Islamic Banking

.. ed in three areas: investment, trade and lending. Investment financing: This is done in three different ways: 1. Musharaka (venture/equity financing) where a bank may join another entity to setup a joint venture, both parties participating in the various aspects of the project in varying degree. 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. 2. Mudarabha (trust financing) where the bank contributes the finance and the client provides the expertise, management and labor. Profits are shared by both the partners in a pre-arranged fashion, but when a loss occurs, it is completely borne by the bank. This type of contract is also used in fund management where the fund manager is the mudarib who is entrusted to manage clients’ money. 3. Financing on the basis of an estimated rate of return.

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Here, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate, the excess goes to the client. If the profit is less than the estimate, the bank will accept the lower rate. If a loss occurs, the bank takes a share in it. Trade Financing: This is also done in many ways.

They are: 1. Murabaha (Cost-Plus Financing): 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 60th month, he will still owe the same amount. 2.

Leasing where the bank buys an item for a client and leases it to him for an agreed period ad at the end of that period the lessee pays the balance on the price agreed at the beginning and becomes the owner of that item. 3. Hire purchase 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. 4. Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after a certain time for an agreed price. 5. Letter of Credit 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: 1. Loans with a service charge 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. 2. No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. 3. Overdrafts are also provided and are subject to a certain maximum.

Free of charge or small fee. It should be noted that Islamic banks are not active in lending like conventional banks because they are not interest based. The point to be noted is that lending in an Islamically acceptable form is not very profitable to the back 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 a global Islamic bond market. ? 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 Eurocurrencies. SHORTCOMINGS OF THE ISLAMIC BANKING SYSTEM Islamic banks are able to provide 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 as follows: 1. Shortage of experts in Islamic banking – The supply of trained or experienced bankers has lagged behind expansion of Islamic banking. The training needs not only affect 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. 2.

Absence of accounting and auditing standards pertinent 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. 3. Lack of uniform standards of credit analysis – Islamic banks have no appropriate standard of credit analysis, especially for profit-and-loss-sharing (PLS) schemes. Similarly, there is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures and portfolio evaluation.

4. Potential conflicts with central banks – Islamic banks have been established as separate legal entities and therefore their relationship 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. 5. Potential conflict between domestic banks, foreign banks and Islamic banks – It seems that domestic and foreign banks will experience continuing difficulty in adopting Islamic banking practices, including the PLS scheme, until they become more confident of the results of investing ventures. 6. Lack of deposit insurance system – The lack of such a system becomes of a greater concern because Islamic banks have standard measures of reserve requirements or liquidity ratios. 7.

Legislation – The depositors’ funds are one of the basic asset acquiring methods of Islamic banks. The existing banking laws, however, do not permit banks to engage directly in business enterprises using these funds. Therefore new legislation and banking laws need to be established. 8. 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. 9.

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 for 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. 10. 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 Islamic banking is a new system yet it has already been implemented many Muslim and a few non-Muslim countries. Despite the successful acceptance there are problems which are mainly in the area of financing. Islamic banks, however, can eliminate the doubtful forms of financing and offer a clean and efficient 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 a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional 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 rulings and put it in effect. Business.