ISLAMIC BANKING VS CONVENTIONAL BANKING
FOZIA AROOJ (firstname.lastname@example.org)
June 23 - 29, 2008
Pakistan's Islamic banking, initiated since 2002, has been able to acquire 3.2% of the industry share. In 2006, financing and investment made by Islamic banks and dedicated Islamic banking branches of conventional banks rose to 2.4% of the entire banking industry from 1.8% in 2005. Now there are six full-fledged Islamic banks and 13 commercial banks with Islamic banking branches.
In international arena Islamic finance is expected to grow at 10-12% per year over the next decade. The current market for Islamic financial product is estimated around $300 billion. Over the last few years, Islamic finance has grown at a good pace across the globe. The UK, the USA and the Middle East have emerged as main centers of Islamic financing. Malalysia which is considered the hub of Islamic banking has a 12% share in its banking sector over a period of 24 years since it first started to operate. Rising liquidity in the international market particularly in the Middle East (as a result of oil prices boom) would take the Islamic banking to new peaks. A lot of activity is taking place in Islamic banking in the Middle East and as the Arab stakes increase in local Islamic banking, more growth is expected.
Islamic banking did not emerge in the year 2002, with the grant of license for the first full fledged Islamic bank, but a number of measures were taken by the government towards the commencement and growth of riba free system in 1978-79. It initiated in the form of Modaraba Companies and Modarabas Ordinance, 1980 along with the Modaraba Companies and Modaraba Rules, 1981. From July 1, 1985 all commercial banking in local currency was made interest free. However, the procedure adopted by banks since July 1 1985, was declared un-Islamic by the Federal Shariat Court (FSC) in November 1991. In December, 1999, the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan gave its verdict banning interest in all forms. In September 2001, the State Bank issued detailed criteria of Islamic Banking Policy for establishment of full-fledged Islamic commercial banks in the private sector. In this way, Shariah compliant banking practices were encouraged, and finally in January 2002, the State Bank of Pakistan issued the first Islamic banking license to Al- Meezan.
There are a number of challenges faced by Islamic banking which have resulted in the smaller industry share. There exists a sheer lack of awareness as people are not certain whether Islamic banks are actually Islamic. These factors give rise to a lowering of customer confidence. Another snag behind its low penetration in the financial market is the absence of Shariah-compliant legal framework required to make interest-free banking acceptable
Some of the most important challenges facing the Islamic banking industry are outlined as follows:
1- There is no legal support to Islamic banking in the form of commercial banking laws and company laws so as to facilitate implementation of Shariah compliant financial system. The scope of Islamic banking activities within conventional limits is being tapered because of the inappropriate provisions in the commercial, banking and company laws. To ensure outreach of this system it is inevitable to promulgate special laws for the introduction and practice of Islamic banking.
2- There is a lack of uniformity and consensus in interpretation of the products and elaborating the features. For instance all the institutions are primarily offering Morabaha and ijara as financing modes but each institution has its own group of Islamic scholars on the Shariah board to approve the product. As a result, the same products come up with different features subject to different rules and regulations. Lack of standard financial contracts and products can be a cause of ambiguity and a source of dispute and cost. In addition, without a common understanding of certain basic foundations, further development of banking products is hindered. Besides, there is no universally followed terminology for Islamic financing. One finds interbank differences in the use of terms. For example, while majority of Islamic banks use the nomenclature Murabahah to stand for financing via sale on deferred payment, some label it Bai" Thaman bil Ajil.- Quite interestingly, these latter institutions also offer Murabahah financing products.
3- There is a dire need of regulator for these institutions and there should be a separate and effective set of Prudential Regulations. It is also important to note that the nature of risk in Islamic banking is different from those of conventional banking and therefore some special prudential, accounting and auditing standards should be applied to them.
4- Conventional banking system is equipped with instruments of long term financing like bonds and equities. To further reinforce the system ancillary services are provided by investment banks, mutual funds, insurance companies and pension funds. Equity can also be raised through general public. On the contrary Islamic banks don't deal with interest bearing bonds. Therefore, their need for equity markets is much higher. On the top of it Islamic banks are in need of derivative products and consequently of Future Exchanges in order to hedge the risk. The risk exists because most of the products in Islamic banks are based on goods and commodities while prices and currency rates go up and down frequently, creating a big risk for them being traders in reality especially in the case of Salam and Istisna'a.
5- Islamic banks are also adopting the conventional interest based benchmarks (Kibor etc.,) as the base of pricing an Islamic financial product. This commonality creates a negative perception among the consumers as to the presence of any prudent difference in Islamic and commercial banking. The mechanism for long-term financing could be devised on the basis of prevailing renting system adopted by the private landlords while renting their assets/properties etc. Standard pricing formulas, in the light of Shari'ah principles, are needed for those on the front desk for efficient working of the Islamic financing model. Their development will also help promotion of Islamic financing in academic and professional circles.
6- Islamic banks are offering only Murabaha and Ijarah while leaving the core and difference making Islamic financial instruments such as Musharakah and Murabah. It is necessary to enhance and facilitate the implementation of real Islamic banking activities i.e. promoting risk sharing through equity type facilities on the asset side and profit sharing investment accounts on the funding side.
7- Islamic banks are reluctant to enter into long-term transactions due to the lack of availability of liquidity through secondary market. There is liquidity support in the form of lender of last resort facility.
8- There is no proper mechanism of transparency and disclosure to the public in order to ensure consumer protection as provided by Shariah.
9- Designing technological solutions around a concept requires extensive knowledge of the domain. Conventional banking today is technologically advanced; however, for crafting Islamic financial solutions, considerable time and expertise are required.
10- Lack of qualified manpower is one of the biggest hurdles in the advancement of Islamic banking. Pioneers in Islamic banking developed their financial instruments and painstakingly trained their staff. There is no training institute to meet manpower needs of existing and future Islamic banks. Some of the reasons for this lacuna are understandable. For example, lack of consensus on form and details of Islamic financial instruments and nonexistence of Islamic reporting and accounting procedures. Some work has been done. But a lot more is still needed, especially on the fundamentals. Nevertheless, there is enough material to offer short training courses in Islamic banking.
11- Trading modes of financing require contact with suppliers in the case of murabahah financing and marketing channels for disposing of merchandize produced in the name of financial institutions under salam financing. Similar considerations also arise in other Islamic financing modes, for example, leasing. Standing arrangements with suppliers and marketing agencies can considerably reduce transaction costs and financial risks for Islamic banks. Retail Islamic banking shall also be helped in this way.
12- There is a need of Financial Products Yielding Stable Income Flows. These are needed for pensioners, widows, orphans and similar other vulnerable groups in the society that rely on fixed income schemes. This is a challenge that Islamic banking has to answer.
13- Further Shari'ah Research is both important and sensitive matter. Its importance is self-evident. The long fiqhi tradition of last fourteen centuries warrants utmost care for any fresh attempts. Is it not that, notwithstanding complexities in the transactions and the institutions that developed after the first century of Islam, in particular last two hundred years, the transactions as well as institutions represent derivatives of those prescribed in the Qur'an and Sunnah? Should the argument on various matters be developed in the light of the principles laid down in the Qur'an and Sunnah? Is there not a need review and reaffirm the received doctrines through a systematic and integrated analysis of the vast Hadith sources compiled in the 3rd Century after Hijrah? A consideration of above points is very likely to be fruitful for expeditious development of Islamic financial paradigm, as also for making it a living reality. Emergence of Islamic banking has provided a golden opportunity for unifying the fiqh. Moves are already underway to look for common ground and to define common fiqh for all Muslims.
In short pace of development of Islamic banking can be expedited through the following:
* Establishment of Shari'ah Governance Systems
* Settling unresolved Fiqh Issues
* A sufficient number of well-trained, competent, high-caliber Islamic finance professionals and management teams with the required expertise
* Well-informed individual and corporate consumers, knowledgeable about Islamic banking and takaful
* The availability of Sharia'h compliant products (Sharia'h Compliant Stocks, Sukuks, etc.)
* Development of a Legal, Regulatory, and Institutional Framework complying with Sharia'h
* Advanced technology solutions designed to support Islamic Finance Islamic financial model is feasible. There is no question about this. In fact, with the availability of more financing modes than those recognized at present, it is bound to be more versatile and efficient. But it faces problem of general acceptability. Every citizen is not fully aware of the rules and regulations of the Shariah. Many of them do not know what modarba, murabaha, musharika or ijara is. Industry experts and government should jointly make arrangements for dissemination of knowledge and lay emphasis on information regarding Islamic banking. Even though, Islamic banks have spent a lot in marketing their products but they have not been able to fully inform their potential customers of the ways they operate that makes them religiously and ethically correct. In addition attempts should be made to modify the existing structure to provide better products and quality service within the ambit of Islamic laws.