Islamic banking is an interest-free banking system which emerged on the global scene barely four decades ago.
The Islamic banking business has emerged as an ethical banking system which is designed to cater for the interests of about a quarter of the world’s population.
Islamic banks engage in three major services: free services; services rendered by banks on fixed exchange, commission, or discount; and creation and development of funds.
The crystallization of the Islamic banking system in the 21st century has made it a force to be reckoned with to avert any future global economic crunch.
As an alternative banking system, Islamic banking emerged in the global landscape with the advent of Islam. This form of interest-free banking has developed over a long period of time with the introduction of new products in the industry. The crystallization of interest-free banking based on Islamic legal principles has won a positive global image for Islamic banking in the modern world. The underlying philosophy in Islamic banking is to facilitate financial intercourse and spur symbiotic commercial relations that will ultimately bring benefit to the parties involved. One must work for whatever he or she earns in the long run. According to Rodney Wilson, “The Islamic banking industry has grown rapidly since the 1970s, reflecting the demand by pious Muslims to manage their finances in a way that avoids interest and complies with Islamic law” (Wilson, 2006). This emerging discipline of banking business in the modern world has reached a crescendo where it has become a force to be reckoned with in the global banking business. The best practices in the Islamic banking industry are worth exploring with a view to harmonizing practices in global banking to strengthen the world economy.
It is, however, important to emphasize that Islamic banking and Islamic finance are two inextricable disciplines in Islamic commercial law, but it is believed by most experts that the former is a subset of the later. Meanwhile, the global banking business needs several alternative banking models in order to cushion the effects of economic meltdown that may arise in the future. The experiences of Islamic banking in Muslim countries as well as Muslim-inhabited countries in Europe and America have been very encouraging, even though some problems were encountered at the outset (Hassan, 1999). The emergence and development of Islamic banking in the modern world has witnessed dramatic changes, especially in the recent global financial plummet. As an urgent step toward cushioning the effects of the global financial crisis, American International Group Inc. (AIG) had to offer Islamic insurance to the United States. This was after it had earlier reached two major bailout agreements, worth US$152.5 billion in taxpayer dollars. As a further move to step up its deals, AIG has established subsidiaries in some Muslim-majority countries such as Bahrain, Malaysia, and the United Arab Emirates. It is axiomatic to observe that Islamic insurance (takaful) is an aspect of Islamic finance which was one of the Islamic financial mechanisms embraced during the troubled times that engulfed most financial-cum-insurance heavyweights in recent years.
Emergence of Islamic Banking
Although Islamic banking was practiced during the classical period, the modern experiment of profit and risk-sharing business, which is the cornerstone of Islamic banking business, was first undertaken in 1963 in Mit Ghamr, a city in the Nile Delta in Egypt. “Its purpose was to explore the possibilities of mobilizing local savings and credits as an essential requirement for socioeconomic development in the area.” (El Naggar, 2005). The ripple effects of this successful experiment were felt in some other Muslim countries after some years. “Few years before the bank consolidated its services in 1981, other banks such as the Islamic Development (IDB) and Dubai Islamic Bank opened their doors to customers in 1975. Also, Malaysia followed suit with the enactment of the Islamic Banking Act 1983. This brought about the establishment of the first formal financial institution in Malaysia in 1983 known as the Bank Islam Malaysia Berhad (BIMB)” (Oseni, 2009). The Islamic banking and finance industry has continued to grow in leaps and bounds over the years. The industry grows at a rate of 10–15% per year (Khan et al., 2007). It is now the fastest-growing segment of the global financial system, with the unremitting establishment of Islamic banks in the Muslim world and beyond.
What is Islamic Banking?
In simplified form, Islamic banking and finance can be defined as “banking and finance in consonance with the ethos and value system of Islam. Hence, it is governed, in addition to the conventional good governance and risk management rules, by the principles laid down by the Islamic Sharī’ah” (Ayub, 2007). In a similar vein, it has been described as “a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Sharī’ah (Jurisprudence) and forbids of the receipt and payment of interest on any of its transaction” (Islam, 2006). This is the nature of the Islamic banking business. Although interest is proscribed in Islamic banking business, there are specific avenues through which the bank gets its returns. One may wonder how Islamic banks make profits and ensure that they stay in business. In general, banking services can be classified into three categories: free services; services rendered on fixed exchange, commission, or discount; and the creation and development of funds. In Islam, free services are part of the role of banks, so they are required to render this service as part of their customer care service, which is in line with the spirit of Islamic commercial transactions (for example, benevolent loans without interest). The second category of services, which attract some sort of commission, fixed charge, or fee, is considered an important source of income for banks. Therefore the sources of funding for Islamic banks are mainly owner’s equity, deposits, and special funds. This is illustrated in Table 1.
|Sources of funds||Use of funds|
|1. Owner's equity } = Total fund|
|2. Deposits } (a) Current account||1. Deployment of funds (a) Qard al-hasanah (i) Overdraft } = Where PLS method is not possible (ii) Cash credit application } (iii) Demand loan (iv) Priority sectors, individuals, and the poor|
|(b) Profit/loss sharing accounts||(b) Profit/loss sharing investments (i) Equity financing (ii) Leasing (iii) Hire purchase (iv) Normal rate of return|
|(c) Direct investment by banks (i) Bank’s own projects (ii) Investment auctioning (iii) Commodity trade (iv) Spot transaction in foreign exchange (v) Bai-muajjal (vi) Bai-salam (vii) Discounting equity|
|Special 3. (a) Zakat (c) Social welfare fund||2. Zakat (a) Charity to target groups (b) Project for eligible target groups|
Why the Islamic Banking System?
The Islamic banking system is unique, with its own features. Even though some of the products look similar to conventional modes of finance, there is a need for an alternative banking system to suit the needs of Muslims and non-Muslims alike who prefer the interest-free option. The global banking system must have alternatives for all sorts of customers with different religious and sociocultural backgrounds. Against this backdrop, the Islamic banking business has emerged as an ethical banking system that is primarily intended to cater for the interests of about one-fourth of the world’s population. The universal welfare and profit and loss sharing principles of Islamic banking are meant for humankind. The need for Islamic banking in the modern world cannot be overemphasized. “Modern businesses need huge amounts of funds, while people at large have mostly small savings. This necessitates the presence of such financial intermediary institutions through which business needs can be directly and indirectly fulfilled with savers’ pooled money in such a way that savers/investors can also get a just return on their investments and business and industry can get the funds required for ensuring a sufficient supply of goods and services for the welfare of mankind” (Ayub, 2007). This is the value-added feature of Islamic banks that makes them a socially responsible financial intermediary within the economy.
Essential Requirements for Islamic Banking
The Islamic banking system is an integral part of the Islamic economic system. Provided that certain key requirements are complied with, Islamic banking can be established in any part of the world. Hussain Lawai identified nine essential requirements for a successful Islamic banking system. According to him, for a successful Islamic banking system, there must be: a supportive legal framework and swift judicial system; disciplined entrepreneurship; a conceptual change from credit risk to overall risk management; strong ethical values; a Supreme Shariah Council; uniform accounting standards, committed management, and a progressive and modern outlook; and a body to evaluate Islamic financial institutions (Lawai, 1994). The principles of Islamic banking as contained in the Qur’an and the Sunnah are summarized thus: any predetermined payment over and above the actual amount of principal is prohibited, and the lender must share in the profits or losses arising from the enterprise for which the money was lent (except in benevolent loans). Making money from money is not allowed since it is a mere medium of exchange that has no value in itself, transactions involving gharar (deception) and maysir (gambling) are prohibited, and investments should only support practices or products that are not forbidden or even discouraged by Islam (Ahmad and Hassan, 2007).
Brief Overview of Modes of Financing in Islamic Banking
There are numerous modes of financing in Islamic banking. Many more products are being certified periodically by the shariah advisory councils of the banks to meet the modern challenges posed by the conventional banking system. The modes of financing in Islamic banking are based on certain terminologies introduced by Muslim jurists. Although it may not be necessary to examine each of the modes of financing in Islamic banking, it suffices to give an overview of some of the notable modes of financing. Table 2 gives a general outline of some basic terminologies in Islamic banking upon which the modes of financing are built.
|Amanah (Demand deposits)||Deposits held at the bank for safekeeping purposes. Their capital value is guaranteed and they earn no return.|
|Bay mu’ajal (Predelivery, deferred payment)||The seller can sell a product on the basis of a deferred payment, in installments or in a lump sum. The price of the product is agreed upon between the buyer and the seller at the time of the sale and cannot include any charges for deferring payment.|
|Bay salam (Prepayment, deferred delivery)||The buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date.|
|Ijarah (Lease, lease purchase)||A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.|
|Istisna’a (Deferred payment, deferred delivery)||A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to bai salam). It may be paid in installments or part may be paid in advance with the balance to be paid later, based on the preferences of the parties.|
|Ju’ala (Service charge)||One party pays another a specified amount of money as a fee for rendering a specific service in accordance with the terms of the contract stipulated between the two parties. This mode usually applies to transactions such as consultations and professional services, fund placements, and trust services.|
|Kafalah||A pledge given to a creditor that the debtor will pay the debt, fine, or liability. A third party stands surety for the payment of the debt if unpaid by the person originally liable.|
|Mudarabah (Trustee finance contract)||The Rabb-ul-mal (owner of the capital) provides the entire capital needed to finance a project, while the entrepreneur offers his or her labor and expertise. Profits are shared between them at a certain fixed ratio, whereas financial losses are exclusively borne by the rabb-ul-mal. The liability of the entrepreneur is limited only to his/her time and effort.|
|Murabahah (Markup financing)||The seller informs the buyer of his or her cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.|
|Musharakah (Equity participation)||The bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project. Profits (and losses) are shared strictly in relation to the respective capital contributions.|
|Qard hasana (Beneficence loans)||These are zero-return loans that the Qur’an encourages Muslims to make to the needy. Banks are allowed to charge borrowers a service fee to cover the administrative expenses of handling the loan. The fee should not be related to the loan amount or maturity.|
Best Practice: The Crystallization of Islamic Banking
It goes without saying that best practice in the Islamic banking industry must be standardized and universalized with a degree of benchmarking. The development of the Islamic banking system has demonstrated its potential to be used as a viable global financial intermediary (Siddiqi, 1988). The sustainable and profitable practice of Islamic banking is based on ethical norms of Islamic financial transactions (fiqh mu’amalat). The banking operations have “positive socio-economic implications through real sector development and just and equitable pricing policies, in addition to cost efficiency and profit adequacy” (Ayub, 2007).
Making it Happen
The Islamic banking business is becoming more complex, with new products appearing from time to time. Stakeholders in the Islamic financial industry must face the challenges headlong if contemporary demands are to be met. The process begins with the introduction of a robust legal framework to strengthen Islamic financial houses.
The regulatory challenges posed by the Islamic banking business must be addressed to further enhance the productivity of the business.
The duties of the shariah advisory councils should be properly defined to ensure the efficiency of their work.
A proper framework must be formulated to ensure a sustainable means of dispute resolution for the banks. Legal reforms may be required here to further streamline practices in the industry.
Amicable resolution of disputes arising from customer–banker relationships should be encouraged, backed up by an arbitral tribunal of industry experts.
Support should be given to a degree of standardization in the Islamic banking industry through uniform practices that are generally agreed by Muslim jurists and experts in the field.
Care should be taken to see that products are genuine and do not simply mimic conventional products.
With the gradual shrinking of world banking toward a global hamlet, it is important to emphasize the growing need for the recognition of more Islamic banking products to prepare for the likelihood of any future economic crunch. The crystallization of the Islamic banking business in the 21st century has made it a force to be reckoned with in the world economy. The Islamic banking business is not only meant for Muslims; non-Muslims have patronized Islamic banks as shareholders and customers in many countries across the world, and many are still transacting business with them. The recent global economic crunch, and the quick adoption of some Islamic finance products by some giant corporations, is an important example of the dire necessity and unfeigned relevance of Islamic banking and finance in global finance. Islamic banking has indeed survived the test of time as a viable global financial intermediary in the world economy.