Islamic Finance System - Research Paper Example

Islamic finance History The financial industry is a significant industry which plays a critical role in the economy of different countries across the world. The history of banking is an old and varied history which started in the 14th century BC. The Islamic banking and finance processes started during the medieval times when it was recognized that the existing modes of banking and finance were violating the Islamic laws. The Islam population across different parts of the globe encouraged the popularity of financial transactions based on the principle of Sharia in Islam religion. The tradesmen in the Middle Eastern region of the globe were the main facilitators of Islamic financing processes following the principle of Sharia as described in Islam. These principles were similar to those followed by the European financial transactions at that time. The Arab people belonging to the Ottoman Empire engaged in increased trading activities with the Spanish people and were the forerunners in establishing a financial system which was based on a profit and loss sharing principle and removed the system of interest payment. These principles were followed in the financing of trade processes as well as for other enterprises. With time, the Asian and Middle Eastern regions emerged as important partners in trade for the European companies like the Dutch East India Company. Therefore, the European banks started to set up their operations in these regions. These banks followed the interest based principle. At that time, the conventional financial system was considered as more important due to the role of the financial systems flowed in the Western countries from the global economic perspective. The Islamic financing systems existed in small geographic regions and their activities were limited. It is indicated by the researchers that the first trends of Islamic banking were noticed in the way the Islamic institutions conducted the transactions and payment procedures related to trade in the medieval times. But the first noticeable Islamic finance process was established in Egypt during the 1960s. The movement related to Islamic finance accelerated in the 1970s wh3wen the Arab countries saw a boom in their oil capacity and the Islamic institutions renewed and modified their interest payment and other financial systems to adhere to the Islamic laws and principles. The high growth of the predominant Islamic countries in the Middle East contributed to the accelerated diversification and expansion in the Islamic finance and banking systems. The Mit Ghamr Savings Project set up in Egypt in the mid-1980s is considered as one of the earliest milestones in the history of Islamic finance. Mit Ghamr was an organization which started the financing schemes based on the Islamic principles or the principles of Sharia. The cooperative allowed the depositories to take loans from the organization and also drew funds for financing its projects based on the profit and loss sharing principle of Islamic finance (Jairus, 2007). This project was later incorporated in Nasser Social Bank. The late 1980s saw considerable developments in the Islamic banking industry with many banks being established and run on the principles of Islamic banking and finance. The Dubai Islamic Bank and the Islamic Development Bank were the pioneers in popularizing the Islamic financing system. By the late 1990s The Islamic banking industry started growing by an impressive rate of 10-15% every year. The geographical limitations of Islamic financial services were soon replaced by a worldwide popularity for the system and the Islamic banking system started competing efficiently with the conventional banking systems. Major countries saw the establishment of Islamic Banks which included the United States of America, Malaysia, Bangladesh, Kuwait, the European Union, Saudi Arabia, Bahrain, Pakistan and many more. The history of Islamic finance is much longer than the last 40 years of its inception. The Islamic finance developed from existing transaction and payment methods and ultimately emerged as a finance system in which characteristic features of both conventional banking laws and Islamic laws could be identified. The underlying principles and the basic framework of Islamic finance are attractive to investors and depositories across the globe, irrespective of whether they belong to the Islam community or any other community. Actuality Islamic finance system involves banking and financing activities based on the principles of Sharia or the laws embedded in Islam religion. The practical application of the Islamic finance and banking processes is done through ensuring the development of Islamic economics. Islamic banking can be explained as finance processes that are compliant with Sharia or the rules of Islam. According to Islam laws, taking specific fees or interests for loans given are considered as sinful. The payment of interest as well as the acceptance of interest whether at a floating or a fixed rate are considered to be haram i.e. an action which is considered to be sinful and is prohibited according to Sharia. The fees or interests payable on amounts of loan are known as usury or Riba. The Islamic finance processes also follow the policy of not investing in the businesses which deals with products and services forbidden in Islam. The Islamic banks established in various parts of the world apply these basic principles in their commercial transactions and activities. The purpose of Islamic banking can be aligned with that of conventional banking systems. Both these systems aim at making money for the organizations through the process of lending out money as loans and through other financial transactions. But the Islamic banking system also makes sure that the activities of the business are in complete adherence to the Islamic laws and regulations. At the core of Islamic banking lies the objective of ensuring and encouraging fair play in the banking and financial services provided by the financial institutions (Rammal and Zurbruegg, 2007). The Islamic law forbids taking interest from the loan given out. Therefore, the Islamic finance processes use the rules of transactions known as Fiqh Al- Maumalat to prevent any payment or acceptance of interest or fees in the Islamic financing activities and institutions. Another basic principle underlying the Islamic financing processes is the risk sharing principle which is considered as an element of trade instead of risk transfer as applicable in the conventional banking processes. Other principles underlying the Islamic financing processes include safekeeping or Wadiah, profit sharing or Mudharabah, cost plus or Murabahah, joint venture or Musharakah and leasing or Ijar. The Islamic financing system is constrained to operate under the Islamic laws and conduct only those transactions which are acceptable by the Islamic laws. The ultimate aim of implementing these policies is to encourage moral purchasing and ethical investing in the financial systems. The Sharia principles and their interpretation or Fiqh provide for the ethical framework of the Islamic finance system which focuses on the essence of the development and wellbeing of individuals as well as economies (Timur, 2005). The framework of Islamic financing is applicable to banks as well as businesses in general. Honesty, fairness, removing tort and hoarding are integral elements embedded in the Sharia laws as is the prohibition of usury or riba, uncertainty or ghara and speculation or maysir (Saeed, 1996). Riba or usury is the interest or fees taken by a lender from the borrower apart from the principal amount given as loan. Riba is considered to be sinful according to Sharia and is strictly avoided in the Islamic finance processes. Gharar or uncertainty is involved in the processes in which one consciously exposes a person or his property to jeopardy or sells a product or service whose features or existences in future are uncertain. In the context of Islamic financing system, the financial institutions advising a person to invest in shares of a business which is on a pre-takeover stage, assuming that the prices of the stocks of the company will increase after the takeover is an example of Gharar or uncertainty. The principle of Gharar is not applicable to business risks like investments done in a startup company. Maysir or speculation is prohibited activity in Islamic finance which poses the threat of complete loss for one of the parties involved in the financial transaction. In the modern Islamic finance process, money is seen as a way of facilitating trade processes rather than a way of storing value. Therefore, the Islamic financing modes focus extensively on following the Islamic laws while providing suitable means of financing for the betterment of individuals as well as economies. Statistics The Islamic Financial institutions have started becoming popular with many countries adopting the models for the betterment of their economies. A survey by The Bankers in 2009 shows that the Sharia Compliant Assets volume calculated with respect to the top 500 Islamic banking and financial institutions have demonstrated an increase by almost 29% with the valuation of the assets increasing from USD 822 billion in 2008 to USD 640 billion in 2009. This can be considered remarkable especially when it is noted that in the same period the assets of the world top 100 conventional banks slumped from 21.6% to 7.1%. The Sharia compliant assets in the Islamic financial system are estimated to USD 2.20 trillion by 2014. The Islamic bonds or Sukuk are expected to increase to more than USD 220 billion in 2014. The opportunities for expanding the Islamic financing systems are increasing with the non-Muslim countries like UK, Japan, Singapore, US, Australia, Hong Kong, Germany and Thailand trying to tap in the surplus funds available in the oil rich Islam dominated countries. The Muslim communities in countries like France and United Kingdom have started showing more interest in the products and services provided by the Islamic financing systems. Currently, the Islamic financial institutions operating in 52 countries across the globe include almost 450 financial institutions and more than 210 windows for conventional institutions. The valuation of the assets in the Sharia complying financial institutions have shown continuous growth with the assets vale increasing by almost 16% every year. The major Islamic banks and financial institutions operate in the United Arab Emirates, Qatar and Saudi Arabia, whereas United Kingdom, Malaysia and Bahrain operate as the global hubs for Islamic financial systems. The Islamic Republic of Iran and Sudan follow completely Islamic financial processes in their economies. In the global perspective, the banks hold more than 89% of the Islamic assets and about 14% of the Muslims currently use Islamic financial products and services. The major expansions of the earnings and savings involved in the Islamic financial system are directed to Sukuk or Islamic bonds. Growth of Sukuk Issuance (Source: Ignacio, 2011). The two major organizations with respect to Islamic financial processes are the Accounting and auditing Organization for the Islamic financial institutions and the Islamic Financial Services Board. The Accounting and Auditing Organization oversees and monitors the development and maintenance of Sharia compliant auditing and accounting practices and standards. The Islamic Financial Services Board is used to set the standards in the areas of Islamic banking supervision and regulation. According to a survey done on 118 Islamic banks with an asset valuation of USD 685 trillion in 2011, the deposits and short term funding’s account for the average of the liabilities in the Islamic financial institutions deposits and other short-term funding over three quarters. The current trend of development in the Islamic financial sector and the macroeconomic conditions prevailing in the predominant Muslim countries indicate that the Islamic financial institutions can maintain a surplus on deposit funding and also indicates a lack in the investment opportunities in these countries (Arjomand, 1999). The Islamic financial sector is a heterogeneous sector with many misbalances between the demand of financing for long term projects and the demand for short term project financing. Tunis, Turkey and Libya are considered to be major markets in which there are high opportunities for the Islamic financial system to thrive. Evaluation Islamic financial system is based on the pattern of the conventional banks with respect to the objectives, procedures, training, outlook and modus operandi. But along with these the Islamic financial institutions have to embed fairness, honesty and other principles relevant to the Islamic laws. The Islamic financial institutions are also expected to undertake long term ventures, risky business ventures, project financing and contribute to the social and economic development in specific countries. Though the Islamic financial systems and institutions have been steadily growing in terms of customer base and asset valuation, yet the macro environmental factors and the internal factors prevailing in the system can hardly be considered to be supportive for the Islamic financial systems to achieve their long term goals like improving the society and economy. The United Kingdom is presently a leading hub for Islamic financial services with 22 banks operating in the country. But out of these only 5 banks have become fully compliant with the principles of Sharia which include 1 retail bank and 4 wholesale banks. The Islamic financial institutions in practice are more focused on the short term or medium term project financing. The factors of late profit rates, deferred contracts, risk aversion and dividend policies are majorly used to evaluate the performance of the Islamic financial system. Islamic finance has evolved as a strongly established sector but it still remains far behind when a comparison is drawn to the conventional banking system. This can be indicated by the chart below. (Source: Jaffar and Manarvi, 2011). In practice, it is very difficult to comply with all the objectives of Sharia until and unless there is a complete change in the transaction systems, operations method, and use of funds and sources of funds as used in the traditional banking system. The establishment of strongly established guidelines including proper regulatory mechanisms by the central banks of different countries would create a positive development for the Islamic financing sector. This would help to align the deferred contracts and the profit and loss sharing schemes involved in Islamic finance so as to bring about efficiency in the performance and a balanced growth for the Islamic financial system (Hassan and Bashir, 2003). It is indicated that a sector of the world society would be ready to switch to the Islamic financing systems if the benefits and quality of products and services offered by the Islamic banks are equally good as compared to the traditional banking systems. Islamic financing and banking system has evolved as a mainstream business and is no more confined to the usage of conservative Muslims. Religious beliefs and reward in cash or kind are considered as the major motivational factors that have led to the widespread use of Islamic financial systems. Islamic Financial industry is characterized by restructuring of complex products and services and is indicated to have the potential for high growth in the coming few years with increased demand from Muslim as well as non-Muslim countries all over the world. The Islamic financial systems should compete effectively with the conventional banking system by implementing better liquidity management, increasing the range and depth of products, reducing asset concentration risks and by being flexible in adopting to the rapidly evolving global financial markets and standards. References Arjomand, S. A. (1999). Law, Agency, and Policy in Medieval Islamic Society: Development of the Institutions of Learning from the Tenth to the Fifteenth Century. Comparative Studies in Society and History. Vol. 41, pp. 263–93.  Hassan, M. K. & Bashir, A. H. M. (2003). Determinants of Islamic Banking Profitability. Stamford: University of Durham. Ignacio, T. (2011). Four lessons that Western banks can learn from Islamic Counterparts. Journal of Banking, Finance, Markets. Vol. 54(2), pp. 17–19. Jaffar, M. & Manarvi, I. (2011). Performance Comparison of Islamic and Conventional Banks. Global Journal of Management and Business Research. Vol. 11(1), pp.59-66. Jairus, B. (2007). Islam, the Mediterranean and the rise of capitalism. Historical Materialism. Vol. 15 (1), pp. 47–74. Rammal, H. G. & Zurbruegg, R. (2007). Awareness of Islamic Banking Products among Muslims. Journal of Financial Services Marketing. Vol.12 (1), pp.65–74. Saeed, A. (1996). Islamic Banking and Interest: A Study of the Prohibition of Riba and its Contemporary Interpretation. Leiden: E.J. Brill. Timur, K. (2005). The Absence of the Corporation in Islamic Law: Origins and Persistence. American Journal of Comparative Law. Vol. 53, pp. 785–834. Read More