Islamic Banking State of the Art by Ziauddin Ahmad

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islamic 295 banking 191 banks 177 financing 67 profit 63 deposits 54 financial 52 based 47 sharing 45 investment 40 basis 39 operations 38 finance 37 funds 37 loss 37 economy 36 muslim 36 countries 33 central 29 mudarabah 25

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the final section draws attention to certain issues which need further study and research in the light of the practical experience gained so far in the field of islamic banking
yet it is a fact of life that the muslim societies were unable to keep away from interest based transactions when modern banks appeared on the scene

among the followers of islam the institution of interest has always been regarded as highly ignoble because the holy qur an strictly prohibits interest based transactions in all for miss in the early history of islam the injunction relating to prohibition of interest was strictly observed but with the decline of the hold of religion and spread of western influence financial practices based on interest began to permeate muslim societies as well
the theory of islamic banking the theory of islamic banking is based essentially on the premise that interest which is strictly forbidden in islam is neither a necessary nor a desirable basis for the conduct of banking operations and that islamic teachings provide a better foundation for organizing the working of banks

the earliest references to the reorganization of banking on the basis of profit loss sharing are found in the writings of certain muslim scholars in the late forties and early and mid fifties of this century
with the progress of trade and industry and increased financing requirements of productive enterprises direct finance proved an inadequate mechanism for such transference and banks emerged on the scene to undertake financial intermediation between savers and investors

the jurists of the early islamic period closely examined the features of mudarabah and musharakah as found in the pre islamic period and built a corpus of juridical opinion in regard to the attributes that must be possessed by these two types of financial arrangements to make them fully compatible with the ethos of the value system of islam
profit is distributed among the partners in pre agreed ratios while loss is borne by each partner strictly in proportion to the respective capital contribution

the shari ah experts associated with the working of these banks saw no objection to banks engaging in activities like murabahah a contract in which a client wishing to purchase equipment or goods requests the bank to purchase the items and sell them to him at cost plus a declared profit bai muajjal a trade deal in which the seller allows the buyer to pay the price of a commodity at a future date in lump sum or installments ijara leasing ijara wa iqtina hire purchase and bai salam advance cash purchases of products

as for the profit sharing arrangements between the bank and the users of bank funds islamic banking models stick to the basic principle laid down in the shari ah that profit earned from mudarabah business will be distributed between the provider of funds the bank and the user of bank funds on the basis of proportions settled in advance
similarly a distinction could be made between the providers of redeemable capital and non redeemable capital with provision of larger return to providers of non redeemable capital

for the purpose of profit loss sharing in musharakah business the respective capital contributions of parties utilized for varying periods would be brought to a common denomination by multiplying the amounts with the number of days during which each particular item such as equity capital of a firm its current cash surpluses suppliers credit as well as the finance provided by the bank were actually deployed in the business

the rationale for this is that since the funds available to a bank through demand deposits belong to the public and the banks do not pay any return on these deposits a part of these should be utilized for meeting the financial needs of the government
judged in this perspective the task of the replacement of conventional banking by islamic banking does not consist of a mere mechanical replacement of interest by noninterest modes of financing

the new financial instruments that have been suggested in this context include participation term certificates which would entitle their holders to share in the profits of the concerns issuing them specific investment certificates which would carry the name of the enterprise in which the proceeds of the certificates would be invested and in whose profit their holders would share and leasing certificates which would entitle their holders to a proportionate share in the yield of the assets leased by a company net of administrative expenses

for influencing the flow of bank funds in the desired manner and for encouraging or discouraging the use of bank finance for specified purposes the central bank will be able to use measures of selective control like restricting the use of bank resources for certain purposes and setting mandatory targets for financial assistance to be provided by banks for stated purposes

to compensate for the loss of the bank rate weapon some study groups and scholars have suggested that central banks operating on a non interest basis may be empowered to vary the profit sharing ratios applicable to various types of financial assistance to be made available by the central bank to commercial banks
viability of islamic banking a good deal of literature on islamic banking is concerned with the viability of banking institutions which seek to operate on an interest free basis

on the contrary one should expect that the incidence of defaults would be less because on account of their having a direct stake in the profit of concerns to whom finance is provided islamic banks would be more vigilant in monitoring the end use of funds as compared to the traditional banks which attach greater importance to the security pledged against the loans compared to the actual monitoring of the business dealings of their clientele
a study on the relative merits and demerits of interest based and pls profit loss sharing based banking attributes the dominance of interest based banking in the world at large to the problem of existence of the moral hazard in pls based banking even though pls based banking is superior to interest based banking in several other respects

it has been agreed that the actual outcome would depend on a number of factors such as the form of the utility function and its risk properties for example the degree and the extent of risk aversion the degree to which future is discounted whether or not increased risk is compensated by higher return and finally the income and substitution effects of increased uncertainty

this position is defended on the basis of the general proposition that any financial development that causes investment alternatives to be compared to one another strictly based on their productivity and rates of return is bound to produce allocative improvements and such a proposition is the cornerstone of the islamic financial system
d consequences for the stability of the banking system it has been argued in the literature on islamic banking that a switch over from interest based banking to pls based banking would impart greater stability to the banking system

in the pls based system the nominal value of investment deposits is not guaranteed and shocks to the assets positions are promptly absorbed in the values of investment deposits
side therefore lead to divergence between assets and liabilities and the banking system can suffer a loss of confidence in the process leading to banking crises

e effects on the stability of the economic system the literature on islamic banking has taken note of apprehensions expressed in certain circles that replacement of interest by profit loss sharing may make the whole economic system highly unstable as disturbances originating in one part of the economy will be transmitted to the rest of the economy

it also takes note of the activities of the islamic development bank which is an international development financing institution working on shari ah principles the islamic banking experiments in some non muslim countries and offer of islamic banking services by conventional banks in certain muslim countries
saving deposits are differentiated from demand deposits as they are subject to certain restrictions with respect to the amounts that can be withdrawn from such accounts at any one time and the periodicity of such withdrawals

excepting the three countries where islamization of the banking system has taken place on an economy wide basis islamic banks in other countries are at a considerable disadvantage in facing the competition with conventional banks as they cannot avail of the facilities of the money market which operates on the basis of interest
secondly they are in competition with interest based banks and are therefore anxious to earn at least as much on their investments as will enable them to give a return roughly comparable to prevailing interest rates to their investment account holders

there are of course substantial differences in the performance and profitability of individual institutions within the islamic banking community but this is not surprising because operating conditions and business environment differ widely from country to country and from time to time in the same country
kuwait finance house faisal islamic bank of egypt and massraf faysal al islami of bahrain had made such rapid progress that they were counted among the seven largest banks of their respective countries within a short period after their establishment

islamic banking in pakistan the process of economy wide islamization of the banking system in pakistan was initiated soon after a declaration by the then president of pakistan in february that government planned to remove interest from the economy within a period of three years and that a decision had been taken to make a beginning in this direction with the elimination of interest from the operations of the house building finance corporation national investment trust and mutual funds of the investment corporation of pakistan
however time series data which are available for some islamic banks show that as a bank grows in age and experience it tends to bring about a shift in the pattern of its financing operations in favor of both longer duration financing and greater attention to the developmental requirements of agriculture and industry and that it expands its client base and pays greater attention to its social responsibilities by extending larger assistance to small scale industries and new employment generating activities

trade related modes of financing include the following i purchase of goods by banks and their sale to clients at appropriate mark up in price on deferred payment basis ii purchase of trade bills iii purchase of movable or immovable property by the banks from their clients with buyback agreement or otherwise iv leasing v hire purchase and vi financing for development of property on the basis of a development charge

the law required the banks to convert their deposits to an interest free basis within one year and their other operations within three years from the date of the passage of the law and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks
however banks are permitted to provide incentives to depositors through i grant of prizes in cash or kind ii reduction in or exemption from service charges or agent s fees payable to banks and iii according priority in the use of banking facilities

these include power to determine a minimum and maximum expected rates of return from various facilities to the banks b minimum and maximum profit shares for banks in their mudarabah and musharakah activities and c maximum rates of commission the banks can charge for investment accounts for which they serve as trustees

the banking system has also been used as an instrument of income redistribution through the provision of qard al hasanah loans to low income groups financing the building of low cost houses and provision of financing for small scale agro business and industrial cooperatives often without stringent collateral requirements

it is also charged with the responsibility of assisting in the promotion of foreign trade especially in capital goods among member countries providing technical assistance to member countries extending training facilities for personnel engaged in development activities and undertaking research for enabling the economic financial and banking activities in muslim countries to conform to the shari ah
the first attempt to islamize the entire banking system was made in when a presidential decree was issued directing all commercial banks to stop interest based dealings with immediate effect and to negotiate the conversion of their then existing interest bearing deposits and advances into islamically acceptable for miss foreign transactions were allowed to be continued on the basis of interest for the time being

the over anxiety of the bank in its initial years to expand the network of equity financing to cover as many of its member countries as possible lack of sufficient professional expertise in the bank to undertake an adequate appraisal of projects and to pursue the task of vigorous follow up of its equity investments delay in the implementation of projects financed by the bank marketing difficulties and currency devaluation have been cited as the main factors responsible for this situation
it is reported that the bank is engaged in devising corrective measures and safeguards and equipping itself better for undertaking equity financing by directing greater attention to macro economic conditions and policies affecting its projects stricter supervision and linking disbursements to project implementation

along with the theoretical developments the practice of islamic banking has been growing rapidly and there have been a number of contributions shedding light both on the operating procedures of islamic banks as well as the results achieved in terms of deposit mobilization profitability and achievement of islamic socioeconomic objectives
islamic banking in non muslim countries and offer of islamic banking services by conventional banks in muslim countries some interesting experiments have been made of what may well be called institutionalized use of islamic modes of deposit mobilization and financing if not fullfledged islamic banking in quite a few non muslim countries

operational issues relating to the practice of islamic banking i shall the banks remain financial intermediaries or enter directly in trade and industry ii identification of reasons both general and country specific which have stood in the way of greater use of profit loss sharing techniques in islamic banks financing operations
iv what concrete steps can be taken to better attune the islamic banks for playing a more dynamic role in the attainment of islamic socioeconomic objectives v issues relating to accounting determination of profit and loss in profit loss sharing arrangements and treatment of costs and reserves in such accounting

the present state of islamic finance movement paper presented at a conference on the impact and role of islamic banking in international finance issues and prospects held in new york in june

some theoretical and philosophical aspects of islamic banking a dimension of islamic economics paper presented at the third international course in islamic banking tehran central bank of the islamic republic of iran

mirakhor abbas some theoretical aspects of an islamic financial system paper presented at a conference on islamic banking sponsored by the central bank of the islamic republic of iran tehran

fiscal policy and resource allocation in islam jeddah international center for research in islamic economics and islamabad institute of policy studies

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Main Category

AlHuda Material\islamic banking

KeyWords

islamic banks banking financial finance investment conventional institutions funds risk financing deposits assets services management international countries equity profit products

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Number of Pages

38

Published Date

2006-06-06 12:08:55

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Islamic Banking State of the Art by Ziauddin Ahmad

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