THE CHALLENGES FOR ISLAMIC BANKING
MOHSINS KHAN
The growth of Islamic banking over the past two decades has drawn the attention of academics, bankers and regulators, as well as international financial institutions, such as the International Monetary Fund (IMF) and the World Bank.
To understand the phenomenon of Islamic banking and to anticipate the type of changes that may result from its adoption, it is worthwhile to take stock of what has been broadly achieved in the field of Islamic banking to date, and to look further to what lies ahead in the future.
Such an examination can be divided into three main areas: the analytical or theoretical aspects of Islamic banking; central banking and the operation of monetary policy in an Islamic economy; and experience with Islamic banking. After a brief look at each of these areas, one can proceed to identify the main challenges for Islamic banking.
Analytical Aspects of Islamic Banking
Since the early 1980s, a number of economists have been involved in developing analytical models of banking in an Islamic environment where interest (Riba) is forbidden.
The initial efforts have basically yielded a model of an Islamic bank that integrates the assets and liabilities sides of the balance sheet of the bank, based on a profit-sharing principle called the two-tier Mudaraba.
This particular mode l envisages depositors entering into a contract with a bank to share the profits accruing to the bank. The bank, on its asset side, enters into another contract with an entrepreneur who agrees to share his profit with the bank in accordance with a predetermined percentage stipulated in the contract.
The banks earnings from all its activities are pooled and are then shared with its depositors and shareholders according to the terms of their respective contracts. This type of model has proved to be an extremely useful descriptive device for understanding how an individual Islamic bank, or the Islamic banking system as a whole, operates.
From this original concept, a series of second-generation models have emerged. These models, using modern economic theory and analysis, have shown that an equity-based system, which essentially is what Islamic banking is, can work as efficiently and effectively as a debt-based system. As such, the replacement of a positive interest rate by an uncertain rate of return based on realised profits does not in principle hinder the functioning of an Islamic bank.
Furthermore, an interesting result that emerges from these newer analytical models is that an Islamic bank may be better suited than a conventional bank to adjust to shocks that can lead to banking crises.
The reason is that in an equity-based system, shocks to the asset positions of banks are immediately absorbed by changes in the nominal value of shares (deposits) held by the public in banks. Therefore, the real value of assets and liabilities are equal at all points in time.
In the conventional banking system, since the nominal value of deposits is guaranteed by the bank, an adverse shock to the assets of the bank can create a divergence between the real values of assets and liabilities – leading possibly to negative net worth for the bank, contagion effects, and a banking crisis – and it is not clear how long this disequilibrium will last and how it will be corrected. From the standpoint of adjustment to adverse external shocks at least. Islamic banks would thus appear to have a comparative advantage over their conventional counterparts.
Central Banking and Monetary Policy
In an Islamic system, the chief role of a central bank is to take the lead in evolving financial institutions and instruments that facilitate efficient mobilisation of savings and allocation of resources consistent with the economic objectives of the Islamic economy.
The central bank, in particular, has to initiate and foster the development of primary, secondary, and money markets. Beyond the developmental aspects, the central bank is expected to ensure macroeconomic stability, specifically price stability, making its principal objective very similar to that of traditional (Western) central banks.
The work on the subject to date has shown that monetary policy in an Islamic state can be conducted within a framework in which all conventional tools normally available in a modern Western economy are at the disposal of the central bank with, the exception of the discount rate, open-market operations with government debt instruments, and other policy tools that involve an interest rate.
Additionally, the authorities in an Islamic system can utilise profit-sharing ratios to achieve changes in the stocks of money and credit, and thereby affect market rates of return.
All the usual regulation, supervision and control functions of the central bank can be expected to continue in the Islamic system. Therefore, in theory, there is nothing that makes central banking in an Islamic economy differ in a major way from the traditional concept of central banking and monetary policy.
Experience with Islamic Banking
Although the restriction against the use of interest would seem to be a binding constraint, at least in the eyes of economists, Islamic banks and financial institutions have, in fact, grown rapidly.
At present there are about 50 countries, encompassing most of the Muslim world, that have some type of Islamic financial institution. This development in Islamic banking has basically taken two forms. The first has been an attempt to establish Islamic financial institutions side by side with traditional banks, and the second form involves the restructuring of the whole financial system in accordance with Islamic concepts.
Attempts in this latter direction have been made in Iran and Pakistan, and more recently in Sudan.
The basic question is whether these experiments in Iran and Pakistan, initiated in 1979, have been successful in transforming the banking systems in these two countries into a form envisioned by scholars and analysed by economic theorists.
The general conclusion that can be derived from the experience of Islamic banking in Iran is certainly a mixed one. The adoption of Islamic banking has not led to a collapse of the financial system. There has been a rapid growth of private sector deposits in Islamic modes, demonstrating that the system can be effective in mobilising resources.
But at the same time, government policies have strongly influenced the asset acquisition behaviour of the banking system. How the system would work in the absence of strong government intervention remains an open question. Clearly there has been considerable progress in the Islamisation of the banking system in Iran, but just as clearly, the current system still retains many of the features of the Western financial system it was designed to replace, particularly on the lending side.
Other Challenges
Basically, both theory, as well as experience, shows that Islamic banking is a viable system. Nevertheless, Islamic banking faces significant obstacles and problems that need to be overcome if there is to be further progress, and especially if Islamic banks are going to be credible competitors to conventional banks. These include, inter alia, the following:
1. While it has been relatively easy to create a system in which deposits do not pay interest, Islamic banks, in the introduction of true profit-sharing arrangements on the lending side, have encountered serious difficulties.
Thus far it has proved extremely difficult to develop a system of contracts between the lender (the bank) and the borrower, that would keep monitoring costs at a reasonable level and eliminate the moral hazard issues that arise when the lender and the investor have asymmetric information on the profits from the investment.
As a consequence. Islamic banks by and large have come to rely primarily on mark-up, leasing and instalment sales operations. This has meant that the portfolios of Islamic banks tend to be concentrated in short-term, trade-related assets. In the longer run, this emphasis on short-term financing is bound to have an inimical effect on investment, growth and economic development.
2. The absence of suitable long-term assets available to Islamic banks is mirrored by a lack of short-term, tradable financial instruments. At present, aside from Malaysia, there is no equivalent of an inter-bank market where banks could place, say, overnight funds, or where they could borrow to satisfy temporary liquidity needs.
Trading of financial instruments is also difficult to arrange when rates of return are not known until maturity. Furthermore, it is not clear whether Islamic banks can utilise more exotic instruments, such as derivatives, that are becoming increasingly popular with conventional banks. Obviously, these factors place Islamic banks at a distinct disadvantage relative to conventional banks.
3. While in principle the central bank can continue to play the same role in regulating banking and financial transactions when dealing with Islamic banks, in practice problems have arisen where such banks operate side-by-side with conventional banks.
Should Islamic banks be subject to reserve requirements similar to those of other banks? Should there be a distinction between reserve requirements on investment deposits versus demand deposits? Are Islamic banks inherently more or less risky than traditional banks? How can a central bank conduct open-market operations with securities not paying interest? These questions are extremely important to the efficient functioning of an Islamic banking system.
4. At present there is also the lack of a well-defined regulatory and supervisory framework within which Islamic banks should operate. Regulators have to establish a strong legal system, which may mean a separate law for Islamic banks, appropriate licensing requirements, prudential regulations, including minimum capital and liquidity standards, and methods for establishing risk-weighted asset classifications.
5. Another important issue facing Islamic banks is how to organise their relationships with foreign banks, and more generally, how to conduct international operations. This is, of course, an issue closely related to the creation of financial instruments which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks.
6. There is also as yet no acceptable way for governments to finance fiscal deficits other than through money creation, which in turn may be at variance with the objective of macroeconomic stability.
In Iran, for example, the government currently borrows directly from the banking system at zero rate of return, arguing that since all banks are nationalised it does not make much sense for the government to pay itself for the money it borrows.
In Pakistan, on the other hand, the government borrows from the banking system at a fixed rate, or directly from the public at rates higher than that paid on deposits. Neither approach is strictly acceptable in an Islamic system. While many suggestions have been made in this area, there remains considerable controversy on how this problem can be resolved.
7. Islamic banks face a serious shortage of suitably qualified personnel to conduct their operations. Even though the picture has been improving over the years, further expansion of such banks on the scale observed to date has come up against this constraint.
Not only do Islamic banks need trained managers, but they are now in particular need of finance and investment specialists who could create and develop the full range of financial instruments these banks require to compete with conventional banks.
In conclusion, the rapid expansion of Islamic banking in the past decade or so has demonstrated that there is a sizeable market for the products that Islamic banks have to offer Islamic banks have obviously found a niche and suitably exploited it.
Overall, it is acknowledged that these banks have operated well, although some have encountered problems, such as large losses.
However, in many cases, the problems were similar to those faced by conventional banks.
But Islamic banks operating in a modern economy also face their own particular set of problems. These need to be addressed if Islamic banking is to reach a level that would place it on a par with conventional interest-based banking.
The Islamic monetary system is evolving and solutions to the types of problems listed above will undoubtedly lead to further progress in the development of a full-fledged system that can undertake a whole range of financial operations and transactions efficiently and effectively.
Obviously, this is a long agenda requiring considerable research and experimentation – but it is an agenda that will have to be addressed if Islamic banks are to prosper and take on an increasingly important role in financial transactions in the next century.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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