Page 2 - Saiful Azhar

Dangers of interest-based system

At the same time, the money lending system has evidenced income disparity between the rich
and poor. Banks lend deposit funds to creditworthy borrowers who usually make more money
from the loan. For example, a bank charges 7% interest on a loan to the big corporation who use
the money in a business deal to make 40% profit while depositors receive a meagre 1% or 2 %
interest income, hence a stark income inequality between big business and households appears.
One study found that an increase in private bank credit in Europe increased inequality, as
measured by both the Gini index and the top-income shares. Another study in Indonesia found
that loans extended to big companies have increased income inequality instead. A positive
association between the probability of banking crises and the level of income inequality also has
been found in as many as 33 advanced countries.

Possible causes of convergence can be detected in many ways
such as:

 Fractional banking system: Islamic banks are set up based on the fractional banking
system where most of the money in the economy is created by banks when they make
loans. The danger point occurs when too much loan ie digital money is made out of
greed or irrational exuberance as Allen Greenspan puts it, that create bubbles in the
stock and property markets and eventually recession, as evident in the 2007 US
subprime crises. The power of money creation is put in the hands of the superrich who
own the banks, hence the concern for poorer society is side-lined. Central banks can put
a stop to this powerful system by requiring the bank to place a fraction of deposit as cash
that serves as a tool of monetary policy in controlling the money supply. But often, this is
frustrated by the procyclical behaviour of the commercial banks that goes against central
banking stabilization policies.

 Deposit-taking banking system: Islamic banks take deposits to extend financing. As a
deposit-taking entity, it is leveraging on borrowed funds to make the Although these
deposits are labelled profit loss sharing (PLS), it remains a deposit fund in which Islamic
banks must hold sufficient capital to back-up the Murabahas as required by the Basel
Committee. It will frustrate any attempts to diversify assets into PLS and true Murabaha,
istisna and salam as the capital charges are exorbitantly high due to the business risk
carried by these real-sector based products. The way out is to use tawaruq instruments
that are only too similar to interest-bearing loans.

 Tawaruq fatigue: the tawaruq contract applied in Islamic financing has detached asset
that consumers intended to buy from the tawaruq sale contract. The customer no longer
needs to enter into an agreement with Islamic banks into buying and selling, say a house
or machinery. By entering into the tawaruq scheme, customers obtain the liquidity
needed to purchase the assets they want, like taking a bank loan. While undoubtedly,
tawaruq sales have evidence underlying asset attached to the sale, business risk or price
risk is avoided by way of quick sale and purchase of the assets. The danger of high
contract concentration risk is in sight if less effort is done by regulators to control the use
of tawaruq.