A Comparative literature survey on Islamic Finance and Banking

A Comparative literature survey on Islamic Finance and Banking

INTRODUCTION

Islamic finance was practiced predominantly in the Muslim world throughout the middle ages.  European financiers and businessmen   later adopted many concepts, techniques, and instruments of Islamic finance. In contrast, the term

‘‘Islamic financial system’’ is relatively new, appearing only in the mid-1980s. In fact, all earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either ‘‘interest free’’ or

‘‘Islamic’’ banking. This, no doubt, prohibits  the receipt  or payment  of interest as the  nucleus  of the  system, but  is supported by other  principles  of Islamic doctrine  advocating  risk sharing, individuals’ rights and duties,  property  rights, and  the  sanctity  of  contracts.   Similarly, the Islamic financial system is not limited to banking, but covers financial instruments, financial markets,  and all types of financial intermediation.

There is a debate among the Islamic community over the effectiveness of an interest-based banking system.  While  it  is  acknowledged   that  banks  play  a pivotal  role  in the  development of a  country  through  their  role  as financial intermediaries, the  question   is  how  efficient  an  interest-based  system  is  in performing this function.  In fact, there is even some debate as to whether or not an interest-based system actually contributes to cyclical fluctuations.   A new system of banking has emerged known as Profit-Loss-Sharing ŽPLS. Most likely in response to the interest-based banking system debate, but more due to religious beliefs in the Islamic community. Currently, this banking system is integrated into over 60 countries throughout the world with over 250 Islamic financial institutions in operation.

Aside from the   economic   debate,   the   main contributing factor   in the emergence of a PLS-banking system is the prohibition of ‘riba’ Žor interest. in the holy Quran.  The basic intention behind  establishing  Islamic banks was the desire  of Muslims  to  reorganize  their  financial  activities  to  complement the principles  of the  Shariah  Žthe Islamic  Law. And enable them to conduct their financial transactions without indulging in ‘riba’. The term riba is used in the Shariah in two senses. First is riba al-nasi’ah, which is the fixing in advance of a positive return on a loan as a reward for waiting to be repaid.  Second, riba al-fadl is encountered in a hand-to-hand purchase and sale of commodities. The   Shariah   prohibits   both   forms of ‘riba’.   Clearly,   with  regard   to  riba al-nasi’ah,  the  prohibition is on  an  increase  occurring  from  the  mere  use  of money  with no  measurable real  economic  increase.  On  the  other  hand,  the Islamic  community  does  not  consider  an increase  in business  activity derived from invested  money ‘riba’. It is important to realize that the Islamic commu- nity has no objection to true profit as a return on entrepreneurial efforts that benefits all of society.  Furthermore, in  the  case  of  riba  al-fadl,  the  Islamic community  is only interested in ensuring  justice and fair play in spot transac- tions to avoid any exploitation  through  unfair  exchanges.

While the original basis for the prohibition of interest was divine authority, recently Muslim scholars have placed a major emphasis on the lack of a theory for interest.   Muslim  scholars  have  rebutted the  arguments  that  interest  is a reward  for  savings, a productivity  of capital,  and  provides  for  the  difference between  the value of capital goods today and their value tomorrow. In terms of interest   being  a  reward  for  savings, they  argue  that  interest   could  only  be justified if it resulted  in reinvestment and subsequent growth in capital and not solely as a reward for forgoing consumption. With regard  to the productivity of capital  argument, modern  Muslim  scholars  argue  that  the  interest  is paid  on the  money  and  is required regardless  of whether  or  not  capital  productivity results,  and  thus  is not  justified.  Finally,  with  regard  to  the  argument that interest  enables  an adjustment between  the values of capital  goods today with their  value  tomorrow,  the  response  is that  this  only explains  its inevitability and not its rightness.  Specifically, if that  is the  sole justification  for interest,  it seems more  reasonable to allow next year’s economic  conditions  to determine the  extent  of  the  reward,  as  opposed  to  predetermining it  in  the  form  of interest.

The Islamic Community has rationalized the elimination of  riba (interest) based upon value of justice, efficiency , stability and growth. In terms of  justice, the removal of riba results  in  the  sharing  of  the  risk  of  a  project between  the  borrower  and  the  lender.  In addition,  by tying the  reward  to the performance of the business  venture,  the resulting  returns  are more  equitable during  good times  and  bad  times.  Finally,  returns  are  only earned  when  the business  venture  results  in the  addition  of value, which benefits  all of society. Regarding   the  efficiency  of  allocation   of  capital   argument,  interest   based lending  with adjustments for  risk capital  tends  to  result  in serving the  more creditworthy  borrowers  and  not  necessarily  the  most productive  projects.  The Islamic  PLS-  banking   allocates   financing  to  the  most  productive   business ventures,  as the share  in returns  is more  promising. In addition,  profit sharing results  in  both  the  borrower   and  lender   working  more  closely  together to ensure  the  business  venture’s  success,  which is more  productive  for  society. Finally, Muslim  economists  argue  that  the  PLS system provides  for cohesion between  social classes because  financing is equally available  to anyone  with a productive  idea.  With  regard  to  the  subject  of  stability,  Muslim  economists argue that an interest-based banking system fosters inflation, as the creation  of money  does  not  have  any direct  tie  to  whether  or  not  a business  venture  is productive.  The result is a higher cost to society for failed projects that interest was paid without any economic benefits. There  are many legally recognized  forms of business arrangements in Islam, which  are  derived  from  four  main  sources  of  Islamic  law:  the  Quran,   the sunnah,  the  ijma, and  the  qiyas. Although  modern  Islamic  banking  is consid- ered  to  be  a recent  development, it has  a long  historic  background  with its earliest  beginnings  being traced  to the  practice  of mudaraba Žan ancient  form of partnership. Used by the Prophet Muhammad ŽPeace be upon him. Himself. Another earlier business arrangement known as Musharaka was also prevalent in ancient times.  Both of these business arrangements are essentially agency arrangements. The  difference  between  the  two is that  in the  latter,  the  agent contributes to the  capital  for the  project  and thus  may receive  a higher  share of the profits and losses of the business venture.  The former relieves the agent from any loss potential, but provides for a lower share of the profit. Therefore, modern  Islamic banking was derived from these earlier  forms of business relationships, with the  disparity  being that  today lenders  are  brought  together in  a  centralized  location,   the   bank,  so  that   their   money  can  be  lent   to entrepreneurs for investment  in new business  ventures.

Ø  In this paper we provide a comparative literature survey on Islamic financial system.

·         Section I we discuss the basic features of Islamic finance and how they relate to traditional Western finance. 

·         Section  II  we introduce the  Islamic  financial contracts  that  are  currently  utilized  by Islamic financial  institutions around  the  world, and  include  a comparison  of them  to existing Western  financial instruments. We also discuss the legal problems that investors in these instruments may encounter.

·         Section III highlights the challenges and problems facing the Islamic banking market.

(Section I)

BASIC FEATURES OF ISLAMIC FINANCE

Islamic finance is a financial system, the fundamental aim of which is to fulfill the teaching of the Holy Quran,  as opposed  to reaping  maximum  returns  on financial  assets.  The basic principle in the Sharia ŽIslamic Common Law.  is that  exploitative contracts  based on Riba Žinterest or usury. or unfair contracts that  involve risk or speculation ŽGharar. are unenforceable. However the Holy Quran  contains  no condemnation of morally acceptable  investments  that  yield fair  legitimate  profits and economic  social ‘‘added-value’’ ŽSiddiqi 1999.. Two more principles are fundamental to understanding Islamic finance.  First, the Islamic law reflects the totality of Allah’ ŽGod’s. Commands that regulate all aspects of the life of a Muslim. Second, Islamic finance is directly involved with spiritual   values and social justice.  Under   Islam, there   is no separation of mosque and state or of business and religion ŽNicolas 1994..

The   fact  that   Islamic   laws  prohibit   Muslims  from  paying  or  receiving interest,   prevents   observant   Muslims  from  taking   out  mortgages,   carrying balances  on  credit  cards  or  investing  in any  fixed income  securities  such  as T-bonds,  T-Bills, CDs or any other  financial  security  that  promises  a guaran- teed  return.   This  does  not  imply  that   Islam  frowns  on  making  money  or demands  that  Muslims revert to an all-cash or barter  economy, but means that all  parties  to  a  financial  transaction  share  the  risk  and  profit  or  loss  of  a venture,   and  that  no  one  party  to  a  financial  contract   gets  predetermined return.  For example, ‘‘depositors’’ in Islamic banks are really shareholders who earn dividends when the bank turns a profit, or lose a portion of their savings if it posts a loss. In effect, the Islamic financing functions much like Western equity financing.  Investors   and  lenders   have  the  right  to  a  decent   rate  of return;   it  is  just  the  certainty   of  the  return   that   is  an  issue.  This direct correlation between investment and profit differentiates Islamic banking from conventional or western banking, which defines maximization of the sharehold- ers’ wealth as the sole objective of the firm.

While the banning of interest is rooted in the Islamic theology, proponents of Islamic finance provide economic rationales to support the ban of interest. Some  of  these  rationales  are  described  by the  International  association   of Islamic  banks  Ž1995, pp. 3-4.. First,  in an  Islamic  profit  sharing  contract,  the return  on capital  will depend  on productivity,  and  the  allocation  of funds will be primarily  based  on  the  soundness   of  the  project.  This will improve the capital   allocation   efficiency.  Second,  the  Islamic  profit-sharing   system  will ensure  more  equitable   distribution of wealth  and  the  creation  of additional wealth  to its owners. This system would no doubt reduce the unjust distribu- tion of wealth under the interest system.

Third, the profit sharing regime may increase  the volume of investments  and hence  create  more  jobs. The interest  regime  would make feasible  and accept- able  only those  projects  whose expected  returns  are  higher  than  the  cost  of debt,  and  therefore filter  out  projects  which are  otherwise  acceptable   under the   Islamic  profit-sharing   system.  Fourth,   the   Islamic  finance  system  will reduce   the   size  of  speculation  in  financial  markets,   but  still  allow  for  a secondary market  for trading  stocks and investment  certificates  based on profit sharing  principles.  This  will bring  sanity  back  to  the  financial  market   and promote  liquidity to equity holders.  Fifth, under the profit-sharing system, the supply of money is not allowed to overstep the supply of goods and would thus curb inflationary pressures in the economy.

Some  Islamic  bankers  argue  that  Islamic  finance  may even  have  a role  to play in underpinning the stability of the international economy ŽDudley 1998.. Under the Islamic financing system, investments or finance is targeted to the specific needs of an entity.  Financiers  or investors  will need  to  satisfy them- selves  as  to  the  reliability   of  a  project,   their   lease  rentals   or  the  return promised  in any financing  deal.  The investors and financiers have to exercise due diligence and careful monitoring of their investments.  There  is not  much room  for  raising  a  variety  of  unsecured debts  that  are  not  targeted to  the specific  needs  of  borrowers.   Conventional Western   financing,  on  the  other hand,  lacks a corrective  mechanism  to stop  excessive borrowing  beyond  indi- vidual  companies’  means.  In  good  times,  raising  funds  is easy, while  in  bad times  the  cost  of  raising  funds  is high;  therefore, the  risk  to  the  financing institution  is increased.  The amount  of borrowing under  a conventional system is several times more than  it would be under  an Islamic system, and so are the risks inherited from these  excessive borrowings.

(Section II)

ISLAMIC FINANCING CONTRACTS

There  are  five basic Islamic  Financing  contracts.  The  underlying  concept  for each technique is simple and can be compared to an existing Western  financial instrument. However,  actual  financing  deals  can become  very complicated  as some banks modify the structure to suit the requirements of specific investors. These  deals  may  contain  elements   of  more  than  one  of  the  basic  Islamic contracts.   In  this  section   we  discuss  the   basic  features   of  these   Islamic financing contracts.  We also discuss some of the  legal problems  that  investors in these instruments may encounter. Table 1 presents  various modes of Islamic finance.

MURABAHA

A Murabaha transaction is basically a cost-plus  profit financing transaction in which a tangible  asset  is purchased by an Islamic institution  at the  request  of its customer  from a supplier.  The Islamic institution  then  sells the  asset  to its customer  on  a deferred sale  basis  with a mark-up  reflecting  the  institution’s profit.  The  customer   takes  the  responsibility   of  negotiating   all  of  the  key commercial  terms with the seller of the asset. The mark-up  on the asset cannot be  altered  during  the  life of the  contract.  The  size of the  mark-up  is deter- mined  in  relation   to  an  interest   rate   index  such  as  the  LIBOR Inter-Bank Offered  Rate. or US- short  T-bills rate,  and  is also a function  of the  client’s  credit  rating,  the  transaction’s  size and  the  type  of goods  being financed. The Murabaha deals offer enough  flexibility to be used in real estate and  project  financing,  but  historically  it  has  been  used  primarily  for  trade finance.

A  number   of  legal  issues  may  be  encountered  by  the  Islamic  financial institutions that  finance  a  Murabaha transaction. First,  the  Islamic  financial institution   cannot   earn   excessive  profits  from  the   client.   If  the   profit  is excessive,  remedies  may  include  a  return   of  the  ‘‘excessive’’ portion  of  the profit  to  the   client.  A  second   legal  issue  is  rejection   of  the   goods.  The customer  may reject  the goods for non-conformity and leave the bank holding the goods. To eliminate  the possibility of rejection  of goods, the customer  will generally  act as the  bank’s agent  in determining the  conformity  of the  goods prior to acceptance. Finally, the Islamic financial institution 

IJARA  AND   IJARA  WA-IQTINA.

Ijara   and  Ijara   wa-Iqtina   are   Islamic  leasing  concepts   similar  to  western operating and finance leases. Ijara  is similar to a conventional operating lease, where in an Islamic bank Žlessor. leases the asset to a client lessee. for agreed on  lease  payments   for  a  specified  period   of  time,  but  with  no  option   of ownership for the lessee. The maintenance and insurance  of the leased asset is the lessor’s responsibility. On the other  hand, Ijara  wa-Iqtina  is comparable to the  Western   financial  or  capital  lease,  where  the  lessee  has  the  option  of owning the asset at the termination of the lease. In this case, the bank Žlessor. purchases  the  asset  such as a building,  piece  of equipment or even an entire project  and leases it to the clients for an agreed  on lease rental,  together with client  agreement to  make  lease  payments  towards  the  purchase  of the  asset from the lessor. The conditions  governing both types of leasing are that  assets must  have  a  long   secure  productive   life,  and  must  not  be  handled   in  an un-Islamic   way,  meaning   that   the   lease   payments   must  be  agreed   on  in advance  to avoid any speculation.

As  with  Murabaha  transactions,  there   will  be  concerns   relating   to  the Islamic  institution’s  ownership  of real  property,  disclaimers  of warranties,  the application of strict  liability  and  the  enforceability   of a  fixed payment  upon default.  The loss and destruction risks generally remain  with the lessor, unless caused  by the  negligence  or  default  of the  lessee.  Although  insurance  is an option for western lease financing, there  may be issues as to whether  insurance in this context  is acceptable  under  Islamic law. The lessee should start  making lease  payments  only after  the  leased  asset  has actually  been  delivered  to him Žher.. In  addition,  if the  leased  asset  were  destroyed,  the  lessee  would cease making payments to the lessor. This practice  is contrary  to the practice  in most western  lease  financing  where  the  lessee  continues   paying  rent  even  if the property  is destroyed

Islamic leasing has also been criticized for being a complicated  concept  with a  limited  scope  for  business.  However,  the  product   is  becoming  the  most popular  form of Islamic finance. The products  involved in Islamic leasing run the  standard gamut  from European oil refineries  to medical equipment in the United  States. Western  banks offering Islamic instruments, such as Citicorp in the  USA  and  Kleinwort  Benston  in London  are  now more  active  in Islamic leasing,  and   the   leasing   funds   have  been   raised   from  both   Muslim   and non-Muslim  investors ŽCollett 1995.. Many investors, especially Islamic banks, have been  attracted to leasing by the promise  of higher  yields than  Murabaha Žtrade finance., which  accounts  for  the  bulk  of  Islamic  banking  activity.  In addition,   since  Islamic  leasing  has  the  advantage   of  dealing  with  tangible assets, it has escaped  the kind of criticism given to other  Islamic products.  This suits  the   Islamic  finance  ethos,   and  as  investors   move  towards  providing medium-term  and  long-term   financing,  the  interest   in  Islamic  leasing  will increase.

ISTINSA

Istinsa  is a  pre-delivery  financing  and  leasing  structured mode  that  is used mostly  to  finance  long-term  large-scale  facilities  involving, for  example,  the construction of a  power  plant.  The  Islamic  institution   could  either  own the plant,  charge  the  lessee  Žproject  company.  a fee based  on profits, or sell the plant  to the project  company on a deferred basis with a profit mark-up  similar to a Murabaha transaction. Unlike  a Murabaha transaction, however, certain expenses that  cannot  easily be reflected  in a sale and purchase  agreement can be  included  in  the  fees  to  be  paid  to  the  Islamic  institution   by the  project company.

MUDARBAH

Mudaraba is a trust  based  financing  agreement whereby  an  investor  ŽIslamic bank., entrusts  capital to an agent ŽMudarib. for a project. Profits are based on a pre-arranged and agreed  on ratio.  Mudaraba agreement is akin to Western- style limited  partnership, with one  party  contributing capital  while the  other runs the business, and profit is distributed based on a negotiated percentage of ownership.  In case of a loss, the bank earns  no return  or a negative  return  on its investment  and the  agent  receives no compensation for his  effort.

MUSHARAKA

Musharakah is a type of Shirkah al-Amwal which literally means sharing. In the context of business, it refers to a joint enterprise in which parties share the profit and loss of the enterprise. It plays a vital role in financing business operations based on Islamic principles, which prohibit making a profit on interest from loans.  Musharakah may sometimes include Shirkah al-Amal, where a joint partnership is formed to render some services without requiring any capital investment.

Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses. The relationship established between parties, in Musharakah, is by a mutual contract; hence, all the necessary ingredients of a valid contract must be present. However, there are number of conditions that apply specifically to the contract of Musharakah.

In fact, the capital to be invested in a joint venture can be unequal between the partners and should preferably be in cash. If it were to be based on commodities or other Shari’ah-compliant assets, the market value prevalent at the time of the contract would have to be appropriately valued with the mutual consent of all the partners in order to determine the share of each of them. The commodity should be compensable by similar commodities or assets in quality or quantity, in case it could be destroyed. Otherwise, its price should be paid. The capital may also be in the form of equal units or shares representing currency. And if partnership capital involves a variety of currencies, it must be translated into the currency of the enterprise at the current rate. Finally, Debts or receivables alone cannot form part of the capital until they are received, although, they may become part of the capital contribution where they become inseparable from the other assets of the business.

Moreover, the proportion of profit to be distributed among the partners must be determined and agreed upon at the time of the contract. Otherwise the contract wouldn’t be valid. And it is necessary that each partner’s share in the profit is exactly equal to the proportion of initial investment into the partnership. The ratio of profit distribution may vary, however, for non-active partners, who only contribute capital. A party which has no capital invested in an enterprise does not have to share its loss. The partnership would also be invalid if a partner were to receive regular payments of a fixed, pre-determined amount as a percentage of its investment. In addition, a person can become a partner in a running business having fixed assets by investing capital in cash or kind; it is also allowed to merge various partnership businesses. Valuation of the fixed assets will be based on their fair value agreed upon by the partners.

Further, Musharakah is not a binding contract and any partner may unilaterally terminate it unless provided otherwise in the contract. It is agreed upon by the Muslim jurists that a partnership is terminated if one of the partners terminates the partnership or if one of the partners dies or becomes insane. If the remaining partners want to continue the business under any of these cases, it is possible with mutual agreement. The remaining partners would have to purchase the share of the out-going partner.

(Section III)

PROBLEMS AND CHALLENGES OF ISLAMIC BANKING IN

PAKISTAN

Regulated by the   Central   Bank   of  Pakistan State   Bank   of  Pakistan-SBP. Securities  firms, and  Insurance Companies are regulated   by separate regulatory  bodies  Major  banks  in  the Public Sector; bank regulation  and supervision effected  by govern- ment policies  Islamic banking law does not exist  Mudarabah Companies Law exists  Sharı’ah board concept  does not exist  Islamic   banks   are   not   identified   distinctly   Basel   capital requirements and  supervisory standards adopted   Bank merger is on cards to strengthen capital      Concept  of onsite  and offsite supervision  exists  Major  financial  transformation is called  for by the  Supreme  Court  of Pakistan  to  introduce Islamic  banking and  financial  system;  a Financial  Services  Transformation Com- mittee  has been  established  by the  SBP(State Bank Of Pakistan).

CONCLUSION

During  the last twenty years, a large-scale  growth in Islamic finance has grown in Muslim countries  and around  the world. This growth was a result  of several factors  such  as the  desire  for  sociopolitical  and  economic  systems  based  on Islamic  principles  and  a  stronger  Islamic  identity.  Islam  remains  the  fastest growing religion in the world. Muslims now constitute about  27 percent  of the world  population. The  introduction of  broad  macroeconomic and  structural reforms  in financial systems, liberalization of capital movements,  privatization, global integration of financial markets,  and introduction of innovative and new Islamic products  have also paved the way for the expansion  of Islamic finance. Islamic  finance  is  now  reaching   new  levels  of  sophistication.  However,   a complete  Islamic financial system with identifiable  instruments and markets  is still at an early stage  of evolution.  Many problems  and  challenges  relating  to Islamic  instruments, financial markets,  and  regulation  must be addressed and resolved.