Currently Islamic banks are facing few challenges. Firstborn, they have not yet been doing well in formulating an interest-free system to place their funds on a short-term substance and basis. They face the same problem in financing consumer loans and government deficits. Second, the risk occupied in net income-sharing seems to be so high that approximately all of the banks have resorted to those methods of financing which fetch them a determined expected and guaranteed return. As a result, there is some genuine criticism that these banks have not eliminated interest but have in point of fact only altered the nomenclature of their transactions. Third, the Islamic banks do not have the legal assistance of central banks of their various countries (except in Pakistan and Iran), which exposes them to great risks. Fourth, the Islamic banks do not have the rudimentary and essential expertness and trained manpower to appraise, monitor, valuate and audit the plans and projects they are expected to finance. As a result, they can't exaggerate in spite of having excess liquidity.
The future of Islamic banks hinges, by and large, on their ability and skill to find a viable substitute to interest for financing all types of loans. They will have to distinguish that their efficiency and success in eliminating interest has been leastways partial and they have yet to go a long way in their search for an acceptable substitute to interest. Simultaneously, Islamic banks require improving their managerial capabilities and potentials by locality and training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks similarly depends on fabricating and putting into practice such accounting standards which provide timely and reliable data of the type that the Islamic banks would require for net income-sharing, rent-sharing or for cost-plus financing. These standards are yet to be developed. The Islamic banks will without doubt have to work hard to harass and pursue their customers to accept these standards so that a reliable database is established and recognized.
Islamic Banking or, the separation of Bank and State. (n.d.) [Online] http://aeconomics.blogspot.com/2007/07/participatory-banking.html
The operation of an interest-free banking raises a number of questions and possible problems if seen from the macro and micro operational point of view.
2.12.1 Issues Related to Macro Operation of Islamic Banking System
2.12.1.1 Liquidity
Islamic banks consider money as medium of exchange, and it is not asset but a mean to get acquire it. Conventional banking on the other hand emphasizes the want for preserving liquidity and hence requires an adequate quantity of reserves. The primary principle of Islamic banking being profit and loss sharing based financing and thereby having been exposed to increased risk; it would conceivably require higher liquidity and reserves. The cause is that its investment in assets has by nature lesser divisibility and reversibility. This means that reserve ratios for interest-free banking are to be calculated on the substance and basis of risk calculation in complex and various forms of investment.
The manifold and complex problem in measuring liquidity is that liability management in the conventional banking establishment and scheme has been gradually replacing asset management to fund liquidity needs. At present, no such facilities subsist under the Islamic banking and financial system. As a result, these banks have to depend on their central bank to supply cash. The liquidity ratios required by the banking laws on demand and time deposits differ from country to country. In a good deal of countries, the supervisory authorities reserve the right to impose various ratios on different banks as stated by their emplacement. At present, the liquidity ratio is 35% of demand and time indebtednesses in Pakistan.
IBBL: Concept and Ideology. (n.d.). Retrieved from [Online] http://www.islamibankbd.com/issues_and_problems_of_islamic_banking.php
With regard to the elements comprising the liquid assets of Islamic banks, it would be fundamental and necessary to grant these reserves to be kept in the form of financial instruments. Similarly, the bank capital requisites underneath Islamic banking would be higher to defend the depositors against unusual and unexpected losses, whether or not any, on the investment portfolios, incrementing the requirement of legal and prostration and loss reserves that could provide additional shelter and safety allay.
2.12.1.2 Valuation of Bank's Assets
It is argued that Islamic banks can suffer a prostration and loss of validity and value of its sum totals assets in the absence of a determined real and positive rate of return. Further, without the provision of insurance Islamic banks can face disturbance in inducing their institution and strategy and making it stable and avoiding liquidity crises. So far, under Islamic banking, no such insurance institution and scheme exists.
Theoretically, Islamic banks are likely to face a dual danger: (a) the 'moral' danger due to lack of honesty and integrity on the part of the borrower of funds in declaring a prostration and loss, (b)the 'business' danger arising from strange and unexpected market behaviour.
The deposits under the profit and loss sharing schemes are conceptually more parallel to a mutual fund's part certificate. These deposits would part in both the realised in addition as unrealised benefits and losses on the investment of Islamic banks. Characteristically under current in general accepted accounting principles, the investment portfolio is adjusted to market values in investment companies. An upward adjustment of the sum totals account requires an offsetting credit to either revenue or unrealised capital increment. Unrealised capital decrement requires recording of an unrealised prostration and loss on long-term equity securities as a contra item in stockholder's equity.
The problem related with proper valuation of Islamic banks' sum totals has crucial significations for bank shelter and safety and bank regulation. Any specification of reserve or provision requisites laid down by the regulatory agencies will have to look at how far the benefits (losses) on banks' investments are passed on to the depositors. Whether or not in the ultimate case, these benefits and losses are wholly reflected in the validity and value of the deposits, the banks probably would be passing on all the risks to their depositors.
2.12.1.3 Financial Stability
Conventional banking grounded on the fragmental reserve system has built-in jeopardy and instability as illustrated by western economists suchlike Hayek (1933), Mintz (1950), Fisher (1930) and Friedman (1957). The jeopardy and instability arises, as argued by them, from the lack of synchronisation amongst the decisions of mercantile banks and the central bank thereby resulting in destabilising forces. Modern banking grounded on interest issues limited validity and value indebtednesses to its depositors. In the absence of deposit insurance the validity and value of assets can fall underneath its limited indebtednesses, resulting in bankruptcies. In the worst scenario, the welfare of each depositor depends on the action of other depositors. For example, whether or not one of the bank's major borrower's default and a financial panic is triggered, each depositor will attempt to withdraw funds as soon as possible. This negative externality generated by the depositors can cause risk and instability in the banking organization and system. The provision of deposit insurance has scaled down the problem of financial panics, but it has at the same time led to inefficiency in the intermediation procedure.
By that reasoning, lack of insurance coverage is conceived to be a problem for Islamic banks. It is presumed that depositors in Islamic bank, due to the fear of capital and or earnings losses in the event of having no insurance coverage, would not remain with the Islamic banks. Islamic economists argue that under Islamic banking, because there are no limited indebtednesses, depositors feel encouraged to remain in the bank when it suffers a decline in the validity and value of its assets. Hence, there is no externality formulated. It does not require the condition of deposit insurance. Even though, it would need several provision of insurance against fraud and theft in Islamic banking.
2.12.1.4 Lack of Capital Market and Financial Instruments
Islamic banks working beneath traditional banking framework in different countries lacks capital market and instruments for investment of their surplus liquidity. Availability of Islamic capital market and instruments support growth of these banks. Growth of Islamic capital market and financial instruments also assists creating the situation for government financing.
2.12.1.5 Insufficient Legal Protection
A comprehensible establishment and scheme of Islamic banking requires legal cover. This means an in-depth review of all relevant laws having a bearing on banking business is necessitated. Laws relating to companies, investment, commerce and the courts and legal procedures require to be reviewed and reformulated to suit the requisite of the competent and effective functioning of Islamic banks. It is not worthy of acceptance or satisfactory that company law continues to discuss bonds and interest while ignoring participation performance and profits. Investment advertisement laws ought to conciliate rules and regulating, which permit Islamic banks to employ their profit and loss sharing methods so that they can participate in partnership businesses also in the form of Musharakah or direct investment.
2.12.2 Issues Relating to Micro Operation of Islamic Banks
2.12.2.1 Increased Cost of Information
Islamic scholars commonly agree that the monitoring cost as well as the cost of writing and implementing the contracts would be higher in Islamic banking as compared to the interest-based system. This is because, with Musharakah, the bank finances the working capital of a business venture taking a quasi-equity position in the economy. In financing, a management company is formed which proposes a flexible ease and security, or the bank may altogether finance a project within the autonomy and scope of its charter. Furthermore, from that time of the economies of countries implementing Islamic banking are generally characterized by market and informational limitations, additional determination of these difficulties will increase the cost of information. This higher cost of information could be a major obstruction in the thorough and effective implementation of the profit and loss sharing scheme.
2.12.2.2 Control over Cost of Funds
An interest-based banks and financial institutions maximises its profit dependable to the amount of funds as it is in a position to apperceive in advance, with a reasonable extent of certainty and the profit it may acquire in the abbreviate term. Through the use of uncertainty it can as well motivate the akin of profits in the continued run. Under the PLS system, on the other hand, there is no such scope to apperceive the funds beforehand. The depositors are paid an allocation of the bank profits and the aggregate of which is acutely uncertain. In this bearing if profit amount accepted by the depositors is not realised, the Islamic banks could face greater uncertainty in their profit base.
Ideally, Islamic banks are expected to calculate and acknowledge their rate of return on PLS deposits periodically. The normal practice is that the deposits are abounding to reflect differences in their maturity. The bank prepares a six monthly summary of its operations and sends it to the central bank, which determines the alone PLS amount to be paid by each bank. In animosity of that individual banks are accustomed to marginally deviate from the proposed amount of return. In sum, it can be argued that Islamic banks accept no dominance over the cost of funds.
2.12.2.3 Mark-up Financing
There is advanced apprehension that little variation can be established among mark-up practised by Islamic banks and conventional banks. However, admitting not considered carefully interest-free by many Muslim scholars, mark-up was apparent by the banks as a tool to facilitate the alteration to Islamic banking without distracting the system. Because the ultimate aim of Islamic banking is investment-oriented long term financing, the alteration from mark-up to equity finance would also require a larger spread between rates of return to the banks and to their depositors
2.12.2.4 Utilisation of Interest Rate for Fixing the Profit Margin in Murabahah Sales
It is furthermore criticized that Islamic banks make use of the interest rate as a condition for fixing the profit margin in the Mudarabah sales. To be fair, there is no recognized way of avoiding the so-called link up as long as Islamic banks coexist with conventional banks. Still Islamic banks should avoid exceeding the current interest rate or exploiting the clients through accounting techniques as used by some banks.
2.12.2.5 Lack of Positive Response to the Requirement of Government Financing
It is a known and recognized fact that the new state is perpetually in need of funds and capital to put into operation valuable plans and projects, such as the provision of schools, electricity, roads, water and telecommunication services. Normally, government's substitute to issuance of treasury bills with interest in accordance with the form applied by conventional banks. Islamic banks are required to enter into this field so as to prove their ability to play their role in the financing of plans and projects in a means that conforms to the Islamic banking and financial system through the issuance of deeds of Musharakah, advance-sale, salam and such other forms that satisfy the requirements of the state for financing and, at the same time, benefit from investment of their solitary and idle liquid surpluses.
2.12.2.6 Failure of Islamic Banks to Establish Co-operation among Themselves
In spite of good intents, Islamic banks are held responsible for their lack of open-mindedness to each other, a state of affairs that stop the accomplishment of mutual co-operation between them. This is in spite of the constant enterprises of the Islamic growth and development bank to bring them closer to each other and combine their stands. Following examples are enough to prove the point:
Not all-Islamic banks are members of the worldwide association of Islamic banks. The association has neither been competent to unify their regulations, nor build bridges of trust and self-confidence and promote understanding amongst them.
The ideas of establishing a "bank of Islamic banks" is hushed and still a mere idea, although there is an urgent need for its institution. As an effect of its absence, Islamic banks have lost hundreds of millions with the collapse of the BCCI.
Islamic funds carry on to sneak out by hundreds of millions into investment houses doing business in the west while the Muslim earth remains thirsty for investment resources.
Trade amongst countries of the Muslim earth is entirely paralysed as the Islamic financing institution and system goes along with the traditionalistic trend in financing imports from foreign countries without giving any preference to productions of the Muslim earth. Only the Islamic growth and development bank has been paying due attention and care to the want for preferential tone and treatment for the productions of Muslim countries.
Funds of expatriates from Islamic countries do not find their way back to their own countries to grant to the growth and development of their distinguishable and original homelands.
2.12.3 Problems of Islamic Banks Operating under Conventional Banking System
Problems faced by Islamic banks functioning under traditionalistic banking framework have been identified in a recent study as follows:
Islamic bank fails to fitting and appropriate high earnings from high-return plans and projects since the owners of these plans and projects prefer borrowing from traditionalistic banks where pricing of borrowing turn out to be lower. That means, only the plans and projects with rates of return equal to or under the market rate of interest are left with the Islamic banks. At this circumstance, Islamic banks are not capable to invest on the plans and projects having rates of return under the potent and prevailing rate of interest thereby limiting their capacity to apply investment time and chance to the level of their traditionalistic counterpart. This leads to limiting the application of earnings-prostration and loss-sharing modes such as Mudarabah and Musharakah. In other words, Islamic banks, at that circumstance, switch over to other modes of financing such as Murabahah, hire buy, leasing, etc.
It has likewise been found that distributive precision and efficacy of Islamic banking is lost when an Islamic bank starts operation under traditionalistic banking framework. Any shift from profit and loss sharing modes leads the organization and system break the direct relationship amidst the incomes of the enterprisers, the bank and the depositors. The inefficiency of traditionalistic banking with regards to distribution is neither influenced nor modified by the first appearance of Islamic banking in the economy.
