A Critical Review of Islamic Banks Finance Essay

Islamic banking is now one of the world’s fastest-growing economic sectors, comprising over 300 institutions in over 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia being the largest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15 percent a year. The reasons behind the recent growth in Islamic finance are: The strong demand from a large number of immigrant and non-immigrant Muslims for Sharia-compliant financial services and transactions; Oil wealth, with demand for suitable investments soaring in the Gulf region; and The competitiveness of many of the products, attracting both Muslim and non-Muslim investors. Islamic banking refers to a system of banking or banking activity which is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called “riba”. Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered “haram” (such as businesses that sell alcohol or pork, or businesses that produce un-Islamic media). In the late 20th century a number of Islamic banks were created, to cater to this particular banking market.

1. An Overview on the Review of Problems

https://www.scribd.com/doc/112128781/IPIslamic-Banking The Islamic banks face a number of challenges. First, they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits. Second, the risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions.1 Third, the Islamic banks do not have the legal support of central banks of their respective countries (except in Pakistan and Iran), which exposes them to great risks. Fourth, the Islamic banks do not have the necessary expertise and trained manpower to appraise, monitor, evaluate and audit the projects they are required to finance. As a result, they cannot expand despite having excess liquidity. The future of Islamic banks hinges, by and large, on their ability to find a viable alternative to interest for financing all types of loans. They should recognize that their success in abolishing interest has been at least partial and they have yet to go a long way in their search for a satisfactory alternative to interest. Simultaneously, Islamic banks need to improve their managerial capabilities by training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks also depends on developing and putting into practice such accounting standards which provide timely and reliable information of the type that the Islamic banks would require for profit-sharing, rent-sharing or for cost-plus financing. These standards are yet to be developed. The Islamic banks would have to work hard to pursue their clients to accept these standards so that a reliable information base is established.2

2. Issues and Problems in the Implementation of an Interest-Free Banking

The implementation of an interest-free banking raises a number of questions and potential Problems if seen from the macro and micro operational point of view.

2.1 Issues Related to Macro Operation of Islamic Banking System

2.1.1 Liquidity

Islamic banking stands for the use of money as a medium of exchange. Conventional banking, on the other hand, emphasizes the need for maintaining liquidity and hence requires an adequate amount of reserves. The basic principle of Islamic banking being PLS-based financing and thereby having been exposed to increased risk; it would conceivably require higher liquidity and reserves. The reason is that its investment in assets has by nature lesser divisibility and reversibility. This means that reserve ratios for interest-free banking are to be calculated on the basis of risk calculation in various forms of investment.

2.1.2 Valuation of Bank’s Assets

It is argued that Islamic banks may suffer a loss of value of its assets in the absence of a fixed positive rate of return. Further, without the provision of insurance Islamic banks may face trouble in making their system stable and avoiding liquidity crises. So far, under Islamic banking, no such insurance system exists. Theoretically, Islamic banks are likely to face a dual risk: (a) the ‘moral’ risk due to lack ofhonesty and integrity on the part of the borrower of funds in declaring a loss, (b) the ‘business’ risk arising from unexpected market behaviour.

2.1.3 Lack of Capital Market and Financial Instruments

Islamic banks working under conventional banking framework in different countries lacks capital market and instruments for investment of their surplus liquidity. Availability of Islamic capital market and instruments help growth of these banks. Growth of Islamic capital market and financial instruments also helps creating the environment for government financing.

2.1.4 Insufficient Legal Protection

A comprehensive system of Islamic banking requires legal protection. This means a thorough review of all relevant laws having a bearing on banking business is needed. Laws relating to companies, commerce, investment and the courts and legal procedures need to be reviewed and reformulated to suit the requirement of the efficient functioning of Islamic banks. It is not acceptable that company law continues to talk about bonds and interest while ignoring participation deeds and profits. Investment promotion laws should accommodate rules and regulations, which permit Islamic banks to apply their profit/loss sharing modes so that they can participate in partnership businesses either in the form of Musharakah or direct investment.

2.2.1 Lack of Positive Response to the Requirement of Government Financing

It is a well-known fact that the modern state is always in need of funds and resources to implement useful projects, such as the provision of schools, roads, electricity, and water and telecommunication services. Generally, governments resort to issuance of treasury bills with interest in accordance with the form used by conventional banks. Islamic banks are required to enter into this field so as to prove their ability to play their role in the financing of projects in a manner that conforms to the Islamic system through the issuance of deeds of Musharakah, advance-sale, salam and such other forms that satisfy the needs of the state for financing and, at the same time, benefit from investment of their idle liquid surpluses.

2.2.2 Failure of Islamic Banks to Establish Co-operation among Themselves

In spite of good intentions, Islamic banks are blamed for their lack of open-mindedness to one another, a state of affairs that obstructs the achievement of mutual co-operation among them. This is in spite of the persistent endeavors of the Islamic Development Bank to bring them closer to one another and unify their stands. Following examples are enough to prove the point: • Not all-Islamic banks are members of the International Association of Islamic Banks. The Association has neither been able to unify their regulations, nor build bridges of confidence and promote understanding among them. • The idea of establishing a “Bank of Islamic Banks” is still a mere idea, although there is an urgent need for its establishment. As a result of its absence, Islamic banks have lost hundreds of millions with the collapse of the BCCI. • Islamic funds continue to sneak out by hundreds of millions into investment houses doing business in the West while the Muslim world remains thirsty for investment resources. • Funds of expatriates from Islamic countries do not find their way back to their own countries to contribute to the development of their original homelands. • Trade among countries of the Muslim world is completely paralyzed as the Islamic financing system goes along with the traditional trend in financing imports from foreign countries without giving any preference to products of the Muslim world. Only the Islamic Development Bank has been paying due attention and care to the need for preferential treatment for the products of Muslim countries.

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