Islamic Banking & Finance - Literature review Example

Islamic Banking Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 12th December, 2012 Executive Summary The banking industry is a challenging industry to undertake operations in any region or country. As a result, several laws, regulations and strategies have been deployed to embark on this industry. Islam banking is one of the braches of banking that has been operated for a long period of time. Islamic banking has been in operation since the early 1970’s and through several challenges and transitions this banking sector has grown tremendously. One of the biggest challenges that Islamic banking faced is financing. Islamic banks faced the problem of raising capital for the purpose of financing its operations and thus most of the opened banks collapsed in the 80’s. Some of the countries that pioneered and successfully implemented Islamic banking includes Egypt, Malaysia, Pakistan and Iran; these countries have Islamic banks that are well established globally (Kettell, 2011). These banks were established by shareholders or governments under laws such as Mudarabah, Murabahah and Musharakah which enabled people to borrow while capital was raised. Since, Islamic banks do not charged interest they made use of partnerships and agreements that ensured banks and customers interests were served. Other methods used in mopping funds included use of custodial services known as Wadiah and Ijara which dealt with finance and leasing (Venardos, 2010). Consequently, the operation of Islamic banks is different from that of commercial banks due to the profit driven motivation that commercial banks posses. In the recent past, the economic crisis hit numerous commercial banks hard but Islamic banks remained competitive and largely unaffected. This is because of the low risk that these banks usually take in the process of implementing their operations (Mullineux, et al., 2003). The banking model that is used under Islamic banking is a good model that should be adopted by other institutions in the banking industry. Table of Contents Islamic Banking 1 Executive Summary 2 Introduction 6 Literature Review 7 Case Study 9 Ijara: This is a leasing type of business which is used by banks in realizing profit with the aim of expanding their operations. Under this arrangement, banks finance ownership of properties or machinery to businesspeople while the property remains in the hands of the lessor (bank). This is done so that the businessperson only benefits from the use of the property or machinery. In Islamic banking this is referred as the transfer of usufruct (manfaa) to the businessperson. This is a method commonly used by Islamic banks in realising profits in the pursuit of building up their finances (Banking Regulations and Islamic Finance, 2007). 12 Wadiah: This is the custodial services that banks offer to keep money for its customers and in Islamic banking this practice is done whereby the customer’s money does no earn interest. Moreover, the money kept in the bank will be used by the bank for other activities and the customer can access any time the money he/she deposited with the bank. In some cases, if the bank makes a profit then using its own discretion the bank can give out Hibah (a gift) for the funds used (Hassan, et al., 2007). 12 Market Instruments: Islamic banks also utilise capital markets to raise capital though use of sukuk (Islamic bonds) and rights issue to raise capital. In some, instances rights issue is used in raising capital through different stock markets. For example Jaiz bank in Nigeria made use of rights issue to raise capital. 12 Loans: Commercial banks are started out by investors who invest their funds with the purpose of lending out to its customers. Loans form a big chunk of the finances and profits that banks utilize in running their operations. Capital invested by investors in most cases is treated as a debt or converted to shares for the purpose of capitalising banks (Klein, 2005). 13 Custodial services: Commercial banks offer customers facilities to deposit their funds safely with them with them. These customer deposits are utilised in loaning out to other customers and to conduct trade among different entities for the realisation of profits. 13 Trade Services: Commercial banks do engage in trade by use of facilities such as asset finance, bonds market, insurance and other trade activities. Due to the wide array of financial investments, banks engage in these activities with purpose of making profits or raising capital to be used in undertaking their activities (Scott, 2008). 13 Market Instruments: Commercial banks utilize capital market in the process of raising capital and these instruments include rights issue, corporate bonds and listing through different stock exchanges in the world. These instruments are utilized on a frequent basis among banks in these different locations (Pond, 2010). 13 Solution/Recommendation 14 Conclusion 15 Bibliography 16 Introduction Islamic banking is one of the mainstream banking sectors that has witnessed immense growth over the years. This sector of banking has been practised since the early 1970’s and today there are over 200 banking institutions which practice Islamic banking. These banks are spread all over Europe, Middle East, North Africa and other regions of the world. The economic system in which Muslims operate under is heavily influenced by religion. The Islamic religion has norms and values that are followed by Muslims in most actions they undertake in the process of living. These norms extend to the banking and economics sector in the banking sector among Muslim faithful. As a result, the main tenets of Islamic banking do not believe in profiting from a debt or charging interest on debts levied out. This is because according to Islam a person is not supposed to profit from lending out to other people. Since, a debt is not supposed to grow and therefore banks lend onto borrowers in the hope that the borrower will get a profit which the bank will share with the borrower. Moreover, borrowers who save with an Islamic bank are not supposed to earn interest on their deposits but they are rewarded with Hibah, a gift is given when the bank makes some profit. The art of safekeeping is known as Wadiah is one source of Islamic banks raising their funds. This essay is going to examine methods which Islamic banks use to raise funds and we would compare the same with commercial banks. The operation of commercial banks compared to Islamic banks is different since these banks raise their finances through levying of interests on loans and other banks facilities. Literature Review Islamic banking has been in operation for a long time in different economies in the world and there is potential growth in the sector. Islamic banks came into existence in the early 1970’s when financers and the Islamic community decided to come up with an Islamic bank. Countries such as Malaysia, Pakistan, Egypt and Iran are some of the countries that have been on the forefront of coming up with Islamic banks. For instance, in Egypt the concept of banking based on the Shariah laws was developed by Ahmad El Najjar whose key principles included profit sharing. The main aim of the establishments of Islamic banks in Egypt evolved to include banks which had the idea of funding activities such as trade and industry. It is around the year 1963 when the first Islamic bank by the name of Dubai Islamic bank that was came into the picture. But it was not until the year 1975 when the first Islamic commercial bank was introduced and these banks continued to grow (Islamic Banking , 2004). Most of the initial Islamic banks were financed by governments since it was seen as not a viable venture to start a bank. In the initial stages on the development of Islamic banks, most of the funds were sourced from shareholders based on the mode of sharing. The foundation of Islamic banking in Malaysia started out by pilgrims mobilising money for the purpose of going to Mecca. This group of Malaysian pilgrims were known as Tabung pilgrims and they utilised Mubarabah, which involved sharing of profits and Musharikah which involved joint ventures. This venture was successful in the launch of fully fledged Islamic commercial banks in the latter years. In the year 1983, an Islamic bank (Bank Islam Malaysia Berhad (BIMB)) came up with products and services that were modeled on Shariah laws. This bank was instrumental in shaping Islamic banking in Malaysia since the bank came up with several products for its clientele. Funding is major task within the banking industry and thus in the case of BIMB bank, it made use of its wide range of products to fund its development. For instance the bank used Wadiah (custody) or safekeeping of customer deposits and other options such as Mudarabah which constituted profit sharing. Thus these deposits contributed to funding the bank’s operations while the profits accrued from its activities led to the development of funds for the bank (Islamic Banking in Iran and Pakistan: A Comparative Study , 2003). In the year, 2003 the bank was listed in the Malaysian Stock Exchange and the bank had grown tremendously within Malaysia. The other case of Islamic banking that we can observe was the practiced in Pakistan in the early 1970’s and 80’s. This system was not organized due to the sudden changes in the Pakistani economy. Many Pakistani banks were also slow in complying with Shariah laws in the process of banking and as a result, financial modes such as Musharikah, Mudarabah and Ijara took time to adopt. When this was found out, the courts in the country talked of the lack of banks following Shariah based laws and as a result, these banks were declared as non-Islamic. Therefore, the government though the Ministry of finance and trade came up with regulations that made the Pakistani economy free from interest based trade (Islamic Banking and Finance: Postcolonial Political Economy and the Decentring of Economic Geography , 2007). This move assisted in the establishment of Islamic commercial banks such as the Meezan Bank Limited (MBL) which received a banking license in the year 2003. As of today Islamic banking is on the growth trend and this is set to continue in the future (Islamic Banking and Money Demand Function in Malaysia: An Econometric Analysis , 2006). On the other hand, Islamic banking flourished in the Islamic Iranian state due to the influence of the religion in the country. Moreover, the many Islamic banks had the support of the government and today Iranian Islamic banks are the largest in the world. Conventional banks have been in existence for a long period of time dating back to early trade in Europe. The banking and financial system began in England where old banks such as the Lloyds, Barclays and Midland were opened acting as keepers of gold coins. These banks evolved to include safekeeping of funds and lending out to customers especially businessmen. As these banks grew they increased the suit of services they offered to include mortgage, trade and asset finance service with aim of making profits (Rosly, 2005). Most of these commercial banks were started out though capital from investors who met certain laid down laws and procedures. As a result, when their services and profits grew, all these funds would be re-invested in the banks. These methods are still used in raising capital among numerous commercial banks (Collins, 2012). Case Study Islamic banking is widely used in countries such as Iran, Malaysia and Egypt were these banks serve millions of customers and citizens. As a result, the impact that Islamic banks have can be significant compared to commercially oriented banks. However, the operation of Islamic banks is quite difficult and it requires a good business model and strict adherence to rules. Making banks available for the purpose and process of making profits based on Shariah laws is quite difficult. The republic of Iran is one of the largest economies in the Middle East and its banking industry is well developed (Islamic Banking and Friedman's Rule , 2002). As a result, we are going to analyse the development of Islamic banking in the country with a use of some banks that successfully implemented Islamic banking. Iran is a country that is ruled through the use of Islamic laws and this makes the banks in the same country to operate through the use of the same laws (Schoon, 2010). The country has some of the largest banks in the world that operate under the use of Shariah laws. Banking in Iran began long time ago at around the year 1920’s but this changed in the latter years. For instance, the Iranian Central Bank (Bank Markazi) was in operation by the year 1960 for the purpose of issuing currency and monitoring monetary policy. The industry grew through the 60’s and 70’s until after the revolution when all banks were nationalized and made to comply with the Islamic rule of interest free banking. Most of the Iranian banks are huge and they adhere to the laws and rules of Islamic banking. As a result, Iran is a good country to study and understand how Islamic banking operates. Some of the banks that were taken over by the government after the year 1979 were restructured to comply with the new law of Islamic banking (Iran's Tortuous Path toward "Islamic Liberalism”, 2005). Some of these banks include Bank Melli, Bank Saderat Iran and Bank Sepah. The need for Islamic banks to raise capital to fund their operations is necessary and as such, banks in Iran started out as units which raised funds through use of investors. Investors in the banking industry within Iran raised funds through the use of own capital funds. The banks in Iran are required to raise at least $ 70 million for a bank to be licensed by the Central Bank and these are the ways the use to raise funds: Mudaraba: This is an Islamic banking term used to mean the art of profit/loss sharing whereby a financer lends out money to another person/party for the purpose of undertaking a certain activity. Under Islam banking law, a financer known as (rabb al-mal), lends/entrusts money to a businessperson (mudarib) for the purpose of undertaking a certain activity. Under this arrangement the financer is not allowed to take a managerial position. It is the mudarib who will return to the financer (rabb al-mal) the principal amount and agreed profits. In case of losses, it is the financer who will bear the losses unless the terms are supposed to include the entrepreneur (mudarib). Another form of raising funds for Islamic banks is through the use of Musharaka which involves the raising of funds between two or more parties with the intention of funding a commercial venture (Islamic Banks and Investment Financing, 2006). Under this arrangement, profits and losses are shared in the ratio of the contribution between the partners. Through the use of this model, investors raised their monies which is borrowed and used by other people in the hope that profit will be realized. Ijara: This is a leasing type of business which is used by banks in realizing profit with the aim of expanding their operations. Under this arrangement, banks finance ownership of properties or machinery to businesspeople while the property remains in the hands of the lessor (bank). This is done so that the businessperson only benefits from the use of the property or machinery. In Islamic banking this is referred as the transfer of usufruct (manfaa) to the businessperson. This is a method commonly used by Islamic banks in realising profits in the pursuit of building up their finances (Banking Regulations and Islamic Finance, 2007). Wadiah: This is the custodial services that banks offer to keep money for its customers and in Islamic banking this practice is done whereby the customer’s money does no earn interest. Moreover, the money kept in the bank will be used by the bank for other activities and the customer can access any time the money he/she deposited with the bank. In some cases, if the bank makes a profit then using its own discretion the bank can give out Hibah (a gift) for the funds used (Hassan, et al., 2007). Market Instruments: Islamic banks also utilise capital markets to raise capital though use of sukuk (Islamic bonds) and rights issue to raise capital. In some, instances rights issue is used in raising capital through different stock markets. For example Jaiz bank in Nigeria made use of rights issue to raise capital. Compared to conventional banking, Islamic banking has remained true to the tenets of interest free banking. This is compared to commercial banks which are started out by investors and they possess a lot of avenues for raising capital. Banking has been in existence in a region like the United Kingdom for a long period of time (Collins, 2012). The Barclays bank Plc is one of the oldest banks in the world and thus tracing its route we can have an idea on how commercial banks raise capital as outlined below: Loans: Commercial banks are started out by investors who invest their funds with the purpose of lending out to its customers. Loans form a big chunk of the finances and profits that banks utilize in running their operations. Capital invested by investors in most cases is treated as a debt or converted to shares for the purpose of capitalising banks (Klein, 2005). Custodial services: Commercial banks offer customers facilities to deposit their funds safely with them with them. These customer deposits are utilised in loaning out to other customers and to conduct trade among different entities for the realisation of profits. Trade Services: Commercial banks do engage in trade by use of facilities such as asset finance, bonds market, insurance and other trade activities. Due to the wide array of financial investments, banks engage in these activities with purpose of making profits or raising capital to be used in undertaking their activities (Scott, 2008). Market Instruments: Commercial banks utilize capital market in the process of raising capital and these instruments include rights issue, corporate bonds and listing through different stock exchanges in the world. These instruments are utilized on a frequent basis among banks in these different locations (Pond, 2010). From the above methods of raising capital we come to witness the different ways in which capital is raised by different banks. Most Islamic banks such as the Iranian Bank Melli made use of the above methods to raise funds for funding its operations. Moreover, in the United Kingdom the Barclays group is one of the banks that have implemented the operation of the above methods in raising capital and growing its operations into different regions of the world (Corporate Governance in Islamic Banks, 2008). Solution/Recommendation Islamic banking has grown over the years to withstand several challenges in the ever changing global business environment. The operation of these banks comes at a time when several commercial banks in the world faced and had to cope with the financial crisis. Several banks suffered due to their business practices due to exposure to bad debt. When we examine the model used by Islamic banks then we have reason to conclude that Islamic banks run better operations. This is because these banks do not expose their businesses to high risk and moreover, Shariah laws prohibit these banks from excessive profiting through their operations (Koch, et al., 2009). The law and the rules that are utilized by Islamic banks are very prudent since it allows for people to save money and raise capital in an easy and less risky method. As a result, many Islamic banks face the challenge of raising funds especially within developing nations or countries. However, raising funds through the use of methods such as Mudaraba and Musharakah require the use of active mobilization of funds (Banking Regulations and Islamic Finance, 2003). These methods are quite safe and appropriate for a lot of customers. Since, Islam does not approve for interest (riba) to be charged onto people and this is quite appropriate in attracting customers to open accounts with Islamic banks (Theory and Practice of Islamic Banking, 2001). The risky practices carried out by commercial banks in regions like the United Kingdom and the US has made it difficult for customers to borrow funds. From the examination of commercial banks in comparison to Islamic banks we realise that commercial banks are purely driven by profits. While on the other hand, we notice that Islamic banks are in pursuit of partnerships under the Shariah backed laws. Out of the different methods of raising funds through the use of Islamic banks, the most commonly are Mudaraba and Musharakah. Research conducted showed that Murabaha contributed to around 45% of all operations (Islamicity of Banking and Modes of Islamic Banking , 2003). While, Mudaraba and Musharaka contributed around 15% and 9% respectively in the banking operations. Conclusion The existence of Islamic banking and their operations is fundamental in understanding financial systems in the world. As a result, many people have questioned the methods that have been deployed by Islamic banks in raising capital to support their operations. The use of facilities such as Murabaha, Mudaraba and others in the development of the banking industry has heralded a new trend in banking. The use of partnerships in Islamic banking is quite different from that of commercial banks which utilize interest based banking to raise capital and make profits. Islamic banking has evolved from small units that operated out countries such as Egypt, Malaysia and Iran to emerge as strong banks in the globe. Unlike commercial banks which have been in operation for long periods of time such as the Barclays banks from the UK. Islamic banks have grown due to their appeal of their products from the Islamic populations in different parts of the world. Investors interested in banking would be advised to invest in Islamic banking due to the potential of the growth of these banks in locations globally. Bibliography Aggarwal Rajesh and Yousef Tarik Islamic Banks and Investment Financing [Journal]. - New York : Journal of Money, Credit and Banking, 2006. - 1 : Vol. 32. Anwar Muhammad Islamic Banking in Iran and Pakistan: A Comparative Study [Journal]. - Karachi : The Pakistan Development Review, 2003. - 4 : Vol. 31. Ashraf Ahmad and Banuazizi Ali Iran's Tortuous Path toward "Islamic Liberalism" [Journal]. - Washington : International Journal of Politics, Culture, and Society, 2005. - 2 : Vol. 15. Bishnoi Torrel Banking Regulations and Islamic Finance [Journal]. - London : Economic and Political Weekly, 2007. - 48 : Vol. 25. Collins Michael Money and Banking in the UK (RLE: Banking & Finance): A History [Book]. - London : Cengage Learning, 2012. Delwin Roy Islamic Banking [Journal]. - Manchester : Middle Eastern Studies, 2004. - 3 : Vol. 27. Hassan Kabir and Lewis Mervyn The Handbook of Islamic Banking [Book]. - Chicago : Jossey-Bass, 2007. Kaleem Ahmad and Mansor Muhammad Islamic Banking and Money Demand Function in Malaysia: An Econometric Analysis [Journal]. - Islamabad : Pakistan Economic and Social Review, 2006. - 2 : Vol. 44. Kettell Brian Introduction to Islamic Banking and Finance [Book]. - New York : Pelshiver, 2011. Klein Edward Capital Formation, Governance And Banking [Book]. - Boston : Springer Publishing Company, 2005. Koch Timothy and MacDonald Scott Bank Management [Book]. - Boston : Allen & Unwin, 2009. Mohammad Afzal Theory and Practice of Islamic Banking [Journal]. - Amman : Pakistan Economic and Social Review, 2001. - 2 : Vol. 31. Muhammad Anwar Islamicity of Banking and Modes of Islamic Banking [Journal]. - Doha : Arab Law Quarterly, 2003. - 1 : Vol. 18. Mullineux Andrew and Murinde Victor Handbook of International Banking [Book]. - Lowell : Routledge, 2003. Pollard Jane and Michael Samers Islamic Banking and Finance: Postcolonial Political Economy and the Decentring of Economic Geography [Journal]. - London : Transactions of the Institute of British Geographers, 2007. - 3 : Vol. 32. Pond Keith Retail Banking [Book]. - Detroit : Ashgate Publishing, 2010. Ramachandran Singh Banking Regulations and Islamic Finance [Journal]. - New Delhi : Economic and Political Weekly, 2003. - 52 : Vol. 24. Rosly Saiful Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Investments, Takaful and Financial Planning [Book]. - Chicago : AuthorHouse, 2005. Schoon Natalie Islamic Banking and Finance [Book]. - Boston : Cengage Learning, 2010. Scott William Banking [Book]. - Melbourne : Prentice-Hall, 2008. Suleiman Nasser Corporate Governance in Islamic Banks [Journal]. - [s.l.] : Society and Economy in Central and Eastern Europe, 2008. - 3 : Vol. 22. Venardos Angelo Case Studies in Islamic Banking and Finance [Book]. - London : Penguin Books, 2010. Yousefi Mahmood, McCormick Ken and Abizadeh Sohrab Islamic Banking and Friedman's Rule [Journal]. - Riyadh : Review of Social Economy, 2002. - 1 : Vol. 53. Read More