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Islamic banking: A non-conventional banking

The main purpose of every religion is to fill the ethical value in its believer that is also about the Islam. Islam considers everyone equal either he is king or a laborer. This is the reason that Islam prohibits all that ways which is against the equality and also against the fraternity of the society. In today’s scenario interest is a burden upon the loan takers. Islamic banking introduces a concept of interest free banking.

Because not only in Islam but interest is also not allowed in Christianity, Jewish religions. According to principles of Islam nobody can take benefit from the difficulties of others. Islamic banks have different products as compared to conventional banks like murabah, mudhrabah, musharakah, ijarah, salam etc.

Islamic banks work on the principles of profit-sharing basis. For instance, if anyone wants to take a loan from the Islamic banks for any project the bank will not charge interest but enter into a contract with client and fix the share in profit but if the project fails then client will not compensate the banks. Also, such banks do not invest in alcohol, pornography, gambling etc.

After the establishment of first Islamic bank in Dubai and also Islamic development bank in 1975, Islamic banking movement spread all over the world. Islamic banks have its existence in many Middle East countries. Malaysia performed the prominent rule in the movement of Islamic banking. Islamic banks performed excellent even in the economic crisis of 2008, which is why many non-Muslim countries are attracted towards it.

However, there are various challenges towards the smooth working of this banking system which is mentioned here in the essay. Many steps have been taken and have still to be taken in this regard to wipe all the challenges. According to the present scenario, the next few years are going to be tough in this regard and may face many other technical and regulatory difficulties.

Introduction
O’mankind eat of which is lawful and wholesome in the earth, and follow not the footsteps of devil. Lo! He is an open of you. -The Quran

Islam is total way of life. It regulates not only religious field but also the social, cultural, political, economic life of its believers. The principles which emphasize moral and ethical values in all dealing have wide universal appeal. Islamic banking has the same purpose as conventional banking except that it operated in accordance with the rules of sharia known as ‘fiqh-ul-muamlat’ (Islamic rules in the transaction).

Islam categorically prohibits the interest-based transaction with the view that it is against the fraternity of society. No one can gain that benefit to which he did not work.
Quran states that all treasure of the world cannot purchase the love between hearts. (8:62:63).

This orders of prohibition of interest lead to introduce a very new and different financial system to the world, that was based on the sharia principles and was against the interest based western financial system.

Sources of rules of Islamic banks

Islamic banks based upon the shariah and Sariah is the collaboration of teaching of Quran and the saying and actions of prophet Muhammad-the hadith.

Where the solution cannot be found in these two sources, rulings are made with the consensus of a community learned Islamic scholar and custom but this should not be out from Quran.

Origin of Islamic banking

Islamic banking is not the origin of modern times, but Islamic finance is old as the religion itself. It has not only principles of before 1400, but it’s some principles are from the time of Abrahamic tradition.

The origin of Islamic banking dates back to the beginning of Islam in 7th century. The Prophet Muhammad’s wife Khadija was a merchant. He acted as an agent for her business, using many of the same principles used in contemporary to Islamic banking.(1) After the arrival of Islam, this form of ethical banking and finance was also existed in the time of Caliph era.

In the Islamic Golden age, when Islamic world established the relations with Europe, Muslim merchants practiced the business with Europe especially like the country Spain. Also, they engaged to follow shariah principles transaction during that time. Ethical and interest free transactions attracted the local people of those European countries and they also adopted profit and loss sharing model.

Modern Islamic economics emerged amongst Indian Muslims in the 1930’s as the country’s Muslim minority feared an independent and Hindu dominated India would subject them to hostility and discrimination.(2) Later, a movement of banking in Pakistan gained prominence in 1950’s a bank established to give loan without charging interest. But this idea did not succeed due to run out of deposits and lack of trained staff.

By following this idea, Ahmad-el-Nagar opened a Mit ghamar saving project in Egypt which gave the interest free banking facilities at the local level, which was based on sharia principles. This bank was a success and led to founding of the Nasser social bank in 1971. The success of these Islamic banks attracted and inspired the Muslim countries.

Dubai was the first country where in 1979, Dubai Islamic bank was established. In Asia, Malaysia played the prominent role in the establishment and regulation of Islamic banks. Before the establishment of the first Islamic bank, Malaysia had a financial institution, which was for the deposit facility to pilgrims for Haj. This later renamed Tabung Hajj and it eventually led to the bank Islam Malaysia.

What is Islamic banking?

Such banking practice which is based upon the principles of Islam and follows the sayings of Islam. Banking is all about finance, its major role is to grant loan on interest but Islam prohibits interest. According to Islam, God has permitted trade, but forbidden Riba (interest). (2:275). As per this saying, Islam actually prohibits the interest-based banking and permits only ‘profit sharing based banking’.

The concept of Islamic finance actually came in 1963 in Malaysia but the Islam’s holy book itself mentions about this. Islamic banking is different from the traditional banking in all aspects. The returns for the banks are guaranteed through the assets purchased with your money.

Sharia identifies three major prohibitions associated with finance, which are as follows:

  1. Riba is the predetermined interest collected by the lender, it is received over and above the principal amount lent out. According to Islam collection of Riba is an unfair technique for all lender, borrower and the economy. Riba can result in inefficient allocation of available resources in the economy and may contribute to the instability of the system. In an interest-based economy, capital is directed to the borrower with the highest creditworthiness.
     
  2. Gharar (uncertainity) is defined as sale of a probable item whose existence or characteristics are not certain. An example in the context of Islamic finance is to advise a customer to buy shares in a company that it is the subject of a takeover bid on the grounds that the share price is likely to increaser. Gharar does not apply to business risk such as investing in a company.
     
  3. Maysir (speculation) is a situation where there is a possibility of total loss for one party. Maysir has elements of gharar, but not every gharar is a mysir.
The major characteristic of such type of banks is that they prohibit the use of its funds for various purposes like Alcohol, gambling, weapons, adult entertainment like pornography which are socially unethical practices and prohibited under the provisions of Islam.

As of today, Islamic banks does not mean merely a lending institution, but it is a package of shariah-complaint financial services like Islamic mutual funds, Islamic bonds, Islamic insurance, Islamic credit cards etc. the two categories of financing are:
  1. Profit & loss sharing, also called participatory modes, i.e. musharakah and mudarabah
  2. Purchase and hire of goods or assets and services on a fixed return basis i.e murabaha, istina, salam, ijarah.(3)

These are the products of Islamic banking which can be explained as:
1. Profit and loss sharing
  1. Mushrakah- Musharakah means shurkah (participation). This is a type of partnership which is also called ‘shurkah-ak-mutanaqisah’.
    In this type of partnership, a financer and a client enters into a contract where financer purchase the ownership of property or other which that client wants to purchase. After purchase, the share of the property is divided into units, and client purchase those all units one by one, until he becomes the sole owner of that property on other thing as the case may be. This is mainly a means to purchase the property by someone.

  2. Mudarabah- In this type of contract one partner gives the finance and the other partner uses his expertise and service. The investor is called ‘rab-ul-mal’ and the working partner is known as ‘mudarib’ and investment is known as ‘Rasul-Ul-Maal’.

    Mudarabah is also of two types:
    # Mudarabah Mutlaq- where there are no restrictions from the investor.
    # Mudarabah Muqayyadd- where some restrictions are imposed from the investor.
In such type of partnership, they pre decide the distribution of profit ratio but if any loss occurs than there will be no compensation from mudarib and rub-ul-mall will bear all the loss.

2. Purchase and hire of good on assets and services on a fixed return basis.
  1. Murabaha – In this type of contract, the client petitions the bank to purchase an item for him/her. Complying with the client’s request, the bank establishes a contract setting the cost and profit for the item, with repayment typically in installments. Because a set fee is charged rather than Riba (interest), this type of loan is legal in Islamic countries.
    However, many argues that this is simply another method of charging interest.
  2. Ishtina – Ishtina is generally a long-term contract whereby a party undertakes to manufacture, build on contract assets, with an obligation from the manufacturer to deliver them to the customer upon completion. (4)
  3. Salam – in the pre-Islamic era, farmers used to take interest-based loan for growing crop and harvesting. But when Islam prohibits it, them Salam contract allowed to do. In Salam contract, seller takes the advance full payment from the buyer to supply some specific goods at future date. It creates a moral obligation on the seller to deliver the goods.
    The main difference between the Ishtina and Salam is that in Salam it is allowed to take full payment, but in Ishtina the payment can be in installments.
  4. Ijarah – it is like a lease contract. In this contract, bank purchases any property or equipment for an individual. In Ijarah, fixed assets must be returned to the lessor, at the end of the lease period. If the lease agrees to buy the asset at the end of the lessee, it is called ‘yajara wa iqtita’.

Islamic banking in all over the world

The idea of Islamic banking is not new, it has its many dimensions in all over the world in different forms. Any financial institution that adds to the capital of any economy is crucial. The factors that drives the growth of the market are directing investment towards tremendous growth opportunities in the promising Islamic sectors.

According to recent research study, turnover of Islamic finance is 1810 billion dollars: in 2020 the turnover will increase to 3,250 billion. This huge market has attracted the interest of many countries, which are trying to become international Islamic centers.

According to the studies, the effect of Islamic banking on finance is totally dependent on the legal origin of the countries in which that operates. To determine the correlation of the Islamic banks, they are negatively correlated with the financial system developments in countries of British origin and positively correlated to the French legal origin. Islamic banking tends to grow Muslims prominently as Muslims are underserved financially and are from less developed countries.

As of 2008, Abdus and Kabir found the implementation of Islamic banking in the Middle East such as UAE, Kuwait, Jorden, Iran, Iraq, Turkey, Indonesia and Malaysia. The leading areas in this regard are Malaysia and Bahrain.

Islamic Banking in Malaysia

Malaysia established the first Islamic bank in July 1983 with the incorporation of bank Islam Malaysia buhad. After a decade, they introduced interest free banking scheme, 17 conventional financial institutions participated and offered Islamic financing techniques by opening ‘Islamic windows. (5) These various techniques started developing the domestic financial system for its global integration. In 2005, the Islamic banking industry has showed prominent results.

As a comparison with conventional banks in Malaysia, the share of Islamic subsidiaries of commercial banks in total bank deposits has risen sharply from 3.7% in 2007 to 19.7% in 2015. (6) As mentioned earlier, the major hallmarks of the Islamic banking are real sector connectivity and risk sharing. The current Islamic banking products are typically same as conventional products, with shariah complaint being the differentiating factor.

The products of the Islamic subsidiaries are just Islamic as wholesome Islamic banks. It took several centuries for Islamic bank to become what it is today; it will take long way to go before Islamic banking can reach to a pinnacle. For now, next few years are challenging to this industry.

Despite Malaysia, there are other countries and other parts of the world where Islamic banking is growing to heights. In Jordan, the majority of the populations are Muslims (92%), and as per the facts in 1980’s, Jorden was the only Arab country in which the Islamic banking had been developing the most. Currently, there are two major banks operating in Jorden, IIAB and JIBFI, which has a very high growth and profitability. These banks have focused more on the short-term investment rather than long term investment.

Even after, the global spread of Islamic banking after creation of a trillion-dollar industry, the mainland China remains a major market where Islamic finance has not yet reached. But this would set to change. Previously, industrial and commercial bank of china has agreed to establish sharia complaint banking products in China. In 2016, asset management in Hong Kong partnered with UAE sharia complaint company to issue Islamic finance.

Islamic banks will soon be making their way into new markets where regulators are increasingly open to accommodate this finance model. At the world economic forum in London, David Cameron has announced the UK to become the first non-muslim country to establish Islamic banking.

India’s scenario
Several years, several debates and several drawn conclusions. India is a country with 13.4% Muslims of the total population of India according to the census of 2011. The idea of introduction of the Islamic banking in India was started in 2005 by RBI. Under the directions of Ananda Sinha, RBI formed a committee where the idea was rejected considering the existing banking system. However, Muslims possess a greater population and the self-employment is the main source of income for them.

Hence, to empower the community economically, there is a need to ensure a good credit facility to them. A new committee was formed by the planning commission under the chairmanship of Raghuram Rajan in 2008, they suggested the interest free banking as a part of financial sector reforms. Otherwise, the one section of the society will remain disadvantaged.

The committee gave two major recommendations: 1) interest free finance will add to the growth and innovation in the country. 2.) After appropriate measures, the challenges to this system can be removed.

In 2009, securities and exchange board of India gave approval for India’s first official shariah complaint mutual find scheme, ‘Taurus ethical fund’ in 2009. Then again, I 2010, a major step in this regard was taken by the Kerala’s government.

They started Islamic NBFC (Al Barakah financial services ltd.) with a partnership of state government department. This setup greatly garners to the growth and innovation of the Islamic banking in India. The step gave a push to the Islamic finance in India.

However, the idea of Islamic finance received opposition from SBI.
And inter departmental group in RBI studied the various technical and regulatory issues for introducing interest free banking in India.

The results show that Indian banking laws explicitly do not prohibits the Islamic banking system but there are various provisions and there are various regulatory problems that make this system an unrealistic option. Such banking provisions are:
  1. Sec 5(b) and 5(c) of the banking regulations Act, 1949 prohibits the banks to invest in profit & loss sharing basis.
  2. Sec 8 of the Banking Regulations Act, prohibits the dealing in buying, selling or bartering of goods.
  3. Sec 21 of the Banking Regulations Act, requires payment of interest. (7)

There are other challenges in the country too which bars it to introduce such system as: Difficult tax procedures, Inability to maintain Capital adequacy, confusion due to various interpretation of the Shariah by various groups.

Despite such legal and regulatory restrictions, there is need and benefit of Sharia complaint banking as it will greatly contribute to the economic growth and will act as a mechanism to overcome the country’s liquidity issue. If awareness is spread among all the parts especially illiterate one’s, then that would result in lessee exploitation. Funds for business will be available easily to various parts. Special benefits to Muslims where the Islam support only interest free loans. Introduction of Islamic banking in India will offer Muslims a socio-religiously acceptable mode of finance and investment, which will motivate many investors.

Hence, RBI recommended an ‘Islamic window in conventional banks for a gradual introduction of Islamic banking because our Indian law needs to be changed in order to establish Islamic banking.

Challenges of Islamic banking
  1. Tax procedures – Islamic financial products are not simple as the products of conventional banks instead of a single contract with a onetime government fee or stamp duty, they usually involve two or more contracts, government fee and stamp duties, and it is also difficult to decide the tax, whether it is income tax or sales tax. (Value added tax).
     
  2. Lack of standardization – the main challenge to Islamic banking is its lack of regulations and standardization. Due to the various sects, there are also various view points on the question to decide anything. For instance, scholars of Malaysia are more flexible than those in Saudi Arabia.
     
  3. Difficult survival – Islamic financial institutions have not only competition with each other but also with the other conventional banks and the Islamic windows. Indian financial institutions should introduce new ideas continuously and also should offer large number of products.
     
  4. Lack of awareness – a challenge before Islamic banking is lack of awareness. Most people including Muslim and non-Muslim what Islamic banking actually is, what type of product it provides and how does it work. Therefore, there are lack of customer as well as workers and experts.
     
  5. In many countries, like India also, due to the complexities in the legal framework, this is too difficult to implement its idea.

What should we do?
  1. First of all, there should be an advisory board at the global level to decide, what is permissible and what is prohibited. This can be an advisory board or any Islamic banks like world bank on WTO.
     
  2. Many countries which have Islamic banks make their separate rule and regulation. To foster the development of Islamic finance, they should come together and should decide about the Islamic finance collectively. There should also be an advisory board in every country to suggest about the Islamic finance.
     
  3. For harmonizing standards and structures, the industry does encourage Ijtihad in the global community through international conference and convocation.

Conclusion
In essence, the main purpose of Islamic finance is to eliminate exploitation and to establish a just society by the application of the sharia or Islamic ruling in the operation of banks.
Quran states –
Deal not unjustly, and you shall not be dealt unjustly (2:279)

Interest is not prohibited in Islam only, but the early Jewish and Christian tradition also prohibit interest.

Do not charge your brother interest, whether on money or food or anything else that may earn it interest

If you lend money to my people, to the poor among you, you are not to act as a creditor to him. You shall not charge him interest.-The Holy Bible (American Standard Bible).

It is clear that many people do not take initiative to do business due to the interest-based loan. So Islamic banking will perform the important role in these cases because it is interest free and share of Profit and risk together.

References:
  1. Islamic banking definition- Investopedia. https://www.investopedia.com/terms/islamicbanking
  2. Genesis of Islamic economics: a chapter in the politics of muslim identity by Timur kumar, page 303- https:public.econ.duke.edu/tk43/abstracts/articles/ar-32A.pdf/the
  3. A history of Islamic finance by Naveed. https://www.islamicfinance.com/2015/02>an-overview-of-the-history-of-islamic-finance/
  4. Ishtina-Islamic markets, https://www.islamicmarkets.com/education/istihad.
  5. Islamic banking and economic growth: empirical evidence from Malaysia, article in journal of economic coporation and develpomant : january 2009
  6. Supra.
  7. Islamic banking and finance in india: a koshar or a myth. October 2015. By Aisha baduddin

Written By: Arshi Hayat Gangohi and Garima Vasuja
- LLB II year, Department of Laws, Punjab University 

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