Working Principles of Islamic Banking - Research Paper Example

The difference between Islamic and Convectional Banking This paper presents an overview of the banking systems and the values driving the operations and organizational objectives. Further, the paper articulates characteristics and working principles of in Islamic banking and the religious interventions in development of systems. The paragraph follows an outline of the convectional banking systems and contemporary goal in the banking sector. Further, the paper presents detailed comparisons of the Islamic and convectional banking systems as practiced across the world. The concept of application of each banking approach is detailed in subsequent contexts. The paper uses real world examples to conclude and affirm the differences between Islamic and convectional banking systems. Table of content: Contents The difference between Islamic and Convectional Banking 0 Contents 1 Introduction 2 Financing and Investments 2 Overdrafts/Credit Cards 3 Customers Availing Opportunities 4 Mortgage 5 Methodology 6 Results 7 Islamic Banks and Their Operations 7 Deposits 7 Markets Borrowing 8 Effectiveness, Success and Efficiency of Islamic Banks 11 Medium and long term loans 11 Efficient Concepts 11 Conclusion 13 References 15 Introduction Islamic Financial Institutions abbreviated as IFIs operates within similar societies as the conventional banks. The banks perform each function that is expected from financial institutions. The IFIs assists business processes through provision of the services necessary in smoothly running the economy. However, the operations and philosophy differ in many aspects. This paper analyzes the products and operations of IFIs as it compares them with the traditional conventional banks. All financial systems are expected to offer assistance in running economic activities through provision of services of different kinds. The financial institutions have the role of encouraging savings and mobilizing goodwill among savers and entrepreneurs. The financial institutions also provide general utility services such as transfer of funds, consultancy services, international trade facilitation, and safekeeping of valuables for a fee. The industry does not have restrictions on the scope of the provision of IFI services for services that are not against Sharia laws. On the other hand, there are mechanism differences in funds mobilization across savers and entrepreneurs in describing the development and economic growth. Savings mobilization includes phases such as extending investments and financing and accepting deposits. Financing and Investments The other phase within the process of mobilizing savings includes the extension of more credit facilities to businesses and the industry to have desirable returns. The Islamic and Conventional forms of institutions provide financing towards productive channels to gain a reward. The major difference exists in the financing agreements. Most conventional banks offer loans at fixed rewards while the IFIs take alternative approaches because they do not charge any form of interest. IFIs can charge more profits on the investments and not interest on extension loans (Greuning & Iqbal, 2008, p 75). Conventional banking offers three forms of loans issued to clients. The forms include overdrafts, long-term loans, and short-term loans. Islamic banking does not extend loans other than interest-free loans for all requirements. However, they are not in a position of doing business through the provision of required assets to different clients. The management provides comparative working for different products through ascertained financing schemes for each system (Iqbal & Mirakhor, 2011, p 23). Overdrafts/Credit Cards Conventional banks have the overdrawing facility from customers’ accounts at an interest. A critical form includes the credit card use in which there are limits to overdrawing for customers as required by set by the bank. Credit cards provide dual facilities for customers such as financing and plastic money facilities where customers meet their requirements without using cash. The facility involved in financing and concerns that offering Islamic banks with the exception of the Murabaha form, IFI deliver desired commodities without involving cash transactions and not the cash (Schoon, 2010, p 128). However, the facility of shopping and meeting requirement allows for the provision of debit cards where customers use their cards in case their accounts carry a credit balance. Conventional banking requires that customers are charged interests once the facility availed (Weber & Sven, 2011, p 32). Banks continually improve financial services among their customers through consecutive systems for purposes of increasing customer loyalty and abiding by the banks. The concept contributes to the reduction of phenomena for the sudden drop in depositors’ withdrawals (Ariff & Iqbal, 2011, p 45). It is important to improve the financial investments’ quality for the systems where there is particular concern for commercial banks. For instance, investments from financial derivatives, like the credit default swap, are an important reason for current financial crisis. Islamic banking applies financial concepts in developing mergers and acquisitions policies between banks for purposes of increasing strengths of banks in times of potential risks and hardships (Kettell, 2011, p 56). Commercial banks are required to have a careful consideration of Islamic banking systems for purposes of deriving positive points from Islamic banks. The initiative has careful study of commercial banking system for taking positive points. The banks establish international Islamic banking systems within international financial markets to support the established regional Islamic markets (Krasicka & Nowak, 2012, p 43). The Islamic financing model is easily computed through Islamic Banking Systems from scattered and elevated speeds as compared contrast to the conventional Banking. The financial declarations within different researchers illustrate that Islamic Banking systems grow in most Islamic regions. Strategy makers should avail essential significance towards awareness. This is because most people are not fully familiar with the different Islamic beliefs and principles around the globe. Islamic Banking allows for similar and conventional dissimilarities in the nature of operations (Schoon, 2010, p 98). Customers Availing Opportunities Further, conventional systems have customers availing opportunities of rescheduling through entering in new agreements of paying interest to extended periods that are not similar to the case of Murabaha. IFIs claim the initial receivable amounts that are agreeable to initial contracts. The other practical issues from Murabaha include the way of dealing with intentional defaulters. There are various options that IFIs use including blacklisting defaulters from further financing facilities. Stipulating the consequences in contract terms in case of fraud and default of the installments allows for clarity in defining the contract penalties to be imposed. However, the penalties are not income forms for IFIs but proceeds for charity (Greuning & Iqbal, 2008, p 68). Islamic financing operations work under the framework of Shariah law. The financial activities and services follow certain religious restrictions. First, all IFIs are not capacities to provide finance towards activities that Islamic law prohibits irrespective of the level of economic viability and profitability. This includes business of pork, pornography, and liquor. Further, IFIs do not lend an amount on interest basis. However, need is ascertained through required asset supplies and loss and profit sharing. Certain financial requirements of different sections in the society can be ignored through financing options such as personal loans as well as working capital requirements among the not-for-profit firms (Schoon, 2010, p 64). Under the teachings of Islamic financial systems, immediately financing is availed through profit and loss sharing basis, the profit is shared based on the agreement between parties involved. However, loss is shared based on capital contribution and ownership. Mortgage Conventional mortgage provides conditionality for purchasing properties where customers are required to borrow money and repay with additional amounts in the agreed period. Additional amounts are levels of interest that are against Shariah rulings in Islam. Islamic mortgage finance facilities allow for the Islamic bank sharing with customers in developing a purchasing desire for the property. The customers and bank are joint property owners based on proportions of their share contributions in purchasing a property. For purposes of owning and using the property, customers purchase a share of bank’s property during the period and pays rent while using bank’s property share (Kettell, 2011, p 43). Over time, customers manage to purchase the whole share owned by the bank for the property. The customers become sole owners of Islamic mortgage finance where the rent is charged on the lessee while taking delivery reports to the property. The focus also involves workable and usable conditions. Rent is not charged between the days of pricing and payment to acquire property of the asset. Where suppliers delay delivery after receipt of full price, lessee is not liable for rent during such periods. For conventional mortgage financiers, the lease rentals begin from the day that the bank makes front payment to purchase property or assets. Methodology The research team collected data from secondary sources of data. The data focused on various newspaper articles coupled with journal articles from financial magazines. The recent recent financial critisis made the sources prove rather reliable in offering plenty of opinions regarding the subject. Newspapers, articles, magazines coupled with journals were reviewed based on the determination of credibility of authors and other contributors writing the piece to be analysed. Further, the research team uses internet sources in many sections of the study. Results Islamic Banks and Their Operations Deposits Both types of institutions collect deposits savers for reward despite banks operating under Islamic system or conventional system. The variation is observed in making agreements of the rewards. In conventional systems, rewards are predetermined and fixed while, in Islamic, deposits can be accepted based on Mudaraba and Musharaka where rewards are variable. Conventional banking returns are high on deposits held on the long-term and significantly lower for those in the short-term. Similar practice within Islamic banking allows for the sharing of profits with the depositors. Higher profit sharing weights are assigned to the long-term deposits made available to the bank for purposes of investing on longer term projects (Greuning & Iqbal, 2008, p 94). The investments yield superior returns. Further, lower weights are allocated to short-term deposits that are not invested within long term projects. The major difference between Islamic and conventional systems is based on risk and reward sharing. Conventional systems allow for total risks to be borne by banks while total rewards belong to it through servicing of depositors through fixed rates. Under Islamic systems, reward and risk are shared across depositors. Depositors’ rewards are linked to outcomes and investments derived from IFIs. Islamic financial systems only allow IFIs that are in a position of collecting deposits to establish trust upon masses and lead into situations of optimal performance across the financial industry. IFIs have succeeded in the establishment of credibility among savers through gradually increasing the deposits collection trend (Cevik & Charap, 2011, p 8). Conventional Banking is based on contribution Interest while Islamic Bank allows for profit and loss sharing among the customers. Focal points should be established within the subject who engages consciousness for the enormous disparities between Islamic and Conventional Banking. The extensive awareness offers an essential consideration in making clear differences between Conventional and Islamic Banking. Special regard is addressed on sure the training programs that work within Islamic Banking Institutions. All Islamic Banks are required to provide proper training seminars among team members for purposes of allowing them work in better ways. Banking networks from Islamic Banks are the poor and rear composites of Conventional Banks network. The considerable grounds include valuations of Conventional Banks that are based on the introduction of Islamic Banks. Islamic Banks develop good growing rates of Branch networks even as they require more investment in fulfilling the essence of markets. Islamic Banks are required to introduce modern Islamic financial products. Such customer service is easily competed and compared with the conventional banking products for purposes of attracting more clients. Markets Borrowing Banks create markets for dealing with short-term borrowing for Islamic banks that offer assistance in the management of liquidity. Further, the market involves commercial banks that borrow among one another. For example, the London Interbank market that deals in LIBOR interest of between a day and five years (Krasicka & Nowak, 2012, p 76). Islamic banks apply hedging policies in their investment portfolios based on respective geographical distributions for financial risk and overall interventions for distributive risks and apparent financial markets collapse. The concept remains unaffected by subsequent financial markets from different countries (Weber & Sven, 2011, p 34). Both commercial and Islamic banks develop liability, liquidity and asset management policies that contribute towards the reduction of impacts from the financial crisis within the both systems. Islamic bank branches are gradually increasing within non-Muslim countries including European countries and America. The concept of their existence within large Muslim communities adds to interests appearing from hedged risks and fluctuations of revenues within foreign currency deposits (Greuning & Iqbal, 2008, p 73). Medium term and short term loans are products availed to customers with the aim of meet the working capital requirements within firms from conventional banks. The working capital is necessary for operations of the firm while investing in accounts receivables and inventories to meet the daily expenses. Inventory investment is addressed through provisions of the Islamic banks based on Murabaha. To meet the daily expenses in business, it is important to consider the financing concept of participation through certification of profits within certain periods such as quarter, one year and six month. IFIs share the proceeds through prorate categorization (Greuning & Iqbal, 2008, p 64). However, the scope of financing based on participation allows for certification of lease in short term loans for conventional bank and relevance of risks involved in transacting for the IFIs. Firms seek short-term facility within IFIs and are required to prove their viability and validity of their projects and businesses in satisfying the investor. To meet the requirements working capital for nonprofit organizations, IFIs do not have a specific arrangement within Islamic financial system. All forms of personal consumption loans cannot issue through IFIs. On the other hand, individuals and firms with a sound financial standing can acquire various elements for personal use through Murabaha financing and certain profit percentages are added to IFIs’ costs (Krasicka & Nowak, 2012, p 32). Various approaches are used with business transactions for Islamic banks lending money to firms through issuing interest loans based on floating rate. Floating rates of loan interests pegged to rate of return for companies and individuals. The profits of the bank on loans are equal to various percentages of company profits. The approach has its independent way of pursuing business while operations are substantially certified through Sharia experts who range between Sharia boards to Sharia advisors and Islamic Fiqh Academy. IFIs’ portfolios are dominated on Sharia-compliant financing modes where negligible investments become reputable elements in Mudaraba and Musharaka. Sharia financing modes based create real differences within a society without getting any momentum from the IFIs operations. The financing elements identify different hindrances such as profit manipulation, lack of awareness, riskiness of sharing-financing, unskilled human resources, and widespread conventional banking. The implications affect the ways in which Sharia gains popularity based on financing and conclusion of existing business and accounting frameworks (Sole, 2007, p 34). The global environment does not provide a favorable platform to apply Mudaraba and Musharaka. Islamic banks do business within nonconductive environments that make operational aspects more challenging. IFIs are not in a position of claiming interest through balances from subsequent banks. Mandatory cash reserves are maintained across central bank while investments within interest-based bonds and government securities do not achieve value of money among defaulters. The scope also bears more risks in the sale and leasing transactions. The banks can only invest within Sharia compliant securities which are not always available equities. The investment schemes should compete with the conventional banks for deposit servicing and in financing (Kettell, 2011, p 34). Effectiveness, Success and Efficiency of Islamic Banks Medium and long term loans Loans on a medium to long-term basis are availed for purposes of purchasing and building fixed assets through firms and expanding or replacing the existing financial assets. The Islamic financial system requires that firms and individuals fulfill the laws of Bai Muajjal, Istasna, and Murabaha. The other financing option involved in long-term financing includes profit sharing through the principles of Musharaka and Mudaraba (Iqbal & Mirakhor, 2011, p 65). Even though financing through Bai Muajjal, Istana and Murabaha is similar to conventional loans, the major difference is the provision of assets without cash to clients. However, more differences exist through contract agreements that alter the scope of returns and risks. Financing through Musharaka and Mudaraba become a challenging concept for IFIs and other firms. Financing schemes based on Sharia allow firms to have the viability and profitability of projects and businesses while majoring on the IFIs satisfaction in getting financing due to higher risks of losing amounts involved. Leasing becomes a relative source for financing. Usufruct of financial assets is transferred to lessees through agreed rental amounts. The leasing concept permits transfer of ownership on the agreed basis (Kettell, 2011, p 76). Efficient Concepts Islamic banking does not have foreign contexts to the modern business world in certain quarters. The IFIs have business frameworks that compare to conventional banking in certain restrictions that the Islamic law imposes. Business needs are addressed through IFIs for more efficient concepts based on Ijara, Murabaha, Bai Muajjal, Istasna, Bai Salam, Mudaraba, and Musharaka. Characteristics of Islamic financial systems include linkage between real sector and financial. IFIs do not extend their credit facilities without support solicited from real sectors. Financing can either be through risk or reward sharing as well as asset backing. Further, there are unique Islamic financial system features that take the form of Mudaraba in playing the catalyst role for the transformation of the society and prosperity of extending capital facilities to skillful persons without capital. The Mudaraba financing mode allows for partnership between skill and capital formed providing self-employment among jobless skillful citizens. All forms of Islamic banking are not mere copies of conventional banks perceived from certain Muslims. The logic on banning interest and the Islamic financial system significance is discussed in different Islamic economic systems. Islamic financial system principles include the creation of financial atmosphere across intermediaries, partners, borrowers and lenders. Islamic system in financial systems is based on the goals of accomplishing the Holy Qur’an education in contrast to collecting income from financial assets. Further, Islamic financial systems have exclusive Islamic principles that are based on ethical practices where major Islamic finance system concerns are addressed (Kettell, 2011, p 121). Islamic Law standards are generated from Shariah while different Islamic system dealings of finance are governed based on Shariah and Fiqh. The fundamental stage within the Islamic financial system includes illustration of complimentary and fair arrangements. Fairness presents a critical purpose as it restricts the scope of freedom for Islamic financial system while contributing to free forms of business. The freedom of entry is based on contracting the mean entry for transactions that involve Gharar and Riba. Islamic Banks develop strong associations with the depositor while making time to have an affiliation with other businessmen. The depositors’ funds are concerned with productive Islamic financing and on the other side; conventional banking offers an illustration of borrowing and lending of funds (Schoon, 2010, p 53) Conclusion The Islamic banking formations are interest-free system while the principles allow for profit and loss distribution with customers and share the services with other business intermediaries. Similar to commercial banks that are interest based, Islamic banks act as guardians within the people’s interests and assets where disparities are involved in developing Islamic banking systems. The banks encourage sharing profits and losses with customer while conventional banks do not. The superiority allows for Islamic banking to have a unique form of conventional banking through giving people more ownership rights among customers. Conventional and Islamic banking is dissimilar from their operations through the elements of conventional banking and interest based ideologies. The banking systems also illustrate huge differences in terms of authority configuration. All Islamic banks are required to pursue diverse elements of regulations as stated within the Holy Qur’an. The elements also meet within the Muslim culture viewpoint while administering adequate financing for Islamic modalities. Islamic banks compare to the non-Islamic banks as they share an element of equal proposition of financial services to customers. The banks play critical roles in economic expansion of respective civilizations. Various interest based banks can be categorized as analogous while Islamic banks deal with adverse financial services and the conventional banking rules in terms of Islamic Shariah. The diversity of financial services also permits products contribution towards customers of Islamic Law. According to the Islamic Shari’ah, all forms of exploitative contracts that are solicited through Riba (interest or usury) or unjust contracts involving conjecture or risk are unforeseeable. References Ariff, M., & Iqbal, M., 2011. The Foundations of Islamic Banking: Theory, Practice and Education. New York: Edward Elgar Publishing. Cevik, S., & Charap, J., 2011. Behavior of Conventional and Islamic Bank Deposit Returns in Malaysia and Turkey. New York: International Monetary Fund. Greuning, H., & Iqbal, Z. 2008. Risk Analysis for Islamic Banks. New York: World Bank Publications. Iqbal, Z., & Mirakhor, A., 2011. An Introduction to Islamic Finance: Theory and Practice. New York: John Wiley & Sons. Kettell, B. 2011. Introduction to Islamic Banking and Finance. New York: John Wiley & Sons. Krasicka, O., & Nowak, S., 2012. What s in It for Me? A Primer on Differences between Islamic and Conventional Finance in Malaysia. New York: International Monetary Fund. Schoon, N. 2010. Islamic Banking and Finance. New York: Spiramus Press Ltd. Sole, J. 2007. Introducing Islamic Banks Into Coventional Banking Systems. New York: International Monetary Fund. Weber, O., & Sven, R., 2011. Social Banks and the Future of Sustainable Finance. New York: Taylor & Francis. Read More