Islamic Banking. Previous attempts to study Islamic Banks focused primarily on the conceptual issues underlying interest-free financing. The issues of viability of Islamic banks and their ability to mobilize saving, pool risks and facilitate transactions

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University Degree Business and Administrative studies

Religion, more often than not, and to varying degrees, has something to say about economic behavior. The word “Religion” itself, its Arabic counterpart “Deen” and the essence of the message of all religions imply and indicate setting norms and standards for human behavior which, by definition, extend to the economic arena. Hence, it is not surprising that religion and economics are related. Islam addresses all aspects of human behavior at once with the purpose of integrating morality and spirituality in all spheres of human life and by all means of social organization. This message is directed to man, whether singularly as a person for whose up lifting, purification and delivery all religions aim; or socially as groups, nations and communities of nations. Consequently, Islam is usually said to be a total way of life or system for societies. This means Islam extends its realm to organize all aspects of human life: politically, socially, spiritually, morally and of course economically around the basic pillar of faith, that is the absolute oneness of Allah.

ISLAMIC BANKING

The steady expansion of Islamic banks has been the hallmark of the Muslim world financial landscape in the 1980s and 1990s. With a network that spans more than 60 countries and an asset base of more than $166 billion; Islamic banks are now playing an increasingly significant role in their respective economies. Based on their charters, Islamic banks have the flexibility of becoming shareholders and creditors of firms, as well as the advantage of providing investment-banking services. In this respect, Islamic banks are rapidly gaining market shares in their domestic economies. In retrospect, the presence of Islamic banks exemplifies the empirical success and the viability of eliminating fixed interest payments from financial transactions. Indeed, consolidation among banks, rising competition and continuous innovation to provide financial services, all contribute to a growing interest in a detailed critical evaluation of Islamic banks. In fact, evaluating the performance of Islamic banks is essential for managerial as well as regulatory purposes. While managers are keen to determine the outcomes of previous management decisions, bank regulators concerned about the safety and soundness of the banking system and with preserving public confidence, monitor banks’ performance to identify banks that are experiencing severe problems. Without persistent monitoring of performance, existing problems can remain unnoticed and could lead to financial failure in the future. Depositors may also be interested in characterizing the performance of their bank(s) since they are not entitled to fixed returns and the nominal values of their deposits are not guaranteed. Most importantly, performance evaluation is needed to provide answers to key policy questions such as: should Islamic banks be held to the same set of regulations as conventional banks? Are they relics of a bygone era, propped up by subsidies and distorting financial-sector competition? Or, are they efficient and focused financial institutions that could, if unleashed, eventually dominate the retail financial landscape? Previous attempts to study Islamic Banks focused primarily on the conceptual issues underlying interest-free financing. The issues of viability of Islamic banks and their ability to mobilize saving, pool risks and facilitate transactions did not get enough coverage in the existing literature. To compete in local and global deposit markets, Islamic banks have to design instruments which are according to Shariah bindings and which can cope with the continuous innovations in financial markets. In addition, Islamic banks should find investment opportunities (for fund mobilization and utilization) that offer competitive rates of return at acceptable degrees of risk. Equally, banks’ management must carefully consider interactions between different performance measures in order to maximize the value of the bank.

HOW ISLAMIC BNKING HAS DIFFUSED OVER TIME

The expansion of Islamic banking has in the past few years accelerated, with the industry diversifying out of traditional territories into countries with large Islamic populations such as the United Kingdom. Africa in particular, with a large Muslim population million, has seen an expansion in recent years while estimates vary; Islamic finance has grown into a US$1 trillion industry. Islamic banking is now expanding out of its niche, becoming a market that could rival the conventional sector in many countries. It is an increasingly visible alternative to conventional banks in Islamic countries and in countries with large Muslim populations, such as the UK. Globally, the assets of these institutions have grown at double- digit rates for a decade, and some conventional banks have opened Islamic windows, with Shariah-compliant financial assets reaching an estimated $509 billion at end-2007. The International Organization of Securities Commissions predicts that as much as half of the savings of the worlds estimated 1.2-1.6 billion Muslims will be in Islamic financial institutions by 2015. SOME of the factors which drive its diffusion are as under:

  • Islamic Population: All else being equal, we expect that the higher the percentage of Muslims in a country, the faster the diffusion of Islamic banking. Current estimates suggest there are an estimated 1.2–1.6 billion Muslims worldwide, with high concentrations in the Middle East, North Africa, and South-East Asia but otherwise spread across the globe.
  • Interest Rates: Although Islamic banks are not allowed to charge interest, they compete with traditional banks and have to offer competitive products. While devout Muslim individuals will put their money only in Islamic banks, less devout Muslims, and non-Muslims, see the opportunity cost of putting their money with Islamic banks as the current prevailing interest rate. If it is low, the opportunity cost foregone is low, and Islamic banking should be stimulated.
  • Income per capita: higher income per capita should result in greater demand for Islamic services. As income rises, savings tend to rise and the need for financial activities lending, trade credit and other activities similarly grow.
  • September 11, 2001: It has been suggested that an important driver of Islamic banking was the terrorist attacks of 9/11. Following that event, money coming out of Islamic countries was viewed with suspicion in Western countries. The risk of funds being seized by Western governments made it more appealing for Islamic investors, who traditionally had exported their savings to the West, to keep their money in their own region.
  • Distance from Islamic Centers: Bahrain and Malaysia are the two major Islamic finance centers. We expect that the closer a country is to one of them, the higher the familiarity with Islamic finance concepts tends to be and the more likely Islamic banks are to develop.
  • Financial System Development: The effect of a country’s current banking system on Islamic banking is ambiguous. On the one hand, a more sophisticated banking system could act as a substitute for Islamic banks, making their diffusion more difficult. At the same time, a sophisticated banking system, by providing infrastructure (for example, human capital) on which Islamic banks can build, could promote the diffusion of Islamic banking. In this latter scenario, Islamic banks would act as a complement to conventional banks.
  • Macroeconomic Stability: A key determinant of the size of the banking system is macro-economic stability. Typically, as an economy becomes less stable, we can expect disintermediation. Also, because their basic principle is to share risk with investors, lower investment returns from higher macroeconomic risk should negatively affect diffusion of Islamic banks.
  • Institutions: Most Islamic countries were colonized and inherited the institutions of their colonizers. For Muslim countries, this means either English common law or French civil law. Some scholars have argued that English common law has a more positive effect on financial and economic development than civil law, on the grounds that the latter tends to place less emphasis on protecting private property rights. We expect that Islamic banks, like conventional banks, are more likely to grow in environments where the regulatory system is built on a solid foundation. Individuals trusting the banking system are more likely to put their money in banks and use banking services.
  • Petroleum Exporters: Islamic countries, particularly in the Middle East, depend on extraction of petroleum products. Since 2000, oil prices have risen substantially. Positive improvements in the terms of trade for these countries should therefore increase purchasing power, which raises incomes and should stimulate the diffusion of Islamic banking. Positive terms of trade shocks have a positive effect on income not only in oil-exporting countries but also in countries where a large share of the population works as migrants in oil exporting countries, for instance Egypt, Pakistan, and Yemen. While many oil-producing countries have created sovereign wealth funds that invest much of their assets overseas, we expect enough money is entering the economy and spilling over to the domestic sector to have a noticeable impact on growth.
  • Economic Integration with the Middle East: How much a country’s economy is integrated with the Middle East—as proxies by the share of exports and imports to that region—is also likely to be a crucial factor in determining Islamic banking diffusion. Countries with closer trade ties to the Middle East are more exposed to businesses dealing with Islamic banking systems, and will be more likely to develop their own Islamic banking back home.

ISLAMIC BANKING VS CONVENTIONAL BANKING

Difference in definitions:

  • An Islamic bank is a deposit-taking banking institution whose scope of activities includes all currently known banking activities, excluding borrowing and lending on the basis of interest. On the liabilities side, it mobilizes funds on the basis of a Mudarbah or Wakalah (agent) contract. It can also accept demand deposits which are treated as interest-free loans from the clients to the bank and which are guaranteed. On the assets side, it advances funds on a profit-and–loss sharing or a debt-creating basis, in accordance with the principles of the Shariah. It plays the role of an investment manager for the owners of time deposits, usually called investment deposits. In addition, equity holding as well as commodity and asset trading constitute an integral part of Islamic banking operations. An Islamic bank shares its net earnings with its depositors in a way that depends on the size and date-to-maturity of each deposit. Depositors must be informed beforehand of the formula used for sharing the net earnings with the bank.
  • Commercial banking is based on a pure financial intermediation model, whereby banks mainly borrow from savers and then lend to enterprises or individuals. They make their profit from the margin between the borrowing and lending rates of interest. They also provide banking services, like letters of credit and guarantees. A proportion of their profit comes from the low-cost funds that they obtain through demand deposits.

DIFFERENCE IN WORK FLOWS:

WORK FLOW OF CONVENTIONAL BANK

WORK FLOW OF ISLAMIC BANK

Islamic banking is unique, but by no means anomalous. It is neither at odds with nor incomparable to conventional banking.

  1. They are both financial intermediations. A financial intermediary is the institution that acts as a middleman between cash surplus units (savers) and deficit spending units (users of fund).
  2. The financial intermediary in conventional banking is a “borrower- lender” institution. Since such institution will not survive unless it at least covers expenses, then an income must be generated from such arrangement. This is where interest appears. An Islamic bank, on the other hand, is based on a multi-tier Mudarbah. The income accruing to the Islamic financial intermediary is coming out of profit not from interest. The root of such a conception is the fact that Shariah does not distinguish between a sellers being a trader or a final intermediary, unlike positive law where civil law is different from commercial law. In Shariah all people stand against one legal code.
  3. There are those who say if an Islamic bank does Murabahah any other form but the trader’s way of doing things it will not be permissible from Shariah point of view,
    and an Islamic bank would be in their view a “dubious” conventional
    bank. They say: since it is never the intention of the bank, to own
    there assets and hold on to them then, such bank is not sufficiently
    Islamic.     According to this viewpoint, an Islamic bank must have huge
    warehouses and elegant stores full of goodies for sale. This is not valid and those who think so miss two important points:     Intention is of no consequence on the permissibility or otherwise of any exchange contract in Shariah. In an authentic Hadith, the Prophet (PBUH) showed one companion how to substitute a usurious transaction by another non usurious to reach the same purpose, He (PBUH) didn’t object to the intention nor that he nullified the contract on the basis of intention. Rather he corrected the form of contract. If the anatomy of the contract is in line with Shariah requirements, then the transaction is acceptable. Hence, if bank actually buys and then sells, with ownership passing from seller to buyer and that the subject of contract is a good or commodity then the transaction is correct. In conventional banking the subject of contract is money hence any increase is usurious.
  4. The way conventional banks render financial intermediation is very simple. They borrow money and lend money. Both assets and liabilities are one form of lending. Islamic banking functions in a rather “elaborate” (not perplexing) way. They have to continuously innovate to satisfy the needs of their clients. It is because of this we
    see Murabahah, Musharakah, Mudarbah, Istisna, and Salam to name just a few Islamic modes of finance. This makes the job of an Islamic banker “not all roses”, but certainly a more interesting one.
  5. A conventional banker is a risk manger. He is concerned with all kind of credit, market, interest rate, legal and other risk factors. An Islamic banker should be just as concerned. However, there is one added risk for the Islamic banker; this is what we may call Shariah inobservance risk”. Risk analysis refers to the forces that may cause the outcome of investment to be sub optimal. Certainly an Islamic investor earning on-permissible income is an outcome that is most undesirable, and it may cause the value of his investment to be reduced.
  6. Contrary to popular opinion, being concerned about time value of money is a similarity not a difference between Islamic and conventional banking. There is no basis for the current thinking that Shariah doesn’t allow the attachment of monetary value to time in the contracts exchange. The contract of Salam and differed-payment sales flies in the face of this argument. It is only in loans that Shariah requires that no time value of money is considered (but replaced by great rewards in the hereafter).
  7. A major difference, however, remains in the handling of delinquency and default. When a borrower delays payment of debt, interest will accrue on his delayed portion. Unless, such borrower defaults and become incapable of paying back his debt, such interest will compensate the conventional bank for lost business. This can’t be done in Islamic banking as this is considered usurious. Clearly, this is a disadvantage from two aspects: Firstly, an Islamic bank will not have the opportunity in a Murabahah transaction for example, to be compensated for lost profit. But more importantly, it increases significantly, the Murabah risks. Since bank clients are rational people who will seize an opportunity when they see one, they will always delay payment. One major Ijtehad of contemporary Shariah scholars is to allow the Islamic bank to impose penalties. Rather than accrue such penalties as income, and hence become usurious, they are disposed off to charity. This way the pressure will mount on the debtor to pay in time, without falling into Shariah impressibility.

DIFFERENCE in RULING PRINCIPLE BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING:

The conventional interest- based banking is mainly a business of financial intermediation between savers and entrepreneurs. It earns its profit by borrowing at one rate of interest from those who have surplus and lending it a higher rate to those who can use it profitably. Islamic Banking, on the contrary, is sharing the fruits of economic activity generated through intermediation of savers and investors. The reason for elimination of interest in banking transactions is its prohibition in Islam. The injunctions against interest, synonymous to Riba, are explicit and the word, under various connotations of prohibition, appears several times in the Holy Quran. It extends to financing for trade and industry involved in prohibited goods and services.

Islamic banking is emerging in an era when the world is settling down to a free market economy and when phenomenal changes are taking place in the global economy. A free-market economy envisages three essential features - free trade, open capital market and minimum governmental intervention. The vagaries of protectionism and regionalism are transforming the economy to free trade and globalize. The changes could provide ample scope for the Islamic banking to grow and work in competitive environment.

There are two major differences between Islamic Banking and Conventional banking appears as follows:

  • Conventional banking practices are concerned with "elimination of risk" where as Islamic banks "bear the risk" when involve in any transaction.
  • When Conventional banks involve in transaction with consumer they do not take the liability only get the benefit from consumer in form of interest whereas Islamic banks bear all the liability when involve in transaction with consumer. Getting out any benefit without bearing its liability is declared haram in Islam.

While the basics of what the business is are the same, the term refers to operating the business within Islamic law. The main thing that affects this business under that law is that Islam prohibits the charging of interest. Certainly a problem in modern banking! However, what is considered to be interest has different definitions by different Islamic scholars...some say it can only be considered on gold and silver...but paying back the same weight as you borrowed (the same weight of paper money for example), is not interest. Like in all religious things, there would seem to be some conflict and differences between followers that may seem strange to outsiders. So basically, modern Islamic banking may take many forms, each of which strives to adhere to it understands of Islamic law.

  • Requisites of conventional banking

Conventional banking is based on the principle that the more you have, the more you can get. In other words, if you have little or nothing, you get nothing. As a result, more than half the population of the world is deprived of the financial services of the conventional banks. Conventional banking is based on collateral. Conventional banks look at what has already been acquired by a person Conventional banks go into ‘punishment’ mode when a borrower is taking more time in repaying the loan than it was agreed upon. They call these borrowers “defaulters”. When a client gets into difficulty, conventional banks get worried about their money, and make all efforts to recover the money, including taking over the collateral. In conventional banks charging interest does not stop unless specific exception is made to a particular defaulted loan. Interest charged on a loan can be multiple of the principal, depending on the length of the loan period.

  • Requisites of Islamic banking

Islamic banking, being an integral part of an Islamic economic system can be practiced more effectively in an environment, which conforms to the tenets of Islam. Thus there are some essential requirements for a successful Islamic banking, such as:

  • Supportive Legal Framework and Swift Judicial System: An effective legal framework ensuring speedy justice is essential for a good society, it is more so for the success of Islamic banking, because its investment risk is more than that of a conventional interest-based bank as its dealings are on profit and loss basis.
  • Disciplined Entrepreneurship: It would minimize cases of malfeasance and mismanagement. Besides, a banker must extend from being merely a financier to a role-player in business. Although a Murabah transaction in Islamic banking does provide an opportunity to a banker to share in business, the Islamic banks generally limit themselves to being inactive partners for their credit risk only. The real entrepreneurial role of an Islamic bank needs, therefore, to be increased.
  • Conceptual Change from Credit Risk to Overall Risk Management: While it is difficult to predict, with any degree of certainty, the operating results of an enterprise and the magnitudes of profit and loss, all the same, it seems unjust if the party providing the capital is guaranteed a fixed and predetermined rate of return, and the other party undertaking the enterprise is made to bears the uncertainty alone. Under the circumstances, an Islamic banker has not only to focus on credit risk but also to view all the business risks of the enterprises in which he has invested the bank money.
  • Strong Ethical Values: The Islamic economic system offers a balance between the two extremes of public or social and private or individual ownership of property. The success of Islamic banking in a society is related to the extent of acceptability of the doctrine of trusteeship and transformation of the self-interested and profit-oriented behavior of people into an altruistic and value-oriented behavior.
  • Supreme Shariah Council: The function of Shariah Council in maintaining Islamic banking activities in a country within the orbit of Islamic injunctions is dependent on its legal status and the extent of implementation of its opinion. The opinions of Shariah Councils of different countries may not necessarily be uniform. There is, therefore, a need for a Supreme Shariah Council representing Muslim community all over the world to decide about various issues con fronted by Islamic banks. A beginning has been made in this direction by establishing the Council of the Islamic Fiqh Academy at Jeddah, Saudi Arabia under the auspices of the Organization of Islamic Conference (OIC) but its role has to be augmented.
  • Uniform Accounting Standards: there is need for harmonization of financial reporting of Islamic banks in respect, particularly, of the following;
  1. The significant accounting policies on which the statements are based should be fully and clearly declared,
  2. The methods of translating foreign currency transactions would be appropriately disclosed,
  3. Appropriate and sufficient disclosures regarding the quality of banks +assets is of much concern to the depositors,
  4. Additional disclosure of the nature of the financial contingencies and commitments (Non Funded Liabilities) of the banks in their financial statements.
  • Committed Management: If the management of a bank is determined to step into the business of Islamic banking, it can easily evolve a strategy for the same, formulate a plan for a specific time frame and implement it accordingly.
  • Progressive and Modern outlook: In order to ensure successful management in Islamic banks, There is need to apply all the available  modern tools of managing corporate business, including management of human assets, offices, information resources, marketing etc.
  • Body to Evaluate Islamic Financial Institutions: In order to ensure quality and standard in management of Islamic financial institutions and to build confidence of the general public in Islamic banking, there is need to establish some professional body responsible to define professional standards and ethics and other aspects of Islamic financial institutions. It may also certify the level of financial health of such institutions.

Many are skeptical about Islamic banks’ performance as newcomers to the market. There are several reasons for this.

  • First, Islamic banks are non-conventional financial institution. Interest, the cornerstone of conventional banks, is completely prohibited under Islamic banking.
  • Second, Islamic banks operate under dual constraints. While operating as a commercial bank, Islamic banks obey not only conventional business laws of the land, but also the Islamic laws. They have to sacrifice many profitable investment opportunities because those are not permitted under the divine laws of Islam. Thus, it is natural that Islamic banks, as new competitors, face steep challenges in sharing deposit and credit markets. As such, it is hypothesized that Islamic banks may not be on par with the conventional banks in terms of profit, liquidity risk, and credit risk.

STRUCTURAL DIFFERENCES BETWEEN ISLAMIC BANKS AND

CONVENTIONAL BANKS

In order to understand the strength and weakness of Islamic banks with regard to its performance, it is essential to know the basic environment in which Islamic banks operate. It is the difference in environment that makes the Islamic bank unique and distinguished.

  • The Islamic attitude regarding life:

But seek, in that which God has given you to attain the Everlasting residence. And do not forget your share in this world. Do well, as God has been good to you, and do not corrupt in the land, God does not love those who corrupt. [Al-Qasas: 28:77]

  • The Islamic attitude regarding business:

O you, who believe, when you are called to prayer on the Day of the Congregation (Friday), hastens to the Remembrance of God and leaves your trade. That is the best for you, if you but knew. Then, when the prayer has ended, disperse in the land and seek the favor of God, and, remember God often, so that you prosper}. [Al-Jumu’ah:62.9-10]

  • The safe guards in Islamic finance:
  1. The limits 

Such are the limits set by ALLAH; he that exceeds the limits of God wrongs himself.

[At Talaaq: 65:1]

According to the Shariah Islamic financial institutions must be based strictly on four basic principles:

  1. All transactions must be interest free, i.e., free from RIBA
  2. Activities or transactions involving speculation (GHARAR) must be avoided.
  3. The implementation of ZAKAT, the compulsory Islamic tax.
  4. No involvement in the production or consumption of goods and services which are HARAM (i.e., illegal from the Islamic point of view)

(i) Riba

The Quran explicitly prohibits RIBA but does permit trade.

“Those who consume Riba shall rise up before God like men whom Shaitan has demented by his touch; for they claim that trading is like Riba. But God has permitted trading and forbidden Riba. He that receives an admonition from his Lord and mends his ways may keep what he has already earned; his faith is in the hand of God. But he that pays no heed shall be among the people of fire and shall remain in it forever.” [2:275].

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There now seems to be a general consensus that the term RIBA includes any amount charged over and above the principal. The payment of interest or receiving of interest, which is the fundamental principle of conventional banking and financing, is explicitly prohibited in Islamic banking and finance. Thus, the prohibition of interest, in payment or receipt, is the nucleus of Islamic banking and its financial instruments, while the charging of interest in all modes of transaction whether it is in loan, advances or leasing is the core in the conventional banking. The Islamic banking is not simply interest-free banking.

(ii) ...

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Islamic Banking. Previous attempts to study Islamic Banks focused primarily on the conceptual issues underlying interest-free financing. The issues of viability of Islamic banks and their ability to mobilize saving, pool risks and facilitate transactions
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