Assignment on Islamic Banking System Analysis

Overview

For an expanding economy, a developed and efficient banking system is indispensable. Among others, it helps transfer of financial resources from surplus units to deficit units and, hence, helps accelerate the pace of development by securing uninterrupted supply of financial resources to people engaged in numerous economic activities. The tremendous development that the world economy has experienced in the last few decades was contrib­uted by several factors among which, growing institutional supply of loan able funds must have played the pivotal role. The role of banking is comparable to what an artery system does in the human body. Both commercial banks and other development financial institutions provide short-term, mid-term, and long-term credits to business persons and entrepreneurs who usually take the lead in ventures of economic development.

Institutional supply of credit has been made possible by a system of financial inter-mediation organized in a way where conventional banks collect small savings from the public by offering them a fixed rate of interest and advancing the loan able funds out of the deposited money to enterprising clients charging relatively higher rates of interest. The margin between these two rates is the bank’s income. In addition, banks also provide many other services to the public for which it receives service charges.

Despite the outstanding contribution of the conventional banking system (interest-based), several ancient and modern economists are critical about its efficiency level. Some economists consider the role of interest in the conventional banking mechanism as a major negative factor that contributes to cyclical fluctuations in the economy. Specifically, the ineffectiveness of interest rate as a stabilization tool during the period of the Great Depression is a case to note. This eventually called for Keynesian prescription of government intervention. Similar concern was expressed in a story published in Newsweek regarding Henry Kissinger, the former Secretary of State of USA. To quote, “The instability has persisted and the uncertainty has continued. After going through the throes of painfully high levels of inflation, the world economy has experienced a deep recession and unprecedented rate of unemployment, complicated further by high level of real interest rates and unhealthy exchange rate fluctuations”. More recent concern over the potential instability of the world monetary and financial system was expressed by Maurice Allais, a Nobel Laureate, who called for an urgent reform of the World Economic Order. Others vehemently oppose the argument for using rate of interest as a stabilizing tool in the economy.

This called for the emergence of a new system of banking capable of tackling new challenges that the present world economy, particularly the financial sector, has been facing.

In response, though not exactly to that exigency but for quite a few other reasons, the second half of the twentieth century witnessed a distinctly separate line of thinking on banking. This was institutionalized at the end of third quarter and subsequently emerged as a new system of banking called Islamic banking {also called Profit-Loss-Sharing Banking (PLS)}. The world has now been expe­riencing operation of as many as 250 Islamic banks and financial institu­tions in more than 50 countries, Muslim and non-Muslim. There are religious as well as economic reasons, which have contributed to the emergence of PLS-banking as an alternative to its conventional counterpart. It is the prohibition of Riba in the Quran that, according to the proponents of the PLS-system, was the source of inspiration for establishing banks in line with Islamic Shariah. The basic intention behind establishing Islamic banks was the desire of Muslims to reorganize their financial activities in a way that do not contradict the principles of Shariah and enable them to conduct their financial transactions without indulging into Riba. These writers consider rate of interest in the conventional banking mechanism synonymous to Riba, the term as used in the Quran. One of the reasons for this is that the outcome of the productive effort is uncertain, and so interest necessarily involves an element of Gharar, that is, uncertainty. On this religious ground, proponents of the PLS-system urge the Islamic community to avoid all transactions with institutions those are interest-based.

The economic reason derived from a verse of the Quran providing inspiration to devise an interest-free financial system has been substantiated in the way that interest, instead of increasing wealth, reduces it. The primary reason of why the Quran has taken such a hard approach towards interest is that Islam stands for establishing a just economic system free from all kinds of exploitation. Further, Muslim economists consider depression and stagflation very often found in the capitalist world as an outcome of the financial system based on interest.

Thus, Islamic banking emerged as a response to both religious and economic exigencies. While religious exigency calls for avoiding any transaction based on interest, economic exigencies, on the other hand, provide a new outlook to the role of banking in promoting investment/productive activities, influencing distribution of income and adding stability to the economy. Islamic banking is thus perceived as an improved system in all dimensions.

What is Islamic Banking?    

Islami banking has been defined in different ways. The definition of Islamic bank, as approved by the Secretariat of the OIC, is stated in the following manner.

“An Islami bank is a financial institution whose statutes, rules and procedures expressly state its commitment to the principle of Islamic Shariah And to the banning of the receipt and payment of interest on any of its operations”.

Shawki Islami Shehta viewing the concept from the prospective of an Islamic Economy and the prospective role to be played by an Islamic bank therein opines:

“It is, therefore, natural, and indeed, imperative for an Islamic bank to incorporate in its functions and practices commercial investment and social activities, as an institution designed to promote the civilized mission of an Islamic Economy”(Ibid).

It appears from the definition that Islamic banking is systems of financial intermediation that avoids receipt and payment of interest in its transaction and conducts its operation in a way that it helps achieve the objectives of an Islamic economy. Alternatively, this is a banking system whose operation is based on Islamic principles of transaction of which profit and loss sharing (PLS) is a major feature, ensuring justice and equity in the economy. That is why Islamic banks are often known as PLS bank.

Objectives of Islamic Banking

The primary objective of establishing Islamic banks all over the world is to promote, foster and develop the application of Islamic principles in the business sector. More specifically, the objectives of Islamic banking when viewed in the context of its role in the economy are listed as following:

• To offer contemporary financial services in conformity with Islamic Shariah;
• To contribute towards economic development and prosperity within the principles of Islamic justice;
• Optimum allocation of scarce financial resources; and
• To help ensure equitable distribution of income.

The objectives of Islamic banking are discussed below:

Offer Financial Services: Interest-based banking, which is considered a   practice of Riba in financial transactions, is unanimously identified as anti-Islamic. That means all transactions made under conventional banking are unlawful according to Islamic Shariah. Thus, the emergence of Islamic banking is clearly intended to provide for Shariah approved financial transactions.

Islamic Banking for Development: Islamic banking is claimed to be more development- oriented than its conventional counterpart. The concept of profit sharing is a built-in development promoter since it establishes a direct relationship between the bank’s return on investment and the successful operation of the business by the entrepreneurs.

Optimum Allocation of Resources: Another important objective of Islamic banking is the optimum allocation of scarce resources. The foundation of the Islamic banking system is that it promotes the investment of financial resources into those projects that are considered to be the most profitable and beneficial to the economy.

Islamic Banking for Equitable Distribution of Resources: Perhaps the must important objective of Islamic banking is to ensure equitable distribution of income and resources among the participating parties: the bank, the depositors and the entrepreneurs.

Distinguishing features of Islamic Banking

An Islamic bank has several distinctive features as compared to its conventional counterpart. Chapra(1985, PP.154-57) has outlined six essential differences as below:

Abolition of interest (Riba): Since Riba is prohibited in the Quran and interest in all its forms is akin to Riba, as confirmed by Fuqaha and Muslim economists with rare exceptions, the first distinguishing feature of an Islamic bank must be that it is interest-free.

Adherence to public interest: Activity of commercial banks being primarily based on the use of public funds, public interest rather than individual or group interest will be served by Islamic commercial banks. The Islamic banks should use all deposits, which come from the public for serving public interest and realizing the relevant socio-economic goals of Islam. They should play a goal-oriented rather than merely a profit-maximizing role and should adjust themselves to the different needs of the Islamic economy.

Multi-purpose bank: Another substantial distinguishing feature is that Islamic banks will be universal or multi-purpose banks and not purely commercial banks. These banks are conceived to be a crossbreed of commercial and investment banks, investment trusts and investment -management institutions, and would offer a variety of services to their customers. A substantial part of their financing would be for specific projects or ventures. Their equity-oriented investments would not permit them to borrow short-term funds and lend to long-term investments. This should make them less crisis-prone compared to their capitalist counterparts, since they would have to make a greater effort to match the maturity of their liabilities with the maturity of their assets.

More careful evaluation of investment demand:  Another very important feature of an Islamic bank is its very careful attitude towards evaluation of applications for equity oriented financing. It is customary that conventional banks evaluate applications, consider collateral and avoid risk as much as possible. Their main concern does not go beyond ensuring the security of their principal and interest receipts. Since the Islamic bank has a built in mechanism of risk sharing, it would need to be more careful in how it evaluates financing requests. It adds a healthy dimension in the whole lending business and eliminates a whole range of undesirable lending practices.

Work as catalyst of development: Profit-loss sharing being a distinctive characteristic of an Islamic bank fosters closer relations between banks and entrepreneurs. It helps develop financial expertise in non-financial firms and also enables the bank to assume the role of technical consultant and financial adviser, which acts as catalyst in the process of industrialization and development.

Conventional and Islamic Banking

Conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on the one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.

Islam, on the other hand, considers a loan to be given or taken, free of charge, to meet any contingency.  Thus in Islamic Banking, the creditor should not take advantage of the borrower. When money is lent out on the basis of interest, more often it happens that it leads to some kind of injustice.The first Islamic principle underlying such kinds of transactions is that “deal not unjustly, and shall not be dealt with unjustly”. Hence, commercial banking in an Islamic framework is not based on the debtor-creditor relationship.

The second principle regarding financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk. Thus, financial intermediation in an Islamic framework has been developed on the basis of the above two principles. Consequently financial relationships in Islam have been participatory in nature. Several theorists suggest that commercial banking in an interest-free system should be organized on the principle of profit and loss sharing. The institution of interest is thus replaced by a principle of participation in profit and loss.That means a fixed rate of interest is replaced by a variable rate of return based on real economic activities. The distinct characteristics which provide Islamic banking with its main points of departure from the traditional interest-based commercial banking system are: (a) the Islamic banking system is essentially a profit and loss sharing system and not merely an interest (Riba) banking system; and (b) investment (loans and advances in the Conventional sense) under this system of banking must serve simultaneously both the benefit to the investor and the benefit of the local community as well. The financial relationship as pointed out above is referred to in Islamic jurisprudence as Mudaraba.

For the interest of the readers, the distinguishing features of the conventional banking and Islamic banking are shown in terms of a box diagram as shown below:

Table- (Difference Between Conventional and Islamic Banking)

The Genesis of Islamic Banking in Bangladesh

At birth, Bangladesh inherited an interest based banking system, which was introduced here earlier when the country was a part of British Colony. Since its inception Bangladesh saw a new trend in banking both at home and abroad. Islamic banking was successfully tries in Egypt. After establishing the Mit Ghamar Model, Naser Social Bank was in the process of establishment. During the seventies, Islamic Development Bank (IDB) and a number of Islamic banks at national levels were established in the Islamic world. At home, the Islamic groups were vigorously working for adoption of Islam as the complete code of life. They found Islamic banking in ready form of immediate introduction. Two professional bodies “Islamic Economics Research Bureau” (IERB) and “Bangladesh Islamic Bankers Association” (BIBA) were taking practical steps for imparting training on Islamic Economics and banking to a group of bankers and arranging some national and international seminars/workshops to mobilize local and foreign people and attract investors to come forward to establish Islamic bank in Bangladesh. Their professional and right-thought activities were reinforces by a number of Muslim entrepreneurs working under the aegis of Muslim Businessman Society. The body concentrated mainly in mobilizing equity capital for the emerging Islamic bank. Due to continuous and dedicated work of the above groups and individuals and active support from the Government, Islamic banking could be established in early eighties.

Islamic banks have been operating in Bangladesh for about one and half decade alongside with the traditional banks. Out of over 50 banks only six banks have been working on Islamic principles. Like any other traditional commercial banks, they do mobilize deposits and produce loans. But their modes of operation, based on Shariah, are different from the other traditional commercial banks. However, the six Islamic banks operating in Bangladesh are:

• Al-Arafah Islami Bank Limited (AIBL);
• Islami Bank Bangladesh Limited (IBBL);
• ICB Islamic Bank Limited;
• Social Islami Bank Limited (SIBL);
• EXIM Bank Limited (EXIM); and
• First Security Islami Bank Limited

The Future of Islamic Banking in Bangladesh

Need for Re-organization of the whole financial system

Review of the problems of Islamic banking in general and Islamic banks of Bangladesh in particular poses a challenging feature for the promotion and survival of Islamic banks in Bangladesh. The policy implication is not that Islamic banks should never be floated within the conventional banking framework. Rather it is the conventional banking system whose operational mechanism needs to be re-examined and converted into PLS system considering beneficial impact of the latter on the economy. However, as long as Islamic banks are to operate within the conventional banking framework, the recommendations under the following heads may be taken note of.

New banking philosophy for the Islamic banks

There seems to be a gap between the ideals and actual practice of Islamic banks in Bangladesh. In their reports, booklets, bulletins and posters there banks express their commitment to striving for establishing a just society free from exploitation. Study shows that a little progress has been achieved so far in that direction. Though this failure is attributed mainly to the pervasive influence of conventional banking system itself, lack of vigilance of the promoters of Islamic banking in realizing the objective is no less to blame. There should be a through review of policies that have been pursued by these banks for about a decade and points of departure have to be identified to redesign of their action.

Future policy and strategy

The first action that deserves immediate attention is the promotion of the image of Islamic banks as PLS banks. Strategies have to be carefully devised so that the image of Islamic character and solvency as a bank is simultaneously promoted. To this end, Pilot schemes in some much selected areas should be started to test innovative ideas with profit-loss-sharing modes of financing as major component. Islamic banks should clearly demonstrate by their actions that their banking practices are guided by profitability criterion thereby establishing that only Islamic banking practices ensures efficient allocation of resources and provide true market signals through PLS modes. Islamic banks should continuously monitor and disseminate through various means the impact of their operations on the distribution of income primarily between the bank and the other two parties: the depositors and the entrepreneurs, and then on different income groups of the society. These presuppose establishment of a fully equipped research academy in each Islamic bank.

Promotion of efficiency

The Islamic banks can improve their efficiency be satisfying social welfare conditions in the following manner. First, they should allocate a reasonable portion of their ingestible funds in social priority sectors such as agriculture (including poultry and fishery), small and cottage industries and export-led industries like garment, shrimp cultivation. Secondly, when the percentage shares of allocation of funds are determined among the sectors of investment financing, profitability of projects should be the criterion for allocating investment funds. The criterion would be best satisfied if more and more projects were financed under PLS modes.

Modern banking policies and practices

Islamic banks, with a view to facing the growing competition either fellow-Islamic banks or the conventional banks which have launched Islamic banking practices, will have to adapts their functioning in line with modern business practices, though improvement and expansion of the range of dealing in the banking sector. Thus, it is necessary for them to provide comprehensive banking and investment services to clients and simultaneously to take advantage of modern technological breakthroughs in areas such as electronic communication, computerization etc.

A summary of History and Present Status of Islamic banking around the World

1. In 1962- Pilgrims Saving Corporation was established in Malaysia under Islamic Principle.
2. In 1963- Dr. Ahmed A El-Naggar established an Islamic Bank named Savings Bank in Mitgamar, 100 km a way from Cairo, Egypt.
3. In 1969-An Islamic Specialized Bank named “Tabugn Haji” was established in Malaysia.
4. In 1970- Foreign Ministers of OIC countries in their meeting decided to form Islamic Banking in Muslim countries.
5. In 1971- Nasir Social Bank was established in Cairo, Egypt.
6. In 1973- Finance Ministers of OIC countries in their meeting decided to form an Internal Islamic Bank on 18-12-73.
7. In 1974- Finance Ministers of OIC countries signed a charter to form an International Islamic bank, during August.
8. In 1975- Islamic Development Bank (IDB) was formed in Jeddah, KSA on 20-10-75.
9. In 1975- Dubai Islamic Bank was established in Dubai UAE

10. In 1977 i) Faisal Islamic Bank was established Sudan.

  ii) Kuwait Finance House was established in Kuwait.

11. In 1977- International Association of Islamic banks (LaIb) was formed in Jeddah, K.S.A Total member of LAIB was 180.
12. In 1978- Jordan Islamic Bank for Finance and Investment was established in Jordan.
13. In 1978- Pakistan declared all Banks as Islamic
14. In 1983- Islamic bank Bangladesh Ltd. (IBBL) was established in Dhaka, Bangladesh.
15. In 1983- Islamic bank was established in Turkey.
16. In 1984- Iran declared all Banking system Islamic
17. In 1990-The accounting and Auditing Organization for Islamic Financial.

Institutions (AAOIFI), formerly known as Financial Accounting Organization for Islamic Banks and Financial Institution was established on 26-02-90 in accordance with the Agreement of Association signed in Algiers, Algeria Corporation body in 1991 on 27-03-91 in the state of Bahrain.