I will present my comments after short quotes from the book review:
"Certainly Islamic finance and banking institutions are thriving relative to conventional finance. The Banker's 2009 survey of Islamic finance found the volume of sharia-compliant assets of the Top 500 grew by an extremely healthy 28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that this figure will top $1 trillion in 2010)."
I don't know whether the statistics on the size of the industry are accurate and I would not be comfortable myself relying on statistics of growth down to the tenth of a percent when the industry has been described often has having a size of $750 billion or $1 trillion for several years with growth rates usually quoted at 15% to 20%. The vagaries of the statistics, in my opinion, mean that there is really no data on the true size of the industry globally.
"Advocates claim Islamic finance has been immune because sharia-compliant institutions are focused on the fundamentals, with simple products bearing robust mechanisms for risk mitigation. Market analysts have stressed the correlation between asset quality in Islamic institutions and their conservative approach to risk as an insulating factor."
While I consider myself an advocate for Islamic finance, the idea that Islamic finance is immune from anything related to economic downturns is flatly wrong. It would contradict even the theoretical claims that the industry for it to be immune from economic downturn affecting its customers. If the industry were 100% profit-and-loss sharing, it would suffer a downturn comparable to the rest of the economy, depending upon the underlying leverage of the financial institutions. Even with ijara and murabaha making up most of the financing available, Islamic finance will still be susceptible to downturns through rising default rates and asset value depreciation.
"Many conventional bankers contend the success of Islamic finance in riding out the financial storm can be attributed to the fact it is underpinned by tangible assets such as real estate."
This, in my mind, has been completely disproven by the near-deafult of Nakheel, which relied almost entirely upon rising property values for its solvency and used sukuk to fund a large portion of its projects (and to add leverage). Besides Nakheel, many Islamic financial institutions suffered greatly when the Dubai real estate boom turned to a bust, whether they were conventional or Islamic.
"First, credit losses from debt default to the depreciation of assets may create a large divergence in relation to the liabilities that remain fixed in nominal value."This is true in Islamic finance as in conventional finance. Even institutions that use Shari'ah-compliant debt financing retain the same economic characteristics as conventional finance. Those that use profit-and-loss sharing financing may be somewhat insulated from the fixed liabilities side, but the sukuk are typically structured to protect the creditors from a decline in the assets on which the sukuk is based or backed.
"Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return."
The rate of return in LIBOR or other interest rate benchmarks are affected by changes in the economy and Islamic financial products typically use these benchmarks to price Islamic financial products because the benchmarks provide guidance on the risk-return trade-off as viewed by creditors in the market.
"Third, banks caught in a credit freeze, with a drying up of liquidity. may default on their payments."
With fewer methods of liquidity management and no lender of last resort, Islamic financial institutions are more--not less--vulnerable to liquidity-driven crises.
"Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. A credit crash causes a dramatic contagion and a domino effect that may impair even the soundest banks. "
With fewer Islamic banks offering the large majority of sukuk (at least prior to the AAOIFI ruling which restricted the issuance of mudaraba and musharaka sukuk), there is more counterparty risk to Islamic financial institutions. There are fewer issuers which leads to each issuer having a greater spillover effect on other banks' balance sheets if they were to fail or have their solvency questioned.
"In an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth is positive. "
As I mentioned above, interest rates are determined so that they represent the balance between the needs of recipients of capital and the providers of capital, incorporating the rate of return of the funds used (which affects the probability of repayment), as well as the risk-return ratio on the debt itself (the return balanced against the probability of default). Islamic financial institutions can make bad investments just like conventional financial institutions and can lose money even when economic growth is positive.
"A critical feature noted by the authors, and one consistent with the Austrian ideal for banking, is the fact that the Islamic system operates on a 100% reserve requirement. In this system, investment banking operates on a risk/profit sharing basis, with an overall rate of return that is positive and determined by the real economic growth rate."
Islamic finance is not based on 100% reserve requirements. An increase of $1 in equity or deposits is met with a larger expansion of assets by an Islamic bank through the use of debt-financing through sukuk issue. Also, nothing guarantees that any investment, whether financed using a risk/profit sharing method or not, will be profitable. The closer the asset side of an Islamic financial institution is to risk-sharing, the closer its profitability will be to an equity investment. The return on these investments--and stock markets or economic growth can be used as a proxy for the rate of return--can and often are negative.
While these criticisms are rather harsh, I do still believe Islamic finance can provide a positive example to the financial system. Limits on leverage will on their own make a financial system more stable because of the magnifying impact of leverage on returns, both positive and negative. There remain, however, many issues that Islamic finance as an industry needs to deal with to become fully mature so it has at least an equivalent risk management system including liquidity management and finding an Islamic way to provide lender of last resort financing, as well as Shari'ah-compliant hedging. The Islamic banking industry in particular has demonstrated the ability to be profitable and sustainable while adhering to Islamic ethics. Even as the financial system globally was on the verge of melting down, many Islamic financial institutions were able to weather the storms through a conservative approach to risk and high levels of liquidity (in part due to a lack of lender of last resort and adequate liquidity management tools). That is not to say that they remained profitable: many did not. However, they were able to remain in business and live another day even as banks that had been around for decades collapsed. As economies and financial systems recover, Islamic financial institutions will once again move in to the black, but they should not adopt the complacent attitude that by virtue of their Islamic nature they are immune from future downturns.