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Islamic Banking and Finance - Essay Example

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The paper "Islamic Banking and Finance" discusses that the short-term targets for the development of PLS finance should be towards medium and large corporations with regular and steady dissemination of education among customers of micro and small enterprises…
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Islamic Banking and Finance
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Islamic Banking and finance Introduction Since 1960s, Islamic Banking has been a part of the financial world. Their structure was initially built up on unique profit and loss sharing system, instead of the general interest based financing. Over the years, financial forefront in Islamic banks has seen the challenge associated with their profit and loss sharing structure and altered present practices. A lot of arguments have cropped up in response to drawbacks associated with the profit and loss sharing (PLS) structure. These include issues like, risks associated with instruments of the PLS format, lack of technological support and sophistication for dealing with long drawn projects and existence of information asymmetry in relation to unique products offered by Islamic banks (Abduh and Omah, 2012). The paper is aimed at a detailed discussion of Islamic Banking development and foundations that lay the basis for their banking system. The paper attempts to understand critical aspects of the Islamic banking system and one of its critical schemes of profit and loss sharing mechanism within their lending process. Through an understanding of the PLS structure, the paper comprehends reasons for its unpopularity and reduced acceptance over other modes of finance, despite its evident advantages. The identification of problems also brings forth solution to problems associated with PLS finance. The paper makes recommendations to improve and revive the PLS finance based on such comprehensive analysis. Islamic Banking With independence of Muslim community, it has been increasingly felt that modern financial institutions need to come into the Islamic Banking system and run in compliance with the Islamic sensitivity. The first degree of concrete steps towards combining modern day finance with Islam was seen in Egypt through Mit Ghamur project of savings in 1963 (Al-Alwani and El-Ansary, 1998). This project refrained from calling themselves to be Islamic in nature, yet there was an inherent culture of providing financial intermediation, as per teachings of the Islamic community. Dubai Islamic Bank was the first of its kind in commercial modern Islamic Banking and was founded in 1975 (Thomas, 2006). Out of a total of 176 Islamic banks as of 2006 that have been registered with Bankscope, 70% have been reported to be concentrated in Middle East. The remaining is split between South East Asia with 17% and Sub-Saharan Africa with 15% (Al-Hejailan, 2000). The report by Alvi (2010) also states that development of organizational structures towards more sophisticated financial instruments like, takaful, sukuk has diminished popularity of musharakah and organizations like, Islamic Investment bank, Islamic Commercial Bank and Intergovernmental Development Bank (Al-Hejailan, 2000). The prime idea behind development of Islamic banking system was to have banking operations that run and function in conformity with Islamic viewpoint. This idea has come as an extension of the belief that God is the sole and primary owner of all things present on this earth (Mohammed, 2006). In order for human being to become an owner to anything, he shall be deemed as a temporary owner and has to be trusted in the eye of God. Following from this line of thought, it is believed that God has the right to determine the manner in which things should be used or otherwise. This right comes from the ownership and knowledge of all things. This is the reason why Islamic banking has all of its economic activities in line with the Islamic religion. The economic activities in the context of Islamic banking have been learnt and inferred from the primary source of religion. Such a collection of religion based rules and regulations have been known as shariah as per the Islamic law (Rayner, 1991). So, Islamic banking can be clearly described as a banking system, which is guided by shariah supervisory board and runs in compliance of shariah conditions. The shariah conditions set Islamic banking apart from the conventional and commercial banking system. The core difference between the Islamic Banking system and the Commercial Banking system can be presented as below. Criteria Islamic Banks Commercial Banks Compatibility Islamic Economy Capitalist and Liberal Economies Based on Shariah No religious basis for rules & regulations Interest and usury Absence of Interest and riba or usury Based on usury and interest Relationships Trust based Debtor – Creditor Risk Shared Debtors Excessive Risk taking Avoidance of excessive risk and gharar or uncertainty Free allowance for uncertainty and excessive risk Aim Social responsibility Profit maximisation (Source: Sadr, 1982; Saeed, 1995) Islamic banks put funds from non-interest based investment or sales on the assets side and present the profit and loss based sharing of investment accounts within the liabilities side as a source of finance. The distinctive financing method of Islamic Banking system also mentions that ijarah is a lease format, where the lessee is provided with the right to use the product, but the subject matter is not leased out; mubarah sale contracts are supported by mark up profit (Saeed, 1996). Istisna transacts a commodity even before it comes into any real existence, while salam refers to the advance payment done for any sale contract, when the product shall be delivered on a future date (Siddiqui, 1981). Profit Loss Sharing System The main two pillars of the Islamic banking structure have been profit-loss sharing method and remaining interest free. Being the pioneer in terms of PLS and no interest banking model, the Islamic banking system has formed the legal business in banking as a co-partnership of the capital providing partner as an owner to income entitlement of the bank, without any active part in the banking concern (El-Gamal, 2003). Commercial banking system, on the other hand, depends entirely on the interest provision and receipt mechanism. This reasoning raises the question on survival mode of Islamic banks in absence of any interest income or expenditure. The answer to this comes from the existence of Islamic banks as partners to trade, commerce and business, rather than becoming creditors to business. Sharing profit and loss on account of ownership can act as a mode of income for modern day Islamic banks (DeLorenzo, 2000). The PLS banking system cannot be called as a complete failure. Such has also been stated with proper evidence to support the argument. Researchers have proved that PLS financial can indeed be successful and more efficient than conventional financial methods of the western world. In his significant study, Al-Suwailem, (2000) had established that interest free lending had yielded better results on a simulation based study than the interests based system of banking and wealth distribution, leading to low collection of gross debt. Another work by El-Gamal (2001) presented a theoretical model for elaborating welfare improvement through PLS banking system. With a view to obtain a better understanding of Islamic banking finance, it is important to comprehend those operational aspects of Islamic banking principals in connection with the profit and loss sharing concept. Here, it becomes necessary to mention two most important concepts (Ireland, 1999). 1. Aqad underpinning or the contracts 2. Services issued or products Both of these principles are essentially interdependent, while their formulation has been based on disciplines of fiqh muamalah (Rahman, 1964). According to theorists, the two principals have been historically based on the similar concepts of Islamic financing which are; 1. Mudharabah or the profit sharing contract 2. Musyarakah or the profit and loss sharing contract Both of these contacts have been incorporated into equity financing, but have been neglected by the present Islamic financing world. Mudharabah is a passive partnership that is defined as a business contract between the owner of capital or rabb-al-mal and the working partner or mudharib. Here, profit is shared in accordance with the agreed ratio that was decided at the time of the contract. Any financial loss is borne by owner of the capital and the working partner bears the lost opportunity cost for his labour that had incurred losses (Nasr, 1991). Musyarakah or the active form of partnership is like, mudharabah, but with a slight difference in terms of participation of partners in business activity (Saleh, 1988). Here both partners entering into the agreement are involved with the business activity and bring in capital in their agreed ration. Losses are distributed in exact proportion of their capital ratio (Kuran, 2004). The underlying operational principal behind the Islamic banking regime is a free usurious technique that refuses any earnings that have been based on interest. It is based on maintaining a routine balance in profit and losses sharing; service contracts and trade contracts are the founding bases for linking investment holders to business entrepreneurs (Mallat, 1993). The profit and loss sharing mechanism is based on source of trade, productivity of investment and skill exchange in an economy that is responsible for generating profits. The involved sides are to benefit from the entire arrangement as per their contribution. It has been justified that profit and loss sharing mechanism should be formulated as a base for Islamic banking and finance because it is capable of transforming financial operations into an improved life through mutual exchanges of skill and encouragement. Neither of the involved parties is required to make unjust contributions of their wealth towards the system and profits are realised through mutual consent (Mallat, 1988). Despite all its benefits, modern day Islamic banking system is increasingly neglecting profit and loss sharing scheme because of its inherent limitations and weaknesses and are moving towards the murabahah principal or trade based system of finance (Kuran, 2005). Nature and scope of Islamic finance in relationship with conventional finance The very philosophy of partnership finance, be it modern day venture capitalism or traditional Islamic finance with PLS mechanism, is that both the borrower and lender should be responsible for sharing the rewards and risks (Arabi, 1998). Venture capitalism is nothing, but lending funds to a borrower after an assessment of his ability and of the risk associated with the proposed venture. The venture capitalists lend the money to the entrepreneur with managing and decision making rights. This section shall be dealing with the comparison and contrast of Islamic finance with the conventional financing system through profit and loss sharing and venture capital measures (Hallaq, 2009). Lending Profit and loss sharing mechanism is similar to the conventional banking system in lending in multiple ways. It turns savings into investments by providing money to businesses through collection of money from people who have excess savings and providing them as investments (Kuran, 1995). However, core difference between profit sharing technique and conventional technique rests in the fact that profit sharing involves lending of money in exchange of partnership and decision making rights in business; whereas, conventional lending mechanism is fixed and has a specified rate of return (Haque, 1985). Participants Partnership finance involve depositors or mudaraba, the professionals who judge upon the investment or mudarib, working partner and the second degree mudaraba or the entrepreneur to whom funds have been provided (Iqbal, 1999). Conventional finance venture capitalists involve own funds, apart from these three components (Azmi and Ali, 2007). Transaction Structure Venture capitalist has limited liabilities, while partnership finance provides active right and liability up to the capital sharing ratio for investors (Buang, 2000). Limitations of PLS Finance The limitations associated with profit and loss sharing finance can be classified on the basis of demand side considerations and supply side considerations (Hassan, 2002). On the demand side implications, profit and loss sharing mechanism requires that; 1. Detailed records for all kinds of transactions are maintained, which is not desirable for most businessmen (Chapra, 1992). 2. The mechanism allows for restricted opportunity for bringing in additional funds, thereby hampering scope of expansion (Dusuki, 2007). 3. Diminishing the musyarakah would be a long drawn process, which in turn can slow down the speed for becoming sole owner of the business (Hallaq, 1997). Additionally, on supply side of limitations, considerations for profit and loss sharing mechanism can be highlighted as; 1. Islamic banking requires higher controls and closer monitoring for tracking and checking for moral hazards and issue of adverse selection (Hamoudi, 2007). 2. The deposit structure for Islamic banking is not quite long-term for the liabilities side and hence, avoids long run projects. 3. Banks are unable to provide accurate and reliable information while undertaking the sharing contract. This is because profit and loss sharing mechanism requires one to have access to highly accurate information, which also invites additional costs. The reasons behind reluctance of Islamic banks in engaging in PLS financing are critical to this study. It has been argued that PLS financing is not among the most popular ways of financing in modern Islamic banking; primarily due to the amount of risk associated with PLS finance and its stark uniqueness (Warde, 2004). Such riskiness is associated with credit riskiness, operational risk, risk associated with rate of return, market risk and investment risk. In addition to this, banks had a very low appetite for risk bearing, while cost for monitoring these risks was also very high. There is a lack for transparency and high levels of information asymmetry in Islamic banking and this makes Islamic bank depositors reluctant to take risks associated with their deposits (Weiss, 2002). Such problems associated with Islamic banking can be safely segregated into two basic categories. 1. Internal problems The issues in internal management of banks are associated with human resources and technical aspects of banking. The upper management have a basic lack of understanding for the Islamic economy, community and the system. There was a general lack of understanding in banking and finance fundamentals for people who were at the top and were more philosophically oriented. Islamic banking was slowly getting inclined towards profit making objective rather than mutual social welfare. The general behaviour of higher officials was risk averse, which made it impossible to presume and accept riskiness in transactions and loss bearing ability. There is a general lack in any attempt for improvement in the area of PLS financing. 2. External problems The external problems were associated with society, customers and the authority. Problems with PLS financing Research has indicated eight major problems associated with Islamic banking and finance in relation to PLS financing. These can be enlisted as follows; 1. A general lack of understanding for PLS finance and a widespread lack of knowledge for the same (Hallaq, 2001). 2. Inability to construct financial report in most of the small and medium enterprises, which form the greater customer set for Islamic banks. 3. Lack of desire among clients to report for the financial transactions on a monthly basis (Rubin, 2009). 4. The customer mix for Islamic banks has a major set comprising of floating customers, who keep moving from one bank to another (Siddiqui, 1973). 5. A general lack of awareness and understanding among practitioners within Islamic banks for the economy, banking fundamentals and issues of finance (Furqani and Mulyany, 2009). As per academicians, three problems that are most critical with Islamic banks and PLS financing are: 1. Widespread and rampant issue with understanding related to PLS financing 2. Inability of customers in preparing financial reports for their business transactions. 3. Most of the Islamic banks do not have a complete understanding of the functioning of Islamic banking. This implies that there is a general lack of study in the Islamic banking process, which also fails to contribute towards a constructive literature for rules and regulations concerning the banking norms and standards (Tripp, 2006). The research indicates that the observations of both academicians and researchers have been similar on most grounds. The problems associated with PLS financing are largely arising from consumers’ end of such banking activities. The study indicates that customers have been functioning within PLS financing scheme for many decades now, yet fail to completely understand the fine details of PLS financing scheme; this makes them quite apprehensive in its adoption process (Weiss, 1998). There is a general assumption made by these consumers regarding the instalment system of financing and they assume that such instalments terms shall remain fixed for the entire period of PLS financing, quite like the murabaha or trading system. Additionally, it is of utmost importance that profit sharing or revenue sharing terms are fluctuating in order to make adjustments for income received by customers. Profit and loss sharing financing products is quite similar to conventional Islamic banking products, as that of the mudarabah and the musharakah. The practitioners of Islamic banking also tend to agree to the provided reasoning. As a result of such high levels of confusion and low degree of customer understanding, Islamic banks have started to resort to PLS financing that involves simpler calculation terms, which is quite similar to the murabahah; instead of real PLS financing. This decision by Islamic banks is also influenced from the fact that most of the clients of these banks are floating and not loyal to a particular one for long periods of time. Hence, customers tend to prefer any finance plan that is easy to understand and implement. The implementation of PLS mechanisms does not face any issues with information technology or standard operating procedural compliances. Even in the practical scenario, there are few systems that can incorporate the profit sharing mechanism in an automated manner. This scheme is still highly manual in nature. This manual calculation and application brings in further discouragement in relation to its implementation and maintenance. There is enough reasons for consumers to state that they find problems with account maintenance and reflection of monthly transactions in the PLS mechanism of financing. The marketing official is to negotiate terms of the PLS funding scheme with the potential customer and then after a conclusive negotiation, he has to submit the file to finance division of the Islamic bank. The approval of the finance division is communicated to the marketing official, who then redirects the file to bank office for framing and structuring the profit and loss sharing terms for the customer. This process is long drawn and more time consuming than conventional financing mechanism. This allows for an evaluation to be done once in a year or six months, instead of the traditional requirement of one month. On the practice of updating financial records by customers every month, the issue has been rampant and highly unacceptable by practitioners of Islamic banks. As discussed, customers find it difficult and are often unwilling to maintain monthly records of their financial transactions. They also do not want to report all transactions. In the PLS financing practice, it is ideally required for customer to report their financial transaction each month so that adjustments within the profit and loss sharing terms could be made at the month end. The non-compliance by customers comes largely from small companies and micro enterprises, where most records are manually maintained. Manual tracking requires a lot of labour and effort. In an attempt to resolve this issue, banks provide for their dedicated marketing officials who support these companies in maintenance of their monthly records by arranging records as per information and data provided by customers. This, however, demands a lot of time and effort of the marketing official as well as involves huge costs. Additionally, for medium enterprises and large companies, there is a widespread reluctance to provide such highly updated financial records each month, which becomes a problem for schedules that are to pay instalments in the beginning of each month. They have to provide their financial statements before releasing their instalments. Suggestions for Development of PLS Finance Based on observations of the studies, following recommendations can be made for the purpose of reviving the Islamic banking system and profit and loss sharing mechanism. 1. Educating consumers on the principles of working of Islamic banking in general and profit and loss sharing system in particular. This education should involve high focus on the mechanism for PLS financing and the mode of lending and charging within the system. Customers should also be made aware of need and benefits of monthly updating of trade balances in order to facilitate the process of making monthly revisions of profit and loss sharing terms (Hubbard, 2002). 2. Restructuring in the human resources skills and knowledge with reference to the Shariah law and Islamic banking. The human resources development is essential for improving understanding of the shariah laws pertaining to the banking system, thereby facilitating promotion and development of Islamic banking (Iqbal and Hiroshi, 2006). A well-trained staff shall be able to disseminate knowledge better among potential clients and thus, help in building a larger client base and an improved customer loyalty (Iqbal and Mirakhor, 2007). 3. Development of standard operating procedures and information technology that is commensurate by a well-trained technical staff in order to support such high mechanization of Islamic banking process. High mechanization of banking procedures shall induce faster transaction processing and ensure that delays in monthly recording and evaluation of PLS terms are brought under control. Also, introduction of information technology shall facilitate accounts maintenance for profit and loss sharing deals. This shall also enable small and micro enterprises (SMEs) to enjoy advantage of IT systems in PLS deals (Lewis and Algaoud, 2001). Introduction of standard operating procedures shall be helpful in laying down clear terms and conditions of the agreements. These documented procedures shall also bring in clarity in the dealing process for both marketing managers as well as customers. A structured attempt shall be made towards dealing with the PLS transactions and this shall allow for some degree of standardization in the process (Meera and Larbani, 2009). As per the practitioners’ viewpoint, most prominent solution that can help in revival and renewed acceptance of the PLS mechanism in Islamic banking is imparting education to customers on the PLS terms, benefits and norms. High efforts shall be needed in such education and promotion of PLS products because of the very nature of the target client set. This is because the general client set of Islamic banking is not very loyal. They are floating, which means that they make quick shifts from one bank to another. In order to induce client loyalty, programs and innovative deals have to be offered, such that clients find high benefits in long-term association with banks. In addition to this, implementation of PLS finance schemes was found to be highly beneficial, when it was implemented with medium and large companies. PLS financing is more suitable for large corporations because the finance rates are more flexible in relation to the conventional finance. This is because profit and loss sharing is dependent on monthly cash flow in the business and this does not bring in an additional burden on the customer. In addition to this, amount of liability borne by the customer is not the same for every month. It is largely dependent on income earned by the client. Secondly, PLS finance is a preferred measure in the context of short-term finance. This is because short-term finance shall invite fewer revisions in finance terms and reduce monitoring to a large extent. Additionally, short-term finance shall also ensure efficiency on part of the companies as well as the Islamic banks. Thirdly, in comparison to other financial products available in Islamic banks, PLS financing seems to have the lower rung pricing, when compared to the likes of sale contracts such as, the pricing of murabahah. This also comes from the short-term nature of PLS financing and more particularly in case of musharakah. In addition to this, risks are also reduced for both banks as well as customers (Rubin, 2010). Lastly, large and medium corporations have their financial statements that are listed and widely available. This also reduces compliance complexity associated with PLS financing for such companies. Conclusion The study has observed that problems associated with PLS acceptance and use of Islamic financing comes from the fact that there is a general lack of awareness in Islamic banking and finance. The customers lack a general understanding of the mechanism of PLS finance system. This, they assume is a mechanism in which the instalment shall bear fixed amount during the period for which such instalments run. Customers have confused the murabaha or the trading system with PLS financing schemes (Rubin, 2008). Additionally, when revenue or profit sharing instalment tends to be revised on a monthly basis, conventional products bear stark similarity with the new innovative financial products like, the musharakah and the mudarabh in the PLS finance system. In consequence, Islamic banking promotes PLS financing and customers tend to choose simpler methods of financing, which they easily understand; rather than complex ones that renders comprehension difficult. This is because people want to fully understand their financial issues. The study is directed towards making recommendation for improvement of the deteriorating condition of Islamic banking and PLS finances mechanism to seek more prominent solutions for the decline faced by Islamic banks and their products. Education shall contribute towards adding awareness regarding the PLS financing and this shall bring about loyalty among customers. Such a promotion shall require high degree of efforts. Until then, the only evident and prompt solution towards radical development of Islamic finance can come from efforts towards medium and large corporations. The focus on these areas can develop acceptance of PLS financing. Medium enterprises and large corporations do encounter the complexity associated with financial updates required on a monthly basis because they have a mechanism for such financial recording owing to their listing requirements. Furthermore, they are in great need of efficiency in management of short-term finance; and PLS financing offers them the scope to fulfil this need. Hence, it is viewed that short-term target for development of PLS finance should be towards medium and large corporations with regular and steady dissemination of education among customers of micro and small enterprises. The debate concerning the conventional banking and Islamic banking needs to come to a rest and more focus needs to be directed towards bringing justice and compassion among people through financing modes. This is an important function of Islamic banks and their survival and sustenance is important for the presence of Islamic religion in banking traditions. Reference list Abduh, M. and Omah, M. A. 2012. Islamic banking and economic growth: the Indonesian experience. International Journal of Islamic and Middle Eastern Finance and Management, 5(1), pp. 35 – 47. Al-Alwani, T. J. and El-Ansary, W., 1998. 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The Islamic Banking and Finance in Iran derives its guidance and inspiration from the Islam religious edicts and has to conduct its entire operations strictly in accordance with the Shariah laws directives.... The Islamic Banking and Finance in Iran derives its guidance and inspiration from the Islam religious edicts and has to conduct its entire operations strictly in accordance with the Shariah laws directives.... The Islamic Banking and Finance in Iran derives its guidance and inspiration from the Islam religious edicts and has to conduct its entire operations strictly in accordance with the Shariah laws directives....
9 Pages (2250 words) Research Proposal

The Islamic Banking and Finance

The paper "The Islamic Banking and Finance" is a decent example of a Finance & Accounting case study.... The paper "The Islamic Banking and Finance" is a decent example of a Finance & Accounting case study.... The paper "The Islamic Banking and Finance" is a decent example of a Finance & Accounting case study.... xchange-based contracts are in most cases used as a financial instrument in Islamic finance institutions when there is an exchange of currency with a particular country on a certain agreed date and at a given or an agreed date....
8 Pages (2000 words) Case Study
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