Islamic Financial System - Essay Example

Islamic Finance Based upon the analysis of the chapter, it has been revealed that the Islamic financial system has changed the entire operational procedures of banking practices in the Islam communities. Moreover, the system has made the financial institutions to avert banking crisis with the assistance of equity based banking practices, which is quite different from the traditional banking system. It has nurtured the banking system through the development of new financial instruments wherein the cash flow in banks is obtained from transaction and investment deposits along with the lending operations. In this regard, the Islamic financial system with the assistance of macroeconomic models is able to conduct their operations effective in the Islamic economy. Introduction Islamic financial system came into existence in the mid-1980s wherein this system was practiced mostly in the Muslim communities that eventually nurtured trade and commercial activities in numerous nations. Islamic merchants became the brokers of trade related activities in Spanish and Mediterranean regions, which helped in promoting Islamic finance amid European financiers and capitalists. In the modern day context, Islamic finance has made a huge impact in various parts of the world, as it has been promptly growing in the financial sector. Islamic finance is not just limited to Islamic nations, but it has spread to other nations wherein the Muslim community is quite large. It has been identified that there are over 100 financial institutions using Islamic finance and the system is presently practiced in more than 45 nations. Industries using Islamic finance have witnessed a growth rate of 15% in their annual turnover from the estimation of the last five years financial performances. Accordingly, it has been witnessed that the market’s annual turnover has grown to about 70 billion USD as compared to 5 billion USD in the year 1985. It has been further estimated that markets, which use Islamic finance will witness a growth of 100 billion USD by next century. In reality, Islamic finance commenced successfully from the time when the Islamic nations obtained surplus profit in their oil exporting businesses. It will be worth mentioning that anatomic and macroeconomic reforms in the financial system, privatisation of industries, assimilation of the financial markets and liberalisation of capital have cemented the growth of the Islamic financial system (Iqbal, 1997). The paper is primarily intended to summarise the chapter ‘The Financial System and Monetary Policy in an Islamic Economy’, which will help in understanding the Islamic financial system and its instruments. Summary of the Chapter Khan and Mirakhor (1987), in the chapter emphasised two different sections which includes the characteristics and the theoretical model of Islamic financial system. According to the chapter, the prime characteristic of the Islamic financial system is that it renounces the traditional sources of fund such as interest on deposits along with traditional banking operations. Banks operating under the Islamic financial system are unable to execute lending practices, which are based on pre-set return rates due to the guidelines laid down by the Islamic law. It has been further noted that the Islamic financial system has certain characteristics based on which the savings are mobilised and the investors are able to directly engage in commercial activities. In addition, the Islamic financial system has empowered the banks to serve as mediators amid the investors and the savers. The system also aids in maintaining consistency with the Islamic guiding principles. With reference to Khan and Mirakhor (1987), the theoretical model of the Islamic financial system, uses a simplistic form of macroeconomic model that integrates the fundamental characteristics of the banking system in Islam communities. This model focuses on evaluating the financial aspects wherein the function of monetary policy is analysed that directly influences the market participants along with numerous household and companies. The model mainly represents the financial system used under Islamic law, which has proven to be an appropriate device for analysing the monetary policies followed in the Islamic economy. According to Khan and Mirakhor (1987), Islamic financial system can be referred to as an equity-based system wherein the banks’ depositors are considered as the shareholders. In this case, the depositors are not assured of a pre-set return rate and nominal value in terms of deposits. The banks using Islamic financial system follow a different pattern based on which the depositors are eligible for receiving a certain portion of profit depending upon the profit obtained by the bankers. In order to provide a proper understanding of the Islamic financial system, key findings obtained by Khan and Mirakhor (1987) are elaborated in the discussion henceforth. Institutional Characteristics of the Islamic Banking System Sources of Funds Ahmad (n.d.) revealed that there are three sources of funds in the Islamic Banking System which include share capital, demand deposits and Mudarabah deposits of the bank. On the other hand, Khan and Mirakhor (1987) in the chapter identified that deposits are the major sources of funds available for the Islamic Banking System which includes the transactional deposits and investment deposits. Transactional deposits. Transactional deposits act as a source of funds for the Islamic Banking System, as the deposits are directly associated with payments and transactions undertaken by account holders in their respective banks. Under this system, banks provide variety of services to its account holders but are unable to use such deposits for profitable purposes. Instead in this system, banks are provided with the authority of levying certain service charges on the account holders in order to recover the costs incurred by the banks in maintaining their accounts. Khan and Mirakhor (1987) argued that banks must maintain a 100% reserve on the deposits made by the account holders and these deposits must be financed by foreign exchanges or currencies. This in turn will ensure that the account holders receive a certain amount of assured nominal value on their deposits within appropriate time. Consequently, the account holders are satisfied with the practice of transactional deposits in the Islamic banking system, as they are eligible for receiving nominal value on their deposits and financial assets. Moreover, it will also prevent the banks from facing a crisis situation, as they will be exposed to lesser market risk through the practice of maintaining 100% reserve of funds. Investment deposits. Investment deposits are a major source of fund for banks operating under Islamic financial system wherein the depositors or the investors are treated as the shareholders. In this case, the banks do not provide any assurance of returning a nominal value to the shareholders or paying back a fixed rate of return. However, the depositors are either eligible for receiving a share of profit obtained by the banks or they will have to share the loss incurred by the banks wherein the nominal value on their deposits are written down. Khan and Mirakhor (1987) stated that the investment deposits are intended to transform the conventional system of banking into equity based system based on which exterior shocks are absorbed by the deposits or shares held by the public. It will be worth mentioning that Islamic financial system reduces the possibility of banks witnessing instability or breakdown in their payment mechanism, as the value of deposits is associated with the overall profits and assets of the banks. Lending Operations There are certain methods formulated by the Islamic law in order to carry out lending operations in the Islamic Banking system which includes Mudarabah financing, Musharakah financing and other financing modes. According to Halabi & Mirza (2001) there are two methods in lending operation which includes ‘Murabaha or cost plus financing’ and ‘Mudaraba or profit sharing’ which is quite similar to the lending operations stated by Khan and Mirakhor in the chapter. Mudarabah financing. In the Mudarabah financing system loans are provided to business enterprises or entrepreneurs for carrying out an economic activity and the proportion of return is predetermined in accordance with the revenues earned by enterprises. The financing system is based upon the assumption that the lender of loan (banks) will be considered as the sole proprietor of a business enterprise until its lifetime and the borrower will be considered as a manager. Under the rules of Mudarabah financing, profits obtained by businesses are shared amid a lender and a borrower, while in case of financial loss, it should be incurred by businesses and the entire loss is borne by the lender i.e. the bankers. Banks providing loans to business enterprises receive Mudarabah certificates in which the face value of a company is mentioned and these certificates can be exchanged among banks. Musharakah financing. Musharakah financing is a system in which there is more than one contributor of loan funds that are borrowed by a business enterprise. In this case, all the contributors are identified to invest or lend in a different proportion and accordingly, profits or losses are distributed on the basis of the proportion of contributed capital. It is considered that Musharakah financing suffices the law framed by the Islamic financial system in all the banking operations. Business enterprises use this mechanism wherein the funds are raised from contributors or investors and correspondingly, Musharakah certificates are provided. These certificates are convertible corporate instruments, which are protected by the assets of a company. In addition, the price and the return rates of the Musharakah certificates highly depend on the market forces. Other Financing Modes Islamic financial system emphasises that both Mudarabah and Musharakah financing are appropriate for larger borrowers or business enterprises. However, it is quite problematic for small business enterprises or borrowers to avail Mudarabah and Musharakah financing, as their capability of sharing loss or profit is comparatively lesser than large business enterprises. Therefore, the banks under Islamic law can use alternative form of instruments for financing which are described hereunder. Deferred payment sale. Deferred payment sale is an alternative mode of financing in which a financial product is purchased by bankers and is sold to borrowers or buyers in terms of deferred payments. The payment is made by borrowers through instalments or in a lump sum manner wherein profit margin and instalment amount is determined by bankers through mutual negotiation with the consent of borrowers. Purchase with deferred delivery. In the case of purchase with deferred delivery, a buyer i.e. a banker makes full payment to a seller for delivering the agreed product in the future stipulated period. In this financing system, the price of the product is negotiated in advance and the loss incurred in this activity is wholly borne by the bankers. This mode of financing is usually applicable to farmers in which the quality and the quantity of the agricultural product are determined in the contract agreements. Leasing. Leasing is a method used by Islamic banks based on which a product is procured and then leased to borrowers for a specific amount and time period. Borrowers in this leasing method can negotiate the terms of payment with the bankers wherein they can apply for paying a portion of amount during ownership transfer of the agreed product. In addition, the risk of damage associated with the leased product is shared among both the parties. Service charges. Under the Islamic financial system bankers are allowed to regain certain cost of operation or commission on the loan lent by them. However, the banks are unable to frame service charges in proportionate to the size of the loan in order to ensure that the service charges do not turn out to be equal to loan’ interests. Theoretical Model of Islamic Financial System Astrom (2011) stated that the Islamic Financial System is based upon two theoretical models which include the elimination of interest and the usage of sharing mechanism for either profit or loss. However, Khan and Mirakhor (1987) noted that theoretical model is focussed on the accounting structure of the Islamic financial system and its fundamental behavioural relationships. In order to understand these particular aspects, an in-depth description of the model has been provided below. Structure of the Model In relation to the financial assets of Islamic financial system, it is recognised that the model comprises a single article of trade that is both manufactured and used up domestically. In order to simplify the model of Islamic financial system, it is presumed that the economy is closed wherein there are no movements of trade and capital. Additionally, commercial banks under Islamic law provide investment deposits facilities to the people in Islamic communities and there is no assurance that the fixed rate of return will be provided to the depositors within the desired time. The rate of return fluctuates in accordance with the variation of profits obtained by the banks and the overall stock of deposits. Commercial banks under the Islamic system cannot borrow funds from the central bank, but in some cases the commercial banks are allowed to borrow funds in terms of equity participation. In addition, it is mandatory for the commercial banks to maintain certain percentage of liabilities with central bank as reserves. Central bank on the other hand, maintains a streamlined system on the basis of which liabilities mostly comprising the reserves are provided by commercial banks. While the assets of central bank involve the commercial bank’s equity shares and the corresponding rate of return. Thus, the structural model of Islamic financial system is also represented by the public sectors, which contribute towards the investment deposits along with their financial wealth. The public can generally have two types of fund that is Mudarabah financing received by commercial banks and their own savings. Behavioural Relationships The model used for studying the monetary policies in the Islamic economy is recognised as IS-LM model. The model is developed on a simple structure based on certain assumptions. The first assumption is that no efforts are bestowed in understanding price-output breakdown for ascertaining the national income. The second assumption is that the anticipations of financial agents are completely realized under this model. Lastly, both the financial sector and the economy are presumed to be at continuous equilibrium wherein the analysis of these aspects is relative in nature. Thus, each economic variable in this model is considered to be deviated from its equilibrium value. According to Iqbal & Mirakhor (1987), the theoretical model of the Islamic financial system does not foresee the reduction in the efficiency of central bank regarding performing their roles and formulating monetary policy. Central bank has an exemption of discount rate but all the other conventional tools of monetary policy are available to the bank. Iqbal & Mirakhor (1987) further asserted that the theoretical model influences the ratios, which eventually results in determining the profit that has to be shared amid the bankers and the depositors. The theoretical models also foresee that the central bank in the Islamic economy can directly invest in a sector, unless the financial securities do not have the feature of par value or signify the real assets. It could be revealed that central bank under the system can either buy or sell financial securities, which actually means that central bank can get involved in open market operations for better management of capital market. It will be worth mentioning that the Islamic banking system is quite compatible with the allocation of financial resources and the financial rate of return. Moreover, it is quite important that the primary and the secondary market is organised in an effective nature so as to ensure that the financial system works effectively. Schaik (2001) stated that Islamic banking is a modernised form of banking, which highly depends upon the Islamic legal notions that uses risk sharing aspect and excludes the concept of pre-determined rate of return. Accordingly, it was identified that there are 7 principles in the Islamic economy which are completely normative and highly represent the value of Islamic communities. The first principle is justice and equality wherein it is believed that business should be undertaken honestly and each individual in the Muslim community must pay certain tax on their personal wealth which is called as zakat. The second principle is banned objects and creatures wherein the Islamic banking system considers that there are certain objects and creatures such as pigs, which cannot be traded or might be subjected under a legal transaction. The third principle is acquisition of property rights, which signifies that the interests of Islamic banks, which are not identified as property cannot be acquired or traded in a legal way. The fourth principle under Islamic bank is that wealth must be used in a rational and fair manner and it cannot be used unresponsively. The fifth principle states no profit without effort or liability by the Islamic banks signifies that monetary benefit cannot be received without providing a counter value. The sixth principle is common credit condition in which Islamic banks consider that debtors are required to be treated moderately in cases where a debtor cannot pay back a principle amount within a given time. The seventh principle is duality of risk in which most of the Islamic communities and banks consider that two parties in order obtain a share of profit must get indulged in certain extent of risk or liability. Conclusion It can be asserted from the above analysis and interpretation of the Islamic financial system that the overall operations of the financial institutions in various nations have witnessed a significant change from the past few decades. In addition, the Islamic law has adopted equity based system, which has contributed towards making the financial institutions such as banks to address the problem of banking crisis in a more responsive and suitable manner. In a broader context, equity based financial system have recognised depositors as the shareholders of banks, which has increased their involvement in banking activities along with spreading the banking system in numerous nations. However, certain issues have been raised in the implementation of this system as pre-set rate of return is not provided to the transactions or deposits made by the investors. In this context, the requirement for developing alternate financial instruments has increased in order to provide a fixed rate of return to the depositors. Additionally, issues relating to the operation of monetary policy in an interest free Islamic economy have been raised. Conversely, it can be mentioned that Islamic financial system has changed the conventional system of banking to a modernised form of banking, which has streamlined the entire banking activities and practices. The Islamic financial system has played a huge role in nurturing business and trade related activities because of which the Islamic banks have been focused towards developing financial instruments that are accepted by the Islamic law. Khan and Mirakhor (1987), in the chapter emphasised the characteristics of Islamic financial system wherein it has been stated that the system has denied the orthodox sources of funds wherein banks have to depend on transaction and investment deposits along with the lending operations such as Mudarabah financing and Musharakah financing so as to maintain the flow of cash and carry out banking activities sustainably. In relation to the theoretical model of the Islamic financial system, it has been proven that the macroeconomic model has been the most appropriate device in managing financial operations in the Islamic economy. References Astrom, Z. H. O. (2011). Enhancing the Structure of Islamic Banking by Lessening the Asymmetric Information Pertaining to Profit and Loss Sharing Instruments. 8th International Conference on Islamic Economics and Finance, 1-24. Ahmad, Z. (n.d.). Islamic Banking: State Of The Art. Islamic Development Bank, 1-36. Halabi, A. K., & Mirza, A. M. (2001). Islamic banking and the housing industry. Monash University, 1-5. Iqbal, Z. (1997). Islamic financial systems. Finance & Development,. 42-45. Iqbal, Z., & Mirakhor, A. (1987). Islamic banking. United States of America: International Monetary Fund. Khan, M. S., & Mirakhor, A. (1987). The financial system and monetary policy in an Islamic economy. Chapter 8, 163-183. Schaik, D. V. (2001). Islamic banking. The Arab Bank Review, 3(1) 45-52. Read More