Critical Issues in Islamic Banking and Finance - Coursework Example

Islamic Finance and Banking Name Institution Course Date of Submission Introduction A central bank also referred to as a reserve bank (Banaji, 2007) is a public institution that manages the currency of a state, their money supply, and the rates of interest charged on loans from commercial banks. It also controls the banking activities of commercial banks of a country. It differs from the commercial banks in that it prints the currency of the nation which acts as the countries legal tender; it is usually the key determinant of the countries monetary base (Aggarwal & Yousef, 2009). Islamic banking also referred to as participant banking involves the consideration of the sharia law and also has the evidence that their source of funds is through the development of the Islamic economics (Abeng, 1997). This means that ventures involving pork, alcohol and gambling are not the source of funds. Sharia law forbids the taking of fixed or floating payment, and the receiving of specific interest fee on loans offered. Investing in ventures that are not in line with the principles of the Islam is also prohibited because this is considered sinful. However, these Islamic principles have been applied variably due to the difference in the Islamic historic economies. This is caused by the lack of the practice of Islamic religion. This type of market economy known as ‘mercantilism’ which refers to an Islamic capitalism is based on the gold dinar which was commonly used as a currency (Nakagawa, 2009). The regions that were involved were economically independent. The various strategies that were involved in the Islamic banking are the: bills of exchange, mufwada which consists of limited partnership referred to as mudaraba, al-mal which is also a type of capital, and nama-al-mal which is also a form of capital accumulation (Ahmed, 2011). Some banking institutions also independent of the government in these countries also existed at that time. When these principles were introduced, these capitalist principles were adopted and further improved in the early Europe from the 13th century and the later years. Just like the convectional banks, the main aim of the Islamic bank is to make money but that is not the only purpose (Ahmad & Najmi, 2008). It also involves ensuring that that the Islamic laws are followed as required. Islam forbids the lending of money at an interest, there are some rules on transaction that have been set up based on the Islamic laws. This has been done with the aim of preventing the charging of interest which is termed as a sin in the Islamic laws. Islamic banking is based on the sharing of risks rather than the transferring of risks which is the main objective of the commercial banks and the central bank. Analysis Islamic financing started a long time ago and can be said to be as old as Islamic region itself; it has been regulating the modern Muslim world and the past (Rosly, 1999). In 1960s, modern Islamic financing began and its growth was accelerated in 1970s by the petro-dollar boom. In 1975, Islamic Development Bank was formed with an aim of promoting acceptance of Islamic finance financial practices to Islam (Rice, 1999). As from the mid-1970s, the Islamic financing has evolved from a micro financial institution to a widely spread financial system globally. After the first full Islamic (Dubai Islamic Bank) bank was founded in 1975, the number has speedily grown to more than five hundred Islamic financial institutions globally (Munawar, 2001). For the past three years, more than fifty Islamic banks have been established specifically in the Middle East, for instance, the Noor Islamic Bank in UAE, Bank Al Bilad in Saudi Arabia, and Boubyan Bank in Kuwait (Jobst, 2009; Aggarwal & Yousef, 2009). This has contributed to the speedy development of the Islamic finance globally. Thriving Islamic banking finance has been attained as a result of the high demand of banking clients to borrow and invest in agreement to their beliefs. In several nations like Malaysia, the state government has supported the sector through funding and this contributes to a successful Islamic financing service institution (Pramanik, 2002). As a result of it expansion as economic and demographic growth in nations where Muslim has predominated, it has contributed to demand of Sharia compliant resolutions. This establishes awareness amongst the clients contributing to a competitive and successful Islamic finance (Hesse, Jobst, & Sole, 2008; Reuters, 2012). The functions of Islamic banking include, among others, joint venture and safekeeping, an example is Murabahah which involves transactions on houses (Asutay, 2007). The bank buys the house, sells it to the customer at a fee inclusive of a profit. The bank then takes strict guarantee to protect itself against non-payment, but in case the buyer is not able to make the payments on time there will be no fine for late payment because the land is registered under the name of the buyer. They also do the same for loans on vehicles and this referred to as Eljara wa Elqtina. Another approach carried out by the Islamic banks is on home loans called Musharak al Mutanaqisa, which allows for rental purchase (Ayub, 2007). The buyer and the bank purchase property together and then rent it and then finally share the proceedings depending on the agreed equity shares; this takes place until the ownership of the property is transferred to the buyer and the partnership is dissolved. Another approach is the use of floating rates on companies; this is referred to as the Musharak (Joanna, 2007). This involves the charging of the floating rate depending on the rate of return for each company, so that the money taken as the floating interest is from a certain agreed percentage of the profits that are obtained by the company. Once the payment of the loan by the company to the bank is complete, the sharing of the profits is stopped. The other type of transaction is the Mudaraba .This is a capital funding of an entrepreneur who gives services such as labor, while funds are given by the bank so that the customer share both the risk and the profits. This type of arrangement shows the Islamic view that the borrower must not bear all the risk and that the lender should not dominate the economy. The Islamic banking is also limited to Islamically acceptable transaction, which alienates the transactions involving alcohol, pork and gambling (Ayub, 2007; Banaji, 2007). Although Islamic banking is full-reserve banking, it is supposed to achieve 100% reserve ratio. Practically, no reserve banking is observed. Despite the Islamic banking being taken up in most Muslim countries, it does not have a reasonable share in the global banking. Micro-lending organizations started by Muslim use the lending systems that are also used by the commercial and central bank. This is widespread in some Muslim countries but others do not consider it as the true Muslim banking. Although the founders argue that, the lack of large amounts of interest charged on the borrowers and also the lack of collateral is in line with the Islamic rules on the banning of usury. A sharia supervisory board is supposed to be in all the banking institution that offer Islamic banking as a condition, so as to ensure that the activities undertaken by these banks correspond to the sharia laws. For example, in Malaysia there is the National Shariah Advisory council, which has been set up by the Bank Negara Malaysia (Haq, 2006). This advisory council advises the bank on the principles of the sharia laws in their institution. There has also been an emergence of the sharia advisory entities which perform the same functions as the advisory boards. Microfinance is also an aspect of Islamic banks in the Muslim states, it is similar to Islamic finance, in that it capable of obeying the shariah and also dominates a big size of the market (Choudhury, 2001). The Islamic tools of microfinance can improve the tenure security and contribute to the changing lives of the poor. The use of interest found from the products and services of the convectional microfinance can be avoided by hybrids in the microfinance. These are used to implement Islamic contracts of joint ventures and profit sharing. An example of a microfinance institution such as FINCA Afghanistan has come up with instruments in their financial activities that accept the sharia law (El-Gamal, 2000). The Islamic banking has some controversies which are directed to their principles of not issuing interest. Some of the banks that follow the sharia law charge for the time value of money and this in the commercial banks is what is referred to as interest or riba according to the Muslim terminologies (Hussein & Omran, 2005). The Islamic banks that charge on the basis of money value are accused of not adhering to sharia law. Leasing is also used by some of the Islamic banks; a fixed amount is included to the loan given. This is paid whether the loan generates a return on the investment or not (Rosly & Bakar, 2003). The reasoning behind this is the amount of money that has been charged on the loan given is constant and thus not considered as interest but rather profit. This is therefore termed to be in accordance to sharia law. Another controversy in the Islamic banking is the mudarabah; the banks offering the loans are eager to share profits but they tend to have very little patience to risk sharing (Pramuka, 2009). Although these banks are following the strict laws of sharia, they are not recognizing the intent of the law. Some of the functions of the central bank are the implementation of the monetary policies, which involves the determining the type of currency the country will have. This can either be fiat currency, or a currency union. When a country has its own currency it also has to issue some of standardized currency which is important in the formation of a promissory note. This is a note that indicates a pledge to give out money under certain circumstances. A central bank may utilize other countries currency in a currency union which is direct or in a currency board and this is indirect (Saeed, 1996). In case of a currency board, the currency is stored at a fixed rate by the central banks holdings of another country e.g., in Hong Kong and Bulgaria. Monetary policy can also be interpreted as the targets of the interest rates and other activities carried out by the monetary authority responsible for the implication of the monetary policies. One of the goals of the monetary policies is high employment; they try to reduce frictional unemployment (Siddiqi, 2006). This is the unemployment which occurs when there are many jobs compared to the labour available. The employees resign from their current jobs in order to search for better paying jobs. It also tries to reduce unintended unemployment which may occur in cases of structural unemployment, whereby the skills and labour available are not corresponding to the available jobs. Monetary policy also aims at ensuring price stability; this is done by ensuring stable rate of inflation. Inflation causes the amount of real wage to be low and thus reduces the cases of involuntary unemployment. Nevertheless unexpected inflation leads to losses to the lenders as the interest rates will be low, thus steady rate inflation is the best. Another goal of monetary policy is economic growth; this can be improved by investing of money in capital such as improved machinery (Zaidi & Mirakhor, 1991). A minimal interest rate is usually set so that the firms can be given money to invest on their company and in return pay interest rates that are low. In order to encourage economic growth, minimal interest rates are usually charged. A contra-cycle in case of high economic growth is usually the charging of high interest rate so as to control the economic growth in case it is abnormally high. The other goals of monetary policy are usually interest rate stability, financial market stability, foreign exchange market stability and resolving conflict among goals. Due to the conflict of goals, costs are usually carefully considered prior to policy implementation. The central bank also intervenes on certain types of short-term interest which influence the stock market, the bond market and mortgage. The European Central Bank announces the rates they have set to be charged on interest at the meeting of its Governing Council while the US Federal Reserve does it through the Board of Governors. The ECB and the Federal Reserve have one or more core bodies that make the major decisions about the interest rates, the operations of the open market in terms of size and type (UKTI, 2013). Several other branches implement the policies that have been laid down. There are also limits on the policy effects because the knowledge by the public that the central banks controls both the interest rates that have been set and also the currency rate has been shown to be impossible by the reliable mathematical evidence. This is due to the fact that it is impossible to control both the monetary policy and the exchange rates and maintain a free capital movement at the same time, since the economies that are considered open. Free capital movement has been adapted by most countries in the west; this means that the central bank may target either the monetary policy or the fixed rate with credibility but not both of them simultaneously. The most common example of policy failure was shown in the relationship between the pound sterling’s relationships to the ECU (UKTI, 2013). Some of the policy instruments that are utilized by the central bank include, the open market operation, reserve requirement, policy on interest rates, term purchase market and the trade policy which co-ordinates the credit policy (Sheffrin & Arthur, 2003). In order for the open market operations to be to be possible, a central bank holds the money obtained from foreign exchange in the form of government bonds. It also has control on the mandated exchange rates; this is the most obvious function of the central bank. Contrary to belief they rarely set rates to a fixed number, the mechanism used my different countries to control the interest rates differs and most countries use the central bank’s ability to create fiat money required as their mechanism (Bordo, 2007). The mechanism used to move money towards a target rate is usually to lend and borrow money excessively until the target market rate is achieved. The central banks may do so by taking deposits from a limited number of qualified banks or by buying and selling bonds. The central bank through open market operations influences the money that is supplied in the economy of a country directly by buying securities, and giving out money (Wilson, 1994). Getting security raises the supply of money in the economy. Selling of security lowers the amount of money in circulation in the economy. Capital requirement is another policy instrument used by the central bank, in which all the commercial banks are required to hold a percentage of their assets as capital. This is a rate which is usually set by the supervisor of banks. The minimum amount of the capital for the international bank is 8% of the assets that have a high risk (Warde, 2000). The assets that have lower risks are usually exempted from the total assets. The other policy instrument is reserve requirements, bank reserves have only a small percentage of the deposits and this is usually referred to as fractional reserve banking. The purpose of banks holding only a small percentage of their reserves as cash is to use it as security against bank runs. Exchange requirement is also another strategy instrument used by the central bank. This is a condition whereby a directive is set by the central bank that the foreign exchange received from the goods that are exported to other countries is exchanged so that the local currency is obtained. Money supply is augmented in the economy when the central bank buys the foreign currency by selling the local currency. The money supply is reduced by the central bank through the selling of bonds (Wilson, 1994). A margin requirement is also another tool used by the central government so as to control the capital markets indirectly. The central bank regulates and supervises the activity of the banking entity in some countries. The regulation is carried out by branches in the government such as the UK Treasury, or an independent department in the government. It examines the financial statements and the policies that have been set by the bank to the clients when offering services. It also provides money to these banks as a lender of last resort. It transfers currency whether local or foreign. Many countries such as the central bank will control regulate the banks in their country through the use of different branches which carry out different responsibilities. These agencies are usually linked to each other. The banks that have merged are usually closely regulated because the government is usually cautious of the dangers of group think. The central bank is independent to determine the steps of achieving the goals it has set for its policy, the policy instruments to be utilized and the time of practically carrying out the steps. Conclusion There is a difference in the management of the central bank and the Islamic banking. Islamic banks require that the national sharia council is formed, so as to that the activities of the Islam banks are undertaken in line with the sharia law. The central bank on the other hand has independence in its governance, they determine for themselves the policy to used, the instruments to be used and the time of their implementation. The central bank has reserve requirement which is a policy that is also seen in the Muslim banking. This became a requirement when banks started getting involved in financial transactions that were advanced; the profits were made from transactions that were carried out globally (Ahmed, 2011). Reserve requirements became a preliminary in ensuring that there was a limit on the excess supply of money, although the implementation of such limits is cumbersome. There is also a difference on the functions of both the Islamic banking and central banking, the central banks controls the monetary aspects of a country and at the same time controls the activities of the commercial banks. It ensures the implementation of monetary policies, determines the interest rates, and regulates money supply in the economy of a country. It also oversees foreign exchange and the stock records of the government. It also supervises and regulates the banking sector of a nation, and also determines the interest rate to be charged so as to keep both inflation and the rates of exchange in check. The central bank is only one in a country (Archer & Karim, 2012). The Islamic bank is a bank that practices within the limits of the sharia law. In contrast to the monitoring functions the central bank carries out, the Islamic banking is limited in its functions by the sharia law. Apart from lending out capital so as to make more money, the Islamic bank also ensures that there is fairness between the bank and the individuals acquiring money from the banks. This is mainly because Islam forbids the lending out of money at an interest; Islamic rules on transaction have been made so as to inhibit usury. The comparison between the principles of the Islamic banking and the central bank is that, the central banks has monetary tools and instruments set so as to control the interest rates and the currency circulating in the economy. The principles of Islamic banking are mostly within the sharia law which forbids riba which is usury, but operates under the concepts of murabah, mudarabah, cost plus and ijarah. The areas that should be researched on are in microfinance, which is a major source of concern to the Islamic banks. It is capable of carrying out its transactions in line with the shariah law and it also commands a sizeable prospective market. The micro finance tools used in Islamic banking can improve the security and contribute to the changing of the lives of the poor. Interest obtained in the activities of the Islamic banks that are the same as those of the commercial banks, are used for microfinance hybrids which are carried on the basis of the Islamic contracts of mudaraba, musharaka and ijarah. The matter of whether available Islamic banks are really Islamic is an issue that is not clear-cut, this debate between the scholars in Islam. This is because the customers in Islamic banks are found in the Gulf States and in the developed countries. Majority of the Muslim are poverty stricken and the Islamic banking is little benefit to the general population. Majority of these banks are owned by non-Muslims and the Muslims who work in these banks are employed in the in the marketing departments. They have minimal contribution on the management tasks of these banks. Therefore, there is suspicion that the investments of these banks are made on services that are considered sinful according to the sharia law (Safiullah, 2010). 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Stabilization and Growth in an Open Islamic Economy. Review of Islamic Economics, 1(2), pp. 1-20. Read More