Islamic Banking (Middle East)

Module: Middle East

Topic: Islamic Banking

The financial industry in the Middle East has been traditionally influenced by religion. Today, Islamic banking appears as a growing and successful industry, not only in the Middle East but also in some western countries.

Internet based research activity:

 Explain what Islamic Banking is and its background.

1. What are the key principles of Islamic banking?
2. Islamic law forbids institutions from charging interests on loans. How do they make profits when lending money?
3. Explain the concept of ethical investments under Islamic law. Who is to determine whether an activity is allowed or not?
4. How does Islamic banking influence the economy in the Middle East?
5. Based on your research and knowledge about this topic, what is the future of Islamic Banking in terms of global expansion and growth?

 Solution

1.  To talk about the Islamic banking system, it is necessary first to make a brief description of the Islamic economy, which characterizes by the encouragement of communal, non individualistic values, and fighting against selfishness .Islamic banking refers to a banking system based on the principles of Shari'ah.

Background: the Islamic banking concepts are traced back to the birth of Islam, but the consolidation of Islamic banks in the 20^th century had its first experience at 1963 in Egypt where the first Islamic bank provided financing based on partnership agreements with customers and based on the profit and loss sharing principle.  An important factor that contributes with the Islamic banking growth was the surge in oil prices, all the economic dynamics that were experienced in this sector make that Arab countries organize their income flows through the establishment of Islamic Banks.

[1]“Within the financial system, Islamic banks are unique in being non-interest based operationally. They abide by the Islamic rules and regulations (Shari’a) to promote Islamic financial standards and code of ethics from a business transactional point of view”.

2. The basic principles of financing in Islamic countries are:

Qard al Hasana: Islam only allows this type of loan and it states that the lender cannot charge any interest or additional amount over the money lent.  This form of financing transaction was encouraged by the Prophet to channel the savings into more productive activities. So in this non-interest- bearing loan, the lender doesn´t obtain any type of tangible benefits and the loan is repaid when the borrower is able.

Participatory Financing:  This principle states that both the lender and borrower should share the profits or losses arising out of the project for which the money was lent. The provider of capital and the user should see themselves as partners who share profits and risks of the business, instead of creditors. Also it is not well seen that people receive some profit without affronting any risk.

Prohibition of Gharar:  Under this principle, the financial transaction should be free from uncertainly, risk or speculation. The contracting parties should know all the exchange conditions. Despite parties cannot fix a predetermined profit, they can use mechanisms to minimize the risk.

Prohibition of unlawful activities: The investment should only support those activities that are not forbidden by Islam, so Islamic banks cannot finance activities related with alcohol trading, pork products or night club activities. Besides an Islamic bank cannot lend money to other bank charging an interest fee.

 3. The two basic categories of financing modes are:  profit and loss sharing (PLS) and the purchase and hire of goods or assets and services on a fixed-return basis, here are illustrated two examples of the respective alternatives. A financing mode known as mudarabah is a way to obtain profits from the participative transaction that Islamic banks undertake. This is a profit sharing agreement between two parties (the investor and the entrepreneur). The investor gives to entrepreneur the funds to undertake his business venture and receives a return on the funds he put into the business based on profit shared ratio that was previously agreed and [2] “a Murabahah transaction involves the sale of goods at a price which includes a profit margin agreed by both parties. However, in Murabahah, the seller must let the buyer know the actual cost for the asset and the profit margin at the time of the sale agreement”.

4. Also the investment activity has certain principles to obey, these are some restrictions that ethical investor should impose himself based on his belief and moral conviction. According to the Institute of Islamic Banking and Insurance the principles that grant an ethical investment and good returns are:

-          [3]“Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation

-          Investments are made in permissible activities

-           Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity”.

A Religious (Shari’ah) Supervisory Board monitors that Islamic financial institutions comply with the rules that Islam states in order to prevent that financial institutions deviate their operations from the faith based system.

5.      The Islamic banking represents the fastest growing sector in the Middle East economy. According to the Journal Managerial Finance the Islamic banking sector has been growing at an estimated rate of 15% a year and its estimated value for 2008 fluctuated around USD$300 billion. One of the activities that are becoming relevant for the sector´s performance is the personal finance. The Islamic banking has played an important role in financing the development of other productive sectors such as Industry, mining, construction and agriculture in the Jordan case. Besides some academics consider the Islamic banking an efficient financial system to implement in difficult situations just like the previous global economic meltdown.

6.      In my opinion the Islamic banking has a promising future because this sector has been able to adapt itself to the changing conditions that international markets present, the introduction of structural reforms towards a major liberalization and integration of capitals has contributed to Islamic banking expansion to non- Muslim countries. However there are still many challenges that Islamic banking has to face, for example the need for risk management tools to hedge the high risks related to currency and commodities markets, those markets have always deeply rooted in the Islamic banking interests. Also the Islamic banking needs to develop a more appealing approach in order to provide a better insight of the banking dynamics for ordinary people and it is necessary the standardization of accounting practices that fit with the Islamic banking in order to grant its expansion.

Reference Sources:

Institute of Islamic Banking and Insurance.

http://www.islamic-banking.com/Default.aspx

Banking Info

http://www.bankinginfo.com.my/_system/media/downloadables/islamic_banking.pdf

Fundamentals of Islamic Economy and Finance: Theory and Practice. Assist. Prof. Dr. M. Kutluğhan Savaş ÖKTE. İstanbul University Faculty of Economics

Islamic Banking Performance in the Middle East: A Case Study of Jordan. Ali Salman Saleh and Rami Zeitun. University of Wollongong.

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[1] ELAF Bank  http://www.elafbank.net/banking.aspx?id=8&sid=2

 [2] Banking Info http://www.bankinginfo.com.my/_system/media/downloadables/islamic_banking.pdf

[3] Institute of Islamic Banking and Insurance.  http://www.islamic-banking.com/Islam_approach_to_ethical_investment.aspx