OVERVIEW OF ISLAMIC BANKING AND FINANCE
DAPHNE BUCKMASTER
1. What is Islamic Banking and Finance?
Islamic banking and finance is part of the broader concept of Islamic economics, one aim of which, as suggested by Islamic scholars, is the introduction of the value system and ethics of Islam into the economic sphere. Because of this ethical foundation. Islamic banking and finance for many Muslims is more than a system of mere commercial transactions. Following Islamic precepts in financial transactions is viewed by many as a religious obligation. The ability of an Islamic institution to attract investors successfully may depend not only on the profitability of that institution, but also on the perception that the institution faithfully observes Islamic religious restrictions.
The central feature of the Islamic banking system is the prohibition in the Qur’an of the payment and receipt of riba, or interest. A closely related principle set forth in the Qur’an is the prohibition of gharar, or speculation. Both of these prohibitions were extended and elaborated on by the Prophet Muhamma d through the Sunnah. The Qur’an, which is the Islamic holy book, and the Sunnah, which are the deeds, statements and unspoken approvals of Muhammad, are the two main sources of Islamic law, commonly referred to as the Sharia.
Although riba in a broad sense means any unlawful advantage by way of excess or deferment, in the context of financial transactions it is commonly understood to mean any form of interest. In recent years, there has been an attempt on the part of some Islamic law scholars and Islamic financial institutions to re-examine interest, or usury. That debate now appears to be over, however, and the prohibition of riba continues to be viewed as a prohibition of all interest.
The underlying policy behind the prohibition of gharar is the protection of the weak against exploitation by the strong. This policy has led to the formulation of a rule of general application to the effect that all transactions should be devoid of uncertainty and speculation. Islamic jurists believe that this objective can only be achieved if the contracting parties have complete knowledge of the terms of the transactions in which they engage.
The Islamic financial system rejects the concept that a borrower is liable for the repayment of the funds borrowed and a predetermined return on those funds, regardless of the performance of the borrower’s business. Under the Islamic system, this rejection of interest is replaced with the concept that the lender is to assume the risks of the borrower’s business and share in the profits and losses of that business. Money is not considered to be capital on which a return may be obtained, but only “potential capital” requiring the services of an entrepreneur to put it to actual productive use. The lender who advances money for trade or production can only contract to receive a share of the profit, because he is just a part owner of the enterprise’s capital and has to share in the risk of the enterprise. Put simply, the Islamic financial system replaces debt financing with equity financing.
All the traditional Islamic financial instruments derive their legitimacy and validity under Islamic law from the fact that either the Prophet himself adopted them or they were in practice in his time and he either expressed his approval of them or did not prohibit or make any changes in them. Hence, the preferred Islamic investment vehicles of mudaraba and musharaka have been specifically approved. Likewise, other instruments such as ijara and murabaha, rely on similar authority for their validity under Islamic law.
In subsequent years, Islamic jurists analysed the transactions approved or disapproved by the Qur’an and Sunnah in an effort to determine those interests which the Sharia sought to ensure and those practices that were to be avoided. This methodology has enabled Islamic jurists to work out the details of the instruments that were prevalent during the time of Muhammad (Pbuh). Most importantly, this methodology provided a mechanism whereby Islamic law could keep pace with changing times. It is important to note that in its application to business and finance, the Sharia recognises change and, as a policy, encourages flexibility and commercial practices, provided those practices are consistent with certain broad limitations.
2. The Islamic Financial Market
Today, some commentators estimate that Islamic financial institutions are present in more than 45 countries. The amount controlled by these institutions is estimated to range from $50 billion to over $100 billion. Although Islamic institutions are concentrated in the Middle East and Africa, there is a growing Islamic banking presence in South East Asia and Sub-Saharan Africa. Islamic financial institutions have also made an appearance in Europe and North America.
The amount controlled by Islamic institutions, while large in absolute terms, is moderate in comparison with the total financial resources of the regions in which they operate. It is sometimes suggested, perhaps unfairly, that Islamic financial institutions have not been as successful as they could be in tapping the Islamic market. Modern Islamic finance is a relatively recent phenomenon, and its growth has come in the context of a world financial system that is interest-based. Undoubtedly, a significant portion of the Islamic population has reconciled its religious beliefs with the interest-based banking system and views Islamic banking as just another investment alternative that may not be consistent with its financial objectives. But what are some of the reasons that Islamic financial institutions have not been as successful as they might be in attracting funds from the population that would prefer to invest its funds in an Islamically acceptable manner?
Perhaps the most significant reason is the doubt held by some investors that the financial investments offered by Islamic banks truly comply with Islamic requirements, in substance as well as in form. For example, when Pakistan officially converted to an Islamic financial system, the banks in Pakistan simply changed the terms applicable to their transactions and began to charge a “mark-up” rather than “interest”. Th e resulting scepticism of the Islamic investing public was not surprising.
Another important reason that Islamic institutions are hindered from obtaining more funds, or perhaps are reluctant to seek those funds, is a perceived lack of acceptable financial instruments in which those funds may be invested. The lack of suitable investments into which Islamic institutions may deploy their funds is reported to have caused an excess liquidity problem for some institutions, which may have an impact on the profitability of those institutions and the returns paid to their shareholders and investors. Another segment of the Islamic investing public interprets Islamic banking to mean intra-regional co-operation between Muslim states and consequently questions the investments made by Islamic banks in the West. Finally, it is not clear that Islamic investors have a robust appetite for risking their capital, which is one of the fundamental principles of Islamic finance.
The establishment of Islamic financial institutions is a relatively recent phenomenon. One of the first Islamic banks was set-up in Egypt in 1963; a second institution by the same sponsor was established in Egypt in 1972, this time with the financial support of the Egyptian government. Although the origin of modern Islamic banking was in Egypt, it probably would not have developed as an important financial force without the strong support-of Saudi investors. In 1975, with the support of the Saudi Arabian government, the Islamic Development Bank was established as an Islamic multi-lateral lending agency to promote economic development and trade between Muslim countries. The same year, the first private Islamic bank, still in existence, the Dubai Islamic Bank, was set up. As was expected, all the new Islamic banks received a very warm welcome. In the Sudan, the Faisal Islamic Bank took in US $10 million in deposits on its first day of operation. From its opening in 1977 to 1984, deposits at the Kuwait Finance House doubled almost every year.
The biggest Islamic bank is the A1 Rajhi Banking & Investment Company of Saudi Arabia, with capital of approximately $1 billion. AI Rajhi has a presence in London in the form of the Al Rajhi Company for Islamic Investments, and it also owns the Islamic Finance House of Luxembourg.
The Al Baraka group, also from Saudi Arabia, is considered to be the second largest Islamic banking group. Al Baraka was a licensed deposit-taker in England until 1993. Al Baraka has a very visible presence in many places. It maintains several finance offices in the United States, particularly in Houston, Chicago and Pasadena.
Dar Al-Maal Al-Islami (DMI), headquartered in Geneva, is the third largest Islamic financial institution. Most of its deposits come directly from its Jeddah office or through its offshore banking unit in Bahrain. DMI has subsidiaries or affiliates in several countries in the Middle East and South East Asia. The Kuwait Finance House, established in 1977, is the fourth largest Islamic financial institution. It is owned almost entirely by the Kuwaiti government.
Although it is common to use the terms “Islamic banks” and “Islamic banking”, the current trend is away from the term’s “bank” or “banking”. Instead, the terms currently preferred are “Islamic finance and investment” and “Islamic financial institutions”. There are two reasons for this shift. First, Islamic financial institutions have sought to distinguish themselves from Western banks, which are identified with the conventional debtor-creditor relationship. Second, some Islamic banks feel that the use of the terms “bank” or “banking” does an injustice to the spirit of their operations and should therefore be avoided.
There are three basic sources of funds for Islamic banks: equity capital, transaction deposits and investment deposits. Equity capital, of course, represents the owners’ investment and, like investors in Western banks, the owners of Islamic institutions expect to make a reasonable profit on their investment. Transaction deposits are the equivalent of demand deposit accounts in a conventional bank. The funds on deposit do not accrue any type of return and are available on demand. The depository institution is liable for the full return of the deposit. Investment deposits are the principal source of funding for an Islamic bank. These deposits are quite similar to equity investments because there is neither a fixed rate of return on the deposit nor a guarantee on the return of the principal amount of the deposit. The rate of return paid to the depositor depends on the contractual agreement between the depositor and the bank, which will stipulate the manner in which profits and losses are to be allocated. Investment deposits can be tied to the overall performance of the financial institution or can be limited to a specific project or investment undertaken by the institution.
One distinct feature of the modern Islamic banking movement is the role of the Sharia Board, which forms an integral part of an Islamic bank. A Sharia Board monitors the workings of the Islamic bank and every new transaction that is doubtful from a Sharia standpoint has to be cleared by it. These boards include some of the most respected contemporary scholars of the Sharia and the opinions of these boards are expressed in the form of Fatwas. In addition, the International Association of Islamic Bankers, an independent body, supervises the workings of individual Sharia boards while its Supreme Religious Board studies the Fatwas of Sharia boards of member banks to determine their conformity with Sharia.
Because of the restriction on interest-earning investments. Islamic banks must obtain their earnings through profit-sharing investments or fee-based investments. Profit-sharing investments are preferred as they are considered to be more beneficial to society, but they are more difficult to structure and implement and are less common than fee-based transactions. The fee-based transaction, known as murabaha, is essentially a cost-plus sale transaction. Islamic financial institutions also have the flexibility to engage in leasing transactions, including leasing transactions with purchase options, and certain other less common investments. Islamic law recognises the legitimacy of contracts making possible a virtually open-ended variety of transactions and instruments. The principal constraint, of course, is that the transaction does not provide for the charging or receipt of interest.
The different structure of an Islamic institution, in particular the focus on profit -and-loss-sharing transactions, can present challenges to the institution’s management. In making an investment, an Islamic bank would not rely primarily on the net worth of the borrower. Instead, it would base its investment on its analysis of the commercial viability of the borrower’s enterprise. As anyone who has worked with conventional projects or structured financing can attest, the analysis involved in that type of transaction is significantly more complicated and riskier. In addition, investments or financings that are dependent on the success of the financed enterprise require significantly greater monitoring and attention after they have been made than do conventional asset-based loans. The bank officer needs to have a greater degree of experience to handle such transactions, and the inability to standardise the transactions raises the overall cost of investment.
Another management problem for Islamic banks is the challenge of utilising surplus liquid funds. At present there exists no Islamic money market fund or secondary market. As a consequence, money managers have few options but to let surplus funds remain uninvested.
The response of Islamic banks to the risks, costs and limitations of profit-sharing arrangements has been to rely on short-term murabaha transactions, the cost-plus resale method of financing. This has been used mostly in trade finance transactions. Some commentators estimate that approximately 80% of the assets of a typical Islamic institution are murabaha transactions. This phenomenon has led to the accusation that the Islamic banking movement, because of its reluctance or inability to invest in long-term projects, has failed to promote adequately the development of the Muslim world. Despite some recent improvement in this trend, the financing of longer-term projects continues to be a very small portion of an Islamic institution’s investment.
The Islamic banking movement has not been confined to Islamic institutions in Muslim countries. Western banks have been active in Islamic finance from the beginning of the movement. At first, their involvement was primarily the taking of interbank deposits from Islamic financial institutions that had attracted retail deposits from the Muslim population in the countries in which they operated. The Western banks that received those interbank deposits agreed to use those funds in accordance with Islamic principles.
As western banks became more comfortable with Islamic finance, they began to establish so-called “Islamic windows” from which they would offer their own products. Today, Western banks are significant players in the Islamic market in their own right. Some of the more active Western participants have been Citibank, ANZ Grindlays Bank, Chemical Bank, Klienwort Benson, Union Bank of Switzerland and Goldman Sachs. In addition, multilateral institutions such as the International Finance Corporation and the World Bank have been involved in Islamic financing. The financings undertaken by these institutions are significant and diverse. Goldman Sachs, for instance, has arranged for the Islamic lease financing of an oil refinery in Europe. Citibank International, Klienwort Benson and ANZ Grindlays, all based in London, are reported to have booked cost-plus financing, known as murabaha, with a value exceeding $10 billion in 1993. ANZ Grindlays handles Islamic fund and cash management for its Middle Eastern and Asian clients out of its London office.
Two recent events demonstrate the continued interest that Western institutions have in the Islamic banking movement. First, Citibank has established a wholly owned Islamic bank in Bahrain. Second, Albany International, the UK subsidiary of Metropolitan Life, announced the launch of the Median Islamic Equity Fund in Britain. AI Median is the first such fund to be established by a western insurance company.
The West’s increasing interest in Islamic finance is further evidenced by an ongoing research project at Harvard University. In a collaborative effort of the law school, the business school and the Centre for Middle Eastern Studies, research is being undertaken in order to arrive at a more thorough assessment of the Islamic financing structures currently in use. This research effort, which is expected to be completed in 1996, has received the support and attention of several Islamic financial institutions.
Although the Muslim population in the United States, which is estimated at 6 to 8 million people, is now significant, only a limited number of Islamic finance and investment opportunities are available. One of the first opportunities was the Amana Income Fund, a mutual fund investing only in US traded common stocks of companies that do not engage in un-Islamic activities. In 1994, a companion growth fund was established to attract Islamic investors interested in a more aggressive investment approach.
In the late 1980s, the AI Baraka group made an effort to establish finance offices in several cities in the United States. Th e principal purpose of these offices was to engage in home finance for the Muslim population and other acceptable activities.
Recently, a financial institution known as the Muslim Credit Union received the permission of the regulatory authorities in Pennsylvania to establish a credit union in Philadelphia that would serve that area’s 100,000 Muslims. The Union will be operating on a cost-plus basis rather than charging interest.
3. Conclusion
Although the principles of Islamic finance originated centuries ago, the modern Islamic banking movement is a recent phenomenon. Some of the advances it has made have been impressive, and it is clear now that the movement is not merely a passing fad. Islamic finance is likely to continue flourishing in the Middle East and the Muslim countries of Southeast Asia, and its presence is likely to grow in the North America and Europe as well. As a new movement, many of its practices are in a formative stage. It is that condition which presents opportunities for creative financiers to refine and reformulate those practices in a manner consistent with the modern requirements of finance and economic development.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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