According to Lewis and Algaoud, Islamic banking is a financial system anchored on Sharia and related principles (23). In this banking model, profits and losses are shared between the various stakeholders. Accumulation of interests is not allowed. The system appears to operate on the ‘no risk, no gain’ logic. Considering that it is based on Sharia laws, Islamic banking is distinct from other forms of financial operations. Morals are adhered to in the promotion of a model based on the Islamic faith. Practices that fail to comply with Sharia are prohibited. They include, among others, investments touching on alcohol and pork.
In this paper, the author will provide a general overview of Islamic banking. Among others, the author will analyze the strengths and weaknesses of this system. A review of how the model operates will also be provided. In addition, the researcher will examine how the banking system survived the recent global economic crisis.
Islamic Banking: An Overview
Islamic banking institutions operate on religious principles. As such, every financial organization is expected to have a Sharia board (Rammal and Zurbruegg 4). Members are trained on Sharia law to help them advise the bank. Unlike conventional institutions that lend money based on financial criteria, Islamic banking focuses on investment and the ‘soundness’ of a given project. Another word for this practice is ‘interest-free’ banking. It serves as an alternative to interest-based financial transactions. It is noted that this system has taken root in both Islamic and non-Islamic countries. It has grown rapidly over the years. Some countries have even done away with traditional banking to adopt this system.
The banking model can be traced back to the era of Prophet Muhammad, who was conducting trade on behalf of his wife. Egypt is regarded as the country where the system started before spreading to other countries. The first local savings accounts were started in this North African country (Rukhsar, Kamran, and Immamuddin 43).
Principles of Islamic Banking
To achieve results in any given endeavor, a set of rules and principles is needed to guide the activities of the various parties. To this end, an advisory council (Sharia Board) is established in each and every Islamic institution. Any person trained on Sharia law, including lawyers and religious scholars, is eligible to join the council.
The first and most important principle of this form of banking is the prohibition of interest generating transactions. Muslims believe that it is wrong to charge or receive any form of interest. Riba or Usury is the name given to this concept (Rukhsar et al. 42). Investors make a lot of money when they focus more on returns associated with their investments than on the welfare of their clients. However, Muslims view this practice as a form of negative outcome since the investors address selfish interests. One of the aims behind the establishment of an Islamic banking system is the abolishment of the aforementioned riba. In light of this, the borrower only pays what they owe to the bank. However, they are free to make additional payments as a form of gratitude.
Another principle is adherence to ethical standards. Sharia law is used to determine whether a given business deal is appropriate or not. Liability and risk is another principle that defines Islamic banking. In this case, it is assumed that if one is willing to enjoy profits, then they should be prepared to share risks. Most people are unwilling to take part in this. The fear of losing what they already have overwhelms them (Banaji 53).
The last principle involves moral and social values. The Quran encourages people to help fellow humans who are in need. As such, financial institutions should endeavor to offer special services to the needy by engaging in charity work. A good example is the Quard Hasan. It is a form of funding given to those in need for a short period of time, such as one year. The lender expects no returns from such money. If one wants to study or cater for a medical bill, they can have access to Quard Hasan. In summary, money does not generate profits. It should only be used to promote the economy (Lewis and Algaoud 17).
History of Islamic Banking
Banking activities were present in the early days of the Prophet Muhammad. However, these activities were not well developed. After the introduction of conventional banks across Europe, non-interest based banking came to a standstill. The situation changed with the inception of Mit Ghamr Local Savings Bank of Egypt (Rukhsar et al. 63). The institution marked a new beginning for Islamic banking. It was established in 1963 (Rukhsar et al. 63). Two types of accounts were offered. One of them was a savings account, which was interest-free. The other was an investment account, which involved profit sharing.
In countries like Sudan, the growth of the banking system was associated with two ‘periods.’ Full support from the government was the first one. Later, the system encountered various obstacles after the government withdrew its support. In 1984, the authorities decided to turn all banking systems into Islamic establishments. As a result, no conventional banks are found in Sudan today.
According to Lewis and Algaoud, Dubai Islamic Bank was the first Islamic financial institution in history (28). The institution was formed in 1975 (Lewis and Algaoud 28). It grew rapidly both in volume and in numbers. Today, over 60 countries have operational Islamic banks. Most of them are based in the Middle East and Asian countries. Some countries like Sudan and Pakistan have no traditional banks since they were all converted into Sharia institutions.
The main reason for the establishment of Islamic banks is the promotion and development of financial services and products based on religious principles. The institutions act as investment partners to any person in need of money to venture into Sharia-compliant business. The bank becomes a ‘part-owner’ of the business after funding. As a result, clients live in fear of repossession, considering that they are in debt (Kayadibi 435). That notwithstanding, Islamic banking remains the only financial system that uses its funds to benefit people. Moral values are promoted since the institutions adhere to Sharia laws. They aim at enhancing the welfare of members of society.
Basic Techniques Used in Islamic Banking
The first technique is Musharaka (Banaji 65). It is also referred to as equity participation. The main idea here is the sharing of profits and losses (Banaji 72). The bank and the client enter into a form of partnership. The two parties are entitled to the management of the business. It is observed that the sharing of profits and losses is determined by the shares held by the parties.
Another approach is Mudaraba (Banaji 53). It is also regarded as trustee financing. Unlike in Musharaka, the bank or investor provides all the funds needed for a particular project as far as Mudaraba is concerned. In return, after the project is over, the investor gets a share of the profits generated. The lender can be a number of people who share the profits and losses.
Murabaha or markup is another term used in Islamic banking. Involved parties meet and agree on the cost of goods and services. They later settle on the profit margins. The amount agreed upon is settled in installments. A third party can be involved in the transaction. Clients can approach a bank to ‘buy’ financing from the seller at a given price. The client then pays the bank with interests. However, this practice is discouraged. The reason is that, according to Sharia, both parties should be involved in risk-taking. However, in this case, the bank earns profits without risking its money (Kayadibi 434).
Last is Ijara or lease. In normal banking systems, people lease a property at a profit. However, the case is different in Sharia banking. Islamic institutions can agree with the client to buy an asset from the seller (Banaji 65). The client later pays the bank in installments for a limited period of time. The whole process is based on profit sharing.
Islamic Banking in Malaysia
The system has a long history in this country. According to Rukhsar et al., the banking model started in September 1963 (72). However, the first formal bank was established in 1983. Islamic banks function in the same way as conventional institutions. The only difference between the two is that the former follows Sharia rules. Malaysia was the first country to adopt a dual banking system. Interest-free banking has flourished in this Asian economy. The practice acts as a model in the establishment of foreign banks, such as the Asian Finance Bank in Malaysia.
Another element associated with this banking system in Malaysia is the Islamic Capital Market (ICM). The development of this market-led to the issuance of Sukuk or Islamic bonds. Kuala Lumpur Regional Centre for Arbitration was established to resolve disputes that may arise from Islamic banking and finance (Kayadibi 433). Learning institutions have also been created to avail personnel certified to conduct Islamic banking. Statistics from the Malaysian Central Bank indicate that the number of these banks increased from 126 to 766 between 2004 and 2005 (Kayadibi 431).
Islamic banking was introduced in Malaysia as an alternative to other forms of financial systems. However, structures were put in place to separate it from conventional banks. Islamic Banking Scheme (IBS) was established to help companies provide these Sharia-compliant financial products (Kayadibi 435). Both Muslim and non-Muslim Malaysians have shown interest in this banking system. It is noted that Sharia principles and values are relevant to all aspects of human life. Lenders are not just investors looking to grow their wealth, but also friends and partners to the borrower.
The Malaysian government is determined to achieve a complete Islamic banking system. However, the system has encountered some challenges. A few banks have adopted riba, which involves the generation of interests. Such institutions are criticized for their inability or unwillingness to adhere to Sharia. As already indicated in this paper, Mudarabah advocates for the sharing of risks. However, most banks are eager to make profits but unwilling to take risks (Rukhsar et al. 48). Some non-Muslims who engage in Islamic banking fail to observe Sharia laws. As a result of this, some people criticize Islamic banking as a way through which the rich accumulate wealth at the expense of the poor (Rammal and Zurbruegg 5).
Islamic banking in Malaysia is viewed as one of the most progressive systems in the Muslim world (Rammal and Zurbruegg 3). However, the government should make efforts to address the problems identified above to sustain this trend. Failure to counter these challenges may lead to a situation where the differences between Islamic and conventional banking systems become blurred. Banking malpractices may impact negatively on the foundations of Sharia laws. The development may affect the faith and belief systems of the people. The objectives of Islamic banking are unique and they should be respected.
Islamic Banking in Pakistan
Pakistanis decided to adopt non-interest based banking model to address their economic and religious needs. The system was started in 1970. However, it became more practical in 1980. Initial plans to promote Islamic banking were not very successful. The state was required to eliminate riba in order to accommodate the new model. In spite of this, the financial system that was launched failed to effectively embrace Sharia elements, leading to its failure. It was re-launched in 2001 when the government decided to promote Islamic banking (Lewis and Algaoud 54). As a result of this determination, the authorities allowed the establishment of Islamic banks in the country. In addition, conventional banks were allowed to open stand-alone branches offering Islamic financial products.
There is a difference between Islamic banking in Malaysia and Pakistan. In the former, the institutions work together with the other financial establishments. The case is different in Pakistan. In this country, all banks operate on Islamic financial laws (Lewis and Algaoud 32). However, the principles of banking remain the same in both countries. Just like in Malaysia, the banking system in Pakistan encountered some challenges during the formative stages. For example, the number of these institutions was lower compared to that of other banks.
Many people believe that non-interest based banks can grow faster than the interest based establishments. However, the lack of certified and skilled personnel impedes this growth (Rukhsar et al. 62). Since penalties are viewed as a form of interest, people take advantage of this and take long to clear their debts (Rukhsar et al. 53). To address this issue, penalties imposed on delayed payments should not be designed to benefit the investor. On the contrary, they should be aimed at improving the economy.
The Global Financial Crisis and its Effects on Islamic Banking
A number of factors triggered the recent global financial crisis. They include excessive and uncontrolled lending by banks over a long period of time. House mortgage is a good example of this form of lending (Rammal and Zurbruegg 44). Traditional banks were affected the most by the crisis compared to Islamic institutions. The latter showed some resilience during the difficult times. Scholars believe that lack of discipline among the interest-based banks was also a key factor behind the crisis. As already indicated in this paper, Sharia advocates for the sharing of profits, losses, and risks. The principle is not observed in other banks. Islam regards the failure to adhere to this provision as a form of financial and moral injustice (Rammal and Zurbruegg 66).
It is important to note that compared to conventional financial institutions, Islamic banks were adversely affected by the global crisis with regards to losses. It is a fact that interest-based banks were affected by the economic meltdown, but they did not incur high losses like the Islamic establishments. In spite of this, Islamic banks are said to have contributed to the stability of the economy during the crisis. The reason is that a significant part of their portfolio was held by consumers who were less affected by the economic disaster (Rukhsar et al. 54). The crisis enabled Islamic banks to identify and focus on some challenges unique to the system.
Islamic Banking and the Future
Any form of profit making is prohibited in Islam. The future of Islamic banks is based on this principle. That is why this form of financial transaction is regarded as non-interest based banking. The system started small, but has grown considerably over the years. The growth has seen the establishment of this model in countries that are regarded as non-Muslim. People who do not adhere to the Muslim faith are taking part in these transactions (Kayadibi 438).
Moving forward, Malaysia is likely to remain one of the leading countries in Islamic banking. Other nations like Sudan have no standard banks given that all of them were changed into Islamic institutions. The main reason for the establishment of Islamic banking is to enhance Sharia compliance in all aspects of economic undertakings. The banking system has led to the development of several institutions like schools, which offer training on Sharia laws (Lewis and Algaoud 34). In future, the visibility of organizations formed to deal with problems arising from Islamic banking is likely to increase.
There are rules that every Islamic financial institution must adhere to. A group of personnel trained on Sharia is appointed to advice these companies and guide their activities (Rukhsar et al. 72). During the recent economic crisis, Islamic banking proved to be resilient mainly because it operates differently from other financial institutions in the world. The crisis also helped the banks to point out various weaknesses in the system. The ability to withstand such crises implies that Islamic banking has a bright future.
In conclusion, it is important to reiterate the advantages and disadvantages of Islamic banking. One advantage is that profit and losses are shared by both parties since any form of interest making is not allowed. Morals are upheld because of the strict Sharia rules that are observed. According to the Quran, it is the duty of all Muslims to help and care for the needy. That is why Islamic financial institutions offer help to those in need. As such, the banks are not interested in profits only (Lewis and Algaoud 22).
Just like any other form of business, Islamic banking has a number of weaknesses. For example, the banks act as investment partners when they lend money. As such, the client is indebted to the institution and lives in fear of losing the assets that the bank helped them acquire (Rammal and Zurbruegg 95). In addition, some institutions fail to observe the provisions of Sharia laws. As a result, the establishments may be viewed as profit making ventures. In addition to creating suspicion, such malpractices weaken the Islamic faith and the teachings of the Quran.
Another major problem involves the payment of debts. As indicated in this paper, Islamic banking discourages profit making. Many people take advantage of this principle given that they are not penalized for late payments. To address this problem, Sharia banking institutions should come up with rules to punish such people.
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Lewis, Mervyn, and Latifa Algaoud. Islamic Banking, Cheltenham: Edward Elgar Pub., 2001. Print.
Rammal, Hussain and Ralf Zurbruegg. “Awareness of Islamic Banking Products among Muslims: The Case of Australia.” Journal of Financial Services Marketing 12.1 (2007): 65-74. Print.
Rukhsar, Ahmed, Siddiqui Kamran and Mufti Immamuddin. “Islamic Banking in Pakistan: Problems and Prospects.” Asian Journal of Research in Banking & Finance 3.7 (2013): 42-72. Print.