Similarities Between Conventional and Islamic Banks

According to the CISI (2015) workbook Fundamentals of Islamic Banking and Finance, the similarities between conventional and Islamic banks are as follows.

1. Both are commercial entities licensed by the central bank, involved in collecting deposits from the surplus units in society and applying the funds to borrowers, entrepreneurs or deficit units.
2. Both types of banks offer current accounts for the safekeeping of funds, payment facilities, cheque books, debit cards and without any interest or profit.
3. In fixed deposits of conventional banks and investment accounts of Islamic banks the customers agree to deposit their funds for a fixed period, though the return with conventional banks is a fixed interest while for Islamic banks it is a pro-rata share in the profit.
4. Both types of banks use the interbank market for liquidity management.

Differences Between Conventional and Islamic Banking

Table 3.1 lists the differences between conventional and Islamic banking.

Relationship with the Central Banks

For both conventional and Islamic banks, the central bank plays the important roles of supervisor in case of applying monetary policy, clearing house and lender of last resort. Central banks are required to balance the impact of the public's preference to save or to spend. Public demand for cash leads to a cash shortage in banks, and banks try to borrow at the interbank market. In case the interbank market is not able to meet the needs completely, the central bank acts as the lender of last resort and lends funds to the banks. In the case of conventional banks this loan is interest based, but in the case of Islamic banks the central banks need to provide an alternative profit and loss-based financing, like Mudaraba or Musharaka. Such special Shariah-compliant alternatives are usually only available from central banks in Muslim-majority countries with dual banking environments, or where the banking system is totally Shariah compliant. Central banks also provide cheque clearing services to both conventional and Islamic banks. Moreover, central banks need to deal with Islamic banks differently, due to the differences in their products and operations. Statutory cash reserves for both kinds of banks would be the same for their current accounts but are required to be different for fixed deposits compared to investment accounts, since the investment account holders – unlike the fixed deposit holders – accept some risk. The liquidity ratios, insurance schemes, credit ceilings, etc. also require differing treatment. Central banks have similar controls on permissions for new branches, minimum capital requirements, appointment of BOD members and auditors, regulations of foreign exchange and submission of financial reports for both conventional and Islamic banks.

Generic Risks

Liquidity or funding risk. This is the risk of a bank not being able to meet its obligations when they fall due, either because the bank does not have sufficient cash and/or liquid assets or because it is unable to raise the cash from external sources.

Banks are originally set up with shareholders' capital, which also provides for the banks' infrastructure and operational reserves. The financing business of the bank mainly uses depositors' money. When depositors want to withdraw their deposit, banks need to honour this obligation, or a panic will be created which may lead to a run on the bank. There are two types of deposits in a conventional bank – current (or demand) deposits and time deposits – with the savings account falling between these two. The demand deposits are payable on demand. Though technically banks do not have to pay out time deposits or savings account deposits on demand, they usually prefer to do so. Hence, withdrawal from these accounts can further deplete banks' cash. Often banks pay withdrawing depositors from funds placed by new depositors, but this is not a stable solution. Rather, banks should source the funds externally by selling commercial papers or borrowing from external sources. Similarly, an Islamic bank also holds current and savings accounts and instead of time deposits it holds investment accounts. In practical terms, an Islamic bank would honour withdrawal from any of these accounts too. The process of funds management to meet the withdrawals demand is also the same, either by using funds from new deposits or by external Shariah-compliant sourcing.

The conventional as well as the Islamic banks manage their depositors' cash withdrawals by holding cash and liquid assets, holding their own reserves and via the reserves held at the central bank. However there are some Shariah restrictions related to Islamic banks holding part of the deposits as reserve instead of applying them to profit-generating activities. Islamic banks deal with the liquidity needs best by raising deposits of varying maturities. Central banks that recognize Islamic banking also deal with their reserve requirements against their partnership deposits differently from conventional banks.

Risk of holding excess liquidity. When banks hold cash and other liquid assets, mainly to meet the withdrawal demands as discussed above, they are not investing this money and are losing income. Both conventional and Islamic banks need to balance the risk of holding too little in liquid assets and failing to meet withdrawal demands against holding too much in liquid assets and giving up on income. A conventional bank invests its liquid funds in the interbank or highly liquid money markets. While Islamic banks cannot avail of the common interest-based interbank or money markets, they rather deal with excess liquidity by investing in Shariah-compliant divisible and tradable instruments like Shariah-compliant certificates of deposit, short-term Sukuks (Islamic bonds, to be covered in Chapter 11), etc.

Credit risk of the client. This risk is when the bank client defaults on their obligations to repay. Some measures the bank can take to reduce this risk are to select creditworthy clients only, take security or collateral to recover payments in case of default, properly match the financial instrument to the client's need and abilities to repay and, especially in the case of Islamic banking, supervise and monitor the client's operations to ensure that they were managed efficiently and that any profit earned was shared with the bank.

Settlement or payment risk. This risk comes from interbank payments. A bank may not have sufficient funds to repay an interbank obligation or may not receive its dues on time from the other bank to which funds were loaned.

Interest rate risk. This is a major risk category in conventional banking, arising from interest rate mismatches in both volume and maturity. Islamic banks do not have this risk.

Market price risk. If the bank is exposed to equity market price changes, then any negative movement is a risk. The Islamic bank, especially, may be exposed to market price risk when it underprices its financing. To avoid this the Islamic bank needs to better forecast the market demand and supply; moreover, Islamic securities are affected by the volatility of market prices more, since they are linked to real assets.

Currency risk. Any adverse exchange rate fluctuations can affect both the bank's own and its clients' funds held in foreign currency. Conventional banks use foreign exchange options or futures to reduce this risk. These hedging products are not Shariah compliant and hence Islamic banks cannot use them.

Operating risk. This risk originates from the bank's operations. Some examples are unexpected expenses, fraud or involvement in litigation. The solution lies in prudent banking operations, minimizing fraud and ensuring legal issues are avoided as far as possible.

Risks Specific to Islamic Banks

Since Islamic banks tend to be partners to their depositors on the liability side and to their borrowers or entrepreneurs on the asset side of their businesses, and because they share in the profit and loss of the activity or enterprise financed by them instead of charging a fixed interest rate, there is inherent risk in Islamic banking. As discussed by Kettel (2010), a major source of risk is asymmetric information, which is known to one party only. Asymmetric information has an impact on the equity market where, since none of the returns are known, investors expect premium income from good stocks to compensate for less than expected return on weak stocks. Asymmetric information also affects the debt market, since the borrower or entrepreneur has more information about the project than the lender. Two of the major risks faced by an Islamic bank because of asymmetric information are:

• Adverse selection risk. This problem is faced before the transaction has happened. Since borrowers or entrepreneurs have more information than lenders about the project, the bank could make an error in the selection of projects. Risky borrowers are often keen to borrow and may get selected. As such, Islamic banks need to be very vigilant in selecting borrowers, concentrating more on the profitability of the project and the managerial skills of the borrower rather than their creditworthiness.
• Moral hazard risk. This problem is faced after the transaction has happened. Only the borrower or entrepreneur has full information on the running of the business, and may engage in activities that are harmful for the business, hence affecting the profit earned. Conventional banks charge the borrower fixed interest in addition to the principal repayment, irrespective of the profit or loss scenario of the business, and would be concerned only if the cashflow of the business is not sufficient to make the fixed repayments. In contrast, the Islamic bank shares in the profit or loss, thus a high profit of the business is beneficial for the bank while a loss would mean a loss for the bank, since as capital provider it bears the loss pro-rata. Islamic banks are therefore required to engage in thorough and careful monitoring of the business to ensure that all operations are in the best interests of the enterprise.

Other related risks faced by an Islamic bank are:

• Equity investment risk. Islamic banks in many contracts take partnership roles, as in Mudaraba and Musharaka; the bank and the borrower or entrepreneur mutually decide on a suitable profit-sharing ratio. The loss sharing, though, is as per the capital contribution. Usually the bank is the major contributor of capital and is exposed to significant risk. Moreover, in Islamic banking a collateral or guarantee cannot be taken against regular business risk, hence if the business fails, the bank can lose significantly.
• Default risk. If the borrower delays payment or fails to repay, conventional banks charge interest on interest. Islamic banks cannot do so and if they do impose a penalty, the bank cannot benefit from it but is required to donate it to charity.
• Higher costs. Islamic banks are concerned more about the profitability of the business than the creditworthiness of the borrower, leading to more conservative decisions, so less financing is achieved incurring higher costs. Moreover, due to the profit and loss-sharing relationship, Islamic banks need to monitor clients more extensively, incurring additional costs.
• Shariah compliance risk. Conventional banks match their operations to economic and business requirements only, while Islamic bank operations also need to follow the principles of the Islamic economics and the Shariah. Any Shariah non-compliance can affect their reputation and lower the loyalty of their customers.
• Rate of return risk. Conventional depositors earn fixed interest and are protected by bank regulations and deposit insurance. In contrast, Islamic bank depositors share in the profit and loss of the bank, which in turn shares in the profit and loss of its financing clients. Thus, the PLS system involves variability of returns both for the bank and in turn for its depositors.

The Definition of Financial Intermediation

The core business of banks is financial intermediation. In other words, banks exist because of the need for financial intermediation. Financial intermediation is the process by which banks match savers with borrowers. The income and expenditure streams of the different economic entities are not always synchronized. As such, some have excess cash that they want to save or lend to others and some have a shortage of cash and want to borrow from others. Banks play the role of connecting these two groups. On the demand side, households may need money for general consumption or the purchase of items, businesses may need money for short or long-term expenses, while governments may need money to complete various projects. Conversely, on the supply side, households may save for the future, businesses for future expansion or replacement of assets and governments for future expenses. Through financial intermediation banks play the role of the trusted intermediary for all parties. Banks collect all information related to savers and borrowers, efficiently allocate resources collected from savers to borrowers, ensure safety of savers' money, and take the responsibility of recovering repayments from borrowers and returning savers' funds with additional income. Banks also assist the government in achieving its economic policies by channelling financial resources to priority sectors. Banks are profit-oriented businesses and they earn their margin from the difference between what they pay savers and what they charge borrowers.

Conventional Financial Intermediation

A conventional bank collects deposits from customers, mostly in the short term, pays them a fixed interest rate and then lends this money to other customers who are borrowers, usually in the medium or long term, and charges them an interest rate which is usually higher than that paid to depositors. This difference between interest charged and interest paid is the bank's spread or profit. In the process of financial intermediation banks are taking liquidity risk, since they are responsible for returning depositors' funds when they demand, while they cannot recall the loans they give before maturity. They also take credit risks, the risk of borrowers defaulting on repayments. The profit made by the bank is considered as income for taking these risks.

Islamic Financial Intermediation

Financial intermediation in Islamic banks has a fundamental difference from that in conventional banks. As discussed earlier, in Islam money is a medium of exchange and not a commodity, so money cannot be earned from money. As such, the conventional financial intermediation process of transforming deposits into loans and earning interest or Riba from them is prohibited and the justification for bearing credit and liquidity risk to earn the interest margin is not sufficient. In Islamic financial intermediation interest is replaced with profit and loss sharing. Instead of the debit–credit framework Islamic banks use the Mudaraba concept. In Mudaraba the capital is completely provided by one party, the Rab al Maal, while the business is managed by the other party, the Mudarib. Mudaraba will be discussed further in Chapter 5. In Islamic financial intermediation, the Islamic bank executes a Mudaraba contract with the depositors, where the depositors are the Rab al Maal while the bank acts as Mudarib or entrepreneur. On the other hand, the Islamic bank enters a second Mudaraba contract with the users of the funds, the borrowers or entrepreneurs. In this Mudaraba the bank acts as the Rab al Maal and the fund user is the Mudarib. This is called the two-tier Mudaraba of Islamic financial intermediation. In both tiers of the Mudaraba contract, profit is shared in a pre-agreed ratio, while the financial loss is borne solely by the Rab al Maal; the Mudarib is liable only to lose their time and effort. In case of profit calculation in Islamic financial intermediation, all operational expenses are deducted from the bank income to derive the net income or profit. From this the Mudarib, or bank's, profit share is deducted, and the balance amount is distributed on a pro-rata basis amongst the depositors. Islamic banks usually apply different profit-sharing ratios to different types of deposits.

As per Shariah requirements, the money lent by Islamic banks needs to be applied to real assets, usufruct or services. Productivity and entrepreneurship as measures to grow the economy are emphasized in Islam. Islamic banks provide financing in two ways. Firstly, as asset-backed financing, where all transactions have an underlying asset, enterprise or service and these are sales, trading, lease, investment or fee-based contracts. Secondly, as participation finance, where the bank becomes a partner in the contract and shares in the risk and return. This can be done as a Mudaraba contract, one party providing the entire capital and the other providing effort and skill. It can also be executed as a Musharaka contract, where all parties contribute to the capital and all or some are involved in managing the business with their effort and skills. Musharaka will be considered in more detail in Chapter 6. In both contracts, profit is shared in a pre-agreed ratio while losses as per the capital contribution. In Islamic banking the focus is more on the trustworthiness and abilities of the borrower rather than the creditworthiness or financial worth of the borrower and the collateral provided. Islamic banks need to be prudent in selecting projects to finance and are required to supervise and monitor much more closely, since they do not charge a fixed interest but rather share in the profit and loss of these projects.

The Mudaraba concept is used to structure both demand deposits (current and savings accounts) and time or fixed deposits. Demand deposits can be withdrawn on demand and the profit for them is calculated based on the balance maintained in the account at regular intervals, often every quarter. Time deposits, which are called investment accounts in Islamic banks, require the commitment of the deposit for specified periods (e.g. 3, 6, 9, 12 months). If the deposit is withdrawn early, the principal is returned, but no profit or only part of the profit is paid. There are two types of investment accounts: general investment account, where the depositor gives the bank complete responsibility to invest their funds as the bank sees fit and agrees to a standard profit-sharing ratio; specific investment account, where the customer specifies some conditions related to where their deposit can be invested and accepts a negotiated profit-sharing ratio. The deposited amount in the investment account does not have a capital guarantee from the bank and theoretically, in case of loss, depositors may lose their deposit. The rate of return is not fixed in advance, rather the historical rates of return are given as an indication. At the end of the investment period the actual rate of return is calculated and distributed; this rate may or may not differ from the indicative rate. The deposits of customers in Islamic banks, therefore, are not risk free, and as such they have equity-like characteristics.

For the benefit of the depositors and to stay competitive, Islamic banks take some measures to smooth the income provided to depositors. During periods of high profit, banks keep aside a portion of the profit in a reserve fund and during periods of low profit, they add to the profit from the reserve fund. There are problems related to such income smoothing and reserve funds. The investment account holders may not be aware of, or have any influence over, the income smoothing process and may have distrust related to it. To deal with such issues, investment account holders should be informed about the income-smoothing process and their consent should be taken. Moreover, the adjustment method should be very transparent and apply standard guidelines as specified by the supervisory authority of the jurisdiction. The Islamic standard setting body, AAOIFI, to be discussed in more detail later in this chapter, allows the Islamic banks to have two kinds of reserves.

1. Profit equalization reserve (PER). During years of high profit a specified amount is moved to the reserve to compensate for years of low profit. This amount is moved from the profit before any profit is distributed to the unrestricted investment account holders or shareholders.
2. Investment risk reserve (IRR). An amount is moved to this reserve after the bank has taken out its income as Mudarib, the balance of the profit being distributed to the unrestricted investment account holder.

In Mudaraba-based Islamic financial intermediation the Rab al Maal has no capital guarantee and may lose their capital in the event of a loss. Even though Islamic banks cannot directly provide any guarantee to the investment account holders as Rab al Maal, it is common for investment accounts to have a third-party indirect guarantee either from the government via the central bank or from a deposit insurance or Takaful scheme. This form of indirect guarantee is a topic of debate. Arguments against such guarantees are that Mudaraba represents risk capital and should have equity-like characteristics, and such guarantees are not Shariah compliant and may make the profit like Riba. Also, when such guarantees are provided on the bank's liability side with no such guarantee on the bank's asset side, it may create a mismatch in the risk profile affecting the design of the two-tier Mudaraba. Supporters of such guarantees highlight the comfort of investment account holders and the minimization of social costs in case of big losses at the bank and to encourage depositors to accept Mudaraba-based investment accounts instead of interest-based fixed deposits. Additionally, the capital adequacy requirements of the Islamic banks provide an indirect guarantee and sometimes the banks as Mudarib provide a quasi-guarantee for depositors' funds.

Islamic Financial Intermediation Models

As discussed by Askari, Iqbal & Mirakhor (2015), Islamic financial intermediation has three different models. These are discussed below.

Sources of Funds

The sources of funds for an Islamic bank are the cash inflows and comprise the liability side of the bank. Islamic banks' liabilities or common sources of funds include current, savings and investment accounts.

Current accounts. These accounts are opened by individuals and businesses and the funds are deposited as cash, cheques and bills. Current accounts are used by clients to pay and receive funds. Depositors can withdraw their money anytime. Islamic banks accept the funds in these accounts as Amanah (trust) or Wadia (deposit), which involves safekeeping. Legally, Wadia authorizes the Islamic bank to keep the customer's funds in safe custody on explicit or implicit terms. In contemporary Islamic banking, the Wadia contract is combined with the contract of guarantee or Dhaman, to provide the same functionality as conventional current and savings accounts. In this case, the bank provides a guarantee of the deposited amount. The funds in these accounts are not usually applied to any risk-bearing venture. If the funds are applied to any venture, then it is at the risk of the Islamic bank itself not the depositors. Depositors are not entitled to any profits in this account. The bank may charge a fee for the safekeeping. Overdrafts are usually not allowed and if the account accidentally goes overdrawn a charge may be applied, but it will not be a proportion of the overdraft amount, rather it will be the cost of collecting and processing the items for which there was insufficient funds in the account.

Savings accounts. The Islamic bank accepts the savings account funds based on Wadia (safekeeping), Wakala (agency), Mudaraba (trust financing) or Musharaka (equity financing). The bank uses the funds in these accounts to finance borrowers and entrepreneurs. These accounts bear some risk and provide the depositors with some profit from the profit earned by the bank in a pre-agreed ratio. The calculation of profit and loss is made based on the minimum available balance left in the account during a calendar month.

Investment accounts. These are the most important sources of funds for Islamic banks. The funds are accepted on the Mudaraba basis, where the customer and the bank enter into a joint-venture agreement. The funds are applied to profit and loss-based ventures and bear the risk of capital loss. The investment accounts of an Islamic bank are in the true sense not liability but non-voting equity, where depositors are the principal providers of funds in the Mudaraba contracts, the bank being the Mudarib and sharing in the profit at a pre-agreed ratio while bearing the total financial loss.

Conventional banks guarantee the principal and fixed interest rate for their depositors; in contrast, Islamic banks can neither guarantee the principal amount nor a fixed return. Islamic banks take efforts to reduce this risk by providing efficient management, supervision, minimal risk taking, selection and monitoring of the projects with utmost care and investing in a portfolio of projects. Islamic banks also build a reserve fund by setting aside part of the profit in years of above-expectation profits to compensate for years when low or no profits are made and thus aim to provide a competitive return. Moreover, Islamic banks also hold a significant amount of capital on their liability side.

Since Islam prohibits interest and speculation, transactions that involve either of these will not be accepted in Islamic banking. When a conventional bank also offers Islamic banking via an Islamic finance window or through a separate branch or subsidiary, there is concern about the possible mixing of funds sourced from non-Shariah-compliant sources with the funds of the Islamic banking operations. On this issue, Qatar Central Bank asked all Islamic finance windows in the country to close in 2011.

Application of Funds

The Islamic bank applies the funds it raises from depositors as well as its own funds to various financing transactions with the aim of earning profit. The risk of loss is also there. The application of funds of an Islamic bank comprises its assets and includes a variety of products. For short-term, limited-risk investment they use Murabaha and Salam contracts which are used for trading, working capital, etc. Medium-term financing uses asset-based instruments like Ijara and Istisna. Both these instruments can have a fixed or floating-rate feature, as required. Longer-term financing can be done using Mudaraba and Musharaka contracts, which act like private equity or venture capital.

Islamic banks, unlike conventional banks, do not deal in pure money lending. They act more like merchant banks. All liabilities and assets on an Islamic bank balance sheet are risk capital. The most common form of funds application is deferred exchange contracts with fixed income. There are four products in this category: Murabaha, Ijara, Istisna and Salam are all debt-like financing contracts, though each has an underlying asset. Murabaha or cost-plus sale, Ijara or lease, Salam or forward sale and Istisna or project finance. Mudaraba and Musharaka are equity-based products. The Islamic banks and the regulators prefer fixed-income products as their income is predictable, while scholars prefer the equity-like profit-sharing methods of Mudaraba and Musharaka. In conventional banks, the bulk of funds applied is in the form of fixed-interest lending.

Retail Islamic Banking Products

The most common Islamic banking products offered for the retail segment, serving individuals and households, are discussed below.

• Current, savings and investment accounts. These three very important products have already been discussed in detail in the Sources of Funds section earlier in this chapter.
• Credit cards. Islamic banks offer credit cards but instead of charging interest like conventional banks, they have a variety of ways of charging for their cards. As discussed in Schoon (2016), these methods are:

1. Periodic service charge. Monthly or annual fixed fee.
2. Deferred payment sale. Here the cardholder uses the card to pay for goods or services, the card issuer becomes the owner of the good or service by paying the merchant, then sells the good or service to the cardholder at the original price plus markup to be paid at the end of the period or in instalments over a period.
3. Lease purchase agreement. The card issuer is the owner of the good or service till the cardholder makes the final payment and becomes the owner. During this period, the cardholder pays a rental on the good or service to the card issuer.
4. Prepaid credit card. The cardholder deposits an amount on the card and uses it to purchase goods or services.

• Home financing. This is provided using Murabaha (Chapter 4), diminishing Musharaka (Chapter 6) and lease financing or Ijara contracts (Chapter 7).
• Personal loan. Personal loans are offered most commonly by Islamic banks as:

1. Lease and hire purchase. The bank buys and leases to the client. The client pays, over a period, repayment of the price of the asset plus rent.
2. Murabaha or deferred payment sale. The bank buys the asset and sells to the client at a markup. The client repays over an agreed period in instalments.

Corporate Islamic Banking Products

Islamic banks provide products and services for most needs of corporates, like assisting in equity or Sukuk issue, financing joint ventures, financing acquisitions and management buyouts, working capital financing, trade and project financing, etc. Some of the most common Islamic banking products and services offered for the corporate segment and for governments are discussed below.

Trade finance. Murabaha and Ijara contracts are used to provide export and import financing. The importance of trade financing comes from the problems in trade – which are that there is a lack of geographical proximity between exporters and importers and both are concerned that the other party may not meet their obligations. Owing to these problems, hand-to-hand or spot trading is not possible, instead deferred payment and deferred delivery are essential features of import and export transactions. As such, exporters and importers both need reliable third parties as intermediaries and banks provide this intermediation. Shipping companies and insurance companies facilitate trading. Common trade finance services offered by banks are as listed below.

1. Letter of credit. Operates like a conventional letter of credit – an undertaking by a bank to make payment to a certain party on presentation of required documents. Often used with trade-related Murabaha and Salam. Depending on the type of client, the letter of credit ensures goods are delivered before payment is made or insures against non-payment for goods where the risk is transferred to the bank. Islamic banks charge an administration fee for this job, which cannot be proportional to the amount of the contract since that would be the same as interest. The letter of credit provides security to both exporter and importer.
2. Bill of exchange. Written by the exporter against the importer stating the exporter's payment claim, time of payment or tenor and any other payment terms. If the importer pays at the time of receiving the bill of lading, the tenor is ‘at sight’, otherwise it is when the importer is obliged to pay as per agreement.
3. Banker's acceptance. Exporters can receive a banker's acceptance on their payment claims against the importer, which they can sell to raise funds earlier if required.
4. Bank guarantees. The exporter may directly, or via its bank, ask for a bank guarantee for payment from the importer's bank.

Project finance. Islamic banks provide project financing to corporates based on the build, own, operate, transfer, lease and rent options. The most common is BOT: build, operate and transfer.

Syndication. When the financing required by the borrower or entrepreneur is very large or very risky, it may go beyond the capabilities of one financial institution. In this case more than one Islamic bank come together to provide the financing. This is called syndication. Not all banks play an equal role in the syndication. One of the banks usually takes the lead and has the most involvement. This bank is called the lead bank. The lead bank's role is to negotiate and prepare the documents and memorandum, communicate with all relevant parties and resolve all matters related to the syndication. The benefits of syndication are that the risk of the project is diversified amongst the banks, income is shared, the client relationship is managed – even though the funding is of a large size, each of the syndicate banks bring their own comparative advantage and reputation into the financing.

Objectives of Islamic Financial Accounting

It is crucial to develop reliable and globally acceptable Islamic financial accounting standards and procedures because:

1. Existing conventional financial reporting standards are not adequate for the IFIs.
2. Commercial as well as the unique religious and social features of the IFIs need to be considered.
3. An accurate and fair system to recognize, measure and record financial information is required.
4. Transparent and equitable valuation and disclosure of financial information is important.
5. Growth of the Islamic finance and banking sector demands a competent and internationally relevant financial reporting framework.
6. Provision of standard information, understandable to all stakeholders and comparable with other companies, locally and globally, is important for the future of Islamic financial institutions.
7. Shariah compliance of transactions needs to be ensured.

Features of Islamic Financial Accounting

1. Islamic financial accounting follows the same general framework as conventional financial accounting, with modifications made to ensure Shariah compliance is met.
2. A standard double-entry method of recording is used.
3. Shariah compliance principles and rules are clearly applied in the accounting procedures.
4. Unique Islamic finance products like Murabaha, Mudaraba, Musharaka, Ijara, Salam and Istisna are recognized and applied in the procedures.
5. Financial accounting information is generated in a manner that is useful for both internal and external users.
6. Islamic financial accounting includes the calculation and distribution information of applicable Zakat.

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

The AAOIFI was set up in 1991 in Bahrain. It is one of the leading standard setting bodies in the global Islamic finance and banking industry and is an autonomous, non-profit institution. These standards are developed to bring harmony to the principles and practices of the global Islamic finance and banking industry and ensure uniformity and transparency in their financial reporting. AAOIFI is the Islamic counterpart of the IASB and its standards derive significantly from the IFRS. AAOIFI members originate from 45 countries and include banks, central banks, other regulatory authorities, non-banking financial institutions, accounting and auditing and legal firms. AAOIFI standards are not mandatory on countries or institutions, though increasingly more are opting to self-regulate themselves based on the AAOIFI issued standards.

Islamic Financial Services Board (IFSB)

The IFSB was established in 2002 and is based in Kuala Lumpur, Malaysia. For the global Islamic finance and banking industry it is one of the main standard setting bodies that stabilizes the industry by developing prudent and transparent standards and Shariah governance. Its role is like that of the BIS. IFSB members consist of the Islamic Development Bank and the central banks or main regulatory authorities of Muslim countries, especially those where Islamic banking has a significant presence. According to the IFSB website as of April 2017, the IFSB has 183 members, including 70 central banks and regulatory authorities, 7 inter-governmental organizations, 106 financial institutions, professional firms, stock exchanges and industry associations.

Liquidity Management Centre (LMC) and International Islamic Liquidity Management (IILM)

The LMC was established in 2002 in Bahrain and its main shareholders are the Bahrain Islamic Bank, Dubai Islamic Bank, Islamic Development Bank and Kuwait Finance House. The IILM is based in Kuala Lumpur and its current shareholders are the central banks and monetary authorities of Malaysia, Indonesia, Kuwait, Luxembourg, Mauritius, Nigeria, Qatar, Turkey and the UAE. The key purpose of both organizations is to create an interbank money market and issue short-term Shariah-compliant instruments to invest short-term liquidity surpluses of IFIs and facilitate liquidity management of the IFIs.

International Islamic Financial Market (IIFM)

The IIFM was set up in Bahrain in 2002 through the joint efforts of the central banks of Bahrain, Brunei, Indonesia, Malaysia, Sudan and the Islamic Development Bank. The key purpose of the IIFM is to set standards applicable to the Islamic capital markets. It focuses on the standardization of the Islamic capital market products, related documents and processes and is working towards the self-regulation and promotion of Islamic capital and money markets. The IIFM aims to develop both national and international trading infrastructures with transparent and standardized regulations and knowledge sharing amongst the various participants.

International Islamic Rating Agency (IIRA)

The IIRA was established in 2005 in Bahrain. It is the only rating agency whose sole purpose is to provide rating services for Islamic banking and for Islamic capital and money markets. The IIRA also aims to make its ratings acceptable by regulators in different jurisdictions. Its key functions are to set up benchmarks for issue and issuer ratings, ratings of timely repayments of debt obligations of sovereigns, corporates and banks, and assessment of the level of Shariah compliance and corporate governance. The IIRA also aims to publish reliable data about research, analysis and evaluation of sectors, industries and individual enterprises.

General Council for Islamic Banks and Financial Institutions (CIBAFI)

The CIBAFI was established in 2001 and is based in Bahrain. It acts like a bankers' association. It has nearly 120 members spread over 30 jurisdictions and includes IFIs, international inter-governmental organizations, professional firms and industry associations. The council was set up to represent and promote the Islamic financial services industry globally and enhance cooperation amongst its members. It advocates regulatory, financial and economic policies that would benefit its members. The CIBAFI distributes appropriate and accurate data amongst all stakeholders of the Islamic finance industry and promotes sound industry practices.

International Islamic Centre for Reconciliation and Commercial Arbitration for Islamic Finance Industry (IICRCA)

The IICRCA was established in 2003 and is based in Dubai. Its key function is to mediate in case of financial and commercial disputes amongst IFIs and commercial institutions.

Islamic Development Bank (IDB)

The IDB is part of the pioneering stage of the global Islamic finance and banking industry. It was set up in 1975 in Jeddah, KSA as a multilateral development bank. Currently the IDB's members are 57 countries, a requirement for membership is that the country needs to also be a member of the OIC. Within the IDB it has established the Islamic Research and Training Institute (IRTI), which aims to promote Islamic economics and finance via various academic endeavours like research, training, publications, seminars and conferences.

International Islamic Fiqh Academy

The Fiqh Academy was created by the decision of the OIC in 1974 and was inaugurated in Jeddah, KSA in 1988. It is an institute of advanced learning on Islamic studies and Shariah law.

Discussion Questions

1. Define Islamic banking.
2. What are the core objectives of an Islamic bank?
3. Discuss the similarities and differences between a conventional and an Islamic bank.
4. Describe the relationship of banks with the central bank.
5. What are the generic risks faced by all banks? Briefly explain each.
6. Discuss the risks specific to Islamic banks.
7. Compare ‘risk sharing’ in Islamic banking versus conventional banking.
8. Define financial intermediation in modern banking and why it is important.
9. What is financial intermediation in conventional banks?
10. Explain financial intermediation in Islamic banks.
11. What financial intermediation models can an Islamic bank use?
12. How do Islamic banks smooth out the profits given to depositors? Why is this important?
13. Conventional banks are also participating in Islamic finance and banking. What are the different distribution options used by them?
14. Contrast conventional financial intermediation with Islamic financial intermediation.
15. Discuss the main sources of funds for Islamic banks.
16. What are the common applications of funds of an Islamic bank? Which products are deferred exchange contracts, and which are equity-based products?
17. What are the requirements of a valid Shariah-compliant contract?
18. Briefly discuss a few unilateral contracts used in Shariah-compliant commerce.
19. Describe examples of bilateral Shariah-compliant contracts.
20. Discuss the common exchange contracts used in Islamic finance and banking.
21. What is the Shariah position on buying and selling of foreign exchange, especially forward transactions?
22. Discuss common retail and corporate products and services offered by an Islamic bank.
23. Why is it important to develop Islamic financial accounting procedures?
24. What are the objectives of Islamic financial accounting?
25. Describe the features of Islamic financial accounting.
26. Standardization in Islamic banking is required to reduce confusion. Briefly discuss any one confusion.
27. Discuss the challenges faced by Islamic banks today.
28. How did Islamic banking fare during the financial crisis of 2007–2008?
29. List the most important international Islamic regulatory and standard setting bodies.
30. Discuss the AAOIFI and its main functions.
31. Discuss the IFSB and its main functions.
32. Briefly describe the LMC, IILM, IIFM and IIRA.
33. What roles do CIBAFI and IICRCA play in Islamic finance and banking?
34. Discuss the IDB and its main functions.
35. What is the International Islamic Fiqh Academy?
36. How does the FSA in the UK deal with Islamic banks?

Multiple Choice Questions

Circle the letter next to the most accurate answer.

1. Which of the following principles applies to Islamic banking and finance?
   1. Prohibition of speculative behaviour
   2. Only Sharia-approved activities are permissible
   3. All profit-making is impermissible
   4. a and b
2. Islamic banks:
   1. Pay interest to their depositors
   2. Charge interest to their lenders
   3. Do not provide financing without collateral
   4. Base their investing criteria on the investment potential of the project and not just on collateral
3. Which of the following is a characteristic that differentiates Islamic banks from conventional banks?
   1. The absence of interest in all financial dealings
   2. Making profit from trade
   3. Allocation of funds to areas that increase economic activity and benefit society
   4. Provide home financing via mortgages
4. Islamic banks:
   1. Base their investment decisions entirely on the collateral submitted by the client
   2. Base their investment decisions on the investment potential of the project and not just on collateral
   3. May accept interest on their liabilities but donate it to charity
   4. Both a and c
5. Applying Islamic finance principles means:
   1. Islamic banks cannot provide lines of credit that bear interest
   2. Islamic banks can make money out of money
   3. No restriction on speculative behaviour
   4. Avoiding all kinds of risks by the Islamic bank
6. The main objective of Islamic banks is to:
   1. Provide funds for Muslims
   2. Make maximum profits for shareholders
   3. Finance building of Masjids and other Muslim religious institutions
   4. Provide an alternative to interest-based banking
7. The main objective of Islamic banks is to:
   1. Ensure Halal activities are not financed
   2. Finance the building of Islamic schools and colleges
   3. Provide Riba-free banking products and services
   4. Develop the retail and consumer banking in Muslim countries
8. Which statement below does not apply to an Islamic bank:
   1. Does not charge interest on funds given as loans
   2. Does not pay interest to its depositors
   3. Provides collateral-free loans to Muslims only
   4. Ensures no Haram business activity is financed
9. Which of the following is a Shariah rule applied to Islamic banking?
   1. Selling money for money is permitted
   2. Any profits made are not permitted
   3. A deferred sale at a price higher than the cost is not permitted
   4. A deferred sale at a price higher than the cost is permitted
10. The main Islamic banking products are:
    1. Musharaka, Mudaraba and Murabaha
    2. Ijara and Istisna
    3. Salam
    4. All of the above
11. An Islamic bank is a business, and so must make profit. Which of the statements below best explains the mechanism by which the Islamic bank earns profit?
    1. The Islamic bank charges a low interest on loans, and thus remains profitable without overcharging its clients
    2. The Islamic bank charges a competitive fee on loans and most of its profit comes from the fees
    3. The Islamic bank finances various needs of customers, linked to assets, on the basis of sale, leasing or partnership and earns a share of the profit from the transaction
    4. The Islamic bank does not lend money but instead acts as an agent between seller and buyer and receives a fee for its services
12. Sharia-compliant sales contracts have three requirements. Which of the following is not one of them?
    1. Assets need to be in existence
    2. Sales profit should be reasonable
    3. Owner should own the asset
    4. Asset should be in physical or constructive possession of owner
13. Abdulla agrees to sell his house to Ahmed at the market price. Is the sale valid under Islamic finance?
    1. Yes, the sale is valid because it is not fair that Abdulla loses money should the market price go up. At the same time, it is not fair that Ahmed pays too much for the house should the market price go down
    2. No, the sale is not valid because Abdulla and Ahmed did not sign a written bilateral contract agreement specifying this condition
    3. Yes, the sale is valid because both Abdulla and Ahmed agree to this condition and therefore they enter into a bilateral contract agreement
    4. No, the sale is not valid because the specific price has to be stated under the Islamic finance contract requirements
14. Rafe took a loan of £10,000 from Helen for a small business. The business incurred a loss and the capital reduced to £5,000. Can Rafe ask Helen to share in the loss? Which statement below is the best answer?
    1. Yes, because Rafe took the loan for the growth of his small business. Rafe does not have to pay the full amount back to Helen
    2. Yes, because in Islamic finance two parties always share the profit and loss because it is just and fair. Rafe does not have to pay the full amount to Helen
    3. No, because the transaction between the two of them is that of a loan and not any form of partnership. Rafe is liable to pay £10,000 to Helen
    4. No, because the transaction between the two of them was not recorded by the Shariah Supervisory Board. Rafe is liable to pay £10,000 to Helen
15. In Badr's grocery store there is surplus flour currently. He decides not to sell it now and to do so in the future, when there is a deficit of flour, so he can make a higher profit. Is this transaction acceptable under the principles of Islamic economics? Why?
    1. Yes, because taking advantage of a deficit of goods will result in higher profits for Badr
    2. Yes, because Badr speculates for changes in commodity supply, which is a proper business risk he is taking
    3. No, because Badr is hoarding food, and hoarding food and other necessities is unlawful under Islamic economics
    4. No, Badr is making the decision based on the issues of supply and demand of flour, which is unacceptable in Islamic economics
16. Noor purchased 1,000 bags of sugar from Islamic Bank on credit. While transporting the bags to her factory, the sugar was destroyed by heavy rains. Choose the statement that correctly explains who bears the loss.
    1. Noor bears the loss because she is the owner of the goods
    2. Noor bears the loss because she was transporting the goods at the time of the rain
    3. Islamic Bank bears the loss because it is the owner of the goods sold to Noor on credit
    4. Islamic Bank bears the loss because the heavy rains were an act of God and nature, and there was no insurance in place to cover the loss of the goods
17. As per the OIC Central Bank Governors declaration of 1982, which one below is not an aspect of the relationship between central banks and Islamic banks?
    1. Lender of last resort
    2. Supervisor regarding monetary policy
    3. Shariah supervisory
    4. Clearing house
18. Which international IFI is based in Dubai?
    1. LMC
    2. IFSB
    3. IICRCA
    4. GCIBFI
19. The key function of the IIFM is to:
    1. Create an interbank money market
    2. Set up accounting standards
    3. Mediate in IFI disputes
    4. Develop, regulate and promote Islamic capital and money markets

True/False Questions

Write T for true and F for false next to the statement.

1. The creditor–debtor relationship does not apply to Islamic banking.
2. Islamic banks use a high level of expertise and technical know-how to evaluate and monitor financing projects to ensure profitable use of funds.
3. Islamic banking transactions have to be based on tangible assets and not on intangible assets.
4. Conventional banks and Islamic banks cooperate on various issues.
5. Compared with conventional banks, Islamic banks take more risk.
6. Under central bank supervision in Muslim-majority countries an Islamic bank can operate without a Sharia Supervisory Board.