Islamic Financing and Banking Essay Example

investing in businesses that offer goods and services that perceived to be contrary to the teachings and principles of the law (Memon, 2007). In spite of these principles being used as the basis for the economy that flourished during the early years, it was not until the twentieth century that Islamic banks which applied these principles were formed (Neal, 1999).

Modern Islamic banking which is characterized by profit sharing between the bank and the client started in Egypt and has been growing at a relatively constant rate of between 10-15 percent per year. There are signs of this growth remaining consistent in the years to come. The principle by which Islamic banking institutions operate has made them so stable such that they are unaffected by the current prevailing recession that has seen many established banks go to bankruptcy (Schoon, 2009). There even are suggestions that conventional banks need to start applying these rules for them to restore client confidence in times of global financial crisis.

Islamic banking functions to serve the same purpose as the other conventional banks except that its operation is based on the Sharia rules that relate to transactions. Islamic banking operations are based on sharing of profits and lose with the prohibition of payment or charging of interest in an effort to emphasize on ethical investments that are directed towards contributing to the greater good of the society.  The Islamic concepts that are mostly applied in Islamic banking include joint venture, profit sharing, leasing and cost plus (Kuo, Aziz, & Akhtar, 2008).

In a mortgage transaction for ample, Islamic banks will buy the house or whichever item it

is from the seller and resale it at some profit to the buyer instead of loaning them money required to buy it. The bank then allows the buyer to pay bank in installments but since explicit profit making is not allowed, the buyer is not penalized for paying late (Kuo, Aziz, & Akhtar, 2008). These banks protect themselves against default by asking for strict collateral where they retain ownership of the bought property until the loan is completely paid.

The desirable features of Islamic banking have begun offering an appealing alternative to customers over conventional banking. The increased growth in this industry is partly because of the Paul O'Neill's statement in 2002 in which as the United states Treasury Secretary; he said that Islamic finance was a legitimate way of doing business This statement is argued to have had a great impact on the non-Muslims' perspective and sentiments about this banking as more individuals began turn to these banks for their financial solutions (Kuo, Aziz, & Akhtar, 2008). Islamic banking currently has presence in over seventy five Islamic as well as non-Muslim countries. The industry's growth is also attributed to the diversification of the financial products they offer, the progress in development of regulatory frameworks and the enhancement of the industry’s international linkages.

1.2 Islamic Banking and Non-Islamic Banking

Islamic banking whose operation is based on the Islamic economic system that is founded on Sharia law is not restricted such that it serves Muslim believers only. Current reports show that these banking institutions have became popular and more appealing to non-Muslims as well due to their loss and profit sharing feature. Islam

injunction is argued to aim at ensuring that interests of the whole humanity and its welfare are taken care of. Islamic banking and non-Islamic banking both function to serve similar purposes. There however is difference in the basis by which they operate and the principles that guide their operations (Memon, 2007).

The modes by which Non-Islamic (conventional) banking function and operate on are fully based on man made principles. These banks operate based on organizational structures and aspects such as culture, values, mission and vision which are all manmade and as they are laid down by each institution's management based on their strategies goals. These principles also vary from one banking institution to another as different banks have different goals, value and culture. The principles that govern the way conventional banks operate therefore depend on what the institution's management perceives to be best for the growth of the institution (Neal, 1999). Islamic banking` however functions and operates based on the injunctions that are provided by the holy Koran. Islamic banking operates in conformity with the Sharia law. Since these laws are universal, all Islamic banking institutions tend to operate in a manner that is similar as they are all bound by these laws.

In non-Muslim banking, the investor is assured of being charged rate of interest that is predetermined. In the event one borrows money from these institutions, they are required to pay back with an interest which increases as one takes more time to pay back. Delay in paying is not allowed as the interest rates are predetermined. In the event one delays to pay back the loan, conventional banks own whatever

was put forward as the security or in the event of a mortgage, resell it to raise money that is owed to them. Conventional banks can also charge penalty in terms of additional charges in the event of defaults.

The fundamental function of these institutions is to lend out money and get it back by making profits through charging of compound interest. Islamic banking however, does not charge any interest on money loaned to its investors the Sharia law prohibits it (Akhtar, 2007). On the contrary, these banks function in such a way that risks and loses are shared between the capital provider who is the investor and the individual borrowing the money for use that can be viewed as the entrepreneur. These banks have no provision for charging penalty or extra money from defaulters. These banks usually charge a very small of money in terms of compensation which is not used by the bank as profits but given to charity. The fundamental function of Islam banking institutions is to participate in business partnership, sharing both the risks and opportunities that arise (Iqbal, & Llewellyn, 2002).

Non-Muslim banking institutions function in a way that ensures that there is maximization on profits. All the strategies that these institutions implement are directed towards ensuring that maximum profits are attained. The growth of these institutions is measured based on the number of sales made size of profit margins. There are no limits to the amount of profits that need to be made and no restrictions on the measures taken to achieve them as long it is legal (Akhtar, 2007). Islamic banking similarly seeks to maximize on

profits but is restricted in the man used to attain the profits by the Sharia law. This implies that all the strategies used must be in accordance with the Sharia law.

Conventional (non-Islamic) banking does not involve the investors offering Zakat which refers to the giving of alms. These banks do not have procedures that provide for the investors to give part of their wealth or profits to charity as a sign of cleansing of the acquired wealth. Islamic banking institutions however provide their clients with the opportunity to give Zakat (Neal, 1999). One of the functions of these institutions is to actually act as centers where Zakat is collected as they also pay out their own Zakat.

Conventional banks concentrate on serving their own interests and make no attempts to ensure that there is growth and equity within the society. Islamic banks however are concerned about public interest as their ultimate goal is to promote growth with equity within the society. Based on the fact that conventional banks are commercial and interest based, it is easier for them to borrow from the money market unlike the Islamic banks whose borrowing must be based on a transaction that is approved by the Sharia law which complicates and makes it hard for these banks to get loans from the money market as most of the systems in the money market do not apply Sharia laws in when lending. Non-Muslim banks also have to guarantee all their deposits (Kuo, Aziz, & Akhtar, 2008). Islamic banks however based on the al-wadiah principle guarantee only those deposits made on deposit accounts. This principle guarantees the depositors of

repayment of their money. In the event the account is based on concept of Mudarabah, the client then has to share with the bank the in he event of loses.

Conventional banks are usually not concerned with the development of expertise in project evaluation and appraisal before giving loans as they are assured fixed income from the loaned advances. Islamic banks however pay a lot of attention to development of appraisal and evaluation of projects. This is as attributed to the fact that they share profits as well as loses with the entrepreneurs (Iqbal, & Llewellyn, 2002). Most non-Muslim banks use credit to emphasize on the worthiness of their clients. Islamic banks on the other hand emphasize more on the viability of their clients' projects (Kuo, Aziz, & Akhtar, 2008). In the same line, the relationship between non-Muslim banks and their clients can be described as one that exists between creditors and debtors while the status of the relationship between Islamic banks and their clients is one that exists between partners, buyer and seller or investors and traders.

2. Islamic Banking & Finance over Traditional Banking System

Islamic banking is significantly different from traditional banking. It is worth to note that it was not until the twentieth century that this industry began to grow. One of the characteristics of the twentieth century is development in technology, particularly in information and communication. Islamic banking institutions in their growth have implemented new technology as well improving their final efficiency as compared to traditional banking that was characterized by the absence of technology application in its operations and in the event it did, the technology

was inferior to the one being used by modern Islamic banking institutions. Modern Islamic banking is also characterized by product as well as service diversification (Akhtar, 2007). This is one of the industry's aspects that are contributing to its tremendous global growth. The services and products offered by traditional banking were not as diverse as those being offered by the Islamic banks. This diversification is supported by deployment, implementation and application of new technology which is not available with traditional banking systems.

Islamic and finance is characterized by allocation of funds to projects that it perceives to be viable after comprehensive evaluation and appraisal. This is based on the fact that these banks function such that all risks, loses, opportunities and profits are shared with the users or entrepreneurs who borrow money from them. This is unlike the traditional banking system in which money is allocated to anyone as long as they have security (Memon, 2007). There also is difference in the way savings are mobilized by the two systems of banking and finance. In Islamic banking and finance savings are mobilized and used in a way that brings a greater good to all in the society. A significant percentage of these savings are used for charity purpose and to promote growth and equity within the society. In traditional banking and finance system, savings are mobilized for only one major purpose; to maximize the profits of the bank that is providing the banking services.

Traditional banking and finance is also characterized by interest rate charging on loans offered to clients. Charging compound interest on loans is in fact the fundamental reason for the

existence of traditional banks. Most of the strategies implemented by traditional banking system aim at selling products and services that will enable them to earn more profits out of interest charged on loans given out. Islamic institutions do not however charge interest on their loans (Iqbal, & Llewellyn, 2002). They aim at making profits by to assist those who borrow money from them to make as good use of it so that it earns profit that is shared by both Islamic bank and the borrower. Islamic banking and financing ensures that the profits it makes are enjoyed by the client as well.

3. Challenges in the Implementation of Islamic Banking & Finance in the West

It is clear that Islamic banking and finance is growing globally at a consistent rate. There however are several challenges that hamper this growth especially in the west. These challenges include;

3.1 Requirement of extensive research in Islamic Banking & Finance

Islamic banking and finance is an emerging industry that is still growing and has not yet established itself especially in the west. This industry has however proved to have so much potential. There is therefore need for tremendous investment to be made in research and development so as to promote and enhance innovation in this industry. One of the challenges facing the industry in this area is the need to come up with a variety of broader Islamic financial market tools and instruments that include securities that are Islamic asset backed, features of equity ownership, credit enhancement permissible forms and risk mitigating instruments that comply with Sharia law (Kuo, Aziz, & Akhtar, 2008).

In

order for this industry to flourish and be a success, there is need to engage international Sharia scholars in the research that will provide a forum and platform on which the compatibility of Sharia and Islamic financial markets and tools that are newly developed can be deliberated. The industry also requires practitioners who are familiar and understand the how functioning of the international finance, modern Islamic legal system and Western common law can be integrated in an economic system that is global (Akhtar, 2007). This requires significant research and development.

Just like any other successful industry, there is need for research to be done on consumer needs, so that the services offered by these banks can be tailored in a way that meets these needs while at the same time complying with the Sharia law. Islamic banking and financing can only be sustained through flexibility and innovation and creating different types of services and products (Memon, 2007). Islamic finance is distinguished by the profit-risk sharing feature, research and development enables more innovations to be done that will increase financial products that have this feature. All this needs innovation and creativity which can only be achieved through investment in research and development.

3.2 Development of Instruments to Assist in the Implementation of Islamic Banking & Finance

The lack of adequate and efficient supply of talent and expertise in addition to lack of adequate investment in research and development has resulted inadequacy in development of instruments to assist in the implementation of Islamic banking and finance (Kuo, Aziz, & Akhtar, 2008). These instruments which mostly include marketing tools are vital for introduction and implementation

of this industry in the western society. These instruments enable Islamic banking and finance institution to identify the needs of the market and implement strategies that will satisfy these needs. Lack of these instruments implies that these institutions can not effectively operate in these markets.

3.3 Modification of Traditional Banking Services to Compliance with Islamic Banking Regulations

Modern Islamic banking regulations are very different from those used in traditional banking services. Modern Islamic banking regulations are characterized by product and service diversification and have implemented new technology especially in information and technology to enhance their operations. The result has been finance efficiency. Traditional banking services which are characterized by few financial products and services and have not employed the use of technology in their operations find it hard to comply with modern Islamic banking regulations (Memon, 2007).

This greatly hampers the growth of this industry as the efficiency of traditional banking is inferior causing the industry to lag behind. Compliance of the traditional banking services with modern Islamic baking regulation would ensure faster and more effective business transactions (Memon, 2007). It would also improve customer services increasing the competitive advantage of the Islamic banking over conventional banking which is its competitor. This modification is very vital in the global growth of this industry particularly in the western society where technology is more enhanced than anywhere else in the world.