Comparative discussion on Islamic Banking and customary banking system

  1. INTRODUCTION

Islamic banking is gradually moving into an increasing number of conventional financial systems. It is expanding not only in nations with majority Muslim populations, but also in other countries where Muslims are a minority, such as the United Kingdom or Japan. Similarly, countries like India, the Kyrgyz Republic[1], and Syria have recently granted or granting, licenses for Islamic banking activities. In fact, there are currently more than 300 Islamic financial institutions spread over 51 countries, plus well over 250 mutual funds that comply with Islamic principles. Over the last decade, this industry has experienced growth rates of 10-15 percent per annum; a trend that is expected to continue. Despite this rapid expansion, in most conventional banking systems, Islamic finance is still uncharted territory for most practitioners and policymakers. Since current trends indicate that Islamic banking will continue to increase its penetration of conventional systems, policymakers and practitioners need to become acquainted with this process and its implications for financial supervision.

 2. PRELIMINARY BEFORE INTRODUCING ISLAMIC BANKS

 Owing to the growing demand by the Muslim population in Western countries and also to the increasing interest of Islamic investors to diversify[2] geographically their portfolios, conventional banks are increasingly becoming interested in entering the market of Islamic financial products. Unfortunately, it is often the case that these institutions, as well as the supervisory agencies overseeing them, are not entirely familiar with the gamut of principles governing Islamic banking. Besides the well-known Quran admonishment against riba (interest), gharar[3] and maisir (contractual uncertainty and gambling), and haram industries (prohibited industries such as those related to pork products, pornography, or alcoholic beverages), there are other principles that must be observed by practitioners and supervisors in order to comply with Islamic jurisprudence.

 3. ‘SHARIAH’ FULFILLMENT

 Islamic finance in based on the principles established by the Shariah as well as other rulings, known as fatwa, issued by qualified Muslim scholars. Admittedly, some of the issues covered by these rulings can be quite complex. As a result, it has become a common practice for Islamic banks to appoint their own board of Shariah scholars. Nevertheless, since expertise in these matters is still relatively scarce in some countries, different Islamic banks often share the same scholars. This fact has the beneficial side-effect that it promotes reliability across the services and products offered by these institutions.

4. ISOLATION OF FUNDS

 An important principle behind Islamic finance is the desire to maintain the moral purity of all transactions. The funds intended for Shariah-compatible investments should therefore not be mixed with those of non-Islamic investments. This requirement is not based on the assumption that the activities of non-Muslims are intrinsically impure. The justification behind this principle is taking all the necessary precautions to ensure that Islamic funds do not become mixed with other funds that may be involved with riba, gharar, or haram[4] activities. Therefore, in order to ensure compliance with Islamic principles, conventional banks wishing to offer Islamic products must guarantee and publicize that the funds devoted to conventional activities will not be mixed with those destined for Islamic activities. In operational terms, this requires that banks establish different capital funds, accounts, and reporting systems for each type of activity.

 5. ACCOUNTING AND AUDITING STANDARDS

 The rapid expansion of the Islamic financial industry that started in the 1970s was not initially accompanied by the creation of a set of internationally recognized accounting rules. In consequence, Islamic institutions around the globe had to resort to developing their own accounting solutions for their new products, rendering comparisons across institutions difficult, and sometimes even giving the impression of lack of transparency. The need for a body of accounting standards purposely designed to reflect the specificities of Islamic products became even more pressing as new and more complex instruments were being marketed. To close this widening gap, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was created in 1990. One of the main goals of this organization is to design and disseminate accounting and auditing standards that can be applied internationally by all Islamic institutions.

 6. AWARENESS CAMPAIGNS

 The speed and degree of success with which Islamic banking will emerge in conventional systems will largely depend on whether potential depositors and investors are well informed about the opportunities and risks at hand, and on whether Islamic banking is perceived as a transparent and well-regulated activity. Furthermore, from a prudential standpoint, it can be argued that guaranteeing that depositors are well informed, at least in the initial stages, should also be seen as a regulatory duty. Consumers should be duly informed of all the risks they run when entering into new contracts.

 8. OFFERING SELECTED ISLAMIC FINANCIAL PRODUCTS

 An increasing number of commercial banks around the world are considering the possibility of offering Islamic financial products. In many countries, this interest responds to the banks’ desire to offer services to a growing Muslim population, but it is also motivated by the wish to tap the growing pool of international investors attracted to Shariah compliant[5] products. At first, a commercial bank may only want to probe the potential of this market, and thus may be interested in launching a pilot project[6]. The bank can take advantage of its existing branch network.

 10.  FULL ISLAMIZATION OF THE FINANCIAL SYSTEM

The decision of whether to completely transform a country’s financial sector into a fully Islamic system is a choice that will be based primarily on political and religious grounds. With the existing evidence at hand today, it is not possible to assert whether a purely Islamic financial system would be more or less efficient than a conventional one at intermediating financial flows.

Obviously, it is in countries with a predominantly Muslim population that a tendency towards full Islamization[7] is more likely to develop. Two notable examples of this trajectory are Iran and Sudan. Iran’s transition towards a fully Islamic financial system started with the enactment of the 1983 Usury Free Banking Law, which abolished interest-based banking operations. Similarly, Sudan pursued the full Islamization of its financial system with the promulgation of the 1992 Banking Law.

11. ISLAMIC BANKING AND ITS POTENTIAL IMPACT

 Islamic instruments are simply a narrow group of familiar financing instruments[8]. Any transaction, with any distribution of proceeds, can be conducted as a lease, a sale, a partnership, a fee-generating transaction, or a loan. Islamic instruments generally avoid loans. Though the scheduled distribution of proceeds may be the same as for a conventional loan, the legal risk in case of default is often different in the different forms of financing. Those who promote Islamic finance often prefer partnership arrangements in which profits or turnover is shared because this conforms more fully to the goals of Islamic banking.

 12. CONTROVERSIES AND CHALLENGES INVOLVED IN ISLAMIC BANKING

 At present time there is no ultimate authority or a single organization that governs the Islamic Financial Industry, nor there any set of rules and guidelines regarding Shariah interpretation. All the Islamic Banks have their own shariah boards which oversee and verify conformity of the bank’s practices with Shariah Law. These Shariah Boards normally consist of a number of shariah scholars who have well equipped with shariah and finance knowledge. However, due to the limited number of scholars who are well versed in both finance and religion, the Shariah boards tend to be overburdened and the approval process becomes difficult and unpredictable. From this backdrop, fatwa shopping can be described as the procedure that enables the financial institutions to seek a fatwa on financial product or contracts from the scholars whom they assume will consider such product as Shariah Compliant and later grant them the fatwa[9].

 13. CONVENTIONAL VS ISLAMIC BANKING SYSTEM

 Because of the fractional reserve system, they produce derivative deposits, which allow them to multiply their low-cost resources. The process of bank lending is, however, subject to some problems that can make it inefficient. Borrowers usually know more about their own operations than lenders. Acting as lenders, banks face this information asymmetry. Because borrowers are in a position to hold back from banks, they can use the loans they obtain for purposes other than those specified in the loan agreement exposing banks to unknown risks. They can also misreport their cash flows or declare bankruptcy[10] fraudulently. Such problems are known as moral hazard. The ability of banks to secure repayment depends a great deal on whether the loan is effectively used for its purpose to produce enough returns for debt servicing. Even at government level, several countries have borrowed billions of dollars, used them unproductively for other purposes and ended up with serious debt problems. Banks can ascertain the proper use of loans through monitoring but it is either discouraged by clients or is too costly and, hence, not commercially feasible. Hence, why the purpose for which the loan is given plays a minimal role in commercial banking. It is the credit rating[11] of the borrower that plays a more important role.

Conventional System

Islamic System

Money is a product besides medium of exchange and store of value. Real Asset is a product. Money is just a medium of exchange.
Time value is the basis for charging interest on capital. Profit on exchange of goods & services are the basis for earning profit.
Interest is charged even in case, the organization suffers losses. Thus no concept of sharing loss. Loss is shared when the organization suffers loss.
While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made. The execution of agreements for the exchange of goods & services is must, while disbursing funds under Murabaha, Salam & Istisna contracts.
Due to non existence of goods & services behind the money while disbursing funds, the expansion of money takes place, which creates inflation. Due to existence of goods & services no expansion of money takes place and thus no inflation is created.
Due to inflation the entrepreneur increases prices of his goods & services, due to incorporating inflationary effect into cost of product. Due to control over inflation, no extra price is charged by the entrepreneur.
Bridge financing and long term loans lending is not made on the basis of existence of capital goods. Musharakah[12] & Diminishing Musharakah agreements are made after making sure the existence of capital good before disbursing funds for a capital project.

Government very easily obtains loans from Central Bank through Money Market Operations without initiating capital development expenditure. Government can not obtain loans from the Monetary Agency without making sure the delivery of goods to National Investment fund.
The expanded money in the money market without backing the real assets, results deficit financing. Balance budget is the outcome of no expansion of money.
Real growth of wealth does not take place, as the money remains in few hands. Real growth in the wealth of the people of the society takes place, due to multiplier effect and real wealth goes into the ownership of lot of hands.

 14. CONCLUSION

 Islamic banking and finance now is the strong industry in the Islamic and Western markets, but will continue to face struggles in the process. Due to the religious underpinning, the Islamic finance industry faces a set of unique challenges. The above points are only a handful. As more experts join in the ranks, the industry players should carefully consider the challenges and develop processes to consciously improve every aspect of industry. Unlike conventional finance[13], the success of Islamic finance depends on both satisfying faith and economics. As such, industry stakeholders are invited to share their knowledge between each other and to have a better communication with the scholars and finance experts.

 BIBLIOGRAPHY

 AAOIFI, 2003, Conversion of a Conventional Bank to an Islamic Bank, Shariah Standard

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Abd Rahman, Ust Zaharuddin, 2006, “Shariah-compliant paid-up capital,” Business Times

RHB, August, 16th, 2006 (available at www.rhbislamicbank.com.my).

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Retail Banking and Finance, Sohail Jaffer (ed.), published by Euromoney Books.

Al-Awan, Malik Muhammad Mahmud, 2006, “Globalization of Islamic funds,” Islamic

Banking and Finance, issue 11, pp. 14-15.

Ayub, Muhammad, 2002, Islamic Banking and Finance: Theory and Practice, published by

State Bank of Pakistan Press, Karachi, Pakistan.

Bacha, Obiyathullah Ismath, 1999, “Derivative Instruments and Islamic Finance: Some

Thoughts for a Reconsideration,” International Journal of Islamic Services, Vol. 1

No. 1, April-June, 1999.

BIS Review 49/2005, speech by Dr. Zeli Akhtar Aziz, Governor of the Central Bank of

Malaysia, “Building a progressive Islamic banking sector—charting the way

forward”.

Brodhage, Eberhard and Rodney Wilson (2001), “Financial Markets in the GCC: Prospects

for European Co-operation,” European University Institute Policy Paper 01/2.

Solé, Juan, 2007, “Prospects and Challenges for Developing Bond and Sukuk Markets in

Kuwait,” Selected Issues Paper SM/07/84, (Washington: International Monetary

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Sundararajan, V., David Marston, and Ghiath Shabsigh, 1998, “Monetary Operations and

Government Debt Management Under Islamic Banking,” IMF Working Paper

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[1] Kyrgyzstan is officially a democratic parliamentary republic.

[2] reducing risk by investing in a variety of assets

[3] An Islamic finance term describing a risky or hazardous sale, where details concerning the sale item are unknown or uncertain. Gharar is generally prohibited under Islam, which explicitly forbids trades that are considered to have excessive risk due to uncertainty.

 

[4] rabic term meaning “forbidden”, or “sacred”.

[5] Shariahcompliant funds are investment vehicles which are fully compliant with the principles of Islam.

[6] A pilot project refers to an initial roll out of a system into production

[7] slamization (also spelt Islamisation, see spelling differences) or Islamification (pejorative Muhammadization) has been used to describe the process of a society’s conversion to the religion of Islam. In contemporary usage, it may refer to the perceived imposition of an Islamist social and political discourse on a society with a tradition of a more varied interpretation of Islam.

[8] Islamic Financial Products -. Islamic Banks & Financial Institutions Information System. 1. Musharakah (Partnership). 2. Mudarabah (Passive Partnership)

[9] Fatwa is a legal pronouncement in Islam, issued by a religious law specialist on a specific issue.

[10] Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors.

[11] A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise

[12] joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic Banking System

[13] Use of modified loan terms or eligibility requirements that allow lending to borrowers with limited financial resources.