Challenges Facing Islamic Banking by Munawar Iqbal

Top 20 FREQUENT WORDS

islamic 662 banks 462 banking 216 financial 190 institutions 107 finance 95 funds 84 modes 70 conventional 63 countries 61 financing 61 shari 57 deposits 51 markets 51 data 49 important 46 profit 45 assets 43 percent 43 equity 41 murabahah 41

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isbn the views expressed in this book are not necessarily those of the islamic research and training institute nor of the islamic development bank
islamic research and training institute C islamic development bank king fahd national library in publication data munawar iqbal ausaf ahmad tariqullah khan challenges facing islamic banking pages a x cm

present state of islamic banking and finance section challenges facing islamic banking institutional aspects
contents page foreword section scope and methodology section taking stock

taking stock of islamic banking practices

it is with this objective that the islamic research and training institute irti of the islamic development bank idb presents this paper on challenges facing islamic banking as decided by the idb board of executive directors

section scope and methodology this paper aims at taking stock of the developments in islamic banking over the past two decades and to identify the challenges facing islamic banking to remain viable to meet the growing competition and to develop and prosper
islamic financial institutions other than banks in some muslim as well as non muslim countries and d

where generalizations on broad features were to be made the technique of pooling time series and cross section data has been used because this technique minimizes the impact of inter bank and inter temporal variations

the rationale and theoretical models of islamic banking in any economy there is a need to transfer funds from savers to investors because people who save are frequently not the same people who have the ability to exploit the profitable investment opportunities

financial intermediation enhances the efficiency of the saving investment process by reducing transactions costs and eliminating the mismatches inherent in the needs of surplus and deficit units of an economy
the surplus units are often small households who save relatively small amounts and the deficit units are the firms who often need relatively large amounts of cash

historically the role of a financial intermediary in the islamic economy is found in the principle of al mudarib udarib a practice which has existed in islamic history since early centuries
islamic financial intermediation endeavors to replace interest by other modes and instruments both for mobilizing savings and for putting those savings to productive use

the main business of the bank is to obtain funds from the public on the basis of mudarabah and to supply funds to businessmen on the same basis
the bank can have general unrestricted investment deposits or restricted investment accounts in which deposits are made for investments in particular projects

risk sharing the most important feature of islamic banking is that it promotes risk sharing between the provider of funds investor on the one hand and both the financial intermediary the bank and the user of funds
islamic banks have also developed various forms of price and object deferred sales such as short term murabahah declared cost plus profit based financing installment sale long and medium term murabahah pre paid or pricedeferred manufacturing orders istisnaa and pre paid or rent deferred leasing ijara

in islam this kind of unjust distribution is not acceptable and hence in islamic banking both the investor and the entrepreneur shares the results of the project in a way that depends on the supply and demand for funds
emphasis on productivity as compared to credit worthiness under conventional banking all that matters to a bank is that its loan and the interest thereupon are paid to it on time

the later growth of the islamic banking movement has been helped by the encouragement provided by the governments of some muslim countries
for example they will not finance a wine factory a casino a nightclub or any other activity which is prohibited by islam or is known to be harmful for the society

the estimates with respect to the saving in costs due to scale economies range from percent to as high as percent

table islamic banks and financial institutions by size of assets assets frequency us dollars millions distribution total source directory of islamic banks and financial institutions international association of islamic banks jeddah

table islamic banks and financial institutions by size of capital size of capital frequency us dollars millions distribution total source directory of islamic banks and financial institutions international association of islamic banks jeddah

table key financial indicators islamic banks vis a vis conventional banks percentages top ten top ten top ten top ten indicator middleworld asian islamic eastern east capital asset
second the size of the bank capital has safety implications as it provides some cushioning albeit limited against the possibility that the bank cannot satisfy its obligations to its creditors

the bank must then meet two capital requirements it must have core or tier capital stockholder equity capital of at least of total risk adjusted assets and total capital tier capital plus tier capital which is made up of loan loss reserves and subordinated debt of at least of total risk adjusted assets

it should also be noted that the lower rates of profit for the top ten banks in the world as well as in asia are due to the fact that some of these banks have posted losses during recent times bringing the average rates down

the banks included in the sample account for more than percent of the total assets of islamic banks in
instead we pooled the data for these three years and computed three year averages in order to minimize year to year variation

murabaha musharaka mudaraba ijara others chart shows the use of various modes by simple averages of the ten banks
it can be seen that murabahah accounts for percent of total financing

this drop in the percentage use of murabahah is almost entirely explained by lesser use of this mode by kuwait finance house only about which is the largest bank in the sample and hence carries a lot of weight
financing by sectors once again in order to examine the current position of financing by various sectors we compiled three year averages for the period in order to minimize inter year variations

table financing by sectors agriculture real estate agriculture name of total trade industry services other trade industry institution financing percentage total us dollar albarka isl
bahrain islamic bank

chart agri industry services real estate others chart financing by sectors weighted average of nine banks
estate other

it is obvious from the data that in case of most of the banks trading gets the biggest proportion of financing
this calls for rethinking the role of islamic banks in economic development against the hopes which had been raised in the past regarding their ability to finance agriculture and industry

section challenges facing islamic banking institutional aspects islamic banks have struggled for a quarter of a century gaining some success yet facing some proble miss it is perhaps the time to take stock of the challenges they face especially that they will soon be ushered into a new millennium
the functions being performed by various institutions in the conventional framework should be examined and attempts should be made to modify the existing institutions in a way that enables them to provide better support or establish new ones as needed

in that context the legal framework of islamic banking and finance might include the following islamic banking laws this set of laws will be concerned with the establishment functioning and supervision of islamic banking in the country
in addition laws are needed to allow financial institutions to operate according to islamic rules and to give room in financial markets for islamic financial transactions

there are three main reasons why regulation and supervision of banking industry are important to increase the information available to investors transparency to ensure the soundness of the financial system and to improve control of monetary policy

in order to introduce standardization in the accounting practices of islamic financial institutions some islamic banks under the guidance of the islamic development bank have established an organization called accounting and auditing organization for islamic financial institutions aaoifi

the need for an autonomous shari ah supervisory board banking supervision is needed in case of islamic banks as much as in case of conventional banks
it must be mentioned here that since islamic banks do not fall under the jurisdiction of a single government such a board can be constituted only if the islamic banks agree to abide by a common discipline

table growth of equity markets in selected countries values in us dollars millions annual annual capitalization rate of rate of country growth growth bangladesh

in view of the importance of long term capital for economic growth establishment of institutions providing equity capital is a prerequisite for the survival and success of islamic finance
similarly the number of specialized equity institutions and other institutions which traditionally provide equity capital through stock exchange ie pension funds mutual funds and insurance companies is negligible

inter bank transactions among islamic banks are minimal because in most of the countries the number of islamic banks is very small
there are several ingredients of a secondary financial market financial papers dealers and financial institutions

while the need for overnight placement of funds may not be very pressing in case of islamic banks there is still a need for a market for short term placements of funds

financial engineering financial engineering as the word indicates refers to the art of designing financial products to meet the needs and tastes of the users with regard to risk maturity and yield
but in case of salam the prophet pbuh allowed such sale because of need of the people but laid down clear rules to protect the interests of both parties

even after a new product is put into use shari ah auditing of the operations of financial institutions is very important to ensure that the actual practice complies with the requirements of shari ah
the final contract may be say a leasalam contract a combination of leasing and salam a ijarka contract a combination of ijara and musharakah or even an entirely new product

in the absence of the required expertise in the field of finance among shari ah scholars this approach of group ijtehad is playing an important role in safeguarding against serious mistakes in adopting doubtful instruments
as any participant of the workshops and meetings of the fiqh academies can notice that the interaction between fiqh scholars and the experts of modern economics and finance does not always proceed smoothly

this may also be confirmed by the fact that the islamic banks have not been able to find a reasonable number of suitable managers from the graduates of those universities nor could anyone of them find a place in the shari ah board of any islamic bank
in the area of teaching some universities in some muslim countries particularly egypt saudi arabia pakistan and malaysia have initiated some teaching programs to produce graduates with the dual specialisation

the managers of islamic banks may have been attending some short term courses either on the job or elsewhere but there are not many formal training programs meant to prepare the employees of the islamic banks for the needs of the system
there is also a need to arrange short courses for shari ah scholars in economics and finance and similar courses for economists in shari ah

creating a special department in central banks through which information of project feasibility and evaluation can be exchanged in addition to provision of technical assistance to islamic banks when needed

defaulters and the issue of compensation and penalties by using fixed rate modes of financing the islamic banks are able to side step the problems of moral hazard and adverse selection
now while it is permissible to charge a higher price in credit sales as compared to cash sales the wherewithal of murabahah mode of financing once the deal has been entered it creates a fixed liability

the problem assumes a more critical dimension in view of the fact that in most of the muslim countries the major domain of islamic banks well developed securities markets do not exist
even though it is conceivable to design an installment sale murabahah contract spreading over many years the needs for which the murabahah contract can genuinely be used are by and large short term

it must be realised that much of the deposits now with the islamic banks came not due to the attraction of higher returns but because of the religious commitment of the clients
it must be noted however that leading shari ah institutions have ruled that it is not permissible to take equity stake in companies which deal in interest even in small proportions

therefore it is reasonable to assume that the rate of growth of deposits of the islamic banks will be much lower unless they are able to attract deposits on competitive basis and from new sources
as conventional banking and financial institutions apply their vast experience to establishing financial instruments that conform to islamic modes muslim savers will continue to find alternatives to depositing their cash in islamic banks at lower rates of return

on the other hand it may be argued that such competition may be good for islamic banking as western banks may bring their efficiency market research and innovative capabilities sophisticated banking and result oriented approach to islamic banking which may lead to the development of new products and provision of better services to consumers
although it is difficult to know with certainty how many conventional banks around the globe practice islamic banking techniques even a randomly selected short list may contain some of the giants of international banking business such as chase manhattan citibank anz grindlays klienwort benson along with others such as union bank of switzerland girozentale of australia the abc international

in all major islamic banks there is a shari ah board which regularly reviews the operations and contracts of the bank to determine their compliance with the requirements of the shari ah
in the event they do mix islamic money with their general pool of investible resources or they do not keep separate accounts for islamic banking activities there is a strong possibility that permissible halal returns may be a contaminated by riba

globalization refers to growing economic interdependence of countries worldwide through the increasing volume and variety of cross border transactions in goods and services and of international capital flows and also through the more rapid and widespread diffusion of technology

what all this means for islamic banking shall it help islamic banks or harm them it may be difficult to venture out a definite answer to these questions but it may not be too adventurous to put on record some initial conjectures a
this would enable islamic financial institutions to channel domestic as well as foreign savings into muslim countries to meet the great demand for such resources in those countries

the successful operation of these institutions and the countrywide experiences in pakistan iran sudan and partly in malaysia are sufficient to show that islamic banking offers an alternative method of commercial banking
while many problems are a result of the inappropriate environment in which islamic banks are working there are others which have arisen from the practices of islamic banks themselves

in addition to a better rate of return on capital if one considers the fact that the capital asset ratio of islamic banks is higher than their counterparts one can easily conclude that islamic banking as a business is doing reasonably well
as far as the use of various modes of finance is concerned murabahah accounts for percent of total financing

firstly it must be realized that much of the deposits now with the islamic banks came not due to the attraction of higher returns or better services but because of religious commitment of the clients
the functions being performed by various institutions in the conventional framework should be examined and attempts should be made to establish institutions that can perform those functions in an islamic way

the conventional banks particularly the western banks have a large advantage over islamic banks in terms of their size experience market coverage and long standing in the industry
this development is a clear recognition of the viability of islamic banking as an alternative model but at the same time it has increased competition

in the light of the principles of ijtehad a needs approach to financial engineering is desirable of course within the known principles of islamic finance
it will also be useful to build bridges between existing islamic banks and those conventional banks that are interested to do banking on islamic principles

even after a new product is put into use shari ah auditing of the operations of financial institutions is very important to ensure that the actual practice complies with the requirements of shari ah
this is important not only for religious reasons but also for purely business considerations because the clients of islamic banks will not have confidence in their operations unless shari ah scholars clear their activities

is extremely important to have the people with the right kind of skills and commitment to run the islamic banks
it is difficult to expand a business financed through mudarabah because of limited opportunities to re invest retained earnings and or raising additional funds c

however in order to have a more diversified portfolio it would be desirable that the predominance of fixed return modes such as murabahah and leasing on the asset side is gradually reduced over the long run
if transformation into a more equity based financial system is to take place steps should be taken to encourage business corporations to

in view of the importance of long term risk capital for economic growth establishment of institutions providing equity capital is very important for the survival and success of islamic finance
although stock market investments have not become any less risky over the years savers are beginning to accept the historical evidence that in any five year period since world war ii with one exception stocks have produced higher returns than bank accounts bonds or bullion

the central banks subject the islamic banks to the same controls conditions and regulations that they apply to the interest based banks
to protect the interests of the public and the economy from financial panics most governments have created elaborate regulatory bodies

in countries where the central bank conducts open market operations islamic banks are not able to participate in these operations because of interest based nature of the securities bought and sold
to promote teaching training and research in islamic banking and finance and to produce and disseminate authentic information on their

in addition there is also a need for central banks in muslim countries to consider the special nature of islamic banking and devise suitable international standards for major control variables similar to the basle committee for banking supervision

it can be seen that lack of financial engineering illiquidity of assets due to lack of negotiable instruments implication of globalization lack of profit sharing on assets side and lack of mechanism to deal with defaulters of debt are perceived to be the five most important challenges facing islamic banking in general

main sources of published statistical data on the islamic banks in the corporate sector are the following i annual reports of islamic banks ii directory of islamic banks published by international association of islamic banks iii the harvard islamic finance information program hifip database iv the bankers almanac annual reports of islamic banks are the main source of data
for example if some researcher is interested in finding out the size distribution of deposits in order to determine whether islamic banks attract small depositors or not he will not be able to do so as relevant statistical information is not readily available

this results in dissimilarity of accounting practices among different islamic banks to the extent that any meaningful comparison between the balance sheets or profitand loss accounts of two different islamic banks becomes a very difficult task if not altogether impossible

although the association has been making a commendable effort which deserves to be supported and strengthened the data collected by the association suffers from certain shortcomings originating from the primary data i the association writes to central banks of all countries in order to obtain the list of islamic financial institutions
it is a sad reflection on the state of availability of statistics on islamic banking that even premier institutions of islamic banking do not possess a complete set of annual reports of islamic banks

however the availability of scientifically collected accurate and reliable statistics can go a long way to improve the quality and quantity of research on islamic banking and finance
moreover it gives data for some main variables only such as capital total deposits reserves assets and some selected items from the profit loss account

fibb ibb dib fibe jib abbb bhib kfh murabahah musharakah mudarabah ijara others
financing by modes banks murabahah musharakah mudara ijara others frequency dis bah abbb

murabahah musharakah mudarabah ijara others ibb dib jib kfh abbb bhib fibb fibe
financing by modes muraba frequency banks hah musharakah mudarabah ijara others abbb

bhib fibb ibb dib fibe jib kfh abbb ijara others murabahah musharakah mudarabah
financing by modes other banks murabahah musharakah mudarabah ijara s frequency abbb

se fibb ibb fibe jib kfh bim qib average bhib fibb ibb fibe jib kfh bim abbb trad
others frequency distrib abbb bhib trad

abbb ibb bim bhib fibb fibe kfh jib trad
financing by sectors banks trad

servi fibb ibb fibe jib kfh bim qib average abbb ibb bim bhib fibb fibe jib kfh trad
others frequency distribu abbb bhib trade agri

presley financing developing a system of economic development in islamic financial instruments jeddah islamic economics attitudes islamic research and training towards islamic finance in institute small manufacturing business in bendjilali boualem and khan saudi arabia in mannan m

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AlHuda Material\islamic banking

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islamic banks banking financial finance investment conventional institutions funds risk financing deposits assets services management international countries equity profit products

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Number of Pages

92

Published Date

2006-12-25 15:17:35

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Challenges Facing Islamic Banking by Munawar Iqbal

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