Growth and Development of Islamic Banking in the UK - Dissertation Example

The Islamic financial model demonstrates the principle of fairness and promotes the rights of individuals to pursue personal well being. The sharia principles prohibit riba (interest) in any form. This is because riba is considered to be unfair and corrupts society apart from leading to negative growth as it demeans human personality (Iqbal & Molyneux, 2005). Islamic banking has been found to be not only feasible and viable but also an efficient way of financial intermediation. Modern Islamic financial system has developed a mechanism where the income does not arise from the income. Instead, wealth generating investments are made to enhance the cash flow. In this model, hence both parties share risk and profits and because of this the Islamic banks have been able to mobilize large amounts of funds. Growth and development of Islamic banking in the UK It is only in the last five years that the growth of Islamic finance and banking in the UK has taken place but according to Ainley et al (2007), the sharia-compliant transaction in the London financial markets existed even in the 1980s. The Middle Eastern institutions attained liquidity through murabaha type transactions. Retail Islamic products such as home finance had also started in 1990s. However, due to the absence of any regulatory framework, the consumers of Islamic banks did not have protection as consumers of traditional banking. The UK government has played a proactive role in developing Islamic finance in the country. The government pursued a policy of “financial inclusion” as it realized that a large section of the Muslim community was excluded from benefiting from the financial services (BTA, n.d.). They could not even avail of house mortgages. With the change in the policy and gradual growth of the Islamic banking sector in the UK, London is all set to be the hub for Islamic banking. The Islamic banking principles do not require the banks to offer an unconditional obligation to repay the amount received. They raise funds based on a profit and loss arrangement through Mudaraba accounts. As such, the Islamic banks act as the investment manager without bearing the risk of loss of the underlying accounts. While the loss has to be borne by the customer, the customer has to share the profits with the bank. This principle was not acceptable in the UK and hence certain changes had to be made. The Financial Services Authority (FSA) and the sharia law arrived at an agreement under which the risk to the customer would be very low. The banks would have to set aside certain reserved earned from the investment of the funds before sharing the profits with the customer and the bank. At the same time, the customer also had the option to exercise the sharia law in case of losses, the premise being that the customer would not want the losses to be made good by the bank. The FSA granted the license to Islamic Bank of Britain in late 2004 and thereafter there have been a series of development in the Islamic financial sector. Islamic banking principles The Islamic principles forbid all forms of interest and the Islamic financial model works on the basis of risk and profit sharing. In addition, the Islamic principles also do not permit investments in alcohol, betting and pornography (FSA, 2006). An Islamic banking institution is forbidden from lending to other banks for any form of gains like interest income. The Muslim population is expected to be about 1.8million in the UK which translates into 3 percent of the population. About half of them reside in the London area. In addition, the numb re of Muslim visitors to the UK is also phenomenal – about half a million - and another 12 million Muslims reside in the EU basically in France and Germany. It is expected that over 160,000 Muslims from the overall Muslim population are high net worth individuals that may be considered to be prospective banking and financial services clients (Martin, 2005). Three-fourths of the British Muslims prefer Islamic banking as it fits in with their religious faith and perhaps this is responsible for the rapid pace at which the Islamic banking sector in the UK has grown (Islamic Mortgages, 2010). Economic reasoning suggests that Islamic banking is superior to conventional banking because there is equity between the borrower and the lender (Iqbal & Molyneux, 2005). In this business model, even distribution of credit is more equitable. Islamic banking is preferred because it promotes innovation. Role of FSA The FSA, which is the regulatory authority in the UK does not offer any special favours and nor does it create any obstacles towards the Islamic banks. FSA is trying to bring about parity between the conventional banks and the Islamic banks. FSA is keen to promote Islamic banking because this gives diversity to the UK’s financial products while also strengthening the sector. The legal definition of a deposit in UK is “a sum of money paid on terms under which it will be repaid either on demand or in circumstances agreed by the parties” (FSA, 2006). The conflict arises because the UK law wanted that the customers’ capital be secure while the Sharia law maintains that the customer must be prepared to accept the risk of loss. Islamic banks have resolved the problem as they now offer full repayment of the investment but the customer is informed of how much should be repayable to comply with the risk-sharing strategy. Hence the Muslim customers have the choice of not accepting full repayment if their religious beliefs do not permit so. At the same time, it safeguards the other customers whose investment is safe. FSA has pledged to support the Islamic banking sector as London is becoming a global hub for Islamic finance (UKTI, 2010). Regulatory framework Anyone wanting to conduct a regulated activity in the UK has to seek permission under the Financial Services and markets Act 2000 (Ainley et al, 2007). The activities under the Act include accepting deposits, carrying out contracts of insurance and advising on investments. The Islamic applications received by FSA have all been able to establish Islamic banks and all financial institutions are bound by the same regulations irrespective of the home country. The FSA approach hence can be summed up as “no obstacles but no special favours”. All firms have to procure the legal status necessary for the activities that it wants to pursue. A firm incorporated in the UK must have its headquarters in the UK and its talent pool should also be in the UK. The firm must have adequate financial and non-financial resources to carry out the activities its aims to. The FSA also give importance to the role of sharia scholars on the board of a firm because they have to approve of any new transaction or for m of instrument. Any firm operating in the UK must have the competence and capability, which is ascertained by the FSA. The FSA also insists that advertising should not be misleading and it should reflect the statutory objectives to protect the consumers. This is important in the case of Islamic banking products that are still new and their structure differs from the conventional banking products. Besides, those who use these products may be relatively inexperienced in financial products, which further emphasize the need to have transparency in advertisements. Islamic Banking products Currently several High Street banks offer current accounts and mortgages that have been customized for the Muslims in the UK (FSA, 2006). The Islamic banking products include Murabaha and Ijara. Murabaha is an extension of credit without interest and is not called a loan. The system works differently. In this model, the bank first buys the goods itself. It is then re-sold to the customer at a price that has been agree upon in advance after adding some profit margin. The customers make good the payments through the deferred payment system. The customer thus gets to pay in instalments. This is just another method of the traditional EMI which may or may not bear interest. Ijara is the same principle applicable to the purchase of assets. The bank leases the asset to the customer at a fixed rental for a specified period of time. This is another form of home mortgages and in this the customer has to make payments of the principal amount in addition to the rentals. The ownership is passed on to the customer once the payments have been cleared. Because of the resilient nature of the Islamic financial products, during the economic downturn and the turbulent market conditions, there has been growth in Islamic banking in the UK (UKTI, 2010). The Islamic finance sector is currently worth £250 billion worldwide and an annual growth of 15% has been predicted. This is because the investors want their investments to be sharia compliant. To facilitate murabaha and Ijara mortgages, changes were made in the UK Tax law through the Finance Act of 2003, 2005 and 2006. Islamic finance are cheaper than conventional finance and has positioned itself as an alternative to traditional banking products. Some consumers have the wrong perception that Islamic finance is costly. This is because the products have to be well structured with due care, diligence and detail (AMEInfo, 2009). Size of the Islamic banking sector in UK The FSA first granted the license to the Islamic Bank of Britain (IBB) and soon thereafter authorized the European Islamic Investment Bank (FSA, 2006). In February 2005, Lloyds TSB became the third British bank which offered the services for a current account which was sharia compliant. They soon added home finance to their services and this was done with the aim of enabling the British Muslims to buy their own homes (Islamic Mortgages, 2010). HSBC has played a significant role in the growth and development of the Islamic banking sector. It aims to provide Islamic financial services through out the world where the Muslim community lives. They also plan to enter into sharia insurance, pensions and savings (Ahmad, 2008). They already provide mortgages and current accounts while also offering Murabaha and Ijara mortgages. HSBC also offers HSBC Amanah cards against which they charge a fixed fee for the services offered. In addition, they offer personal loan based on the theory of Tawrraq. Islamic Bank of Britain offers savings accounts, term deposit accounts and treasury deposit accounts. They then invest this money in sharia-complinat investments. They have eight branches with over 50,000 accounts and some 42,000 consumers (Ainley et al). The FSA has also authorized one Islamic fund manager. FSA is also in the process of finalizing the application from the first wholly Islamic Takaful provider. London is all set to become the global financial hub because many major international firms have their presence here. While in the Middle-East, Islamic banks have emerged as the mainstream bank, their potential is yet to be discovered in the West (Martin, 2005). This is because the Islamic banks have been able to blend the religious faith with financial innovation. The Middle-Eastern Islamic banks want to take advantage of the large Muslim population residing in the UK and hence want to use London as the centre for offering Islamic financial products. This Islamic Bank of Britain and European Islamic Investment Bank specialize in Islamic finance. They offer products such as Islamic securities, treasury and capital markets, asset management, trade finance and capital-protected structured products (Khan & Bhatti, 2008). Besides, Middle East’s biggest traditional banks offer Islamic products here. UK’s fifth Islamic bank – Gatehouse Bank – started operations in the first half of 2008. At the same time, Principle Insurance, a sharia-compliant insurance company also started trading during this period (UKTI, 2010). Several foreign banks having presence in the UK have started offering Islamic banking services. These include the Citibank, HSBC, UBS, The Royal Bank of Scotland, Bank of Ireland, and Lloyds TSB (Martin, 2005). The Islamic banks in the UK compete with the mainstream banks that have now opened Islamic windows. International financial institutions such as Friends Provident International, HSBC Amanah, Lloyds, Lloyds TSB, Mortgage Insurance UK, United National Bank have set up Islamic windows or through their subsidiaries they offer a wide range of Islamic financial products (Khan & Bhatti, 2008). These include fund management, retail and commercial property investment, consumer finance, saving products, credit cards and Takaful to Muslims in the UK. Other competitors include companies such as Blue Ocean that are trying to promote Islamic banking into the mainstream by attracting the non-Muslims. Even during the global financial crisis, the Persian Gulf oil producers had dollar surpluses. The Bank of London and the Middle East, or BLME drew on these petrodollar surpluses (Grose, 2008). London has some 25 companies offering some form of Islamic financing. Kuwait-owned, Bank of London and the Middle East, or BLME is the largest of the five wholly sharia-compliant banks operating in Britain. It started operations in the UK just before the financial crisis and has offered finance to a big transportation company. However, the Islamic banks in London also have to meet the level of transparency as the traditional banks. Since they did not face liquidity crisis and because of their conservative business model, they have been able to attract the non-Muslims in the UK. The Islamic banks are thriving in London because of the strong financial talent pool. Islamic banking has experienced a growth rate of 10-15% annually at the global level but its popularity and the way it operates is not known to many. Islamic banks are benefiting from the financial knowledge and skills available in London because of their expertise in conventional banking. The Islamic banks are hiring these staff from the traditional banks into Islamic banks. As far as the product life cycle is concerned, Islamic banks in the UK have crossed the development phase and have now entered the growth stage. Islamic banking sector faces challenges in UK However, the UK Islamic banking sector faces certain challenges. The staff at these Islamic banks is not well trained in the Islamic banking and financial products and services. Islamic banking in the UK faces regulation problems as it does not have network of branches as the traditional banks that have been in existence for decades (Ahmad, 2005). IBB had only eight branches in 2005 and this was insufficient to compete with the mainstream banks. The other challenge is that conventional banks have been allowed to open Islamic windows and offer their services while still continuing their regular business. Islamic banking also faces challenge because they do not have Accounting Standards and contravention policies in the financial markets. Just being sharia compliant is not enough. The customers want that there should be a regulatory framework to which the banks adhere. They also lack a supervisory framework. The staff being insufficiently trained, the sector also needs to educate and train the personnel in the range of products and services. As the potential of Islamic banking in the UK is high, staff training has a vital role to play. As far as the consumers are concerned, there is lack of awareness as well as lack of sufficient information on Islamic banking that would help them make an informed choice about their investments. This implies that marketing efforts by the Islamic banks is poor. Perhaps they rely on the assumption that the Muslim population being high in the UK, they would get business anyway. However, they need to attract the non-Muslims as well. They also need to take note that other banks have started offering different products and services in the sector. The Islamic banking sector also faces the challenge of liquidity management because they lack sharia-compliant instruments (Ainley et al). The conventional banks use inter-bank deposits and the government and corporate bonds but these are not sharia-compliant and hence the Murabaha transactions are being structured in order to offer the same effect in terms of liquidity as the conventional banks. However, the UK has a highly developed advisory services sector. London with its expertise would be able to help the global Islamic banking and finance centres to face the challenges and make a strong position for themselves in the future (AMEInfo, 2009). The UK organizations have the capability and strength to deal with the challenges that Islamic banking sector faces. Thus, the Islamic banking sector in the UK is fairly new but has a promising future growth potential. This is because of the large Muslim population in the UK and it is expected that sector would see phenomenal growth. Islamic banks want to reach the Muslims in every country – be it a Muslim country or in non-Muslim countries. While the FSA – the regulatory authority has been playing a vital role in the support and growth of the Islamic banks in the UK, the firms have to abide by certain regulations and stipulations. There are several private banks – both domestic and foreign banks that you providing Islamic banking facility. Even banks that do not have full Islamic banking operations have opened Islamic window within the bank to offer these products. Moreover, the HSBC too has been trying to reach the Muslims everywhere. The sector is fairly new – having started operations only in 2004 but considering the short span of time, the growth has been at a fast pace. The global financial crisis gave the sector a boost as people wanted to rely on conservative investments and banking. Today the Islamic banks are able to offer all products and services as the conventional banks with reduced risks. All the products on offer are sharia-compliant which enables the Muslims anywhere in the world to abide by the dictates of the religion while having security of their money. References Ahmad, W. (2008). “Islamic Banking in the United Kingdom: Opportunities and Challenges”. Retrieved online April 10, 2009 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1349170 Ainley, M. et al. (2007). Islamic Finance in the UK: Regulation and Challenges. Financial Services Authority. Retrieved online April 10, 2009 from http://www.fsa.gov.uk/pubs/other/islamic_finance.pdf AMEInfo. (2009). UK Islamic finance leaders talk up growth beyond challenging times. Retrieved online April 10, 2009 from http://www.ameinfo.com/218113.html BTA. (n.d.). Evolution of Islamic Banking Outside Middle East. Retrieved online April 10, 2009 from http://bta.kz/files/about_fin_iconf_Session_9-evolution_of_Islamic_banking_2.pdf FSA. (2006). Islamic Banking in the UK. Retrieved online April 10, 2009 from http://www.fsa.gov.uk/pages/About/Media/notes/bn016.shtml Grose, T.K. (2008). The Rise of Islamic Banking. U.S. News & World Report. 145 (13). Iqbal, M., & Molyneux, P. (2005). Thirty Years of Islamic Banking: History, Performance and Prospects. Islamic Mortgages. (2010). Islamic Banking & Finance. Retrieved online April 10, 2009 from http://www.islamicmortgages.co.uk/index.php?id=263 Khan, M.M., & Bhatti, M.I. (2008). Islamic banking and finance: on its way to globalization. Managerial Finance. 34 (10), 708-725 Martin, J. (2005). Islamic Banking Goes Global. The Middle East. June 2005 UKTI. (2010). UK committed to Islamic banking’. Retrieved online April 10, 2009 from http://www.ukinvest.gov.uk/Financial-Services/100087/en-JP.html Read More