTS OFFERING

Primarily there are two sources of funding business projects (a) debt which consists of all kinds of fixed return structures (loans) and (b) equities which cover variable return securities compatible with Islamic principle of profit and loss sharing. Working on any aspect (banker, adviser, lawyer etc) of conventional debt is unacceptable in Islam. However, advising, structuring and distribution of new equities through Initial Public Offerings (IPOs) or capital increase through Rights Offering to existing shareholders of established companies is a lucrative business for banks and income derived from this perfectly meets shari’ah requirements.

This function is performed by both independent Investment Banks like Merrill Lynch, Goldman Sachs and Morgan Stanley and fully owned subsidiaries of commercial banks like Citibank, HSBC, NCB (in Saudi Arabia) and SBI (in India) etc. Banks receive fee from companies raising funds from the capital market in return for providing services including drafting of prospectus (containing business details), development of financial model, putting together the underwriting syndicate, printing and distribution of share application forms and liaison with capital market regulators – like SEC in the US, SEBI in India and CMA in Saudi Arabia – for meeting regulatory requirements.

– UNDERWRITING AND DISTRIBUTION

Another core function of Investment Banking which is closely linked to managing IPOs is the underwriting of equities. Business projects worth billions of dollars are dependent on companies’ ability to successfully raise funds from public (new shareholders) and/or existing shareholders. If companies fail in this endeavor, not only projects for which funds are being raised get adversely affected, capital market sentiments in general are negatively impacted too. Such a failure may strongly damage economies through depressed investor sentiments. In order to avoid such an eventuality, capital market regulators insist on fully underwritten offerings.

Banks conduct extensive due diligence to evaluate all aspects of risk before giving their commitment to underwrite an IPO or a Rights Offer. Banks (both conventional and Islamic) with strong balance sheets are approached by issuers of equities. Banks commit to distribute a fixed percentage of those shares to their client. If they fail to distribute, then they themselves buy the un-sold number of shares. In a bullish capital market with high level of IPO activity, this income is quite substantial for banks and acceptable from an Islamic perspective.

– RECEIVING BANK FOR PUBLIC/RIGHTS OFFERINGS

For making large IPOs successful, companies target hundreds of thousands of investors across their target markets. To solicit share application forms from such a vast number of investors, large commercial banks with extensive network of branches are appointed as Receiving Banks. Their function includes helping potential investors fill application forms correctly, process them, collect cheques/payment from investors, transfer the collected funds in a designated account of the issuers on a regular basis, report to the share issuing company, the regulator and financial adviser about the aggregate collections on a regular basis. For performing this function, banks are paid usually a lump sum fee. Though this fee is insignificant in terms of the total income of banking organizations, yet appears to be perfectly legitimate from a shari’ah standpoint.

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