The Development of Islamic Banks

Introduction

The Islamic banking system is a system of banking that is mainly practiced by banks in the Muslim nations together with those targeting the Muslim population. Islamic banking is modeled on Sharia law, which is a set of laws that govern the Islamic faith. Under Sharia law, a Muslim is not supposed to charge interest on a fellow Muslim’s money borrowed. The Muslim community has passed and adopted this law into the modern banking system (Ashfaq & Iqbal 2010, p. 138). The origins of the Sharia law informing the Islamic banking system can be traced to the Arab traditional lending system that was in existence way before Islam was introduced into the Arab world. The basic factor that drives the Sharia law on borrowing and lending is that it forbids one from charging interest on the money lent. The question that always comes to mind is, “how does the system make profits if it does not charge an interest?” So far, over 50 countries worldwide with approximately 300 institutions have this system in operation with an annual turnover of over $951million with the bulk of it being found in the Persian Gulf area (Qureshi, Hussein & Rehman 2012, p. 197).

The development of the Islamic Banking System

The Islamic Banking system has a very long history because it has its roots in the traditional Arabic system of lending and borrowing. The first institutionalization of the Islamic Banking system into the modern banking system happened in the 1970s with the opening of the first Islamic bank in Saudi Arabia in 1975. Although the Islamic lending and borrowing system had been there since the inception of the religion, it only came into the modern banking world formally in the 1970s. Before then, the European banking system, which is the conventional banking system, had been in place within the Islamic world due to inter-trading between the Europeans and Arabs, as well as the Muslim world. Muslims embraced the new banking order due to its organization, clarity, and for the sake of smooth trading between them and the outside world (Mariani, Davis & Giulliani 2010, p. 28). The only challenging factor, in this case, was that Muslims are not required to pay or receive interest. Most of them used the banks mainly as conduits of transferring money because they were trying to live strictly within the tenets of Sharia. They used the banking services sparingly not to go against their religious laws. In 1975, finance ministers from Islamic countries converged and agreed to form an Islamic banking institution that would operate under Sharia law. Most Islamic banks started as departments of conventional banks. They were therefore a package that would be offered to Muslims. To date, there are many fully-fledged Islamic banks all over the world. The rise of Islamic banking has seen other conventional banks tapping into this trend by offering Sharia-compliant services to Muslims as a way of tapping into Muslim money (Kabir, Benito & Faisal 2012, p. 465). The economy of the Muslim world was not very attractive. It could not hold sway in some matters before the world. This case has changed drastically with oil money boosting the economy as well as buying power and hence the need to tap into this phenomenon. To date, Islamic banking has seen a huge rise in turnover due to its rapid development since its inception.

A comparison between the Islamic banking system and conventional banking draws a very big contrast between the two systems that are both recognizable as banks. The Islamic banking system is fashioned in such a way that it does not allow the payment of interest otherwise called riba between the lender and the borrower. This case is contrasting to the conventional banking system that thrives in its business by charging interest to borrowers and payment of interest to depositors (Quresh, Rehaman & Hussain 2012, p. 125). The payment of interest rates by the conventional banking sector is what differentiates it from the Islamic banking system. Without interest, most banks will simply run out of business. Conventional banks make much profit through lending their money at certain fixed, as well as flexible rates. On the other hand, Islamic banks are not allowed to charge interest thus making it difficult for them to make money from the services they offer in comparison with conventional banking. This case, therefore, places them at a disadvantage in the cutthroat competitive banking industry. Whereas conventional banking can adjust its products according to the market forces to package them according to the law, the Islamic banking system has to get permission from the Islamic scholars and religious leaders who have to analyze any new package before approving it. Once compared to the conventional banking system, this provision is a hurdle because it takes a form of a coincidence for a package to be compliant with the law, and at the same time to be competitive commercially. The Islamic banking system should be compared to the insurance business in terms of loss spreading because of the way the loss is shared between the lender and the borrower. The main departure, in this case, is that, in the case of insurance, the loss is shared among the insured in such a way that the other clients cannot feel it due to the pooling of their resources. The difference between insurance and Islamic banking is that the Islamic banking systems lend money to clients in addition to taking money from clients. The common line between the two is that they pool money together for their business.

Challenges Facing Islamic Banking

Difficulties to Attract Investors

Since its inception, Islamic banks have found it difficult to attract investors from the mainstream investor groups because of its policy of non-interest charging and giving. In business, investors are there for a profit and more so a quick profit. Investors nowadays conduct very incisive analyses of the institutions in which they wish to invest. From the analysis, they can project returns from their investments within a given period (Natasa 2012, p. 286). This type of analysis makes it difficult to sell Islamic banking to investors who are in for a quick and sure profit. Investors trying to invest in this sector have found it difficult to project the expected profits from their investment. The challenge is thus a big factor that has shied them off. Profits from this system of banking take time to accumulate. Moreover, because there are three parties involved, it has to be divided by three. For instance, an investor will deposit his or her money with the bank, which will lend it to a borrower. When the money makes a profit, it will have to be divided between the investor, the bank, and the borrower. The prospect of sharing profit is a definite put-off to investors because they are always looking forward to maximum profits. This challenge has therefore made it difficult for this type of banking to thrive in attracting investors from outside the Muslim world (Quresh, Rehman & Hussain2012, p.198). The only source of finance for Islamic banking has been the rich members of the Muslim society who have surplus finances and who in the end invest in such banks for religious reasons. When members of society become rich and seem to have surplus amounts of money for the investment, they tend to become philanthropic by promoting religious and cultural activities. This case can be equated to how the Islamic banking system can attract so much money flowing through the system.

Difficulty in attracting Non-Muslim Clients

The development of the Islamic bank has been hinged on the Muslim Sharia law, which ostensibly applies to Muslims alone. The present-day society has been divided into different religious groups that try to expand their followers every day by trying to get more converts. This effort has led to each group working hard to secure the followers it has thus creating hard-line stances on religious issues. This case has made it difficult for such members to subscribe to a service that is based on another religious group’s law thus confining the Islamic Banking system to mostly Muslim populations. Shah, Raja, & Khurshid (2012) find that most people are not aware of Sharia law and its economic philosophy (p. 1028). The problem goes further even to the Muslim community because not all Muslims understand the Sharia economic philosophy. This challenge has made it difficult for the system to attract clients from almost all areas of life because it is mostly considered a charitable system. Because of its lack of clarity, the system has failed to convince clients in the aggressive financial sector.

Higher Risk Factors

The Islamic banking system has a higher risk factor for defaulting than the conventional banking system thus making it a risky venture for investors because there is no actual transfer of titles in the sale and purchase of transfers. Mutual trust between the parties conducting the transaction is the baseline for the exchange of money. Thus in the case of flight, it becomes difficult for the lender to get his or her money back because of the absence of a form of collateral. Although many members of society identify with different religious groups, they tend not to follow all rules within their groups. This case also happens with Muslims some of whom can break some rules. In case of someone getting such a facility and running away, it becomes difficult for the bank to recover the lent money. The biggest challenge this system faces is that it has to operate within the strict tenets of Sharia law. Thus, when the bank’s management makes any decisions, they have to conform with Sharia (Kumran 2012 p. 83). This sort of conformity is inhibitive to the banker who has to do so much to recover his or her investment.

Difficult to Embrace

The Islamic banking system has been difficult to embrace not only by the non-Muslims but also by Muslims. In the year 1980, the Pakistani government embarked on a mission to turn its economy into an Islamic economy. This effort happened for a period of 20years before the national government dropped the idea slowly. The challenge to such a move has been that the world today has become a global village, and that anything done can only be successful if it conforms to the international standards (Thumbiah, Ramanathan & Mazunder 2012, p. 440). The Islamic banking system has therefore failed to have its footprint in the world of business outside Muslim countries because of the confusion that might arise. This system seems to work best in Muslim countries that are clustered together or within countries that are predominantly systems. The challenge that comes up is that there are nations that are strictly Muslim-based while others are secular Muslim states. Therefore, this variation makes the acceptability of this system to the Muslim population scattered in a sense that it can never be uniform.

Overcoming the Challenges

The Islamic banking system has come a long way to get to where it is today from a traditional practice to a formal and internationally recognized system. In Pakistan for instance, the Islamic banking system has been able to take about 15% of the financial institution’s transactions. This achievement can be attributed to the help from the Pakistani central government, which has been in the forefront through its central bank by formulating rules to govern the Islamic banking system (Akram, Rafique & Alam p.127). The Malaysian government has been able to create an enabling environment for the Islamic banking system in that it became the first country to develop a completely parallel system to the conventional banking system. According to Thambiah, Ramanathan, and Mazunder (2012), “…the Islamic banking has become one of the fastest-growing industries with an estimated growth rate of 15-20 percent per annum” (p.437). The purpose of the Islamic banking system is to enable Muslims to comply fully with the tenets of Sharia law as an obligation for them to go to heaven. The Islamic banking system has made it possible for it to operate well within the Sharia law by having an advisory board consisting of Islamic scholars and clerics who have the duty of endorsing or rejecting any packages they feel conform to the law or are in contravention with the law. This achievement has provided the much-needed certainty to the public that whatever is being sold as a financial package by the bank is fully compliant with religious laws. The bank has embarked on educating the non-Muslim community on how the system works as a way of attracting them to their services without them having to be Muslims. This information of the general community indiscriminately will enable them to tap into the market without clients having to convert to Islam.

Conclusion

The Islamic banking system has had slower growth than it had been anticipated when it was started in the 1970s due to the complex nature of conventional banking, which is fully accepted in the whole world and has been in practice for a long time. Thus, integrating Islamic banking within conventional banking or replacing conventional banking with Islamic banking has become difficult (Alani & Yacoob 2012, p. 85). The only good news is that many banks in the world have begun opening departments dealing with conventional banking within their services as a way of tapping into the money that comes through the Muslim nations.

References

Akram, M, Rafique, M, & Alam, H 2011, ‘Prospects from Islamic Banking: Reflections from Pakistan’, Australian Journal Business and Management Research, vol. 1 no. 2, pp. 125-136.

Alani, F & Yacoob, H 2012, ‘Traditional Banks Conversion Motivation into Islamic Banks: Evidence from the Middle East’, International Business research, vol. 5 no. 12, pp. 83-101.

Ashfaq, A & Iqbal, S 2010, ‘Islamic Banking Experience of the Pakistani: Comparison between Islamic and Conventional Banks’, International Journal of Business Management, vol. 5 no. 2, pp. 137-143.

Kabir, H, Benito, S, & Faisal, S 2012, ‘Impact of Financial Liberalisation and Foreign Bank Entry on Islamic Banking Performance, Conference Proceedings’, International Conference of the Faculty of Economics Sarajevo(ICES), vol. 1 no. 1, pp. 460-487.

Kumran, S 2012, ‘Risk Management and Mitigation Techniques in Islamic Finance: A Conceptual Framework’, International Research Journal of Finance and Economics, vol. 4 no. 98, pp. 84-99.

Mariani, A, Davids, S, & Giuliani, B 2010, ‘Efficiency in Islamic and Conventional Banking: An International Comparison’, Journal of Productivity Analysis, vol. 34 no. 10, pp. 25-43.

Natasa, M 2012, ‘Interest Free Banking and Economic Development’, Megatrend Review, vol. 9 no. 1, pp. 285-300.

Quresh, A, Hussain, Z, & Rehman, K 2012, ‘A Comparison Between Islamic Banking and Conventional Banking Sector in Pakistan’, Information Management and Business Review, vol. 4 no. 3, pp. 195-204.

Shah, S et al. 2012, ‘Islamic Banking Controversies and Challenges’, Interdisciplinary Journal of Contemporary Research in Business, vol. 3 no. 10, pp. 1018-1028.

Thambiah, S, Ramanathan, S, & Mazumder, M 2012, ‘The Determinants of Islamic Retail Banking Adoption in Malaysia’, International Business and Economics Research Journal, vol. 11 no. 4, pp. 437-444.

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