Banking institutions form the backbone of a national economy. The growth and development of a country is intertwined with the efficiency of the banking system. Traditionally the global financial system has been dominated by the conventional western banking system. Islamic banking has emerged in the last three decades as a viable and competitive substitute to the conventional banking systems. As per the International Monetary Fund (IMF) there are over 300 Islamic financial institutions in over 75 countries. "The Islamic banking and finance sector has experienced rapid global acceptance since the establishment of the first commercial Islamic bank in 1975 (Hammed SG, Ahamed F, 2010).
With annual growth rates of between 15 percent and 20 per cent, the assets of the Islamic finance sector are expected to reach the US $ 2 trillion mark by the year 2015 (Rammal, 2010).
Islamic banking concept has been in the industry for over three decades now and various Islamic institutions are easily identifiable, but our research topic has looked to study various facets of Islamic banking which include an introduction to Islamic finance - its growth and evolution, key challenges faced by Islamic banking in various geographies. We have tried to look at the following related questions as follows:
How do conventional banking and Islamic banking operate in various geographies?
What are the various financial products in Islamic banking and its workings?
Implications of introducing Islamic finance to western economies where traditional banking has a strong hold?
Rationale behind selecting the research topic
Islamic banking concepts though known to a wide range of people are not understood well. Since Islamic banking is mainly prevalent in countries where Islam is a dominant religion, many businesses are unaware of the services offered by Islamic banking. By way of this research paper we wish to focus light on the various services provided by Islamic banking.
People have traditionally associate Islamic Banking with religion and certain countries. Our objective is to shed light on the fact that Islamic banking is a much wider concept and offers a wide range of products and services to businesses and individuals of all religions. By way of our research we wish to highlight the strengths and weaknesses of Islamic banking.
There has been a rapid growth and spread of Islamic banking into western economies which have traditionally used only conventional banking. We find this phenomenon very interesting and by conducting this research we wish to understand the reasons behind this growth and spread.
Further, as the participants of the research paper are students of finance, we find this research matter very interesting and believe that the understanding of the concepts of Islamic banking will help us add value in the future.
Objective of our research topic
Islamic banking is driven by multiple factors and although the banking system has been around for decades the growth and implications of Islamic banking have been phenomenal on both the Muslim and non Muslim nations. The objective of our research was to presents a broad analysis of Islamic Banking, its growth and its future. The main objectives of the research are as follows:
Understand the concepts and principles that govern Islamic banking
Study the evolution and growth of Islamic banking in the Muslim nations
Draw a comparison between conventional and Islamic banking systems and outline the major differences in terms of various services, functioning etc
Understand and examine the various financial products offered by the Islamic banking
Understand the inroads made by Islamic banking in western economies which have a large Muslim population
To provide detailed insight into Islamic banking and challenges faced by it
To Examine overall Islamic banking sector and assess the opportunities
To analyse the impact of implementation of Islamic banking in western economies
To understand the constraints and limitations Islamic banking could face when implemented in western economies.
Theoretical Framework
Key concepts
Key Product concepts that are covered:
Identifying the key fundamental of Islamic banking which forms the basis of Islamic finance, i.e. prohibition of interest or riba (Rammal, Zurbruegg, 2007).
Musharakah ïƒ Similar to a Partnership concept whereby the Bank provides funds to the customer and takes a stake in the customer's portfolio. The Bank and Customer agree upon a profit sharing ratio bases the Investment by the Bank and Expertise & Investment of the Customer. (Taylor, 2003)
Murabahahïƒ Financing on a 'Cost plus' basis, Murabahah is a contract whereby the Customer request to buy an asset that will be sold to the customer on a deferred payment bases. A profit margin will be added to the cost price of the asset when being sold to the customer as compensation for deferred payments. This is the same as tawarruq(Sole, 2007)
Ijara ïƒ Also known as Sharika, Similar to Lease Financing, The Bank buys the asset on request of the customer and leases it to the customer. In return, the customer pays a rental for using the asset. However, unlike traditional lease the customer is not bound to buy the asset from the Bank at the end of the lease.(Taylor, 2003)
Sukuk ïƒ On the same lines as conventional Bonds. Differences being that the coupon is not Interest based but 'Profit sharing' basis. The repayment of the principal is not face value but 'current value of the underlying asset.(Gavin, 2012)
Takaful ïƒ Also known as Islamic Insurance is on the lines as Mutual Insurance where in the Policy holder is the end beneficiary of the profit and loss of the Mutual Insurance Plan. (Kwon, 2007)
Components of the research topic
AUSTRALIA
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MALAYSIAMalaysia 2.jpg
Islamic Banking Penetration
Snapshot of economies following Islamic banking
Pakistan
Pakistan is one of the three countries of the world that started working towards interest free banking in the country. Pakistan has endeavoured to implement Islamic Banking systems since the early 1980's and in December 2001 the State Bank of Pakistan issued detailed criteria for establishment of full-fledged Islamic commercial banks in the private sector in Pakistan (Mumu., Guazho, 2012).
The success of the growth and re launch of Islamic Banking in Pakistan has been due to planning and smart work by the State Bank of Pakistan. The results issued by the state bank of Pakistan show that the strategy to promote Islamic banking has worked well (Mumu, Guazho, 2012).
As per the State Bank of Pakistan (2009)
Islamic Banking Industry's assets grew to over [1] Rs. 225 billion by June 2008, capturing a market share of over 4.5% in 5 years time. In Pakistan Islamic banking emerged as a response to both religious and economic needs (Taylor, 2003).
Malaysia
The first Islamic bank in Malaysia was established in 1983. Commercial Banks were allowed to sell Islamic banking products and services under Islamic banking Scheme (IBS) in 1993.
The governments of Malaysia's efforts to grow Islamic banking in their country have been yielding positive results (Gavin, 2012). Assets under management for Islamic Banks is 20% of assets under management for all banks in Malaysia in 2012, this is up from 12% in 2006. Attractive tax incentives and a more liberal interpretation of Islamic financial norms and a heavier focus on dismantling barriers to foreign investment by increasing the foreign equity ceiling in Islamic financial institutions to 70% has helped shore up the country's status as a global Islamic finance hub.
Malaysia had made commendable progress in both Equity and Debt market. In June 2005, Dow Jones and Company of New New York and RHB Securities of Kuala Lumpur, teamed up to launch a new "Islamic Malaysia Index". Over 65% of the listed equity scripts in Kuala Lumpur Stock Exchange are Shariah compliant. On the Debt side of investments, Kuala Lumpur has extended its dominance of the global Sukuk market and held ~70% of the $210bn-worth of Sukuk outstanding globally at end of 2011. This is 500% higher than Saudi Arabia which stands 2nd in the list with 13% of Global Sukuk issuances (Ariff, M., Rosly S.A. 2011).
Western Economies
Australia experience
Muslim's in Australia come from diverse ethnic and socio political background. There are about 476,300 Muslims living in Australia today. (Australian Bureau of Statistics, 2011)
The Islamic banking movement in Australia is gaining momentum with every passing day, which implies that the Muslim Community in Australia will have an option of dealing with interest-free banking services.
The first Islamic bank, 'Muslim Community Co-operative (Australia) Ltd. (MCCA) was setup in 1989 in Melbourne. In Feb, 2010, Westpac opened an Islamic Window to cater to Muslims in Australia and Non-Muslims looking to diversify their risk from Conventional Banking.
Financial products in Islamic banking
Retail Lending Products in Islamic Banks and product offerings in Pakistan:
In Pakistan, Islamic banks provide finance for four categories of house, construction of a new house, buying a house, balance transfer and renovation. There are 2 products that have been extensively used By Islamic Banks in Pakistan as follows:
Diminishing Musharakah (Joint Venture)
Lil-Amiri BI-AL-Shira of Murabahah (Profit Sharing)
Diminishing Musharakah - replica to the Joint Venture concept in Commercial Financing
This is a combination of 3 contracts
Sharikah (Partnership)
Ijarahh (Lease); and
Bay (Sale)
The Islamic Financial Institution (IFI) and the Customer purchases the property as a Joint Venture on the basis of Sharikah tul Milk.
Sharikah tul Milk - The share of the financier/ IFI is divided into a number of units and the customer purchases those units one by one periodically.
The customer purchases units from IFI until the customers become the sole owner of the property. The customer pays rent to IFI for using resources of the IFI. As the customer purchases units from the IFI his payable amount of rent decreases. Finally the payable amount of rent becomes zero (Shahzad, 2012).
Lil-Amiri BI-AL-Shira of Murabahah - replica to a pre-denied profit sharing sale concept in Commercial Financing.
It is a sale of goods/property at a price covering the purchase price plus a profit margin agreed upon between the contracting parties.
Through this scheme an Islamic financing facility is provided for the purchase of a residential property on a deferred payment basis which is based on the Shari'ah concept. The Islamic banking institution earns a profit by purchasing the asset and subsequently sells it back to the customer at a marked-up price on a deferred payment basis (Shahzad, 2012).
Issuances of Sukuk (Islamic Bonds):
Sukuk - Islamic Bonds
Sukuk differs from conventional bonds in 3 ways
Unlike conventional bonds, Sukuk represents ownership in the asset of the enterprise issuing the Sukuk.
Unlike conventional bonds, the investor does not receive a fixed interest but a profit share in the revenue or profit of the enterprise.
Unlike conventional bonds, at maturity, the investor does not receive face value of the bond but the current value of the asset underlying the bond. (Gavin, 2012).
The impact of Sukuk globally
Malaysia is by far the largest issuer of Sukuk with over 70% of global market share followed by Saudi Arabia with 13% of issuances.
Japan has revised its laws to allow for more Sukuk issuance but no great impact
Singapore has also introduced a level playing field [in terms of taxation] but no great impact
Indonesia's primary Sukuk market registered growth in issuance of more than 200% over the year to the end of June 2012 to $142m.
In 2009, the South African government invited banks to bid for the advisory mandate on a sovereign Sukuk, designed to diversify the country's funding and investor base.
London has made tax treatment and the regulatory architecture as simple as possible for investors to conduct Shariah transactions as they would in Kuala Lumpur or Manama (Gavin, 2012)
Takaful - Insurance Plans
'Takaful' is on the same lines as Mutual Insurance Plans where by the Insured parties are beneficiaries of any gains or losses on the total premium collected which differs from commercial Insurance plans wherein the stock holders are the beneficiaries of the gain and losses on the premiums collected. (Kwon, 2007)
Principals of Takaful Insurance:
Primary objective of the Policy holders is to cooperate within a group of like minded investors for the common good of all.
To cover those who need assistance, every policyholder pays his subscription.
The liability is spread in accordance with the pooling system of the community and hence there is diversification of individual's losses.
Elimination of uncertainty concerning compensation and subscription.
Objective is not to derive any advantage at the policy holders cost
Tafakul issuances have been growing at over 20%p.a. since 2008 (World Takaful Report, 2011).
Total Tafakul market in 2011 ïƒ $12billion
Saudi Arabia ïƒ $3.86billion
Malaysia ïƒ $1.15billion
UAE ïƒ $640million
Literature review
History and Growth of Islamic Banking
The history of Islamic Banking dates back to the medieval era (1,000 - 1,500 AD), wherein businesspeople in the Middle East engaged in financial transactions (Ariff, Iqbal, 2011).
However the first visible signs of an actual financial establishment began in the Ottoman Empire (more commonly referred to as the Turkish Empire) in 1856. Barclays Bank opened its Cairo Branch in the 1890s, to manage the transactions pertaining to the erection of the Suez Canal. These banks were the first commercial banks set up in the Muslim world, but were widely opposed by Islamic Scholars who began condemning interest as forbidden by Quran (the Holy book of the Muslims) (Akgündüz, 2009).
The Egyptians and Malaysians were the first to apply and practice Islamic principles in finance. The same was evident as in 1962, the Malaysians established the 'Tabung Haji' (Malaysian Hajj pilgrims fund board), which is the oldest Islamic Financial Institution of modern times (Mokhtar,Abdullah, Habshi, 2006).
In Egypt, Islamic Banking was initiated in the structure of a savings bank based on profit/loss sharing in an Egyptian town in 1963. This bank existed till 1967, by the end of which there were nine such Islamic banks in the country (Akgündüz, 2009).
Taking lead from Egypt and Malaysia, the Dubai Islamic Bank and Islamic Development Bank (IDB) were set up in 1975 (Molyneux,Iqbal,2005).
The Organization of Islamic Conferences (OIC) started operations in 1975 with its headquarters in Jeddah, Saudi Arabia, which took several steps cumulating the establishment of banks of Islamic Countries that would provide to the entire Muslim community (Molyneux, Iqbal, 2005).
After the 1980's, there was no stopping the growth of Islamic financial cultures all across the globe from Pakistan to Switzerland (Akgündüz, 2009).
Gradually, the western academic circles were also intrigued by the growing Islamic financial systems and large conventional banks started operating Islamic windows. The Dow Jones and Financial Times commenced Islamic Indexes to enable the wealthy Muslim people to trade Islamic instruments on their exchanges (Akgündüz, 2009).
The IDB works in close coordination with all regional and international financial institutions like IMF, the World Bank, and the Asian Development Bank (Molyneux, Iqbal, 2005).
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The size of Islamic Banking is about 250-750 Million USD. Arab investors hold roughly 800 billion USD of resources in Banks and are increasingly tending to invest these assets in Islamic products (Akgündüz, 2009).
The assets of the Islamic finance sector are mounting at a rate of 15-20%, and are expected to reach the US$ 2 trillion mark by 2015. Also the conventional finance and Islamic finance are quickly converging in the world (Rammal, 2010).
With the growing Muslim population (ranging from 1.3 billion to 1.8 billion) all across the globe, it is becoming imperative for financial institutions to capitalize on the wealth owned by these stringent Muslims and provide opportunities to them to invest their wealth in the Islamic windows of these conventional banks (Akgündüz, 2009).
Islamic Banking - Evolution
The Gatehouse Bank (2011) in its report on Development of Islamic Banking describes the evolution over a period of four decades.
Time Period
Institution
Products
Geographical Area
1970s - Birth
Limited number of institutions.
Commercial Islamic banking products
Gulf/Middle East
1980s - Development
Growth in the number of institutions.
Commercial Islamic banking products Takaful & Project finance and syndication
Gulf/Middle East and Asia Pacific
1990s - Growth
Increased growth and expansion into retail banking.
Takaful, Sukuk, Shariah - compliant stock, & Islamic Stock Broking
Gulf/Middle East and Asia Pacific
2000s - Maturity
Internationalisation and acceleration in market growth.
Islamic investment companies, Brokers/dealers, Asset management companies
Gulf/Middle East, Asia Pacific and Europe/America
Differences between Islamic and Conventional Banking
Islamic banks perform primarily the same functions as conventional banks, however they do so in a unique manner based on the rules of Shariah, the lawful code of Islam(Molyneux, Iqbal, 2005).
The main distinguishing factor between islamic banks and conventional banks, is that the former operate in harmony with the Shariah law, which prohibits the use of interest or riba (as is commonly known in the islamic jargon)(Yudistira, 2004).
The fous point of Islamic banking and finance is justice, which is accomplished through sharing of risks. Since interest is forbidden, risks are shared between provider of funds and users of funds (Molyneux, Iqbal, 2005). In traditional form of banking, all risks are borne by the entreprenuer, whereas Islamic banking promotes equitable distribution of risk, and ensures that the decisions are made in the interest of the stakeholders, and hence follows the path of social sustainability (Saidi, 2009).
The creditworthiness of the borrower plays a crucial role in the lending of loan in case of a conventional banking system, however the same is not true for a bank following the Shariah Law. As mentioned above, islamic banks operate on the basis of profit and loss sharing and the bank receives a return only if the project, for which the money has been borrowed from the bank, results in profit. Consequently, an Islamic bank is more concerned about the reliability of the project, managerial proficiency and the business acumen of the investor(Molyneux, Iqbal,2005) and (Saidi, 2009).
Saidi, (2009) calls islamic banking as an ethical banking system, wherein the banks prefer to invest in activities that are meant for the welfare of the society and the environment. All economic agents of this ethical banking system should work within the moral value system of finance which proscribes investments in projects which involve alcohol, casino, night clubs etc. The International Monetary Funds (2010)in its report also mentioned Shariah compliant banks do not invest in financial assets such as collateralized debt obligations and credit default swaps, as they are considered to be toxic assets.
So the main sources of finance in islamic banking is profit sharing investment accounts (PSIA) and safekeeping. The difference between the two is that the PSIA holders, expect a return on the basis of the market average return of banks in general (including conventional banks). However, if due to positive market conditions, and good management skills, the bank performs better then one would receive a higher return than the market average and vice versa. Safekeeping deposits on the other hand are synonyms with current accounts, wherein they do not participate in profit sharing, and are not exposed to any losses (Hasan, Dridi, 2010).
Hence from the above, it can be seen that conventional banking is principally debt based and permits for risk transfer, whereas Islamic banking on the other hand is asset based and centres around risk sharing (Hasan, Dridi, 2010).
Islamic banking - challenges
Islamic banking has been around for around four decades now and has seen a successful growth in nations where Islam is a dominant religion but in spite of the growth and success Islamic banking faces certain challenges and as Islamic banking is being adopted and implemented in many western economies they face challenges from within and from the conventional banks.
The challenges faced by Islamic banks can be classified as follows:
Challenges on the Institutional side:
Lack of proper institutional framework to support like the ones that support conventional banks.
Lack of supervisory framework
Lack of equity institutions providing long term long term investments
Requirement of establishment of organized secondary market
Lack of shirt term instruments to invest for short periods (Iqbal, Khan,1998)
Challenges on the operational side:
Financial engineering - Limitations of Islamic financial tools of being classical models and not sophisticated and competitive like commercial banks
Issues with Shari'ah in terms of rigidity in product development and clearances by Shari'ah boards.
Globalization has increased the competition from conventional banks. (Iqbal, Khan,1998)
"A survey by Sudin Haron, Norafifah Ahmad and Sandra L. Planisek , on Bank Patronage Factors of Muslim and Non-Muslim Customers (1994), in a small town at Kedah and Perlis with a Muslim dominant population discovered that, only about 63 percent of the Muslims have understood either partly, or completely the difference between the Islamic bank and conventional banks, while about 39 percent of the Muslims respondents believe that religion is the only reason why people patronised the Islamic bank." (Hamid, Nordon, 2000)
The above extract describes a part of the key challenge faced by Islamic banking even among the Muslim population.
Further, a study on the UK experience with the implementation of Islamic banking as bought out the following limitations as listed below:
Regulation and Legislation
Capital and Liquidity requirements
Tax discrimination
Accounting practices
Liquidity and risk management
Staffing and Training
Marketing Islamic banking Products and Services (Karbhari, Y., Naser, K., & Shahin, Z., 2004)
Islamic banking - positive aspects
As mentioned earlier, Islamic financial products are based on profit and loss sharing (PLS) principle rather than the conventional fixed interest based principle. Under the Islamic PLS arrangement, the relationship between the borrower, lender and intermediary are based on financial trust and understanding (Yudistira, 2004).
When interest is substituted by profit sharing, the allocation of funds by these banks are guided by the soundness of the project. This inturn improves the efficiency of investor, as this arrangement makes it imperative for him/her to perform well in the project (Aggarwal, Yousef, 2000). A perfect example of this kind of a financial product is the Musharakah or the joint venture arrangement, wherein the investor and the lender share the profits of a particular project on the basis of a pre determined rate (Molyneux, Iqbal, 2005).
Another benefit of this kind of an arrangment is that creation of money is possible only when there is a corresponding increase in the supply of goods and services. Incase the project for which the profit and loss sharing arrangement was entered into, results in a loss, which thereby implies that the repayment of capital to the bank is diminshed, resulting in a lesser flow of money in the economy. Also an unsuccesful project means lesser supply of goods and services, thus curbing inflationary pressures in the economy (Aggarwal, Yousef, 2000).
The restrictions on forward transactions, along with elimination of interest rates as presecribed by Sharia helps to curtail speculative transactions (Hasan, Dridi, 2010). The Governor of Central Bank of Turkey, expressed a similar opinion at the World Bank Annual Meeting in 2009, to discuss the issue of global financial crisis. According to him, the PLS forms a sort of hedging instrument against macro economic factors wherein the banks absorb any negative shock on the asset side by transfering it to the liability side.
During the global downturn, these institutions were relatively less impacted than conventional financial institutions due to prohibitions on excessive leverage and troublesome financial innovative products (Hasan, Dridi, 2010).
Having proved its worth in times of crisis and providing opportunities for diversification, and as an alternate source of finance, assets of islamic finance sector is expected to reach US $2 trillion mark by 2015 (Rammal, 2010).
Research Methodology
We have conducted our research by first defining the objectives of our research topic and then proceeding on to collecting secondary data in order to analyse various concepts, issues and data related to our research topic and eventually draw an unbiased conclusion. Our research methodology can be summarized under the following heads:
Sources of data - For the purpose of literature review, research has been conducted using full text and scholarly reviewed academic journals and published books. Reports of International Monetary Fund and Gatehouse Bank (an absolute Shariah compliant, London-based comprehensive investment bank) were also delved into in order to identify the various aspects involved in the growth and evolution of Islamic Banking.
Geographies covered - The geographies of the Middle East, Pakistan, Malaysia and Sudan were analysed. This was primarily because they constitute of a high Muslim population and also because the early history of Islamic banking can be traced to these regions. Apart from the above, the geographies of Asia/Pacific, Europe and USA were also covered to identify the growth of non-conventional form of banking in these areas.
Time Period - The journals, books and other online reports extracted for the purpose of this research were published by the respective authors within the last decade.
Research approach - We used the descriptive - qualitative method of research in which we used various sources of data to analyse information for our research topic and draw appropriate conclusions.
Research Design - Our research mainly focused on qualitative data analysis. Design of our research is focused on descriptive aspects of the subject.
Data Analysis
There is more to Islamic banking than the elimination of riba, as the Islamic instruments are free from all forms of deceit, exploitation, and ambiguity (Ariff and Rosly, 2011).
The 4 key principals which form the basis of Islamic finance are Risk-Sharing, Materiality, No exploitation and No financing of sinful activities (Noor M.A., Ahmed N.H., 2012).
Such universal values mean a lot to nearly all, apart from religiosity.
As discussed in our research topic above, the demographics of most of the western nations are changing rapidly. There has been a sharp increase in the Muslim population in countries like the United States of America, European Union countries and Australia. As the Islamic banking movement gains momentum the Islamic banking services are now being made available to businesses in the western economies (Taylor, J. 2003).
It would be interesting to point out that the Islamic banking products have been evolving continuously to suit the new customer base in the western economies. Further, it is important to understand Islamic banking from a financial stability perspective as Islamic banking is increasingly interacting with conventional banking. (Solé, J., 2007)
Aggarwal & Yousef, (2000) concluded that based on the economic situations in which Islamic finance is prevalent, the application of only profit sharing sharing arrangements, or asset backed instruments is not a feasible option. They also laid down, that the evolution of banks and their growth in the Muslim countries can be brought about through an informational environment and not on the basis of explicit religious ideologies (Aggarwal & Yousef, 2000).
Yudistira (2004) rightly indicated that for Islamic banks to be successful in the international economy, they would have to indulge into cardinal amalgamation with other banks. Also it becomes imperative for these two diverse banking systems to build bridges between themselves, so as to provide comprehensive Islamic and non Islamic financial services to the world.
Conclusion
The growth and spread of Islamic banking has been tremendous. Individuals and businesses cannot ignore the phenomenon of Islamic banking any more. The products and services offered by Islamic banks are competitive and can be used by small business and individuals.
Although there will always be a niche market for Islamic banking and a constant competition from conventional banks, the introduction of Islamic banking in western economies could benefit various businesses and also serve the purpose of servicing a large Muslim population wanting to acquire Islamic banking products and services.
Therefore the entrance of Islamic banking into the western economies can be seen as an opportunity to attract funds from oil rich Middle East countries and also expand the customer base for the banking systems. There are many challenges that Islamic banking faces which will need to be diligently solved taking cues from economies like that of Malaysia.
Appendices
Global Sukuk Issuance
Country
Market share
Malaysia
70%
Saudi Arabia
13%
Indonesia
7%
UAE
6%
Others
4%
Source: NCB (Gavin, 2012)
Malaysia Banking Sector
Particulars
Conventional Banks
(In $Billions)
Islamic Banks
(In $Billions)
Islamic bank Market Share
Number of banks
24
17
41%
Total assets
446.08
97.49
18%
Total loans
228.3
60.17
19%
Total deposits
318.56
76.61
19%
Source: IMF (Gavin, 2012)
