New Generation Islamic Banks

Introduction

The ideology behind Islamic banking, i.e., `interest-free banking’, is based on basic ethical standards with just one main difference – Muslims are not allowed to pay or receive interest. This does not mean that business activities or making a profit are not encouraged, in fact, they are, but only as long as they don’t involve interest in any form. To fulfill this purpose and to satisfy their needs, financial instruments have been introduced by the Islamic financial institutions. For instance, equity financing is used, instead of debt financing. Furthermore, instead of giving a fixed interest rate on the savings account, Islamic banks offer a share of the bank’s profit, as a return on deposits.

The modern banking system was introduced into the Muslim countries in the late 19^th century. These banks founded branches in the capital cities of major Muslim countries to cater to their business needs. However, the branches were limited to the capital cities while other surrounding cities were totally ignored by the banking system. Nevertheless, most local businesses still refrained from engaging with these `commercial’ banks, mainly for religious purposes.

Current Practices

Generally speaking, all interest-free banks agree on the basic principles of Islamic banking. However, individual banks differ in their internal characteristics, functions, and services. These differences arise as a result of the country’s laws, the citizens’ needs, and the individual bank’s objectives and experiences. Despite this, Islamic banks have deposit accounts: All Islamic banks have the same types of deposit accounts – current, savings and investment products. While the number of current accounts has steadily declined, savings and investment accounts have proliferated. The reason for this is due to the increasing confidence of savers and investors in Islamic banking. Although the current accounts are the same as in conventional banks, the savings account operates in a different manner.

In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back. Banks adopt several methods for inducing their clients to deposit with them, but no profit is promised. In other banks, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit or loss in a given proportion with the bank. In addition to the above deposit accounts, some Islamic banks have additional accounts as follows:

Trust Deposits: These deposits are not subject to any conditions for drawing or depositing. The bank may use such deposits at its own risk and responsibility in respect of profit or loss.

Joint Investment Accounts: These are deposits received by the bank from persons who desire to participate with the bank in multilateral and continuous investment operations. Such deposits receive a certain percentage of the annual net profits realized. The way of investing these funds is left to the bank’s means of financing. Banks adopt several means of acquiring assets discretion or financing projects and these can be categorized in three areas: investment, trade and lending.

Investment Financing: This is done in different ways like:

Musharaka (venture/equity financing) is where a bank may associate with another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profits and losses are shared in a pre-arranged fashion. The venture is an independent legal entity and the bank may withdraw gradually after an initial period.

Trade Financing: This is also done in many ways. These include:

Murabaha (Cost-Plus financing) is a contract between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank, which then sells them to the client at an agreed mark-up. Repayment is usually in installment. This type of financing is very commonly used for various installment-related financing needs. As an example, we can look at a customer who wants to finance a car purchase for $10,000 but cannot afford to pay the full amount now. The bank buys the car on the customer’s behalf and sells it to the customer for $15,000. The bank charges a mark-up because it is willing to accept installments (over 60 months) instead of one lump sum payment. The mark-up is profit as the bank acted as a middleman; no money was lent, a product was only bought and sold. If the customer decides to pay off the entire amount next month or at the end of the 60^th month, he will still owe the same amount.

Leasing is where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period, the lessee pays the balance on the price agreed at the beginning and becomes the owner of that particular item.

Hire purchase is where the bank buys an item for the client and hires it to him for an agreed rent and period and at the end of that period the client automatically becomes the owner of the item.

- Sell-and-buy-back is where a client sells one of his properties to the bank for an agreed price payable on the condition that he will buy the property back after a certain time for an agreed price.

Letter of Credit is where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.

Lending: The main forms of lending are:

Loans with a service charge is where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities.

No-cost loans is where each bank is expected to set aside a part of its funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc.

Overdrafts are also provided but are subject to a certain maximum. These are free of charge or with a small fee. It should be noted that Islamic banks are not active in lending like that of the conventional banks because they are not interest-based. The point to be noted here is that lending in an Islamically acceptable form. It is not very profitable to the bank and they, therefore, have to resort to other `lending’ related practices, such as leasing and mark-up transactions. Islamic bonds are becoming very popular and Malaysia and Bahrain are currently developing global Islamic bonds.

Services: Other banking services such as money transfers, bill collections, trades in foreign currencies at spot rates etc, where the bank’s own money is not involved are provided on a commission or charges basis. Many Islamic banks provide traditional banking services to the extent that Shari’ah and the local government rules and regulations permit for example, they receive OPEC surplus funds and trade Euro currencies.

Shortcomings of the Islamic Banking System

Islamic banks are now providing almost all the services that are provided by other common banks. However, the only exception seems to exist in the case of letters of credits, where there is a possibility of interest being present. There have been, however, some other major difficulties involved with Islamic banking that are mentioned below:

Shortage of Experts in Islamic Banking: Trained or knowledgeable bankers have delayed the expansion of Islamic banking. The lack of training affected not only Arab domestic banks (both Islamic and non-Islamic) but also foreign banks. Academic institutions, international organizations, and translation firms must respond to the need by organizing training materials, lectures and workshops.

Absence of Accounting and Auditing Standards Related to Islamic Banks: Uncertainty in accounting principles involves revenue realization, disclosures of accounting information, valuation, revenue and expense matching etc. Thus, the results of Islamic banking schemes may not be adequately defined, in particular, the profit and loss shares attributed to depositors.

Lack of Uniform Standards of Credit Analysis: Islamic banks have no appropriate standard of credit analysis, especially for profit-and-loss-sharing (PLS) schemes. Likewise, there is a extensive training need involving allied aspects such as financial feasibility studies, supervision of ventures and portfolio evaluation.

Potential Conflicts with Central Banks: Islamic banks have been established as separate legal entities and therefore their association with central banks and/or other commercial banks is uncertain. Problems may be complicated when an Islamic bank is established in a non-Muslim nation and is subject to the nation’s rules and regulations.

Potential Conflict between Domestic Banks, Foreign Banks and Islamic Banks: It seems that domestic and foreign banks will experience continuing difficulty in implementing Islamic banking practices, including the PLS scheme, until they become more certain of the results.

Lack of Deposit Insurance System: The lack of such a system becomes of greater concern because Islamic banks have standard measures of reserve requirements or liquidity ratios.

Legislation: The depositors’ funds are one of the basic asset acquiring methods of Islamic banks. The existing banking laws, however, do not allow banks to engage directly in business enterprises using these funds. Therefore new legislation and laws have to be established.

Re-training of Staff: The bank staff will have to acquire substantial knowledge and skills for new procedures to operate the Islamic banking system. This seems to be a very time-consuming process as a large number of persons have to be re-trained.

Taxation: The bank is comparatively a big business and thus needs to disclose its profits and losses every year. The Government requires banks to perform an audit of its financial statements and determine the result of the operations. Once this is done, the taxation authorities commence to claim the taxes due from the bank.

Uneasy Questions of Morality: The practices in use by the Islamic banks have aroused questions of morality. Some argue that the practices that involve interest have simply changed names to appear in an interest-free manner. It is questionable whether the Islamic banking system is truly adopted by Islamic banks and institutions or not.

Conclusion

Though Islamic banking system is still at a nascent stage, it has already been implemented in most Muslim and non-Muslim nations. Of course, though there is such wide acceptance, one can over look the problems associated with it. Islamic banks, however, can eliminate the uncertain forms of financing and offer a clean and capable interest-free banking. This can be put into effect by making use of only two forms of financing — loans with a service charge and Mudaraba (or participatory financing) — both of which are fully accepted by Islam. Such a system will create a competitive advantage where Islamic banks and conventional banks both co-exist. In addition, Islamic banks will have no difficulty in establishing and operating in non-Muslim countries. Mudaraba is an exclusive feature of Islamic banking and can suggest accountable financing to socially and economically relevant development projects. This is an additional service Islamic banks propose in excess of the customary services provided by conventional commercial banks. Therefore, Islamic banks have the potential to compete with perhaps even outperform the common commercial banks that are currently available if they follow the Shari’ah rules and put it in effect.