What is Islamic banking ?
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 basic principle of Islamic banking is the prohibition of Riba- (Usury - or interest):
"While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.
"The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens - ranging from the equitable distribution of wealth through to man's fundamental right to work - is clearly present in modern Islamic society.
"Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997)
It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.
The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalization of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and philosophy of Islam.
Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.
Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems Haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:
1. While permitting the individual the right to seek his economic well-being, Islam makes a clear distinction between what is Halal (lawful) and what is haram (forbidden) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious.
2. While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.
3. While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat.
4. While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.
5. Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.
The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and- loss-sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.
It is possible, that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of the Shariah.
The concept of profit-and-loss sharing, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management.
Islamic banks are structured to retain a clearly differentiated status between shareholders' capital and clients' deposits in order to ensure correct profit-sharing according to Islamic Law.
Key Islamic Financial Instruments
Mudaraba
Under the principle of no pain no gain, no one is entitled to any addition to the principal sum if he does not share in the risks involved. The capital provider or rabbulmal may 'invest' through an entrepreneur borrower or Mudarib, hence the name of the structure; profits are shared on a pre-agreed basis but losses, if an are wholly suffered by the rabbulmal. This financing structure is called Mudaraba and is similar to non-recourse project finance. Mudaraba has also been called Shirka.
Musharaka
Financing through equity participation is called Musharaka. Here the partners or shareholders use their capital through a joint venture, Limited Partnership to generate a profit. Profits or losses will be split between the shareholders according to some agreed pre-formula depending on the investment ratio.
Mudaraba and Musharaka represent the desired forms of Islamic banking even though their current use is not significant. Islamic bank depositors act as Rabbulmals and place funds with the bank. The bank is the Mudarib on its liability side with respect to the depositors.
The bank uses the funds on the Mudaraba or Musharaka basis or any other Islamically approved basis with clients in search of funding. Here the bank is the Rabbulmal with respect to the end users of the funds. Under such a scenario the bank acts as a principal. The bank may also act in an off-balance sheet capacity as a fee earning agent on behalf of the fund providers and/or fund seekers or as a traditional fund manager investing in a diversified portfolio of Musharaka contracts.
Retail Islamic Banking Products
At a retail level, Islamic banks provide current, savings, and investment accounts.
The current account is basically a safekeeping or Alwadiah account and used for day-to-day cash management. It is very similar to such accounts in conventional banks. No return is paid to depositors. The instant access accounts allow the depositors to withdraw their money on demand and permit the bank to use the depositors' money. Cheque-books are provided along with bill payment facilities, bank drafts, bills of exchange and travellers cheques. Credit cards are unlikely to be provided but debit cards do not seem to be a problem. Most banks have no charges for such accounts.
Alwadiah structures are also used for higher return savings accounts. Banks may, as they see fit, pay the savers a return depending on their own profitability. This seems to be allowed as the bank's payment, if any, is level and is not determined in advance. Savings account holders do not have the same level of service as current account holders but get savings books and instant or short notice access. There may or may not be a service charge incurred. Losses are not, in practice, passed on to depositors and are absorbed through the banks' reserves.
The investment accounts use the Mudaraba format. Deposits are fixed term and cannot be cashed in before maturity. The profit-sharing ratio varies between institutions and could be a function of the bank's profitability or that of the portfolio of end borrowers. In practice there is only profit sharing and no loss sharing for retail investors. The lower risk means a lower profit share.
There are considerable variations on the Mudaraba principle. The Islamic Bank of Bangladesh has been offering Profit and Loss sharing Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit accounts. Bank Islam Malaysia provides wholesale and retail investment accounts both on the PLS principle.
The frequency of payment is another variable. Profits are declared and distributed monthly in Malaysia, whilst in Egypt there is a quarterly distribution. In Bangladesh and Pakistan distributions tend to be half-yearly.
A common thread is the short-term liquid nature of the deposits. Long-term mortgage-type finance is hard to come by. The longest term deposits appear to be raised in Malaysia. Even there almost all the deposits are under two years in maturity.
Murabaha
As indicated earlier, the vast majority of Islamic financial transactions measured by principal do not involve a share of profit but generate a locked-in return. The Mudaraba and Musharaka transactions are often seen on the retail liability side of Islamic banks. The asset side, retail and wholesale is a good deal riskier. The most common financial instrument is the 'mark-up' structure called Murabaha, similar to 'repo' or sale and repurchase agreement used in the West.
In a Murabaha transaction, the bank finances the purchase of an asset by buying it on behalf of its client. The bank then adds a 'mark-up' in its sale price to its client who pays on a deferred basis. The 'cost-plus' nature of Murabaha sounds very much like the interest into capital gains manipulations of tax-avoiders. Islamic banks are supposed to take a genuine commercial risk between the purchase of the asset from the seller and the sale of the asset to the person requiring the goods. The bank stands in between the buyer and the supplier and is liable if anything goes wrong. Thus there is some form of guarantee with respect to the quality of the goods provided by the bank to the end user in the strict form of Murabaha. Title to the goods financed may pass to the bank's client at the outset or on deferred payment. It is argued that the services provided by Islamic banks are substantially different from those of money lenders.
Baimuajjal
It is deemed acceptable to charge higher prices for deferred payments. Such transactions are regarded as trades and not loans. Property financing on such a deferred payment basis is called Baimuajjal.
Ijara
An Islamic form of leasing is called Ijara. Here the banks buy machinery or other equipment and lease it out under instalment plans to end-users. As in Western leasing there may be an option to buy the goods built into the contracts. The instalments consist of rental for use and part-payment.
Baisalam
When a manufacturer seeks to finance the production of goods he seeks Baisalam financing. This involves the bank paying for the producer's goods at a discount before they have been delivered or even made . It is similar the Bankers' Acceptance financing in the West.
Prizes and bonuses
Iran and Pakistan have both attempted to fully Islamise their entire banking systems. Iran converted to Islamic banking in August l983 with a three-year transition period. In Iran banks accept current and savings deposits without paying any return. The banks are permitted to offer bonuses and prizes on these deposits very similar to the UK's premium bonds. This is apparently not regarded as gambling by the Iranian Islamic banking units.
No fee accounts
There is a substantial Muslim population in South Africa and they are serviced by two small Islamic banks. The main product being offered is the 'no fee' current account which is also provided by conventional banks by arrangement. Transaction charges are waived and interest is not paid on current accounts. Interest is charged on loans by conventional banks.
'Gifts'
Gifts to depositors are given entirely at the discretion of the Islamic banks on the basis of the minimum balance. These gifts may be monetary or non-monetary are based on the banks returns.
Interest free
The avoidance of interest has been abused by those who merely seek to be seen to be Islamic bankers. Many convert interest into capital gains and find a Koranic justification. The rules have been tightened progressively as they have been in tax avoidance.
Trade related
It is unfair to criticise devices converting interest to capital gains as all such instruments have to show some underlying commercial need and therefore probably go some way towards the Islamic objectives. There are Western parallels with Commercial paper and Bankers Acceptances which also have to be trade related. Many emerging markets, under their exchange control regimes, insist that all overseas financing or foreign exchange transactions have to be trade related.
Equity related
It has been suggested that 'pure Islamic banking' involves profit and loss sharing or equity participation in the Mudaraba and Musharaka forms. There is no pre-determined interest income for the lender or, in this case, the investor. The investor's return is uncertain: Sounds good and just the sort of venture capital financing many in the West have been demanding of their risk-averse banks.
Devices can be created so that pre-determined interest can be made to look like pre-determined capital gains. Also a tiny bit of uncertainty may be introduced into the equation. But there is also a requirement to avoid exploitation. If under a profit-sharing arrangement, because of the entrepreneur's poor bargaining position and the banker's monopoly status, the bank received 95 per cent of a ventures' profits. Would this be deemed Islamic? Perhaps. There do not appear to be rules that determine fair sharing ratios of profits.
Usury
Under the current interpretation of the rules governing Islamic banking, Usury and Riba are regarded as synonymous. The prohibition is on interest and not just on usurious interest. In practice, there appears to be more emphasis on the prohibition and restructuring of interest than on the potentially exploitative aspect of financing.
Ethical investments
Islamic investments have to avoid undesirable sectors. This little different from many Western Ethical investment funds.
Ethical guidelines include: environmental protection, charitable giving, community involvement, human dignity and sanctity of life, exclusion of companies involved in pornography, alcohol and gaming. Such objectives are remarkably similar to the objectives of many an Islamic investment fund.
Islamic Derivatives
It is generally assumed that the term Islamic Derivatives is a contradiction. The requirements of derivatives and rules of Shariah, at first sight, are diametrically opposed and all derivatives are therefore Haram. But it is important to recall the generalised definition I use of a financial derivative. It is simply a financial instrument that is derived from another financial instrument or a combination of such instruments. It is argued that as derivatives unquestionably involve interest or interest-based products they are contaminated and should be prohibited. Derivatives only involve interest if one or both parties using the derivative seeks to hedge the derivative. It could be argued that Murabaha could involve interest if the parties seek to match the interest free but guaranteed return product with an interest-bearing equivalent. Islamic banking derivatives should be perfectly acceptable so long as they do not involve interest.
In Malaysia there is a dual financial system. An Islamic banking system works alongside a conventional interest bearing banking system. But there is only one purely Islamic bank compared with 26 dual system banks offering Islamic windows. These dual system banks do not completely separate the Islamic banking units from the rest of the bank and there is inevitably a crossover of the effects of derivatives from the conventional system into the Islamic system. Most of the research into the acceptability of Islamic derivatives has been accordingly carried out in Malaysia. There have also been developments in Bahrain.
Baisalam, which involves pre-payment for goods, is indeed an Islamic banking derivative and can be regarded as a kind of forward contract. Options are just insurance policies. Just as Takaful is an acceptable Islamic form of Insurance, options for delivery of commodities by a producer of such a commodity should be acceptable. So also should options or forward contracts on any of the Islamic financial instruments mentioned.
The acid test seems to be the presence or otherwise of an underlying trade transaction to justify the derivative transaction. There will undoubtedly be developments that attempt to make Islamic derivative contracts look and feel like non-derivative contracts. The process is similar to that in the early days of derivatives. There was a problem with the tax treatment of FRA's. A synthetic FRA was created to overcome the problem. Such a product could be tweaked to serve as an Islamic derivative.
It will be a long time before Islamic derivatives are deemed to be acceptable. The developments will prove to be very similar to the developments in derivatives in the late 1970s. The Islamic banking derivatives winners will be those who remember or research into financial history rather than the rocket scientists.
Thank you.