TABLE OF CONTENT
Chapter 1 – Introduction
Overview
According
to the simplest definition, Islamic finance is that form of financing in which
all the tenets, perspectives of Islamic Shariah
are followed and all the products, activities, contracts, agreements,
procedures etc are conducted in the light of Islamic rules and regulations that
are applicable to the field of economics and ethics. Here are numerous
perspectives if we talk about Islamic finance or banking but for our purpose we
will continue with this basic aforementioned concept.
It is estimated by the
financial experts that the Islamic assets is approximately US$ 1 trillion
worldwide (Soraya and Omar, 2010). As evident from this figure, the global
Islamic financial market has grown almost 10% since the mid 1990s (McKenzie,
2008). It is expected that the market potential for Islamic products can get as
high as US$ 4 trillion (McKenzie, 2008). The majority of these assets are under
the commercial banks while the equity funds, sukuk and takaful assets come
under investment banks which account for 25% of Islamic assets (McKenzie,
2008). It is surprising to note that the Islamic financial banking activities
are not limited to countries with legal Islamic bases.
The
most important feature of the Islamic Bank that differs from other commercial
banks is that the former avoids interest or any kind of return derived on a
loan or debt according to the requirement of Shariah. Compared with other
ordinary commercial banks, Islamic banks deal in goods and documents instead of
money. Money would only be used in order to earn the profit as a method of
exchange for purchasing the goods for the purpose of leasing or selling onward.
Besides, activities such as gambling and the unofficial contract are forbidden in
Islamic banks due to the limitation of Shariah that every benefit should gain
from a reasonable practice.
Shariah compliance
Islamic Banking with branches in over 70 countries has been
synonymously linked with interest free banking because of which it has become a
steady force in the financial world over the past 30 years (Warde, 2000).
According to Economist (2008), the world’s Islamic assets were valued to be
about US$700 billion in 2008 which according to Benaissa et al. (2005) has been
growing past the year 2005 at 15% per annum. Islamic Indexes was created by Dow
Jones in 1999 to offer the public, particularly pious Muslims, a Shariah
compliant investment portfolio for cash investments. Several of the leading
Western banks such as Citibank, Bank of America, ABN Amro, Standard Chartered,
HSBC and Union Bank of Switzerland Middle East .
The basic requirement to be a Shariah
compliant financial institution is to have a board of Shariah experts who keep
an eye on policy making and product development. The banks are free to comply
with Shariah guidelines for their operations all over the world or at particular
institute only. Iran Britain Wilson
Basic Principles
El Hawary et al. (2004), with a more practical
view explain Islamic Banking as an arrangement that sticks to the mentioned
four rules:
1.
All financing will be
taken for lawful and permissible activities. Production of good banned by Holy
Quran such as alcohol cannot be financed under these principles.
2.
Every participant will
bear the certain portion of risk in the business.
3.
The financing and profit
sharing should be fair and transparent. No part should be exploited in any
transaction.
4.
All financial transaction
will be based on “material finality”. It means they would be connected with
economic transaction in real sense. It implies that under these guidelines,
options and other similar derivatives are not permissible.
The latest strict interpretation of the hadıth
about trade and commercial dealings would restrict any transactions that
involve items which are not in physical possession of the seller (e.g., short
sales), derivatives, i.e., financial securities with no primary ‘real’
transaction and all speculative financial dealings like options and futures,
for example, interest-rate swaps or hedging by forward sale (Venardos, 2005;
Usmani, 2002). A more shaded view of derivatives and other financial
instruments is taken by Warde (2000), considering them to break Islamic rules.
Similarly, bill discounting and debt issues of government related to a fixed
coupon rate are banned. These activities provide the foundation of modern Open
Market Operations conducted by central banks. They also help in financing the
national debt. In addition to these two
factors, securitized debt obligations, inflation indexing and foreign exchange
dealings are also banned if difficult arbitrating measures similar to the
medieval contractum trinius are begun. This should make sure that Islamic Bank
is not only interest-free banking according to the common view but more than
that.
Historical practice
The obsession of
ensuring a banking environment free of interest for the Muslims is a main
concern of the post WWII era. Basically, in the Islamic world, the financiers
that include the village moneylenders explicitly operated on the basis of
interest as well as the financial transactions that did not have the
characteristics of direct-equity participation. After the analysis of 17th
century Ottoman Shariah, Jennings (1973) found Kayseri Egypt , it was found
by Gibb and Bowen (1960) that the trade between Egypt
and Barbary States
According to
Faroqhi (1997) recent researches in the field approve that the charging of
interest was not controversial but usury was; for instance in the Ottoman
Turkey in 16th century, the interest rate charges were 10% - 20%
inviting al the Aleppo
However, a tension
remains between the religious orthodoxy and praxis which made some Muslims shy
away from the professional even though on certain occasions they used to be
clients (Gibb and Bowen,
1960). A significant Ottoman Islamic moralist and political theorist Kınalızade
Ali Efendi (1510–1572) (Uysal, 2007) and a contemporary theorist Mehmet Ebusuud
Efendi mentioned in his trifold categorization of professions (noble, inferior
and neutral) placed the entertainment professions and usury in the inferior
category but also accepted that the these professions are all necessary if a
good order of the world is to be maintained (Inalcık, 1995). After the 18th
century, however it appeared that the main financiers and bankers in the Middle East particularly east were Christian and Jewish
as well as Greeks, but they invested their money in business. It was only
during the Turkish period that these groups were joined by the Armenians
(Gaudefroy-Demombynes, 1968).
During the decade between 1840
and 1850, the Ottoman officials circulated treasury notes. They were anxious
about the religious connection of the notes and irked them on the grounds of
having perpetual harm of usury (Cizakca, 1996). These notes were finally retired in 1851. The
reason is more related to financial grounds than religious grounds.
Muslims formed a minority (sometimes ruling) of
the society in India
Pal’s (2006) comment that ulama of South Asia are
ultra-traditionalist and even more conservative than those ulama present in the
Middle East, and denounce un-Islamic rituals, e.g., riba, with more clamor and
incompetency than their fellows in Middle East .
May be it is due to the fact that Muslims were a minority (although large) in South Asia and Indian’s ulama feared a continuous danger
from the Hindu majority and the British colonial rulers that caused the growth
of concurrent Islamic Economics. Hence, as compared to Middle Eastern Muslims,
for South Asian Muslims, absolute interest-based finance was less agreeable.
As almost all financial ways embrace the interest
rate in one way or the other, ‘interest-free’ transactions have become a must
factor for any bank claiming to be ‘Islamic’. Then, how is Islamic Bank
implemented in real and how ‘interest free’ is its working? We will be studying
it in later sections.
The first Islamic bank “Mit
Ghamr Local Savings Bank” was established in 1963. The bank operated on the
basis of Shariah law and developed well because it was able to meet the savings
and credit needs of its customers (Venardos, 2006). Following these initial
successes, since the middle of 1970s, a number of Islamic banks were founded in
various Muslim countries. After years of development, the business and
expansion of Islamic Bank is remarkable. Not only the Islamic banks have
covered most Muslim areas, but also in some of the non-Muslim or western
countries, Islamic banks have also find their own corporate way. However, the
Islamic Bank, lies in the principles of the Shariah, is facing different kinds
of risks, especially the financial risk which determines the benefit.
Major Islamic financing modes
The
two types of Islamic Banking finance are: profit and loss sharing that is known
as PLS and non – profit and loss sharing that is known as non – PLS (Sundarajan
and Errico, 2002). In PLS the financier will decide whether to participate in
the equity stake or partnership or not. Therefore, equity participation is not
taken as the main pillar of Islamic financing instead the idea of Islamic
banking is something different then participation in equity stake.
Trade based financing modes or
non- participatory finance are taken as an alternative to equity participation
in Islamic Banking Finance in situation when equity participation is not
reasonable ground to consider especially in case of small personal loans
(Usmani, 2002; Kuran, 2004; Ayub, 2002; Sundarajan and Errico, 2002; Zaher and
Hassan, 2001 and Warde, 2000). The earlier Islamic Bank theorists are stuck to
the argument that weak Islamic forms are only permitted when the two parties
are willing to share risk of financing. Non – PLS are considered the weak
Islamic forms as compared to strong Islamic forms that involve sharing of
returns (Siddiqui, 2002).
Main
participatory forms
Mudaraba,
a form of Islamic Bank in which an expert utilises his knowledge and
capabilities and uses the capital of his sleeping partner. The other form is
musaraka, which gives the opportunity of direct participation in venture to the
financier.
Main
Non – Participatory (trade – based) forms
o
Murabaha –
this is a mark-up based or cost- plus sale form,
o
Ijara – work
as lease,
o
Bay salaam or istisna known as deferred delivery,
o
Bai muajjal
known as deferred payment ,
o
Jo’alah known
as service fee and
o
Qard al hasana
known as charity/ beneficence loan
There
is an incessant debate over whether Islamic banking is Islamic in its real
essence or it’s just a change of name. Some of the religious scholars are the
proponent of the notion that Islamic banking is just the mirror image of
conventional banking system and is not in the conjunction with the principles
of Islamic Shariah. It just manipulates the conventional banking transactions,
contracts, products and services to portray the image of Islamic banking. Prof.
HaiderAlaHamoudi, a renowned scholar at the University Of Pittsburgh Law
School, is of the view that contemporary Islamic financial contracts infringe a
fundamental premise of Islamic contract law, according to which one sale
contract cannot encompass two contracts (AlaHamoudi). ). For example; Murabaha is a particular kind of
sale, compliant with Shariah, where the seller mentions the cost he has incurred on the
commodities and sells it to another person by adding some profit thereon which
is known to the buyer, the contract of promise and the sale deed are considered
two contracts in one sales contract. So the Islamic mode of financing is
proliferating despite of ample criticism.
Purpose of the research
The dynamics
of the world are changing and so the business environment. Islamic banks now
have new challenges and opportunities. The changes must be made, which must be
in accordance with the Shariah principles. The purpose of this dissertation is
to study Shariah principles and how they affect operations and progress of
Islamic banking. In other words, we want to see that is Islamic banking really
based on Shariah principles or not.
Structure of the dissertation
Chapter 1: This is the introductory chapter of the
dissertation. This involves providing an overview of the Islamic Banking
industry and on what principles it is based. It will introduce the general concept of Islamic law and
Islamic financial environment. By comparing the differences between Islamic
banks and normal commercial banks, it will provide better understanding on the
features of Islamic banks.
Chapter 2: This chapter would provide literature
review regarding the research topic, which is the impact of Shariah principles
on the working of Islamic banking.
Chapter 3: Methodology of the research would be
conveyed in this chapter. This dissertation is based upon qualitative approach
and secondary data. The research has been done on the basis of literature
review of various journal articles and books. This chapter will also discuss
ethical issues and limitations of the study.
Chapter
4: This chapter would present the findings of the research methodology
undertaken. Later on, the results will be discussed and probable reasons to the
deviation shall be outlined. Findings and analysis will be based on the
discussion of previous researches’ results and analysis.
Chapter
5: This last chapter would conclude the dissertation and provide suitable
recommendations for the betterment of Islamic banking. This chapter would
summarize and discuss possibilities for future research.
Chapter 2 – Literature Review
Introduction
During
the past decade, the proliferation and success of Islamic finance and banking
throughout the world, has triggered the universities around the globe to take
major research initiatives in the area of Islamic banking and finance so that
in depth study of this field could be conducted that will lead to better
understanding of the subject.
Shariah
Shariah is a literary name of
Islamic laws. It refers to the divine teachings and the inferences from these
guidelines. The most important feature of Shariah is that as a religion
product, it regulates all of religion practices, such as pray and every
activity (Venardos, 2010). In addition, according to Venardos (2010), since all
of the aspects of social life have to conform the Shariah rules, for example, behaviour
between Muslim people, dress, morals and traditions. Similarly, all the
business and financial contract should also obey such regulations to achieve
Shariah. It is important to mention that Shariah hold the status of law but is
not a commercial law nor should it be equated with any secular national laws.
The basic difference is that state owns the responsibility of enforcing its
laws while Shariah compliance is largely the matter of one’s beliefs and
conscience. This is the reason, many states are not very supportive towards
Islamic banking and adopt it only based n their choice. So far, Islamic
Republic of Iran is the only country that prohibits all types of commercial
banking except Islamic Banking. It has passed Usury Free Banking Law in 1983
which requires all banks to comply with Shariah instructions (Wilson
Shariah is a name that includes
all the Islamic laws including the religious, ethical, liturgical and
jurisprudential systems. The decisions in Shariah are based on the group
consideration with legal evidence and proof that may either lead to specific
knowledge about the ruling of Shariah or lead to a reasonable assumption under
the same judgment made by the qualified judges. The primary proof sources
arrived at such rulings are based on Quran and Sunnah (Al-Marzouqi, 2001).
Using these sources, the jurists may issue a verdict by referring to the
companions’ opinions for precedential authority along with the analogous
reasoning, consensus, and policy-related matters including precautionary
measures, public interest and custom.
Fatwa
There is an obvious reason
of having multiple fatwas over the same issue. The reason is that every scholar
has his own view and he interprets the Islamic teachings in own way. There are
multiple sects among the followers of Islam and each sect has his own
guidelines and religious leaders (Malik et al., 2011). The clashing views of
these leaders and misinterpretation of teachings make things complicated. Since
interpretation is largely the function of one's knowledge bank and expertise
over financial matters, the final verdict issued will be different. One school
of thought accepts one product as Shariah complaint while the other one rejects
it. The difference not only exists in countries but also in regions and
countries. For instance, there is relaxation in financial constraints in Malaysia while in Middle
East they are stringently applied. Likewise, the concept of
permissible and prohibited practices is also different in various countries.
General principles
Under
Islam, all the economic activities take place in the light of Holy Quran and
ahadith. All the Muslim scholars have declared that charging interest (riba) is
strictly forbidden in Islam (Ayub, 2002). Quranic teachings prohibit engagement in all
those activities which involve uncertainty in outcomes. Even activity like
gambling (maysir) is forbidden under Islam. Trading is encouraged in Islam,
provided it should be of all lawful goods, which excludes all those items which
are considered as ‘haram’ for the Muslims. Under trade the profits must be the
result of the risk that this faced in undergoing the transaction. No profits
should be earned under a risk free situation.
The inherent concept is that
the banks have been trusted with the safekeeping of the savings of depositors
and the capital of shareholders which are being put to good use. This makes the
banks responsible not just financially but also morally for conducting their
business (Haniffa and Hudaib, 2007). Therefore, it is expected of the Islamic
Banks to communicate the following points clearly in their annual reports.
(i)
Operate within
the ideals and principles of Shariah
(ii)
Provide
returns under the ideal and principles of Shariah
(iii)
Dedication to practice in Shariah compliant
investment activities
(iv)
Commitment to
practice in Shariah compliant financial activities
(v)
Under the uqud
statements, fulfil shareholder contractual relationships
(vi)
Mention the
current and future directions for serving the community
(vii)
Annual
appreciation statements to stakeholders
Restrictions
Riba
Being
influenced by the value and ethos of Shariah, the Islamic financial system has
formed the feature of obeying the traditional regulation of Islamic principle
besides the normal rules, such as risk management, as a financial instrument.
Since 1980s, in contrast with the conventional interest based system, the
Islamic Bank has formed its own system, the “interest-free system” (Venardos, 2006).
Though according to later analysis, the “interest-free” regulation had led to
the avoidance of interest by several banks, it has been world widely followed
by Islamic banks under the supervision of Islamic law.
Besides the interest-free
feature, compared with conventional banks which are mostly based on the debt
style, the Islamic finance is based on equity. It is worth to notice that
equity does not equal with against of money, however, it means that the money
gained by the institutions should be earned through the legal trading
practices. Neither unfair nor the “money earned by money” such as interests are
permitted. Only through the productive activities can the wealth be shared with
its benefits. Similarly, for the owners, they should also take the
responsibility of any losses which might caused by investments they have taken
part in. In addition, uncertain contracts are also not allowed in Islamic
financial activities (Ayub, 2009). The above features indicate that the Islamic Bank is
based on a moral and religion system, and it not only forbid interest but also
avoid the uncertain contracts because of the term of “wealth could only come
from the productive way”.
Speculation
Another kind of activity which
Islamic Financial Institutes have to avoid is gambling or games of chance (Ayub, 2009). Since the instruments of lotteries are provided as
an uncertain or unknown event which mostly depend on chance, and rewards gained
from the gambling are far more than the deserved income, therefore, any style
of gambling are forbidden by the Islamic law. Similarly, according to Ceechetti
(1999), the investment comes from prizes related with interest generated from
unreasonable activities are also unacceptable for the Islamic Bank. Involving
into the financial transactions as well as commercial banks’ products, gambling
is officially been forbidden by the Islamic bank (Ayub, 2009). Islam says that a Muslim should never lend money
with the intention of making money, whatever is lend the same amount should be
taken back, without any charge of interest. Moreover, the borrower is also not
allowed to borrow for the purpose of business financing (El Gamal, 2000). Money
has no opportunity cost, therefore there should not be any compensation taken
in return of its use (Ayub, 2002). However, all the earnings should be in
correspondence with the level of work, there should not be any excess value
generated by money itself (Presley and Sessions, 1994). Therefore, Islamic banks will not take or give any loan or
enter into contracts seeking any increase over the principal of loans or debts
created as a result of any credit transaction (Walker and Blair, 2007).
However, referring to the
usurious transaction, there is controversial argument on it. Some scholars said
that the activity of lending interest is an act of trade; therefore, it should
be permitted (Ayub, 2009). Defenders argued that according to Shariah, any
increase of the “interest” over the receivable standard was forbidden (Hassan
and Bashir, 2004). Therefore, lending on interest is alien to Islamic banks and
financial institutions. In case of any debts created by way of trade or Ijarah
transactions, they are not allowed to charge anything over and above the
principal of the debt. They are not allowed to charge costs of funds or rent on
money in short-, medium or long-term loans, overdrafts, guarantees, financing
against bills, receivables or other instruments or sell their debt instruments
(Ayub, 2009).
Essential Elements of a Valid Islamic Contract
Islamic
banking is dealing with a number of different types of contracts and documents
relating to investments, deposits and most importantly financing. There are a
number of conditions which need to be fulfilled in order to qualify as an
Islamic contract (Shanmugam and Zahari,
2009).
Below mentioned are the conditions which may aid to settle down the potential
disputes:
·
Offerer and Offeree: Formation of a contract does not take
place when there is only one party present. A single party involvement would
mean making a lot of disclosures regarding the self-imposed obligations, like
declaration of a charity or remitting of a debt. Therefore, single party
involvement is not taken as a contract in Shariah.
·
Offer and Acceptance: A contract comprises of both offer
(ijab) and acceptance (qabul). Both offer and acceptance should take place at
the same time. Contract must comprise of more than one party and any party, i.e.
either the buyer or the seller both can initiate with the offer. The contract
can take place in many ways, it can be in oral form, or in written form or can
even take place in the presence of a mediator or an agent. Regardless of the
form under which the contract has taken place, it is binding on all the
acceptors.
Subject
matter and Consideration: The matter as well as consideration both should be in
compliance with Shariah, which means it should not include any material which
is considered as unlawful. Both the parties should be well aware of the
specification, quantity and quality of the subject matter that is attached with
the contract. Both the parties should be in proper state of mind, must not be
intoxicated, insolvent or minor and should be legally knowledgeable at the time
when contract is being made (Bakar 2005). Whatever consideration
is to be given should be agreed at the time of agreement. If the preceding situations are not complied
with then it means the contract is void in view of Shariah.
Main forms of participatory (profit
and loss sharing) Islamic finance
Mudaraba: passive partnership or ‘trustee finance contract’;
the parties share the profits on a settled basis; one party provides expertise
and management and the other gives finances; losses are borne by finance giver.
Musharaka: ‘Equity participation contract’ provides for
profit/loss sharing in shared business; the funder gives a part of the total
investment and all parties may share the management; profits are distributed in
pre-determined ratios but losses are borne in proportion to capital
contributions, respectively. A ‘declining Musharaka’ is more common in the
cases of instalment purchase of assets. An example is a tenant who pays the
fixed rental to the financer and gradually owns home when his accumulated
amount of rent is considerably large.
Sukuk: also mentioned as Musharaka Term Finance Certificates,
Islamic bonds etc. They pay a ‘LIBOR+X%’ rate to the investors but may enjoy a
fixed rate if it is backed by transactions of Ijara or Murabaha. It is backed
by assets and does not violate Shariah.
Direct
Equity Investment: It is a form of buying shares from the open market, etc.
Main forms of non-participatory
(non-profit and loss sharing, or trade based) Islamic finance
Murabaha: Under Murabaha, which
ever asset the client wants to purchase, is bought by the bank who then resells
it to the client on a predetermined price. This predetermined price is often
referred to as mark up sale, whose price is paid in instalments.
Ijara/ijara wal iqtina: This is described as a lease or a lease- purchase contract
Bay’ salam (including istisna): This comprises of the purchase of items which can
completely be specified in terms of quantity, quality and attributes. This
clearly excludes all the monetary items. It is also referred to as deferred
delivery acquisition.
Bai’ muajjal: This is a scheme under which the buyer is informed by the
seller about the cost, the selling price and the date of final payment. This
payment can be made as a lump sum amount or in instalments. In such cases the
deferred payment price is often higher than the spot price. This method is just
like credit sale and can even be termed as Murabaha Muajjal.
Musawama: This method involves a normal sale under which there is no
obligation to disclose the cost.
Ji‘a la: It is a fee which is borne in the name of service charges,
placement fees or consultancy fee.
Qard al Hasana: This is a loan which is provided to the needy individuals.
This is a zero interest loans. As far as the repayment is concerned, the
borrower can return whenever he has sufficient fund to do so.
Usmani (2002) provides
extensive discussion of these and other forms of Islamic finance.
Communicating
the importance of application of Shariah principles in the economic and
financial fields has been one of the successful elements of Islamic banks
(Al-Salem, 2009). Complete Islamic financial products in compliance with
Shariah were offered by Islamic banks such as Murabaha, Istisna and Mudaraba.
However, the other Islamic products failed because it was difficult to apply
the concepts in real practice such as a few Musharaka products that were
conceptualized on the ideal of trust of Amana. In addition, the lack of tool or
method to ascertain the degree of Shariah compliance makes Islamic banks’
expansion in new products difficult (Al Alaywi, 2006).
PLS
Dar
and Presely (2000) have explained that despite of the fact that Islamic banking
has received worldwide popularity but it has failed to abide with the rules of
PLS. Very few banking operations are in harmony with the PLS technique and are
not even avoiding interest. It has been reported in the International
organization of Islamic Banks’ that Mudaraba and Musharaka techniques are being
adopted by just 20% of the Islamic operations and that also in the large
intergovernmental banks (the Islamic Development Bank). Most of the operations
are based on deferred payment in collaboration with mark-up on sales rather
than on PLS (Dar and Presely, 2000). Shariah Supervisory Board (SSB) has
approved all these interest bearing products and services (SSBs: in-house
religious advisors to Islamic banks, Karim, 1989). There is a vast contribution
of AAOIFI’s standards in legitimizing these services as Islamic to the public
(Kuran, 2004; El-Gamal, 2006). Shariah Supervisory Board includes all renowned
Islamic scholars and their role is quite significant in promoting the Islamic
Banking services and products. The statements that the SSB provides in the
Bank’s annual report works as an efficient marketing tool (El-Gamal, 2006).
Islamic banks are not able to comply with the PLS technique because they are
unable to make difference between the bad and the good investments (Kuran,
2004). There is a constant fear of facing losses rather than profits if PLS
technique is adopted in lending, because there would be chances of making wrong
investments. According to many observers it is merely a fiction that the
Islamic banking is interest free (El-Gamal, 2007). It has been explained by
El-Gamal (2006) that Islamic Banks have ended up with a completely identical
framework to that of conventional banking. El-Gamal further adds that Islamic
products like Sukuk have interest element present within them. The financing is
not based upon classical jurisprudence but is a slight modification of the
conventional banking, which is strictly forbidden in Islam.
Criticism
None of
the current periods activities of Islamic Bank are entertained without
criticism (e.g.,
El Gamal, 2006; Kuran, 2004; Zaman, 2002; Nomani, 2006). According to the
critics the Islamic Bank is following the same old principles and has just made
changes in the terminologies. Like for example, it has used ‘markup rate” as a
substitute for interest rate. Therefore, they conclude that the distinction
made is not genuine.
According to Kuran (2004,
1993), the materialization of Islamic Bank took place in the colonial India
The
conventional banking arose quite centuries back, it took birth in an asymmetric
environment. Similarly, the Islamic banking system also arose in an asymmetric
information environment but is still sticking to the techniques and
methodologies of the conventional banking system. The techniques are so similar
that it is difficult to distinguish one from the other (Kuran, 1993). Hence, there is not much difference between the policies of
the conventional banking and those of the Islamic one, which comprises of
terminologies which are classically Arabic and are agreed by all Islamic Bank
advocates.
Ahmad (1993) has laid down
thesis which is not in agreement with the work of Kuran. Ahmad is a leading
Islamic Bank advocate and he argued saying that there are similarities between
the two methods of accounting but it is truly because they wanted to offer the
Muslim clients products and services with which they are familiar (Kamla, 2009).
Ahmad (1993) further added that the importance of Murabaha is waning in the
financing function of Islamic banking. Ahmad (1993) has been writing about the
establishment of Islamic banks in many parts of the world, like for instance in
1978 he wrote for Saudi Arabia ,
in 1983 for Malaysia and Iran and in 1975 for United Arab Emirates
The supporters of
Islamic Bank had been securing it from similar charges, approximately a decade
after Ahmad. Yousef (2004), on the other hand, argues against “Murabaha” by
saying that more or less Islamic banking is following similar banking
practices. According to him; this phenomenon are not strong enough to support
Islamic Bank as a mere alternative to traditional finance option. In fact this point has now been used to
absolutely outcast Islamic Bank conveniently.
The Kuran Thesis
was introduced after three decades of Islamic Banking. It is considered as an
important and valid classification of Islamic Bank. Current Islamic Bank
practices are very much similar to that of traditional banking and are not same
as of actual Islamic Bank according to its advocates. While Ahmed’s points, in
support of Islamic Banks, are highly unconvincing and weak. And Islamic Bank
advocates even condemn how it is currently being practiced.
Islamic Banking in theory
The two basic
resources to finance a venture are; either take another partner on board or opt
for borrowing money. According to supporters
of Islamic Banks; as compare to debt finance, equity financing is way better
since it is interest-free. Besides, in case of failure, the loss is shared by
both the parties involved in the transaction. On the other hand, collateral is
also secured. In case of successful new venture, the return is much bigger for
the investor as compare to already fixed interest in case of debt finance (Usmani,
2002).
Equity Financing
is an easy to access financial solution for almost all small and growing
businesses. Not only profit and losses are divided in a particular ratio before
transactions, but it also creates an equal opportunity to finance everyone
irrespective of their historical performance or credibility in the financial
markets. Apart from this, the only problem of such financing is accumulation of
unearned income.
Supporters
on this subject have presented a critical analysis on the alternative tool i.e.
Islamic Banking which minimise uncertainties for above stated problem. Iqbal
and Molyneux (2005) argued that efficient, stable and GDP motivated values can
be derived from this risky financial statement. One of their followers, Ahmad
El Nagar has further elaborated in Warde (2000) that an equity based Islamic
system can provide an infrastructure where existence of inflation,
unemployment, profit utilization techniques and poverty is not possible.
Earlier, Zaher and Hassan (2001) predicted similar to early Islamic Bank
scholars that it is a risk-taking institution but with lifelong benefits for
investments through partnerships. This helps us to understand that Islamic
Banks serve as a mediator for worthy investments and profit sharing assumption
with extended benefits for all parties involved rather than conventional
methods of collateral and cash-flow financing that saves us from suspected
liquidity and loan recovery issues.
Accounting
Many
interesting issues are revealed when accounting concepts are reviewed under
Islamic perspective (Napier, 2007). Shariah affects the interpretation of the
main accounting impressions, like for instance there exists different aims and
objectives of accounting, in fact under Islamic principles accountability is
viewed in a broader perspective. There are many accounting issues on which
there is still disagreement among the Islamic scholars. There are disagreements
on the usage of historical values and also on the recording being done on cash
or accrual basis. The decisions are made by the scholars on religious ground
but the explanation provided by all of them is inconsistent in explaining the
Islamic principles.
Challenges
Arising from Interpretation of Shariah
The different interpretations
of the Shariah by the Shariah advisory boards lead to vast meanings on
important matters. These varied understandings of the Islamic rules have caused
the inability of benchmarked Islamic financial rules. Most financial firms
depend on their own Shariah boards for interpretation of their products, in
many countries. As a result, varied judgments can be found on what is “Islamic”
(Shanmugam and Zahari, 2009). The five schools of Islamic thought - Shafi’i,
Shia, Hanafi, Hanbali, and Maliki are the main source of varied understandings
of the Shariah. Thus, a Shariah board has a choice to interpret the Islamic law
under any of above mentioned schools of thought in its decision making process.
Ambiguity, disorientation and
doubt are caused amongst intellectuals and customers due to no standard
religious decisions. The in-competencies that come forth from lack of
standardization limit the abilities of the institution. For example, varied
understandings of the Shariah cause the inability of different Islamic banks to
adopt each others’ products as models, causing restrain in the merging of
Islamic finance at international and national levels.
Need
for Harmonization of Islamic Banking Standards
The standards and product
designs in Islamic financial system need much agreement prior to full maturity
of the system. More standardization would mean more efficiencies and services
and without standardization, there is an increased chance of low development of
the shares that their counterparts in conventional banking have. To overcome
this, the formation of Shariah advisory boards and a council, acting as a
single body, that represents all five schools of Islamic thought is suggested
at national and at international levels. The decisions they make about what
services and products adhere to the Islamic law that can be and must be
introduced (Ahmed 2007).
Shariah training and common
regulatory standards for Islamic financial institutions are being made by the
AAOIFI. The AAOIFI indicates that there are 16 and more fields to look into for
benchmarking that accommodate all of the Islamic schools of thought. Individual
intellectuals of same fields may provide with varied interpretations since the
standards of the AAOIFI are not implemented (Shanmugam and Zahari, 2009). There
is a strong suggestion presented by the critics. They state that Islamic
financial system must offer the products that are unique to Islamic banking and
do not resemble to conventional banking products in any sense. In other terms,
there is strong need of innovation in Islamic financial institutions. This
industry is relatively new but attracting many customers hence it is mandatory
that design of the product satisfies the customers.
Risk Management
Risk management is an
important area which helps discriminate between conventional banking and
Islamic banking. There are some risk factors which are general in nature and
belong to both types of banking e.g. market risk, credit risk, liquidity risk
and operational risk. However, there are certain specific risks pertaining to
individual banking sector. Shariah compliance risk and displaced commercial
risk are present only in Islamic banking. There are certain banks which adopt
Internal Ratings-Based (IRB) approach for risk management. This approach is
more advanced in nature and quantitative risk components e.g. exposure at
default (EAD), loss given default (LGD), maturity (M) and probability of
default (PD) are used to derive risk weights. Conventional banks manage their
risk through Base II capital adequacy by using ratings from External Credit
Rating Agencies (Ahmed, 2012).
There
are three categories of risks that are associated with the Islamic financial institutions.
The first category of risk encompasses the risk that is characterized to all
financial institutions and this type of risk can be controlled by applying
conventional risk management mechanism. Like, Islamic financial institutions
use the risk management mechanism by framing structures and authorization
limits for the renewal and approval of credit exposure limits so that the
credit and market risks could be hedged. Second category includes the risks
that are characterized to the Islamic financial institutions and conventional
risk management is of no use. Like Shariah-compliance risk or “risk of loss
arising from products and services not complying with Shariah compliant
requirements or in accordance with Islamic principles” (IBB 2010). Finally, the
third category includes the risks characterized to all types of financing.
These risks are the main focus of this paper and they also cannot be managed
using conventional risk management mechanism, for example; a usual liquidity
risk management mechanism is to go the
interbank markets and in these markets, banks with surplus funds lend
their surplus funds to banks with deficit funds and the profit earned from the
loan is interest. These financial instruments have very short maturity period,
usually overnight. Conventional risk management cannot be applied to the
Islamic system because interest (riba) is forbidden in Islam and Islamic
financing institutions cannot access these conventional interbank markets.
Within Islamic finance, the concept of risk management is a comparatively new
and there is a need for study in this field.
The nature of the risk
determines the weights of risk, though the rule of thumb is to maintain total
capital adequacy ratio above 8%. Islamic banks are different from conventional
banks hence the Base II capital adequacy requirement fits hardly any of them
(Ahmed, 2012). It is a big challenge for all of them to comply with this
requirement in addition to maintaining their operation in Islamic framework.
The balance sheet of Islamic banking is different from that of conventional
banking not only in terms of account volume but also the account heads. Islamic
banks are also required to comply with the requirements of Base II capital
adequacy requirements.
Liquidity Management Risk
Most of
the funds in Islamic institutions are contributed by short-term customers and
these funds generated from short-term sources are utilized to finance the
long-term contracts like infrastructure financing projects and Islamic
mortgages. Islamic financial institutions invest almost all of their funds in
long-term projects. This is a problem because; it results in a maturity
mismatch with Islamic financial institutions having long-term financial assets
versus short–term financial liabilities as shown in the balance sheets. This
leads to margin and liquidity risks (Idris, 2012).
Investment strategies
It is very costly to be in
compliant with the accounting and auditing standards because of the range of
disclosure and monitoring requirements (Wals, 2007). Furthermore, the
development of investment strategies that are in compliance with Shariah is
different from conventional investment strategies. Western banks mostly invest
in an interest-bearing and fixed income securities which are prohibited by
Islamic law. Islamic financing system prefers to use equity over debt unlike
the conventional banking system which prefers to use debt in order to make leverage
for the project to be financed.
The conventional debt system is
replaced with asset-backed debt system under the Islamic financing. For
example, a savings account in compliance with the Shariah will be investing the
money directly in investments instead of earning a fixed interest on it.
Profits can thus be made but are not derived from the money investment alone.
The objective behind such a system is that the money needs to be working for
the profit to be earned. Therefore, the cost, relationship and innovation along
with Islamic scholars are necessary for creation of new models.
Valid Gains on Investment
All gains on investment or
principal of a business are not prohibited. On the basis of the overall
principles indicated by the Shariah, scholars have identified methods of
gaining surplus value through additional resources created by the loans or the
original wealth. Profit is permitted by the Islamic law as a reasonable reward
of capital and surplus resources created by the capital are also allowed. The
ex-post profit, allowed by the Shariah, symbolizes entrepreneurship and the
creation of additional wealth (Ayub, M. 2009: 66). Nevertheless, besides the profit that the
entitlement of the investment, the potential threat of losses should also be
taken by investors since it is unavoidable for the appearance of the loss been
shown on capital. For the permissible and the purpose of earning profit, the
financial transactions should be associated with real assets. In the Islamic
framework, money itself could not be regarded as capital, therefore it is also
not been permitted to earn a profit by money itself (Archer, S. & Ahmed, T,
2003:87).
Balance Sheet and Off-Balance Sheet (OBS) Risks for
Islamic Banks
Islamic
banks are well integrated and do not operate in isolation, therefore, they are
likely to be impacted by the global recessionary trends and changing market
fundamentals. Generally, financial institutions, be they conventional or
Islamic, thrive well as long as they have proper access to both retail and
corporate funding on the liabilities side and they are able to maintain
adequate risk management and diversification on the asset side to preserve
profitability and financial soundness. Managing the balance sheet’s risks,
whether for an Islamic or conventional bank, requires proper recognition of
industry and individual transaction-specific risks, well-developed alternate
avenues of investments and money market instruments. This helps the bank build
an investment portfolio that is diversified across asset classes, geography,
issuers, and currencies, and one that is more liquid than its credit exposures
and more profitable than its interbank liquidity management (Venardos, 2010).
Banks further face underlying market imperfections, typically moral hazard,
asymmetric information, and externalities that become significant with the
rising stress in the real economy and downswings in asset prices. Under this
scenario, banks often become either over-competitive or risk-averse, both with
associated negative consequences. These factors compound when there is panic
and/or growing market illiquidity that may trigger market failures and high
volatility, which tests the resilience of financial markets and institutions.
In a number of ways, Islamic Banks operate on similar lines as conventional
banks in terms of raising cash flow resources and re-cycling them to a range of
investments and assets dominated by credit exposures. In this regard, Islamic
banks face the same risks as conventional banks including credit risks,
maturity and currency risk, solvency risks, market risks, and operational
risks. An Islamic bank, if practiced in letter and spirit, however, has
structural features that nurture the conservative business approaches and
transactions and promote profit sharing (Ayub, 2010).
Supported by a deeper economic
and ideological base and with recognized potential for financial engineering
and innovation, Islamic economic and financial architecture has now achieved
broader appeal and depth that go beyond Muslim countries. The Islamic economic
system offers perspectives on allocation of resources, production and exchange
of goods and services, and distribution of wealth as well as offering ethical
and socially sustainable approaches to development finance. Islamic finance
further recognizes the right to property supported by stakeholders’
obligations, principles, and rules of conduct; a contracting system and
institutional framework; and procedures for enforcement of rules that all
together lay the foundation for Islamic business and financial architecture.
The core of these relationships, backed by solid principles of rights and
obligations of parties to contractual arrangements, offers a rich array of
opportunities for risk diversification. Together these elements help strengthen
Islamic Banks’ resilience and stability to withstand crises. Depending on the
nature and structure of transactions, Islamic Banks do face some different
risks that vary in specifics and substance. It is therefore critical that the
industry determines, recognizes, and addresses all types of risks facing the
industry on a timely basis (AOIFI, 1999). These risks emanate from certain
types of permissible and innovative products and businesses, and from the lack
of supportive regulatory and supervisory infrastructure. Central banks need to
launch aggressive efforts to recognize Islamic financial risks and advocate
appropriate corrective actions and implementation of prudential regulations.
Islamic bank liabilities, when structured along Islamic principles, have a
different risk profile and such risks could be higher than those in
conventional banks depending on how a given product or transaction is structured
(Venardos, 2010).
Chapter 3 – Methodology
Introduction
Because
of the accumulation of sovereign wealth and excess liquidity in oil producing
countries, dominated by Muslim population, with an appetite for alternative
asset classes, Islamic finance has grown uninterruptedly over the last few
years. In addition, the rising demand for Shariah-compliant products and
services, as well as the acceleration of in some Muslim oil generated, economic
and infrastructural development countries using revenue surpluses, the richness
of Muslim ethical framework and the wide range of trade, exchange and business
practices have catalyzed a real breakthrough, and renewed commitment and fervour
in the Islamic Financial industry (Venardos, 2006).
In this
dissertation, through the review of various literatures on the Islamic law, the
Islamic financial instruments especially of Islamic banks, as well as Islamic
financial market, and the financial environment of Islamic will be analyzed.
This research will analyse and identify the pros and cons of Shariah principles
and how they may hinder success of Islamic Banks. This chapter will provide
detailed information about the selected methodology, which is qualitative and
secondary in nature.
In the
literature, the definition of methodology is given in different words and
terms. A scholar considers it as the explanation and description of methods
used in the research and the likely justification of those methods. Researcher
does not include the actual methods in the definition of methodology (Kaplan,
1964). It is also defined as “a theory and analysis of how research should
proceed” (Harding, 1987, p. 2) while methods are the techniques used in data
and evidence collection (Harding, 1987). The analysis leads to creation of body
of knowledge. Yet another definition states that methodology is the analysis of
guidelines related to approach of research. It includes the basic assumption,
rules and processes which are part of a research approach (Schwandt, 2001). On
the other hand, methods are defined as techniques, tools and procedures used in
research (Schwandt, 2001).
Methodology: Justifying Method
Methodology
is a commonly used term in literature; however, it is not used in the precise
meanings. The researchers interpret the term methodology in their own way.
Kaplan (1964) defines it as the systematic study of methods including their
description, analysis, explanation and justification. He does not include the
methods themselves in the methodology. Certain other authors differ from his
views and take into consideration that entire subject such as anthropology, the
target audience such as focus groups etc in the definition of methodology as
well.
Three Approaches To Research
Research
approach can either be qualitative, quantitative or mixed (Creswell, 2009). It
is a combination of strategies, knowledge claims and the overall method. The
three approaches are explained below.
Quantitative
approach is based on numerical analysis. The data used in this analysis is
collected through defined instruments which are calibrated. Usually the
findings from surveys and experiments are used in quantitative analysis.
Knowledge is developed using postpositive claims. The processes related to
observation, data measurement, cause and effect thinking and the test values are
also used in this analysis.
On the
other hand, qualitative approach takes into consideration the constructivist
perspectives to develop knowledge. The analysis is not based on numerical data
but the subjective information that is gathered based on history and social
trends. These trends are analysed to develop theory or body of knowledge. Case
studies, grounded theory studies, ethnographies, phenomenologies and narratives
are included in this domain. Open ended information is used to develop a theme
which is alter on used to develop theory in participatory and advocacy
perspectives.
In the
mixed methods technique, a researchers’ knowledge claims reside on pragmatic
reasons (e.g. pluralistic, consequence-oriented and cantered around the
problem). Such inquiry strategies are used which gather data simultaneously or
in a sequence which helps gain a deeper understanding of the research problem.
Collection of data involves the collection of numeric information and textual
information. This means that the final database contains qualitative and
quantitative information.
Method: Research Action
Research
action is technically known as method. There is a complete set of activities
that make research methods. These activities include data collection, sampling,
data management, analysis and lastly the reporting. Qualitative data is
gathered to serve a purpose rather than using it in the calculations. The
qualitative sample helps acquiring the required information more than
representing the population (Ritchie et al., 2003).
According
to Charmaz (2006), purposive sampling includes theoretical sampling, place or
time-based sampling (Ritchie et al., 2003), and sampling for maximum variation.
The methods used for data collection for qualitative research include
collection of organisational record and relevant documents, observation of
related factors, interviews with concerned persons and focus groups, reading
participant’s diaries, and know-how of organisational images and videos. Data
collection method can go beyond the traditional methods and include emails and
blogs communication as well.
Data
management methods are different form data collection methods. They largely
include data recording for future retrieval and analysis. The common techniques
are transcription generation and its checking. There are certain methods for
data analysis as well. These methods include memo writing, theory building
(Charmaz, 2006), constant comparison, microlinguistic analysis techniques (Gee,
2005) and narrative analysis techniques (Lieblich et al., 1998). It is
important to mention here that all documentation and reporting are included in
analytical process while the person who prepares the documentation reflects his
views and judgment in it (Richardson
Purpose of the Literature Review
There
are a number of reasons to include a literature review in any research study.
First and foremost, it provides the reader with the outcome of various other
researches which are linked to the study in question. In addition to this, the
literature review helps in linking the study to the bigger debates in the topic
literature, adding to previously conducted studies and filling in any gaps in
research (Marshall and Rossman, 1999). Finally, it sets a framework within
which we can describe the significance of the research and also set a benchmark
in order to compare outcomes with the results of other studies.
Some or
all of the above stated reasons could be the goal behind adding scholarly literature
within a research. Other than the matter of ‘why’ we use scholarly research,
there is also the point of how its use can be different in the three available
research methods (Creswell, 2009).
Literature Reviews In Qualitative analysis
For
qualitative research, the researches make use of the scholarly literature in
such a way that they match the stated learning assumptions of a participant and
that they do not prescribe to the questions which have to be answered (keeping
in mind the point of view of the inquirer). The aim of a qualitative research
is to conduct an exploratory research (Creswell, 2009). Within such a research,
there is not a lot of research available on the topic being considered and the
inquirers goal is to find more participants and develop the topic more on the
basis of the information gathered.
Due to
the popularity of adding a literature review to a study, it is important that
we study this area briefly. This section can be shaped in various ways and
there is no particular ‘right’ or ‘preferred’ format for a literature review.
It has been suggested that literature reviews can take an integrative approach,
where the inquirer summarizes the over arching themes of the topic (Creswell,
2009). Dissertation proposals and dissertations make use of this model most
frequently. A theoretical model in which the inquirer gathers existing theory
and information regarding the study problem can be developed. This information
can be gathered from journals and research articles which are then included into
the study introduction. Lastly, in the metrological review, the inquirer
focuses primarily on definition and methods. The study can be summarized and
also critiqued through these review methods. There are many authors who use
such methods in their dissertations and in their ‘reviews of related
literature’ gathered from journal articles.
Ethical issues
Along
with conceptualizing the proposal’s writing process, the inquirer has to also
take into consideration any ethical issues which could arise during the course
of the study. It is important to talk about these problems during the course of
stating an argument in a research study and also for any important discussion
in the proposal (Creswell, 2009). Many ethical problems can come up during talk
regarding professional conduct codes for inquirers and also during any
commentary regarding ethical dilemmas and any probably solutions. Along with
the ethical practice codes, the writer states and discusses the different
ethical dilemmas that the researchers face during the course of their work.
Application of these issues can be found in mixed methods, quantitative and
qualitative research. Furthermore, the writer has to make sure not only to
anticipate any issues but also to specify them within the research plans.
Chapter 4 – Finding and Analysis
Introduction
The literature review explained the Islamic
Banking norms and regulations. The description given to the interest-based or
debt-based financing by Islamic Bank Advocates which is a usual and common way
of financing but in Islamic financing schemes it is expected to deal with
direct financing or equity-participation. Actually this is incorrect as in
Islamic financial transactions Murabaha and Ijara (leasing) operations are
under practice. It can be explained that if an organization wants to upgrade
the present machinery available with the help of an Islamic bank by making an
associated purchase agreement on marked-up prices. The Bank will buy that
machinery and suppose the actual price of purchase is $100,000 and it will sell
the machinery to an organization for $110,000 which is payable in agreed 12
periodical instalments. The machinery will be under bank’s ownership till the
last payment is made as this will make the bank secured in all aspects. But
according to some scholars (e.g. Usmani, 2002, pp. 52–54 and Warde, 2000, p.
133) this procedure is appropriate in the point of view of Shariah as the
purchase is made on real direct financing including the mark-up rate that is
properly calculated according to the time engaged in repaying to bank (Mills
and Presley, 1999, p. 17). The Murabaha is now advisable as bank is completely
secured because of retaining the ownership of the machinery till the last
payment so it faces a risk too; therefore a 10% mark-up is applied on the
behalf of risk.
Business Model
It is required by the Islamic
law that a different strategy be made for business transaction in comparison to
traditional profit-maximizing system (Wals, 2007). In an Islamic business
transaction, the intermediary will buy an item on behalf of the purchaser from
the seller. The purchaser then agrees to pay the intermediary in monthly instalments
for a higher price compared to the bank’s pay price (mark up value). This
mark-up value is same as interest rate.
The vital component of this
business transaction is the possession of the bank of the item for a certain
period of time. Furthermore, if a late fee is collected by bank because of late
payment, the fee needs to be donated. For instance, in US Crescent Capital Investments,
which is a First Islamic subsidiary (Gimbel, 2005), in order to avoid any leverage buy-out, purchased the
assets of Loehmann’s Department Stores and leased them again to the company.
Thus models have been built that are in compliance with Shariah and
conventional laws.
In Islamic banking personal loans are also availed
under Murabaha. This can be explained by an example that Saudi Banks provide
loans on behalf of stock of gold or any other item (United Nations Conference
on Trade and Development, 2006). What they do is they sell the stock; let’s
assume gold for 25,000 riyals to the customer on 12 monthly instalments and the
customers immediately sell that item back to either bank or any dealer in
23,000 riyals. This deal is completely according to the Shariah although an
interest rate of 8.7% is applied on transaction. However, interest is involved
in this trait also but not directly, with some restrictions. This is openly
practiced by Islamic Shari’s banking using this way termed as Hiyal. This is
designed in order to attain the basically dissimilar ways to Shariah (Coulson,
1978). It is insignificant to calculate the rate of interest if the sale,
purchase and time duration is clearly known. However, these matters are just
related to general banking but with some dissimilarity the very traditional
Ulamas follow Ijara, Murabaha and other such non-PLS ways despite of being
considered as nearly non-Islamic.
Murabaha
According to other
Scholars (e.g., El Gamal, 2006; Kuran, 2004) Islamic
banking is a very vast field. One more analyst Coulson (1978) commented that
mostly currently followed Murabaha is considered a latest Islamic version of
previously followed contractum trinius. All over the world Murabaha and Ijara are more commonly known
and used for Islamic financing transactions as Profit and Loss dealings that
constitute only 5% of deals and operations conducted in Islamic banks and other
financial institutions (Warde, 2000), whereas in
appropriate and typical Islamic banking, non-PLS forms are dominantly utilized
that can be exceeded up to 80% (El Hawary et al., 2004).
According to the financing pattern observed among
the 10 largest Islamic Banks of the world in 1994-1996, it was observed that
PLS constituted less than 14% of the total US $8.56 billion of financing, while
Murabaha accounted for 65.66% (Iqbal et al., 1998). Non-commercial and
non-profit making multilateral development agencies also follow this financing
pattern. It was revealed by the asset portfolio analysis of Islamic Development
Bank for 1976-2004, that non-PLS financial transactions were approximately 91%
(Islamic Development Bank, 2004). This however changed in 2006-2007, due to the
fact that the 11.3% of its current portfolio was direct equity participation.
However, non-PLS sources provided 92% of the income (Islamic Development Bank,
2007).
Commodity Placements
Islamic banks lack many Shariah-complaint
short-term investment opportunities which are well enjoyed by conventional
banks such as commercial paper, Treasury Bills, or overnight-interbank market),
which cater them in investing the excess funds in short term projects. Islamic
banks are prone to “excess liquidity” problem (Ahmed, 2011), due to which they
need to lend out their surplus funds to other Islamic Development Banks, or
conventional financial institutions for providing funds to traders or utilizing
them for their own purposes which is referred as “Commodity placements” or
‘Commodity Murabaha’.
About 94% placement of Islamic Development Banks’
were mostly with non-Islamic Banks in the year 2004, in which the borrowing
bank guaranteed principal and minimum return as well. Approximately 31% of the
bank’s operational assets attributed to these ‘placements’ (Islamic Development
Bank, 2007). The usage of these funds is
restricted to Shariah-complaint purposes such as financing trade in Islamically
permissible commodities. However, there isn’t any check on the utilization of
these funds, as the borrower only assures that those funds wouldn’t be used for
any non-Islamic purposes. If non-Islamic Banks succeed in finding more Shariah-complaint
investment opportunities as compared to the Islamic ones, then it would become
more beneficial. Al Nasser (2008) declared that although Shariah authorities
demonstrate immense confidence in the dealings with parties in the industry,
yet financial audits which are also referred as independent external financial
audits are essential for verifying that Islamic Bank institutions are
delivering the customers with what they have committed in accordance with the
principles of Islamic laws. The audits aim to ensure transparency and guarantee
that religion is not being exploited for financial gain and Islamic Banks
adhere to the regulations as well. In external Shariah audits, auditors usually
complain that they are unable to discuss and witness violations as the records
are usually tampered (Al Nasser, 2008). This view is also seconded by Zaman
(2008), and he believes that Islamic Banks try to show themselves to be
profitable through this strategy.
Auditing
Another important
challenge faced by Islamic financial institutions is related to the function of
auditing. Audit adds authenticity to the operations of banks in terms of
compliance with general principles and ethical standards of transparency (Malik
et al., 2011). It is a challenge for Islamic financial institutions as audit
practices are to be developed under the teachings of Islamic Shariah and this
subject is not well developed as yet (SunGard, 2009). This confusion in the
proper procedure of Islamic financial audit creates much difficulty in
compliance with the regulation of yearly audit. The standards of AAOIFI also
require a yearly audit. The banks cannot skip this practice so are trying to
streamline this process. No specific success has been achieved in this field as
yet.
Current reliance on
non-participatory finance
Islamic banks are still dominated by
interest-based financing; however such financing is not explicitly defined as
interest-based finance. Moreover, the non-Muslims do not deal with such
business now. Another stark difference between actual scenario and Islamic
banking theory was presented by El Hawary et al. (2004) according to which none
of the Islamic banks; translate the bad debts into ‘losses’ for depositors.
This implies that since no preset interest rate is allowed, which implies no
accepting of PLS based deposits and none of the Islamic banks have written the
value of its depositor’s account, once the value of non-performing assets have
been written down. Despite the financial difficulties, Islamic banks have
declared returns to the depositors which are comparable to that prevalent rate
in the market, in order to lose faith in Islamic Banking and avoid outflow of
deposits. Islamic Bank deposits are guaranteed by many central banks which do
not adhere to the Islamic risk sharing principles. This was depicted in 1998,
when a massive embezzlement scandal was made on Dubai Islamic Bank which
resulted in the withdrawal of US $138 million. This comprises of 7% of the
total deposits in a day. The bank would have collapsed due to the massive
withdrawal. However, Dubai Islamic bank stepped in as the “lender of last
resort” and guaranteed all the deposits in an effective way (Warde, 2000).
According to the head of Bahrain based Accounting and Auditing Organization
of Islamic Financial Institutions
(AAOIFI), which is one of the body entrusted with the task of setting up
standards for Islamic Bank institutions, the banking system would collapse wholly,
if the banks share losses right and left (Wigglesworth, 2009).
Theoretically, Fractional reserve system allows a bank to issue loan stacks
that are equal to the reserve requirement. For instance, on a deposit of $100,
with a reserve requirement of 10 percent, a loan less than or equal to $90 can
be issued. The remaining $10 of $100 is used to compensate the day to day
transactions. However, the loan of complete $90 that is deposited with another
bank will also make the 10 percent reserve requirement and is capable of
issuing new loans of $81. Unless the original investment of $100 becomes
equivalent to the amount of $1000, this procedure carries on. The fractional
reserve banking system’s guiding philosophy, under normal working conditions is
that a small part of the bank’s savings will be in use for compensation and
deliverance of their customers. If a bank is not able to meet low reserve
requirement even by taking funds from money markets, selling assets or drawing
lines of credit, the central bank becomes the supplier and a saviour. Shariah
does not accommodate fractional reserve banking because it is based on interest
that is made and charged on the loans taken. In Islamic banking, interest is
firmly banned in all aspects (Shanmugam and Zahari, 2009).
Information asymmetry,
moral hazard and adverse selection
The conventional economics
has a long-established consensus in finding the best possible way for resolving
the equity finance versus debt finance question considering the presence of
costly state verification and non-trivial information symmetry. The standard debt contract is at a superior
level in comparison to equity financing. Due to this reason Islamic bankers
usually prefer non-PLS financing for the problems occurring due to information
symmetry in all financial transactions. There lies a dire risk of two types of
problems occurring due to information symmetry (Khan, 2010).
Misuse
of invested funds/loans/and underutilization is the ex post moral hazard
problem. The adverse selection of investments/loans/ in a risk of poor credit
is the problem ex ante. The information flow is improved by the institute like
credit rating bureaus; it reduces the adverse selection likelihood. While
criminal, civil and socially sanctions possibly reduce the danger of moral
hazard. Naturally at the degree of adverse selection resulting and problems of
moral hazards, the beginning information flow, and all such things depend on
the quality and amount of the information flow between borrower, investor, or
lender. However, to minimize their risk of issues of information asymmetry,
while institutions are not available the bank prefers the collateralized
debt-finance as a financing mode.
Warde (2000) in his extended
list of “Islamic Moral Hazards” problems confirm this serious issue and
discuses them in detail. Jalali-Naini (2000) reports “worldwide tax evasion
both in informal and formal sectors” of North African (i.e. Arab) and Middle East countries. According to E1 Hawary et al.
(2004), given relatively poor quantity and quality of flows of financial
information and having substantial operations of Islamic Bank in most
countries, resulting information problems asymmetry would make the contract
secured standard debt by exceptional collateral more preferable and
participation of equity is even less desirable. Kemal (2007), for instance,
estimated the tax evasions incidence 2005 in Pakistan
According to
Transparency International (2006), a ranking presented by Transparency International’s
Corruption Perception Index
highlighted the corrupted Muslim countries. The result showed the top Muslim
country of the ranking to be the 31st least corrupt one. Moreover,
the large numbers of other Muslim countries were among the more corrupted ones.
This results in lack of
availability of authentic financial information to Islamic Bank institutions of
the Muslim countries. It resulted in critical moral hazards and biased
selection criteria. Hence, creditors make use of collateralized and conventional
debt contracts for making justified participation in such affected companies.
The working of Islamic
financial institutions is primarily dependent upon the proper supervision and
if good supervision is lacking, it can have negative consequences and undermine
the productivity of these institutions. Islamic financial institutions are in
the dire need of good supervision and support at present (Al Hokm Al Rasheed ).
Good supervision and governance has major role in the survival of Islamic
institutions (Rifaat, 2006). The development and establishment of banking
instruments in conjunction with the principles and rules of Shariah is
cumbersome and complex process and a committee of skilled personnel to handle
this whole process must also be formed. The progress of big Islamic financial
institutions in establishing committees for development of Islamic instruments
is fast paced and advanced. Proper resources play a vital role in proliferation
of Islamic banking system (Al Aloush, 2005; Al Muzaini, 2005) and big Islamic
financial institutions have all proper resources, capabilities, skills and
expertise available that are required to fulfil the goal of development of the
Islamic financial institutions.
Avoiding true equity
participation
There are various
types of PLS financing, one of which is “mudaraba”. In this, one partner provides capital and other
managerial skills. Another type is Musharaka financing. It is supposed to let the financier to have a
direct equity stake but somehow it is not a pure PLS financing system. It is
mostly shown that the involvement of direct equity stake taken by an Islamic
Bank is not actually practically done so.
In respect to ownership of
home, similar tactics are used because of the prohibition of using traditional
interest-based mortgages. Previously two options were available to a Muslim for
home ownership: either buy the house completely or rent it perpetually. A new
system has come to surface with lease-to-own method in which a buyer pays instalments
monthly of the principal home amount plus the rest to any institution that
purchased the house on behalf of the owner (Wals, 2007). However, the amount of
rent is based on interest rate prevailing in the market. Equity is built by
these instalments in a home and the interest of ownership is accumulated to the
renter.
As
an example, “declining Musharaka”
is a mean of building an Islamic
residential mortgage. It involves following steps:
ü
The
house is purchased, with or without a down payment, by the financier on behalf
of the ultimate owner.
ü
The
financier rents the house to the final owner.
ü
The
monthly rent has two parts (El Gamal, 2000):
·
Rental:
it provides house’s share to the financier.
·
Buyout:
it provides money for the house’s purchase.
ü
The
contract is finished till the financier portion of the house is purchased on
the whole.
Principally
speaking, the rent of the property should be fixed in comparison to the nearby
holdings rates; however, it contradicts the practices. It is commonly found
that rental income is based on prevailing mortgage interest rate rather than
rents in that area (e.g., see Islamic Bank of Britain
Chapter 5 – Conclusion and Recommendations
Introduction
With great support of the Gulf States
Business model
A
sadist system is formed as a result of the activities going on in financial
sector. Many people, who tend to follow the religion, also tend to avoid the
debt but in many situations, this practice becomes improbable. This factor is
positively used as a marketing technique by many banks yet people avoid dealing
with them. In the same connection, they tend to look for the scholars who can
certify their products as Shariah complaint. Traditional scholars strongly
oppose Islamic Bank as an Islamic practice. They also oppose AAOIFI, which is
the standards-setting body in the financial industry. The scholars strongly
condemn many of the products offered by it.
The
old practices of Islamic Bank are not in harmony with El Hawary et al.’s (2004)
fourfold taxonomy of Islamic Banks. It is narrated that Islamic Bank is simply
the reflection of conventional banking while the terms are changed so that the
new Arabic terms introduced in the banking may appear lucrative to the customers
who have religious mindset. This technique is also confirmed by Ahmad’s (1993)
and Yousef’s (2004) (and other Islamic Bank advocates’) as well.
There is still a debate
over whether Islamic banking is Islamic in its real essence or it’s just a
change of name, the instrument are really designed in accordance with the
Islamic legal and ethical system and how much they differ with the conventional
banks’ instruments (Al-Salem, 2009). Although Islamic finance and banking has
proliferated, many developments have taken place during the past decade.
Islamic banking is in great demand but still there are several hurdles that
need to be overcome for further growth of this sector. Application of the
Islamic Shariah in the banking system is the key to achieve the goal complete
Islamic system that can benefit both the customers and the financial
institutions simultaneously. Transition process from conventional to Islamic
system is still underway, many of the financial problems can be solved in the
guidance of Shariah by first understanding the financial problem and then
devising the proper solution to the funding (Boodai, 2006; George, 2005). Many
people are of the view that Islamic instruments are not totally Islamic and
following the tenets of Islam in this area can result in huge profits to the
institutions. Islamization of banking system has bright future prospects. But
we need to work on the Islamization of the instruments as well (Al Aloush,
2005).
It is noted by many scholars
that offering truly Islamic products is not possible for any conventional
banking system because the charters and agreements of the conventional bank are
not in accordance with the Shariah (Wals, 2007). Therefore, it can be assumed
that the funds drawn from such banks are not based on Shariah. This is because,
if the basic bank charter is not in compliance with the Shariah, then any
branch, fund, product or window cannot be considered in accordance with
Shariah. Still it is voiced by many scholars that the other services if offered
by institution are not in accordance with Islam are still acceptable. Such
scholars argue that the compliance is sufficiently met if the funds are
segregated such as Shariah supervisory board, a commitment to the concepts of
Islam prevails and auditing standards of Islam are adhered to. Furthermore,
co-mingled funds that contain non-compliant and compliant funds can be purified
and be used for Shariah acceptable investments. This is because the Islamic
financial system cannot isolate itself from the world financial system.
Accommodation of the methods
and risk management in Islamic monetary centres are handicapped due to the
conflicts in the understanding of each financial institution by the Shariah
supervisory boards and also, due to the absence of one, central Islamic
financial regulatory association. Very few Shariah intellectuals are seen who
also possess in-depth knowledge of monetary matters so they may guide others
with the delinquency that resides in Islamic banking. Thus, the number of
people skilled in Shariah and finance has to be raised (Khir et al., 2007).
Management
Islamic financial
institutions are still facing many organizational difficulties that are barring
the standardization of various products and processes; although governments of
many Islamic counties are supportive in this respect as they have passed
various laws and regulations pertaining to this sector of the economy. Islam is
not governed by a monolithic theology
and there are four main centres of Islamic laws providing judgement on
what is right and what is not in Islamic finance and they have different point
of views regarding what comes under the umbrella of interest “riba” (that is
not allowed) and what can be classified as profit (that is allowed. This
difference of opinion leads to confusion and disruption in the system and also
damages the infrastructure of a project finance transaction (De Belder and
Ruder, 1999; Martin, 1997; Yasseen, 2005). Societal values in different
societies are different as a result of which it is necessary to establish a
uniform Shariah criteria governed by selected group of scholars so that Islamic
banks can achieve their goal.
Moreover, the biggest
confusion prevailing in the modern financial system is the lack of consensus in
guidelines and interpretations used in the development of this very sector.
There is no authority that is considered superior to all organisations for Shariah
verdicts. This weakness leads to the practice that each bank has its own board
which is held by Shariah scholars and their practices are confined to that very
bank and its products only. These scholars are required to have knowledge of
both finance and Shariah. Since such scholars are limited in number, they are
often over occupied with their duties pertaining to Shariah board. This defect
leads to incomplete processing of many cases of banks and their products.
There is a term known as
fatwa shopping. It is a process of obtaining fatwa from Islamic scholars to
declare their products as Shariah complaint. Bank assumes that the particular
scholars can possibly give them fatwa on the basis of their inclination towards
a bank or some other purposes. This process is known as fatwa shopping (Wilson
Fatwa shopping is creating
much confusion in the Islamic financial institutions as there are many scholars
and each one has his own fatwa. These fatwas may not match with each other and
create more complexities. There is variety of products offered by Islamic
financial institutions and these products are inconsistent with each other.
When the different fatwas are applied to these variety of products, the users
get confused (Lawai, 1994). This confusion is drastic in a sense that it does
not only deviate the people from Islamic financial products but also make them
lose faith and belief in the Islamic financial system. People do not understand
the specific principles lying behind these products and tend to get information
from the bankers who present information in a manner that is convincing for
their product only. The say of multiple marketers confuse the clients and the
net result is massive confusion in this regard.
Lack of properly trained Shariah
scholars indicates that, in countries where it is permissible, the individuals
work for several Shariah supervisory boards of companies, simultaneously. The
effectiveness of the board’s ability in challenging the company’s product and
services, whenever deemed necessary is questioned due to one member of the
board being engaged elsewhere. Another problem is the clash of interests when
both annual Shariah audit and the sanction of goods for Shariah agreement are
to be done by the Shariah advisory board of the company. Efforts have been made
to find the possible solution for this matter however, at a very small scale.
Misinformation and
adverse selection
It was previously shown
as predicted by Kuran (1993) that Islamic Banks would transform to conventional
ones due to moral hazards and adverse selection issues. These issues have
crossed the boundaries beyond the Muslim or Third World
countries. According to Mishkin, 2007), these issues are also prominent in even
today’s modernized financial structures including credit rating systems and
wide-ranged financial markets. Due to these problems, such modernized financial
infrastructures have debt-based transactions instead of justified ones.
There
are some other perspectives in addition to asymmetric information flow.
According to El Gamal (2006), for an Islamic product to be approved by both
Islamic and non-Islamic countries’ regulators, it should be identical in
functionalities to the conventional products. A fraud has been found in banking
transactions which are presented as purely Islamic ones, but actually they are
based on conventional ways. According to Iqbal and Molyneux (2005), the sixth
largest Islamic Bank of the world i.e. Faisal Islamic Bank of Egypt
In countries having common and
civil law, the phenomenon of Islamic banking has experienced growth because of
two reasons. The first reason is that it is considered a lucrative sector by
investors (McKenzie, 2008). It offers a viable growth source with high positive
reputation for being controlled by a responsible management. Secondly, the
increased demand fuelling the growth of Islamic financial products is
stimulated by the increasing Muslim numbers in the civil and common law
countries worldwide (Soraya and Omar, 2010).
It is
mandatory that national laws are aligned with Shariah laws implemented in the
country (Wilson Malaysia
It is this growth of the
Islamic finance worldwide that will cause the international financial system to
develop an understanding of the Shariah based transactions in business. Judges
who do not have experience in passing judgment under the Islamic law are
required to compare the case before them to the Islamic financial systems’
practice so that an accurate judgment can be delivered for the commercial
purpose (Colon
Final Words
In
order to achieve the Shariah compliant goals, it is important for Islamic banks
to develop products that meet the society’s economic needs. Islamic finance has
been criticized by many saying that there is no real difference between the
conventional economics and Islamic economics and if any contrast does exist is
it fabricated which cannot be substantiated in any manner (Hafeth, 2006; Al
Yasseen, 2007). Given this, the result was that the majority of the customers
believed that Islamic products are same as conventional products and therefore
separation of Islamic banking operations from non-Islamic will be unrealistic. The widespread use of a few unreal Sukuk
products, securitization (tawreeq) and the fabricated Murabaha deals as Islamic
finance products is commonly seen by different financial institutions. The main
reason that such practices prevail in the financial system is because of the
manner of conventional banks or rabawiyya banks offering the Islamic products
without any difference between the conventional financial operations and
Islamic operations on which the control systems are applied (Hafeth, 2006).
It is not easy to follow the
Shariah compliant laws as circumventing the rules of Islam. Even though the
market opportunity is huge for the banks to offer the Muslim community a
diverse investment opportunity in comparison to conventional banking, it is a
difficult undertaking to be compliant with Shariah. Islamic world is rich in
resources but Muslims are hesitant to invest in conventional banking system. It
is the reason, Islamic Bank who portrayed the practices of Islamic banking gain
much fame in the past two decades. It has been more than three decades that
Islamic Bank is charging its investors higher than the rates of conventional
banking yet the procedures are still doubtful.
Islamic financial
institutions still need to figure out the problem of risk of rate of return as
their balance sheets are facing this risk. Various tools that are in accordance
with the Shariah are available to mitigate the risk of rate of return but some
of these tools are under observation so that they can match the international
standards of risk management (Arbuna, 2006).The sale of debt in which no
interest is involved is allowed otherwise, one of the main principle of Islamic
banking and finance is the restriction on sell of investment guarantees and
debt.
New ideas, products and innovative
processes and continuous development are required in the Islamic finance and
banking industry so that Islamic financial institutions can progress further
and remain competitive in the industry. The competition in the Islamic banking
and finance industry is getting tougher everyday like in any other industry and
effective management of financial industry is essential for the future growth
and sustainability of this industry. Developments of new products and processes
are required to further strengthen this industry.
References
AAOIFI.
(1999) Statement on The Purpose and Calculation of The Capital Adequacy Ratio
for Islamic Banks, The Accounting and Auditing Organization for Islamic
Financial Institutions.
Ahmad, A. (1993)
Contemporary practices of Islamic financing techniques. Islamic Development
Bank, Islamic Research and Training Institute Research Paper #20, [online]
available at <http://www.irtipms.org/PubDetE.asp?pub=25> [accessed 15
June, 2012].
Ahmad A., Rehman K., & Saif M.I. (2010) Islamic Banking
Experinec of Pakistan
Ahmed, O.B. (2001)
Islamic financial instruments to manage short-term excess liquidity. Islamic
Development Bank, Islamic Research and Training Institute Research Paper #41,
2nd ed., , [online] available at
<http://www.irtipms.org/PubDetE.asp?pub=43> [accessed 14 June, 2012]
Ahmed, M, H. (2012) Risk Management in Islamic Banks, MPRA.
Al Alaywi, R. (2006), “Islamic banking products”, Al
Qabas Newspaper, September 1.
Al Aloush, M. (2005), Interview, Al Qabas
Newspaper, 10 April.
Al-Marzouqi, I, A. (2001) Human Rights in Islamic Law, Volume
10, pp. 30-33.
Al Muzaini, Y. (2005), Statement, Al Qabas
Newspaper, April 17.
Al Nasser, L.
(2008) Islamic banking and external auditing. February 16. Ashraq Alawast
(English ed.). http://aawsat.com/english/news.asp?section=6&id=11799>
[accessed 14 June, 2012].
What does Shariah Fixed Income mean?
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