Strengthening Islamic finance

Indonesia's nascent but growing sharia banking industry gets a major boost this week from the passage of the new Islamic banking law, putting the country on a stronger footing to attract Islamic funds.

Together with the Islamic bond law, adopted a few months ago, the Islamic banking law will serve the interests of the growing number of Muslims who are not comfortable with conventional financial systems which charge interest on capital.

Many Muslims consider interest as riba, (prohibited by sharia law) and that's an important reason why more Indonesian Muslims are turning to Islamic banking services and even looking at Islamic investment in the form of sukuk, Islamic bonds.

Sharia bank lending increased by 30 percent in 2007, higher than the 25.5 percent lending growth of commercial banks. But sharia banking is expanding from a smaller base, currently accounting for only 1.98 percent of the total banking market.

This small sharia banking market segment is attributed to the country's late entrance into Islamic finance. Indonesia saw its first sharia banking in the early 1990s, with the establishment of Bank Muamalat Indonesia in 1991.

This was the only fully compliant sharia bank until the financial crisis in 1997, which many Muslim scholars attributed to the false logic of a financial system based on debt contracts.

To them, the crisis was generated by a debt structure whose nominal values and maturities were out of line with the ability of the economy to service them.

After the crisis, along with the rise of fundamentalism and some resurgence of mainstream orthodoxy among Muslims, sharia banking is becoming more popular. Two more full sharia banks were established, Bank Syariah Mandiri, the largest sharia bank by assets, and Bank Syariah Mega Indonesia.

On top of that, several conventional banks, including foreign-owned banks, have established sharia windows. These are not separate institutions, but specialized units within conventional banks that offer sharia-compliant products for their clients.

Sharia operations in this country have been governed by regulations from Bank Indonesia (BI), the central bank. The passage of this Islamic banking law provides a stronger legal basis for sharia banking and finance.

Unlike the present BI regulations, the law gives more room for sharia banking to develop. The law, for example, requires any sharia window in a conventional bank whose assets already reach 50 percent of its mother bank (or after 15 years of institutional existence since the passage of the law) to be separated from the conventional host bank and become an independent fully compliant sharia bank.

The passage of the law, however, does not automatically address all the problems currently faced by sharia banking and finance. The double taxation issue is one of them. Because sharia banking does not charge interest, sharia banking transactions often involve selling and buying of assets, which belong to the bank until the end of the transaction, when the client buys the asset back. This selling and buying cycle is subject to taxation, which may mean double taxation, compared to a conventional loan to buy an asset where it is only purchased by the client once.

The government has promised to address this with changes in taxation laws.

Another big problem for sharia banking is the limited choice of instruments currently available to Indonesian customers compared to countries with more developed Islamic financing institutions. Many fixed rate instruments currently available from sharia banks are not really very different from interest based transactions in conventional banks.

If you want to borrow money from a sharia bank to buy a car, for example, you have to buy the car from the bank and not from the car dealer. The bank would charge you a price based on the original price of the car plus management fees and the profit for the bank and its depositers.

Therefore, technically, there is not necessarily a big difference in pricing between sharia banks and conventional banks. That's why even Muslims themselves have expressed some skepticism and even cynicism regarding the present practices of Islamic banking.

There is a challenge for sharia finance scholars to devise truly sharia banking instruments or investment instruments that would attract more people to put their money in sharia banks and be recognized as sharia-compliant in Indonesia and internationally. These could include fixed cost instruments where there are fees or charges but not interest, and variable cost instruments where the client may share profits or losses with the bank.

If more instruments are available and attractive and better advertised, then sharia banking should serve not only Muslims but also people of other faiths, who are perfectly free to use it.

The Agriculture Development Bank of Iran, for example, through partnership with farmers, helps them to convert their physical possessions into assets that can generate additional capital, therefore improving their collateral and capacity to borrow.

Similarly, Islamic finance can be used here in Indonesia to convert dead capital of farmers into income-generating assets. This way, Islamic finance will be able to become a vehicle to develop and empower the economy for Muslims and non-Muslims alike.