Banks are institutions licensed by the central bank and allowed to take deposits from people. They also provide a host of other products and services including giving loans, collecting cheques, drafts, transferring money, providing guarantees, dealing in foreign exchange and assisting the client to invest. From the economic viewpoint, Islamic banks have a similar role to that of conventional banks. Banks use the funds collected as deposits to provide financing to other clients and invest their own and customer deposits.
The uniqueness of the Islamic bank comes from the fact that all transactions need to be in accordance with the Islamic Shariah principles. The Islamic bank provides all common commercial banking services within the Shariah framework, mainly incorporating the prohibition of interest or Riba, which is a fundamental difference from the conventional banks. As discussed already in Chapters 1 and 2, in Islam money is only a medium of exchange and is a factor of production used for business activities. In contrast, conventional finance considers money as a commodity, with intrinsic value, allowing money to earn more money, which is interest or Riba. Riba is the increase in the principal amount of a loan, calculated based on the amount of loan and the period for which it was lent. In Islam, all forms of interest are prohibited, small or large, simple or compound.
The central problem to be solved in the process of developing modern Islamic banking was to identify a suitable alternative to the interest-based mechanism. This was achieved by replacing Riba or interest with a profit and loss-sharing mechanism in Islamic banking, and this will be discussed further later in this chapter. Shariah also requires the lender or investor or finance provider to link the funding to real assets or investments, thus the income would either be based on profit and loss sharing in equity-like transactions or profit from a cost-plus-sales contract or from the rentals of a lease transaction. These mechanisms will be focused on later in the book. Owing to their emphasis on the real asset and sharing in the profit and loss of the business activity that is funded, Islamic banks give more emphasis to the productivity of the business and the managerial skills of the borrower, rather than just the credit rating of the borrower and any collateral provided.
Modern Islamic banks, like the conventional banks, aim to provide an efficient financial system through the process of financial intermediation, reliable payment systems, effective links to the money and capital markets and standardization and globalization of the industry. All financial arrangements in the Islamic banks are linked to assets in the real sector, thus providing value addition to the real economy and sharing the risk and return. Islamic banking allows Muslim depositors to become partners in businesses rather than being creditors, where both the provider and the user of funds share in the risks and returns of the business. In conventional banking both the depositor and the bank earn fixed interest, while the risk of loss belongs only to the borrower or entrepreneur. In contrast, in the case of Islamic banking depositors, bank and borrower or entrepreneur all share in the risks and returns of the business.
The core objectives of an Islamic bank are:
Despite the many differences of Islamic banking in contrast to conventional banking, the two systems appear to be more compatible than conflicting. At the onset of Islamic banking, conventional banks did not consider the interest-free system to be sustainable. Over time, as Islamic banking grew globally, the two types of banks – out of necessity – began to cooperate with each other. Both types of banks are working parallel to each other in domestic as well as international financial operations; cooperating in correspondence services – confirming, advising and negotiating LCs; depositing funds and receiving funds to and from conventional banks without interest; also exchanging information or working together as partners related to retail and corporate clients, as well as in various projects.
According to the CISI (2015) workbook Fundamentals of Islamic Banking and Finance, the similarities between conventional and Islamic banks are as follows.
Table 3.1 lists the differences between conventional and Islamic banking.
TABLE 3.1 Differences between conventional and Islamic banking
Factors | Conventional banking | Islamic banking | |
1 | Risk taking | Operates based on risk transfer from the depositors and the bank to the borrowers or entrepreneurs. | Operates based on risk sharing between the depositors, bank and borrowers or entrepreneurs. |
2 | Economic versus social focus | Concentrates on economic wellbeing and profit-maximization principles. | Community oriented, encouraging entrepreneurship, promoting justness and fairness in society, grounded on ethical, social and moral framework. |
3 | Price of money | Time value of money, as in interest, is the price of money. | Money is not a commodity and has no price. |
4 | Fixed income versus profit and loss sharing | Depositors receive a fixed interest and deposits are considered as liability. | Depositors of investment accounts are partners of the bank and share in the profit and loss; these accounts have characteristics of both debt and equity. |
5 | Deposit guarantee | All deposits are guaranteed. | Deposits placed in current accounts are guaranteed only. |
6 | Income | The primary income of the bank is the fixed interest earned from the debt financing it provides, separated from the real economy. | The financing is linked to the real sector and the return of the financial transactions arise from the real economy. |
7 | Asset link | Transactions can be purely financial, with no compulsion to link to real assets. | All financial transactions need to be either asset based or asset backed, with an exchange of goods and services, making the system more stable. |
8 | Size of banks | Many of the global conventional banks are of very large size. | Most Islamic banks are small or medium sized. |
9 | Bank–client relationship | The bank–client relationship is that of creditor and debtor. | Depends on the type of contract, could be of partners, principal and agent, investor and manager, buyer and seller, lessor and lessee. |
10 | Default payment | Default to repay is penalized by compounding interest. | No penalty can be charged in case of default, except cost for recovery of repayments, any additional penalty if charged needs to be donated to charity. |
11 | Restrictions | No restrictions on the investments of funds or projects financed. | Only Shariah-compliant investments and projects can be financed. |
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.
All banks, including conventional and Islamic banks, face some risks inherent to the industry. These are the generic risks of all banks. There are also some risks specific to the Islamic banks arising from their unique structure and operations.
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.
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:
Other related risks faced by an Islamic bank are:
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.
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.
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.
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.
As discussed by Askari, Iqbal & Mirakhor (2015), Islamic financial intermediation has three different models. These are discussed below.
Two-Tier Mudaraba This model includes two tiers of Mudaraba. The first tier is on the liability side of the bank's balance sheet. Depositors and investors enter into a Mudaraba contract with the bank, providing funds as Rab al Maal, and the bank is the Mudarib managing the use of these funds. The depositors share in the profit earned by the bank at a predetermined ratio. If there are any financial losses, depositors bear it as capital providers, the bank only loses its effort.
The second tier is on the asset side of the bank's balance sheet. In this Mudaraba the bank acts as the supplier of funds, Rab al Maal, to entrepreneurs or borrowers, who are the Mudarib. The profits are shared at a pre-agreed ratio. Any financial losses are borne by the bank, while the Mudarib lose their effort. Banks pool all the deposit, and provide funding to various projects. The income or losses from these variety of enterprises are also pooled together, and the combined profit is shared between depositors and the bank at the pre-agreed ratio.
The asset and liability sides of the bank are fully integrated, which reduces the need for active asset liability management, making the model stable and able to deal with economic shocks. This model does not include a specific reserve requirement on either side of the balance sheet.
Two-Windows Model This model is almost the same as the two-tier model, the only difference being that it has a reserve requirement. The model divides the liability side of the bank's balance sheet into two windows, one for demand deposits and the other for investment deposits. It requires 100% reserve for demand deposits as these are placed with the bank as Amanah for safekeeping only. The bank may charge a service fee for these accounts. No reserve is required for investment deposits as these are placed for investment purposes and bear the risk of loss.
Wakala Model In this model the bank acts as an agent or Wakil, responsible for managing depositors' funds and charging them a fixed fee. Other terms and conditions of the Wakala contract are mutually agreed between the bank and the depositors.
As discussed earlier, Islamic banks operate in three types of jurisdictions – those where the entire financial system is Shariah compliant, like Iran and Sudan; those where both Islamic and conventional banks operate side by side with central bank recognition, called the dual banking system, like most Muslim-majority countries (e.g. Malaysia, UAE, Egypt, Pakistan); and those of most non-Muslim countries where Islamic banks or other Islamic financial institutions may be allowed to operate under certain conditions but no separate central bank regulations exist for them, like the USA, Canada and Australia.
In most dual banking environments, there are fully fledged Islamic banks and some conventional banks that offer Islamic financial services. Some countries (like Kuwait, Lebanon and to some extent Qatar) do not allow conventional banks to offer Islamic products. Whether offered by Islamic or conventional banks, Islamic financial products need to be Shariah compliant with respect to Riba, Gharar and Maysir and need to be regulated by a Shariah Supervisory Board or similar body and receive Shariah compliance approval from them. When conventional banks participate in Islamic banking, they bring the benefits of their size, banking experience and specialized knowledge. Conventional banks offer Islamic financial services in the following organizational set-ups:
Table 3.2 lists the differences between conventional and Islamic financial intermediation.
TABLE 3.2 Differences between conventional and Islamic financial intermediation
Factors | Conventional | Islamic |
Religious requirements | No religious restrictions are imposed. | Islamic banks' products and operations need to be compliant with the Islamic law or Shariah. |
Social, ethical and environmental responsibility | No such restrictions exist. | Islamic banks cannot finance any project that is harmful to society or the environment. |
Fiduciary responsibility | Conventional banks have a debtor–creditor relationship with their depositors and provide guaranteed interest. | Islamic banks act as partner, agent, trustee in various asset-linked projects, earn profit on their asset side and share this in a pre-agreed ratio with the depositors or investors. |
Project selection | Conventional banks as creditor emphasize the creditworthiness of the borrower and any collateral provided. | Owing to the profit and loss relationship with the borrowers and investors, Islamic banks select projects considering their soundness, plus the business acumen and managerial competence of the entrepreneur. |
Terms of financing | Conventional banks as lenders adjust their interest rates as per the maturity of the financing project. | The profit and loss relationship with borrowers and investors makes long-term projects preferable to Islamic banks. |
Monitoring of funded projects | Conventional banks are concerned mainly about the borrowers' cashflows to avoid default. | Islamic banks monitor projects extensively to ensure they stay profitable (since they share in the profit), causing the banks to incur higher costs. |
Leverage versus risk sharing | Conventional banks finance via loans and thus encourage leverage; they earn interest irrespective of the profitability of the project. | Islamic banks promote risk sharing between providers of funds and users of funds and they earn only when a project succeeds and makes a profit. |
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.
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.
Contracts are the basis of all transactions in Islam. All aspects of Islamic commercial transactions are covered by the Islamic jurisprudence called the Fiqh al-Muamalat. Shariah-compliant contracts are like any valid conventional contract, with the addition of certain Shariah rulings.
Shariah-compliant valid financial contracts have the following requirements:
Some examples of unilateral contracts in Shariah-compliant commerce are the following.
Some examples of bilateral contracts in Shariah-compliant commerce are the following.
The simplest contract in Shariah law is the contract of exchange or the contract of sale. It involves transfer of ownership of specific items from one party to another, which can be as a barter, exchanging one item with another or exchanging an item with money or exchanging money for money. All valid conditions of a contract would apply to a sales contract in Islamic finance. The most common sales contracts used in contemporary Islamic finance and banking are as follows.
According to Dr Sharifah Faigah Syed Alwi (Hasan, 2014), Shariah-compliant products are developed based on an existing conventional product and expect to meet similar needs, and the features are reworked to meet Shariah requirements; on the other hand, Shariah-based products are completely new products designed by Islamic bankers or Islamic scholars. These two types of Islamic finance products are not alternatives to each other. Both are required depending on the need, the competitive environment, the sophistication of the product and the difficulty of realistically applying Shariah rulings. Today's modern Islamic banks serve individuals, businesses and governments.
The most common Islamic banking products offered for the retail segment, serving individuals and households, are discussed below.
- Periodic service charge. Monthly or annual fixed fee.
- 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.
- 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.
- Prepaid credit card. The cardholder deposits an amount on the card and uses it to purchase goods or services.
- 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.
- 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.
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.
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.
Islam is a way of life and requires accountability in all activity. Moreover, the requirements of transparency and fairness in business dealings and in financial transactions in Islam emphasize the importance of accountability further. Conventional accounting principles are independent of any religious rulings but that is not the case for Islamic financial institutions, and with the growth in the Islamic finance and banking industry, there appears to be a need for the development of Islamic accounting as a sub-discipline within the subject of accounting.
Financial accounting is the process by which the activities and operations of a business and their financial implications are identified, measured and recorded for the use of decision-makers. The decision-makers internally are the management, and externally the creditors, investors, customers, regulators and the government. Islamic accounting, like financial accounting in general, is the process that identifies, measures and records all business financial activities but also continuously evaluates and ensures that these activities are being conducted within the rulings of the Shariah and are meeting with the Shariah focus of socio-economic, ethical and environmental responsibilities.
With the emergence of global companies and global investors, it has become very important to have financial statements of companies that are transparent, consistent and comparable. In the conventional system the International Financial Reporting Standards (IFRS) aim to achieve this. The IFRS was not developed with the Shariah-compliant finance industry's unique characteristics in mind. Yet in many non-Muslim jurisdictions the IFRS, the countries' GAAP rulings and corporate law apply to the IFIs also, creating various complications. The IFRS was developed for conventional forms of business.
For example, in an Islamic investment account the clients give the bank the right to reinvest their funds and co-mingle them with the funds of other clients, as well as those of the Islamic bank, into Shariah-compliant activities; they receive proportional profits as per a pre-agreed ratio and they also bear all risk of losses. As such, the capital is not guaranteed. The IFRS does not have any parallel for Islamic investment accounts and financial reporting, especially in non-Muslim jurisdictions, is a major challenge. To deal with the Islamic investment account under IFRS, one of the following treatments is applied:
The Islamic banks' transactions, reporting standards and disclosures are different, and the need to develop an alternative set of accounting and financial reporting standards became increasingly evident. This led to the establishment of the AAOIFI in Bahrain in 1991. The main objective of the AAOIFI was to complement the IFRS's standards with its own standards that met the specific needs of the IFIs. AAOIFI started with a core set of accounting standards which were expanded to include auditing and corporate governance standards. AAOIFI has set up standards in financial accounting statements for the growing Islamic finance and banking industry, in conformation with the rules of the International Organization of Securities Commissions (IOSCO), International Accounting Standards Board (IASB) and Bank of International Settlements (BIS).
Competent and relevant financial accounting of Islamic banks is useful to the banks' shareholders, all depositors, current and future investors and creditors, management, employees, the Shariah Supervisory Board, government and regulatory bodies, business partners and suppliers of the bank, all Zakat-related bodies and the public.
It is crucial to develop reliable and globally acceptable Islamic financial accounting standards and procedures because:
Islamic banks operate on an interest-free and profit and loss-based mechanism, significantly different from the conventional banks the world and its population are accustomed to. As the niche segment of Islamic finance develops on the global platform, it faces various challenges and some of these are briefly discussed below.
The last major global financial crisis of 2007–2008 has changed fundamentally some of the thoughts related to the world of finance and the principles that guide it. The crisis started from a housing crisis in the USA and the resultant impact was worse than the Great Depression of the 1930s. Most countries around the world were affected to some extent by this crisis. A major source of the crisis was the interest-based financial securities linked to home mortgages. According to J. M. Keynes in the General Theory of Employment, Interest and Money, the schedule of profit rates is rarely in sync with the schedule of interest rates; and when profit rates are much higher than interest rates this can lead to inflation, while when they are much lower they cause deflation and unemployment. This boom and depression can affect the stability of the economy (Hasan, 2014). This shifts significantly in favour of profit and loss-based Islamic banking over interest-based conventional banking. In conventional finance, owned and borrowed funds are treated differently. On the governmental policy level, owned funds receive variable income, which is profit, while borrowed funds receive fixed interest. Further, interest, the cost of borrowed funds, is considered a tax-deductible cost while dividends, the cost of owned funds, are not tax deductible.
Islamic banking has held up well during the global financial crisis. Some of the reasons linked to this are that Islamic banking is more conservative than conventional banking; all Islamic financial transactions require to be linked to real assets, thus there is less uncertainty with them; furthermore, Islamic banking does not permit many of the instruments that were to some extent considered as causes for the crisis, like short selling and mortgage-based securities.
The Islamic finance and banking industry consists of the Islamic banks, the Islamic insurance or Takaful companies, the Islamic capital markets and the Islamic non-bank financial institutions. The Islamic non-bank financial institutions provide supportive functions for Islamic economic activities, like liquidity needs, and include Islamic finance companies, housing cooperatives, private equity and venture capital firms, microfinance institutions, charitable endowment or Waqf management institutions and Hajj and Zakat management bodies. Moreover, these IFIs operate in purely Shariah-based jurisdictions, in dual-banking jurisdictions and in non-Muslim jurisdictions without formal recognition of the Shariah rulings. The global standards of accounting reporting under the guidelines of the IFRS and the banking supervisions under the Basel rules were designed for conventional financial activities and are not always applicable to the participants of the Islamic finance and banking industry. Owing to the Shariah restrictions in their operations, IFIs often require special treatment which cannot be accommodated by either the IFRS or the Basel regulations. To overcome these problems, the Islamic finance and banking industry globally took the initiative to set up regulatory and standard setting bodies especially for its participatory institutions to self-regulate and develop appropriate standards. Efforts were also made to cooperate and coordinate with the global regulatory bodies in the formation of these international Islamic regulatory and standard setting institutions, to enhance acceptability and trust amongst the conventional and Islamic sectors. The role of the international Islamic regulatory and standard settings institutions is to safeguard the deposits and partnerships of the financial institutions and ensure efficient profit and loss sharing amongst the institutions, their depositors and shareholders. The two main bodies are the AAOIFI and the IFSB, with several other supportive institutions. These are elaborated below.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Regulatory Issues for IFIs in Non-Muslim Jurisdictions – A UK Example The following discussion is based on material covered in Kettel (2010).
The UK's regulatory body, the FSA, authorizes all financial institutions operating in the UK irrespective of their country of origin, the sector they operate in or their religious principles. The FSA's approach towards Islamic banking is neither to create any obstacles nor to provide any special favours. Islamic banks appear to face three types of difficulties in the UK, or for that matter in most Western jurisdictions.
The UK's FSA identified five different issues related to Islamic banking. First, Shariah compliance introduces some risks for Islamic banks but these are not too high and as such the FSA agrees to authorize Islamic banks. Second, the FSA defines Islamic demand deposits as simple non-interest-bearing accounts where the bank promises capital repayment and investment accounts as profit and loss-based Mudaraba accounts where the account holder accepts the risk of losing their original capital. Third, related to Shariah compliance and the role of the SSB, since the FSA is a financial regulator not a religious body, it prefers the appointment of internal auditors with Shariah knowledge to monitor Shariah compliance. Fourth, the FSA regulates Islamic banking instruments but not the Islamic products traded in the capital markets, like Sukuks. Fifth, the corporate governance issue which arises from the need of Islamic banks to create reserve funds to smooth the income to investment account holders; since the reserves lead to conflicts of interest between the investment account holders over shareholders or between the present investment account holders over future investment account holders, which can only be controlled through strict unambiguous rules to be followed.
Islamic banking is an alternative to conventional banking, based on Shariah law, prohibiting interest and designed on the profit and loss basis. Both Islamic and conventional banks need to be licensed by the central bank, offer products for various customers and manage their liquidity via the interbank market. Some of the differences between the two types of banks are related to interest versus profit and loss, guarantee to depositors, bank–client relationship and default payments, etc.
The relationship of both conventional and Islamic banks to the central bank is more similar than different. In both cases the central bank acts as the supervisor, lender of last resort, provides cheque clearing services and dictates the statutory cash reserve and other controls. The differences come only from the Shariah compliance and different product structure of the Islamic banks. Both types of banks face liquidity, excess liquidity, credit, settlement, market, currency and operational risks. Only conventional banks have interest rate risk, while Islamic banks have adverse selection, moral hazard, equity investment, default penalty, higher cost, Shariah compliance and rate of return risk.
Financial intermediation is the core business of banking and is the matching of fund savers with borrowers or entrepreneurs. Conventional banks do this using interest, while Islamic banks use the profit and loss mechanism and the models used can be two-tier Mudaraba, two-window Mudaraba or the Wakala model. Today, conventional banks are also participating in Islamic finance and banking via a separate window, branch or subsidiary. The differences in the financial intermediation of conventional and Islamic banks are in the areas of religious, social, ethical, environmental and fiduciary requirements; in the manner of project selection and monitoring; in the terms of financing and related to leverage versus risk sharing.
The sources of funds of an Islamic bank include current, savings and investment accounts, while the application of funds involves a variety of products including Murabaha, Mudaraba, Musharaka, Ijara, Salam and Istisna. Shariah compliance of all financial contracts requires two or more parties, mentally sound; the subject matter should be Shariah compliant, devoid of Riba, Gharar and Maysir, linked to real assets and for sales contracts the asset should exist, be owned and be physically or constructively possessed by the seller. Unilateral contracts include Wad, Hiba, Qard Hasan, Wassiyyat and Waqf and bilateral contracts include Muawadat, Shirkah, Dhamanah, Wakala, Wadia, etc. Islamic banks serve individuals, corporates and governments.
Globally standardized financial accounting and reporting does not always fit Islamic banking operations, requiring the development of Islamic financial accounting which is tailored to Shariah-based operations and products of the industry. Besides the auditory standards and regulatory issues, other challenges faced by the Islamic finance and banking industry include applying the profit and loss system, default penalty, partnership ventures, tax treatment and the lack of qualified employees as well as Shariah scholars. On the upside though, Islamic banking held up well during the last financial crisis. To be more acceptable in the global finance industry, various international Islamic regulatory and standard setting bodies are being established, bringing more acceptability and reliability to this niche segment. These bodies include the AAOIFI, IFSB, LMC, IILM, IIFM, IIRA, CIBAFI, IICRCA, IDB and the International Islamic Fiqh Academy.
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