Islamic Banking, Banking with ethics

Islamic Banking, Banking with ethics

Salaam aleikum, this is a termpaper I wrote a few months ago for my University, inshAllah I will start posting on this blog soon again. Keep me in your du’as jazakAllahu khairan.

Islamic Banking
Banking with ethics

1. 1. Introduction:

In order to understand Islamic banking and the motive behind the system, one must understand that Muslims believe that the rules and regulations within this system comes straight from God, making it the best system that mankind could implement. The major difference between Islamic banks and conventional banks is that fact that Islamic banks are not allowed to charge interest.
The Muslim Holy book, the Qur’an is not the first book banning interest,
” O those who believe, fear Allah and give up what still remains of the riba (interest) if you are believers. But if you do not, then listen to the declaration of war from Allah and His Messenger. ” (Qur’an: 2:278-279)
The Bible also mentions interest and forbids it.
”Thou shalt not lend upon usury to thy brother, usury of money, usury of victuals, usury of anything that is lent upon usury”. (Deuteronomy 23:19)
Many find it hard to believe how an Islamic bank can operate without involving themselves in interest. It has to be understood that interest, from the Islamic perspective means that there is a increase on money, so if person A wants to buy a mug, priced at 5€, he approaches person B and asks for a loan, B agrees but wants a 2€ increase on the loan when it is paid back, making the total price to be paid back 7€. The 2€ increase here constitutes interest, hence making the contract would be unlawful. The correct way to deal with this issue is that person B will buy the mug for 5€ and sell it to person A for 7€, hence getting a 2€ profit on the sell price, this is also called a Murabahah contract.
Many might protest and claim that interest has only changed name in the latter transaction, but this is not true. Yes, the increase in the price is the same, namely 2€, but the real difference here is that an actual asset was sold, person B bought the mug and later sold it to person A, in contrast to the first example, where no asset was sold, only money was.
In order to be a legitimate Islamic bank, the bank has to abide by Shari’ah i.e Islamic law. This means that anything that is unlawful in Shari’ah, is out of bounds for the Islamic bank. In practical terms this means that not only is the bank not allowed to participate in transactions where interest is involved, neither are they allowed to invest in for example alcohol, gambling or pornography. A contract is also rendered invalid if it has not been completely transparent or one of the parties has been not been fully aware of what they are agreeing upon.
The Shari’ahs view on money is that it is only regarded as a measurement of value not an asset in itself. (Ahmed 2.7.2008, Lecture) This means that it is not allowed to profit on the trade of money. It is only allowed to make profit on tangible assets, hence creating an asset based economy, in contrast to the conventional banks, that deal in money and monetary papers. (Usmani 2002:12)
”Those who benefit from interest shall be raised like those who have been driven to madness by the touch of devil; this is because they say: ’Trade is like interest’ while God has permitted trade and forbidden interest”. (Qur’an 2:275)

1. 2. History:

Islamic Banking has a long history which dates back to the early days of the Islamic State, also known as the Caliphate. The foundations of mercantilism, sometimes called Islamic capitalism was developed during the 8th- 12th centuries and a stable currency called the dinar was spread throughout the Islamic state.
Many innovative modes of financing were developed during this time such as bills of exchange, different forms of partnerships, cheques and trusts which later spread to Italy and the rest of Europe in the 13th century because of extensive trade and interaction with the Islamic state. (Moin 2008:)
When the Islamic state was abolished in 1924 the concept of Islamic banks died with it and European styled conventional banking spread throughout the Muslim world.
The first modern revival of Islamic banking came in 1972 when the Mit Ghamr Savings project was started in Egypt. The Islamic Development Bank was established in 1975 with the aim of promoting Islamic banking and being the leading researching organization within the sector and the first modern Islamic commercial bank, Dubai Islamic Bank opened its doors for business the same year. (Moin 2008:)
Today there are many Islamic banks operating throughout the world, such as Islamic Bank of Britain, Dubai Islamic Bank and Meezan, and many conventional banks such as Deutsche Bank and HSBC, who have opened Islamic ”wings” offering for example Islamic mortgages.
There are now over 300 institutes offering Islamic banking services controlling over 800$ billion in assets which is about 0.5% of the current global market. (Standards and poor)
There are also countries that have banned interest. So far Iran, Sudan and Pakistan have done this. (Ariff 2001)

1. 3. Islamic modes of financing

Mudarabah-Passive Partnership:
A Mudarabah agreement has two parties, a mudarib and the rabb-ul-mal. The rabb-ul-mal is the party that provides capital and the mudarib is the one that provides the work. A practical example would be that person A has a business idea, he wants to open a bookshop, and he has the know-how but lacks the capital. He finds person B, who has a lot of capital lying around and wants to invest in something. They sign a Mudarabah agreement where person A is the mudarib and person B is the rabb-ul-mal. The distribution of the profit in this sort of agreement has to be agreed upon before signing the contract. The distribution of the profit is a certain percentage and not a fixed sum, it can for example be split so that the mudarib gets 80% of the profit and the rabb-ul-mal gets 20%, but there cannot be a agreement that one party gets 2000€ while the other will get 8000€ since the profit (if there is any) is unknown. In the case of a loss, the rabb-ul-mal will lose his capital that he invested and the mudarib will lose his job. This is a very clear difference compared to many conventional banks approach, where if the loan borrowers’ business idea would fail, he would still have to pay back his original loan+ the interest. This kind of mudarabah agreement is a very efficient way to invest in grass root projects in order to raise poor people from poverty, while there is also a sense of security for the mudarib, that if the business does not succeed, there is no fear of for examplle losing your house or another asset that you had to have as a guarantee if you would have taken a conventional interest based loan. (Usmani 2002:31,33)
Musharakah-Active partnership
Musharakah comes from the Arabic word shirkah which means sharing. In a musharakah contract two parties put their capital together to invest in a project. This type of contract can be used for example if a company wants to make an investment or if a person wants to buy a house.
If a company wants to make an investment that would cost 100 million in total and the company only has 20 million, it can approach a bank in order to sign a musharakah contract which means that the company invests 20 million and the bank would invest 80 million in the project. The profit or loss would be split on a pre agreed ratio, such as 20/80, but any other ratio can be agreed upon.
This is a good substitute to an interest based loan. This sort of contract is fair to all the parties. If the investment is successful and the company makes a profit then the bank will get its fair share, which then is passed to the depositors in the bank who will also receive their share. (Usmani 2002:15-19)


Murabahah-Sales contract
Murabahah is the simplest of the modes of financing, it is a simple sales contract where person A does not have enough money to buy a product, so they get person B to buy the product for them, and person B sells the product to person A with or without a profit, this example was also mentioned in the section on the principles of Islamic banking.
If person wants to buy a mug that is worth 5€  but can’t afford it so person B steps in and buys the mug and sells it to person A for 7€, the ownership of the mug transfers instantly to person A from person B but the payment can be done later on, in segments or in total.
This is not a traditional mode of financing that Islamic banks use but it does constitute a small percentage of the contracts that Islamic banks engage in. ( Usmani 2002:65-66)

1. 4. Performance during the financial crisis

As the latest financial crisis terrorized the planet we saw many banks declaring bankruptcy or going through drastic changes, such as Lehman Brothers and Goldman Sachs.
Mufti Taqi Usmani comments:”Leaving exaggerations apart, it is incorrect to claim that they were not affected at all, but it is correct to say that they remained pretty safe from the horrors faced by conventional financial institutions. The reason is obvious. In order to be compliant with Shari’ah (Islamic law) they are bound to remain at a distance from interest, derivatives, short sales and sale of debts.” (Usmani 2010: 34)
Mufti Taqi Usmani was also invited to the annual World Economic Forum meeting in Davos this year to deliver a speech and present a paper on the financial crisis in which he commented on how the crisis could have been avoided, if the banks would have followed Islamic guidelines in their transactions. The fact that he was invited to this meeting is a clear sign that Islamic banks have performed better than the conventional banks, hence the big interest in them. (Mufti Taqi Usmani)
So even though the Islamic banks were not directly involved in any of the actions that led to the financial crisis they were still affected, since all sectors of society was dragged in to the crisis globally. An article on The Banker does still claim that Iran avoided the recession because of the banning of interest in the country. (Islamic banking keeps)
Another reason is that Iran has become increasingly isolated because of the economic sanctions, hence creating a unique financial atmosphere.
It should also be noted that not a single Islamic bank needed recapitalization from a government (Wilson)
It should also be noted that not a single Islamic bank needed recapitalization from a government (Wilson)
It should also be noted that not a single Islamic bank needed recapitalization from a government (Wilson)
Shiekh Izam Yaqubi commented on how some of the conventional banks in Bahrain which also had Shari’ah compliant services got both sides of the coin, the Islamic wing did not suffer even though the conventional side took a heavy blow. (Shiekh Izam Yaqubi 2.7.2008, Lecture)
Many investors have also turned to Islamic savings accounts, for example in the UK The Islamic Bank of Britain launched a two-year savings account with a expected profit rate of 4.5% in 2009 beating many if not all conventional savings accounts. The Islamic banks have done well otherwise, promising good profits when the interest rates low.
(Islamic Bank of)

1. 5. Future prospects:

The future of Islamic banking is looking very bright. The assets controlled by the Islamic banks have risen incredibly, in the end of year 2008 the worth was US639 billion and in the end of 2009 it was US$822 billion, this is a 28.6% increase. (Standard and Poor) And they are expected to be worth US$1 Trillion by the end of year 2010.
The overall industry growth is expected to be 15-20 % in the year 2010.
(Future trends in)
It is expected that many more Islamic banks will be established all over the world, The Islamic Bank of Britain was established in 2004 and is the first fully Shari’ah compliant bank in the west. (Financial services authority)
The UK is also home for 4 other Islamic Banks that offer different Shari’ah compliant services such as halal (lawful) mortgages. (Gee 2009)
Some banks have also opened in USA, such as LaRiba and University Islamic Financial.
The first Islamic exchange, The Sharia Ummah Securities Information Exchange (UMEX) is going to launch in May this year in London, this is a way for Shari’ah compliant businesses to raise funds more easily. (Launch of first)
As mentioned in the History section in this article many conventional banks have also opened their Shari’ah compliant wings in order to attract Muslim customers, banks such as Deutsche Bank, HSBC Amanah, Citibank and Union bank of Switzerland. (Rehman)
A lot of non Muslim communities are looking in to Islamic Banking, John Tsang, the Hong Kong Finance Secretary said, ”There is good potential for Islamic products and Malaysia has a niche in Islamic financing. Hong Kong has been learning about Islamic financing from Malaysia”. (Hong Kong can)

1. 6. Conclusion:

Islamic banking is here to stay, with an annual growth of 15-20% and a market potential of US$4 Trillion (Islamic banking to).
It is an economic power that should be recognized. There are a lot of challenges for the industry, the whole world is used to an interest based banking system and when a new method is introduced people feel alienated and in some countries laws have to be changed in order for an Islamic bank to be able to operate properly in a Shari’ah compliant manner. It also has to be noted that Islamic banking is a young industry, only emerging in Egypt in the 1970’s so constant developing of the modes of financing needs to be done in order to meet contemporary financial needs. The Islamic Development Bank located in Jeddah is one of the leading researchers in this field. A lot of conventional banks are interested in Islamic banks as well as many states, Jordan for example has lately been pushing and encouraging Islamic banking activities, through the changing of laws in order to make it easier for the Islamic banks to function.




Bibliography

Books:
Usmani, Muhammad Taqi (2002): An introduction to Islamic Finance. Karachi: Quranic Studies Publishers
Usmani, Muhammad Taqi (2000) The historic judgment on interest. Karachi: Idaratul-Ma’arif
Oral sources:
Advancements in Contemporary Islamic Finance: from practice to scholarship 2.7.2008, Lecture London school of economics Usman Ahmed & Izam Yaqubi
Electronic sources:
Ariff, Mohammad. http://www.islamicity.com/finance/IslamicBanking_Practice.htm [Acessed on 24.3.2010]
Financial Services Authority. www.fsa.gov.uk/pages/About/Media/notes/bn016-shtml [Acessed on 24.3.2010]
Gee, R (2009) www.allvoices.com/contributed-news/2470488-islamic-banks-less-affected-in-global-recession [Acessed on 24.3.2010]
Global Islamic Finance Magazine. www.globalislamicfinancemagazine.com/index.php?com=sponsor_articles_list&aid=796 [Acessed on 24.3.2010]
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Global Islamic Finance Magazine. www.globalislamicfinancemagazine.com/index.php?com=news_list&nid=478 [Acessed on 24.3.2010]
History of Islamic banking. http://www.scribd.com/doc/25162634/History-of-Islamic-Banking [Acessed on 24.3.2010]
Middle east north Africa financial network (2008) . http://www.menafn.com/qn_news_story_s.asp?StoryId=1093226013 [Acessed on 24.3.2010]
My Finances. http://www.myfinances.co.uk/savings/news/islamic-bank-of-britain-tops-best-buy-savings-with-4-5-bond-$1331421.htm [Acessed on 24.3.2010]
Rehman, Amir Khalil. Introduction to Islamic Finance, Securitization and Sukuk. http://www.learnislamicfinance.com/images/Free-Study-Notes/Islamic%20Modes%20of%20Finance.pdf [Acessed on 24.3.2010]
The Islamic Finance Bloghttp://islamicfinancenews.wordpress.com/2010/01/30/mufti-taqi-usmani-presents-paper-at-world-economic-forum-annual-meeting-2010/ [Acessed on 24.3.2010]
The Banker. www.thebanker.com/news/fullstory.php/aid/6785/Islamic_banking_keeps_Iran_recession-proof.html [Acessed on 24.3.2010]
Wilson, R. http://www.islamonline.net/servlet/Satellite?c=Article_C&pagename=Zone-English-Muslim_Affairs%2FMAELayout&cid=1230650190574 [Acessed on 24.3.