ISSUES AND PROBLEMS OF ISLAMIC BANKING IN BANGLADESH
ISLAMIC BANKING SYSTEM
Islamic banking (or participant banking) is banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment or acceptance of specific interest or fees (known as Riba or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also Haraam (forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
MODERN ISLAMIC BANKING
Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950. The writings of Muhammad Hamidullah 1944, 1955, 1957 and 1962 should be included in this category. They have all recognized the need for commercial banks and their perceived “necessary evil,” have proposed a banking system based on the concept of Mudarabha – profit and loss sharing.
In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.
The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.
The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in country.
In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, currently, is still in business in Egypt. In 1975, the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services.
Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed according to The Economist. This represents approximately 0.5% of total world estimated assets as of 2005. According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010.<href=”#cite_note-iran-daily.com-16″>[17]
The Vatican has put forward the idea that “the principles of Islamic finance may represent a possible cure for ailing markets.”
Shariah-compliant assets reached about $400 billion throughout the world in 2009, according to Standard & Poor’s Ratings Services, and the potential market is $4 trillion. Iran, Saudi Arabia and Malaysia have the biggest sharia-compliant assets.
In 2009 Iranian banks accounted for about 40 percent of total assets of the world’s top 100 Islamic banks. Bank Melli Iran, with assets of $45.5 billion came first, followed by Saudi Arabia’s Al Rajhi Bank, Bank Mellat with $39.7 billion and Bank Saderat Iran with $39.3 billion.Iran holds the world’s largest level of Islamic finance assets valued at $235.3bn which is more than double the next country in the ranking with $92bn. Six out of ten top Islamic banks in the world are Iranian. In November 2010, The Banker published its latest authoritative list of the Top 500 Islamic Finance Institutions with Iran topping the list. Seven out of ten top Islamic banks in the world are Iranian according to the list.
What is Loan:
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower.
In a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount.
The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants. Although this article focuses on monetary loans, in practice any material object might be lent.
Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of debt contracts such as bonds is a typical source of funding.
Different Types of Loans:
There are number of types of loans. Some of them are as follows:
1. Emergency Loans
2. Home Loans
3. Car Loans / Auto Loans
4. Student Loans
5. Personal Loans
6. Credit Cards
7. Bankruptcy Loans
8. Wedding Loans
9. Unsecured Small Business Loans
10. Private Loans
11. Consolidated Loans
12. Direct Stafford Loans
13. Secured Loan
14. Unsecured Loan
15. Demand Loans
16. syndicated loan
17. Open-ended loans
18. Closed-ended loans
19. bad credit loan
21. home equity loan
22. Home improvement loans
23. homeowner loan
Now they are briefly discussed below:
· Emergency Loans
We need a loan every time we face a situation where we can not meet the ends meet and we need some kind of financial injection that’ll cure the problem. Specially in emergencies, getting a loan can really help and once the emergency is over, repaying that loan never feels like a burden. Emergencies can vary, one might have to travel to attend an important an event like a wedding or a tragic family funeral or might require some quick cash in order to pay for expensive medicines if he/she falls sick etc.
Ever now and then we face a situation where things are not under our control and if you are low on savings or have low income, a loan provided in emergency does feel like a blessing. In such cases, people mostly prefer short term loans that they mean to pay back on the next pay day or a couple of months max. The best places to get a loan are the financial institutions but you can also apply for payday advance loans that are available online. Google the terms and you’ll see how many choices can be found online.
· Home Loans
Banks, as sure that you are already aware of, can also provide loans. People usually apply in banks for large sum of loans for instance home loans. First time home buyers mostly plan to spend around a hundred and fifty thousand (USD $150,000) to three hundred thousand dollars ($300,000). For the first time home buyers, it’s absolutely important that they find a bank which is offering home loans on lower interest rates and with a good 25-30 years of repayment schedule.
· Car Loans / Auto Loans
At present, one of the most widely used and important loan for a common man is a car loan. These types of loans are designed for people who want to purchase a car and are normally known as car loans or auto loans. You can apply for a car loan regardless what kind of car you are looking for. It can be a small more economical compact car or it can also be a SUV. The amount of loan that you want to borrow and the interest rates will heavily depend on your credit, your monthly income and your age. If you have a poor employment history then that will also have a negative effect on the total amount and the interest rate associated with the loan.
· Student Loans
You can apply for a student loan if you are going to a college or a trade school. You can also apply for student loan if you want to get a new diploma in a specialized field. You can get in touch with government or private sector lenders to borrow these loans. What you have to make sure is that you strike a deal where you don’t have to pay high interest rates. If you are going to a trade school then there is a good chance that you won’t have to borrow as much money as you would if you are going to join a college and graduate in 4 years. With trade schools, your loan repayment schedule will begin after you have graduated.
· Personal Loans
People need loans for personal needs, needs that do not really have anything to do with the basic necessities of life like medical, car loans or loans for home purchasing.
For instance personal needs like traveling during holidays, cosmetic surgeries, going out for a lovely honeymoon or getting a loan to have a wedding of your dream. This type of loan is known as Personal loan. Usually personal loans carry a higher interest rate because these loans are tailor made for personal needs of the borrower that vary from case to case. Before you apply for personal loans with a financial institute, you should do a little research on the internet. There is a good chance that you will find a lender that is offering these loans on lower interest rates.
· Credit Cards
Many people do not realize that by using credit cards, they are already using loans. In fact, many Americans believe that they just have to have a credit card because for them it’s a thing that everybody has which can also lead you to believe that their interest rates are the lowest possible interest rates and life can become very easy thanks to credit cards. The fact is that credit cards are the biggest loan industry in the world, left alone America. It makes your life easier by giving facilities like not paying using cash or having to buy something off the shelf when you don’t have enough to pay for it at once but the interest rates are pretty high compared to any other loan. There are good chances that you will miss paying a monthly bill because lets face it, sometimes work and domestic issues can lead to missing out the deadline of the bill that you need to clear before you cross the due date and that will leave a big bad stain on your credit report.
· Bankruptcy Loans
Filing for bankruptcy is not the end of the world. You should not get confused. It’s true; bankruptcy does leave a big stain on your credit history. If you are considering to file bankruptcy then you should make sure that before you file it, you have tried all the possibilities to find any alternatives to bankruptcy but if you are in one of those situations where you have no option left or if you have already declared bankruptcy then do not let anyone mislead you into believing that you have reached the end of the world and that your financial life is now over.
· Wedding Loans
Let’s face it, weddings can be expensive. You spend a lot of money before your wedding, like when you buy wedding rings, dresses, booking the venue, dinners and then of course afterwards when you go to honeymoon and start shopping together. One of the best ways to stay secure is to have a decent bank balance to support you after you get married. Having a good bank balance means that you can easily avoid any financial pits soon after your marriage begins.
All this gives a rise and importance to availing wedding loans. Wedding loan provides financial support to make your wedding as memorable, special and easy as it could get. Wedding loans are specially created in such a manner that you can easily meet all the expenses before or after your wedding.
The interest rates of wedding loans vary but they are pretty competitive. Interest rates depend on factors such as the amount of the loan you borrowed, the current bank rate, your credit score and your financial status. There are a number of types of the interest rates offered in the financial market but the most commonly offered types are fixed rate wedding loans and flexible rate wedding loans. In fixed rate wedding loan, the rate does not change with the change in the condition of the market. It stays the same hence “fixed rate” while the flexible interest rates, the rates fluctuate. This makes the flexible interest rate wedding loans a bit risky. If you want to stay safe then fixed interest rate wedding loans can be the answer.
· Unsecured Small Business Loans
An unsecured small business loan can give your business the vitality it needs to overcome setbacks, unexpected situations, or to make expansions. Imagine the possibilities. With an unsecured small business loan, you can expand payroll, make renovations, and advertise more effectively, increase your inventory, or make countless other progressions that can give your business the jump it needs.
Unsecured business loans is offered to businesses who either do not have any asset which they can render as security. This is difficult for new businesses since they do not yet have any commercial collateral. Even for those that do, they may not wish to risk it with a secured loan. Many business owners, having no other choice, end up using their personal assets as collateral when seeking unsecured small business loan financing. This is hazardous and jeopardizes their hard earned assets for their hopes at a business venture.
· Private Loans
Undergraduate, graduate, and professional students have the option to take out loans through private sources of funding, such as a bank. You do not need to submit the FAFSA for a private loan but you do have to apply through the private organization. Different types of loans are provided based on your level of education. However, private loans are more expensive than government loans. Only turn to private loans if necessary.
· Consolidated Loans
Consolidated loans offer students the opportunity to combine all the different federal loans received into one big loan with one monthly payment. The advantage of a consolidated loan is that you can take longer to repay your loan and have lower monthly payments. The Federal Perkins and Stafford Loans are eligible for consolidation. To get a consolidated loan, you need to contact the appropriate department of the lender for an application. You can apply for a consolidated loan during your grace period or once you begin repayment. The interest on a consolidated loan never exceeds 8.25% and is a fixed rate.
Because there are limited scholarships, fellowships, grants, and assistantships, all students are encouraged to apply for a loan. Loans can help pay for school, living expenses, textbooks, and other day to day things. Loans can limit the amount of stress involved in finding ways to pay for school.
· Direct Stafford Loans
The Federal Direct Stafford Student Loan program is the most widely used student loan program. Borrowing limits, interest rates, and terms of repayment are defined by the U.S. Department of Education. Direct Stafford Loans are available to virtually all students enrolled in a degree or certificate program. The interest rate is no higher than 6.8%, both while students are in college, and during repayment. Federal law makes it a fixed interest rate.
· Secured Loan
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan.
· Subsidized loan
A subsidized loan is a loan that will not gain interest before you begin to pay it. It is known to be used at multiple colleges.
An unsubsidized loan is a loan that gains interest the day of disbursement.
A mortgage loan is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.
In some instances, a loan taken out to purchase a new or used car may be secured by the car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter — often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. A direct auto loan is where a bank gives the loan directly to a consumer. An indirect auto loan is where a car dealership acts as an intermediary between the bank or financial institution and the consumer.
A type of loan especially used in limited partnership agreements is the recourse note.
A stock hedge loan is a special type of securities lending whereby the stock of a borrower is hedged by the lender against loss, using options or other hedging strategies to reduce lender risk.[citation needed]
A pre-settlement loan is a non-recourse debt, this is when a monetary loan is given based on the merit and awardable amount in a lawsuit case. Only certain types of lawsuit cases are eligible for a pre-settlement loan.[citation needed] This is considered a secured non-recourse debt because if the case reaches a verdict in favor of the defendant the loan is forgiven.
· Unsecured Loan
Unsecured loans are monetary loans that are not secured against the borrower’s assets. These may be available from financial institutions under many different guises or marketing packages:
- credit card debt
- personal loans
- bank overdrafts
- credit facilities or lines of credit
- corporate bonds (may be secured or unsecured)
The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.
· Demand Loans
Demand loans are short term loans (typically no more than 180 days)<href=”#cite_note-Signoriello1991-0″>[1] that are atypical in that they do not have fixed dates for repayment and carry a floating interest rate which varies according to the prime rate. They can be “called” for repayment by the lending institution at any time. Demand loans may be unsecured or secured.
· Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers.
The syndicated loan market is the dominant way for corporations in the U.S. and Europe to tap banks and other institutional financial capital providers for loans. The U.S. market originated with the large leveraged buyout loans of the mid-1980s, and Europe’s market blossomed with the launch of the euro in 1999.
At the most basic level, arrangers serve the investment-banking role of raising investor funding for an issuer in need of capital. The issuer pays the arranger a fee for this service, and this fee increases with the complexity and risk factors of the loan. As a result, the most profitable loans are those to leveraged borrowers—issuers whose credit ratings are speculative grade and who are paying spreads (premiums or margins above LIBOR in the U.S., Euribor in Europe or another base rate) sufficient to attract the interest of non-bank term loan investors. Though, this threshold moves up and down depending on market conditions. In the U.S., corporate borrowers and private equity sponsors fairly even-handedly drive debt issuance. Europe, however, has far less corporate activity and its issuance is dominated by private equity sponsors, who, in turn, determine many of the standards and practices of loan syndication.
· Open-ended loans
Open-ended loans are loans that you can borrow over and over. Credit cards and lines of credit are the most common types of open-ended loans. With both of these loans, you have a credit limit that you can purchase against. Each time you make a purchase, your available credit decreases. As you make payments, your available increases allowing you to use the same credit over and over.
· Closed-ended loans
Closed-ended loans cannot be borrowed once they’ve been repaid. As you make payments on closed-ended loans, the balance of the loan goes down. However, you don’t have any available credit you can use on closed-ended loans. Instead, if you need to borrow more money, you’d have to apply for another loan. Common types of closed-ended loans include mortgage loans, auto loans, and student loans.
· Bad credit loan
A bad credit loan usually refers to a loan offered to a borrower who has a history of poor credit, and can be difficult to obtain at affordable rates.
Combine your existing debts into one debt consolidation loan, and you may significantly lower your monthly repayments and reduce the total cost.
· Home Equity loan
A home equity loan is a loan secured against your home that allows you release the value of your property as cash for almost any purpose.
· Home improvement loans
Home improvement loans allow you to borrow money to make improvements to your home, and are usually secured against your property
· Homeowner loan
A homeowner loan is a loan secured against your house. It is another term for a secured loan, where your property provides the collateral for the loan.
ISSUES AND PROBLEMS OF ISLAMIC BANKING IN BANGLADESH
1. An Overview on the Review of Problems
The Islamic banks face a number of challenges. First, they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits. Second, the risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions.1 Third, the Islamic banks do not have the legal support of central banks of their respective countries (except in Pakistan and Iran), which exposes them to great risks. Fourth, the Islamic banks do not have the necessary expertise and trained manpower to appraise, monitor, evaluate and audit the projects they are required to finance. As a result, they cannot expand despite having excess liquidity.
The future of Islamic banks hinges, by and large, on their ability to find a viable alternative to interest for financing all types of loans. They should recognize that their success in abolishing interest has been at least partial and they have yet to go a long way in their search for a satisfactory alternative to interest. Simultaneously, Islamic banks need to improve their managerial capabilities by training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks also depends on developing and putting into practice such accounting standards which provide timely and reliable information of the type that the Islamic banks would require for profit-sharing, rent-sharing or for cost-plus financing. These standards are yet to be developed. The Islamic banks would have to work hard to pursue their clients to accept these standards so that a reliable information base is established.2
2. Issues and Problems in the Implementation of an Interest-Free Banking
The implementation of an interest-free banking raises a number of questions and potential
problems if seen from the macro and micro operational point of view.
2.1 Issues Related to Macro Operation of Islamic Banking System
2.1.1. Absence of Islamic Money Market:
In the absence of Islamic money market in Bangladesh, the Islamic banks cannot invest their surplus fund. Because the entire Government treasury Bills, approved securities and Bangladesh Bank bills in Bangladesh are interest bearing. Naturally, the Islamic Banks cannot invest the permissible part of their security Liquidity, Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with Bangladesh Bank. Similarly, the liquid surplus also remains uninvested. As such, the profitability of the Islamic Banks in Bangladesh is adversely affected.
2.1.2 Absence of Suitable Long –term assets:
The absence of suitable long term assets available to Islamic Banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an inter – bank market in Bangladesh, where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of returns are not known until maturity. These factors place Islamic in Bangladesh at a distinct disadvantages compared to its conventional banking counterpart.
2.1.3. Shortage of Supportive and Link Institutions:
Any system cannot thrive exclusively on its built in elements. It has to depend on a number of link institutions so is the case with Islamic Banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic Banking are yet to be developed in Bangladesh.
2.1.4. Organizing relationship with Foreign banks:
An issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks.
2.1.5. Long term financing:
Islamic banks as financial institutions as even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamic ally, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.
2.1.6. Liquidity
Islamic banking stands for the use of money as a medium of exchange. Conventional banking, on the other hand, emphasizes the need for maintaining liquidity and hence requires an adequate amount of reserves. The basic principle of Islamic banking being PLS-based financing and thereby having been exposed to increased risk; it would conceivably require higher liquidity and reserves. The reason is that its investment in assets has by nature lesser divisibility and reversibility. This means that reserve ratios for interest-free banking are to be calculated on the basis of risk calculation in various forms of investment.
Director (Planning and Development), Bangladesh Open University.
The complex problem in measuring liquidity is that liability management in the conventional banking system has been gradually replacing asset management to fund liquidity needs. At present, no such facilities exist under the Islamic banking system. As a result, these banks have to depend on their central bank to supply cash. The liquidity ratios required by the banking laws on demand and time deposits differ from country to country. In some countries, the supervisory authorities reserve the right to impose different ratios on different banks according to their location. At present, the liquidity ratio is 35% of demand and time liabilities in Pakistan.3
The existing lending operations of conventional bank for definite maturity are based on the doctrine of ‘anticipated income theory,’ where bank loans are not self-liquidating in the sense of ‘commercial loan theory.’ These loans are paid off out of the future earnings of the borrower, and are liquid according to their nature, guarantee, and marketability. Since Islamic banks are not based on the same principle, but are investing in assets represented by commodities, shares in companies or working capital of companies, the theoretical probability of these assets becoming liquid is more difficult to ascertain than in conventional banks. Also, greater fluctuations in the liquidity ratio due to the still largely agrarian nature of these economies will significantly affect the ability of Islamic banks to provide credit to private sector. This requires special attention when fixing liquidity ratios for each type of deposit and each kind of investment in order to allow a degree of liquidity higher than conventional banks.4
With regard to the elements comprising the liquid assets of Islamic banks, it would be necessary to allow these reserves to be held in the form of financial instruments. Similarly, the bank capital requirements under Islamic banking would be higher to protect the depositors against unexpected losses, if any, on the investment portfolios, increasing the requirement of legal and loss reserves that could provide additional safety cushion.
2.1.7 Valuation of Bank’s Assets
It is argued that Islamic banks may suffer a loss of value of its assets in the absence of a fixed positive rate of return. Further, without the provision of insurance Islamic banks may face trouble in making their system stable and avoiding liquidity crises. So far, under Islamic banking, no such insurance system exists.
Theoretically, Islamic banks are likely to face a dual risk: (a) the ‘moral’ risk due to lack of honesty and integrity on the part of the borrower of funds in declaring a loss, (b) the ‘business’ risk arising from unexpected market behavior.
The deposits under the PLS system are conceptually more akin to a mutual fund’s share certificate. These deposits would share in both the realized as well as unrealized gains and losses on the investment of Islamic banks. Typically under current Generally Accepted Accounting Principles, the investment portfolio is adjusted to market values in investment companies. An upward adjustment of the assets account requires an offsetting credit to either revenue or unrealized capital increment. Unrealized capital decrement requires recording of an unrealized loss on long-term equity securities as a contra item in stockholder’s equity.
The problem associated with proper valuation of Islamic banks’ assets has important implications for bank safety and bank regulation. Any specification of reserve or provision requirements laid down by the regulatory agencies will have to consider how far the g
losses) on banks’ investments are passed on to the depositors. If in the extreme case, these gains and losses are fully reflected in the value of the deposits, the banks probably would be passing on all the risks to their depositors.
Another problem in determining the profit or loss to be distributed to the depositors of the Islamic banks relates to the periodic evaluation of their assets, especially in case of long-term investments, such as Mudaraba, or Musharaka. In the case of Participation Term Certificates (PTCs), market values could be observable if an active market in these instruments exists. Such a market for the PTCs is not fully developed in countries experimenting with the interest free banking system. The value of long-term investments would fluctuate with the changes in the expected cash flows as well as in the opportunity cost of capital. In the absence of an active market in these investments, the valuation process could be very imprecise and costly.
2.1.8 Credit Creation and Monetary Policy
The general perception is that most of the traditional policy instruments of the central bank are largely redundant under Islamic banking. These include: minimum cash reserve requirement, liquidity requirement, overall credit ceilings on lending activities of these banks, mandatory targets for providing finance to specific sectors, and moral suasion. Of course, equating the goals of monetary policy in Islamic banking to those of the free market economies would not be fair since there is a significant difference in emphasis of the two systems to economic values and socio-economic justice.
Monetary policy under Islamic banking assigns a somewhat passive role to money. Chapra opines that the central bank should adjust the money stock to keep pace with the secular growth of output. In his view the control of money supply can be accomplished by regulating the high powered money at the source. He suggested two alternatives. The first is to impose a 100% reserve requirement on the commercial banks, thus permitting the central bank to create credit, which will be channeled through commercial banks on a Mudaraba basis. The second alternative is to allow banks to create deposits. Given the Islamic emphasis on re-distributive justice, this may result in either nationalizing the commercial banks or forcing the banks to pass on to the state the net income arising from ‘derivative’ deposits after allowing for the share of the commercial banks. Under this alternative, he suggests a 15-20% statutory reserve requirement on only demand deposits without extending it to cover deposits, which constitute a part of equity in an Islamic economy. This alternative has its own conceptual problems of dividing ‘net income’ among the shareholders, depositors, and the state. Also, since the deposits will be invested in the long-run projects, which are likely to be more profitable, this scenario will pose greater liquidity constraints.5
M. Khan divides the sources of funds into demand deposits and investment deposits and places a 100% reserve requirement for the first category of deposits6. Such a restriction would reduce the power of banks to create credit. As investment deposits are used for risk-bearing activities, no reserve requirements are needed.
Al-Jarhi proposed a model, which he calls a “productivity-based financial and monetary structure” in which the central bank creates a fiat money through “sale and purchase of central deposit certificates” instead of issuing interest-bearing government securities7. According to 4
Jarhi the expansion in money must be justified by a possible contribution to real balances. The growth of money must go with the real growth of the economy. There are no fractional reserves in the model. The central bank issues certificates as liabilities and holds loan accounts and deposits in member banks. The banks hold assets in the form of cash, equity shares, PLS accounts, and leasing accounts, while their liabilities consist of non-interest bearing demand deposits, investment deposits and certificates issued to their customers. Thus, in Jarhi’s model, the indirect link between financial and goods market established by the financial intermediaries is replaced by direct participation of banks in productive investment projects. The growth and the past behavior of inflation provide the central bank with necessary information on the expansion or contraction of money supply.
The consequences of Jarhi’s model are as follows: (a) there is no discount rate as a policy tool in such an economy. An economy-wide elimination of discount rate will entail profound structural changes, focusing on social justice in the light of existing economic conditions. In the absence of interest rate, and for the purpose of discounting future income streams for project evaluation, some mechanism in an Islamic economy must serve as a discount factor; (b) monetary policy becomes closely intertwined with the development policy of the economy. Therefore, his suggested policy questions the emphasis on the stabilization policy followed by conventional central banks in post-war period. (c) The above emphasis tends to encourage lending of funds on the basis of profitability of investment projects rather than solvency and credit worthiness of the borrower in the debt finance case. This would require trained banking personnel and expertise in project feasibility, evaluation and appraisal by the commercial banks, which may lead to increased monitoring costs for Islamic banks.
There is a recurring emphasis in Islamic banking literature on 100 percent reserve requirements. Though this permits the central bank a direct control of money stock, the emphasis is more pointed in favor of Islamic equity and against the notion of ‘hidden subsidy’ involved in the generation of ‘derivative’ deposits in the interest based banking system. Accordingly, credit creation is confined to the central bank, which extends credit to commercial banks on a PLS basis.
The fractional reserve system versus 100% reserves would have different policy implications. Under the former system, banks would have the ability to draw profits on funds that they have exerted no productive effort. Such earning is against the original spirit of Islamic banking. One solution may lie in the nationalization of commercial banks, which has already occurred in most of these countries. As regards the latter, we have a fair amount of theoretical insight from the western literature but do not have any valuable empirical observations on the operations of 100% reserves even in countries that have adopted Islamic banking. These Islamic banks are still operating under fractional reserve system. Hence, the operation of monetary policy under 100% reserves system needs further research.
In summary, according to the principle of Islamic banking private banks should not have the power to create money. The power to create money should be reserved for the government or its central bank. 5
2.1.9 Financial Stability
Conventional banking system based on the fractional reserve system has built-in instability as illustrated by western economists such as Hayek (1933), Mintz (1950), Fisher (1930) and Friedman (1957). The instability arises, as argued by them, from the lack of synchronization between the decisions of commercial banks and the central bank thereby resulting in destabilising forces. Modern banking based on interest issues fixed value liabilities to its depositors. In the absence of deposit insurance the value of assets can fall below its fixed liabilities, resulting in bankruptcies. In the worst scenario, the welfare of each depositor depends on the action of other depositors.8For example, if one of the bank’s major borrowers default and a financial panic is triggered, each depositor will try to withdraw funds as soon as possible. This negative externality generated by the depositors can cause instability in the banking system. The provision of deposit insurance has reduced the problem of financial panics, but it has at the same time led to inefficiency in the intermediation process.
By that reasoning, lack of insurance coverage is considered to be a problem for Islamic banks. It is presumed that depositors in Islamic bank, due to the fear of capital and or profit losses in the event of having no insurance coverage, would not remain with the Islamic banks. Islamic economists argue that under Islamic banking, because there are no fixed liabilities, depositors feel encouraged to remain in the bank when it suffers a decline in the value of its assets. Hence, there is no externality created. It does not require the provision of deposit insurance. However, it would need some provision of insurance against fraud and theft in Islamic banking.
2.1.10 The Ownership of Banks
The ownership issue of Islamic banks relates principally to the distributional impact on the society. Particularly, credit creation power of commercial banks with fractional reserve ratio has been the point of debate, which has raised the question as to whether the ownership should be with public or private hand. The issue is still unresolved. Commercial banks in Pakistan are required to maintain fractional reserves and they are in the private sector. On the other hand, all commercial banks in Iran are nationalized. Further research is required in this regard to come to a clear conclusion.
2.1.11 Lack of Capital Market and Financial Instruments
Islamic banks working under conventional banking framework in different countries lacks capital market and instruments for investment of their surplus liquidity. Availability of Islamic capital market and instruments help growth of these banks. Growth of Islamic capital market and financial instruments also helps creating the environment for government financing.
2.1.12 Insufficient Legal Protection
A comprehensive system of Islamic banking requires legal protection. This means a thorough review of all relevant laws having a bearing on banking business is needed. Laws relating to companies, commerce, investment and the courts and legal procedures need to be reviewed and reformulated to suit the requirement of the efficient functioning of Islamic banks. It is not acceptable that company law continues to talk about bonds and interest while ignoring participation deeds and 6
profits. Investment promotion laws should accommodate rules and regulations, which permit Islamic banks to apply their profit/loss sharing modes so that they can participate in partnership businesses either in the form of Mishawaka or direct investment.
2.2 Issues Relating to Micro Operation of Islamic Banks
2.2.1 Increased Cost of Information
Islamic scholars generally agree that the monitoring cost as well as the cost of writing and enforcing contracts would be higher in Islamic banking than in the interest-based system. This is because, with Mishawaka, the bank finances the working capital of a business venture taking a quasi-equity position in the economy. In financing, a management company is formed which floats a negotiable security, or the bank may completely finance a project within the scope of its charter. Moreover, since the economies of countries implementing Islamic banking are generally characterized by market and informational imperfections, further persistence of these problems will increase the cost of information. This higher cost of information could be a major setback in the effective implementation of the PLS system.
2.2.2 Control over Cost of Funds
An interest-based bank maximizes its profit subject to the cost of funds as it is in a position to know in advance, with a reasonable degree of certainty, the amount of profit it may earn in the short term. Through the use of hedging it can also determine the level of profits in the long run. Under the PLS system, on the other hand, there is no such scope to know the cost of funds beforehand. The depositors are paid a portion of the bank’s profits the volume of which is extremely uncertain. In this situation if profit rate expected by the depositors is not realized, the Islamic banks could face greater uncertainty in their profit base.
Ideally, Islamic banks are expected to calculate their rate of return on PLS deposits periodically. The usual practice is that the deposits are weighted to reflect differences in their maturity. The bank prepares a six monthly summary account of its operations and sends it to the central bank, which determines the individual PLS rate to be paid by each bank. In spite of that individual banks are allowed to marginally deviate from the proposed rate of return. In sum, it can be argued that Islamic banks have no control over the cost of funds.
2.2.3 Mark-up Financing
There is wide apprehension that little difference can be found between mark-up practiced by Islamic banks and conventional banks. However, though not considered strictly interest-free by many Muslim scholars, mark-up was seen by
the banks as a tool to facilitate the transition to Islamic banking without disrupting the system. Because the ultimate objective of Islamic banking is investment-oriented long-term financing, the transition from mark-up to equity finance would also require a larger spread between rates of return to the banks and to their depositors.
It has been argued by a number of writers that the real substitute of interest in an Islamic financial system is the mode of profit/loss sharing along with qard al Hashanah, while the other techniques like Murabahah, bai-muajal, ijara and ijara was iqtina can not be of equal significance in achieving Islamic socio-economic objectives.9 The reasoning employed is as follows. Islam disallows the interest system because intrinsically it is a highly inequitable7
system. The feature that makes the interest based system inequitable is that the provider of capital funds is assured a fixed return while all the risk is borne by the user of these capital funds. Justice demands that the provider of capital funds should share the risk with the entrepreneurs if he wishes to earn profit. Financing techniques like Murabahah, bai-muajal, ijara and ijara wa
iqtina, which involve a pre-determined return on capital, can not be regarded as commendable
substitutes for interest, and should only be used when absolutely needed.
2.2.4 Excessive Resort to the Murabaha Mode
The repeated criticism against Islamic banks, which is valid in many counts, is that it takes recourse to excessive use of Murabahah mode in financing investment. Yet it is not a violation of Shari’ah as long as the Murabahah contract is correct from Shari’ah viewpoint and is free from intentional or nominal deception.
The objection is from two groups of people. The first group considers Murabahah to be the same as pre-determined rate of return i.e., rate of interest. But this is not true. Murabahah is different from interest based mark-up as the former has to satisfy the following requirements. First, it is necessary that profit margin (or the mark-up) the bank is charging must be determined by mutual agreement between the parties concerned. Secondly, the goods in question should be in physical possession of the bank before it is sold to the client. Thirdly, the transaction between the bank and the seller should be separate from the transaction between bank and the purchaser. There should be two distinct transactions. That is why Islamic banks effect a Murabahah transaction in two stages using two separate contract forms. The first form is a request to the bank through which the client informs the bank of his intention to carry out the transaction. In this contract, the client promises to buy goods from the bank. It should also be noted that a promise is not legally enforceable. Hence the client has a right to change his mind and the
bank runs the risk of losing the money it has invested in this particular transaction. The second contract deals with the sale of goods by the bank to the client on deferred payment basis, the terms and conditions of which are clearly spelled out in the contract form. Unfortunately, the bank violates the condition that the goods should be in physical possession of the bank.
2.2.5 Utilisation of Interest Rate for Fixing the Profit Margin in Murabahah Sales
It is also criticized that Islamic banks utilize the interest rate as a criterion for fixing the profit margin in the mudarabah sales. To be fair, there is no known way of avoiding the alleged link up as long as Islamic banks coexist with traditional banks. Still Islamic banks must avoid exceeding the prevailing interest rate or exploiting the clients through accounting methods as employed by some banks.10
2.2.6 Financing Social Concerns
Islamic banks are accused of following the same course of line as pursued by conventional banks as regards financing of social aspects. These banks are usually found to be interested in extending credit facilities to well-established commercial establishments which often obtain credit facilities from both conventional and Islamic banks without real commitment or attempt to free them from the prohibited means of finance. In this way, Islamic banks have in general become a figure that is added to the number of traditional banks, which do business in the country concerned. No clear prescription has so far emerged on the role of Islamic banks in the promotion of new projects needed by the society as follows: 8
enabling those who have no property, providing employment opportunities to all categories
of people;
demonstrating the impact of Islamic investment on the solution of the unemployment
problem; and,
assisting the state in confronting these ever-increasing problems. Moreover, Islamic banks did not pay much attention to the development of banking services in some socially desirable directions, except in very rare cases. The entire realm of the management of estates, trusts and orphanages, etc., has remained outside the area of interest of Islamic banks, in spite of the fact that a number of western banks have, since the sixties, begun establishing specialized departments for Estates and Trusts.
2.2.7 Lack of Positive Response to the Requirement of Government Financing
It is a well-known fact that the modern state is always in need of funds and resources to implement useful projects, such as the provision of schools, roads, electricity, and water and telecommunication services. Generally, governments resort to issuance of treasury bills with interest in accordance with the form used by conventional banks. Islamic banks are required to enter into this field so as to prove their ability to play their role in the financing of projects in a manner that conforms to the Islamic system through the issuance of deeds of Maharajah, advance-sale, salam and such other forms that satisfy the needs of the state for financing and, at the same time, benefit from investment of their idle liquid surpluses.