The Rise of Islamic Banking in a Time of Economic Crisis

Introduction

On the surface, it may seem odd that Islamic banking is in such demand but when looked at from a cultural and religious perspective, it embodies the very essence of Islamic law. To put it simply, what makes Islamic banking different from conventional banking is that it is based on the principles of Islamic law, which forbids the receipt of interest or riba. Islamic banks cannot charge interest on any loans thus do not lend out loans but profit from transactions such as sales, leases as well as partnership-based instruments (Ahmed and Amr 28). In addition to being unable to charge interest, Islamic banks are also prohibited to engage in any activities that involve pork, gambling, pornography, as well as alcohol. As well all causes of ambiguity must be eliminated from all transactions thus in every sale and lease transaction elements such as price, quantity, quality and estimated time of delivery must be clearly disclosed.

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According to Ayub (35), the primary objectives of Islamic banks are fourfold which include the following: first, modern financial services need to be provided while still adhering by the rules set forth in the Sharia. They are expected to be more focused on development since there is a direct relationship between return and investment. Since all investments taken on by an Islamic bank need to focus on promoting public advancement, investments, which are best for society, need to be made a priority. Last, all parties involved in a transaction need to have equal access to the income and resources.

The reason why riba or interest is prohibited in Islamic transactions is based both on the principles set forth in the Quran as well as economic reasons. In terms of economics, the distributive system is feasible for three primary reasons: first, industrial, and commercial risk is more equitable between the investor and entrepreneur; second, an equal share in profits ensures that returns are equitable despite the amount of the profit. Third, wealth can be expanded if it aids in creating value. In terms of capital allocation, the Islamic system functions on three main principals as well: first, in contrast to conventional banking, caters to those projects, which are productive as well as profitable. Second, profit sharing ensures that productivity is kept the main objective. Third, the Islamic system of profit sharing caters to a greater distribution of wealth rather in contrast to conventional banking (Ayub 72).

Another very important principle that plays a major part in how Islamic finance is conducted is referred to as Gharar, which can be translated into risk. To avoid any type of risky situations within Islamic finance, all parties involved in a particular transaction are responsible for clearly highlighting what the deal will consist of. Details such as price and expected time of delivery for an item are issues that must be covered prior to a contract being signed. Gambling or Maysir is also strictly prohibited in the Quran therefore is not allowed within Islamic finance.

History of Islamic Banking

According to Kablan and Yousfi (4), Islamic banking officially started in the 14th century. However, various factors hindered its expansion among them, powerful influence of conventional banks, and other factors such as colonization and the break of Islam. Islamic banking has principles, which have been applied for many decades and continue to impact on its present operations and its future, providing a variety of products and services to clients.

Hawala involved payments of debts made through transferring claims while suftaja served the purpose presently served by the bill of exchange. Exchange transactions and ruqas were also common, ruqas being the equivalent of checks used presently. Credit based commercial associations such as partnerships called musharakah, and capital trust financing called mudaraba were also common. For several centuries, Muslims used these systems and instruments to carry out transactions before Europe adopted and developed these financial instruments (Al Rajhi Bank 11).

Kettell notes that the Islamic Golden Age between the eighth and twentieth centuries was marked with free markets and proto-capitalism with ‘an early market economy and mercantilism,’ typically called Islamic capitalism (Kettell 21). Various economic concepts were used in early Islamic banking. Bills of exchange, partnerships (mufawada), limited partnerships (mudaraba), capital accumulation (nama al-mal), promissory notes, ledgers, assignments and trusts (waaf) were commonly used (Kettell 22).

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Islamic Banking Principles

Unlike conventional banking, Islamic banking is founded on the sharia law called Fiqh al-Muamalat governing all transactions. The major guiding principle is sharing of profit and loss. Since both the borrower and lender share the profits and losses resulting from the funding, both parties tend to have a close association with one another. The lender will be interested to know in what project the borrower wishes to invest or spend the money. This eliminates chances of such money being used to fund illegal activities or indulgence in immoral activities.

Another principle states that there is no financing or involvement in activities prohibited in Islam. Islam banking mainly applies in transactions that are acceptable in Islam, with the sole objective of promoting ethical and moral transactions. Transactions involving goods and services outlawed in Islam such as alcohol, pork and gambling are not categorized under Islamic banking.

Additionally, no interest (usury/riba) is to be charged on capital funding. During mortgage transactions, a bank will buy an item from a seller and then sell it at small profit to a buyer. The bank does not loan out money to the buyer; it instead buys the item and gives him a chance to pay for the loan in installments. Like conventional banks, Islamic banks demand collateral from the borrower before selling out the mortgage. Once the collateral is approved, the property is registered under the borrower’s name and he then has to start paying in installments, an arrangement called Murabaha in Islam (Kettell 24).

Another loaning arrangement involves the bank applying a floating rate- as rental. The bank and borrower collaborate in funding for the purchase of property. The property is then rent out to the borrower. The borrower the pays rent which is distributed between the bank and the borrower. This arrangement is called diminishing musharakah.

While paying the rent, the borrower buys the shares of the bank in the property at specified installments until the equity value of the property is transferred to him, effectively ending the bank-borrower partnership. In case the borrower defaults on rental payment, the bank and the borrower both share proceeds arising from sale of the property depending on the value of their equity in the property. An arrangement in which the bank provides the capital funding while the borrower (entrepreneur) provides labor and expertise is called mudaraba. This enables both parties to share profit and loss (Kettell 8).

The fourth principle states that some risks have to be shared by all partners in a venture, whether the funds are utilized on a commercial or a productive venture. Such risks are proportional to each partner’s efforts. The risk must be controllable. In such a partnership, the contract must have a clear purpose and this must be assessed at the end of the agreement so as to guard against a one-sided transaction, commonly termed as gharar (Kablan $ Yousfi 2).

Modern Islamic Banking

Initially, Islamic banking was mainly about sharing profit and loss. Later, interest-free banking emerged in the 1950s. The continued growth of interest-free banking in the 1950s to 1970s is attributable to the resultant political interest created in Pakistan and young Muslim economists who emerged during that time. It was then that academic writings on Islamic banking first appeared (Kettell 21). Later in the 1970s, governments and institutions took a keen interest in the interest-free idea, resulting in Islamic Countries’ Conference of Finance Ministers in 1970 held in Karachi, Pakistan, the 1976 International Conference on Islamic Economies and later the 1977 London International Economic Conference. Establishment of the Islamic Development Bank in 1975 resulted from the interest-free idea (Kettell 18).

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Islamic banking implementation began in Egypt in 1963 with the establishment of a savings bank in Mit Ghamr under leadership of Ahmed El Naggar. The bank did not however want to portray itself as an exclusively Islamic bank for political reasons. The bank continued operating under the mudaraba principle until 1972 when it became part of the present-day Nasr (Nasser) Social Bank. In Dubai, the Dubai Islamic Bank was established in 1965 and stands out to this day as the first fully functional modern commercial Islamic bank.

Services Offered By Islamic Banks

Islamic banking has diversified. Presently, services offered are not just commercial and retail in nature- asset management is also offered. According the State Bank of Pakistan, Islamic Banks are to offer a variety of products, which cater for the requirements of many sectors of the economy. Sharia-compliant modes include, Ijarah (letting on lease for rental), Murabaha, Mudaraba, Musharaka, Diminishing Musharaka and Wakala. Asset side products offered include agricultural products, commercial, consumer, small and medium enterprise facilities, treasury and financial institution requirements as well as commodity financing. Liability side products include deposit schemes that enable customers to invest funds such as current accounts, savings accounts, term deposits for different maturities, certificates of investments and basic banking accounts.

Other facilities include bonds and guarantee services, online banking, letters of credit, both local and international remittances, debit cards, payment of utility bills, export bills collection and assigning local and export bills, e-facilities such as e-statements, lockers, phone banking and deposit-taking ATMs (State Bank of Pakistan 2).

The Present and Future of Islamic Banking

Islamic banking sector’s future looks bright with its emphasis on sharia-compliant banking. It has continued to play a significant role globally as seen during the 2007-2009 economic crises. In London for instance, over 25 companies offer direct or indirect Islamic financing. The biggest of them is BLME. Other conventional banks presently seem to offer sharia-compliant products yet some of the largest banks such as Islamic Bank of Britain have been operational for only 7 years, illustrating increased competition from Islamic banks.

Islamic banks have a notable global asset base of approximately between US $ 0.5-1 trillion, and continues to grow at an annual rate of 10-15 %. BLME recorded US$ 2.7 million in pretax profits, with its assets increasing two-fold, reaching US$ 931 million (Grose 8). Consumer awareness about services offered by Islamic banks has continued to grow.

The United States has at least 19 Islamic banking services and product providers. These range from retail and investment banks to mortgage companies and investment advisors. The need for sharia-compliant products has been sparked by an increasing number of Muslims in U.S, whose figure currently stands at between 3 and 8 million. University bank, Devon bank, Broadway bank of Chicago, RornAsia Bank, Mutual Bank and Lincoln State Bank are among the financial institutions providing Islamic Banking services (Shayesteh 32).

Apart from its strong presence in Asia, Islamic finance has been firmly established in several European countries such as Britain and France. In Germany, Kuveyt Türk Participation Bank is growing stronger majorly due to the interest-free policy. The bank stands out among the best in the bond market. In Africa, Islamic banking is prevalent in Egypt, Sudan, and Algeria and among other Islamic nations.

In Asia, Saudi Arabia is the leading Islamic banking market. Malaysia too holds a significant percentage particularly in bond market. It was the largest bond (sukuk) market in the world in 2007 valued at about US $25 billion. Malaysia, considered to be one of Muslims Asia’s financial base supports Islamic banking through among other means, exempting taxes on Islam finance and adoption of foreign exchange regimes considered to be relatively liberal (Wahidin 10).

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Several countries where Islamic banking is well established have taken steps aimed at tapping talent and research into the sector. In Malaysia, several institutions have been set up such as International Sharia Research Academy (ISRA), International Center for Leadership in Finance, and Islamic Banking and Finance Institutive Malaysia, among many others. Measures have also been proposed to integrate some of the international standard practices and systems practiced in conventional banking such as accounting standards and capital adequacy requirements into Islamic banking. According to the governor of Jordan’s central bank Ummaya Toukan, this will strengthen the sector without affecting sharia-compliance (Wahidin 25).

Sharia Advisory Council/Consultant

Middle East advisors to Sharia-compliant Public and Private Establishments hold a significant portion of the approximately US$ 275 billion Islam-held assets in the world. The sharia advisory council offers advice with regard to Islamic Banking and Finance services. The council is composed of scholars and experts in laws about financial transactions. The council advises on issues, which could result in provision of sharia-compliant products and funds. These services are provided to commercial, banking, regulatory as well as finance sectors. Trusteeship, custodianship, listings, auditing and legal areas receive relevant advice and consultation assistance from the council. The aim of the council is to oversee sharia-compliance in commercial and financial transactions that the banks engage in (SAC 28).

Conclusion

For many centuries, Islamic banking has existed. However, it was only in the 1970s that its impact began being felt with its emphasis on sharing of profit and loss sharing and interest-free banking. Presently, Islamic banking is available in many continents: in Europe, America, Africa, and Asia. Although intended to serve Muslims, it often serves other non-Muslim members as well, as seen in UK and U.S. Many Islamic banks were established a few decades yet they continue growing steadily, a factor that has challenged conventional banks to tap into the wide Islam market. The U.K, France, and U.S all have well established Islamic banking systems, which affirmatively contribute to economic growth.

Basically, no interest is to be charged on capital funding, profits and losses have to be shared, and risk has to be taken by both parties depending on their efforts. Under watch and advice of the Sharia advisory council, the sector has continued to grow and its future is promising. Such banks have diversified their services and presently offer as many products and services as those offered by conventional banks, except for the prohibition of usury/ interest on capital funding.

Works Cited

Ahmed, Amr, and Amr Tiby. Islamic banking: How to Manage Risk and Improve Profibility. John Wiley and Sons, 2011.Print

Al Rajhi Bank. “Islamic Banking”. Al Rajhi Bank. 2011. Web.

Ayub, Muhammad. Understanding Islamic Finance. New York: John Wiley and Sons, 2009. Print.

Grose, Thomas. The Rise of Islamic Banking in a Time of Economic Crisis. US news. 2008. Web.

Islamic Banks. Islamic Banks. 2010. Web.

Kablan, Sandrine. & Yousfi, Ouidad. Performance of Islamic Banks around the World: an Empirical Analysis over the Period 2001-2008. Erudite. 2011. Web.

Kettell, Brian. The Islamic Banking and Finance Workbook: Step-by-Step Exercises to Help You Master the Fundamentals of Islamic Banking and Finance, NJ: John Wiley & Sons, 2011. Print

SAC. Shariah Advisory Council: Mission. Arab Chamber of Commerce & Industry. 2008. Web.

Shayesteh, Abdi. Islamic Banks in the United States: breaking through the barriers. New Horizon. 2011. Web.

State Bank of Pakistan. Handbook of Islamic Banking Products & Services. State Bank of Pakistan. 2008. Web.

Wahidin, NUR ALIA.”Future of Islamic banking: Things can only get better.” Todays Zaman. 2010. Web.

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StudyCorgi. 2021. "The Rise of Islamic Banking in a Time of Economic Crisis." June 7, 2021. https://studycorgi.com/the-rise-of-islamic-banking-in-a-time-of-economic-crisis/.

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