ISLAMIC BANKING AND ITS IMPACT
RODNEY WILSON
Modern Islamic banking institutions first appeared on the financial scene in the 1950s with the establishment of farmer credit unions in Pakistan. Later in 1963 the Mit Ghamr Savings Bank, a small rural institution in Egypt, was founded. In 1971 it was incorporated into a new government-controlled institution, the Nasser Social Bank, which had the responsibility for the collection of zakat, the Islamic wealth tax.
However, the major expansion in Islamic banking came in the 1970s with the establishment of the Dubai Islamic Bank in 1975, the Faisal Islamic Banks in Egypt and Sudan in 1977, the Kuwait Finance House the same year, the Jordan Islamic Bank in 1978 and the Bahrain Islamic Bank in 1979. The impetus was partly the oil revenue boom in the Gulf and the growing economic muscle of the more conservative Muslim states of the Gulf.
Gulf business interests strongly supported the new Islamic banking movement. Prince Mohammed bin Faisal of Saudi Arabia was the instigator of the Faisal Islamic Bank. Shaikh Saleh Kamel’s Dallah group, based in Jeddah, aided the Jordan Islamic Bank and funded the Albaraka Islamic Banks, which spread from Turkey to Tunisia, and even to London. The Al-Rajhi money-changing group applied for an Islamic banking licence in Saudi Arabia, and offered Islamic financial services internationally through their London-based investment company. Prince Mohammed founded Dar al-Maal al-Islami, the house of Islamic funds, as an international financing institution based in Geneva.
The new Islamic banks had to compete with the conventional rite-based banks in most Muslim countries, but appear to have been particularly successful in attracting deposits. The Kuwait Finance House accounts for one fifth of total deposits in its home country, and the Jordan Islamic Bank has succeeded in attracting deposits from poorer people who had not previously used banks.
Islamic banking has now spread to Malaysia and Indonesia, and Bank Islam Malaysia has funded many promising industrial ventures, including those run by Chinese-speaking non-Muslims. Bank Muamalat Indonesia would appear to have enormous potential in a rapidly industrialising country with 160 million Muslims.
Some commercial banks have started offering Islamic banking facilities, including the state-owned banks in Egypt and the National Commercial Bank in Saudi Arabia. Even some European banks offer Islamic financial products, including Kleinwort Benson of London and the Swiss Banking Corporation. Islamic financial instruments are increasingly accepted internationally, even in non-Islamic countries, and the basic principles understood.
In Iran and Pakistan, the entire financial system was Islamised in the 1980s, and all banks in those countries operate under the Sharia religious law. Not only is riba prohibited, but all deposits are accepted on a participatory basis and financing is entirely through Islamic instruments. It is too early to assess the success of these experiments, as Iran’s economy was severely damaged in the lengthy war with Iraq, and Pakistan has been subject to political instability and ethnic tensions.
It is clear, however, that Islamic banking is no mere passing phenomenon. Ethical concerns are perfectly consistent with profitability, and the Islamic banks have been able to harness long-term savings on more favourable terms than secular institutions. The substitution of equity for debt finance is advocated by many development agencies. Participatory finance is especially suited for small businesses, and there is a venture capital gap in many Muslim countries.
Islamic finance can meet these needs, and provide a workable alternative to conventional lending. Of course, teething problems have inevitably occurred, but the experience so far is encouraging. The best motivation is moral rather than merely financial, and Islamic financial intermediation has been welcomed by many with considerable enthusiasm.
Islamic banking has become a $100 billion industry in terms of assets held. Yet this represents less than one per cent of bank assets world-wide. There is clearly considerable scope for expansion both in countries with majority Muslim populations and in the financial markets of West. At the retail level it should be possible for Islamic deposits to account for around one quarter of the total in the Gulf states, Jordan and Egypt by the year 2000. Progress in other Arab states such as those of the Maghrib may depend on political developments.
In Syria and Iraq, which at present have no Islamic banks, political factors will also be crucial. In the fastest developing Muslim economies, Turkey and Malaysia, Islamic banking is poised for expansion, with the increasing wealth of the Bumiputra in Malaysia providing much of the momentum. In Turkey there are no official impediments to Islamic banking, it being very much up to the banks themselves, the crucial factor being to convince the banking public through effective marketing.
Iran and Pakistan should see their Islamic financial systems developed, with a wider range of products on offer, and more emphasis on long-term equity financing. The Islamic Banking Law of 1983 has proved successful, as the banks have been able to maintain their deposit base in spite of the financial difficulties caused by the Iraq/Iran War and the fall in oil prices.
For Islamic banks, one of the major challenges will remain how to handle their liquidity. The banks have been more successful in attracting deposits than in identifying funding opportunities. Some have merely catered for their liquidity needs by redepositing funds with other institutions, including Western banks, which have undertaken to use the deposits in accordance with Islamic principles.
This may be satisfactory as a temporary expedient, but in the longer-term Islamic banks will want to handle more of the business themselves rather than passing it to other institutions. To do this they will need to build up their expertise and establish a wider range of business contacts, including those with non-Muslims in the West.
One major problem is the absence of an international market in Islamic financial instruments. A number of instruments have been issued in Pakistan and are traded within that country, including mudaraba certificates of Islamic investment companies, solidarity bonds of Islamic insurance companies, and participating term certificates. The latter were issued as a replacement for interest-based debentures and are based on the principle of profit-sharing, but in practice are less liquid than conventional bills or bonds.
For such instruments to be traded in international markets they would have to be sponsored and accepted by the major multinational banks. This would be feasible if there were a demand from governments in the Islamic world to finance their foreign spending through such instruments. Some criteria for performance would have to be worked out, such as growth in foreign exchange receipts as a proxy for national profits.
Countries could obtain funding from international markets on the basis of projected foreign exchange receipts, which would give an indication of ability to repay. The more favourable the projection for foreign exchange receipts, the more attractive would be the instruments for investors and the greater the country’s capacity to tap international markets.
If foreign exchange receipts were less than those projected, then a lesser amount or even no profit would be distributed to investors. If the foreign exchange receipts were higher than the amount forecast, then a profit rate above the benchmark would be paid. Clearly the forecast for foreign exchange earnings is crucial.
These forecasts could be provided by the Islamic Development Bank in cooperation with the International Monetary Fund to ensure international credibility. The mudaraba certificates could be issued for a period not exceeding five years, as forecasting foreign exchange receipts is difficult. As the aim must be to make the certificates attractive to international investors, it seems appropriate that new, untried instruments, should be issued for a shorter period than conventional bonds.
It is important to bear in mind that this type of mudaraba finance represents commercial funding, not foreign aid. Muslim countries such as Malaysia and Turkey are likely to benefit the most and states like Sudan and Bangladesh the least. This finance should not be seen as a substitute for development assistance, but rather as a way of attracting Euro market funds, which would not otherwise have gone into Islamic instruments.
The advantage is that the access to global capital markets is enhanced for those Muslim states that can best utilise international finance. Such states are not competing with poor Muslim countries for funding, but rather with non-Muslim newly industrialising countries in East and South East Asia and Latin America.
Participatory finance through musharaka was one of the earliest forms of Islamic finance, involving a partnership between the provider of the capital and the user or entrepreneur. Such financing was used widely and successfully in the Muslim world, usually for the funding of small businesses. Short Term trade finance was available through murabaha arrangements, but longer-term capital projects were funded through musharaka. There was usually a formal contract between the parties specifying the amount of the funding, the proportion of the profit shares, what would happen in the event of losses, and the terms of divestment.
Traditional musharaka can be looked upon as a type of venture capital financing, with relatively high risks involved for the provider of the funding. In this modern context the number of individuals who are in a position to provide musharaka financing is limited, although modern musharaka funding through equity market participation may have much smaller risks because of the ease of divestment.
If Islamic banks could liquidate their Musharaka investments they would be more willing to undertake this type of financing. Stock markets are underdeveloped in most Muslim countries. One possibility would be to have a parallel Islamic market run on more ethical grounds, but from a financial, and perhaps conceptual, standpoint, this is by no means straightforward. There has been some debate over the merits of having a specifically Islamic stock exchange, mainly in Malaysia, in the context of securing greater access to the financial markets for the Bumiputra.
Kuala Lumpur has by far the largest stock market in the Islamic world, but much of the trading is dominated by Chinese brokers dealing largely in the shares of companies with only a minority statutory Bumiputra stake. The debate has included proposals to Islamise the Kuala Lumpur stock market, which is regarded in some quarters as too speculative. There are also proposals to create an alternative Islamic market, while leaving the main market free to operate in its present form. Another more modest possibility is simply to introduce Islamic windows into the existing market, where equities would be vetted to see if they were halal from the point of view of the Islamic investor.
Given the lack of development of stock exchanges in much of the Islamic world, one option for Islamic investors is to simply place their funds in Western markets. There has of course been much recycling of oil revenues from Muslim oil-exporting countries since the 1970s, both official and private, although the oil price falls and the defence expenditure needs arising out of the Gulf war have eroded the official asset holdings of Saudi Arabia and Kuwait.
Private Arab investments in London, New York and other major international financial centres remain considerable, with these being channelled through commercial banks, investment companies and, to a lesser extent, unit trusts, or simply placed directly into equities and bonds.
There has also been capital flight from countries facing political uncertainties in the Islamic world, and often a natural desire to maintain hard currency earnings rather than repatriate funds into countries where rigorous foreign exchange controls are in force. The attraction of holding assets denominated in stable currencies has also kept funds in Western markets, especially from those countries with rapidly depreciating currencies.
In the last 10 years there has been an increasing demand by clients from Islamic countries and Muslim residents in the West to ensure that their funds in Western markets are placed and managed according to Sharia law. What criteria should Western investment management use if confronted with such demands, and from where should they get advice? There are of course numerous Sharia advisers versed in Islamic law who can be called upon to advise, although it is best to engage someone with an established reputation.
The other alternative is to enter an arrangement with an institution that already provides such services, through either a one-off deal, or alternatively on an ongoing basis if there is likely to be substantial continuing funding.
Constructing banking facilities for deposits on a mudaraba basis is relatively straightforward, as there are well-established procedures for profit-sharing. More difficulty is likely to be experienced in deploying the funding. However, murabaha mark-up trade financing is the most straightforward type of deal if suitable financing opportunities can be identified. The alternative is simply to redeposit the money Islamically with an institution used to working in this area.
In the Islamic world, pension provision is minimal outside the state sector, and most government schemes are funded on a current, rather than a capital, basis, with pensions being financed out of current contributions by the pensioners themselves and their employers on their behalf. The prospects for developing unit trust business are best where there are properly capitalised schemes with investable funds available, but with the exception of some of the Gulf States, notably Kuwait, this is seldom the case in Muslim countries. The absence of major private pension providers reveals a significant gap in the financial services sector throughout the Islamic world.
Insurance companies are often both unit trust providers and users in Western financial markets, but here again there is a deficiency in most Muslim states. The insurance market is under-developed, with few household policies, car insurance being the main consumer item. There are Islamic objections to life insurance, but no prohibition of other types of insurance business. Indeed, there are specific types of Islamic insurance provided under the takafol principal, which stresses the solidarity of the insured.
In practice, this means that Islamic insurance is best organised on a mutual basis, so that there is no question of profits being made out of policy-holders potential misfortune. The concern is that with a conventional PLC company, there is potential conflict between the interests of the insured and those of the shareholders, and that the management’s responsibility should be to the former rather than the latter.
Islamic insurance companies are free to offer unit trust products to their clients, but in practice none do, as all the companies are small, and most focus their efforts on the business market rather than a retail base of personal clients. Some simply obtain business from referrals by Islamic banks, rather than seeking business through their own efforts.
One way of enhancing business would be to seek custom from conventional banks offering Islamic financing windows or products, but as many of the Islamic insurance companies are wholly owned subsidiaries of Islamic banks, this may mean conflicts of interest. Within Islamic insurance, only a tiny proportion of an underdeveloped insurance market, prospects for encouragement of unit trust development from this source remain limited.
This survey of Islamic banking and finance illustrates how the institutions involved are attempting to provide a comprehensive service for the Muslim saver and investor, as well as potentially providing insurance and pension provisions. There is evidently a long way to go, but a considerable amount has already been achieved, and a solid basis has been laid for further developments.
Islamic finance has developed more instruments than any other type of ethical investment. There is much that those involved in the latter can learn from Muslim financial practices. As ethical savings and investment increase in popularity in the West, there is likely to be considerable synergy with Islamic financing.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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