A Better Understanding of Islamic Finance - Free Essay Example

Abstract The purpose of this paper is to provide a better understanding of Islamic Finance and specially Islamic banking. I have tried to trace the historic root of the Islamic banking system and how now it is shaping the global banking system specifically in the UK. In relation to the current prevailing banking system, the Islamic Banking system is free of interest. One might wonder what the incentive to lend money would be. Others may not understand what benefits could be had by putting their savings into a bank account. While Muslims do not believe in charging or earning interest, they have developed a very complex alternative that is being implemented all over the eastern world. Started from just an idea, this new way of banking quickly spread through the Muslim countries, and has continued to expand all over Europe and Asia. Although the system is proving to the West that it can work, it is still trying to iron out some of the inefficiencies that it currently has. In recent years, Islamic finance has grown rapidly across the world, conservatively estimated at 10-15% a year1. Given the large number of modern Muslim population (around 3% of the population) in the UK and position as one of the leading international financial centres, it is no surprise that part of this growth has taken place in London which is now seen as an emerging global ‘hub for Islamic finance. At the same time, the government has wanted to give the UKs Muslim community access to financial services consistent with their religious beliefs. The Bank of England and the Financial Services Authority (FSA) have been closely involved in these developments. To reach the goal simple examination of the Islamic finance in UK banking sector, analysis as well as risk to carry out to identify the critical success factor for implementation of the proposal and to what extent are these critical success factor likely to be different in financial and banking service sector. Chapter 1 1.1 Introduction Islamic finance adheres to the teachings of Islam, the Muslim religion. The guiding principles for the Islamic financial system are a set of rules and laws, collectively referred to as Shariah (Shariah Guidelines), guiding economic, social, political, and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the Quran and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of the Quran and Sunnah. In a sense, the combination of law and finance in Islam is inevitable. In practice, Shariah means that Islamic finance is asset backed, so the foundation of Islamic banking is asset management. Once the basic tenet of Islamic finance (i.e., the prohibition of riba, or interest) is understood, the most common activities are no different to those undertaken by many conventional banks. In the last couple of deca des the Islamic world has embraced the move towards a global economy. As a result Islamic financial institutes have began to look for ways to provide a broader range of financial services, and products to its people that, are Shariah compatible and yield equally high returns as their counterparts around the world. Islamic Finance is an up and coming discipline and is constantly changing. As a result there is a lot of uncertainty about how to teach it, understanding it and the concepts behind it, how to do business with this method of finance. In spite of this, it is gaining wide spread recognition around the world as more and more people recognize it as a form of finance as well as the benefits of working with Muslim business men and women. Investment in companies with core activities linked to alcohol, pork, insurance, gambling, tobacco, pornography and the arms trade are not allowed. According to many prominent Islamic Fund companies, a Muslim investor cannot invest in the s hares of a company if the non-Shariah compliant sources of income contribute 5 percent or more of the companys total income. 1.2 Historical development It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality by private initiative in some countries and by law in others. We will discuss the two periods separately. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks. 1.1.1 Interest-free banking as an idea Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961).2 Muhammad Hamidullahs 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha profit and loss sharing. In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the l ate sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. 1.1.2 The coming into being of interest-free banks The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House. However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the mid-forties4 and another in Pakistan in the late-fifties.5 Neither survived. In 1962 the Malaysian government set up the â€Å"Pilgrims Management Fund† to help prospective pilgrims to save and profit.6 The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons.7 However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg , Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years. In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could acc ept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent ‘profit rate depending on the type of economic activity. Interest on deposits was also converted into a ‘guaranteed minimum profit. In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985. 1.1.3 The last decade The subject matter of writings and conferences in the eighties have changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking: Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference ‘Into the 1990s with Islamic Banking held in London in 1988 belong to this category. The most recent one is the Workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992. Several articles, books and PhD theses have been written on Islamic Banking during this period. Special mention must be made of the work by M. Akram Khan in preparing annotated bibliographies of all published (and some unpublished) works on Islamic Economics (including Islamic Banking) from 1940 and before. It is very useful to students of Islamic Economics and Banking, especially since both English and Urdu works are included (1983, 1991, 1992). M.N. Siddiqis bibliographies include early works in Arabic, English and Urdu (1980, 1988). Turkish literature is found in Sabahuddin Zaim (1980). 1.1.4 The current market There are more than 300 Islamic banks and investment firms spread among some 75 countries, against almost none 30 years ago, Kuwaits Global Investment House said in a January report. The value of assets managed by Islamic banks is projected to grow 33 percent to $1 trillion by 2010, according to a report in December 2007 by management consultants McKinsey Co. By the end of July 2007, the total value of sukuk outstanding globally totaled $82.4 billion, of which about 62 percent was denominated in Malaysian ringgit, ratings firm Moodys said in an August report.Gulf Arab sukuk sales overtook those in Malaysia on an annual basis for the first time last year, Moodys said in September 2007. Gulf Arab sales totaled about $12 billion in 2007, up from $9 billion a year earlier, Moodys said in January. The UAE was the worlds top issuer of Islamic bonds during the last seven years, contributing 36.2 percent of global sale value, Kuwaits Global Investment House said in the report. Malaysia wa s second at 32.1 percent. The head of the board of scholars at the Accounting and Auditing Organization for Islamic Financial Institutions in November said 85 percent of sukuk did not comply with Islamic law. Scholars and bankers are now trying to fix the problem.A growing number of scholars and bankers say the way in which the most common Islamic banking contract commodity murabaha is often used either does not comply with Islamic law, or no longer suits the needs of the industry, prompting a search for alternatives. Some Islamic financial institutions have launched hedge funds that they say adhere to Islamic law, but others say short selling, a common hedge fund strategy used to speculate on currency and stock moves, breaks Islams law against gambling. Chapter 3 3.1 Advantages: Speed Cost effectiveness Accessibility Reduce cost time Honesty It already exists, so it saves time. It is often cheaper than doing primary research. It may allow access to data could not otherwise get. 3.1.1 Limitations Details of many aspects of the services of Islamic bank of Britain Limited have been skipped in this report due to various constraints, including time, space and security reasons. The principal barrier in compiling this report was the confidentiality issue of data. Though the report writer had access to lot of information regarding the performance in personal lending business of the bank or Islamic financial service due to legal restrictions much of the information available could not be used. In case of other financial institution, the report writer had to depend mainly on the secondary sources of data. 3.1.2 Control of reliability and validity To assess the reliability and validity of information and data from secondary sources, the best procedure is to make comparisons between data and claims of a number of reputable sources, including: In determining validity, students might consider the degree to which evidence supports the assertion or claim being evaluated. In some cases, may be able to make observations or conduct experiments to confirm the reliability and validity of the information have identified. Chapter 4 4. Evaluation and Discussion of Findings 4.1 Starting of the Islamic banking in the UK According to the Islamic Bank of Britain (https://www.islamic-bank.com, 2009) Britains 1.8 million resident Muslims currently have no access to a banking service that is provided by a stand-alone Islamic Institution. There are also estimated to be over 1/2 million long term or regular visitors to the UK who would have a use for an Islamic Banking Service. Shariah-compliant financial products first appeared on the UK market in early 1990s when the first Islamic mortgages were launched. These early products were not very competitive in features and pricing, so growth remained modest throughout the 1990s and early 2000s. But according to Salaam Halal insurance (www.biih.co.uk) the last five years have seen a significant development as more providers have entered the market. The range of products now offered has become more comprehensive and products have become more sophisticated and competitive. Currently, there are around 10 regulated financial institutions that provide some t ype of Islamic financial product. This significant increase in the number of Islamic finance providers indicates a growing demand for Halal financial products. There are currently two types of Islamic financial providers in the UK: Conventional banks which provide different types of Islamic products Islamic banks Until 2004, only conventional banks provided Islamic financial products in the UK. The first stand-alone Islamic retail bank was authorised by the Financial Services Authority (FSA) in August 2004, followed by two more Islamic investment banks. The FSA, as the UKs financial services regulatory body, has committed itself to combating financial exclusion. Robust measures have been taken to remove any barriers that result in the unwillingness of households to access banking and other financial services because of distance, poverty or religion. The UK government also has a strong aspiration to make London the global gateway for Islamic finance. A level playing field is being encouraged by legislative changes made to accommodate the specific needs of Islamic financial products. These measures are increasingly giving UK Muslims an equal opportunity to access finance in compliance with their faith. While addressing business leader at a conference organised by the Muslim Council of Brit ain on Tuesday, Sep 26, 2006, the than Englands chancellor of the exchequer, Gordon Brown said, Entrepreneurial vibrancy and dynamism of Britains Muslims, combined with Britains openness to the world and the historic ties with Muslim countries, that makes the ambition to make Britain the gateway to Islamic finance and trade a realistic and realisable ambition. He also stated that he wants to make Britain the global center for Islamic finance. The chancellor said the Labour government will continue to implement the tax and regulatory reform to support the development of Sharia-compliant finance. (Source: https://islamicbanking.blogsome.com/category/islamic-banking-news/uk/) Ahmed Mohammed Ali, president of the Islamic Development Bank, also present in London, welcomed the chancellors openness to Islamic finance. London has traditionally been a major center for structuring and arranging Islamic finance since the 1980s, said Mohammed Ali. The president of the IDB underlined the impo rtant support of the Financial Service Authority, Britains banking watchdog, which authorized in 2004 the complete inclusiveness of the Islamic Bank of Britain in the UK banking system. Analysts in the city of London appreciated Browns move to grab a slice of the Islamic financial market, which is estimated to be around $400-$500 billion. Paul Sherrin, head of Islamic Financial Services at Lloyds TSB, Having spoken to Muslims across the country we know that more than three-quarters want current accounts and mortgages that fit with their faith. By making these products available nationwide were bringing Islamic banking into the mainstream and were giving the Muslim community access to financial services that meet their needs without compromising their religion. The total Muslim population in Britain is over 1.8 million according to the Office for National Statistics and recent research led by Lloyds TSB show that over 75 percent of British Muslims would prefer a banking system tha t conforms with Islamic laws rather than adopting Western financial services. Despite growing at a much faster pace than conventional banking, at up to 35 per cent in some countries, its volume is comparatively negligible at the global level. Yet economic pundits these days seem to lavish attention on the Islamic model of finance. At least, none is neutral on the subject. 4.2 Products offered by the Islamic Banks in the UK 4.2.1 Current Account Current accounts are offered by almost all of the Islamic banks in the UK. The current account comes with no credit interest and there is no overdraft facility. However, a debit card is provided and there is no fee or minimum balance requirement. Though the banks do not charge any penalty interest to any account that are overdrawn. However, they will charge an administrative fee for items such as returned cheques and letters of notification. In accordance with the principles of fairness inherent in Shariaa banking, the charges usually reflect the expenses incurred. 4.2.1 Savings Account The money held in the savings or investment accounts are used to generate profit through Shariaa compliant trading and investment activities. Then the profits are shared with the customers at a pre-agreed ratio. 4.2.2 Home Mortgage Scheme A new mortgage scheme complying with the sharia law has come into being in the U.K. targeted at Islamic investors. The new deal from the banking organisations are based on the diminishing musharaka principle, which allows the banks to buy the first property first, then lease it to the client, who then sub-lets it to a tenant. The client and the bank own the property together, with the clients share increasing over a period of 25 years. The rent will be charged at London inter-bank offered rate (Libor) plus any other administrative cost. The specialised mortgage is available at Arab Banking Corporation, some branches of Lloyds TSB, Islamic Bank of Britain and HSBC. 4.2.3 Islamic transfer scheme In January 2008 the Lloyds TSB launched a new bank account that enables Muslims to transfer money around the world without breaking the rules of Islam. The Lloyds TSB account is designed to comply with the principles of Shariah law, and it does not pay interest on any money held in the account and does not offer an overdraft facility. It also guarantees that funds will not be invested in certain industries, such as those involved in alcohol or gambling, which are prohibited under Islam. There are around two million Muslims in the UK and around 100,000 Muslim firms, many of which regularly make or receive international payments through the 250 Islamic banks worldwide. Diana Brightmore-Armour, chief executive of corporate banking at Lloyds TSB, said: Were providing the missing link in the chain, so now any person or business receiving payments from abroad into their own Islamic account knows the money will be dealt with according to Islamic law, from start to finish.