The Concept of Islamic Banking - Term Paper Example

Islamic Banking Table of Contents Islamic Banking 1 Table of Contents 1 Introduction 2 Banking sector in Bahrain 3 Islamic Banking in Bahrain 5 Islamic Banking: The way ahead 7 Conclusion 9 Reference 11 Bibliography: 13 Introduction At the end of 19th century, modern banking system had been introduced to the Muslim countries, which, that time, was economically as well as politically at its declining stage. At that time, the banks were mostly confined to few capital cities; as a result most of the population left untouched by the conventional banking system. The local population avoided these foreign banks, mostly because of religious reasons. The situation turned out really complicated to carry on the trade activities without the help of commercial banks. Even, being in this situation, a number of people detained their trading activities to transaction of current accounts and transfer of their money. Borrowing and depositing were firmly avoided to pass up dealing with interest which is forbidden by their religion (Gafoor, 1995). As time move on, at the echelon of more economic and financial activities, it got more and more difficult to keep a distance from the banking activities. Local banks were established to bring the banking system at the reach of the local people. The banking system became inescapable as the countries became independent. Government, individuals and businesses started doing transactions with banks, which raise the concern of Muslim scholars. This was the beginning of interest free or Islamic Banking (Gafoor, 1995). Prohibition of Riba has been the base of Islamic banking. The inspiration has derived its direction from religious proclamations of Islam and is bound to accomplish its operation in compliance with the edicts of Sharia. This Islamic financial system employed the conception of involvement in the enterprise, using the funds at a risk on the basis of profit and loss sharing (Memon, 2007). This report starts with an introduction to the concept of Islamic Banking and a brief discussion has been carried out to enlighten the facts encouraging the emergence. Bahrain has been known to host the largest concentration of Islamic financial institutions in the Middle East. This was the reason to choose Bahraini Islamic Banking system as the foal point of the discussion. Starting with the banking sector in Bahrain, the report goes in depth insight of the Islamic Financial Banking sector. At the later part the future challenges in this sector have opened the way to future developments of the same. The concluding part will discuss the effect of the recent financial crisis on Islamic Financial Banking. Banking sector in Bahrain Bahrain is the hub of Islamic Financial Institutions in the Middle East region. As of 2001, the country hosted a unique blend of varied financial institutions. The banking sector included 48 offshore banking units, 32 investment banks, 19 onshore commercial banks. Apart from that the country had 40 representative offices of International banks, six money brokers, 17 money chargers, nine investment advisory and several other financial services (TheFreeLibrary, 2001). The other financial services include insurance providers and two specialist banks. Out of the 32 investment banks 20 specialised in Islamic banking. Twelve banks of 19 onshore commercial banks are foreign owned. As in 2001, the total amount of assets in the banking sector amounted up to $106.4 billion (TheFreeLibrary, 2001). The banking sector of Bahrain is mostly focused on the services focused on the corporate market and the affluent private clients. The main operational areas include off shore syndications, structured finance, advisory services mostly related to cross border consolidation deals, corporate restructuring, privatisation and other portfolio services provided to the institutional clients and individuals with high net worth. Other financial services like cash management, international trade also are some of the significant services offered by the banks in Bahrain. The kingdom is globally known for its offshore banking. The offshore banking units are exempted from maintaining proper liquidity ratio and do not need to have apposite cash reserve with central bank of Bahrain. A problem which is very much prominent while banking with these banks is that Bahrain Monetary Agency does not provide guarantee for the deposits. As in 2001, 19 commercial banks were servicing a population of 676, 500, which made the onshore market quite overbanked. By end of the year 2000, the consolidated balance sheet of commercial banking sector reached at $10 billion. Major local banking players include Bank of Bahrain and Kuwait, NBB and Bahrain International Bank etc. The biggest foreign players include HSBC, Standard Chartered and Citibank. Excessive competition has been creating downward pressure upon the earnings of 19 banks; the consequence has been lower margins on the consumer business. This must be the reason that Bahrain Monetary Agency has been encouraging the mergers and acquisitions among the banks in Bahrain. Economic development in the gulf region has provided a number of opportunities for the banks to enter into business activities which would fetch them higher margins. Bahrain continued its Islamic banking by attracting local, regional and foreign institution in the year 2004. In the beginning of the same year BMA issued 30 new licences to the banks which raised the number of financial institutions, regulated by BMA, to a huge number of 362 (AME, 2004). Out of theses the banks counted to 186 while others were banking related institutions, insurance firms and capital market brokerage firms. As the banking activities started growing up, it encouraged the banks to mark a robust growth in the asset amount. At the end of September 2003, the asset sixe of Bahrain banking system amounted to US $ 73.9 billion with a jump of 28.1 % from the previous year’s figures (AME, 2004). BMA has been quite worried about the money laundering risk faced by the entire major off shore centres. As a consequence, it has enforced more stringent regulations to fight against the bank frauds. The law has extended apprehensive transaction reporting related to accountancy, investment, and insurance and real estate companies. BMA keeps up a close association with Bank of England and some other central banks. Although Bahrain is not named as the problem areas in global banking sector, still the regulators, here, keep arguing that the sustainable growth and reputation of the financial sector in Bahrain depends on transaction of legitimate deposits and honest bankers to carry on the banking activities. Islamic Banking in Bahrain In recent years Bahrain has emerged as a hub for the Islamic Banking system. The country has the largest concentration of the Islamic Financial Institution in the Middle East region. The financial system in that country deals with a number of diversified activities including investment banking, commercial banking, funds management and offshore banking. The banking system is based on dual banking structure, where the Bahrain Monetary Agency (BMA) provides equal opportunity and identical treatment for both the Islamic banks and the conventional banks. The country also hosts new Liquidity Management Centre (LMC) and International Islamic Financial Market (ITEM) to synchronise Islamic banking operations around the globe. BMA has introduced a comprehensive and apposite regulatory and reporting framework, specific to the Islamic Banking and finance Industry. Further on, BMA has introduced new range of innovations, intended to intensify the profundity of Islamic Finance market and enable the financial institutions to better manage their management of liquidity with extensive opportunities (Memon, 2007). As in 2001, the Gulf region has been the residence of 42 Islamic Financial institutions. Out of these 42 banks, Bahrain hosted 17 banks. To name a few major players: Al Baraka Banking Group, Shamil Bank of Bahrain, ABC Islamic Bank etc. In recent time, Bahrain has rapidly emerged as a global leader in Islamic finance, within Middle East, having the largest number of Islamic financial institutions. Presently Bahrain has been one of the leading countries facilitating Islamic finance with 26 Islamic banks and 19 Islamic insurance companies. Recently, Bahrain has been in the front in the global Islamic finance market for Islamic securities (sukuk). These Islamic securities include short term securities as well as the leasing securities. In these days Islamic finance has grown drastically despite of having recent financial crisis. A glance over the assets of the segment would be more explicable to support this fact. The amount of total assets in this segment for the year 2000 has been US $ 1.9 billion, while after 9 years, in the year 2009, the amount jumped to US $ 26.3 billion. This indicated a rise of about 12 times over the figures in 2000, which is surely an evidence of the steep growth of Bahraini Islamic finance market. As a consequence the market share of Islamic banking sector has shown almost a proportionate growth in the values. In 2000, the market share of the Islamic banking sector in Bahrain had been 1.8 % of the total banking sector share. However in the year 2009, that value rose up to 11.1 %. Islamic banks provide a wide range of products which are introduced and modified in accordance to the Shari’a principles. Various ranges of products include Murabaha, Mudaraba, Al Salam and Istitsna'a, Ijara. Apart from all these some conventional products and services like restricted and unrestricted investment accounts, syndications and several other structural finance products have been the part of services provided by Islamic banks, although these conventional products have been altered as per the Islamic principles. The Central Bank of Bahrain has altered the conventional regulatory and reporting framework as per the specific concepts of Islamic finance sector. The regulatory framework of Islamic finance include licensing agreements, risk management, capital adequacy, business conduct, disclosure or reporting requirements and financial fraudulent activities. Apart from many Islamic financial institutions, Bahrain has been the abode of a number of organisations to support the development of the development of Islamic finance. These institutions include Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market (IIFM), Liquidity Management Centre (LMC), and the Islamic International Rating Agency (IIRA) (Central Bank of Bahrain, n.d.). Islamic Banking: The way ahead Islamic financial system has been able to make its headway to several numbers of Western countries and the number is still growing. In this contemporary market, Islamic Banking has been facing a number of issues. As of now, the Islamic banking system has to be focused on few objectives to carry on. These include having a sustainable growth, fighting against financial uncertainties and competing with the conventional banking system. Hopefully Islamic banks would act as pure financial institution, filling up the financial gaps at the bottom echelon. Specialisation would be recognised as the base of efficiency and gains by the practitioners in the Islamic banking system. This can encourage specialised third party involvement in the banking system. The underlying fact has been that the third party specialised institutions reaps the benefit of economies of scale by reducing the operating expenses. The future expects Islamic Banking to be proper financial institutions and at the same time behave like economic agents. This would demand a lot of changes in the regulatory framework to support enhanced Islamic financial system. As the scope of trading would emerge, mega traders can show up at the cost of small traders as well as businesses. Islamic banking systems would be said to be a more ethical banking system as it would refrain from speculative activities as prescribed in Shari’a. There would be more transparency in the Islamic banking system with the depositors or the fund seekers in compliance with the Shari’a. Islamic banking would continue to contribute to the welfare of the economic growth of the society. However they are supposed to be economic institutions, established by their owners for profit earnings. Islam has allowed the banks to make profit in all ‘halal’ ways, subject to the concern of all the concerned bodies in a transaction. One fact must be taken care in the charity activities carried out by the Islamic financial institutions. The money held with the bank, as either a deposit or the capital, belongs to the customer of the banks. So consent must be taken into account from the depositors as well as the stock investors. As this is the time of globalisation, standardisation is bound to happen in Islamic financial sector. Competition among the Islamic banks worldwide and the rising consciousness would compel the products to be standardised across countries. However to have this standardisation to take place, it is very much needed to have consensus about the fundamental principles of Shari’a for the designing of financial products. Situations where a long term fund commitments or complex reengineering of the financial products is involved, it is very much probable that in absence of interest the price would rule in the Islamic banking sector. In future these Islamic financial activities can be divided into few main categories. Apart from the normal banking organisations, the financial domain can be extended to the horizon of development, microfinance, mutual fund and life insurance. Introducing instruments to yield stable income for the pensioners, orphans, widows and other people staying at the lower echelon could be added in this banking system. Innovation and development of the financial organisation is expected to meet the needs of governments, individual traders and business organisations in future (Tahir, 2003). Conclusion The operations of Islamic banks do not include interest rate in it; this characteristic may come as a limiting factor while competing with the conventional banking system. Despite of having a swift growth in the last few years, the regulators and the practitioners are not quite familiar with the process of Islamic financial banking introduced to the conventional system (Sole, n.d.). Having knowledge about the Islamic finance is quite necessary from the perspective of financial stability. The fact has been established by the recent economic downturn. While the conventional banking system was in a severe trembled situation, Islamic banking has left its mark with the stable operational activities. Many financial intellectuals have confirmed that the recent downturn could not affect Islamic banking. The nature of the banking system has enabled it to keep the crisis away. Islamic banking does not deal in debt trading and moreover it does not host speculative activities; this seems that these were the reasons that the Islamic banks were left untouched by the downturn. Debt trading is prohibited as per the law in Sharia. However, being the part of the global financial system, they are supposed to get affected in indirect way. Islamic banking has kept up its integrity high through the avoidance of the risky projects. They have been safe shelter with a secured liquidity (Hamzani, 2008). In future Islamic banking system can emerge as the alternative to the conventional economic system which is more risk prone at the time of crisis. 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