Islamic Banking and Finance: A Review
So far as the future is concerned, Islamic banks based on participatory finance have much scope to expand in Muslim countries especially in areas of micro credit and finance based on profit-and-loss sharing (PLS) system, writes KASHIF HASAN KHAN.
Islamic banking that is also known by various terms such as interest-free banking, non-interest-banking, ethical banking and participation banking. This christening and rechristening, is given according to the convenience of the bankers and taking consumers in view.
Today, Islamic banking is grappling with innumerable challenges that have led to stand it at cross roads. There are a numbers of issues related to their operations, modes of financing, transparency and risk management, role of oil wealth and even the non-consensus among Ulema on the issues related to financing and investments in the global financial market dominated by the interest-based monetary system. For instance, there are differences of opinion among the scholars of Arab world and Asian regarding the interpretation and practices of Islamic banking and finance in secular environment and practices as well for instance during conducting survey on risk management in Islamic banking author asked ten customers of a now defunct Islamic bank in Bahrain why they had deposited their money with that bank. Eight of them said they had done so because it was Islamic. All of them said they were disappointed with the services and treatment they got from the bank.
This paper basically draws attention towards the arguments build by experts of those who are against the motion and in favor of the motion. It is perhaps rightly pointed out that “raising hope is a desperate situation that can take you along part of the way but not all the way.”
“What could sustain Islamic banking and finance till now can hardly be expected to guarantee its continued progress in future,” said by the prominent Indian scholar of the first generation of modern Islamic economists, M. N. Siddiqi. And also highlights the sensitive issues that are again pointing out the existence of Islamic banking under the competitive environments where the profit and loss sharing modes (Mudharaba and Musharaka) are much on the stake.
In this regard, there are some questions that need to be answered such as; can Islamic banks play any role to resist the financial booms? How experts are looking at its viability in prevailing global financial market? Who are responsible for it Islamic banking or people who are running Islamic banks? What is the future of Islamic banking? etc. This paper aims to focus on these and similar issues.
One can also find that these issues have created much gap between the theory and practice of Islamic banking in modern times, but at the same time, scholars are paying greater attention towards the solution than ever before. This is simply because, Islamic financial industry is getting serious attentions from the global finance professionals partly because of its inherent quality of stable and also due to the massive oil revenues of the Arab Gulf region has attracted the global investors.
DEBATES ON THE VIABILITY ISLAMIC BANKING
It would be not fair if someone starts claiming that all Muslims are fully satisfied with the activities and performance of the existing Islamic banks. Barring the small minority who expresses dissatisfaction either on the ground they are not Islamic enough or because they are inefficient as compare to their conventional counterpart.
The current world is having enough swing to attract the countries’ attention to introduce Islamic Banking. Because of its growth recorded which stands at 15-20% per annum. During the second half of 2009, the total assets of top 25 Islamic financial institutions in Gulf countries stood at $218 billion. But hardly a single Islamic bank has been included in the world list of top 50 commercial banks, and the rates at which Islamic banking is achieving success confront threats at equal rates which are of worth consideration. And there are a myriad of threats that Islamic banking is coping with.
The Islamic banking system is a relatively young concept and the scholars can be divided into three main camps. The first consist of Muslim scholars like Chapra, Siddiqui or Ahmed who support the concept of Islamic banking and are concerned mainly with the theoretical and ideological aspect, but lack an analytical research. The second group engaged mainly to analyse Islamic banking from a theoretical point of view like Mirakhor, Khan or El-Ashker. The third group which came after the operations of Islamic banking and started to look at it critically: this group comprises western scholars like Wilson, Nienhaus, Kuran and Kazarian, although this topic was largely neglected by Western Scholars for many years.
Islamic bankers claim that its goals are to make profit, but also to keep the laws of Shari’ah. Islamic financial industry has been rightly criticized for not doing much about the goal of social justice, which is so high on all Islamic agendas. Keeping the current practices of Islamic banking in view, it can be classified into three modes: those who adhere to Shari’ah and are less preoccupied with making profit, those who ignore Shari’ah completely, and those who have the supervisory board but do not apply Islamic laws in actual banking practice. Now the question that needs to be answered to rescue the Islamic Identity is that, How to remain Islamic and competitive?
To remain Islamic and also competitive seems a paradox, because, evidences indicate that most of the financing provided by Islamic Banks do not conform to the principle of profit-and-loss sharing, instead much of the financing provided by Islamic banks takes the form of debt like instrument and the fear is that this kind of financing may open a “back door” to interest. According to Siddiqui the use of Tawarruq must be of limited use, but it is not there in practical grounds, while conducting survey on Islamic banks in Turkey, author questioned one of the employees of Kuwait-Turkish bank in Istanbul about Tawarruq that has been declared haram but it was still a major share in the earnings of the bank, employee accepted but was afraid of losing customers.
Over the past couple of years, Islamic bankers have been arguing that the banks determine their profit margin by checking the interest rates prevailing in the market. For example: use of LIBOR, SAIBOR and KIBOR (benchmarks), this is driven by market considerations and not by Shari’ah. It is hardly surprising that customers are bitterly “deviations” from Islamic banks “religious objectives.” Or according to Dr Anwar, it is like Rooh-Afza available in a beer shop! Interest-free banking is meant to replace interest-based banking. The idea of interest-free window in conventional banks is ridiculous. Sitting on the lap of what one is supposed to replace is simply a defeatist approach. It is like becoming a counter of what one had to encounter.
Analyzing the concept of Islamic banking, Prof Mahmoud El-Gamal named as first Islamic Scholar from Rice University, America says, “Islamic mortgage companies like to use cheap tricks to attract customers and entice the believers to pay more or less all that these companies sell to their customers is holy water sprinkled over real”, and Kuwaiti Banker Ahmad Alsarraf maintains that “dealing with conventional banks is less costly than Islamic banks. Commercial banks know their way around, while Islamic banks have yet to find their bearings”. According to prof El-Gamal, Islamic Banks have crossed their limits.
DIFFERENCES OF OPINIONS
Presently there are two groups that can be divided on the basis of their perceptions in regard to the objectives of Islamic banking, the one that is against the motion whereas the second one is in favor of the motion. The first one argues that if objective is to abolish interest, the entire banking system will have to be scrapped altogether. In other words, if the foundation of the banking superstructure, namely the norm of interest has to be eliminated, the entire superstructure would have to be dismantled. This became a kind of a debate on Islamic finance that a faith-based system of ethical finance, is growing while it continues to struggle for its identity; it is torn between the market success of emulating conventional structures and developing genuinely Islamic structures that reflects its spiritual ethos.
The second group which is against the motion is generally claims that Islamic banks play roles similar to conventional banks; fundamental differences exist between the two modes. The main difference between is that the former operate in accordance with rules of Shari’ah, the legal code of Islam. The central concept of Islamic banking and finance is justice which is achieved mainly through the sharing of risk. Whereas, some scholars claim that there are no practical differences between Islamic banking and conventional banking, just the labels are different. Moreover, some argue that these Islamic banks are just normal business who wishes to make transactions in the halal way without resorting to unity. They are not institution of social welfare. They are an alternative to the western system of interest based banking.
Some don’t believe that Islam is only about helping the poor, but that Islam is also about making profit but in lawful ways. Some of the scholars have yet to recognize the monster for what it is. They are trying to convince that banking system is a necessary part of economic activity because the deaths of millions of children in Africa every year with the burden of debt repayment to the bank. We need a payment transmission system, a safekeeping service and investment advisory services. And also Islamic banking is Islamic because it complies with the ruling of Islam.
When they think of the word “Islamic” they are thinking of charity, kindness, and love forgiveness. An Islamic bank sounds like a bank that will not take any interest from you (i.e. not put a burden on you) but instead the Islamic bank does put a burden on you and renames it to profit. In fact, the Islamic and non-Islamic cases would be exactly the same, but for a difference in how they handle business risks.
In the Islamic bank, the cost of credit will be higher due to an additional element of risk to the banks. Loans from Islamic banks will be more expensive, but they will be more somewhat safer due to incorporated insurance, and the margin thus allowed for income fluctuation. Though this represents a “real” difference between Islamic and non Islamic banks at last, even this does not change the underlying credit market and interest rate. All that has happened is that Islamic banks are dealing with business risks by selling kind of loan insurance.
ISSUES IN MODES OF FINANCING
In the early years of modern Islamic finance, murabaha and other mark up of transactions were regarded as temporary modes of finance, used for reasons of ease and convenience when mudaraba and musharakah were not possible, and generating income while banks devised authentic risk-sharing instruments but today it constitutes the bulk of activity of most Islamic banks.
Shari’ah issues related to Islamic finance are still controversial in nature, as there is no similarity of opinions among the scholars and jurists on the issues like Tawarruq, Murabaha, Sukuk, etc. While observing the functioning of various Islamic banks in different countries, it appears that same investment products are explained differently mainly because of either the Maslak of the jurist or socio economic conditions of those particular countries. In this respect it can also be seen that, what the jurists of Arab world consider most appropriate to Shari’ah guidelines is found to be different in interpretation and practice in the south East Asian region Malaysia and Indonesia. also, when we come to a secular environment, say, for example, in case of India, we find that here the approach is somewhat related to the very typical nature of the Indian understanding of Islamic finance for the Muslims in the country who are governed under the secular laws.
Nevertheless, since expertise in these matters is still relatively scarce in some countries, different Islamic banks often share the same scholars. There is issue of different interpretation of existing Shari’ah rulings. The existence of various sects in Islam and the fact that each sect has its own authority or body, which provides guidance and interpretations on Shari’ah issues, makes the things complicated.
In the balance sheet of any Islamic bank one can see the share of Mudarabah and Musharakah is very less whereas the other modes of finance which are debt-based have got a big share. The reasons for using short term financing methods the author realized that more use of debt based instrument and lesser use of equity based instruments patronage that, in order to compete the conventional financial system it seems that Islamic banking has crossed the limits but experts must accept that this industry’s objective is not to compete financial system but to abstain from interest with sustainable earning. The industry’s objective is not to give setback to conventional banking rather to be harbinger of holistic development and provide improvement for the community.
Sheikh Taqi Usmani a leading Shari’ah scholars and chairman of the AAOIFI (Accounting and Auditing Organization of Islamic financial Institution) board of Shari’ah said that 80% of sukuk are not Shari’ah compliant. According to him it violates the principle of risk and profit sharing on which it should be based, as a result, the AAOIFI brought together its board of Shari’ah scholars to clarify the issues raised by him and to form a consensus among Shari’ah scholars and published a six point paper in 2008 outlining their position on sukuk, which included a ruling that purchase undertaking at face value for Musharaka and Mudarabahsukuk structures are no longer permissible.Fiqh Academy of Jeddah is also in favor of the six point paper by AAOIFI.
FINANCIAL CRISIS AND ISLAMIC FINANCE
The credit crunch has also highlighted the fragility of Capitalism and the free market economy. As their fallout from the credit crunch and wider economic crisis continues demands for alternatives and certain to grow. The model financial economy differs from Islamic economics in many critical aspects of which the nature of money is one, whilst both system accept, money to be a store of value and a medium of exchange, financial market based economic system permits money to be treated like any other commodity which can be traded for profit and interest. Therefore, Muslims throughout the globe are coming up with the notion of Islamic banking but as mentioned above it is very unambiguous to say that this banking system could be a better alternate. Like other financial institutions, Islamic institutions are subject to cycles of booms and bust, and despite their inherent conservatism, they are not immune to bubbles. It is true that Islamic banking and finance emerged relatively unscratched from the first stage of 2007-2008 financial crisis namely the sub-prime phases and credit default swaps debacles but as soon as the effects of the crisis went beyond the financial sector, being primarily asset based, was negatively affected by the ensuring recession. Chapra (2008) faulted the crisis to inadequate market discipline resulting from lack of using profit and loss sharing modes of financing, expansion of the size of the derivatives, and the policy of “too big to fail”. He calls for a “new architecture” to prevent occurrence of similar crisis. Siddiqui (2008) identifies the root cause of crisis as “a moral failure that leads to exploitation and corruption.
It is also being discussed among experts of the subject that most of the products offered by conventional financial institutions have some Islamic counterpart importantly different. Consider the case of Sukuk or Islamic bonds from an investor point of view both are similar.Since one of main causes of recent crisis is interest whereas Islamic banking is free from interest that can give a sigh of relief to the bankers. Islamic finance industry in its infancy, and although it is trying its best to implement these principles, it has a long way to go before it can fully implement the principle business and finance espoused in the Quran and Sunnah. However, to the extent that the Islamic finance industry continues to strictly adhere to Quranic principles and prophetic examples, it can help provide solution to the crisis. 
But to what extent that would be successful in resisting financial booms, is indeed very tough to predict. Professor Khurshid Ahmed says, we are all concerned that systematic and sustained movement in that direction (equity-based economy) is yet to be made. It would be tragedy if the Islamic movement does not move in that direction. But it would be less than generous to condemn the whole effort and regard it as an exercise in legitimization of the interest banking model. Further, banking is only one part of an economy: public finance also has to follow a just and equitable system for getting the real benefit.
There is another issues due to which Islamic banking at cross roads “oil” The oil revenues, which began to flow into Saudi Arabia, Kuwait, The UAE, Qatar and Bahrain was an important determinant in the development of Islamic Banks. The years between 2002 and 2008 saw an unprecedented boom in project finance in the Middle East, fueled primarily by oil boom. In those years the GCC the economic bloc made up of Bahrain, Kuwait, SA, UAE emerged as the world’s biggest project finance market.
Undoubtedly, oil revenues of the Gulf States have played a very vital role in the expansion of Islamic finance business and since the mid 1970s whatever practical or theoretical developments have taken place in particular areas, can be attributed to the surplus money in the hands of both the government and state or private enterprises. Interestingly, the major share of Islamic banking is still in the hands of private sector. However, does not mean that once the oil revenue will be finished there will be no Islamic finance business. Even some countries such as Bangladesh or many African countries are successfully experimenting Islamic banking where no oil revenue is any major factor behind it.
As the contemporary developments in Islamic banking and finance has seen some thirty to forty years and theoretical and practical aspects have been much focus, it seems that the proponents of the system as well as the critics are still not certain of its future in the coming decades. We have discussed in this paper that the supporters of Islamic banking, though acknowledge that a good deal of progress have been made but they are still not sure whether this interest free system can carry on the Islamic objectives of equity and justice, fair distribution and allocation of resources in comparison to the interest based conventional system, which has gone through a worst phase of uncertainty and instability among the depositors and investors. While going through the practical phase of Islamic banking there is no doubt that a large number of investors are showing inclination towards it, but the question remains – whether this acceptance is due to the inherent philosophies of Islamic banking? For, Islamic banks are still like carbon copy of conventional banking system in whatever developments has taken place in to designing the modes of investment, it is far behind the requirements of a competitive global financial market. Critics of Islamic banking find this as a major flaw in the viability of an ethics-based financial system; in fact, they are still considering this as a phenomenon of religion, money, and politics. So far as the future is concerned, Islamic banks based on participatory finance have much scope to expand in Muslim countries especially in areas of micro credit and finance based on profit and loss sharing system.
The author is a research fellow at the Centre for West Asian Studies, Jamia Millia Islamia University, New Delhi, India. He can be reached via email: email@example.com
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