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Islamic Banking and the Financial Crisis - Essay Example

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The essay "Islamic Banking and the Financial Crisis" focuses on the critical and thorough analysis of how Islamic finance in the United Kingdom has fared through the recent financial crisis, which was a global event and not confined only to the United Kingdom…
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? Case Study: Islamic Banking and the Financial Crisis By Candi s FACULTY OF BUSINESS, DEPARTMENT OF FINANCE (This page intentionally left blank) Introduction Rashwan (2010, pp. 1 – 2) states that the original teachings of Judaism, Christianity and Islam prohibit charging an interest on money lent to others and although Jews and Christians have presented a certain degree of compromises on such issues to follow ‘natural and practical’ inclinations, the followers of Islam have been less inclined to make any compromises. According to Mavrakis (2009, pp. 2 – 5), Islamic finance has emphasised on trying to remove completely any interest involved in financial transactions. The Quran, which is the Divine revelation presented to Prophet Mohammed, who is the Prophet of Islam, expressly forbids charging of interest, or riba, and Prophet Mohammad himself emphasised on this as mentioned in the Hadith, which is the other source of Islamic law, the Shariah. The following verses of the Quran illustrate Islamic prohibitions on riba or usury: “And for practicing usury, which was forbidden, and for consuming the people’s money illicitly, We have prepared for the disbelievers among them painful retribution.” Al-Nisa 4:161 “Those who charge usury are in the same position as those controlled by the devil’s influence. This is because they claim that usury is the same as commerce. However, God permits commerce and prohibits usury.” Al-Baqarah 2:275 “The usury that is practiced to increase some people’s wealth does not gain anything at God. But if you give to charity, seeking God’s pleasure, these are the ones who receive their reward many fold.” Ar-Rum 30:39 Thus, because a need existed for followers of Islam to maintain an adherence to the Quranic injunctions to eliminate riba from financial transactions, Islamic finance maintains adherence to Islamic law, the Shariah, which derives from the Quran, the Hadith, or the sayings of Prophet Mohammad, and consensual scholarly opinion of scholars or clerics of Islam. This essay presents a discussion about how Islamic finance in the United Kingdom has fared through the recent financial crisis, which was a global event and not confined only to the United Kingdom. Clearly, it will be fair to expect that sincere efforts made to abide with the ethical requirements presented in the Quran should meet with sustained growth. Background and Key Concepts of Islamic Banking Holden (2007) states that riba was a pre-Islamic practice that required that when a borrower could not repay a loan owed to another by a specified date, the amount of the loan increased in lieu of an extension in the repayment date. However, such an arrangement presented a problem because borrowers who could not repay a loan were in danger of owing huge sums in perpetuity to lenders. Thus, those that turned to moneylenders in an informal barter economy of the pre-Islamic era at times of famine, disasters or crop failure were in danger of entrapment in a vicious cycle of indebtedness, poverty and deprivation that could result in perpetual slavery for those that could not repay their loans. High risks associated with entrapment in a vicious cycle of indebtedness did not encourage risk-taking in commerce, and this was not beneficial for the society. It is important to note that the concept of a limited liability company in the United Kingdom had evolved due to a societal need for managing better business risks for the betterment of the society and Islamic response for risk management related to the removal of the concept of riba from society. Holden (2007) goes further to suggest that the Quran prohibits profiting from idle money, and a prohibition exists for the practice of riba in Islam. In addition, Islamic law or the Shariah prohibits transactions that carry substantial risk or uncertainty at the time of inception, such as gambling or other forms of risk that present a potential for exploitation. Prohibition under the Shariah also extends to transactions that involve immorality, such as profiting from the sale of pornography, alcohol, tobacco, pork products, etc. However, it is permissible to seek profit from sale at a mutually agreed price as long as the contracting parties have perfect knowledge of the values exchanged. Islamic banks and financial entities should not charge interest on funds made available to them, although Islam does not prohibit any pre-agreed profit and loss sharing arrangements or arrangements for parties to benefit from the fruits of a commercial undertaking. Thus, according to Hassan (2007, Chapter 5), although Hinduism, Judaism, Judaism and Christianity have all opposed usury, traditional finance tolerates payment of interest as a means for precise calculations needed for financial engineering. However, Islamic finance maintains a prohibition on interest because of prohibition in Islam for payment for use of funds for a commercial venture and other means for sharing in profits and loss arising from commercial transactions are emphasised. Malik, Malik and Shah (2011) state that Islamic finance encourages participatory finance in commerce, and the lending mode is discouraged. Islamic Banking and Finance (IBF) are attractive to Muslims because IBF makes it possible for Muslims to deal with their financial affairs in accordance with the dictates of their faith and for others, Islamic finance presents a curiosity because of its prohibition on interest (Malik, Malik and Shah, 2011, pp. 179 - 181). Islamic Banking in the United Kingdom and Globally Malik, Malik and Shah (2011) state that although it is possible to trace the origins of Islamic finance in the United Kingdom back to the early 1980s, significant developments only commenced during the last decade of the 20th century. The idea of an Islamic bank first emerged in the 1950s and the earliest Islamic banks emerged from Egypt and Malaysia in the early 1960s. Later, Islamic banks were to succeed in Dubai; (Dubai Islamic Bank), and Bahrain; (Al-Baraka) to encourage further global expansion of Islamic banking in other regions of the world. In the year 1982, the Al-Baraka Investment Company, which was the investment arm of the Al-Baraka banking group of Bahrain, acquired Hargrave Securities, which at the time had a license to accept deposits in the UK (Malik, Malik and Shah, 2011, pp. 179 - 181). The Hargrave Securities acquisition was to serve later as the first Islamic bank in the United Kingdom, catering primarily to wealthy Arabs who spent the summer in London. This bank had an investment focus and accepted investments on a Mudaraba basis. According to Robbins (2010), Zaher (2001) and Gait & Worthington (2007), a Mudaraba arrangement is a profit-sharing contractual agreement between a financial institution, and an entrepreneur established according to a decided ratio for sharing of profits, and losses decided prior to commencement of business arrangement. The first Islamic bank in the UK was to see its deposits increase from ?23 million in 1983 to ?154 million in 1991 of prior to its demise in the year 1993 due to its investment rather than conventional banking orientation. Malik, Malik and Shah (2011) state further that in the year 1976, an Institute of Islamic Banking and Insurance established in King’s Cross in London. Later, in the year 1997, the United Bank of Kuwait entered the housing finance market in the UK by offering a Murabaha instalment structure. A Murabaha instalment structure involves a financial institution buying an asset and selling it to a customer for a single or multiple deferred multiple payment according to mutual agreement. However, although the United Bank of Kuwait offered an ethical alternative for Muslims to buy a home, a double stamp duty, later abolished by the British government, was to make the Murabaha process uncompetitive. However, the conflict between the United States of America and the Middle East acted to attract funds to the United Kingdom and other countries that presented an interest in becoming the financial hub of Islamic finance outside Islamic countries. By the year 2008, the City of London was to offer 20 Sukuk issues raising US$11 billion, 22 banks, 5 fully Shariah compliant banks and institutions offering educational and training products in Islamic finance. Hassan and Mahlknecht (2011, pp. 328 - 334) suggest that the UK has now established a lead to become the European leader in Islamic Financial Services and the establishment of the Islamic Bank of Britain in the year 2011 demonstrates a level of commitment by the government in the UK to maintain this lead. Establishment of other financial institutions, such as the European Islamic Investment Bank and the offering of Shariah compliant products by leading banks in the UK including Bank of London, Barclays Bank and The Middle East Plc. present further evidence of a willingness on the part of Muslim investors to invest in the UK Islamic offerings. Although precise figures are unavailable, estimates indicate that the value of Sukuk, or Islamic bond listings on the London Stock Exchange exceeds ?5 billion (The City of London, 2007, pp. 14 – 15). Assets controlled by Islamic banks at the global level exceed US$ 200 – 500 billion, with a growth rate of 10 – 15% per annum (FSA, 2012, “Islamic Banking in the UK”). There are perhaps six important reasons for the growth of Islamic finance in the UK and these are as follows (Ainley et al, 2007, pp. 6 – 10): Global expansion of Islamic finance is the result of a relatively young industry expanding overseas, and the UK offered the right incentives with a culture better understood in the Arab and Islamic world. The markets and skills base for finance existed in London, which has been an international financial centre since the early seventeenth century. Major international financial institutions with links to London with a presence in the Middle East and South-East Asia encouraged growth of Islamic finance in the UK. Excess liquidity in the Middle East made it possible for investors to seek attractive investment locations and London offered global opportunities. The government in the UK has moved to introduce a set of tax and legislative changes designed to attract Islamic finance, with the Finance Act 2003 removing multiple payment of Stamp Duty Land Tax on Islamic mortgages and the Finance Act 2005 and 2006 presenting further improvements. The Finance Act 2007 clarified further tax framework for Sukuk. A single financial regulator for the UK, the FSA, is easier to deal with and presents efficiency in regulation. Sadoveanu (2011) and Malik, Malik and Shah (2011) suggest that the 14 million Muslim inhabitants of the European Union, and the investment potential in Europe presents an attraction for Islamic banks. There are 2.4 million Muslims in the UK, which are about 2.8% of the total population. France with 5.5 million Muslims, or 8% of the population and Germany with 4.3 million Muslims, or 3.9% of the total population, are also an attraction for investment of Islamic funds. However, the UK has won because of the encouragement presented by its government and because the affluent Arab investor speaks English rather than French or German. Those that immigrate to France from North Africa are not capable of matching the investment potential of former British colonies in the Middle East. In addition, although Islamic finance presents a strong potential for France, key obstacles persist. Regulators in France must move to reduce bank protectionism, with legislation, and tax rules fitting without friction into commercial and banking law (Hassoune and Haladjian, 2008, pp. 2 – 3). A need exists for quantitative measurement of demand for Islamic banking in France and in other parts of Europe and because France is a Catholic country, a potent symbolic impact of Islam in France is a sensitive issue. Now there are more than 200 Islamic banks operating in 70 countries of the world and more than 50 Islamic insurance companies now operate in 22 countries around the world (Hassan, 2007, pp. 1 – 5). Islamic investment firms, leasing companies, mutual funds and commodity trading companies abound, and many of the larger Islamic banks engage with the markets multilaterally. Malaysia and Bahrain are the more important hubs of Islamic finance in the South-East Asia, and the Gulf Cooperation Council regions and Islamic finance presents continued signs of sustained growth from around the world. Regulation of Islamic Banking Ainley et al (2007, pp. 10 – 14) states that Financial Services and Markets Act 2000 (FSMA) (Regulated Activities) Order 2001 (RAO) requires all firms accepting deposits, advising on investments or carrying out contracts of insurance to apply to the Financial Services Authority (FSA) in the UK for permission. Under Section 19 of the FSMA, any person who carries out a regulated activity in the UK must be authorised or exempt, and a breach of this is a criminal offence. Thus, those operating or wanting to operate an Islamic bank must register with the FSA to undertake Islamic banking or other Islamic finance activities under FSA supervision. Ainley et al (2007, pp. 10 – 14) goes further to state that the FSA maintains a non-discriminatory regulatory regime that presents the same standards for all financial institutions in the UK, regardless of whether they are Islamic or not. The FSA does not present any obstacles, but there are no special favours. A credible business plan must exist and the following ‘threshold conditions’ are necessary for authorisation: Because the European directives present limits on the legal form for firms accepting deposits or indulging in the insurance business, it is necessary for all firms to present the right legal status for authorisation. The head office and ‘mind and management’ of firms incorporated in the UK for undertaking financial activities must be located in the UK. Any person or firm with close links to another person or firm will ensure that these links do not impede effective supervision. All those wanting to undertake banking or financial activities in the UK should have adequate funds to do so. All those wanting to undertake banking or financial activities in the UK should demonstrate that they are ‘fit and proper’ to conduct their intended activities in a sound and prudent manner. Thus, the quality of employees and shareholders should support the capacity for engaging in intended activities. Examples of Islamic Financial Instruments Robbins (2010), Zaher (2001) and Gait & Worthington (2007) suggest that the following are the more important Islamic financial products available today: Mudharabah: This is a profit-sharing contractual agreement between a financial institution, and an entrepreneur established according to a decided ratio for sharing of profits, and losses decided prior to commencement of business arrangement. Musharakah: This form of Islamic financing arrangement presents uses for project finance, real-estate purchases, letters of credit, and other investment projects and it is similar to Mudharabah, but offers equal management authority over ventures. Murabaha: This involves a financial institution buying an asset and selling it to a customer who makes either a single or multiple deferred multiple payment according to mutual agreement. Ijarah: This is Islamic leasing, which involves lease or transfer of ownership of service or an asset delivering service for a specified period in exchange for a pre-arranged consideration. Bai' Bithaman Ajil (BBA): This is a deferred payment sale or credit sale according to mutually agreed terms. Wadiah: The term “Wadiah” means custody in Arabic, and Wadiah involves an account holder keeping funds with a bank without entitlement for any rewards or interests. The bank guarantees providing sums on demand. Sukuk: These are the Islamic bonds with owners entitled to a share in sukuk revenues and proceeds of realisation of sukuk assets. However, issuers of sukuk do not have an obligation to pay interest and principal. Tawarruq: This involves buying a commodity from a bank or a financial institution and selling the commodity to a third party with repayment to the bank or financial institution over fixed time with inbuilt profit according to mutually agreed terms. Implications of Islamic Financial Instruments Aggarwal and Yousef (2000) state that because Islamic banks remain uncertain about returns for an investment, a tendency exists for these banks to avoid long-term financing to entrepreneurs seeking capital. In addition, Islamic banks maintain a preference for debt-like instruments rather than equity-like instruments and prefer an emphasis on collateral when providing funds. Because Islamic banks must face a prohibition on charging of interest according to Islamic law, a tendency exists for these banks to finance retail and trade in which goods are involved so that Islamic banks can exert control on goods to recover from any losses should things not go well with a commercial venture. Thus, Islamic banks remain less than inclined to finance ventures in the industrial and agricultural sectors because it is difficult to recover funds from such ventures if things do go wrong. Often, Islamic banks get the worst kind of entrepreneurs as clients who come to these banks because other banks turned them down, and a selection problem is apparent. It is important to remember that conventional banks are often more attractive to all types of entrepreneurs because these banks impose fewer non-pecuniary costs such as religious restrictions. El-Gamal (2003), agrees with the observation about prohibition of interest, or riba, in Islamic law and Islamic finance, but this work by a Muslim scholar laments that prohibition of interest on capital is paradoxical in the light of actual practices of Islamic financial providers over the past three decades. The bulk of Islamic financial practices formally bases rates of return or cost of capital provided on benchmark interest rates, such as the London Inter-bank Offer Rate ("LIBOR"). Clearly, those involved with providing capital according to the principles of Islamic finance are willing to enter profit and loss sharing arrangements, but they do not want to reduce their rates of return to below market or invest in schemes that offer them arbitrarily low returns as a matter of a norm. El-Gamal (2003) goes further to suggest that minority Muslim opinion has surfaced from time to time about the taking of interest as a matter of practical necessity and Ebusuud Efendi, the Mufti of Istanbul sanctioned this view, which received support from the Ottoman Sultan Suleyman between 1545 and 1574 C.E. However, this view about taking of interest as a matter of necessity received rejection from a majority of Muslim scholars around the Arab world, and the rejection prevented an emergence of a scholarly consensus to render this view contrary to Islamic law, the Shariah. According to El-Gamal (2003), Islamic auto-finance arrangements involving customers of Islamic banks negotiating a cash price for automobile assets for purchase by Islamic banks for sale to customers on credit were surprised to find that credit prices charged by Islamic banks included a pre-specified profit-margin (mark-up) that parallels the market interest rates for auto loans with similar characteristics. In addition, it is possible to observe the interest on the capital paradox in Islamic treasury bonds, or Sukuk, issued by such notable Islamic finance operators as the Bank Negara Malaysia and the Bahrain Monetary Agency, which present annual per cent profits with government guarantees. Thus, according to El-Gamal (2003, pp. 134 – 136), investment account holders in Islamic banks are exposed to significantly higher agency costs in comparison to those holding investment accounts in conventional banks because investment account holders in Islamic bank lack protection as primary claimants as creditors of the bank. In addition, investment account holders in Islamic banks lack representation on board of directors of the Islamic banks because board membership is for the wealthier owners of Islamic banks. Often, those that suffer most in Islamic banks are the depositors who usually get nothing for their hard-earned money, which is available to the Mullah for nothing by the working of a religious contraption devised by the Islamic scholars for their own good, to do as they please to enrich them. Thus, it is possible to argue that Islamic banking fools the Muslims in order to extort money and power for the Mullah by holding to ransom the masses under the guise of religion and Islamic banks present even greater usury by using devices that do not involve interest than conventional banks. After all, even the conventional banks must go to a court to recover amounts should debtors fail to pay and anyone, regardless of their religion, can approach a conventional bank for a loan without being told, “this money belongs only to the Muslim Mullah who has endured over the years to finally use his religion to enrich himself”. It is important to remember that the compassion of Christ is utterly lacking in Islamic and Arab cultures and in those that work with Islamic finance because they are accustomed to the whips and the swords of Mohammad. Chapra (2008), Hassan and Dridi (2010) and Mirakhor and Krichene (2009) present an examination of Islamic finance and the recent financial crisis. Chapra (2008) argues that excessive lending, acceptance of high risks and high leverage led to the financial crisis, which the Islamic banks avoided due to their prudent profit / loss sharing arrangements and aversion to risk. However, it is important to note that the stance of the Islamic banks resulted in injection of funds only in trading activities involving tangible goods, and lack of investments in any risky ventures involving science, technology development, agriculture, etc. presented detriment of the society. It is important to remember that Islamic societies have failed to develop even the less complex technologies in a competitive manner. The only technologies that have received attention in the Muslim world are defence technologies for which a necessity exists, and money is no object for such necessities. Thus, Islamic banks focus on trading in tangibles only with a passion for profiteering and this focus has impeded the progress of the Islamic world. Hassan and Dridi (2010) suggest that although Islamic banks were able to limit adverse impact on profitability in the year 2008, they were to present a large decline in profitability in the year 2009 but asset growth continued. This is again the result of a tilt in favour of investment in tangible goods investments and because of a lack of risk-taking in intangibles involving higher risk and higher yield, neither the society nor the banks benefitted as much as conventional banks. Thus, it will appear that far more sophisticated management strategies, financial engineering and project management are lacking in Islamic banks to their detriment and that of the Muslim world. Mirakhor and Krichene (2009) support the notion of Islamic finance supporting stability. However, without taking risks, it is impossible to fly and this means that innovation is utterly lacking in the Islamic world with its bankers making Muslims dependent on the non-Muslims for all innovations for which they pay from natural resources. As the natural resources become exhausted, it will not be possible for Muslims to continue to finance procurement of innovation and a real danger exists that Muslim societies will remain backward because they will have nothing to export. According to Picknett and Prince (2008, pp. 196 - 299) and Lyall (2008, pp. 142 – 144), when Jesus Christ whipped and threw out the moneychangers from the Temple in Jerusalem, he was not angry about charging of interest, but rather he was angry at the profiteering that moneychangers were indulging in. Like the Mullah, the Jewish Rabbi at the time of Christ had given religious sanction to exploitation of common people in the name of religion and the needless sacrifices of animals sold at exorbitant rates for a God who did not want these sacrifices. Moneychangers did not charge interest, but they profited enormously by exchanging currency at exorbitant rates. However, Islam permits huge profiteering, that is practised in the Islamic world with impunity and Islamic banks rip people off in every way possible while indulging in open discrimination. Thus, a dire need exists for financial innovation in Islamic banking to give something to the depositors, who are after all partners in business with banks, without exploiting them relentlessly and unashamedly in the name of religion at the behest of the Mullah who like his Jewish Rabbi counterpart in the days of Christ has used religion for personal gain. After all, if Mohammad claimed that he did not come to change anything from earlier prophets, including that which Christ put in place, how could he turn back the clock to accommodate that which Christ had already banished from Moses? The Sunnah (Acts) of Mohammad violates the Sunnah (Acts) of Christ in remarkable ways. If Mohammad is the most superior prophet, why did he receive revelations from angle Gabriel and did not talk directly to God, like Moses? If according to Khan (2012), the English translation of Shahi Bukhari, Volume 2, Book 23, Number 414, Mohammad accuses falsely Christians and Jews of burying their prophets in their places of worship, it is Mohammad himself and every notable Muslim who remains buried in a place of worship when the tombs of Christ and Moses remain unknown. Is the God of Christ the same as the God of Mohammad as questioned by Isaac (2002)? Unfortunately, an examination of Bushby (2012) suggests that a situation now exists in which the three followers of monotheistic doctrines do not agree on many things, except Satan, and this is something which is the work of God. Perhaps the essence is exploitation of people rather than charging of modest and affordable interest for delivering needs. Unfortunately, Islamic banks claim that they present superior management of leverage and exposure to risk, but they do this by denying investment and allocation of funds to areas in which investment is sorely needed by remaining confined to tangibles, while Western banks deliver despite the risks. It is unlikely that Islamic banks will invest in scientific research or technology development because their emphasis is on investment in tangible goods from which they will recover in any case, but Western banks do take the risks to deliver to the society, which benefits from risky investment for progress. Thus, Islam and Islamic banks maintain backwardness in society. Islamic banks have very limited investment in schemes for credit for entrepreneurial uplift of poor, aged or needy, but Western banks do have investments in this area also. Islamic banks are mere traders who want to get the maximum possible by dealing in tangibles while shunning all type of interest on funds. Conclusion In the light of the previous discussion, it is possible to argue that Islamic banking has presented substantial growth over the past few decades because of excess income available to petroleum exporting countries and efforts directed towards manipulating the religious zeal of Muslims. However, much more needs doing if Islamic banking is to offer the equivalent of compassion of Christ and worthy financial instruments that make economic sense while doing justice to everyone. It is possible to suggest that because Islamic banks chase profits like crazy, except for devising innovative means to obliterate interest, without any regard for morality, compassion or betterment of their society made possible only by taking risks, they do not serve humanity or Islam well. The backwardness of Islam is the failure to move on into the brave new world and Islamic banks contribute to the backwardness of Islamic societies. When one takes a plunge with due planning and care, one can fall but one can also soar to new heights and the art is in balancing risks with potential benefits to manage with sophistication. It is true that there were times when Muslims of means squandered fortunes in moral, ethical and progressive pursuits with a potential for bringing progress because their spirit moved them to do this but the modern Muslim only believes in screaming Money, Money and more Money. 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