Islamic Banking Muslims
ISLAMIC BANKING SYSYEM
An Alternative System
What Are The Strategic Issues In Islamic Banking System? How are they implemented?
Introduction
Over the last few decades, the Muslims have been trying to restructure their lives on the basis of Islamic Principles. They strongly feel that the political and economic dominance of the West, during past centuries has deprived them of the divine guidance, especially in the socio-economic fields. Therefore, after acquiring political freedom, the masses are striving for the revival of their Islamic identity to organise their collective life in accordance with the Islamic teaching. In the economic field it was the biggest challenge for such Muslims to reform their financial institution to bring them in harmony with the dictates of Shari`ah. In an environment where the entire financial system was based on interest, it was formidable task to structure the financial institution on an interest free basis. The people not conversant with the principle of Shari`ah and its economic philosophy sometimes believe that abolishing interest from the banks and financial institutions would make them charitable, rather than commercial, concerns which offer financial services without a return. Obviously, this is totally a wrong assumption. According to Shari`ah, interest free loans are meant for cooperative and charitable activities, and not normally for commercial transactions, except in a very limited range. So far as commercial financing is concerned, the Islamic Shari`ah has a different set-up for that purpose. The principal is that the person extending money to another person must decide whether he wishes to help the opposite party or he wants to share in his profits. If he wants to help the borrower, he must rescind from any claim to an additional amount. His principal will be secured and guaranteed, but no return over and above the principal amount is legitimate. But if he is advancing money to share the profit earned by the other party, he can claim a stipulated proportion of profit actually earned by him, and must share his loss also, if he suffers a loss. It is obvious that exclusion of interest from financial activities does not necessarily mean that the financier cannot earn a profit. If financing is meant for a commercial purpose, it can be based on the concept of profit and loss sharing, for which Musarakah and Mudarabah have been designed since the very inception of the Islamic Commercial Law. There are, however, some sectors where financing on the basis of Usharakah or Mudarabah is not workable or feasible for one reason or another. For such sectors the contemporary scholars have suggested some other instruments which can be used for the purpose of financing like Murabahah, Ijarah, Salam or Istisna. This research will facilitate to understand the basic principal of Islamic Finance and the main points of difference between conventional and Islamic Banking System.
Background of Islamic Banking System
The late seventies and early eighties proved of great significance because it was during this period that the idea regarding introduction of interest-free banking began to attract world-wide attention in a number of Muslim countries including Pakistan and Iran. It was during this period that in Pakistan the Government entrusted the Council of Islamic Ideology with the task of preparing a blueprint for an interest-free economic system to be introduced in the country. In 1977 the Council appointed a panel of bankers and economists to suggest ways and means of eliminating interest from the economy. In April 1979 the State Bank of Pakistan constituted six working groups. These groups were assigned the task of examine various aspects of interest and went on to propose methods of its elimination. After these early preparations a number of reports were submitted to Government. As a result all the nationalised banks of Pakistan were asked to accept deposits on the basis of Profit and Loss Sharing (PLS) with the effect from January 01, 1981. It is significant to note that the deposits based on these PLS accounts showed phenomenal upsurge in a short span of time. The banks registered a steep rise in deposits to the tune of Rs 22,000 million at the end of June 1984. This indicates that people were willing to opt for placing their funds in PLS accounts rather than those based on interest. From this initial stage the State Bank of Pakistan went on you issue circulars regarding introduction of interest-free banking progressively. It was State Bank Circular No 13 of June 20, 1984 that an across-the-board interest-free system of banking was introduced in the country. The interest-free system thus introduced has shown marginal improvements from the year following 1984 up to now. It appear also that though the work done until that date has not been undone, there has been, so to say, no retracing of steps and further development has remained illusive.
Islamic Banking System is a phenomenon more of expericing than of mere theorising. However, smooth evolution of the concept does require strong theoretical underpinnings, thus theory and practice have to go hand in hand for successful evolution of Islamic
Literature Review
Islamic finance services are expanding worldwide.1 More than 200 Islamic Financial Institutions (IFIs) are reported to have total combined assets in excess of US$ 200 billion (General Council for Islamic Banks and Financial Institutions (GCIBAFI), 2005).2 Some observers expect that Islamic finance may be able to attract 40% of the total savings of the Muslim population worldwide within the next few years (Zaher & Hassan, 2001). To capitalize on the potential of that market, a number of global financial institutions - including Citibank, Hong Kong Shanghai Banking Corporation (HSBC), Goldman Sachs, BNP-Paribas and Union Bank of Switzerland (UBS) - have established Shari`ah compatible services (Sundararajan & Errico, 2002).
The growth of the industry and its potential impact raise public policy issues. International organizations and standard setters, national regulatory authorities, policy makers, and academia are focusing on IFIs' risk management practices, the broad institutional environment in which they operate, and the regulatory framework that governs them. Institutions have been established notably the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the International Islamic Rating Agency (IIRA), the Islamic Financial Services Board (IFSB), and the Liquidity Management Center (LMC).3
Less widely understood than conventional finance, Islamic finance generates mixed perceptions on the risks it introduces. Thus, Islamic finance reminds of Merton's (1995) point that “less apparent understanding of the new environment can create a sense of greater risk even if the objective level of risk in the system is unchanged or reduced”. Thus Islamic finance viewed as financial innovation is generating concerns on its inherent risks and their possible spillover on the rest of the financial system (Merton, 1995).
These concerns are compounded by features specific to Islamic finance. First, there is the divergence between the theory of Islamic finance, and the way it is practiced.4 Second, IFIs have to compete with conventional financial intermediaries while they do not have access to similar risk management tools. Third, each IFI's business conduct is idiosyncratic, shaped by its Shari`ah board, local legal tradition and interpretations, and the specific market's competitive pressure. Fourth, in many jurisdictions, IFIs need to comply with conventional finance regulations that may not be adapted to the business. Fifth, different schools of thought on Islamic finance offer different interpretations of permissible financial contracts.5
Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the 'borrowers' would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah.(6) Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.
Methodology:
Research is often described as an active, diligent, and systematic process of inquiry aimed at discovering, interpreting and revising facts. This intellectual investigation produces a greater understanding of events, behaviors, or theories, and makes practical applications through laws and theories (Trochim et al, 2006). The term research is also used to describe a collection of information about a particular subject, and is usually associated with science and the scientific method
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