An Analysis of the Islamic Financial System Finance Essay

Islam considers the problem of economic development very seriously and views this as an important part of total human development. The fundamental aim of Islamic religion is to lead human development in the right direction. Islam deals economic development as part of total human development and never deviated from this perspective [1] . Islam does not encourage blockage of wealth and regards circulation of wealth as important to an economy. The proponents of Islamic Banking argue that the system based on interest has resulted in concentration of wealth in a small number of hands thus widening the gap between rich and poor. The fact is that the 10 richest men in the world have more wealth than 48 poorest countries of the world. [2] Dr Usmani records, "Just as clotting of blood paralyzes the human body; concentration of wealth paralyzes the economy". [3]

1.1 Islamic Financial System:

The Islamic financial system generally refers to an institution for financial market dealings, operations and services that does not conflict with Sharia Law. In Islamic jurisprudence all rules relate to the allotment of resources, rights on property, production and utilization, and the allocation of income and wealth as specified by the shariah (Islamic Law). [4] As per the rules and regulations stipulated by Shariah risk or reward can not be prohibited or promoted. [5] The Islamic financial system is often referred to as 'interest-free', but this is not the case. The core values in conventional banking system such as promotion, preservation and sanctity of entrepreneurship, property rights and contractual obligation are also part of the Islamic financial system. It is difficult to measure the actual size and rate of growth in the world wide Islamic financing pool. [6] Today, the assets of Islamic financial and banking activities have been estimated to the tune of over US$750bn, which is a sign of the impressive growth in this sector since 1980s. [7] The potential and widespread opportunities within Islamic banking are getting attention from market participants and policy makers. [8] Although there are no obstacles present to the continued development of Islamic finance, this does not mean an absence of challenges. [9] The shortage of investment outlets with profit-loss sharing agreements is one of the main hindrances to the continued growth of this sector. [10] Islamic finance operates in compliance with Sharia (Islamic Law). It is derived from the Qur'an (The Holly book of Muslims) and Sunnah (the traditions of the Prophet Muhammad). [11] One of the basic pillars of Islamic financial system is economic freedom. [12] But it is not the same as under a capitalist economy. [13] One of the main differences between the capitalist economic system and Islamic financial system is that while the capitalist system advocates absolute freedom in the market without any moral obligation, the Islamic banks advocates for the morality in the market. [14] Islamic finance allows an individual to earn wealth and own it. Even though the individual has absolute discretion to spend his wealth, it should in compliance with Islamic rules that apply to everyone. [15] For instance: obligation to pay tax for the poor. [16]

1.2 Islamic Banks:

An Islamic bank is a financial intermediary located in various sectors of an economy that mobilise savings from the public based on different tools within the Islamic financial system and distribute the money to entrepreneurs and other customers by complying with Sharia. [17] It is believed that the system of charging excessive fixed-interest debt led to the creation of a poor economic environment that resulted in the recent global financial crisis. [18] But risk-sharing instruments in Islamic banking aim to promote economic development. [19] The following are considered as core values of Islamic banking principles: Interest as a return for saving does not have any moral foundation Self-restraint from spending of present income does not be worthy of a financial reward Revenue is gained only by taking risks so risks have to be incurred to gain money. [20] The basic principle of Islamic Banking relates to humanity, ethics and morality such as justice, equity, reality and Human nature. [21] Islamic law influence the structure and activities of Islamic banks in several ways, the most important being the replacement of Riba (the receipt and payment of fixed or predetermined interest) with profit -loss-sharing arrangements. [22] In profit-loss sharing principle, the rate of return on an investment is not fixed or not known prior to the transaction. [23] For avoiding Riba, Islamic banks had to develop financial products which were in compliance with Sharia'h. [24] To attain this mission, a number of special Islamic financial products that comply with Sharia have been created by Islamic banks. [25] The most widely used products which have been developed by Islamic banks are Murabaha, Musharakah and Mudharabaha [26] .

1.3 Conclusion:

In a nutshell, Islamic commercial law is a complex system and covers many areas. Islamic banking is just one of the areas within the Islamic financial system. In this chapter only a selective and general overview is given regarding Islamic finance. All rules and regulations of Islamic banking are derived from The Quran and the teachings of Prophet Muhammad. The aim of Islamic financial system is to give economic justice to mankind. Although Islamic finance aims to give economic freedom to the owner of a property it can be argued that the economic freedom is not absolute freedom since there are rules, regulations and moral ethics that are to be observed. Chapter.2

The Nature, Definition and Evolution of Islamic Banking Law

Giving an outline of the financial institutions is useful for understanding the concept and operations of Islamic banking. This will help in understanding how financial institutions and products affect and fulfil the needs of various sectors in an economy

2.1 Banking:

Let us examine what is banking or a bank? The word "bank" is derived from the Italian word "banco", which means shelf or bench. [27] "A bank is an institution authorized to take deposits for the purpose of extending long and short-term finance facilities". [28] The royal palaces and temples in ancient Mesopotamia were considered as the ancient Banks where the commodities were kept for security. [29] The modern banking system operates as financial intermediaries between various sectors in an economy and they offer a number of other services such as safe deposits, overdrafts, easy transfer and agency functions etc. [30] Historically, banks have carried out all their functions oA­n the basis of fixed interest payment which is the basis of all their dealings. [31]

2.2 Why Islamic banking?

Islamic banking and finance has received attention as an alternative model. Interest or usury is considered as a source of exploitation. Generally the highest rates of interest were charged to lower earners in the case of sub prime lending. Such an unfair attitude by conventional banking was one of the reasons which led to the thought of an alternative banking system. [32] More over, the conventional banking system based on interest is incompetent of allocating available liquid funds among the various sectors in an economy irrespective of their efficiency, productivity and growth status. [33] It is also presumed that irrespective of rational economic considerations regarding income distribution, conventional banking is biased towards wealthy people. Thus, profit-loss sharing system in Islamic banking is considered as a competent alternative. [34] When the banks move forward from exploitation and ruthlessness, the relevance of Islamic banking, which is marked by kindness and affection, is increased. More over it is believed that Islamic economy should lead to freedom from economic slavery. [35]

2.3 Origin of Islamic Banking:

According to Lieber "Among Muslims, international trade was particularly stimulated by the pilgrimage to the holy places of Arabia, in which a great body of men converged each year from all over the world. Many of these pilgrims fulfilled their religious obligations and at the same time, marketed their local products along the route, returning home with foreign goods on which they hoped to make a handsome profit". [36] With the development of trade operations such as lending, borrowing, transferring, guaranteeing and safeguarding comes the development of banking operations in Islamic community [37] . The operations of Islamic banking started from the time of the Prophet of Islam who introduced the systemA ofA Bayt al-Mal (State Bank of Muslims)A for the collection and distribution of revenues. [38] The supervisor and director of Bayt al-Mal was called as Khazin al -Mal who was a government officer under the department of central secretariat. [39] TheA Bayt al-MalA was not onlyA A A the propertyA A A of the Muslims aloneA but of non-Muslims also. It was the duty of the Islamic state to support needyA non-MuslimsA as well as indigentA Muslims out of the funds of theA Bayt al-Mal. [40] The public treasury ofA Bayt al-MalA played the role of an agriculturalA credit bank and also a commercial bank. [41] During the period of 844-848 A.D., it lent to the peasants two million dirhams. [42] From the historical writings of some scholars we can understand that there were bankers in medieval Islamic world called sarraffeen or sayarifah or jahabidhah and banks called dawawin al-jahabidhah. [43] It is to be noted that in 913 AD, the state established diwan al-jahabidhah with branches in the main trade cities which were conducting almost all modern banking functions without access to interest. [44] After the 13th century a number of Islamic institutions, including the Islamic system of financial intermediation had been displaced by Western institutions due to various internal and external factors. [45]

2.4 Evolution of Modern Islamic Banking:

From the middle of the nineteenth century, nearly every Muslim country, under direct or indirect pressure from the newly dominant west power, adopted laws and legal systems based on Western models in both civil and criminal areas. [46] After freedom from colonization, the demand for sharia based economic system had been increased in most of the Muslim dominated countries. [47] Because of the increasing demand from the people in many Muslim countries, individual Islamic banks were established. [48] They were operating under the economic and legal controls from the governments in the country in which they were established. [49] Moreover, they faced competition from already established interest-based banks in the system. [50] The first modern trial of Islamic banking was established in Egypt at Mit Ghamr without projecting an Islamic image, because of some political reasons, in 1963. [51] It was the first interest-free institution with 'bank', Nasser Social Bank, as its name. [52] It was a savings bank based on Profit-Loss sharing established by Ahmad El Najjar. [53] This trial lasted until l967. [54] Although the first experiment lasted only four years, this idea received attention from rich people with surplus wealth. After four years, in 1975, Dubai Islamic Bank was established in Dubai, UAE. [55] Even though it was a private initiative; the governments of UAE as well as Kuwait invested 30% of the total share. [56] It is the first full-fledged Islamic Bank in modern history. [57] However, in 1975 the IDB (Islamic Development Bank) was established. It is the most important development in Islamic Banking history. [58] With the development of several Islamic banks and the willingness of some countries like Pakistan, Iran and Sudan to implement the Islamic financial system, has boosted the growth of the Islamic banking sector. [59] One of the milestones in the evolution of modern Islamic banking is that, its products have been recognised as genuine tools of financial intermediation by IMF and World Bank. [60] Islamic banking has grown by about 15 per cent a year since its modern initiation in the 1970s. [61] Nowadays Islamic financial services institutions have spread worldwide numbering nearly 500 [62] and the total asset value of Islamic banks have reached about US$750 billion. [63] 2.5 Definition and features of Islamic Banking: We have already discussed the origin and evolution of Islamic Banking. Let us examine the nature and features of Islamic Banks. 2.5.1 Definition of Islamic banking: An Islamic bank is as an intermediary between the saving surplus and the deficit units like any conventional bank with the difference that the instrument of interest is replaced by a number of other instruments. It mobilizes funds on the basis of a Mudarabha or Wakalah (agency) contract. It advances funds on a profit- and-loss sharing agreement in accordance with the principles of sharia. [64] However in practice, in terms of organisational set-up, Islamic banks hardly look any different from its conventional counterpart. [65] An Islamic Bank has been defined in the following way according to general secretariat of the Organisation of Islamic Conference (OIC) "A financial institution that expressly states its commitment to the principles of Islamic sharia in all of their statues, rules and procedures and that which prohibits receipt and payment of interest in all its operations is an Islamic Bank". [66] In simple terms it can be defined as banking operations in accordance with the beliefs that fit with the value system within Islam. [67] A The Islamic Banking system is based on the concept of sharing profits as well as loss. The general principle of Islamic banking is that only those who are willing to assume risk have the right to get a return on their savings. [68] From the above definition it is understood that Islamic banking neither receives nor pays interest in its transactions. Alternatively, this system operates based on Islamic Law of transactions which is promoting profit and loss sharing (PLS). [69] Because of Profit-Loss sharing principles in their practice, Islamic Banks are called as PLS-Banks. [70]

2.5.2 Basic features of Islamic Banking:

There are strict rules applying to finance under Islamic law. The economic principle of Islam is based on open markets, without price controls and prohibiting riba, gharar and maysir [71] Let us examine the distinguishing features of Islamic banking.

A) Freedom from Riba:

Riba is an Arabic word that means "growth" or "increase" and denotes the payment or receipt of interest for the use of money. [72] The prohibition of "riba" (interest) at Islamic Shari'a on monies lent is ordained by the Quran, Sunna, i.e. the prophetic tradition and Ijmma (unanimity of the masses of ancient jurists). [73] The Quran expressly forbids riba, and gives warning against those who are not ready to give up riba. The holy quran declares that if you do not give up your demand for the interest due to you) then take notice of (a declaration of) war from Allah and His Messenger [74] There is a saying from the prophet to prohibit riba even if it is a smaller amount. For example "From Abu Burdah ibn Abi Musa: I came to Madinah and met 'Abdallah ibn Salam who said, "You live in a country where riba is rampant; hence if anyone owes you something and presents you with a load of hay, or a load of barley, or a rope of straw, do not accept it for it is riba." [75] Riba has been interpreted as any predetermined or assured interest payment on cash advances or on deposits. [76] One learned companion of Prophet Mohammed (peace be upon him) was reported to have said "He who lends should not stipulate more than what he has lent, even a handful of fodder; for it is riba." [77] The universal nature of these principles is seen even in non-Muslim literature. Some of the Major religions like Hinduism, Judaism and Christianity have prohibited Usury in principle. [78] It is to be noted that both Old and New Testaments in the Bible prohibits Usury. [79] For example, The Old Testament clearly says that "If you lend money to my people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest". [80] Shakespeare and many other writers have expressed their anger against this unjust practice through their works. [81] Even though there are no specific verses in the Quran or messages from the Sunna providing reasons for the prohibition of Riba, some studies argue that Riba contradicts the principles of profit/loss sharing which aims to create a proper balance between the lender and the borrower. [82] Different scholars have given different reasons for the prohibition of Riba; the following reasons given by Siddiqi are noteworthy; Riba is a form of social corruption referred to by Arabic scholars as Fasad. Riba implies the wrongful appropriation of other people's property without justification. Riba decreases the resources of states through negative effect on the growth of economies. Riba demeans and diminishes the humanity of individuals. Riba leads to money being made from money: an unacceptable practice in Islamic finance. If people mainly depend on interest for their lively hood then they may be discouraged from working to earn money. [83]

Difference between Riba and Profit

Ribha

Profit

Any income or earnings is collected above the principle amount of money lent which is fixed and doesn't involve any risk. The income and earnings are above the principle amount, but is not predetermined and always bear risk. A compulsory predetermined amount has to be paid by the client as interest to the bank for the money lent. No compulsory returns policy exists since profit is not known in advance. Interest is predetermined and so known to both of the parties thus avoiding contingencies. The element of contingency is present since profit from the business activity is not known to the parties until the end of the activity. Losses never occur since returns are pre determined. Losses are likely to occur since returns are post determined. Source: 'concept and Ideology Islamic banking some conceptual issues'. Onlinearticle<https://www.islamibankbd.com/islamic_banking_some_conceptual_issues.php> accessed on 20/05/2011.

B) Prohibition of Gharar:

Literally Gharar means Risk or Hazard. [84] The term Gharar has been defined by many scholars but the following is noteworthy "Gharar as the sale of probable items whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling". [85] Al-Dareer defines Gharar in jurisprudential terms under the following three headings: First, Gharar applies exclusively to cases of doubtfulness or uncertainty, as in the case of not knowing whether something will take place or not. Thus, Gharar is uncertainty over the existence of the subject matter of sale. [86] Second view holds that Gharar applies only to the unknown, to the exclusion of the doubtful. Thus, Gharar in sales occurs when the purchaser does not know what he has bought and the seller does not know what he has sold. [87] The third view is a combination of the two categories above; as per this view Gharar finds where consequences are concealed. This is the view favoured by most scholars. [88] However Muslim Jurists disagree on the degree of uncertainty in a transaction to be considered Gharar transaction. [89] It is noted that there is no explicit statement known in the Quran forbidding Gharar, it is well-accepted that it is forbidden. [90] But vanity (albatil) is forbidden in many verses. The Holy Quran says that; "And do not eat up your property among yourselves for vanities, nor use it as bait for the judges". [91] "O ye who believe! Eat not up your property among yourselves in vanities; but let these be amongst you traffic and trade by mutual good will". [92] There is a consensus among interpreters of these verses that Gharar is vanity. Ibn Al-Arabi explains that vanity (al-batil) is unlawful because it is prohibited by Sharia such as usury and Gharar. [93] For avoiding Gharar Islamic Banks shall not to engage in speculative trade of shares, discounting of bills and trading in unidentified items. [94] The underlying principle behind the prohibition of Gharar is to make sure full assent and satisfaction of the parties in a contract. It can be achieved only through full disclosure and transparency. The prohibition of Gharar protects unforeseen losses and the possible disagreements among the parties. [95]

C) Free from Maysir:

The term maysir is defined as gambling, bets and wager. [96] There is unanimous opinion from Islamic scholars that maysir (gambling) and gharar are inter-related. So, wherever elements of gharar are present then maysir will also be there. [97] The essence of gambling is taking a risk deliberately created or invited to gain in that way. [98] In simple Maysir is an easy attainment of means by chance. [99] The Holy Quran clearly says that "They ask you (O Muhammad) concerning alcoholic drink and gambling. Say: "In them is a great sin and (some) benefit for men, but the sin of them is greater than their benefit." [100] The element of Maysir is involved in a number of conventional transactions and bank schemes or products which Islamic banks have to avoid. For example some banks and corporations mobilize resources on the basis of lottery draws and prizes which come under the banner of gambling and are therefore prohibited. [101] Moreover for avoiding Maysir Islamic banks should not deal with any instrument where coupons or tabs are given and inducement or incentives are provided by an uncertain and unknown event depending on chance. [102] Islam does not promote a society where gambling and other similar activities support lively hood of the society. Islam aims to promote only a well- developed and healthy society where the hard work and real contributions of the individual in terms of quality, creativity, and service is acknowledged. It is because of the above reasons that Islam prohibits maysir. [103]

D) Prohibition of using or dealing in forbidden commodities:

By virtue of Islamic jurisprudence people are allowed to invest money wherever they like subject to compliance with sharia. According to Sharia some commodities are prohibited which is considered as anti-social. So, Islamic financial institutions cannot engage any dealing with these commodities such as alcohol, drugs, pork etc. [104] The rationale behind this is to promote 'ethical' investments and to prevent the availability of anti-social commodities. [105]

E) Risk and Profit Sharing:

The important Shariah maxim : "Al Kharaj bi-al-Daman" or "Al Ghunm bil Ghurm" means that one has to be prepared to bear loss if he wants to get any profit over his investment or profit has to be earned by sharing risk and reward. [106] The above maxims which legitimize one of the key principles of Islamic banking is known as risk and profit sharing. This principle is unique to Islamic Banking. Under conventional banking systems based on interest, the contracting parties share neither profit and loss nor risk. [107] The principle behind this concept is that the risk of related loss can not be separated from the ownership. [108] Under this principle transacting parties make a contract and invest their resources in a project in which they share the profit and loss. In most cases the profit shall be shared in a pre-agreed ratio while the loss is borne in proportion to the level of investment by the transacting parties. [109] The risk-sharing between the investor and entrepreneur is promoted by Islamic Banks. [110] Under Islamic jurisprudence investment is considered as a real activity in terms of the profit loss sharing agreement not just confined to a mere financial or monetary transaction in which transfer of funds is the only activity [111] . Even though eliminating the risk sharing is prohibited by Islamic Law, it promotes the mitigation of known risk by taking adequate precautions. [112] One of the main criticisms on profit- loss sharing system is that because of the difficulty to ascertain its asset value the bank can not be quoted by the stock exchanges. [113] The other criticism on this principle is that it is impossible for depositors who are indeed investors to assess the outstanding balance of the bank at the time of depositing their money thus exposing them to either profit or loss depending on the banks performance. [114] The rationale behind this principle is that the results of any project can't be known with absolute certainty since there is a risk involved in any project given the uncertain nature of this world. In conventional banking system, whether the project succeeds or fails the owner of capital gets a predetermined return. By virtue of Islamic Law this kind of unjust distribution is not acceptable. In Islamic banking the results of the project shall be shared in an equitable way between investor and entrepreneur. [115]

2.6 Difference between conventional banking and Islamic banking:

Under this heading let us examine the significant features of Islamic banking system compare to conventional banking systems.

Major difference between Islamic and Conventional Banking system

Conventional system

Islamic System

The conventional system functions and operates based on secular principles. The Islamic system functions and operates based on Shari'a rules. Interest on capital will charged on the basis of time value on capital. Interest is not charged as per Sharia rules. However profit on exchange of goods and services are shared based on a pre-agreed ratio between bank and client. Money is considered as a product. Money is considered as a medium of exchange. Because of non-existence of goods and services inflation may be created. Because of existence of goods and services no inflation is created. Interest will be charged by the bank even if the client suffers loss. When the client suffers loss, the loss will be shared between client and bank. Bridge financing and long-term loans lending are disbursed on the basis of Wando Dressed project feasibility and credibility of the entrepreneur. Before disbursing funds for a capital project, the capital good should come in to existence. Risk sharing is not available. Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. If the project has failed then the loan may be written off as non-performing loan. If the project has failed then the project can be taken over by the bank for a better management. Conventional banks may finance any lawful product or service. Islamic banks are allowed to participate only in those economic activities which are lawful as per Shari'a. Conventional banks normally charge additional money (compound interest) in case of late payments or defaults indiscriminately. Islamic banks are not allowed to charge penalties for late payments or defaults. In conventional banking system the relation between bank and client is that of a creditor and debtor. In Islamic banking the relation between bank and client is that of a partner and investor. Conventional banks don't have any religious supervisory boards. Each Islamic bank must have a supervisory board to ensure that all its business activities are in compliance with Shari'a. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates. An Islamic bank must be in compliance with both the statutory requirements of the central bank of the country in which it operates and Sharia also. Sources<https://www.philadelphia.edu.jo/courses/Markets/Files/Markets/a%20(26).pdf > accessed on 13/05/2011.

2.7 Conclusion:

To conclude, Islamic banking is considered as an alternative to conventional banking system. Interestingly the concept and operations of Islamic banking system originated from 6th century AD however the modern banking system came into existence only 30 years ago. Therefore Islamic banking has shown continued growth since its establishment years ago however the fundamental concept that all dealings are in compliance with Islamic Law remains unchanged. There are some fundamental principles within Islamic banking which should be followed in all dealings. It is a fact that most of the religions and many great personalities clearly opposed the practice of Usury in principle. But it is to be noted here that only Islamic Law is strictly prohibiting Usury both in principle and practice. Islamic finance not only prohibits Usury but it puts forward a concept called risk reward sharing instead. Profit- Loss sharing under Islamic banking system is a unique feature of Islamic banking. Islamic banking has widespread difference in comparison with the conventional banking system.

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