Islamic Banks and Financial Institutions

A Study of their Objectives and Achievements

Fayaz Ahmad Lone

• Publisher: Palgrave Macmillan
• Year: 2016
• Print ISBN: 9781137515650
• eBook ISBN: 9781137515667
• Topic: Business
• Subtopic: Business General
• Index: Business

This book is a study of the objectives of Islamic Finance in the modern banking space and offers insight into the effects of changes and developments occurring in Islamic banking products and services.

1

Islamic Finance: An Introduction

Islamic Finance is the subject of growing interest as it provides an alternative banking system to the world economy. Islam considers trade a very important component of economic development and, therefore, the notion of investing finance in an ethical way is essential. On the one hand, interest is forbidden in Islam; on the other hand, the management of investment is a must, so Islam has developed an alternative financial system which encourages the promotion of trade without interest. In this system, therefore, risk is shared rather than being transferred while taking the business transactions into consideration.

1.1 Islamic Finance

In all societies, there is a need to transfer funds from savers to investors because it is frequently the case that savers are not the same as who have the ability to explore profitable investment opportunities. This function may be performed either directly, through securities markets or indirectly, through the process of financial intermediation. The importance of financial intermediation can be seen by the fact that in most countries this process accounts for around two-thirds of new investment (Ahmad, 1998). Financial intermediation enhances the efficiency of the processes of saving and investment by reducing transactions costs and eliminating the mismatches inherent in coordination between the different needs of the surplus and deficit units of an economy. Since savers and investors usually differ, they require a considerable amount of information about each other, and this is not freely available. Therefore, the process of channeling funds from savers to investors involves transaction costs. Moreover, because of asymmetric information, it also gives rise to the problems of adverse selection and moral hazard.

Financial intermediaries can benefit from economies of scale and hence reduce the transactions costs of transferring funds from surplus units to those in deficit. For the same reason, they are also in a better position to tackle the problems arising from the problem of asymmetric information. Similarly, the process of financial intermediation removes some of the mismatches between the two sides in terms of the choices, maturity terms and the amount of necessary funds. Those with surplus funds are often households who save relatively small amounts whereas the deficit units are often firms who need access to relatively large amounts of financial resources. Financial intermediaries remove this size mismatch by collecting small savings and packaging them in such a way so as to make them available in a form that is more suitable to the needs of the users. In addition, users of funds in general need them for relatively long-term deployment, which cannot be met by individual suppliers. This creates a mismatch between the maturity and liquidity preferences of individual savers and the users of funds (Davar, 1999). The financial intermediaries resolve these conflicts by pooling small funds.

There are also differences between the risk preferences of small suppliers and large users of funds. It is often considered that small savers are generally risk averse and prefer safer placements whereas the users of funds are generally more adventurous and will deploy the funds in riskier projects in the expectation of securing higher returns. The mismatch between the risk preferences of suppliers and the users of financial capital implies that direct financing may be of only limited use. The role of the intermediary again becomes crucial in this process. They can reduce this risk substantially through portfolio diversification. Furthermore, small savers are unable to gather information about investment opportunities in an efficient manner. Financial intermediaries are in a much better position to collect such information, which plays such a crucial role in securing the success of an investment. People undoubtedly require access to banking services. Since the banking services are needed but interest is prohibited in Islamic economies, the Muslim countries cannot simply do away with banking on account of the element of interest because of the vital role which banking does plays in the development of the economy. Therefore, such economies have to find alternative ways of performing various banking functions. It is this challenge that provides the rationale for Islamic banking. The role and functions of banks, briefly outlined above, are indeed extremely useful and socially desirable but, unfortunately, the modern economy performs these functions with the help of interest, which plays a central role in each of these functions. Islamic financial intermediations endeavor to perform the same functions, but by replacing interest by other modes and instruments both for mobilizing savings and also to allow them to be put to productive use. The functions performed by the banks are important whether the economy concerned is secular or Islamic. There are various kinds of misconception regarding the nature and functions of Islamic banking. Many of these are the result of insufficient knowledge about the exact nature of such a system. For instance, some people think believe that in Islamic banks depositors are unable to secure any reasonable amount of return on their invested amount. Nothing could be farther from the truth, however. In fact, the return on investment under Islamic banking may range from ‘0’ per cent to ‘100’ per cent or even more, depending upon the performance of investment by the bank.

The functions of Islamic banks and other financial intermediaries are similar to their conventional counterparts. However, Shariah prohibits ‘Riba’ (interest/usury), ‘Maysir¹ or Qimar’ (gambling/speculation), ‘Gharar’² (uncertainty), exploitation, unfairness, undertaking haram (forbidden) activities (alcohol, pork, pornography, etc.). Therefore Shariah does allows a number of feature that would be familiar to any financial system: risk sharing, reward sharing, fairness, transparency, and the sanctity of contracts. Theoretical studies have used alternative Islamic modes of finance to build models through which these functions can be performed (Khan, 2003). Conventional banking is based on the assumption that every depositor is a lender to the bank and receives a predetermined return for the period his funds are with the bank. The funds are also returned in full at the end of the investment period. Similarly, every loan advanced by the bank to the clients is also a loan returnable in full. Thus, in this system every deposit is a liability to the bank which is to be paid back to the depositor and every loan is an asset as it brings income in the form of interest. By contrast, interest-free banking, or Islamic banking, is based on the premise that every depositor participates in the activities of the bank and is entitled to a share in the profits of the bank. That is why it is sometimes referred as participatory banking. Similarly, the advances made by the bank are not really advances in the conventional sense of the term, but rather a share in the capital of the entrepreneur which is then invested by the bank. The return on this investment is a share of profit earned by the entrepreneur. It may vary in accordance with the market conditions and the abilities of the fund managers. Islamic finance also adopts a fee-based financing approach in compliance with Shariah law. The above special modes of financing have emerged in retail, private and commercial banking for debt and capital markets, insurance, asset management, structured and project financing, derivatives, and so on. The following section given a brief summary of the differences between the Islamic and the conventional financial system.

1.2 The conventional financial system vs the Islamic financial system

Table 1.1 The conventional financial system vs the Islamic financial system

Conventional financial system	Islamic financial system
Money is a product besides medium of exchange and store of value.	Real asset is a product. Money is just a medium of exchange.
Time value is the basis for charging interest on capital.	Profit on exchange of goods and services is the basis for earning profit.
Interest is charged even in case the organization suffers losses. Thus no concept of sharing loss.	Loss is shared when the organization suffers loss.
While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods and services is made.	The execution of agreements for the exchange of goods and services is a must, while disbursing funds under Murabaha, Salam and Istisna contracts.
Due to non-existence of goods and services behind the money while disbursing funds, the expansion of money takes place, which creates inflation.	Due to existence of goods and services no expansion of money takes place and thus no inflation is created.
Due to inflation the entrepreneur increases prices of his goods and services, due to incorporating inflationary effect into cost of product.	Due to control over inflation, no extra price is charged by the entrepreneur.
Bridge financing and long term loans lending is not made on the basis of existence of capital goods. Rather, they are disbursed on the basis of ‘window-dressed’ project feasibility and credibility of the entrepreneur.	Musharakah and diminishing Musharakah agreements are made after making sure the existence of capital good before disbursing funds for a capital project.
Government very easily obtains loans from Central Bank through Money Market Operations without initiating capital development expenditure.	Government cannot obtain loans from the Monetary Agency without making sure the delivery of goods to National Investment fund.
The expanded money in the money market without backing the real assets, results deficit financing.	Balance budget is the outcome of no expansion of money.
Real growth of wealth does not take place, as the money remains in few hands.	Real growth in the wealth of the people of the society takes place, due to multiplier effect and real wealth goes into the ownership of lot of hands.
Due to failure of the projects the loan is written off as it becomes a non-performing loan.	Due to failure of the project, the management of the organization can be taken over to hand over to better management.
Debts financing gets the advantage of leverage for an enterprise, due to interest expense as deductible item form taxable profits. This causes huge burden of taxes on salaried persons. Thus the saving and disposable income of the people is affected badly. This results decrease in the real gross domestic product.	Sharing profits in case of Mudarabah and sharing in the organization of business venture in case of Musharakah, provides extra tax to the federal government. This leads to minimize the tax burden over salaried persons. Due to which savings and disposable income of the people is increased, this results the increase in the real gross domestic product.
Due to a decrease in the real GDP, the net exports amount becomes negative. This invites further foreign debts and the currency becomes weaker and weaker.	Due to an increase in real GDP, the net exports amount becomes positive, this reduces foreign debts burden and the currency becomes stronger and stronger.

Source: http://www.learnislamicfinance.com/Free_Notes_Adv_Sukuk_Islamic_Bonds.htm (retrieved on 6 April 2011).

The next section outlines the difference between Islamic banks and conventional banks.

1.3 Islamic banking vs conventional banking

Table 1.2 Islamic banking vs conventional banking

Islamic banks	Conventional banks
Functions and operations are guided by sources of Shariah (Islamic Divine Law) namely the Quran and the Sunnah (traditions of the Prophet Muhammad PBUH).	Functions and operations are guided by secular principles and not based on any religious doctrines and values.
Institutions that aim at achieving a balance between profit maximization doctrine and social responsibility.	Institutions that emphasize p...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables and Figures
• Foreword
• Acknowledgements
• List of Abbreviations
• 1. Islamic Finance: An Introduction
• 2. Historical Development and Research Design
• 3. Islamic Finance – An Overview
• 4. Objectives of Islamic Finance
• 5. The Objectives and Achievements of Islamic Finance: An Analysis
• 6. Compatibility Between Objectives and Achievements
• Appendix I: Questionnaire on Islamic Finance Objectives and Achievements
• Appendix II: Islamic Financial Institutions (By Region and Country)
• Appendix III: Glossary on Islamic Finance
• Notes
• Bibliography
• Index