Development of Islamic Finance and Banking Industry Essay Example

Today comprehensive research studies are being undertaken and academic courses are being offered in universities throughout the world not only to get a better understanding of the system but to verify its practical usability and advantages.

The global financial crisis which started in 2008 and resulted in a major downturn in world economies has increased the importance of alternative economic and financial systems. The Islamic financial and banking system has developed considerably in recent years with heavy research being done in the regions of Egypt, Saudi Arabia, United Arab Emirates, Malaysia, Indonesia and Pakistan, United States of America, United Kingdom and other parts of the world.  Islamic banks and financial institutions have been established in various cities of these countries in the past few years and are working quite effectively to provide an alternative to the conventional banking system.

1. History of Islamic Banking

The modern form of Islamic banking was not introduced until the later part of the 20th century and Islamic finance and economics was generally implemented as a system and the area of banking was quite underdeveloped. The history of Islamic finance and banking can be divided into two parts. The first part comprises of the classical Islamic banking system and the second part is the modern Islamic banking system which is gaining popularity and momentum especially after the recent global economic crisis as one of the main causes of this crisis was the conventional banking system.

1.1 Classical Islamic Banking

The concept of an Islamic economic and finance system was introduced with the introduction of Islam as a religion and way of life. The Islamic system

is dependent on a set of laws which makeup the framework of Islamic law referred to as Shari’ah. Before Islam loans were issued and received but with interest and Islam prohibited Riba which is the Arabic name for interest. As the conventional banking system was based on Riba, there was no room for this system in the Islamic economic system.

The areas of trade and commerce were enhanced and developed to a very large extent during the period of economical and intellectual height of Abbasid, Umayyad and Ottoman caliphates. The Islamic banking system of this era witnessed development in the areas of Islamic partnership forms of Mudarabah and Musharakah. The modes of financing available in this period were direct capital investment and interest free loans. Due to extensive research Muslims had perfected the paper making technology and various paper based modes of payment including bills of exchange, promissory notes and cheques are important elements of this era (Lopez, 2001).

1.2 Modern Islamic Banking

The concept of Islamic banking system originated in Egypt when in 1963 Ahmed El Najjar established a savings bank which was based on profit sharing according to Islamic Shari’ah rather than interest based banking. There were 9 similar banks operating in the country by the end of 1976. All these were banks were based on Islamic principles and no interest was charged or paid to and from the customers. The deposits and loans were made on basis of direct investment and profits were shared on partnership basis. The first formal Islamic bank was Islamic Development Bank which was established in 1974 by the Organization of Islamic Countries. This bank

was established to support Islamic countries and enhance mutual trade among them. The period between 1970 and 1980 witnessed the establishment of various Islamic banks which include Dubai Islamic Bank – 1975, Faisal Islamic Bank of Sudan – 1977, Bahrain Islamic Bank – 1979 and Philippine Amanah Bank. After the 80’s the Islamic banking sector started growing more steadily and several modes of financing and products have been introduced since then (Shari'ah Fortune, 2009).

2. Principles of Islamic Banking

Islamic banks are quite similar to traditional banks with the exception of reliance on interest in transactions. Islamic banks are governed under the Islamic laws of Shari’ah and according to these laws interest is prohibited in any transaction. The avoidance of Riba or interest is the basic principle of Islamic banking and the pillar of Islamic banks throughout the world. This is the distinction between conventional banks and Islamic banks. Various products are used in Islamic banking to eliminate the interest factor from banking such as Mudarabah, Musharakah, Murabaha, Ijarah, Takaful, Qard Hassan and Sukuk.

Islamic banking principles are based on Fiqh Muamlat of the Islamic Shari’ah which provides the rules of transactions. There is a necessary requirement for each Islamic bank to form a Shari’ah board or Shari’ah committee to govern the overall operations of the bank to ensure compliance with Shari’ah principles. Islamic banks deal with traditional banking operations but avoid any transactions which involve interest. The banking operations which involve interest and cannot be avoided are replaced with alternatives like Ijarah and Takaful. The Shari’ah board in an Islamic bank serves as an oversight body performing the functions of an

internal Islamic auditor which ensures that all operations, transactions and deals are free from interest.

The board also ensures that all deals taken up by the bank do not involve business transactions which are Haram- which means prohibited or restricted under Islamic Shari’ah and do not involve any activity related to pork, alcohol and gambling. According to Islamic banking principles, investment is not allowed in any business which involves activities based on alcohol, pork and gambling such as pork meat processing business, wine and alcohol processing and trading which include distilleries and casinos (Khorshid, 2004).

3. Products and Systems in Islamic Banking

There are various modes of transactions available in Islamic finance which can be used as alternatives to traditional financial transaction. Some of these transactions are quite similar to traditional transactions but some of them differ highly in terms of methodology and concept. The modes of transactions in Islamic finance are designed to avoid compounding of interest. There is an assortment of terminologies for these transactions which are explained below.

3.1 Bay’ al-Inah

The concept of Bay’ al-Inah is based on the selling and repurchasing arrangement. The contract of Bay’ al-Inah involves two parties whereby a first party usually a bank or financial institution sells an asset to a second party usually the borrower through a deferred payment contract. The asset is repurchased instantly by the first party for cash at a lower price. This gives the bank a significant margin on the selling and repurchasing price while the borrower receives a sum of money as a loan which would be paid back in installments. A majority of Islamic

jurists label this contract as invalid as the intention in this contract is to obtain a loan through interest which is the difference between selling and repurchasing price. Albeit the majority of Islamic scholars consider this contract invalid under Islamic law, there are some scholars who deem this contract valid and binding under Islamic law such as the Syaffis in Malaysia (Rosly & Sanusi, 1999).

3.2 Bay' Bithaman Ajil

Bay' Bithaman Ajil utilizes the installment sales concept for buying and selling an asset. The contract entails that the asset will be bought and sold on a predetermined agreed price. The agreed price usually consists of profit for the seller and is usually an amount higher than the actual market price of the asset. The contract of Bay' Bithaman Ajil is quite similar to Murabaha with the exception of payments made by the buyer at the end of the contract and the collection of market rate of interest using a discount rate. Sometimes Bay' Bithaman Ajil bonds are also issued by the buyer to the seller of the asset and the payments are made at the maturity of these bonds (Thomas, Cox, & Kraty, 2005).

3.3 Bay’ Muajjal

Bay’ Muajjal is a credit sales contract whereby the seller usually a bank or financial institution sells an asset with a profit margin on the cost incurred on installment basis or by receiving a lump sum payment at a future date. It is on the discretion of the bank or financial institution to set the price of the asset similar to the market price of the asset, lower than the market price or higher

than the market price. The Bay’ Muajjal contract which is also referred to as a Murabaha Muajjal should explicitly state the actual cost of the asset and the mutual agreement on  profit margin being earned by the bank or financial institution (Seznec, 1987).

3.4 Mudarabah

Mudarabah is a form of partnership where two parties agree to do business on specific terms. In a Mudarabah agreement one party agrees to invest the capital required for the business whereas the other party manages the business and provides the labor input of the business. The party investing capital is known as rabb-ul-mal and the party providing the management of the business is called the mudarib. The two parties agree to share profits on the basis of a certain predetermined percentage. If the business faces a loss the rabb-ul-mal will lose money whereas the mudarib will lose the labor effort applied for management operations. The rabb-ul-mal in a Mudarabah agreement can be an individual, a company, bank or financial institution (Usmani, 2002).

3.5 Murabaha

Murabaha is a type of traditional sale of an asset or commodity where one party usually a bank sells the asset with a profit margin on the cost of the asset. The cost, selling price and profit margin are explicitly stated in the Murabaha sales agreement. The buyer pays the bank or financial institution on installment basis and the asset or property remains with the selling party as mortgage until the whole amount of the sales has been paid. Murabaha mode of financing has various advantages over conventional banking practices and operations. This is the main reason why Islamic banks and

financial institutions use Murabaha in place of traditional banking facilities (Vogel & Hayes, 1998).

3.6 Hibah

The term Hibah means a gift from one party to another party. There is no fixed amount for Hibah and no specific conditions are present. Hibah is not a necessary payment and is just a gift from one party to another party. Hibah may include an amount given to a creditor by a debtor for a loan but only if there is no obligation and only on the debtor’s discretion. Islamic banks usually use balances in the savings accounts of their customers in various investing activities and if the bank earns a profit on these activities it can allocate some portion of these earnings to the account holders as Hibah. The amount of Hibah is not predetermined and is at the sole discretion of the bank. The bank may or may not offer Hibah to its accountholders (RHB Islamic Bank, 2006).

3.7 Ijarah

In Arabic the word Ijarah means to rent or lease an asset or service. Under the Ijarah agreement an Islamic bank or financial institution buys an asset required by the customer and gives the asset to the customer with a fixed predetermined amount of rent or lease. Islamic banks and financial institutions widely use the Ijarah system as an alternative to the conventional lease agreements. The asset bought by the bank is delivered to the customer who uses it during the period of the lease and the asset remains as mortgage with the bank. The rent or lease payment in the Ijarah system is based on two rudiments which are variable and

fixed rent. If the customer defaults on rent payments then according to Shari’ah the bank can repossess the asset and sell it to recover any losses incurred due to termination of the Ijarah agreement (Jaffer, 2005).

3.8 Musharakah

Musharakah is a partnership or joint venture agreement between two or more parties where each party invests an amount of capital to start and pursue a business. The ratio of invested capital and distribution of profit is predetermined and is shared on the basis of this ratio. The Musharakah system is used widely in business operations, purchase of fixed assets and property. It is quite similar to conventional partnerships but does not include fixed investments such as loans and debentures. The parties in a Musharakah system are entitled to manage the business but it is not necessary for one or all partner to do so unlike the Mudarabah system where one party invests capital and the other party manages the business. The Musharakah system can be applied with non-Islamic institutions if the business proceedings and operations are Shari’ah compliant and legal according to Islamic Shari’ah (Ayub, 2008).

3.9 Qard Hassan

In Arabic the word Qard means a loan and Hassan means good, so qard Hassan is a good loan which does not involve any interest. Many scholars of Islam believe that qard Hassan is the only true form of financing or loan facility available under Islamic Shari’ah and does not include any interest. Qard Hassan is a type of Islamic loan which is provided to people in need of money and there is no interest charge involved with the loan. The borrower only

needs to repay the principal amount of the loan without any payment of interest. Albeit the borrower does not need to pay any interest but can pay an additional amount to the lender at personal discretion as Hibah or gift without any intention of interest (Haron, 1998).

3.10 Sukuk

The name given to financial instruments or certificates in Arabic is Sukuk. Sukuk are usually referred to as Islamic bonds but it should be considered that bonds based on interest and fixed income are prohibited in Islam. The Sukuk involve the securitization of financial instruments where Sukuk are backed by assets which are similar in nature to debt and equity but do not involve fixed income or interest. There are various types of Sukuk which include istisna’ Sukuk, Ijarah Sukuk, Salam Sukuk and Murabaha Sukuk. A traditional bond holder is usually not aware of the assets being financed through the issue of bonds whereas a majority of Muslim scholars are of the view that Sukuk are permissible only when the assets backing the Sukuk are disclosed to the purchasers of these Sukuk and do not involve interest or fixed income  (Pock, 2006).

3.11 Takaful

In Arabic the name for cooperation and help among people is Takaful. It is an alternative in Islamic finance for insurance. Under the system of Takaful a fund or pool is formed including various members who agree to cover damages through this fund if one of the members faces a loss due to any calamity. If a particular participant or member of the Takaful faces a loss an agreed amount of money would be reimbursed depending on the

terms and conditions of the Takaful agreement. It can be viewed as group cooperative insurance based on traditional insurance methodology but with the exception of interest and other non-Islamic elements (Venardos, 2005).

3.12 Wadiah

Wadiah is a system of safekeeping of money and funds by one party for another party. In Islamic banking there are usually two types of deposits which are qard and al-Wadiah. In al-Wadiah a bank keeps the funds of the customer or account holder as a trustee and is responsible for its safety. Both of these depositing systems work like current accounts in conventional banking systems and the customers are not offered any amount greater than the principal amount. Another form of safekeeping in Islamic finance is Amanah where the assets or funds are kept for safety but the trustee is not responsible for any losses or damage to these assets or funds which does not involve the fault of the safe keeper (Farooq, 2008).

3.13 Wakalah

In Arabic Wakalah means taking supervision of another person’s property or assets. The person or party to whom the custody or supervision is given is called a Wakeel. Wakalah is a form of agency contract or a power of attorney where one party assigns the rights of commencing and carrying out transactions to another party on the firs person’s behalf. The person appointed under a Wakalah contract can proceed with various transactions such as trading, receiving and discharging debts and resolving various disputes for the principal party. There are various types of Wakeel which include Wakeel-bil-kusoomah, Wakeel-bil-taqazi al dayn, Wakeel-bil-qabaza al dayn, Wakeel-bil- bay’ and Wakeel-bil-shira (Ayub, 2008).