BACKGROUND OF MODERN ISLAMIC FINANCE AND BANKING

The idea of interest-free financing has existed since the birth of Islam, but its reintroduction into the world of finance is only a few decades old. The concept of modern Islamic finance emerged in the mid-20th century with Asian and Arab Muslim-majority countries gaining independence from Western colonial powers, searching for their own identity and inspired by Islamic economics distinct from both the Western capitalist and Eastern socialist models. Islamic economics, as a term, was first coined by Abul Ala Al Mawdudi, who sought to develop Islamic social science (Kuran, 2004). Islamic finance and banking evolved from the concepts of Islamic economics, based on the profit and loss system (which is considered more equitable and stable) and with the joint efforts of Islamic Shariah scholars and practicing professionals in the finance and banking industry.

The theory of Islamic banking forbids interest, and considers it neither necessary nor desirable for banking operations; instead, it recommends banks to use the PLS mechanism. The prohibition of interest is common to all three Abrahamic faiths – Judaism, Christianity and Islam (Ariss, 2010). According to the CIA World Factbook (2012), more than half of the world's population of 7 billion belongs to the Abrahamic faith, which prohibits interest, yet the international financial system has been operating mainly on interest for more than 200 years (Chapra, 2007). Aristotle condemned interest, which he said was the birth of money from money; Judaism forbade demanding any increase on the principal when lending among the Israelites, but allowed it in dealings between Israelites and gentiles. In Christianity, Christ said, ‘lend freely, hoping nothing thereby’ (Luke 6:35), while Islam strictly prohibited interest, in any form, small or substantial, fixed or variable. This clearly establishes that the prohibition of interest is not unique to Islam.

Criticism of interest and its detrimental effects exists in Western literature as well as in religious doctrines. According to Dar & Presley (1999), most Islamic finance researchers and writers often implicitly assumed that prohibition of interest was unique to Islam. As such, they failed to acknowledge Western literature, both religious and non-religious, which has been critical of interest for decades and failed to derive any advantage from such supportive Western published material towards its interest prohibition principle. Instead, most Islamic finance and banking scholars and researchers introduced it as a completely new system of finance, based on Shariah law.

CONVENTIONAL VERSUS ISLAMIC FINANCE

Islamic banking was introduced to the world only about five decades ago and the principles under which it operates are significantly different from those of conventional banking, which is a well-established and well-understood form of finance and banking globally. The guiding principle of Islamic finance and banking is the Islamic Shariah law, especially the portion of it that is applicable to commercial transactions. Shariah law prohibits the payment or receipt of interest or Riba in any form, and recommends sharing of risk and sharing of profit and loss between financial institutions like banks and their customers. Shariah law also prohibits transactions involving uncertainty where the features of the contract are not clear between the parties (Gharar) and unnecessary risk and speculation and activities like games of chance (Maysir). Shariah also prohibits industries involved with alcohol, pork, indecent media and entertainment, prostitution, etc. This is in stark contrast to the conventional finance and banking industry that primarily operates on interest and on the profit-maximization principle.

Before the revival of modern Islamic finance and banking, the prohibition of interest made banking activities difficult for the religiously oriented Muslims globally, and especially in the Gulf region. Often, these people either left their money in non-interest-bearing accounts in conventional banks or stayed outside the formal banking system altogether, which significantly hindered the free flow of capital between global financial markets and the GCC. The advent of affluence in the region, with the discovery of oil bringing in enormous amounts of petrodollars, magnified the problem further. Around this time the introduction of Islamic banking was viewed as a major solution, providing distinctive Shariah-compliant means of financial intermediation. Islamic banking was conceptualized through the efforts of Islamic political activists, Muslim legal scholars, economists and businessmen, applying Shariah law to the modern economy and innovatively structuring traditional Islamic financial instruments to provide customers with most of the services associated with conventional banks, within Shariah restrictions (Smith, 2006). Today, Islamic banking has established its place globally.

Islamic and conventional banks serve customers with the same banking needs. As such, Islamic banking often appears similar and at times identical to conventional banking, except that the contracts must comply with Islamic Shariah. Tahir & Umar (2008) identified some main differences between Islamic and conventional banks. Firstly, conventional banks finance customers by simply lending the money, where the bank is the creditor and the customer is the debtor, while Islamic banks finance customers on deferred sales contracts or on a partnership basis. The bank buys the goods or appoints the customer as agent to buy, and sells to customers at a markup, with repayment made in instalments over a specific future period, or provides the funds by partnering with the customer in the project. Secondly, Islamic banks share in the customer's activities, risks, profits and losses; conventional banks, on the other hand, earn fixed interest from customer loans. Thirdly, since Islamic banks are partners in customers' businesses, they need to understand the business well, while conventional banks only lend money and are concerned with getting the principal and interest back. Fourthly, Islamic banks cannot charge penalties from defaulters; profit, once agreed on, cannot be changed. If customers delay repayment and compensation is charged, such money is given to charity. Conventional banks can apply simple or variable interest rates and defaulters are penalized by compound interest. Fifthly, both Islamic and conventional banks face risks related to credit, capital adequacy, liability and asset matching, currency fluctuation and liquidity, although the risk for Islamic banks is higher because they are exposed to profit and loss in each customer deal. In the case of conventional banks, the risk of loss is completely the client's; on the other hand, interest rate risk is faced by conventional banks only while Islamic banks are free from it. Finally, Islamic banks cannot finance any activity which goes against Shariah law, while conventional banks have no such religious restrictions and may finance any profitable and legal activity.

GLOBAL GROWTH OF THE ISLAMIC FINANCE AND BANKING INDUSTRY

Islamic finance and banking is a new sector within the global finance and banking industry. The concept of Islamic banking emerged only in the mid-20th century, the first experimental Islamic bank was established in Egypt in 1963, and the first commercial Islamic bank was set up in Dubai in 1975. Being new and different from traditional conventional banking, there is a significant lack of awareness and knowledge of Islamic banking. According to Mishkin (2001), banking is an integral part of the service industry, its contribution increasing with time. Islamic banks perform operations very similar to those of conventional banks, except that their transactions need to be interest free and in accordance with Islamic Shariah law. Islamic banking has flourished globally over the past decades, becoming popular not only among Muslims, but non-Muslims as well (Rehman & Masood, 2012).

The global expansion of Islamic finance and banking over the decades after its re-emergence was majorly supported by the rise of the petroleum-based economies in the Middle East, mainly the GCC countries. Oil brought affluence to this region amongst the Muslim-majority population, as well as budget surpluses for governments coming in from the export of oil and the rising oil price. The Muslim population of this region, coming out of colonial influence as well as acquiring wealth from the petrodollars, became more aware of the need for banking and preferred to bank according to Islamic beliefs. Initially, Islamic banking experiments were private initiatives of individuals, but later governments in some Muslim countries significantly encouraged their growth, by changing existing legislation to match the Shariah-compliant features of the Islamic banking operations, developing new legislation tailored to the Islamic banks and removing various handicaps in the predominantly interest-based environment (Ahmad, 1994). Islamic finance started as a niche market catering only to Muslims wanting to avoid interest-based banking. Today's modern Islamic finance, a blend of Islamic economics and modern financial principles, is able to serve both Muslims and non-Muslims, with wide product ranges. The Islamic finance and banking industry was able to face the global financial crises better than conventional banks, owing to stricter lending criteria and less risky alternatives, and offering ethical investments, thus aiming to rise above religious beliefs and gain greater market share (Abdullah, Sidek & Adnan, 2012). The current stage in Islamic banking development can be identified as global expansion and acceptance beyond that of the religiously motivated Muslims, as it gains customers amongst non-Muslims. This remarkable global growth of an industry only a few decades old indicates the tremendous opportunities existing in this niche business for the participating banks.

Almost non-existent five decades ago, the Islamic finance industry has emerged as one of the fastest-growing sectors of the global finance industry. Over the past five decades, it has been growing at about 15% per annum, reaching almost 500 institutions in 75 countries globally. The Shariah-compliant assets of the top 500 banks are expected to reach USD2.6 trillion by end 2017, with a further 191 conventional banks offering Islamic products, some on a limited scale via Islamic windows, or via subsidiaries or branches specifically established to offer Islamic banking products. Currently the Islamic finance and banking industry is spread over the Middle East, Asia, Africa, Europe and North America, the largest Islamic banks being located in the GCC countries (Abdullah, Sidek & Adnan, 2012; Duran & Garcia-Lopez, 2012; Hassan, Kayed & Oseni, 2013; O'Sullivan, 2009; Shamma & Maher, 2012; The Banker, 2010).

Modern Islamic banking was neither successful, fully understood nor appreciated from the inception of its introduction. Developments in the theory and practice of modern Islamic banking can be roughly divided into three periods. The first was a period of conceptualization (1950–1975), when Islamic scholars raised Muslim consciousness about prohibition of interest, mostly from the religious aspect; the second was a period of experimentation (1975–1990), profit and loss-sharing Islamic banks were set up, Islamic financial instruments and institutions were established, Western financial institutions entered the market and the sector was accepted as an interest-free alternative to conventional banking; the third period (1990–present) is about earning recognition, confidence and credibility in domestic and international markets, the innovation of products and the standardization of products and procedures (Iqbal & Mirakhor, 1999). The first Islamic banking experiment occurred in Mit Ghamr in Egypt in 1963 with the establishment of a cooperative savings bank, which could not, however, develop into a successful commercial bank. The world's first successful commercial Islamic bank was the Dubai Islamic Bank, which has grown with both governmental and public support since its inception in 1975.

Most Muslim countries apply Shariah law to some extent in their social framework. Its application to commercial activities like finance and banking varies between the Muslim-majority countries. Most countries operate on a purely interest-based banking system, some on a dual banking system, with both conventional and Islamic banking legislation, while only a handful, like Iran and Sudan, operate in an interest-free banking environment. During the 1980s there was movement to make Pakistan's banking sector fully Shariah compliant, but this initiative fell apart due to lack of significant practical steps and now Pakistan operates according to the dual banking mechanism (State Bank of Pakistan, 2008).

Although the global banking environment is predominantly interest-based, Islamic finance has proliferated in the Far East, the GCC, North Africa, the Indian sub-continent, as well as in the emerging CIS countries (Ariss, 2010). Many non-Muslim countries like the UK, the USA, Australia, Denmark, India, Liberia, Liechtenstein, Luxembourg, Philippines, South Africa, Thailand and Singapore have Islamic financial institutions (Ahmad, 1994). Major international banks like Citigroup, HSBC, Barclays, UBS, BNP Paribas and others are diverting some of their operations from conventional practices to set up Islamic windows or fully fledged Islamic subsidiaries (Ariss, 2010). Britain is aiming to convert London into a global Islamic finance centre (Kerr, 2007) to compete with Bahrain and Malaysia. The continuing growth of Islamic banking depends greatly on its acceptability and preference by customers beyond the religiously motivated Muslims, and among all segments of Muslim and non-Muslim populations of the world. Islamic finance is expected to continue its growth, with international standard setting bodies such as the AAOIFI, IFSB and International Islamic Fiqh Academy playing a guiding role.

ISLAMIC FINANCE AND BANKING AND THE MUSLIM COMMUNITY

Islamic banks provided Muslims with the opportunity to bank and invest in accordance with their religious beliefs and without interest, while previously they had to deal with interest if they wanted to participate in the banking system. The Muslim population comprises more than a quarter of the estimated global population of 7.4 billion currently (http://www.muslimpopulation.com/World/). According to the Pew Research Center (2011), the Muslim population is expected to increase by 35%, twice the rate at which the non-Muslim population is growing, reaching 2.2 billion by 2030. Muslims inhabit all five continents, but almost 60% reside in Asia and 20% in the Middle East and North Africa (Estiri et al., 2011). They constitute the majority in more than 50 countries (Damirchi & Shafai, 2011). Muslim countries generate 10% of global GDP (Karasik, Wehrey & Strom, 2007) and include 9 of the 12 members of the Organization of Petroleum Exporting Countries (OPEC) – Iran, Iraq, Kuwait, Saudi Arabia, Qatar, UAE, Indonesia, Libya and Nigeria (OPEC, 2014). The 57 member countries of the OIC have a combined GDP of nearly USD8 trillion, import about USD1 trillion and export USD1.4 trillion, creating a combined market of USD2.4 trillion. Moreover, Islam is the fastest-growing religion and some Muslim countries are the richest in the world, like Qatar, Brunei, UAE and Saudi Arabia, which are listed as having per capita GDP greater than USD50,000 (Alserhan, 2010; World Bank, 2013). The economic and political status in the Muslim world varies significantly from country to country, with the six GCC countries consisting of about 12 million high-end consumers (Marinov, 2010).

To effectively compete globally, Islamic banks need to cater not only for the Muslim population, but non-Muslims as well. Islamic banks play the same role of financial intermediation and offer products to meet the same needs as conventional banks, except that they operate within Islamic principles and regulations. As such, Islamic banks, even those operating in Islamic countries, in most instances face competition not only from other Islamic banks, but also from conventional banks.

BANKING AND ISLAMIC BANKING IN THE MIDDLE EAST AND THE GCC

Islamic finance concepts have been in existence and practiced for centuries, but have been institutionalized only in the last few decades, offering Shariah-compliant products and services. The rise of Islamic banking cannot be separated from the oil economies and the rise of the Arab Gulf countries. The GCC countries entered the global financial markets with the mid-1970s oil embargo, a dramatic increase in oil prices, huge wealth transferred to these countries with modest means, with neither the economic capacity to absorb this wealth nor the financial capacity to manage it, and a concomitant move suddenly from the fringe of the global economy to its centre (Smith, 2006). The Gulf economies were rudimentary at the beginning of the oil boom. They operated mostly with money changers and lenders, rather than banks, dealing with fees and not interest. By the 1970s they had moved to cash and credit systems based on Western interest-based banking, but the population was almost entirely Muslim, adamant about the Islamic restrictions on interest and therefore sustaining a demand for Islamic banking. Moreover, the ruling monarchies also required an acceptable financial system through which to share the oil wealth with their population (Smith, 2006).

The idea of Islamic banking began in the late 1940s; the first experiment was in Egypt with the Mit Ghamr Social Bank. Later, various Middle Eastern countries began to establish Shariah-compliant banks: Nasser Social Bank in Cairo (1972), Islamic Development Bank in Jeddah (1975), Dubai Islamic Bank (1975), Kuwait Finance House (1977), Faisal Islamic Bank in Sudan (1977), etc. Several conventional banks in the Middle East also converted partly or fully to Shariah-compliant operations (Khan & Bhatti, 2008). The world's largest Islamic banks are in the GCC, and by 2008 had captured about 35% of the banking market of those countries (Hasan & Dridi, 2010). The Middle East owns 60% of global Islamic banking assets, estimated to be about USD2 trillion, excluding Islamic windows and branches of conventional banks and Islamic insurance. At an average growth rate of 25%, it is estimated that 40–50% of the savings of the Muslim population will be acquired by Islamic banks within a decade (Al-Salem, 2008). The GCC countries operate on the dual banking system, with both conventional and Islamic banks operating side by side. The GCC banks are small, but financially strong, well-capitalized, with modern facilities (Srairi, 2009). None of the GCC Islamic banks have failed in the last few decades, partly because the governments support them and partly because they help one another (Smith, 2006). Now Islamic banks comprise 20% of the GCC's bank assets and are expected to grow, posing a serious challenge to conventional banks (Benaissa, Nordin & Stockmeier, 2003). The GCC, therefore, is a major region for innovation and growth of Islamic finance and banking, with a supportive legal system and population.

BANKING AND ISLAMIC BANKING IN SOUTH AND SOUTH-EAST ASIA AND BEYOND

The Islamic banking experiment started in around the 1960s. During the first three decades of the Islamic banks' emergence, Islamic finance development was based mainly in Bahrain and Malaysia, which appeared as the leading Islamic financial centres. In 1962, Tabung Haji Malaysia was established as an investment fund to help Malaysians save the money needed to perform Hajj, the pilgrimage to Makkah, and which provided depositors with profit rather than interest. Mit Ghamr was not very successful, as it did not get governmental support, but Tabung Haji has continued successfully to date. The inception of Islamic banking in the 21st century brought both opportunities and threats in the banking sector in other countries besides Malaysia in Asia (countries like Pakistan, Bangladesh, Indonesia, Brunei and Singapore). These Muslim-majority countries and Singapore, with its large Muslim population as well as its proximity to Malaysia, have several Shariah-compliant banks and regulatory authorities that play a significant role in providing the platform for Islamic financial institutions to operate side by side with their conventional counterparts, with regulations that allow their unique characteristics.

Islamic finance initially was concentrated in the Middle East, especially Bahrain, and South-East Asia, particularly Malaysia, but has now spread to purely Islamic Shariah-based countries like Iran and Sudan, as well as those where Islamic and conventional financial systems coexist on a dual basis (like Indonesia, Malaysia, Pakistan, the GCC) and moving beyond to the Western countries of Europe, North America and Australia.

ACHIEVEMENTS AND OPPORTUNITIES IN GLOBAL ISLAMIC FINANCE AND BANKING

The introduction of the profit and loss-based financial intermediation of Islamic banking in a world well content with the highly sophisticated conventional system was challenging. Religion was considered the main motivator of the preference for Islamic banking, but this was important only to committed believers in Islam, while to others it had little appeal. As such, it was necessary to search for another economic rationale to support the replacement of interest with the profit and loss system. By the mid-1980s, economic and financial theory demonstrated the disadvantages of interest-based contracts, which encouraged default or non-performance and suffered from adverse selection, since collateral rather than the project itself is focused on, creating conflict between the interests of the borrowers and the lenders (Iqbal & Mirakhor, 1999). According to Chapra (2007), the rationale behind the prohibition of interest is not only religious, to prevent the exploitation of the poor, but also to make the financial system more disciplined and stable, by increasing equity, offering financing linked to real assets, eliminating speculation, allocating resources efficiently and enhancing economic growth. With this view, the religious-based Islamic banks appear to achieve general economic and financial objectives better than the conventional secular banks.

The mainstream capitalist economic theory is independent of any cultural or religious influences. Islamic finance defies this, but despite this major shift it is not localized to Muslim-dominated regions only, but is spreading globally (Smith, 2006). Islam is the only religion today that requires financial activities to be carried out in accordance with its laws. Judaism and Christianity also have similar ethical standards, but the concept of interest is no longer questioned (Abdi, 2010).

Although Islamic banking is still in its infancy, it has attracted the attention of many investors and has the potential to attract new customers and grow in market share. With the development of viable Islamic alternatives to conventional finance products, Muslims, and to a certain extent non-Muslims, are seeking Shariah-based solutions to their financial needs. The world's largest Islamic banks have outpaced conventional banks with an annual asset growth of 26.7%, beating the 19.3% growth rate in conventional banks, and thus delivering a significant message that Islamic banking, while still in its infancy, is a worthwhile alternative to conventional finance (Ahmad, Rustam & Dent, 2011).

Overall, Islamic banking has been able to establish itself on the global stage, but the debate regarding its pros and cons continues. According to its supporters, Islamic banking has made many positive contributions to global banking and finance. The most impressive argument in its favour is that it integrates the financial sector with the real sector, since an existing or potential real asset needs to correspond with every financial asset, unlike in the conventional system (Siddiqi, 2006). It also focuses on the successful operations and financial viability of the projects it invests in, to be able to share in their profits (as in venture capital financing), rather than on collateral like the conventional banks do (Gupta, 2009).

Islamic finance and banking weathered the global financial crisis better than its conventional counterparts, since many of the underlying causes for the crisis were forbidden in Islam (Hassan, Kayed & Oseni, 2013). Islamic banks have shown strong performance during the global financial crisis, which has enhanced their reputation as a legitimate alternative to conventional financing and they are considered a relatively safe refuge from global financial turbulence. Unlike conventional interest-based banking, Islamic banking is more conservative, requiring real asset backing for its products. Furthermore, it does not permit short selling and is considered a legitimate alternative to conventional banking (O'Sullivan, 2009; Rammal, 2010).

CHALLENGES FACED BY ISLAMIC FINANCE AND BANKING

Overall, Islamic banking has been able to establish itself on the global stage, but the debate regarding its pros and cons continues.

Considering the significant growth of Islamic finance and banking globally, and the remarkable increase in the Muslim population, it is not wrong to expect the sector to occupy a significant position in the global finance industry. Though in reality, Islamic finance accounts for only about 1% of global financial assets (Rustam et al., 2011). A major reason for this slow penetration of global Islamic finance and banking is that only a limited number of people know much about it and very few are studying or researching Islamic banking (Ahmed, 2010). As Islamic banking moves forward and aims to compete on a mass scale as a reliable alternative to the centuries-old conventional banking on the global stage of finance and banking, it faces various challenges, which are discussed below. To succeed, the industry needs to find solutions to these challenges and minimize their impact.

1. Regulatory environment. Ideally, the Islamic financial institutions operate best in a fully Shariah-compliant regulatory environment. Only countries like Iran and Sudan fall into this category, while most Muslim-majority countries operate under the dual banking system where mainly the conventional regulatory regime is in operation, but the Islamic financial institutions and their unique features are understood and the Shariah implications are tailored into the special regulations applying to these institutions. Non-Muslim countries operate under a fully conventional regulatory environment. The interaction between Shariah law and local law and regulation may lead to conflict and confusion, and in pure conventional environments local regulations may make it difficult to introduce Islamic financial products and services with their unique characteristics. Various adjustments to the local laws are required for Islamic finance products to be accepted, and the country in question and its regulatory regime may not be interested in this, thus making it difficult for Islamic financial institutions to operate freely. These complications are less in Muslim countries.
2. Lack of knowledge and awareness. A major problem faced by the global Islamic finance and banking industry is the lack of understanding of this unique finance and banking system, by stakeholders, such as customers, employees, management, regulators, investors and the public with regard to how Islamic finance and banking operates, its uniqueness and benefits, its products and services and its differences from conventional finance and banking. Muslims often patronize Islamic banks for religious reasons only, not based on reasoned choice, while non-Muslims, as well as those Muslims who do not understand Islamic banking and are not religiously motivated, are wary of banking with Islamic banks. When consumers base their decisions not on knowledge of the products, but simply on religious principles, this can lead to the risk of suppliers trying to abuse consumers and undermine the basic principle of informed consumer choice, which is the foundation of the free-market economy (Bley & Kuehn, 2004). Moreover, this lack of knowledge would be a detrimental factor in developing positive attitudes and a preference for Islamic banks, and can be a deterrent to those Muslims not religiously motivated, as well as the non-Muslim customer segment, to patronizing Islamic banks.
3. Lack of educational initiatives. The Islamic finance literature is critical of the future growth of Islamic finance in the 21st century (Tahir, 2009). Islamic banking and the finance industry started its operations before the development of professionals especially trained in this specialized area of banking and finance. During the early years of the Islamic finance industry, most human-resource training for professionals was met through conferences, workshops and in-house training programmes, while formal education at the tertiary level, both at the undergraduate and postgraduate level, was very little (Tahir, 2009). Moreover, neither governments nor the financial institutions have taken significant educational initiatives. In contrast, conventional banking concepts are well known to all stakeholders and are taught in educational institutions. To make rational bank selection decisions, customers rely on their pre-existing knowledge and experience, and this, for many, is conventional banking rather than Islamic banking. A direct impact of this general lack of knowledge leads to the challenge of sourcing employees with the required training and experience for Islamic banks.

   Some of the formal educational opportunities now available in the areas of Islamic finance and banking globally are at institutions like the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB) in Jeddah, International Islamic Universities in Islamabad and Kuala Lumpur, the International Centre for Education in Islamic Finance (INCEIF) in Malaysia, the Qatar Foundation, the International Institute of Islamic Banking and Finance in London, the Islamic Foundation in Leicester, Al Khawarizimi Colleges and Westford School of Management in the UAE. As the growth in the industry takes place, additional institutions, as well as many mainstream universities and colleges in the Middle East and North Africa (especially the GCC), South and South-East Asia are considering offering degrees and diplomas in Islamic finance.

4. Shortage of trained employees. A major hurdle faced by the Islamic finance industry is shortage of human capital, with respect to employees with Islamic banking as well as conventional banking skills, and Shariah scholars, with some knowledge of banking. Training is therefore crucial for both these groups, and this would then lead to educating the customers regarding Islamic banking products. Abou-Youssef et al. (2012) found that consumers were generally not satisfied with the knowledge, experience and efficiency of Islamic bank employees. Some major challenges in Islamic finance education and training are knowledge of Shariah law, a shortage of well-developed curricula, teaching resources and trained teachers, as well as a knowledge of the Arabic language, since the Quran, Sunnah and Fiqh were all originally in Arabic. A pre-existing knowledge of Shariah and the Arabic language is an advantage enjoyed by the Muslim Arabic-speaking countries with regard to both employees and potential consumers.

   The late start of the Islamic finance and banking industry compared with its conventional counterpart, as well as the limited number of Islamic finance educational facilities, constitute the major reason for the shortage of trained employees for this sector. Islamic banks need three types of specialists: finance professionals, familiar with both conventional and Islamic banking products; Shariah scholars and Islamic jurists, to help develop innovative Islamic products; and lawyers, who assist in structuring Islamic products, in compliance with the legal and regulatory issues, in addition to Shariah compliance (Ahmed, 2010). Most Islamic bank employees are educated and trained in conventional banking and do not have sufficient knowledge of Islamic banking; on the other hand, the Shariah scholars, learned in Islamic law and jurisprudence, are lacking in banking knowledge. Training is required for both groups (Tahir & Umar, 2008). Only about 250 to 300 Shariah scholars exist in the world (Shah, Raza & Khurshid, 2012).

   Employees with an understanding of Islamic banking principles and products, its similarities and differences from conventional banking and its unique operations, can enhance awareness of Islamic banking among the stakeholders, especially customers. Though Islamic finance has developed in the global economy, at the theoretical and practical level it is still poorly understood and faces ideological and structural challenges to full integration (Karasik, Wehrey & Strom, 2007). One attributing factor in the lack of knowledge among consumers is the shortage of employees with specific knowledge of and training in Islamic banking (Kharbari, Naser & Shahin, 2004). Islamic banks can integrate with the global financial system, coordinate with leading international Islamic organizations and penetrate the global mass market only if they can address this lack of consumer knowledge and find employees trained both in banking and in Islamic Shariah principles (Bianchi, 2007; Rammal, 2010; Shah, Raza & Khurshid, 2012).

5. Lack of significant innovation in products. Islamic banks are also often criticized for having products very similar to those of conventional banks. Khan (2004) contends though that the distinction between the two banking systems lies more in the operations, rather than in the product features. Considering both the supporters' and detractors' views, and the evidence available in the industry, it is evident that a growing wedge is forming between the theory and practice of modern Islamic banking, which can be a major challenge to its acceptability within its main Muslim customer segment, as well as in the global finance industry.

   The more positive feelings of current users appear more allied to their religious orientation, rather than to a clear understanding of the products and operations of an Islamic bank. Most current customers of Islamic finance and banking appear to have selected Islamic banks for religious reasons more than anything else. On the other hand, Muslims not religiously motivated and non-Muslims do not feel comfortable banking with Islamic banks. Even though some Islamic finance products have been applied for centuries, the modern-day Islamic finance industry is very young and is still trying to develop a full range of products and services that meet the current needs in a Shariah-compliant manner, and these products and services can be structured quite differently depending on the geographic region or the school of thought they are associated with.

6. Competition with conventional finance and banking. Since Islamic banking is a new and unique system, it is less understood amongst regulators and bankers, more so in non-Muslim countries and even in countries with a dual banking system. The banking operations are designed for the conventional system and have been utilized so for a very long time. To be understood and operated, Islamic finance and banking is required to work within this environment. Additionally, the Shariah law precept within the Islamic finance and banking industry is a new paradigm interrelating finance, economy, community and society. Islamic banks are expected to carry out their operations with a combined finance and socio-economic objective, striving for economic efficiency as well as social justice (Choudhury & Hussain, 2005). This can be quite a challenge for the Islamic banks, especially in competing with the conventional banks, which only operate on profit-maximization principles and have no religious or social obligations to fulfil.

   Islamic banking, being quite new in the global finance scene, on the one hand, attracts new customers, but on the other hand, also attracts increasing competition, requiring banks to design innovative marketing strategies to gain competitive advantage and a strong position (Hassan, Chachi & Latiff, 2008). By overcoming these challenges, Islamic banks will further develop as legitimate competitors to conventional banks globally, reaching out to the majority Muslim population who are not always inclined to bank on religious grounds, as well as to non-Muslims.

7. Gap between theory and practice of Islamic finance and banking. Since all Islamic banks are based on Shariah principles, theoretically there cannot be any differences between them, yet their practices differ significantly. Theoretically, Islamic banks are not supposed to deal with interest in any form. In practice, Islamic banks diverge in many ways from the paradigm version, and whether all Islamic banking products are fully Shariah compliant or not is an ongoing debate (Dusuki & Abdullah, 2007). Today, Islamic banks are at a crossroads, between the choice of Shariah compliance and adjusting to business and economic realities (Hasan, 2005). They are competing with conventional banks who offer fixed interest rates to customers, while Islamic banks can only offer a probable profit rate, and their profit and loss system often adds riskier projects to their portfolios (Nienhaus, 1986). Not all Islamic banks follow PLS completely, and only a small percentage of their activities are based entirely on PLS. Most Islamic bank deposits are explicitly or implicitly guaranteed, PLS principles are not applied strictly and banks are encouraged by central banks to maintain reserves to even out profits and losses (Zaher & Hassan, 2001).

The use of PLS-based products such as Mudaraba and Musharaka has declined in recent years, and more short-term financing and other debt-based contracts like Murabaha and leases are used by Islamic banks (Kuran, 2004; Zaher & Hassan, 2001). There is no theological debate about the prohibition of Riba, which is the Arabic term for interest, and it is mandatory for all Islamic banks to have Shariah Advisory Boards to ensure all products and operations of the bank are Shariah compliant. However, there is criticism of the practices of Islamic banks and suggestions are being made that they need to understand and implement Shariah law better (Dusuki & Abozaid, 2007). Many Islamic banks are diverging from their social and economic goals as well (Aggarwal & Yousef, 2000; Asutay, 2007). Often the profit rate on various Islamic banking contracts is the same, irrespective of the asset applied to, and is reminiscent of interest rates, while competitive pressure can be a reason for pegging the Islamic bank profit rates on conventional bank interest rates (Dar & Presley, 2000; Haron & Ahmad, 2000; Khan, 2004; Nienhaus, 1986). These criticisms may drive the original religiously oriented Muslims to mistrust Islamic banks and have negative attitudes about them, deterring them from banking with Islamic banks.

The emerging Islamic finance industry is promoted as an ideal alternative, away from the problems of interest-based conventional systems, where the bank shares the risk and profit with the entrepreneur. In practice, Islamic banks are executing more commercial functions rather than investing (Askari, Iqbal & Mirakhor, 2008). They are replicating conventional bank products, with Arabic names, technically complying with Shariah by mostly using markup sales of Murabaha or leasing called Ijara, rather than the equity financing of Mudaraba and Musharaka. There is little evidence that Islamic banks are significantly involved in venture capital projects, small or micro enterprises, emerging industries or agriculture; they are engaged in practices like those of conventional banks, financing well-established businesses and individuals (Kayed, 2012). Clearly, the widening gap between theory and practice could work against the Islamic finance industry in confusing stakeholders, generating negative attitudes and losing customer preference.

SOCIAL RESPONSIBILITIES OF ISLAMIC FINANCE

Shariah principles require Islamic banks to balance profit motivation with social objectives; it is considered unjust if they are unable to provide sufficient returns to depositors and shareholders who have entrusted them with their money on the one hand, but on the other hand they should not make excessive profits at the expense of their customers or by neglecting their social responsibility (Ahmad, 2000; Chapra, 2007). Dusuki (2008) found that stakeholders of Islamic banks had more favourable attitudes towards them when they served their social and ethical goals. Islamic banks are like the socially responsible and ethical investment funds that have gained popularity in Western economies (Wilson, 1997). The Turkish media report about the Daily Vatican newspaper, encouraging banks to study the ethical rules of Islamic finance to restore confidence among their clients, took Islamic banking to new heights (Loo, 2010). The socially responsible and interest-free operations of Islamic banking are accepted by many scholars as potential solutions to economic instability, unemployment, inflation and poverty, and can serve as a major competitive advantage among the customer group that wishes to patronize ethical banking (Ahmad, 2000; Chapra, 2007; Dar & Presley, 1999; Dusuki, 2008).

According to the International Association of Islamic Banks, the social responsibility of Islamic banks distinguishes them from conventional banks: Islamic banks have to consider the social implications of their decisions; profitability is an important priority, but is not the sole criterion in evaluating the performance of Islamic banks (Al-Omar & Abdel-Haq, 1996); they are expected to focus on the disadvantaged classes of society, aiming to make them self-reliant (Hassan, 1999), for example by offering finance to small businesses, often not served by conventional banks, without collateral on a PLS basis.

This social responsibility advocated for Islamic banks has not gone unchallenged and has generated ongoing debate. There are two dissenting views regarding the social objectives of Islamic banks. The first, called the Chapra model, says that Islamic banks should not be solely profit oriented, but have religious commitments and socio-economic objectives of social justice, equitable distribution of income, and wealth and promotion of economic development, without undermining their commercial viability.

According to the second view, called the Ismail model, Islamic banks are regular commercial entities whose only goal is to carry out business in compliance with Shariah law, and their main responsibility is towards the shareholders and depositors, while social welfare objectives should be left to other bodies such as the government (Dusuki, 2008; Satkunasegaran, 2003). Rosly and Bakar (2003) noted that payment of Zakat as a social contribution is compulsory for Islamic banks, but they should not use shareholders' or depositors' funds for any other non-compulsory social activities that may jeopardize their viability, since Islamic banks are business entities, not welfare organizations.

The world today is much more conscious of the social and ethical behaviour of business entities, and corporate social responsibility is a major competitive advantage of all businesses, including banks. Islamic banks' built-in social responsibility principle is thus an advantage for them. Ismail's model is like the Western neoclassical worldview, especially Friedman's concept of a firm's responsibility. Society is best served by individuals pursuing their own self-interest and profit maximization within the legal context (Dusuki, 2008). According to Satkunasegaran (2003), Ismail's model is more applicable in multi-religious countries like Malaysia, while Chapra's model is more practical in a primarily Muslim country.

The Islamic perspective of global business has largely been ignored by researchers, while interest in business ethics is growing. Research in Islamic finance can therefore add to this body of knowledge, as Islamic finance professes to be more just and equitable for all stakeholders, including borrowers and lenders, with its products operated in partnership and on a profit and loss-sharing basis, thus emphasizing socio-economic justice and equitable distribution of wealth (Dusuki, 2008; Saeed, Ahmed & Mukhtar, 2001; Shah, Raza & Khurshid, 2012).

GOING FORWARD

Islamic banking has grown tremendously over the last five decades, but it faces several challenges that need to be overcome for its continued growth globally as a legitimate alternative to conventional banking.

Islamic banks face competition from other Islamic banks and from global conventional banks. To survive and grow in this increasingly competitive and liberalized global banking industry, Islamic banks need to attract and retain both Muslim and non-Muslim customers. Although Islamic and conventional banks are different, they compete in the same market, offering complementary products and services (Naser & Moutinho, 1997). To effectively compete, Islamic banks need to be customer-oriented, understand well both their current and potential customers, and design marketing strategies accordingly, aiming to gain a competitive advantage and a strong competitive position. Islamic banks need to avoid over-dependence on Muslims, who prefer them primarily on religious grounds, and should find innovative ways to serve overall society, including Muslims not religiously motivated, as well as non-Muslims, but within the basic Shariah guidelines, otherwise they would lose their identity.

To establish their position in non-Muslim countries, Islamic banks need to integrate and adapt to the overall legal and regulatory frameworks of those countries, while maintaining their Shariah compliance to continue to satisfy Muslim communities. At times they may face contradictory social and legal issues, and one size may not fit all; flexibility may need to be exerted, and although Shariah is a global ideal, its interpretation varies (Balz, 2007). The social responsibilities of Islamic banks set them apart from the capitalistic and solely profit-oriented conventional banks. Islamic banks need to balance both profit as well as social objectives (Dusuki, 2008), and though the PLS basis of investment and lending of Islamic banks may disadvantage them somewhat compared with conventional banks (Gupta, 2009), the fairness of the PLS system and the social objectives allow them to be more ethical. This can be important in attracting both non-Muslims and Muslims, beyond those interested in Islamic banking solely on religious grounds.

To ensure long-term growth and prosperity, Islamic banks need to overcome general ignorance about Islamic banking, and educate all stakeholders – customers, employees, competitors, regulators and the public. Competition in Islamic banking will eventually lead to competing for the most knowledgeable and experienced professionals, who are trained in both conventional and Islamic banking, as well as in Shariah law, and such expertise is quite rare (Natt, Al Habshi & Zainal, 2009). Shortage of human capital is currently recognized as a major detriment to the global growth of Islamic finance, and expert human capital will allow banks to enhance current and potential customers' knowledge, as well as develop innovative products that meet customer needs and are comparable to conventional banking products. This is directly linked to the need to enhance educational and training facilities available for Islamic finance and banking, as well as the Shariah principles applicable to the discipline of commerce and finance.

Since Islamic banking is based on Islamic religion and Shariah principles, which are derived from the Quran and the Sunnah, written in the Arabic language, Arabic terminology cannot be completely detached from Islamic banking. On the one hand, Arabic terms reassure religiously oriented Muslims of Shariah compliance, but on the other hand, they alienate non-Muslims and non-Arab Muslims. Moreover, they complicate comprehension of Islamic banking among all customers. It is therefore recommended that Arabic be used only as and when required, and that all Arabic terminology should be appropriately translated for the general customer.

The design of effective marketing strategies is very important for Islamic banks, and they need to develop media campaigns to increase customer awareness and knowledge, build positive attitudes and trust, and reduce negativity. Islamic banks should also compete effectively in service delivery with conventional banks and focus beyond the Shariah-compliance dimension, concentrating on attributes of bank preference deemed important by current and potential customers.

KEY TERMS AND CONCEPTS

• Muslim legal scholars
• Muslim population
• Global financial crisis
• Oil boom and Oil embargo
• Regulatory environment
• Social responsibilities of Islamic finance

CHAPTER SUMMARY

Islamic finance was evident from the time of the Prophet and when Islam was first introduced, though modern Islamic finance and banking was reintroduced to the world in the middle of the 20th century through the efforts of Islamic economists, political activists, Shariah scholars and finance professionals and businessmen. It provides an alternative form of finance that is free of interest, the core of conventional finance, and is based on profit and loss sharing – required to follow Shariah rulings in addition to the profit objective.

Islamic finance and banking, developing over the last eight decades, has gone through early failures but over time has made its place and achieved significant success. The momentum in the Islamic finance and banking industry was majorly driven by the oil boom in the Middle East, mainly in the GCC countries, and the significant growth amongst the Muslim population and their reawakened desire to bank as per their religious beliefs. The South and South-East Asian Muslim-majority countries have also been important.

In the time it has been around, Islamic finance and banking has achieved a niche position in the global finance industry, with significant size and number of institutions operating under this alternate system, as well as several large conventional financial institutions offering Shariah-compliant products. The industry also faces several challenges, specifically regulatory challenges in non-Muslim and some Muslim countries. It also suffers from a lack of knowledge, awareness, educational initiatives, trained employees and innovation in products. Other challenges are competition from the conventional finance industry and the debate related to the gap between theory and practice in the Islamic finance and banking industry.

Islamic finance has been able to weather the global financial crisis quite well and is considered as a more conservative form of financing, with definite social responsibilities and ethical considerations making it attractive to many. The industry is expected to develop further moving forward.

END OF CHAPTER QUESTIONS AND ACTIVITIES