Islamic Banking in the GCC in the Next Ten Years - Essay Example

?Islamic banking in the GCC in the Next ten Years Introduction History of Islamic Banking The foundations of Islamic banking were laid with the emergence and spread of Islamic over 1400 years ago. The first example of Islamic banking surfaced in the year 1963 in Egypt. This bank was brought into existence by Ahmed El Najjar’s pioneering efforts. The fundamental principal according to which this bank worked was profit sharing on the basis of Shariah’s non-interest based philosophy. It took only 13 years till 1976 for nine more banks like this to open in Egypt. These Islamic banks neither charged any interest nor paid it. The functioning of these banks was limited to the industries and trade in which they made investments either as the depositors’ partners, or using their own capital. Considering the functionality of these banks, they were more of financial institutions than the commercial banks we see today. The first commercial bank was opened in 1971 in Egypt with the name Nazir Social Banks. The charter of this bank did not refer to Shariah. The first bank that was entirely and overtly based on the principles of Shariah was made in the year 1974 by the Organization of Islamic Countries (OIC). The name of this bank was Islamic Development Bank (IDB). The function of this bank was to engage in the intergovernmental activities to provide funds to the member countries for developmental projects. The business model of IDB included fees for the financial services as well as financial assistance for the developmental projects through profit sharing. During the 1970s, numerous Islamic banks were established across the world which included but were not limited to the Dubai Islamic Bank established in 1975, the Faisal Islamic bank of Sudan established in the year 1977, followed by the Bahrain Islamic bank established in the year 1979. Several Islamic banks were also successively opened in the Asia Pacific region. The basic foundation of Islamic banking and how it differs from other banking conventions. “The basic principles of Islamic banking originate in the axioms of justice and harmony with reality and the human nature” (Kahf, Ahmad, and Homud 7). The simplest and the most fundamental definition of financing is the provision of goods, services, or any kind of production factors without the demand of an immediate counterpart on the part of the receiver. For example, employees in an organization deliver their services throughout the month and get paid at the end of the month. Islamic banking in its direct sense is very much based on the same principle. Islamic financing means provision of production factors for which payment is rescheduled. “Real-life exchange and production processes have, as part of their components or forms, the provision of goods to consumers as well as equipment, materials and other means of production to producers” (Kahf, Ahmad, and Homud 8). This lays the foundations of the practices of Islamic banking. Islamic baking provides funds in terms of goods, machinery, or equipment for payments that are deferred. Islamic banking also provides the option of profit sharing. Such financing is based on justice as both parties share the profit made from a productive project according to their investment ratio along with sharing the risks involved. Comparison between Islamic Banking and Other Banking Conventions It is odd to draw comparison between the Islamic banking practices and the conventional banking practices because of the immensity of difference between the two. The most fundamental difference between Islamic banking and other banking conventions is that the former is based on the Shariah foundation whereas the latter are not. Islamic baking is characterized by non-existence of transactions that are interest-based. Islamic baking is devoid of any economic activity that involves oppression or speculation. There is imposition of Islamic tax called as “zakat” in Islamic banking. Islamic banking does not allow production of such goods and services that are considered Haram in Islam. On the contrary, “conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other” (Zaharuddin and Rahman). In the conventional banking practice, interest holds the value of price of credit that encompasses the opportunity cost of money. Emergence of Islamic Banking The foundations of Islamic banking were laid more than 1400 years ago by the Prophet Muhammad (P.B.U.H.). “Literature on the model of banking based on profit-loss sharing first emerged in the late forties and fifties and more developed and detailed writings on the concept of interest free Islamic banking were published in the sixties and seventies” (El-Ghattis 3). The true development phase of the institutions of Islamic banking was the 1980s. Initiatives taken before that were inclined more towards the free-of-interest Islamic banking. The financial systems emerged during the 1980s. The pivotal component of the Islamic banking is lack of payment of interest. Islamic banking supports such principles of Islamic financing as rules of risk sharing, sanctity of contracts, and property rights. In the year 1985, “takaful” was declared to be compliant with Shariah by the High Council of OIC. The contemporary spectrum of the Islamic banking not only covers the banking activities, but also supports intermediaries, capital markets, and capital formation. In the year 1991, a revolutionary change with respect to adaptability happened with the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The fundamental objective of this organization was to provide consultation and advisory services regarding the standards of Islamic finance all across the globe. Several other organizations including the Islamic Financial Services Board (IFSB) also supported the development of uniform standards for implementation in the Islamic banks all over the world. Goals of Islamic Banking The fundamental goal of the Islamic banking is to make it a means of achieving the prime socio-economic objectives of Islam like all other aspects of the Islamic lifestyle. “Islamic law reflects the commands of God and this regulates all the various aspects of a Muslim’s life and hence Islamic finance is directly involved with spiritual values and social justice” (El-Ghattis 4). The prime goals of Islamic banking are as follows: Optimum rate of growth of economy Broad-based economic well-being Establishment of socio-economic justice Distribution of wealth and income according to equity Stability in the money’s value, and Generation of adequate savings While apparently, the goals of Islam and those of capitalism are the same, there are some differences in the roots of both. Unlike the morally-neutral and secularist capitalism, the basis of Islamic economic system is morality. The Gulf Cooperation Council (GCC) Leaders of six Arab countries including the UAE, Saudi Arabia, Bahrain, Qatar, Oman, and Kuwait met on 25 May 1981 corresponding to 21 Rajab 1401 AH in Abu Dhabi, UAE where they arrived at a cooperative framework to spread and promote integration, coordination, and inter-connection among them in all respects with an intention to create unity in due accordance with the article 4 of the GCC Charter. This article emphasized upon the need to strengthen and promote the links, cooperation and relations in all areas among the citizens of the member states. “The underpinnings which are clearly provided for in the preamble of the GCC Charter, confirm the special relations, common qualities and similar systems founded on the creed of Islam, faith in a common destiny and sharing one goal, and that the cooperation among these states would serve the sublime objectives of the Arab nation” (“Foundations and Objectives”). The decision of the member states to reach this cooperative framework was the institutional embodiment of various cultural, social, and historical factors rather than a sudden decision without objective reasons. As a result of this framework, the six states have strong cultural and religious ties among themselves and their citizens enjoy a sense of brotherhood across nations. The six states have homogeneous norms, values, trends and traditions. This makes the GCC not only a continuation and institutionalization of the realities that have prevailed over centuries, but also an objective solution to the risks and threats of economic development as well as security in the member states. Citizens of the Arab countries long aspired to reach regional unity and GCC provided them with a means to achieve that. The basic objectives of the GCC Charter are to promote inter-connection, integration, and coordination among all six member states in all areas along with strengthening the links among their citizens, developing and implementing similar laws and regulations in different areas including tourism, trade, economy, legislation, customs, administration, and finance, promoting the technological and research progress in all areas including agriculture, mining, water, industry, and forests, establishing centers for the increase in the frequency and quality of the scientific research projects, and establishing joint ventures. With the passage of time, member states of the GCC and Malaysia have converged a lot in the opinion of scholars. Today, Malaysia is producing products that accord with the standards implemented by the GCC. The industry can be seen drifting away from Shariah’s controversial explanation towards its widely accepted and acknowledged interpretation. Collectively, the six member states of the GCC region possess about 50 per cent of the total oil reserves in the world, with the Kingdom of Saudi Arabia being the most powerful among the six member states. In the year 1984, the GCC developed a collective defense force called as the Saudi-based Peninsula Shield, though the plans to expand this force failed. In the year 2004, the GCC members made a pact of intelligence-sharing to cope with terrorism. The common market of the GCC emerged in the year 2008. In 2010, the member states were planning to adopt one currency across all member states, but the plans did not materialize. The global economic crisis starting the year 2008 affected the GCC countries first of all, though the oil wealth of the member states helped the storm weather more speedily than it did in any other part of the world. “Islamic banks in the Gulf may count their blessings that the tenets of Sharia prevented them from investing in sub-prime mortgages and so from falling victim to the crisis which caused so much pain among conventional lenders” (Gavin et al. 3). Islamic banking in the GCC Region Principles Underlying Islamic Banking Islamic banks have played the role of financial intermediaries in the financial world whose efforts are directed at the mobilization of resources using the instruments of Islamic financing in due accordance with the principles of Shariah since 1950s. There are two basic principles of Islamic modes of financing. The first mode is interest-free financing instruments whereas the second mode is the development instruments which are based on the sharing of cost and profit. There are certain principal instruments that are involved in the resource mobilization. These instruments include but are not limited to trade financing, profit sharing, cost-plus mark-up on the traded products, equity participation that includes costsharing among the partners, rents upon the bought equipment, and use of such secondary financing instruments as stocks and shares that revolve around the aforementioned instruments. The mobilization of financial resources happens keeping in view the important conditions of Shariah. This imparts the need to use the financial resources into the goals and projects that have been recommended by Shariah. Ethical prerogatives and socioeconomic development are the main objectives of the modes of Islamic financing. In this perspective, the mandate of the Islamic banks extends far beyond securing funds from the clients to serve them in the different types of portfolios. Islamic banks function in a way that they become the developmental institutions which play a prime role in the moral uplift as well as economic development of the Islamic society in light of Shariah. Islamic Rules on Transactions Shariah gives the philosophy of Islamic banking. Shariah forbids the Islamic banking to deal in such transactions that include interest. The term used for interest in Shariah is riba. Shariah also forbids the Islamic banks to deal in such transactions which contain the factor of Gharar. Also, Islamic banks are not allowed to deal in transactions with invalid or haram subjects. Islamic Shariah develops links between the gain on capital and performance. The Islamic banks need a huge down payment upon the goods or property that is bought in order to accord with the laws about interest. Islamic banks may also need collateral worth the transaction’s value. Islamic banks do not lend loans like the conventional banks do. Instead, the Islamic banks buy property or goods from the seller and make an agreement with the buyer to sell it to them at a price larger than the purchase price. The Islamic banks are able to make such transactions and profits, because this is not an exchange of money, but goods. This principle is called “Murabaha”. For example, let’s suppose an individual bought a shirt for US$40 and wants to sell it with a 10 per cent mark-up on Murabaha. Since the exact cost of the shirt is known in this case, sale with the principle of the Murabaha is valid. Islamic banks sell property using the principle of Murabaha. They do not give mortgages. These transactions come under particular practices and categories. The customers may give funds to the bank for safety until the repayment of the debt. This is called as safe keeping or “Wadiah”. The bank may invest these funds to make profit from them till the time the debt is repaid. The bank is also allowed to charge the customers a service fee for taking care of their funds till the repayment of debt. If it wishes so, the Islamic bank may provide the customer with a gift known as “Hibah” on his/her account in terms of payment of money at the term’s end. It is extremely essential for the bank to produce all the deposited funds upon repayment of the debt. Evolution and Growth of Islamic Banking Islamic banking is generally thought to be a modern development, though the interest-free financial systems were operated by the Muslims since the very start of the Islamic civilization. In ancient times, the interest-free financial system was used for the organization of resources, conducting finance productive tasks, and satisfying the needs of the consumers. The interest-free financial system has remained quite successful during the emergence of Islamic civilization. However, with the shift of the economic activity towards the West, features of the Western financial institutions developed more as compared to those of the Islamic finance. Nevertheless, there has occurred an increase in the demand of the Islamic financial system over the past few decades. The boom in the growth of Islamic banking occurred during the 1980s. Analysis of the balance sheet of the Islamic banks during the early years provides a fair estimate of their remarkable historical performance. From 1987 to 1988, which was a period when Islamic banks were being established in different parts of the world, the aggregate balance sheets displayed a rise in the accounts’ balance by 7.4 per cent. This percentage increased from 7.4 to 14.9 between the years 1987 and 1989. From 1987 to 1988, the total assets contained by the Islamic banks increased by 107.4 per cent along with an increase in the equity of the shareholders by 12.4 per cent in the same period. Shareholders’ equity in 1987 was US$469.3 million which within a year became US$527.3 million. In 1987, the net distributed income was US$230.3 million and in 1988, it was equal to US$280.1, thus showing 31.7 per cent rate of growth. In the same period of one year, the rate of return upon the total amount of investments remained 15.8 per cent. In the year 1988, the net profit rate was found to be 11.1 per cent. The high returns could mostly be attributed to the immensity of resource mobilization in the area of trade financing while joint ventures and equity financing resulted in a distant small ratio. Overall, between 1987 and 1988, which was an early period of time with respect to the financial returns on murabaha, the performance of Islamic banks was generally remarkable. This financial instrument took good care of the wealth of the shareholders. Islamic Banking of the Macro and Micro Economic Scale  Islamic banking of the micro economic scale is of immense value to the developing economies because they have huge untapped markets. Italy is one such country that has benefited from the micro financing. After the Second World War, Italy gave its small and medium size industries micro financing. Since the end of the Second World War, those industries have become mega corporations. The petty manufacturers of the car parts with limited facilities have today become some of the main manufacturers of the car parts across the world. The indicators can play a very important role in the improvement of the financial system both at the macro and micro economic level. “At the micro level, the indicators should show the condition of individual institutions while at the macro level they should help assess and monitor the soundness and vulnerabilities of the financial system as well as the economy” (Hassan and Lewis 343). Present Status of Islamic Banking Worldwide Owing to the success of the Islamic banking, the practices of Islamic banking are being readily adopted by the conventional banks all across the globe. The recent economic recession has affected all countries of the world in general and the technologically advanced countries like the USA in particular. As a result of the economic quagmire, a lot of western economists are reconsidering the adoption of the Islamic banking system. They are conducting an in-depth analysis of the Islamic banking system with the hope that it can protect them from the economic mess of the magnitude they have recently encountered. The number of Islamic banks in different countries is over 150 today. Financing with an emphasis upon murabaha or trade financing is on a rise. Profit sharing and equity participation have generally kept distant minimum with respect to the allocation of resources. However, secondary financial instruments based on the principles of Shariah were not formed. Islamic financial instruments have been adopted by the conventional stock markets. As a consequence of this, the banks could neither attain the developmental aspects of the Islamic banking directed at the establishment of an Islamic economy nor the distributive objectives for the marginal enterprises or the poor. Islamic Banking in the GCC Countries Over the last decade, Islamic banking has expanded in the member states of GCC at double-digit rates of annual growth. Today, Islamic banks in the Gulf region have become a component of the mainstream financial intermediation, and share 15 per cent of the market share of the assets of the regional banking system. Over the years, Islamic banks in the GCC have increased in the level of diversity in terms of the coexistence of the large pioneers that had established during the 1970s, conversion of the former conventional financial institutions into the banking entities fully compliant with the laws of Shariah, along with consideration of adopting the Islamic banking system by the conventional banks. The strengthening competition has forced the Islamic banks to create relevant business models, improve their commercial entrenchment, fortify their reputation and brands, and offer creative solutions to the clients impressed with the interest-free banking system. “Islamic banks in the GCC are structurally profitable, and their business model robust enough to weather credit cycles” (Hassoune and Satel 8). A lot of commercial banks in the member states of the GCC are being influenced by the Islamic financing system. For example, in Saudi Arabia, Bank Al-Jazira was once a famous commercial bank which extended the credit to the corporate franchise as well as its retail. As the competition in the field of credit from the Islamic windows of conventional banks and the established Islamic banks increased in Saudi Arabia, Bank Al-Jazira has become more diverse in terms of margin lending and brokerage. Likewise, the Qatar Islamic Bank tends to acquire a universal banking status developed upon the core commercial intermediation. Dubai Islamic Bank has made use of its powerful Millennium brand to enhance the business of Islamic investment banking. Islamic banking today is one of the most fundamental promoters of the finance industry in the UAE as at least 20 per cent of all banking assets in the UAE are factored by it. There has occurred a surge in the IFI assets of the GCC countries between the year 2003 and the year 2008 as a result of which, the worth of the GCC IFI assets increased to $288.2 billion in the year 2008. Many factors can be considered to be responsible for this surge. The influx of petrodollars is a consequence of the strong economic growth in the GCC countries along with an increase in the oil prices. In the past, the UAE has drawn a lot of benefit by being an active business hub in the Middle East region. The UAE saw economic prosperity brought by the investments related to the infrastructure till the time of financial recession. With the government’s tweaking of its policies for the improvement of economic activity, the rising per capita income as well as the accumulated wealth in the region stimulated the banking industry in the GCC countries. Increase in the privatization initiatives along with increasing sovereign ratings increased the foreign direct investments (FDI) to spur a flood of liquidity, that resulted into a boost of growth of the Islamic banking as well as the conventional banking. “[T]he Islamic banks in the GCC states have been more innovative than their Iranian counterparts in terms of product development, and provide a much more attractive range of services, possibly because of the need to compete with conventional banks in their domestic markets” (Wilson 2). The fact that the Iranian banks are owned by the state makes them less innovative and more bureaucratic. Global Growth of Islamic Banking Over the past few decades, there has been immense growth of Islamic banking all over the world. Islamic banks have been established from Jeddah to Jekarta all the way up to Jordan. Overall, the total number of Islamic banks which operate in the Shariah space exceeds 280 in over 50 countries. Assets of these banks range from US$250 billion to US$300 billion. “Around 35 percent of these IFIs are located in the Middle East. Currently, Dubai has a very extensive network of Islamic banks; Emirates NBD, Dubai Islamic Bank, and Noor Islamic Bank are some of the major players in the region” (Ilham, Chaudhary, and Waghle). The recent economic crisis has redirected the focus of the Islamic banking to resiliency. In addition to that, lack of exposure of the Islamic banks to the speculative assets as well as the Shariah’s risk sharing model has put the IFIs in a position to overcome the effects of economic crisis while remaining unscathed. Opportunities for Growth There are great opportunities for growth of Islamic banking all over the world in general and the West in particular. Certain factors including the debt crisis in Europe and the anger of the people over the government’s aid to the banks has provided the Islamic banks with a growth opportunity. Islamic banking assumes immense potential to outshine the conventional banks by providing both the Muslim and the non-Muslim customers with an alternative. Today, people all over the world want a better as well as more ethical means of making money. This makes the present time quite suitable to position the industry of Islamic banking as an alternative financial system that provides solutions to the problems caused by the conventional financial system. Islamic banking addresses the needs of all customers generally and particularly the ones “who want to avoid risks which have been rampant in the international conventional financial sector revolving around sub-prime lending, the American market meltdown, toxic assets, mismanagement of leveraged products, speculation, hedge funds, interest rate options, unethical practices, federal bailouts, short selling, mortgaged debts and derivatives” (Ahmad). Direction of Banking in the GCC Region Currently, the GCC region is all set to sustain the efforts for improving the standards. The performance of Islamic banks depends upon the regulatory structure to a great extent just like the conventional banks. Lack of standardization of the financial products as well as contracts across different financial institutions in a certain country is a matter of prime concern. Standards for the operation of the Islamic banks are continually fragmented. Nevertheless, organizations like IFSB and AAOIFI are taking measures to tackle this issue. The growth of such organizations can enhance the growth of Islamic banks. Setbacks and Problems Experienced by Islamic Banks A very critical and narrow analysis of the matter suggests that the term “Islamic banking” is fundamentally illogical. The economic sphere has pseudo-communist tendencies. However, there are certain banks whose practices are generally compatible with the Islamic financing principles like interest-free loaning, and such banks qualify to be called as Islamic banks. Riba is haram in Islam because it provides rich people with an opportunity to become even richer while the poor get even poorer. One of the deficiencies found in some Islamic banks is that they tend to identify loopholes to exploit them with an intention to adopt practices that are if not more, at least as bad as riba. They are able to get away with such practices because they are no considered “technically” harma by the ulema. For example, many banks in Iran extract interest but do not call it interest as such. One of the problems of the Islamic banks in the current age is that although the Islamic finance is fundamentally based upon the traditional practices, yet a lot of modern service innovations and products of the Islamic banks are adapted to their conventional counterparts. Another problem experienced by the Islamic banks is that some commercial banks giving mortgages are gathering more interest of the customers because of their business benefits. “On the one hand, Shari'ah-compliant investment banking has grown as a viable, profitable and successful way to manage alternative Islamic asset classes. On the other hand, specialised financial institutions focusing on mortgage, housing and consumer banking have been providing financing solutions to households facing unprecedented needs in terms of accession to consumption and property” (Hassoune cited in “Comparative analysis”). Conclusion Islamic banking is fundamentally a type of investment banking in which the clients submit money to the bank which in turn plays the role of an investment center that lends the clients returns upon investment as profit rather than interest. The decision whether or not to lend money to the user as loan depends upon the purpose for which the user needs the money. If the client requires the loan for business, he/she has to enter into an agreement with the bank and mention the amount that he/she would share from the profit with the bank upon returning the interest free loan to the client. The whole western banking system runs upon interest. Interest banking is so ingrained in the western culture that eradicating the conventional banking system or replacing it with the Islamic banking system would shake the foundations of the economy of the West. Nevertheless, keeping in view the long-term benefits of the Islamic banking, the change is worth taking despite its enormity. The GCC Islamic banking has not completely become free of the influence of commercial-banking model, though the Islamic financing system complements the commercial-banking model. Robust financial fundamentals normally drive the ratings of Islamic banks in the member states of the GCC. External support also improves these ratings. Imperfect positioning of the risk and modifying operating environments weigh on the risk profiles of the Islamic banks, and eventually, upon the stand-alone credit ratings of the Islamic banks. In spite of the expected dominancy of the commercial banking in the Islamic states that are members of the GCC, it is expected that growth of the specialized and investment houses would sustain as the regional clients’ investment and financing needs are becoming increasingly focused and specific. Taking into consideration the successful evolution of the whole industry, it is expected of the newcomers to intensify the competition, and motivate the already established players to opt for the non-conventional business lines. In the near future, Islamic banks in the GCC countries would explore new territories beyond the homelands. Certain Islamic banks in the GCC countries that include but are not limited to the Qatar Islamic Bank, Kuwait Finance House, and Al Rajhi have already established new operations in the Malaysian hub in search of a larger consumer base. A vast majority of the Islamic banks around the world have experienced growth rates in double-digits for many decades, thus taking over their conventional counterparts. Room for growth of the Islamic banks is ample as it has rarely spread beyond a third of the total share in the market, even in the member states of the GCC and Malaysia, let alone other countries. There are a lot of potential markets that have a large population of Muslims including India. In addition to that, the overall penetration of banking even in the core markets of the industry is still very low. This includes the GCC countries in which the banking penetration levels equal to the UK or France have still not been achieved despite the huge number of Islamic banks in these countries. Alongside, numerous new markets are opening up in different countries around the world where Islamic banking system can be suitably applied. Achievement of standardization is essentially the tipping point that can cause a revolutionary change in the endorsement of the Islamic financial system all over the world, thus replacing the oppressive interest-based banking system that has already caused the world much loss. In light of the points discussed in this paper, it can be said that in a matter of 10 years from now, Islamic banks in the GCC region can be expected to dominate the banking sector. Works Cited Ahmad, Furqan. “Islamic Finance: Opportunities for Growth and Innovation.” Mar. 2011. Web. 17 June 2012. . “Comparative analysis of GCC Islamic banks reveals three distinct banking business models.” 11 Mar. 2008. Web. 17 June 2012. . El-Ghattis, Nedal. “Islamic Banking's Role in Economic Development: Future Outlook.” N.d. Web. 17 June 2012. . “Foundations and Objectives.” N.d. Web. 16 June 2012. . Gavin, James; Gibson, Nigel; McCrum, Philip; and Summers, Mark. “Annual review of Islamic Banking and Finance.” The Gulf. Aug. 2010. Web. 17 June 2012. . Ilham, Luqman Hakim; Chaudhary, Vivek; and Waghle, Makarand. “Islamic Banking in the GCC.” 16 Feb. 2012. Web. 17 June 2012. . Hassan, Kabir, and Lewis, Mervyn. Handbook of Islamic Banking. UK: Edward Elgar Publishing Limited, 2007. Print. Hassoune, Anouar, and Satel, Adel. “Islamic Banks in the GCC: A Comparative Analysis.” Mar. 2008. Web. 17 June 2012. . Kahf, Monzer; Ahmad, Ausaf; and Homud, Sami. “Islamic Banking and Development an Alternative Banking Concept? 1998. Web. 16 June 2012. . Wilson, Rodney. “The development of Islamic finance in the GCC.” 2009. Web. 17 June 2012. . Zaharuddin, Ust Hj, and Rahman, Abd. “Differences Between Islamic Banks & Conventional.” 22 Feb. 2007. Web. 16 June 2012. . Read More