ISLAMIC BANKING AND FINANCE: CHALLENGES AND RECOMMENDATIONS
TAUQIR HAIDER & MUHAMMAD ASHFAQ
Nov 10 - 16, 2008
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Interest, Usury, Riba) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
During the Islamic Golden Age, early forms of proto-capitalism and free markets were present in the Caliphate, where an early market economy and early form of merchant capitalism was developed between the 8th-12th centuries, which some refer to as "Islamic capitalism". A vigorous monetary economy was created on the basis of the expanding levels of circulation of a stable high-value currency (the dinar) and the integration of monetary areas that were previously independent.
A number of innovative concepts and techniques were introduced in early Islamic banking, including contracts, bills of exchange, long-distance international trade, the first forms of partnership (mufawada) such as limited partnerships (mudaraba), and the earliest forms of credit, debt, profit, loss, capital (al-mal), capital accumulation (nama al-mal), circulating capital, capital expenditure, revenue, cheques, promissory notes, trusts (see Waqf), startup companies, savings accounts, transactional accounts, pawning, loaning, exchange rates, bankers, money changers, ledgers, deposits, assignments, and lawsuits.
Organizational enterprises similar to corporations independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.
The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart." or "to ensure equivalency in real value" and that "numerical value was immaterial." During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself (ex natura sua) made no logical sense as its value remained constant relative to all other materials: these metals could be added to but not created (from nothing).
Riba was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value ["fiat money"] or based on other materials such as paper or base metals were allowed to have interest applied to them When base metal currencies were first introduced in the Islamic world, no jurist ever thought that "paying a debt in a higher number of units of this fiat money was riba" as they were concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).
This is a new branch of financial services, and one that has evolved a great deal in the 25 years as an active part of the modern financial services industry. The history of Islamic finance is of course much older; but that, as they say, is another story. Islamic banks and financial institutions now globally manage some US$ 200 billion in funds. Although this is not much compared to the total assets managed by financial intermediaries around the world, it is growing rapidly and with no limit in sight. Two of the key developments that have made this growth possible were in Bahrain - a key intermediary centre for Islamic finance instruments - and Malaysia, whose decision to adopt Shariah compliant financial instruments as an integral component of its financial market have given the sector a general boost. But now rapid growth of Islamic banking in the global financial world is witnessed. Various parts of the world are actively promoting Islamic banking and finance in their respective jurisdictions and emergence of global conventional players venturing into Islamic financial activities.
Islamic finance industry is said to be growing at various rates (10% -15% pa), (15% ñ 20% pa) some even say at 40%-50% per annum and also said to be managing funds $500 Billion to $1Trillion. It is quite evident that the industry is growing .The Gulf Cooperation Countries (GCC) markets are enjoying a period of extra ordinary growth reminiscent to that of the 1970's oil boom. But this time, concentration is on construction, infrastructure, services, tourism and economic diversity as well as greater private sector role. Appetite for Islamic finance is very much high and appealing not only in the GCC or Asian markets, but globally. Islamic banking & finance is 20% tapped, so 80% industry is still untapped. The untapped market Potential is available to tap into and bring benefits to individuals, corporate entities and the government. Standard & poor's International rating agency said that Islamic finance demand to rise to $4 trillion in coming five years. Because international players are capitalizing the enormous growth potentials so they enter through Islamic banking windows, independent branches, fully-fledged subsidiaries and fully converted Islamic banks. As the market players are rapidly increasing but on the hand Competition becoming stiffer and the customers becoming smarter to demand much more than Shariah Compliance.
The challenge going forward is that Islamic finance must be portrayed as a 'distinct alternative' to conventional finance; otherwise Islamic finance will be portrayed as 'just another type of product/service' under the conventional banking umbrella.
TOP 10 GLOBAL BANKS ACTIVELY INVOLVED TO CAPITALIZING INTO ISLAMIC FINANCE. BANK NAME Country UBS Switzerland Citigroup USA Mizuho Financial Group Japan HSBC Holdings UK Credit Agricole Groupe France BNP Pariba France JP Morgan Chase & Co USA Deutsche Bank Germany Royal Bank of Scotland UK Bank of America USA
Islamic banking must be viewed as an evolving system and change management process and it has shown tremendous growth in last 25 years. Financial engineering in the light of Principals of Shariah governance structure and conceptual development of Islamic Banking is the crying need of the hour if we really want to take advantage of the potential of market.
A phenomenal rise in Islamic Banking, Islamic investment, takaful and Islamic businesses in the past four decades confirms a desire of the people to go for halal and avoid haram in their financial matters. The issue today is not viability of Islamic businesses and finance. Even the hardcore capitalist world has resorted to Islamic windows in its conventional banking and financial institutions. The real problem is the workforce, or the human capital, needed for shariah compliant management of business and finances of the people. The human resource produced by the conventional academic and capacity-building programs cannot satisfy the demands and challenges of the Islamic financial institutions. Islamic financial institutions need highly-competent, motivated and involved persons with required knowledge of conventional banking and finance as well as knowledge of Islamic shariah. In a recent survey of over 60 banks in Karachi-Pakistan, 75% of senior bankers needed qualified staff in Islamic banking and finance, and 88% wanted their staff to be trained. 92% considered the organization benefited from training of their staff, while 90% indicated that training enhanced their capacity. 66% of respondents showed willingness to absorb candidates with MBA in Islamic Banking Finance and in their organization.
Muslims makes over 20% i.e. 1/5th of world population and today there are over 265 Islamic financial institutions, in around 70 countries, having capitalization in excess of USD 13 Billion, assets over USD 262 billion, financial investments above USD 400 billion and deposits in excess of USD 202 billion. Pakistan in particular and other countries in general can take the case of Mauritius .Mauritius out of 1.3Million population and which is gateway to the Africa, South Asia & Asia. Establishing an Islamic bank in Mauritius in 1990's was a manifestation of the Muslims. Islamic Finance can be promoted through cooperatives because a cooperative is an autonomous association of persons united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled enterprise. It is suggested that other Muslim countries should take the advantage of Mauritius of promotion of Islamic finance through Cooperatives.
Islamic financial world can implement the emerging Islamic micro finance due to benefits as riba (Interest) free operations , shift of focus to trading mode, better internal controls, reduced miss utilization of money in non productive activities, overall benefits to economic Environment and more Social Acceptability.
Takaful is another avenue for Islamic investment. Takaful comes from the Arabic root-word 'kafala' - guarantee. Serious efforts were made in modern times, in 1970s to come up with an Islamic alternative to the conventional insurance. The first takaful company was set up in Sudan in 1979, almost simultaneously followed by another one set up in Bahrain. There are now around 150 takaful companies in over 40 countries. The total insurance premium of OIC countries for 2004 was USD 50 billion; of this, takaful contribution accounts for 5% (USD 2.5 Billion). This is expected to increase to USD 15 billion by 2015. Non-Muslims are increasingly opting takaful products for commercial benefits.
MicroTakaful is a mechanism to provide Shariah based protection to the blue collared, under-privileged individuals at an affordable cost. Only 80 million out of the world's 2.5 billion poor are currently covered by some form of micro insurance. Only 3% of poor lives are insured in India and China. Only 0.3% of the poor are insured in Africa. In 23 of the poorest 100 countries in the world, there is currently no identified micro insurance activity.
Pakistan is country which has more than 96% Muslim population and demand for insurance increasing with increase in per capita income. Personal lines insurance business (leasing, health, Medicare) growing at a higher rate than other conventional classes and Islamic banking is on sound footing with support of the government now. Pakistan has tremendous prospects regarding micro takaful because large rural/urban divide in population (65%: 35%), 40% population below poverty level, mushroom growth of NGOs, State Bank of Pakistan said that 20% branches of commercial banks required in rural areas, benefit of economies of scale to make these viable ventures and financial Support from Asian Development Band and World Bank etc
Islamic financing is asset-backed and Islam does not recognize money as subject matter of trade except in some special cases. Money has no intrinsic value and is only a medium of exchange and financing in Islam is always based on liquid assets, which create real assets and inventories. Capitalist theory is that capital and entrepreneur are taken to be two separate factors of production; capital earns interest while entrepreneur is entitled to profit. Interest is the fixed return for providing capital but Profit is earned only when there is surplus after distributing the fixed return to land, labour and capital (rents, wages & interest).
Islamic Concept is that it recognizes capital and entrepreneur as a common factor of production. Every person contributing (in the form of money) in a commercial activity assumes risk of loss, hence is entitled to proportionate share of actual profit. Shariah scholars believe that conventional insurance is unlawful due to involvement of riba (interest), maisir (gambling) and gharar (uncertainty).
Insurance and Takaful industry is growing very rapidly due to main advantages like safeguard against sudden losses and assurance of smooth functioning of business activities, improvement in the saving habits in the society and making funds available for productive investments and help of individuals in case of unforeseen financial loss.
The difference between the the conventional and Islamic financial market is that conventional financial instruments are debt based called bond whereas Islamic financial instruments are asset based known as sukuk. The record number of Sukuk issues in 2007 Worldwide with a total volume of US$3 2.65 Billion has helped the Islamic financial institutions in the areas like better liquidity management, diversification of portfolio and increase in portfolio size of tradable instruments with fixed income profile, Short and long term 5 - 10 Years tenor sukuks. In Gulf Co-Operation Council (GCC-) UAE leads in 2007 Sukuks with 58% and Musharika sukuks remained popular in 2007 in amount but on the other side, Ijarah sukuks remained highest as number of issues in the global. In Asia Pacific, Malaysia is dominating with 95% share Pakistan stands second with only 3% Sukuks in Value. the diversification of funding sources, Creating and enhancing, secondary liquidity and ease of clearing and settlement are the main advantages to the sukuk issuer but issuer has to consider Underlying Assets, Applicable laws - SECP rules, Costs to the Issuers and Drafting of Legal Documents etc while issuing the sukuk in the market.
Although sukuk market is growing very rapidly not only in Muslim countries but in non Muslim countries as well but it also facing some critical issues like, Shariah' compliance and convergence, Cost efficiency and Development of market professionals. A variety of target-specific Sukuk can be issued return on which will be either variable or quasi-fixed, not absolutely fixed.
CHALLENGES OF ISLAMIC BANKING AND FINANCE:
* Misconceptions and lacking in know-how of Islamic instruments.
* Competition from conventional financial system.
* Human Resource Shortage and globally accepted standards.
* Synergizing between the Shariah requirements with the legal and taxation framework.
* Innovation in Shariah compliance and viable products
* Legal framework and Liquidity Management.
* Balancing between the monetary gains and fulfilling the Shari'ah objectives
* Issues of transparency and an under developed infrastructure.
RECOMMENDATIONS TO TACKLE CHALLENGES:
* Working knowledge of Arabic needed for understanding of the Qur'an, the sunnah and fiqh literature.
* Knowledge of Ayat and Ahadith that deal explicitly and implicitly with financial matters.
* Knowledge of Islamic jurisprudence, the methodology of usul-al-fiqh and the objectives of shari'ah as well as the qawaid-al-fiqhiyyah.
* Competence to conduct ijtihad in development of new Islamic products.
* Every Takaful Operator will have a Shariah Board of not less than three members and there will be Central Shariah Board appointed by SECP.
* Awareness and training of staff especially product related compliance, Awareness and training of client and his related staff specially product related compliance.
* Shariah compliance Issues in Islamic banking can be solved by developing proper internal shariah audit mechanism.
* The secondary market is still under developed and for sustainable growth of Islamic finance industry, money markets needs and problems must be addressed on priority basis.
* Investments of Gulf residents in United State is estimated US $ 800 billion, these huge funds should be used for Islamic banking and finance.
* Existing Islamic banks should look at microfinance as both a moral obligation and business opportunity.
* A large range of products needed to be expanded to fulfill diversified requirements of the clients.
* Islamic international rating agency (IIRA) should be play proactive role while rating Islamic financial instruments.
* Compliance with accounting and auditing standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
* Islamic financial institutions should consider pooling their resources and networking for establishment of state-of-the-art continuing education institutes in Islamic banking and finance.
* There should be a Shariah Supervisory Board for any institutional Islamic investment body, and that such Shariah Supervisory Board should consist of trustworthy scholars who are highly qualified to issue fatwas on financial transactions.
* The funds of the Islamic investment product and of the financial institution, in which Shariah provisions are not observed, must be completely segregated.
* Competitive pricing strategies should be formulated to attract investors which will lead to make a difference with conventional products offered by banks.
* Shariah advisors are the backbone of the industry without which the integrity of the whole industry will be at stake
* Advisory services are an amanah (responsibility) and must be discharged with utmost professionalism and integrity
* More interactions is needed between the Shari'ah advisors and the market players so that the supervisory role will be enhanced
* Shari'ah scholars must ensure that all the decisions made are realistic and serve the interest of the Ummah
Today there are more than 500 Islamic banks operating all over the world ranging from china, Malaysia, Indonesia, India, Pakistan, Middle East, United Kingdom, Switzerland, Germany, Luxembourg and USA and Canada with the bulk of presence in Middle East, more than 250 Shariah Compliant mutual funds are managing about $ 11 billion in assets and around 300 institutions currently contribute to the Islamic finance industry world wide. According to reports the greatest spread of the industry has taken place in the six member Gulf Cooperation Council (GCC), which includes Saudi Arabia, Bahrain, Kuwait, Qatar, Oman, United Arab Emirates and in GCC alone 18 Islamic banks are working.
With new technology and international standards, Islamic finance could further expanded to create more products acceptable internationally but is need to broaden understanding and knowledge on Islamic finance in line with current market developments. With greater awareness and knowledge of the Islamic finance principles of market instruments such as hedging and derivatives as well as debt instruments, Islamic finance could make a greater impact and gain lager share of the financial market.
Now the whole financial system of the globe is rapidly reshaping the world. Japanese are welcoming the Islamic finance, France has shown its keen intention to facilitate the growth of Islamic finance in the country by making adjustments in its economic and legal frameworks, UK has launched first ever Shariah Compliant insurance company, Salaam Halal Insurance and due to Muslim population South Africa also recording growth in Islamic finance.
The success of Islamic banks, financial institutions and businesses is directly related with highly-qualified business and finance managers with communication skills, knowledge of shariah and present day international business and finance. This can be achieved through Islamic research and training institutes of continuing education fully accredited with recognized universities. It is an uphill but promising and rewarding enterprise, no less than a gift to humanity. The existing workforce in Islamic business and finance institutions must enhance its capacity through short-term courses developed by various academic institutes in a modular form. Similarly, fresh human resource is to be developed as future leaders in Islamic finance.
Looking further ahead, there is scope to expand the market for Islamic products and services to non-Muslims as well as Muslims. The market is not confined to a particular group of consumers and Islamic finance providers can position their products to appeal more to the much larger non-Muslim population. Their success in doing so will in part depend on the ability to demonstrate how the products are underpinned by generally accepted ethical principles. If Shariah Compliant products are no longer seen as niche products, the industry could benefit from economies of scale which would help to sustain it over the longer-term.
"Islamic banking and finance will emerge as a force to be reckoned with in shaping the future development of global finance..."