How Islamic Banking Has Gained Momentum

In the last quarter a century, Islamic banking become as hot issue in both Muslim and non-Muslim World and gained momentum. Many studies have been conducted on commercial Islamic banking but nothing up to date has been done on integrating Islamic banking system with its conventional counterpart.

Islamic banking is steadily moving into an increasing number of conventional financial systems. It is expanding not only in nations with majority Muslim populations, but also in other countries where Muslims are a minority, such as the United Kingdom or Japan. Similarly, countries like India, the Kyrgyz Republic, and Syria have recently granted, or are considering granting, licenses for Islamic banking activities. In fact, there are currently more than 300 Islamic financial institutions spread over 51 countries, plus well over 250 mutual funds that comply with Islamic principles. Over the last decade, this industry has experienced growth rates of 10-15 percent per annum -a trend that is expected to continue.

Despite this rapid expansion, in most conventional banking systems, Islamic finance is still uncharted territory for most practitioners and policy-makers. Since current trends indicate that Islamic banking will continue to increase its penetration of conventional systems, policy-makers and practitioners need to become acquainted with this process and its implications for financial supervision.

CHAPTER 1

INTRODUCTION

1.1 Overview

The Islamic financial system has a century-old history (Chapra and Khan, 2000). From the very early stage in Islamic history, Muslims were able to mobilize resources and facilitate productive activities and consumer needs without interest. The system worked well during the early days of Islamic civilization.

However, as the forces of economic gravity shifted activities over to the western world, western financial institutions became dominant and the Islamic tradition took the back stage and remained dormant.

In recent years, there has been a significant revival of interest in developing a modern version of the historic Islamic financial system, in the wake of Muslims cry to stay away from interest, which is prohibited according to the Islamic shari’ah.

Some countries are however trying a complete elimination of interest in the financial system while others have allowed the establishment of interest-free banking along side the conventional banks.

The Islamic financial system is based on a number of principles found in the Islamic law (Shari’ah) as well as other jurisprudence or rulings known as fatwa. The central distinguishing feature of the Islamic financial system is the absolute prohibition of interest charges. Although, Islamic finance relies on the equitable risk-sharing, it rejects the concept of pre-determined interest rate but permits an uncertain rate of return based on trade and profits.

The financial sector of the economy encompasses financial instruments, financial institutions, and financial markets. Financial instruments are traded on financial markets by financial institutions. However, over the time, some participant will find it necessary or profitable to acquire more worth of goods and services than they currently produce and give in exchange.

Under the modern financial system, interest and enterprises based on interest occupy a prominent position, the whole banking system rest on interest, but the Islamic financial system differs from its conventional counterpart.

Islamic banking is steadily moving into an increasing number of conventional banking set-ups. It is expanding not only in Muslim majority countries but also where Muslims are minority such as United Kingdom and Japan.

An important principle of Islamic finance is the desire to maintain the moral purity of all transactions. The funds intended for shari’ah compatible investments should not be mixed with those of non-Islamic investments. In this sense, when a conventional bank opens an Islamic window, it is only establishing a separate entity from the rest of the bank.

The aim of this chapter is to lay down the objective, aims, importance, methodology, and hypotheses of the research. An overview of evolution of financial systems and a survey of chapters covered in this research will follow.

1.2 Research Objective

This study will attempt to explore the concepts of Islamic financial principles which relate to the integration of Islamic banking with the conventional financial system at the present time. So much, however, has been written on the theoretical side that it might be asked whether a further study can contribute to our understanding of the subject or not. Nevertheless, this research is using HSBC Amanah as a case study with an evaluation of its operations and performance in order to try and answer the following questions to reach this objective:

Can conventional banks legitimately offer Islamic financing facilities given their involvement with interest-based finance?

Are both conventional and Islamic banks converging or becoming increasing distinctive?

How can conventional banks offer Islamic financing facilities?

Do the functions of the Islamic banks differ significantly to that of the conventional banks?

1.3 Significance of the Study

Islamic finance is emerging as a rapidly growing part of financial sector in the world. It is growing at such a rapid pace that Islamic financial institutions are present today in over 51 countries (Sole 2009)

Despite this consistent growth, many supervisory authorities and finance practitioners remain unfamiliar with the process by which Islamic banks are introduced into a conventional system. This work attempts to shed some light in this area by describing the main steps in the integration process, and by flagging some of the main challenges that countries could face as Islamic banking is integrated into conventional institutions.

1.4 Methodology

This research work was carried out using a deductive reasoning approach. To ensure validity and reliability of the research, HSBC Amanah was used as the case study.

Data was collected from HSBC Amanah head office in Dubai, UAE, Islamic Bank of Britain in Birmingham to act as the control data as well as libraries across London such as The British Library in Kings Cross and London School of Economics and Political Science Library.

In more details, the methodology of the research is as follows:

1) A literature review of the western financial system is completed to enable comparisons between the western and the Islamic financial system to be undertaken.

2) The operations of conventional banks are reviewed.

3) Having established acceptable Islamic financial principles, the operations of an

Islamic bank are examined in the context of conventional banks.

4) To evaluate the performance of the HSBC Amanah, historical data available in the annual reports was studied and analysed. The Islamic Bank of Britain is taken as a model for comparison.

5) To provide a more comprehensive evaluation of HSBC Amanah’s performance questionnaires were distributed to collect more information to confirm or otherwise the findings of the financial analysis under 4 above.

1.5 Main Hypotheses

The main hypothesis of the research is that the Islamic financial system model differs from that of conventional financial system. This hypothesis will be examined in the light of

1) The theory of Islamic finance as perceived in the Islamic economic and financial literature.

2) A case study of HSBC Amanah.

3) The opinions of those operating or Governing HSBC Amanah and Islamic Bank of Britain

CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

The importance of the financial system cannot be overemphasized. Before the introduction of the money based economy, the barter system of trade prevailed; this involves the direct exchange of goods for goods in a simple market transaction without the intermediation of money as a medium of exchange.

The main problem with the barter economy is that it is considered primitive and if there is no financial system based on money, there would be no reason to hold money but rather to accumulate physical assets.

This chapter discusses the literature that provides the foundation for the research. It explores the theoretical concepts used in the later analysis and identifies the gaps in the literature that led to the study.

2.1 The Financial System

The financial system consists of financial markets, instruments, institutions, business firms and government in financing the acquisition of goods and services, capital investments and in transferring ownership of securities (Schall and Haley, 1991).

Financial systems are never static but changes over the time as new products and instruments are developed. The influence of the financial system is not limited to investments or borrowing but rather changes in the value of financial assets or the rate set for other financial variables can affects the whole level of activity in an economy.

Financial system is important in any economy for the following reasons:

1- It provides an efficient means of bringing the surplus units and the deficit units together in order to make transactions quicker and cheaper.

2- The financial system includes the secondary markets which facilitates the buying and selling of outstanding securities. This makes it easy for a firm to raise external debt or equity capital.

3- The value of a firm’s stock can be easily determined through the market forces of demand and supply.

2.2 Roles of the financial system

The key roles of the financial system are not specific to conventional or Islamic based system. Financial systems perform most of their everyday operations so quickly and smoothly that their importance is not always well readily recognized.

A well functioning financial system performs its principal roles of effecting payments, facilitating the investment of accumulated wealth, making funds available to finance viable new projects and providing risk management facilities. Parts of the financial system operate to make the system for payments in the economy as smooth as possible. It thus helps money to perform its function as a medium of exchange.

The financial institutions predominantly involved in the monetary system are the “clearing banks?. They assist with the payment mechanism by offering current accounts against which the account holder can write cheques or use debit cards to pay for goods. In the absence of such facilities, people would need to carry sufficient cash in order to make payments.

The role of financial intermediation requires providing mechanisms for saving and borrowing so that agents in the economy can alleviate budget constraints. This involves creating a variety of financial assets and liabilities with different characteristics that appeal to different savers and borrowers. Financial assets (equity and debt) are the basic products of the financial system (Schall and Haley, 1991).

The role of financial intermediation requires providing mechanism for savings and borrowing so that agents in the economy can alleviate budget constraints. This involves creating a variety of financial assets and liabilities with different characteristics that appeal to different savers and borrowers. The conventional banks provide the mechanism for savings and borrowings on the basis of rate of interest on both the assets and liabilities side.

In any particular period, some people in an economy will wish to spend more on goods and services than their income earned in the period allows, and at the same time, other people will have income more than they wish to spend and will want to save the surplus for spend in the future periods. The role of the financial system is to create a wide variety of instruments and incentives for an efficient allocation of scare financial real resources between competing ends. An efficient allocation of resources requires an accurate assessment and efficient pricing of risk. The price of finance needs to include an allowance for the risk involved.

The role of financial system as provider of risk management facilities is often regarded as having emerged in the 1970s and 1980s (Neave, 1998). That view stems primarily from observations of the very rapid growth of risk trading during those decades. Risk management became more popular as the financial environment became more turbulent.

Market trading of such risk management instruments as derivative securities is based on the same considerations that led insurance companies to write liabilities and commodities traders to purchase futures.

2.3 Financial system organisation

This describes how a typical financial system is organised. It was mentioned earlier that the principal role of the financial system is to channel funds from surplus units to deficit units.

The financial system is composed of a collection of financial institutions, financial instruments, and market trading.

2.3.1 Financial institutions

Some financial institutions are involved in direct lending and borrowing of funds. Example includes banks and building societies in the UK. The other category of financial institutions is the “investing institutions?. These institutions channel funds to deficit units in the economy by acquiring financial securities. Investment trusts are institutions which attract money from individuals and then invest it in larger amounts in securities issued by companies or public bodies requiring funds.

Although there is a split between lending and investing institutions, there are increasing overlaps between the two. Banks have traditionally been involved in taking deposits from people who wish to save and lending to those wish to borrow. But of recent, banks are also actively trading financial securities which make it difficult to distinguish between banks and investing institutions.

2.3.2 Financial Markets

A financial market is considered to be a forum for the exchange of financial products, represented in some cases by a physical location. But in others by a common information system sharing data on prices, and volumes transacted, and where a number of professional take an active part in the process of the market (Fell, 2000).

Financial markets exists in most capitalist markets economies for the trade of company shares and short or long-term borrowing securities. The two major components of financial markets can be termed the money and capital markets. The difference between the two lies in that in the money market, money is exchanged for other financial assets having a maturity of one year or less while the capital markets exchange, involves claims with a maturity greater than one year.

Financial Institutions

Deficit Units

Financial Markets

Surplus Units

Figure 2.1: Financial System

2.4 Functions of the Financial System

There are three broad functions performed by the financial system. First, it should provide a smooth and efficient transfer of funds from surplus units to deficit units. This transfer of funds can occur either directly through money and capital markets or indirectly through the

Intermediation market via financial institutions. Efficient transfer and flow of funds mean it

Should be accomplished at the lowest possible cost

Secondly, it should maintain a reasonable degree of soundness between financial institutions and markets in case of adverse economic conditions. Soundness of the financial system here means that institutions and markets maintain an efficient-transfer and flow of funds between SUs and DUs even in cases of adverse economic events such as inflationary and recessionary periods or avoidance of inflation and a lack of confidence in the financial system.

Thirdly, it should be flexible and adaptable to the continuously changing needs of the economy resulting from economic growth and to any new conditions facing the financial system either externally or internally.

If all of these functions (efficiency, soundness and adaptability) have been attained, then it will have a stable financial framework to support a rate of growth consistent with the resource base and technology of the economy, (Cargill, 1986). This stable financial framework must be accompanied by a stable monetary framework which means there must exist methods to allow money and credit to grow at sufficient rates to support economic growth at non inflationary levels,

2.5 Principles of Transferring Funds in the Financial System

There are two methods for transferring the funds from SUs to the DUs which constitute the basic nature of the financial system. The two methods are through direct and indirect finance.

2.5.1. Direct Finance

A direct transfer of money occurs when the DU which wants to acquire money, issues a financial asset (debt or stock) and sells it to the SU which has money available. The financial asset which is issued in this process is a piece of paper to indicate the nature of the asset which meets the legal requirements for establishing the claims (debt or stock).

In this method of finance the SUs and DUs deal either directly face to face or indirectly through the services of specialized brokers, dealers, or agents. Those brokers,

Dealers or agents match the SUs and DUs; they do not actually own the financial assets,

rather, they only charge a commission for their services.

Here the consumption units must sell their factor services to the production units for

which they will receive income payments as wages and salaries. At the same time the

consumption units or the households will purchase the goods and services produced by the

production units or the non-financial business firms and will receive the household current

expenditure payment as a price for these goods and services. The consumption units usually

save part of their income and they are considered SUs and at the same time the production

units usually need funds for investment and are as a result DUs. Production units do not have

sufficient income to cover their current expenditures and purchase of new capital equipment

and building. Since the SUs have income left over after all their spending has been completed, the DUs can use that income under the condition and willingness to pay interest to the SUs for the use of their savings. Thus, the DUs will issue IOUs to the SUs for their borrowed funds which will be used for the DUs investment and they will pay back to the SUs both the principal and the interest cost.

In the direct financing method the needs of the SUs and DUs must coincide before direct financial relationships can occur. Both the SUs and DUs have to be satisfied simultaneously for the transfer of funds to occur. Hence, there are several conditions necessary fore direct finance between SUs and DUs can occur, they are as follows:

a) The amount of the transfer of funds from the SU must be consistent with the spending plans of the DU.

b) The time horizon (the length of the time period) the SU wants to lend must equal the time horizon of the DU who wants to borrow.

C) The degree of risk the SU has to carry may be high, while the DU carries no risk, the SU must be willing to assume the risk of lending to the DU. These conditions create limitations for direct finance to take place and this provides the opportunity for indirect finance to emerge.

2.5.2 Indirect Finance

The indirect finance method overcomes the limitations of the direct finance method. This method separate the SUs and DUs to such an extent that neither one is aware of the other's existence (Cargill, 1986). The indirect finance method involves the introduction of a financial intermediary between the SUs and DUs.

The flow of funds will be advanced from the SUs to the financial intermediaries and in turn will flow to the DUs when demanded. Also, as the figure shows, exchange involves the surplus funds being transferred for an IOU drawn on the financial institution. This financial institution deals with many SUs and will accumulate a large volume of funds which in turn can lend too, many DUs spreading not through the diversification of assets. The DUs will issue in turn IOUs to the financial intermediaries where they received loans. The financial intermediary will assume the risk of the DUs and the SUs only assumes the risk of the lending certificate (IOU) issued by the financial institution. The transfer of funds, therefore, between SUs and DUs will reallocate the burden of risk. A financial intermediary acts as a middleman between those who have funds which they do not wish to exchange for goods, and those who do not have funds, but do wish to purchase goods. They provide an indirect means of transferring funds from savers to borrowers.

The process of intermediation combines two basic and vital functions-First, it provides an opportunity for savers to deposit their savings, and earn a return on them, thereby mobilizing funds which otherwise may be hoarded. Second, it transfers risk from the lender to the intermediary and/or to the borrower. Individuals with available savings may be reluctant to invest themselves, or lend directly or to take equity in a borrower's project.

Those individuals may not want to take the risk, they may not be able to asses the risk, and they may not know how to protect themselves legally and financially if things go wrong.

An intermediary takes these risks away from individuals and in many cases transfers them to the borrower by taking security, (Kitchen, 1986). Savers must have confidence in the intermediary; otherwise they would not place funds with them. This means intermediaries cannot mobilize funds unless savers have confidence in them.

In the case of indirect finance, the excess lending over borrowing of the SUs will be represented by increases in the certificates owed by financial institutions. At the same time, the excess of borrowing over lending of the DUs will be represented by an increase in outstanding certificates held by the financial institutions.

Indirect financing methods have several significant advantages for the SUs, DUs and the intermediary.

Advantages to the surplus unit

1. The surplus unit can purchase any kind of investment (short or long term) and any amount (small or large) of IOUs from financial institutions.

2. Financial institutions can diversify their financial assets to a greater extent than can any single SU does by itself

3. The IOU of a financial institution which pays the same interest return will involve a smaller degree of risk for the SU than IOU drawn directly on a DU, (Cargill, 1986).

Advantages to the deficit unit

1. The DU can borrow large amounts from the financial institution which has a large accumulation of funds from several small SUs.

2. The search costs of the DU in finding a suitable lender will be reduced with the existence of the financial institutions when compared with direct finance.

3. The financial institutions can offer other services to the DU such as market analysis and investment opportunities, (Cargill, 1986).

The financial intermediary, it receives compensation for the services it is providing to the lenders and the borrowers which are achieved through profits generated by the difference between what the financial intermediary pays its depositors and what it charges its borrowers, (Thygerson, 1993).

The following section discusses and examines the role and functions of financial institutions and their importance to the economy.

2.8 Financial Institutions

The financial system consists of markets trading, financial instruments and financial institutions. These two aspects of the system are very hard to separate and in many cases it is financial institutions which create the market. In this section, the role and functions of financial institutions are examined.

All financial institutions serves intermediaries to facilitate the transfer of funds from the surplus unit to the deficit units, financial institutions differ among themselves primarily in the magnitude of their operations and the services they handle to the SUs and the DUs concerning the sources and uses of funds.

The financial institutions (financial intermediaries) come between SUs or suppliers of funds and DUs or demanders of funds. Financial intermediaries or institutions accept savings from SUs and in return these suppliers of funds acquire claims against the intermediaries.

Intermediaries make loans or investments to the DUs or demanders of funds. The suppliers of funds expect some return in the form of interest or cash dividends as a reward for entrusting saving to the financial intermediaries, (Pinches, 1987).

Financial institutions are divided into two groups- depository financial institutions and

Non-depository financial institutions.

2.9 Depository Financial Institutions

The depository financial institutions have a unique role in the financial system. First, they deal with every type of surplus and deficit unit in the economy. Second, they have a very important role in the money supply process. "The liabilities of depository institutions classified as transaction deposits represent the major part of the money supply measured as M1" (Cargill, 1986). These depository institutions have the ability to destroy and create Money because their transaction deposits are subject to a fractional reserve requirement.

This means that for every unit of reserve, depository institutions can support several units of transaction deposits. "Transaction deposits are created or destroyed during the lending investment activities of depository institutions", (Cargill, 1986). Any loan made by the depository financial institutions represents a creation of that amount in transaction deposit.

According to the multiplier function each unit of reserve will support several units of loans and hence transaction deposits. The same outcome occurs if the bank purchases a security.

The securities purchase of the bank involves a payment which will be a transaction deposit under the name of the seller, and so on. The whole operation will be repeated and more transaction deposits will be created and more money supply will be created. The reverse process of destroying transaction deposits during the lending and investment process can also take place by paying off the loan which means drawing down the transaction deposit. In this case if the bank does not make a new loan to replace the paid-off loan this means transaction deposits will be lowered. In the case of the financial investment activity, if the bank sells a security and holds on to funds then it means transaction deposits are destroyed. From the previous discussion it can be seen that the ability of depository institutions to expand or contract transaction deposits depends on the level of reserve requirements. Any changes in the monetary base will lead to multiple changes in transaction deposits and, hence, the money supply, (Cargill, 1986). When reserve requirements decrease then the depository institutions will be able to increase lending and investment activities. Transaction deposits and the money supply; and vice versa.

Depository Financial Institutions are divided into two types: banks and non-bank financial institutions. The primary difference between these two types’ institutions is that: the banks dominate the issuance of demand deposits and demand deposits are considered the largest single component of the money supply. For this reason any changes in demand deposits represent significant changes in the money supply. The non-bank financial institutions do not have that impact on the level of money supply and they do not have the check-clearing mechanism for payments like banks do. In general banks are considered the first to be affected by any change in monetary policy which in turn will affect the entire financial system. The non-bank financial institutions are only indirectly affected.

3.1 Islamic Financial System

It must be understood from onset that Islam is a comprehensive way of life that has its own broad and flexible economic policies which allows its followers their choice of economy irrespective of time and place (Siddiqi, 1970).

Islamic finance can however be described as the operating financial system which is based on the financial teachings and practices of Islam.

It can also be described as a means through which money flow from one unit to another in return for either equity or rights to share in future business profits. It could also be in form of delivery of goods and services in return for the repayment of the value I a later date.

DeLorenzo (2005) described it as actually part of a Muslim’s practice of his or her religion.

To understand the theories and ideas of Islamic financial system we need to understand the rules of Shari’ah from which the idea of the Islamic financial system had been drawn.

3.2 What is Shari’ah?

Shari’ah is an Arabic word meaning the path to be followed (Kettel, 2008). Literally it means a way to a watering place. It is believed by Muslims that the path to Aljanah has been ordained by Allah through his messenger, Prophet Muhammad (PBUH) for whoever wishes to follow the path. Qur’an 2:4;

“And who believe in that which is revealed to you (Muhammad) and that

Which was revealed before you, and are certain of the hereafter?

The fundamental principles governing the Islamic faith are firmly based upon shari’ah and are in the interest of the people.

The sources of the shari’ah law are categorized into four;

The holy Qur’an

The sunnah or the doings and practices of the Prophet Muhammad

The ijma, consensus of opinion of the Ulama-learned in the society.

The Qiyas, analogical reasoning or deductions.

3.3 Tenets of Islamic Finance:

i) Prohibition of Interest:

The central tenet of Islamic finance is the prohibition of interest. This was mentioned in four different revelations in the Qur’an, the first revelation emphasizes that interest deprives wealth, of God’s blessing, Qur’an 2:275 “Those who swallow usury cannot rise up except as he arises whom the devil has prostrated by (his) touch?. The second revelation condemns it, Qur’an 2:276 “Allah has destroyed usury and made almsgiving fruitful. Allah loves not the impious and guilty? The third revelation enjoins Muslims to stay clear of it Qur’an 2:278 “O you who believe! Observe your duty to Allah, and give up what remains (due to you) from usury if you are (in truth) believers? and finally a clear distinction is made between interest and trade and also enjoined Muslims to take principal and forgo debt if the debtor is unable to pay. Qur’an 2: 280 “And if the debtor is in straitened circumstances, then (let there be) postponement to (the time of) ease; and that you remit the debt as almsgiving would be better for you if you did but know?

Although there have been discussion among Muslim scholars on the reason for the prohibition of interest, it is obvious from the above quotations that it is considerations of equity and protection of the poor that lie behind the strong condemnation.

There have been arguments that a system in which interest is not allowed is unlikely to work efficiently in the short run and in the long run, this will result in the eventual dry-up of savings and investments. These views tend to reflect a basic confusion between the terms “rate of interest? and “rate of return?.

Islam clearly forbids the rate of interest but rather encourages trade and profit (Khan, 1986).

ii) Profit and Loss sharing:

The principle here is that the lender must share in the profit or loss arising out of the business enterprise that the money was lent. It is thought that one needs to invest its money and become partner in order to share profits and risks in a business rather than become creditors.

In order to ensure investments are made into productive enterprises, Islamic financial system encourages investment in which the society at large benefits. It does not give room for people who are not willing to take risk but intend to hoard their money or deposit it in a bank and earn interest for no risk.

It encourages the notion of higher risk and higher returns. The whole objective is to encourage investment and production to provide a stimulus for the economic growth.

Under Mudarabah for example, the provider of fund suffers the loss in a business enterprise where as the entrepreneur suffers his loss by not receiving wages for his endeavors.

Due to the nascent experience with economy-wide profit and loss sharing system in the Muslim states, it is not possible to state with confidence that such a system will function as well or better than the conventional interest-based system.

iii) All financial transactions are asset backed:

The idea of making money out of money is not acceptable in Islam. Money itself has no value and is only a medium of exchange, and should not be allowed to generate more money.

Money only become capital when it is put into a productive venture, that is, invested in business.

iv) Acceptance of only shari’ah compliant products:

In Islamic financial system, everyone needs to work within the moral value system of Islam.

All financial products and services developed needs to be approved by the international shari’ah board for the high end of the market. This gives it a wider market acceptance and the mitigation of shari’ah risk for similar products or services.

v) Sanctity of contracts:

Islam places all economic relations on the firm footing of contracts. The freedom to enter into contracts, designed within the framework of the shari’ah and the obligation to remain faithful to their stipulation has been deeply emphasized in Islam.

vi) Role of the State:

The state’s role in the Islamic economy relates to ensuring that, firstly, everyone has equal access to natural resources and means of livelihood.

Secondly, each individual has equal opportunity including education, skills and technology to use these resources. Third, that market is supervised to ensure justice in exchange, and finally, the distributive justice is assured for the next generation through the implementation of the laws of inheritance.

The state is empowered within the framework of shari’ah to design any economic policy that is required to guarantee the attainment of these objectives and to meet the necessary expenditure associated with the performance of its duties through taxation and utilization of natural resources.