Can Islamic Financial Products Be Applied as Main Products in the UK - Term Paper Example

Can Islamic Finance ever become a mainstream product in the UK? Abstract Islamic banking has gained increasing popularity in recent times because it has not been affected by the recent financial crash. Islamic banks have been demonstrating growth and exist side by side with U.K. banks. Islamic financial institutions are bound by Sharia law, which forbids the collection of interest, or engaging in speculative activities. This study examines whether Islamic financial products can be applied as mainstream products in the U.K. Can Islamic Finance ever become a mainstream product in the U.K. Introduction: The emergence of the capitalist system that focuses on the acquisition of individual profits has been long supported as the best economic policy for most countries to follow, because market forces tend to balance out economies in the long run. The banking system in the UK also functions under the capitalist model, wherein acquisition of profits is an integral part of the system and “greed” or the “unbridled pursuit of wealth” has become the popular slogan for individuals and corporations (Ayub,2007, p. 31). The motivation towards profit is the cornerstone of the UK banking system. The recent financial crisis and corporate scandals such as Enron have however, dispelled the deregulation which existed previously and given rise to stricter financial regulation of money markets (Von Hagen and Ho, 2007). Deregulation of the banking system has been blamed for the speculative activities of the stock markets and the unrestricted use and issue of credit, which led to the financial crisis (Money morning, 2009). In the current financial environment, the Islamic banking model offers a completely different approach to banking and lending, because it is not based upon the profit motivation that characterizes UK banks. The Islamic banking system is based upon sharia law, wherein the charging of interest on loans to gain profit is forbidden and is considered to be contravene the religious tenets of Islam. The question that arises in this context therefore, is: Can the Islamic banking system offer a viable financial choice in the U.K.? Since Islamic banks do not charge interest and thereby provide an opportunity for consumers to borrow loans without large additional amounts being charged as interest, would this be a more ethical and equitable form of banking? The research question that is to be examined in this work is: Can Islamic Finance ever become a mainstream product in the U.K.? Banking system in the U.K. In the U.K., the banking system is dominated by four large banking conglomerates, Royal Bank of Scotland, HBOS, Barclays, and HSBC. The financial crisis of 2007 also affected the regulatory system in the UK, producing a tightening up of banking operations (Gola and Roselli, 2009). In March of 2009, the Financial Services Authority in the UK put forward proposals which were geared towards the overhaul of the banking system and its governing rules, especially in regulating lending criteria and clamping down on the unrestricted use of credit, in order to prevent a recurrence of the financial crisis (BBC News, 2009). For many consumers, the high interest rates on bank loans and credit cards are a significant drawback leading to losses, which are especially difficult in the current recessionary environment. The application of Islamic law could therefore potentially lead to the evolution of a “balanced, sustainable and equitable economic order”, because it can help to provide a balance between social and economic principles, as the Islamic system is based upon principles of morality, i.e, Islamic law does not allow collection of interest in banking, for example (Ayub, 49). Islamic banking The shariah or Islamic law is the dominant underlying principle in all Islamic financial transactions, because Shariah compliance is the raison d’etre of the Islamic financial system.(Ayub, 43). Three salient Shariah principles influence the banking industry, i.e, riba, gharar and gambling.This risk sharing model is the cornerstone of Islamic banking, because the collection of riba or interest is considered to be haraam or forbidden under Islamic laws. Verse 39 of the Sura-al-run makes it clear that the collection of interest purely for profit purposes would be antithetical to the religious tenets of Islam (Ayub, 47). In the case of a loan, or qard, a lender is forbidden from demanding more than the amount that was borrowed, and in the case of a debt or dayan, the stipulated debt has to be paid back at a stipulated time and the creditor cannot demand the money back before the stipulated time. According to Islamic law, the collection of money from money, such as by way of charging interest, is not permitted because that is considered to be an unlawful way of earning money; rather it is only through legitimate trade and investment in assets that money should be generated. (www.islamicmortages.co.uk). The second forbidden element is gharar, which in effect, is any uncertainty or hazard associated with the subject matter or prices quoted in a contract or exchange (Ayub,57-58). While risk is a part of any transaction, it is the extent of uncertainty inherent in a transaction which would be regulated under the tenets of gharab. Financial transactions such as futures and options markers practiced in the UK would be illegal under the Islamic banking model. Since uncertainty is an essential element in gambling, the acquisition of wealth by gambling is also forbidden. In the context of Islamic finance therefore, any money that is provided will be viewed as purely a financial transaction rather than constitute any real activity because it does not produce any financial returns for the bank in the form of interest.(Ayub,75). Financial transactions are viewed as trade activities, i.e, an exchange of goods. Since all forms of interest are forbidden under sharia law, the Islamic finance model, as used in Saudi Arabia for example focuses on risk sharing. Under this model, an Islamic bank is viewed as a two tier silent partnership. As a result, deposits made into the bank and seeking some return in the form of interest, would be viewed as silent partnership investments in the bank’s portfolio. The investments made by the banks in terms of lending out this money in the forms of loans and investments are considered to be silent partnership investments in other business ventures (El Gamal, No date). Some of the typical Islamic products include (a) Ijara (b) murabha and (c) commodity murabha. Bai is a straight sales transaction, where the seller can charge a higher payment if the sale, which is permanent, is made on a deferred payment basis (Ayub, 48). The ijarah transaction is a rental or lease, wherein the actual ownership of the lease is not transferred and the owner has the right to charge rentals. The ijarah transaction can also be used for home buying, wherein the home owner pays instalments which include capital and rental. Muraba refers to credits and forward sales, wherein a bank purchases goods for a buyer and the buyer pays the bank back in instalments at a price which has a mutually agreed to profit margin. The commodity murabha for example is the fair market price at which commodities are bought and sold on the commodities market. Traders are not to charge less than or more than the fair market price, so that a two fold purpose is achieved, i.e, buyers are not exploited and genuine businessmen do not suffer losses (Ayub, 69). Advantages of the Islamic system for the U.K. Since the collection of riba and gharib is prohibited, this immediately means that the kind of speculative activity that UK banks engaged in during the period prior to the 2008 crash would be forbidden under Islamic law. In a recent report, a Russian author has stated that the Islamic banking system could have prevented the worldwide banking collapse because (a) it bans the interest rate and the interest rate is the foundation for the development of wealth and the source of trouble (b) the Islamic economy is not based on collecting as much profit as possible (c) Islam dictates that individuals should not buy something they can’t afford, which if applied to the Western banking system could have prevented the housing mortgage crisis (www.digitaljournal.com). These ethical issues highlight the apparent absence of greed that exists in the Islamic system, which, it could be argued, might well have prevented the financial collapse, since the crisis occurred on account of the underlying greed of banks and lending institutions which wanted to capitalize on the existing market demands and profit from speculative lending activity. The fact that Islamic banking continued to grow during the recent worldwide recession has only made the Islamic model more viable, so that it is being seriously considered as a financial model that could be sound and withstand It must also be noted that the Islamic Banking model can be implemented fairly easily in the U.K. because the FSA (Financial Services Authority) operates on the principle of “no obstacles, no special favours”; hence banking systems will be treated and regulated on par with other financial systems (www.fsa.gov.uk). As a result, Islamic banking could be made available easily and quickly in the U.K. and is already operational in the U.K. for the benefit of Muslims as the Islamic Bank of Britain, which was approved by the FSA in 2004. Moreover, the Islamic banking model has proved to be quite profitable, with estimates of annual growth being between 20 and 25%. Speculative instruments cannot be used, which eliminates a considerable level of risk and transactions need to be based on real assets due to the prohibition of gharar, hence speculative activities are unlikely to impinge on the liquidity of banks. The implementation of Islamic banking also brings in some ethical and moral aspects (Ayub,64). For instance, the principle of not allowing banks or individuals to profit from financial transactions is superior from a moral and ideological standpoint. According to Islamic law, the collection of interest opens the door to greed , selfishness, injustice, exploitation and oppression. From a moral and ideological perspective therefore, Islamic banking appears superior. Islam favours philanthropy and does not want anyone to profit at another’s expense. The introduction of Islamic banking could bring some diversity to the financial landscape within the country and strengthen the diversity that is already characteristic of the U.K. Disadvantages of Islamic banking: Despite the growth in Islamic banking, the general Western view still does not favour the introduction of Islamic banking. At the outset, since interest cannot be charged, this means that not only are banks less interested in entering into loan arrangements, customers are also disinclined to keep their money in savings because they do not benefit from interest. Secondly, since banks do not charge interest on loans, there will be unlimited demand with no supply, i.e, banks willing to lend money when they make absolutely no profit on it. The demand supply balance on loans would therefore always be out of equilibrium. Zero interest effectively means that capital flows in only one direction. Another aspect which has recently been highlighted by Malik et al (2011) are the dangers posed by the fatwa, which is used to tackle all problems or need for clarifications arising in respect of financial products. While many of the conventional products that are currently offered by banks tend to be relatively straightforward, the religious angle and the need to ensure conformity with shariah law, the structuring process needs to be altered which only produces higher costs (Malik et al, 2011: 4). For example, these authors point out that with respect to Islamic banking products, some of them incorporate more than one sharia compliant mechanism into a single product, such as a swap mechanism incorporated into a product, such that the Islamic investor was able to swap the return from a sharia complaint instrument by a non-sharia complaint one (Malik et al, 2011: 4). The danger with such a position in Islamic banking is the additional scope for questioning on the basis of every part of the product not conforming to sharia. Another very important disadvantage of Islamic financing systems is that there is no central bank which functions as a repository of bank funds, such that when any bank faces a liquidity crunch, it is able to gain access to funds from the central bank (Malik et al, 3). This is not possible with Islamic banks which make large loans of funds without charging interest, but have no recourse to a central bank when their liquidity is affected. Moreover, the Islamic products on the whole are much more complex than conventional products, since as explained earlier, they need to be structured in such a way that they are also Sharia compliant. As a result, they also pose problems of auditing of Islamic funds, since there are no qualified auditors who can carry out the operations on the basis of standardized principles. There has been a considerable amount of controversy occurring due to the arbitrary nature of the fatwa, which has been known to be conditioned by radical religious beliefs. Specifically, problems arise in the case of fatwa shopping for example, which is in effect a threat to Islamic finance, because it does not work in favour of harmonisation of fatwas, which then increases the complexities of operation of the products, rise in costs and difficulties in standardization. All of this causes uncertainties in the minds of shoppers in reference to Sharia compliance, which leads them to lose faith in the Islamic finance system as a whole. On this basis, implementing such a banking system that is rife with uncertainties would not necessarily be in the interests of either the consumers or the financial organizations, which would face nightmares in execution (Malik et al, 3). Conclusions: On the basis of the above, it may be noted that Islamic banking systems undoubtedly offer some significant advantages in terms of limiting speculative activity and lending on the basis of actual real assets rather than through empty credit. They have been shown to be a good system in recessionary times and are also serving the Islamic sections of the population in Britain very well. When considered from the perspective of widespread application such that Islamic banks can offer their products as mainstream products in the UK, this gives rise to many problems. The policy of riba or the prohibition against collecting interest would be a major disincentive for both banks and investors/consumers alike because their money would not bring them any earnings or profits. In the caes of savings accounts for instance, Uk law requires capital certainty, while Sharia law in this instance would require the customer to be prepared to face a loss. Where the ijarah transaction is concerned, the process could potentially be transferable because of the facility of capital payment plus rental which is very similar to the repayment mortgage scheme. In the case of other products however, the restrictions on pricing of commodities to reflect the true value of the market and the restriction on gambling and speculative activities could prove to be a great disincentive as well, because it would seriously impinge upon the primary business activity and mainstream of the U.K. economy, the financial services where such speculation and risk playing is one of the important features of the existing system. Making the transition to the Islamic banking system would also be very difficult for most banks because very few banks have the necessary high levels of liquidity to supply the huge demand that would ensue if loans were offered on Islamic banking law basis. Auditing accounts also poses more difficulties and complexities in implementing Islamic banking in a widespread manner and discerning whether or not Sharia law has been adhered to would be even more difficult. On an overall basis therefore, it could be concluded that while there is potential for Islamic banks to exist side by side with traditional banks, implementing and using Islamic banking products in the mainstream is likely to be untenable because of the prohibition on collection of interest and the logistic, accounting and regulatory difficulties in implementation. Bibliography * Ayub, M. (2007). Understanding Islamic Finance, Wiley, John & Sons * El Gamal, Mahmoud (No Date). “Islamic Finance”, Retrieved February 27, 2011 from: http://www.jhfc.duke.edu/disc/events/documents/IslamicFinance.pdf * Forsloff, Carol (2009). “Could Islamic finance model have prevented banking collapse?” Digital Journal, Retrieved February 27, 2011 from: http://www.digitaljournal.com/article/273515 * Gola, Carlo and Roselli, Alessandro (2009). “The UK Banking System and its regulatory and supervisory framework”, Palgrave Macmillan *Malik, Ali, Malik, Muhammad Shaukat and Mustafa, Waqas.(2011). “Controversies that make Islamic banking controversial: An analysis of the issues and challenges”, American Journal of Social and Management Sciences, 1-6 * Money Morning (2009). “How deregulation fuelled the financial crisis”, The Market Oracle, January 13, 2009; Retrieved February 27, 2011 from: http://www.marketoracle.co.uk/Article8210.html * “Shake-up plans for the UK bank system”, Retrieved February 27, 2011 from: http://news.bbc.co.uk/1/hi/business/7950355.stm Von Hagen, Jurgen and Ho, Tai-Kuang (2007). “Money market pressure and the determinants of banking crisis” Journal of Money, Credit and Banking 39(5): 1037-1066 Read More