ISLAMIC FINANCIAL AND BANKING SYSTEMS
HUSSAM
MUSA, ZDENKA MUSOVÁ
Abstract
Islamic financial and banking industry is a new phenomenon that has taken many observers by surpise. Islamic banks appeared on the world scene as active players over two decades ago. But „many of the principles upon which Islamic banking is based have been commonly accepted all over the world, for centuries rather than decades“. The industry lacks a unified Islamic banking authority although several competing associations are working on new regulations concerning Islamic financial accounting, lending standards and bank governance. This paper articulates the case for Islamic banking in a very comprehensive and effective manner. It depicts Islamic banking as a growing discipline adding more ethical, competitive and diversified tools and system into global finance.
Key words: Islamic banking, Islamic financing, interest-free
financing, profit-and-loss sharing, Riba.
1.
Introduction
The
last two decades have seen a mushrooming of Islamic banks - institutions
practicing a banking system - Islamic banking -which is consistent with shari'a (Islamic law) and guided by Islamic
economics. The heart of the system is the prohibition of collecting riba (interest or usury). The argument against
riba is that money is not
"goods" and that profit should be earned on goods and services only -
not on control of money itself (i.e., return on assets). Iranian professor of
economics Iraj Toutounchian considers
Western economic treatment of interest to be "dangerous and fatal,"
contributing to inflation, unemployment, recession and stagflation. However,
the real danger, from his perspective, is that in an interest-based banking
system the bank "would not necessarily know for what kind of activity the
loan is being used" (Toutounchian, 1995). One may question whether this
alleged danger has, in fact, to do with economics or whether it has more to do
with a regime that abhors personal choice of any kind.
Generally,
shari'a prohibits trading in financial risk
(gharar), as doing so is seen as a
form of gambling. Moreover, shari'a prohibits investing in businesses that are considered haram (not religiously permitted, in contrast to halal, which means religiously permitted), such as
businesses that sell alcohol or pork, or businesses that are engaged in
gambling or produce un-Islamic media.
Hadith
vs. Fiqh
Islamic scholars
distinguish between two parts of the Islamic law, the Hadith (traditions
attributed to Prophet Mohammad) and fiqh (Islamic jurisprudence). Mabid
al-Jarhi and Munawar Iqbal of the Islamic Development Bank (Jeddah, Saudi
Arabia) elucidate the distinction between the two parts of the law, as follows:
"As for the Hadith, the rule is clear cut: Gold for gold, silver for
silver, wheat for wheat, barley for barley, dates for dates, and salt for salt,
like for like, payment being made hand by hand. If anyone gives more or asks
for more, he has dealt in riba. The receiver and giver are equally
guilty."
The fiqh or fiqh
al-Muamalat (Islamic rules on transactions) refers to the whole corpus of
Islamic jurisprudence. In contrast to conventional (secular) law, fiqh
covers all aspects of life - religious, political, social, and economic. It is
based on interpretation of the Koran and, secondarily, on ijma
(consensus). While the Koran is immutable, fiqh verdicts may change due
to changing circumstances (IDB, 2001). This distinction is significant because
fiqh offers Islamic bankers a certain space for innovation and maneuvering
as they seek to design new financial instruments that are profit-making while
at the same time not conflicting with the rules of shari'a.
While borrowing per se is not prohibited by Islam, a
Muslim is reminded of Prophet Muhammad's warning: "Beware of borrowing -
it is a concern at night and a disgrace during the day." Hence, borrowing
needs religious and legal justification.
2.
The Rapid Growth of Islamic Banking
Islamic banking
institutions worldwide have grown at a remarkable pace since the inception of
the first such institution in Malaysia three decades ago. According to a study
by the International Monetary Fund, the number of Islamic institutions rose
from 75 in 1975 to over 300 in 2005, in more than 75 countries. Total assets
worldwide are estimated at $250 billion, and growing at about 15 percent per
annum (IMF, 2005). However, the size of Islamic banking assets of $250-300
billion should be considered in perspective. The three top banking groups in
assets in 2005 were UBS of Switzerland ($1,533 billion); Citigroup of the U.S.
($1,484 billion); and Mizuho Financial Group of Japan ($1,296 billion). Bank of
America, ranked tenth among the top banking groups, has assets of $1,110
billion, which are 400 percent greater than the assets of all Islamic
institutions.
Islamic banking is
expanding beyond Arab and Muslim countries. The vast liquidity in the oil
exporting countries, particularly the six member countries which make up the
Gulf Cooperation Council (Saudi Arabia, United Arab Emirates, Qatar, Oman,
Bahrain and Kuwait) is attracting a lot of bankers and borrowers who are
prepared to adhere to the Islamic restrictions on the use of capital. Adnan
Yousef, Executive Director of al-Baraka, the largest Islamic banking group,
expects the Islamic banks share of banking activities in the next decade to
rise up to 50 percent of all bank activities in the Arab world. In the United
Arab Emirates, which is considered a hub for Islamic banking, the number of
Islamic banks has increased from one to six banks in six years (www.alarabiya.net).
3.
Financial Vehicles of Islamic Banking
The financial vehicles of
Islamic banking are numerous, but the most commonly used are those with
reference to wadi'ah (safekeeping), mudharabah (profit sharing), murabahah
(cost plus), ijarah (leasing), qardh al-hassan (benevolent loan),
and musharakah (joint venture).
Wadi'ah (Safekeeping)
The Wadi'ah
(safekeeping of funds) is of two categories: The first category is the current
account which, as in conventional banking, gives no return to depositors. It is
essentially an arrangement between depositors and banks which allows depositors
to withdraw their money at any time but permits the banks to use depositors'
money in pursuit of their banking operations. The second category is the savings
account, which is also operated on Wadi'ah basis, but the bank may
at its own discretion pay the depositors a positive return periodically in the
form of hiba (gift), depending on its own profitability. In this case,
the bank compensates depositors for the time-value of their money (essentially
interest payment), but refers to it as hiba because there is no a
priori guarantee of benefits. The Bahrain Islamic Bank, for example, offers
depositors in saving accounts "an annual rate of return based on what
Allah has granted in the form of profits" (www.bahisl.com).
Mudharabah (Profit Sharing)
The mutharabah can be defined as contract between at least
two parties whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or
venture. This type of contract is in contrast with musharaka. In arrangements
based on musharaks there is also
profit-sharing, but all parties have the right to participate in managerial
decisions. In mudaraba, the financier
is not allowed a role in management of the enterprise. Consequently, mudaraba represents a PLS contract
where the return to lenders is a specified share in the profit-loss outcome
of the project in which they a stake, but no voice. In interest lending,
the loan is not contingent on the profit or loss outcome, and is usually
secured, so that the debtor has to repay the borrowed capital plus the fixed
interest amount regardless of the resulting yield of the capital. Under mudaraba, the yield is not guaranteed in
profit-sharing and financial losses are borne completely by the lender. The
entrepreneur as such losses only the time and effort invested in the
enterprise. This distribution effectivley treats human capital with equally
financial capital.
Murabahah (Cost Plus)
Murabahah is
the Islamic verion of a just or equal profit where no one is hurt nor
damaged during business transactions. I tis one of the alternatives for
a just monetary system. Murabahah is a cost-plus contract in which
a client, wishing to purchase equipment or goods, requests the Islamic
bank to purchase the Items and sell them to him at a cost plus declared
profit. By this technique a party needing finance to purchase ceratain
goods gets the necessary finance on a deferred payment basis. The finance
provider does the purchasing of the required goods and sells them on the basis
of a fixed mark-up profit, agreeing to defer the receipt of the value of
the goods even though the goods can delivered immediately. The need for finance
of the one in need is thus met.
This
financing technique is sometimes considred to be the same as interest, however,
in theory, the mark-up is not in the nuture of a compensation for the time
or deferred payment, even though the entire cost had to be incurred because the
needy person did nt have at hand to make the purchase he wanted. Rather, the
mark-up is for the service that the finance owner provides, namely, seeking out
and locating and purchasing the required goods at the best price.
Ijara (Leasing)
Ijara, also known as ijara
waqtina (lease and purchase), is a leasing contract whereby a party leases
an asset for a specified rent and term. The owner of the asset (the bank) bears
all risks associated with ownership. The asset can be sold at a negotiated
market price, effectively resulting in the sale of the ijara contract.
The ijara contract can be structured as a lease-purchase contract
whereby each lease payment includes a portion of the agreed asset price and can
be made for a term covering the asset's expected life. Such contracts are also
common in real estate transactions in the United States (El Qorchi, 2005). This
system is disadvantageous for the buyer, who is unable to refinance a property
he lives in at more favorable terms because it is registered in the name of the
bank. Such a restriction if applied to the U.S. real estate market would have
enormously negative economic consequences for the entire real estate sector.
Qardh al-hassan (Benevolent Loan)
This is a loan extended
on a goodwill basis, wherein the debtor is required to repay only the amount
borrowed. However, the debtor may, at his discretion, pay an extra amount
beyond the principal amount of the loan (without promising it) as a token of
appreciation to the creditor. Muslims consider this type of loan to be the only
type that does not violate the prohibition on riba because none is
promised or paid.
Musharakah (Joint Venture ): The Rising Importance of Sukuk
Musharakah is a form of
an equity participation contract under which a bank and its client contribute
jointly to finance a project. It is done through the issuance of
"Participation Securities," commonly referred to as sukuk or
Islamic bonds. The sukuk is becoming so lucrative that many banks are
rushing to set up shari'a-compliant operation. With abundant
oil-windfall revenues and with many mega infrastructure projects which are
either underway or on the drawing board, the Gulf is fast becoming the logical choice
of new and established players alike to set up shop.
Over the past five years
the sukuk market has grown to $41 billion, with $11 billion coming from
the Gulf countries. According to Khalid Yousef, director of Islamic Finance at
Dubai International Financial Center, the Gulf countries are likely to issue
another $9 billion of new sukuk in the next six months (The Financial
Times, 11.7.2006). For example, SABIC, the Saudi petrochemicals group, has
announced the issuance of up to $800 million of sukuk. The issue was
quickly over-subscribed, which caused the lead managing bank, HSBC, to limit
the amount of each sukuk to $13,300.
The issuing of sukuk continues
to expand. While Malaysia and the United Arab Emirates lead the Muslim world in
this regard, there are a growing number of issuers in the non-Muslim world.
There are several recent examples:
-
East Cameron Partners. It is the first American firm to issue a sukuk
for $166 million for gas drilling in Louisiana offshore
-
Saxony-Anhalt State (Germany) issued a sukuk for 100 million Euros
-
The World Bank issued its first sukuk for 760 million Malaysian ringgit
($202 million)
-
The Japanese International Bank is scheduled to issue sukuk for
$300-500 million to tap petrodollar before the end of the year.
Sukuk are also beginning to
attract foreign investors who represent, according to Neale Downers, partner at
Trowers & Hamlin, of the U.K., "an increasingly dominant segment of
the market for Islamically-compliant debt." These investors are now comfortable
buying corporate sukuk, and not just those issued by sovereign borrowers
(government). (The Financial Times, 18.9.2006)
Characteristics and Benefits of Sukuk
The issuance of
international sukuk is a significant mechanism for raising money in the
international capital markets. Unlike other Islamic banking vehicles, sukuk have
unique characteristics and offer significant benefits:
-
They are tradable in secondary markets
-
They are assessed for quality by international rating agencies, as are
all other conventional financial instruments before their issuance
-
They offer a regular income stream and a possibility of capital
appreciation (www.noriba.com).
4.
Western Banks Adopt Shari'a Rules
With so much business
potential and high liquidity in Gulf countries, coupled with a rising demand
for Islamic banking instruments from a growing Muslim population in European
countries, it is understandable that many Western banks are gearing up to take
advantage of opportunities and to provide tailor-made services to new
clientele. Examples:
-
Lloyds TSD (U.K.) announced in June 2006 that it would be offering
Islamic financial services in all its branches in the U.K. "From today,
Britain's two million Muslims will have access to current accounts and
mortgages which comply with Islamic law (sharia), in every one of the
Bank's 2000 branches." (www.earthtimes.org).
-
In 2006, Deutsche Bank opened an "Islamic Window" - or a
dedicated pool of money for its Islamic business, headquartered in London but,
according to The Financial Times, "strictly ring-fenced from the
rest of the bank."
-
Deutsche Bank announced, also in June 2006, that it acted as a joint
bookrunner for $500 million of sukuk securities for the Islamic
Development Bank (IDB), headquartered in Jeddah, Saudi Arabia. Firas Chakra, a
director at Deutsche Bank, said "This Trust Certificate issuance Programme
by IDB is the first of its kind, and will be a key driver of the further
development of Islamic financing on a global basis by successfully introducing
Islamic financing transactions to the international investor base." (www.db.com).
-
In June 2005, Dow Jones Indexes, New York, and RHB Securities, Kuala Lampur
(Malaysia), teamed up to launch a new "Islamic Malaysia Index"-a
collection of 45 stocks representing Malaysian companies that comply with a
variety of shari'a-based criteria.
-
In April 2006, Dow Jones and Citigroup Corporate and Investment Bank
launched the Dow Jones Citigroup Sukuk Index, which seeks to measure
their global performance in complying with Islamic investment guidelines. It
was created primarily for use as the benchmark for investors seeking exposure
to Shari'a-compliant fixed-income investments.
-
In September 2006, Islamic Bank of Britain, the first Islamic bank in the
U.K., will start operating in the city of Birmingham.
Political Support for Islamic Banking
Support for Islamic
banking is also being offered by Western governments. In a speech at the Muslim
Council of Britain, Gordon Brown, the Chancellor of the Exchequer, declared his
ambition to make Britain "the gateway to Islamic finance and trade."
In the same speech, Chancellor Brown said, "As the hadith
[teachings] from the prophet Mohammed said, the umma [community of
Muslims] is like a body. When one part of the body feels pain, every other part
feels pain." (www.earthtimes.org).
The Financial Times wrote a few months later that Brown opened
his speech with the traditional Muslim greeting of "Asalaam aleikum,"
enunciating the greeting very slowly "as he feared offending with a
mispronunciation." However, The Islamic Banker, which also reported
the speech, added ominously: "To the militant Muslims, this flirtation
between the West and Islamic banking is a way of 'colonizing' Muslim money with
the banking major acting as willing conduit." (The Islamic Banker,
5-6/2006).
In a speech delivered on
March 2, 2005 before the "Seminar on Legal Issues in the Islamic Financial
Services Industry," Thomas C. Baxter, Jr., Executive Vice President and
General Counsel of the Federal Reserve Bank of New York, offered a number of
interesting remarks. As a general rule, the U.S. law is "broad enough to
encompass shari'a compliant structures." Practitioners can produce
products that simultaneously satisfy the demands of secular and religious law.
This is so because the U.S. law is silent on matters of religion and because
the common law tradition of the Anglo-Saxon legal system is flexible and adaptive.
The challenges facing U.S. and Western regulators is to accommodate the free
exercise of religion and still carry the secular mandate of fostering safe and
sound practices in the banks that they supervise. Mr. Baxter gave a number of
examples of a number of U.S. banks which have opened special windows for shari'a-compliant
banking activities as a trend for the future.
Singapore is also seeking
to become a hub for Islamic banking. To that effect, the minister of finance
promised to align the tax policy in the treatment of Islamic contracts with the
tax treatment of conventional financing contracts to which they are
economically equivalent. (The Islamic Banker, 3-4/2006)
5.
Criticism of Islamic Banking
Some Muslim critics
maintain that the Islamic banks hide the payment of interest behind legal
tricks. They compare Islamic banking to "contractum trinium" - a
legal trick designed by European bankers in the Middle Ages intended to allow
the charging of interest for borrowed money, which was against Church teachings.
The trick was in the form of three different contractual agreements, which in
and of themselves were not prohibited by the Church .
Islamic economic
institutions connected with Islamic banking claim to operate on the basis of
"zero interest." Critics of Islamic economics argue, however, that
the fundamental characteristic of charging interest (.e.g., charging a premium
on the principal amount of the loan, for the time value of the loaned money) is
not truly eliminated in Islamic banking but is merely hidden and relabeled. The
Financial Times, drawing upon the book Islamic Banking - A $300 Billion
Deception by Mohammad Saleem, a disillusioned former adviser to Islamic
banks, refers to many of these practices as "financial smoke and
mirrors." (Saleem, 2006). But the
most cogent comment came from Shahid Malik, a Member of British Parliament.
Writing in The Times, Malik told his Muslim co-religionists, "If
you want sharia law, you should go live in Saudi Arabia.
There remain differing
interpretations of the religious principles behind Islamic finance - a problem
that could impede the development of a uniform, global market for Islamic debt
securities. The case of the World Bank sukuk mentioned earlier
underscores the difficulty of defining a no-interest-bearing bond. The
underlying transaction for the World Bank bond is a complicated one and
involves the purchase and sale of a financial asset, akin to a certificate of
deposit. In Malaysia, where the bond was arranged, this transaction was deemed
shari'a-compliant. But some Middle East bankers said the World Bank issue
met none of the shari'a criteria because they felt it was based on the
purchase and sale of money itself, rather than a shari'a-compliant
asset. Nevertheless, the sukuk, priced at a profit rate of 3,58 percent,
well below the equivalent U.S. Treasury rate, was almost twice oversubscribed.
(WB, 2005). In short, in the absence of uniformly accepted standards governing
the practices of Islamic banking, the risks of certain deviations from appropriate
banking standards cannot be ignored.
The dilemma for religious
Muslims is seen through the predicament of a Kuwaiti woman who sought a fatwa
from Sheikh D. 'Adel Mubarak al-Mutairat. The woman tried to deposit money in
her checking account in the ladies' branch of the Islamic Ahli Bank but, alas,
she found it closed. What was she to do? Here is the fatwa: "Depositing
money in a checking account in an interest-paying bank is all right. But, in
your case, there is an Islamic bank for men only. You should go there with your
guardian to deposit your money." (www.ftawa.ws).
Financial instruments are rated
by a variety of rating agencies which focus on the credit risk of such
instruments and the expected loss on each investment relative to its promise.
Moody's, one of the key rating agencies, points out that "Shari'a
or Islamic law adds an extra dimension to the legal analysis that needs to be
considered if there is possibility that its inclusion will have a material impact
on the credit risk profile" of the instrument. (www.ameinfo.com). In other words, an Islamic
financial instrument, such as sukuk, introduces exogenous factors in the
rating methodology which are not encountered in the case of financial
instruments issued by traditional commercial banks or corporations.
Conclusion
A study by the
International Monetary Fund has highlighted the complexity of designing
market-based instruments for monetary control and government financing
"which satisfy the Islamic prohibition on ex-ante interest payments, and
provide for a sharing of profits and losses on underlying transactions."
The primary complexity is methodological - computing appropriate profits and
rates and of return. This is particularly the case when projects, such as
highways, which are considered public goods, but whose costs and benefits are
often variable.
There is also the broader
question about the capacity of the Islamic economic model to survive in the age
of globalization. The Organization of European Cooperation and Development
(OECD) suggests, for example, that "Increasing integration of world
markets and the interdependence of national economies are leaving less and less
room for idiosyncratic institutions or economic policies" (OECD Observer,
2000). Chances are that Islamic banking will survive, and even grow, because it
provides a national identity for the millions of Muslim citizens and immigrants
in Western countries who may feel otherwise threatened by rising anti-Muslim or
anti-immigrant sentiments.
References:
Ing. Hussam Musa, PhD., Department of Finance and Accounting, Faculty of Economics, Matej Bel University, Basnká Bystrica, 048/446 6317, hussam.musa@umb.sk
Ing. Zdenka Musová, PhD., Department of Corporate Economics and Management, Faculty of Economics, Matej Bel University, Basnká Bystrica, 048/446 2724, zdenka.musova@umb.sk