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Islamic Banking System

Article in SSRN Electronic Journal February 2011
DOI: 10.2139/ssrn.1759273

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Name: Ismail Ali Ahmed

Student ID: 185768
University of Atlanta
Doctorate of Business Administration
Course: Business Research Methods II
Tutor: Dr. B. Erastus

Assignment #1: Analysis based research paper: Islamic Banking

System
Word count: 1,953 (excluding bibliography and table of contents)

Version 1.3
Date: Feb. 1, 2011

Electronic copy available at: http://ssrn.com/abstract=1759273

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Table of Contents

INTRODUCTION .................................................................................................................................. 3
ISLAMIC AND CONVENTIONAL BANKING: THE DIFFERENCES AND GROWTH ............ 6
ISLAMIC BANKING: EMERGING BANKING ALTERNATIVE ................................................ 10
CONCLUSION ..................................................................................................................................... 12
REFERENCES ..................................................................................................................................... 13

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Introduction
Over the past decade the Islamic banking sector has grown steadily
and rapidly globally, the multinational banks paid attention while the Islamic
banking expanding out of Middle East and Asia Pacific into European and
African markets.

The difference between Islamic and conventional banking system is

much more related to the product / service offering that based on philosophy
of dealing with the money as an economical tool rather than a commodity and
using the tool in the conscience of religion values.

Being considering money as an economical tool and not as a

commodity for trading, Islamic banking does not allow trading money,
accordingly interest based deals are not allowed (Cash loans).

The ethical principles on which Islamic finance is based may bring

banks closer to their clients and to the true spirit which should mark every
financial service," the Vatican's official newspaper Osservatore Romano said
in an article in its latest issue on March 6, 2009.

Since the institution of the first trial of offering banking system; based
on Islamic principles in Egypt more than four decades ago, the Islamic
banking has been growing across the Muslim communities. The number of
financial institutions that offers banking practices based on the Islamic
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principle increased tremendously comparing to conventional banks; In the

Middle East and Malaysia; more than twenty new Islamic banks introduced
while the major global banks like HSBC, Citibank, Standard Chartered bank
offered Islamic products.
.
As the model getting matured, the government regulated the Islamic
banking practices, as of today almost all of the Middle East countries, has a
regulations and policies to monitor and control the Islamic banking practices
as well the conventional banking practices, some countries like Sudan and
Pakistan allows only Islamic banking practices.
Gartner report issued July 2010 about the competitive landscape of
Islamic banking solutions, indicated that the Middle East and North Africa
countries has developed regulation to control the Islamic banking offering,
however the Islamic banking practice is expanding to other countries with no
clear regulations.
According to most estimates, Islamic banking growth rate surpassed
an average 15 per cent in the last decade and assets under management of
Islamic financial institutions are worth close to a trillion dollars. The number of
operating Islamic financial institutions is well above 300 in more than 75
countries (El Qorchi, 2005).

The Islamic banking system is built on the premise that money should
not be borrowed instead the financial institutions must be sharing risks with
their clients, Islamic financial institutions approach their Banking activities
from a partner perspective.. The customer and the bank share the risk of any

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investment on agreed terms, and divide any profits or losses between them.
In addition, investments should only support practices that are not forbidden
trades in alcohol, betting and pornography are not allowed. Moreover, an
Islamic banking institution is not permitted to lend to other banks at interest.

For example; the famous Islamic banking product, Murabaha - A form

of credit that enables customers to make purchases without taking an interest
bearing loan. The bank buys the goods for the customer and re-sells them to
the customer on a deferred basis, adding an agreed profit margin. The
customer then pays the sale price for the goods over installments, effectively
obtaining credit without paying interest.

While the Islamic banks share the risk of conducting economic activity
by buying, owning and re-selling the commodity to the client, the conventional
banks exposed to a less risky attitude of a lender by considering the interest
as a function of time only without including economic activity.

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Islamic and Conventional Banking: The Differences

and growth

The Islamic banking deals with the customer as an investor or partner

and that reduces the risk of the Islamic banking by passing through the loss to
the depositor/investor as well reduces the operational risk comparing to the
conventional banks, Conventional banks deals with customers deposits as a
liabilities; such liabilities which getting insured - deposit insurance to protect
bank depositors, in full or in part, from losses caused by a bank's inability to
pay its debts when due

The Islamic banking offering is based on several banking business

models including finance, leasing, investment, trading and reverse finance.
All these models are based on Sharia compliant mechanisms. For example
Istisnaa product: The Arabic word "Istisnaa" means "asking someone to
manufacture". It may be further defined and elaborated as a sale contract
between the seller and the buyer for the sale of an asset described in the sale
contract and transacted before it comes into existence. To fulfil its obligation,
the seller can either manufacture/construct it by itself or can get it
manufactured/constructed by someone else to deliver it to the buyer on the
date described in the sale contract. The buyer can pay the sale price in lump
sum at the time of signing the contract or later in different stages as the
manufacturing/construction process proceeds.

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Although the Islamic banking system is incorporated into the global

financial system, but the Islamic banks are not directly affected by the current
global financial crisis. Islamic banks are not involved in trading of debt
securities due to prohibition of interest in Islam. Islamic banking is prohibited
from dealing with derivative products which is not based on asset trading or it
does include high uncertainty, so buying debt securities under Islamic
Sharia'a law is not allowed; therefore, Islamic banks are safer from the direct
effect of the global financial crisis.

However the global crisis has affected the Islamic financial

institutions, the Islamic banks in the Arabian Gulf had negative effect with a
certain degree. As the Islamic banking system is part of the global economy,
and the Islamic banks get to invest into the real estate and stock shares as an
asset. During the global crisis, the value of the real estate assets depreciated
by more than 40% in some geographical areas like Dubai, as well as the stock
shares value decreased globally; accordingly the Islamic banks affected by
the depreciation in the real estate and the stock shares.

The Islamic financial system does not allow the creation of debt
through direct lending and borrowing. It rather requires the creation of debt
through an economic event like the sale or lease of real assets by means of
its sales- and lease-based modes of Banking (murabaha, ijara, salam, istisna,
and sukuk). The purpose is to enable an individual or firm to buy now the
urgently needed real goods and services in conformity with his/her ability to

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make the payment later. The leasing product has several options including but
not limited to:
Ijarah:
Under this mode of financing, the client approaches the bank specifying what
asset he wishes to purchase. The bank purchases the asset and allows the
client to take benefit of the asset for a specified period of time by means of a
lease or rental contract, in return for a periodic lease payment.

Operating Lease Contract:

In this case, the bank assumes the risks related to the asset such as defects,
breakdowns, periodic major maintenance, and complete destruction of the
asset. The bank signs a lease contract with the client for a specified period of
time, after which the bank retains possession of the assets and may rent said
asset to another client at a different lease rate. The lessee assumes daily
operating expenses and maintenance of the leased asset. Furthermore, any
misusage of the assets that is concluded with damages to the assets is the
responsibility of the client.
Financial Lease (Lease and Own):
In this case, the lease contract shall incorporate the clients interest in buying
the asset after a specific period of time. The bank purchases the asset based
on the clients request and leases the assets to the client for a longer period of
time. As soon as the lease contract is terminated the asset may be sold to the
client at an agreed price to be paid as agreed.

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The injection of a greater discipline into the financial system may tend
to deprive the subprime borrowers from access to credit. Therefore, justice
demands that some suitable innovation be introduced in the system to ensure
that even small borrowers are also able to get adequate credit. (Cihak, 2008)

Islamic banking system is capable of minimising the severity and

frequency of financial crises by getting rid of the major weaknesses of the
conventional system. It introduces greater discipline into the financial system
by requiring the financier to share in the risk. It links credit expansion to the
growth of the real economy by allowing credit primarily for the purchase of
real goods and services which the seller owns and possesses, and the buyer
wishes to take delivery. It also requires the creditor to bear the risk of default
by prohibiting the sale of debt, thereby ensuring that he evaluates the risk
more carefully. (Iqbal, 2009)

Another fundamental principle of Islamic Banking is the risk and profitsharing feature of Islamic Banking transactions that requires a level of
transparency to be communicated to the investor and the market.

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Islamic Banking: Emerging Banking Alternative

Its rapid evolution is particularly evident in four dimensions of its
development. First, today Islamic Banking is viewed as a competitive form of
financial intermediation, drawing significant participation by non-Muslims. The
total assets of the Islamic financial system have surpassed $1 trillion, a fivefold increase over their magnitude just five years ago. Islamic Banking is now
among the fastest growing financial segments in the world, with an estimated
annual growth of 20 per cent. (Iqbal, 2009),
With the emergence of more diverse Islamic Banking institutions and
the development of Islamic Banking markets, the scope of Islamic Banking
business has been expanded to include private equity, project Banking, the
origination and issuance of sukuk (bonds), and fund, asset, and wealth
management activities. (Khan, 2008)

The Islamic banking system is not as mature as the conventional

banking system in terms of product standardization, regulatory and policies,
almost each Islamic banking organization has its own Sharia board whom
approving the offered products, services and the operational workflow. There
has been significant evolution in the regulatory, policies and legal framework
of Islamic Banking, The central banks across the Middle East, Asia Pacific,
Africa and some European countries has established central rules, regulation
to monitor and control the Islamic banking practices from accounting point of
view. Some other countries centralized the Shariaa standards through the
central banks like Sudan and Pakistan, where the banks does follow the
approved Shariaa products or services from the central banks.
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Conclusion
In recent years, Islamic Banking has developed into a universal business and
has extended to international financial markets across the world. Analysts
predict Islamic Banking will further grow across Asia, the Middle East, Africa,
South America and the Western World to ultimately increase overall share of
the global financial market.

Islamic Banking is still in its growing stage and shares a very small
proportion of international Banking. The Islamic banking system is, equipped
with offers and business models requested and demanded, however the
standardization of the offering and positioning it as a complementary model to
the current existing banking system, will help to increase the growth rate.

The Islamic banking growth rate in the Western World will not be as
high as the Middle East due to social reasons. The naming convention of
Islamic Banking might be a reason to hinder the growth rate due to
positioning the model as an a religion model rather than a banking model,
however the introduction of the Islamic banking system to the Western world
as an ethical banking model might help to speed up the introduction phase on
the individuals level.

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References
Yahia Abdul-Rahaman, (2010), The Art of Islamic banking and Finance,
Wiley Finance.
Al-Hamzani, M. (2008), "Islamic banks unaffected by global financial crisis",
available at: www.asharq-e.com, accessed January 03, 2011.
Bashir, A. (1999), "Risk and profitability measures in Islamic banks: the case
of two Sudanese banks", Islamic Economic Studies, Vol. 6 No.2, pp.124.
Chapra, U. (2009), "The global financial crisis: can Islamic Banking help?",
available at: www.newhorizonislamicbanking.com/index.cfm?section=academicarticles&action=view
&id=10733 , accessed January 03, 2011..
Cihak, M., Hesse, H. (2008), "Islamic banks and financial stability: an
empirical analysis", International Monetary Fund, Washington, DC,
working paper, .
El Qorchi, M. (2005), "Islamic Banking gears up", Banking & Development,
International Monetary Fund, Washington, DC, .
Khan, M., Bhatti, M. (2008), "Islamic banking and Banking: on its way to
globalization", Managerial Banking, Vol. 34 No.10, pp.708-25.

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