Islamic Banking History, Overview & Future

Transcription

1 Islamic Banking History, Overview & Future By George Reiff, PhD Abdullah Ibn Hanzala reports that Allah s emissary said: "One Dirham interest taken knowingly is worse than 36 immoral acts.

2 Table of Content Introduction 03 History of Islamic Banking 04 Principles of Islamic Banking 06 Precepts of Islamic Finance 07 Pros and Cons Islamic Banking 12 Conclusion 14 References 16

3 Introduction The term Islamic Banking refers to the management of banking and financial transactions, which are in accordance with Islamic rules of ethics and which are in line with the values of Islam and its obligations to assume social responsibility. Islamic Banking is based on Sharia principles and is supposed to be philosophically and practically different than conventional Western banking. The Sharia principles are rules and injunctions that are derived from the holy Quran, the Hadith and other sources, which also involve the exercise of reasoning based on interpretations. Islam is one of the three monotheistic world religions and it strongly guides the believer in various regards. There are sometimes somewhat different interpretations of Islamic banking depending on the country. Islamic banking for example in Germany should be largely relevant to the Muslims living there. There are about 4 million prospective customers. About 250,000 Muslims live for example in Germany s capital Berlin 1 and so Islamic banking is becoming increasingly important even in a centrally Christian nation. Strictly Muslim consumers will want to compare the traditional financial products with sharia compliant products. The Islamic banking industry is still young, but has spread rapidly, and a few years ago so-called Islamic financial products were still regarded as a major future market for the financial sector in the West. The banks expected a large inflow of fresh money from Muslim customers who would want to invest their money according to the rules of Islamic law. And so banks opened funds where the money of the customers was invested exclusively in Sharia-compliant ways. At its very foundation Islamic Banking should be based on trade that is based on the precepts of religion, where a just exchange should take place as described in one of the Hadiths of the Prophet Muhamad: "Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, and salt by salt - like for like, equal for equal, payment being made on the spot. If the species differ, sell as you wish provided that payment is made on the spot". 2

4 History of Islamic Banking In Islamic economic law, the establishment of justice and the well-being of society have top priority. The market symbolizes human freedom and solidarity in Islam. Before Islam, there were different types of purchase contracts in Arabia and business and commerce were characterized by a lack of transparency and arbitrariness, like for example that one had to buy an object as soon as one had touched it. Usually landlords and merchants offered goods and services overpriced. With Islam, there was the belief that the afterlife is following the earthly life. Based on the pillars of Islam (especially Pillar 3, Zakat) 3, economic and social responsibility also grew. They made sure that no damage was caused by trade and business by banning interest rate collection among others 4. The Islamic moral code would demand from the traders leniency, kindness, and honesty. The holding of a share in successful business as a principle of Islamic banking was already applied by merchants at the beginning of Islam. Modern Islamic banking is a new development compared to Western banking with its immediate 400-year-old banking history. The first interest-free bank, which was not yet expressly designated as an Islamic bank, was introduced in 1963, when Egyptian PhD student Ahmad El- Naggar founded a bank in the village Mit-Ghamr in Egypt's Nile Delta according to the model of the German savings banks (Raiffeisen System) 5. The interest-free savings bank project had the objective to take the very economic model as an example, which turned ruined post-war Germany into an economic power. The experiment was conceived and directed by Ahmad El- Naggar 6, a former PhD student of Economy at the University of Cologne 7. Inspired by the central role of municipal and cooperative credit institutions in the stimulation of German peoples austerity, as well as by the promotion of economic and social development in the country, he was convicted that this ideal could be achieved in line with Islam. The property of saving is one of the most important pillars of Islamic law for regulating economic life. In contrast to traditional savings banks, the operation of the interest-free savings bank in Mit- Ghamr was supped to be based solely on the principle of investor participation in profit and in loss. Thus, fixed interest rates in advance would not be included. El-Naggar hoped that his interest-free savings bank project would integrate the population of Egypt into the banking sector

5 and that Islamic banking could gradually replace the traditional banking system already established in Egypt. Four years after the opening of the first savings bank the project failed and El-Naggar made the political circumstances of the time responsible for it. With the failure in Mit-Ghamr the idea of Islamic banking did not disappear. Rather, the experience gained from this experiment shaped the further development of Islamic banking on an international level. Thus Egypt's Ministry of Economic Affairs, with the considerable participation of El-Naggar closely emulating the initial project in the Nile Delta, produced a historically significant document entitled "The Egyptian Study on Islamic Banks". This was finally ratified by the Third Foreign Ministers' Conference of the Organization of the Islamic Conference (OIC) in Jeddah in , and it was intended to replace interest rate transactions in the future through the Islamic principle of participation in both profit and loss. It did not take long after the Egyptian study was facilitated until a number of Islamic banks were launched at a national level. Meanwhile, the Islamic banks have become an integral part of the economic life of many Islamic countries. In Malaysia the Pilgrims Fund Corporation was established as a savings pool for the Haj pilgrimage in and later in 1971 the Nasser Social Bank was founded as a non-profit bank for unbankable people 10. In 1974, the "Islamic Development Bank", which has nowadays 55 member nations 11, was founded by Arab governments. Being in line with Sharia principles, projects are primarily funded in economically undeveloped member countries. In 1975, the Islamic Development Bank in Jeddah and the Dubai Islamic Bank followed. At the end of the 1970s, the Kuwait Finance House was established in Kuwait and the Faisal Islamic Bank in Sudan became the first who called themselves "Islamic banks". However, the spread of Islamic banking was not limited to the Islamic world. In the 1980s, the founding of the "Bank Islam Malaysia" saw the focused expansion of the concept into Asia. Since the early 1990s, Islamic banks can be found around the globe. The background to this development is the prosperity that the Middle East has developed since the 1970s, and the growing religious reverberation of Islam in all Arab countries. Also, international financial institutions like for example the Deutsche Bank have recognized the market potential of this banking system and established so-called "Islamic Windows" 12 in the Islamic countries - especially in the Gulf States and Southeast Asia - to offer Islamic financial services. Moreover, in some Western countries for example the UK the Islamic Bank of Britain was established in 2004 and for example Germany, where the Islamic Kuveyt Türkbank opened her first banking branch in

6 Principles of Islamic Banking Islamic Banking means in short for example to be done with the commonly usual interestbearing money lending (in Arabic "Riba") or with any transactions that have a kind of gambling character ("maysir"). Investment in companies which are not compatible with the ethical principles of Islam is also not possible. Likewise, in-transparent and high-risk speculations ("Gharar") contradict the fundamental ethical values of Islam. Therefore, any transaction should be backed with a good in order to promote the real economy. This ensures that economic savings are channeled into the real sector. Islamic Banks should invest the funds of its investors in industry and trade and have success on behalf of the customers. Islamic banking in its pure form could therefore be regarded a part of the SRI (Socially Responsible Investment) sector and it would stand for sustainable, integrated and responsible investment. Fundamental principles - such as consistent risk management or good corporate governance - apply as much to the Islamic financial systems as to the Western ones and contribute to ensuring a secure and functioning international banking system. Market Overview Islamic Banking In over seventy countries around five hundred Islamic banks and financial service providers offer their services. The world-wide volume of assets managed under Islamic law was estimated by 2012 to be 1.6 trillion US Dollars 14 and so we can safely assume for now about two trillion US dollars. The annual average growth rates of Islamic banking amounts within the last decade always to more than 15 per cent 15 and is therefore significantly higher than in the conventional banking business. The Islamic Financial Services Board (IFSB) is forecasting further growth. The development of Islamic banking in the 20th century Since the year 2000, the interest in Islamic Finance has also increased from Western banks and insurance companies. The major international banks and insurance companies are strongly represented in the Gulf region and in Southeast Asia. Islamic Banking has been recognized by

7 the finance ministers of the G20 as a progressive alternative to the Western economic system and is to be increasingly integrated into the global financial structure. Precepts of Islamic Finance 16, 17, 18 Riba Riba means when literally translated, "surplus". The ban of interest Riba is one of the most important prohibitions in Islam. The Koran envisages an increase in capital through mutual trade and therefore interest or interest-like incomes and expenses are prohibited. The ban on interest is also mentioned several times in the Sunnah. The interest here means only interest on money as rental income and profits are welcome. The interest prohibition is relevant for the consumer both in regards to saving and borrowing. The fixed rate of interest for deposits/savings is forbidden in Islam. Bonds are also prohibited, since interest is paid in fixed amount to the buyer, regardless whether a profit or loss has been generated. Instead, a proportional payout of profits has been established. According to some Islamic scholars, it is permissible to borrow loans against interest payments in emergencies. There are different opinions among the religious scholars about 'Western' mortgage loans. The ban on Riba is based, among many others, on: Sura 3, verse 130, " O you who have believed, do not consume usury, doubled and multiplied, but fear Allah that you may be successful." 19 A more detailed treatment of the riba is represented by the verses of Sura 2:" 20 Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns to [dealing in interest or usury] - those are the companions of the Fire; they will abide eternally therein.

8 Arbun Arbun is a deposit of a buyer, which is payable to the seller after approval of the sales contract, which is not refundable. The down payment serves as a security so that the purchase contract is fulfilled at the specified time. Bai Salam In the case of the form of contract of Bai Salam, payment is made in cash, but the goods will be delivered at a later date. It is important to describe the ordered goods precisely in quantity and quality. The exact delivery date and the delivery location must also be recorded. This form of contract was introduced mainly for farmers who were able to grow products and feed their families before harvesting. Gharar The term "Gharar" means uncertainty or risk under a contract and it has an important meaning in regards to derivative transactions. The prohibition of excessive speculation is one of the pillars of Islamic banking. In order to minimize the risk of Gharar, contracts must be defined precisely for both contracting parties. Moreover, the contract must not be linked to an uncertain event, in which one does not know beforehand whether it occurs or not. Therefore a lack of transparency and incompleteness are a sign of Gharar. On the other hand, the Islamic law schools recognize that successful economic activity is associated with corresponding economic risks. However, the short-term purchase and sale of shares with the aim of realizing short-term price gains is not permitted according to a broad scholarly opinion Ijarah

9 Ijara is the renting or leasing of a property. The bank allows its customers to use a certain asset. The bank remains to be the owner until the end of the contract and, depending on the form of the contract, she receives a fixed leasing rate or a share of the profit generated from the use of the asset. Istisna The term Istisna refers to an industry supply contract. In the context of Islamic banking, the term Istisna refers to the financing of non-finished items. According to Islamic law, only existing goods can be acquired. In the case of an Istisna financing, a contract is concluded in which the project or the item is described in detail. Payment may be made either at the end of the term or in installments. Maysir/Qimar The word Maysir means gambling or betting. These are strictly forbidden in Islam. In addition, contracts which constitute a bet between the issuer and the buyer or investor are prohibited because they ultimately generate a winner and a loser and are economically unproductive. Under Islamic law, only goods which already exist and are the property of the seller may be sold. Derivative transactions are therefore only permitted if they are used to hedge a transaction and short-term sales are particularly prohibited. Likewise, conventional insurance is not permitted because it could be considered a bet between insurer and policyholder on the occurrence of a claim or about the death of the policyholder. Mudaraba In the Mudarabah model the bank is a shareholder in a project of the customer. The bank invests as an asset manager the deposits in Sharia-compliant enterprises, whereby with the economic success of the enterprise the bank and the investor receive a previously fixed share of the generated income of the enterprise in addition to the complete repayment. The customer is solely responsible for the entire business and the bank has no influence on the management. The distribution in case of profitmaking must be defined at the beginning. In the event of loss, only

10 the investor - in this case the bank - bears the risk. Mudarabah is therefore financed in the form of a silent partnership. These accounts can lead to losses for the investor, but Islamic banks usually invest these funds very cautiously. Musharaka Musharakah is the second form of equity-based financing, whereby banks = capital providers and entrepreneurs are jointly involved in financing a project and jointly manage them. Both parties to the contract are liable for the company and for the risks according to their capital shares. Murabaha/Wadiah Principle Murabaha describes a form of contract in which the bank buys a good for herself or the customer is charged with the purchase of the goods on her behalf. After the transfer of ownership, the bank then enters into a purchase agreement with the borrower, whereupon the latter purchases the object of the bank at a premium and pays later and / or in installments. The individual investor is then involved in the average return on all such credit transactions. The bank acts as intermediary. Here, as in the 'western' banking system, there are savings and long-term investments. However, the customer does not receive fixed interest rates for his deposits, but deposits are also subject to profit distribution, depending on the specific design. At the start of the contract, a key is defined according to which the returns from the bank's credit portfolio are distributed between the bank and the customer after deduction of the fixed product costs. Regarding the allocation of funds in Islamic banking the Murabaha due to being close to being an external financing - has the most important relevance. Sharia Board Sharia Board is also known as the Ethics Council. The Ethics Council is a religious supervisory board, which is responsible for monitoring the Islamic conformity of the products. Sukuk Sukuk are Islamic securities where no interest is paid on the invested capital. Instead of an interest payment, investors receive income from investments. It can be compared in a simplified way with a covered bond or with a profit participation certificate. Each Sukuk is based on the

11 securitized ownership of real assets. The volume of the issue is limited to the value of such assets. According to his share, the buyer of the Sukuk receives a percentage of the often variable income from the utilization of the assets. In the case of real estate, for example, the customer receives his share in the form of proportionate rental income. Here, too, the investor does not receive a fixed interest rate. By investing in real-world values, Sukuks are less vulnerable to a separation of the market from the real economy. Takaful The term Takaful refers to an Islamic insurance that works similar like a cooperative. Conventional insurances are largely rejected by Islamic jurists because, in strict interpretation, they violate the prohibition of 'maysir' (as in gambling: there is a winner and a loser). In addition, the financial investment of life insurers in particular violates the interest ban. A Sharia-compliant form of insurance is 'Takaful', the mutual guarantee. A community of insured parties does not only share the risks, they also share the company's profit (assurance of reciprocity). It is similar in principle to the German insurance association on reciprocity. At the Takaful, all policyholders are simultaneously co-owners of the pool of deposits from which the insurance services are paid. If the benefit payments exceed the pool holdings, the insurance company prepays the deficit without interest. Sarf, 21 Bay al-sarf is a contract of exchange of money for money. This contract is tightly regulated under Sharia because it can be easily manipulated for the purpose of producing an interestbearing loan, which is prohibited in Islam. Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, match for match, hand to hand. Whoever wants more or more, has already run an interest business. The beneficiary and the debtor are (in debt) the same. 22

12 Based upon the above hadith, it is established that if gold is to be exchanged for gold, the exchange must be made on the spot, with the amounts being of equal quality and quantity. Because both counter values must be settled immediately, a forward transaction (in which one of the counter values is delivered at a future date) is not allowed. Other scholars argue that if the monetary system were correctly designed, then money would comprise gold and silver throughout the world (i.e. American money would be made of gold, Malaysian money would be made of gold, etc.) and hence there would be no need for foreign exchange in the first place. Here, the arguments over the Sharia position on modern foreign exchange and currency trading are seen to arise because these markets are of themselves built upon un-islamic foundations. Pros and Cons Islamic Banking From a customer perspective many approaches of Islamic banking are theoretically positive based on the principles of overall social benefit and the possibility of a genuine partnership between customer and the banking provider. Because of the relative youth of Islamic banking in our times, it will be necessary to see to which extend transparency prevails and whether commandments of the Quran against outsmarting clients are circumvented with the individual products or not due to the many different Islamic jurisdictions and denominations as well. In the global market of Islamic banking products, there will be certainly examples for both. Because deposits an economic comparability with traditional Western deposits is only partially possible as it can only be conducted in retrospect, the returns on the Islamic deposits are variable in principle and they are also influenced by other factors than the known ones from conventional Western banking. The KT Banks states regarding this: KT Bank promotes the real economy by covering every transaction with a good. This ensures that economic savings are channeled into the real economic sector. KT Bank invests the funds of its investors in industry and trade while sharing the success of the customers. Islamic banking is thus a part of the SRI (Socially Responsible Investment) sector and it stands for sustainable, integrated and responsible investment. Fundamental principles, such as consistent risk management or good corporate governance, apply to both the Islamic and the Western financial systems and help ensure a secure and viable international banking system. As a contemporary Islamic bank, KT Bank is open to all customers

13 who are looking for a socially responsible and sustainable financial service provider - regardless of nationality or religious affiliation. 23 The Sharia-compliant security of deposits is still a question in the various ( not only Islamic) jurisdictions. However, the Islamic KT bank in Germany has been admitted as a member of the compensation institution of German banks. The deposits are therefore secured up to EUR 100,000 per person 24. At the same time this coverage constitutes a theoretical deviation from Islamic banking, which obviously emphasizes the possibility of a loss as much as of a profit. An insurance against loss simply reeks of Maysir. Special offers to Turkish-speaking consumers in Germany are, for example, in the same vein as they do not automatically mean Islam compliant offers just because they are presented in the language of the biggest Muslim group in the country. The basic principle of the Islamic insurance, the Takaful, might be quite useful from the point of view of the customer due to the absence of casino capitalist investments into derivatives at the stock market. However, particularities for the participation in surpluses and the financing of losses must be closely examined. The administration of Takaful policies is relatively complex, which could make them more expensive than traditional policies. The fund-linked pension insurance schemes offered by conventional insurers could no longer be considered Shariacompliant as they are mainly interest-based. In the eyes of a Western financial professional these Islamic guidelines increase the risk of the investor, particularly in the case of long-term investments which correspond in all respects to the principles of Islamic criteria. There are no pre-payments in the form of interest and one may have to wait five or ten years for a profit to be made and one does not know whether said profit is high enough relative to the investment or not. Accordingly, short-term investments are probably preferred. The assumption is that the motivation is not different from the traditional Western banking system in "Islamic Banking": one is looking for an acceptable investment with the greatest possible risk avoidance. These questions have let Swiss banks to even cut back on Islamic banking: Stefan Leins 25, Ethnologist and Specialist for Islamic Banking, sees two reasons why Swiss Banks are not counting in Sharia-compliant financial products anymore. One one hand the financial resources became sparse because of the financial crisis, explains Leins. The funds for expansion into new fields of business is missing.

14 On the other hand, the success did simply not come true as it was hoped for, says Leins. Many banks had considered Islamic Financial Products as cash cows that bring swiftly huge monetary profits. Perhaps, there was simply some patience missing. However, the private bank Sarasin still counts on Muslim customers. According to her own statements she is the Swiss bank with the vastest assortment of own Islamic Financial Products. Fares Mourad, the head of Islamic Wealth Management at Sarasin, believes the division has further growth potential. This is all the more so since governments in countries such as Tunisia or Egypt have adopted new legal framework conditions for Islamic finance in the course of the Arab Spring. "This is a strong signal that Islamic Finance will gain in importance in the future," says Mourad. "The most important factor at present," says Tarik al-rafai, vice-president of the Islamic department of the US-American HSBC, "is to offer as many products as the market demands." For him, Islamic banking is first and foremost a way to appeal to a new clientele: "From the marketing perspective, compatibility with the Sharia brings customers into the bank. Religious principles pay off." 26 The Swiss financial center could also learn from the principles of Islamic finance, believes Leins. The greatest advantage is in the double supervision. "Financial products are judged not only by economic criteria, but also by ethical considerations." This principle has now been adopted by some financial institutions - for example, investment funds with an investment strategy geared to ecological or ethical aspects.. 27 Conclusion Interest on the interest is certainly one of the core evils of our economy as it distributes wealth on the one and poverty on the other hand exponentially. There are quite reasonable considerations why we should stop using interest, says Warren Sofies, a British Financial Expert. "Interest can be an impediment for the creation of work places, interest may create financial crises and aggravate problems in trade." 28 It seems that Islamic Banking in essence tries to implement a kind of basic natural law, which reads that the one who invests either profits or loses and that there can be no accumulation of wealth without taking some risk, which is detrimental to Western Banking that usually favors

15 risk free wealth accumulation in the higher echelons that are only threatened by outright fraudulent activity like Bernie Madoff s 29 but nearly never by normal market mechanisms. Regarding Sharia-compliant financial products there is so far a lack of sufficient information to assess all risks because of the young age of this form of banking. For Sukuks (funds), it has to be examined whether the ownership of Sukuk holders regarding the collateralized assets is sufficiently legally secured. The liquidity of Sukuks is on average much lower than that of conventional bonds. In the equities area, the Islamic-motivated stock selection limits the possible spread of equity investment. However, the Islamic-ethical substance of the products is quite different depending on the product class and supplier. For example, Murabaha, which is oriented towards Western reference rates due to their sheer dominance, is regarded as just being tolerable by many Islamic scholars and more often than not it seems a critique of word plays instead of really working without interest under Islamic law the use of interest is prohibited so any apparent resemblance to interest should be avoided. This study seeks to identify other suitable benchmarks, which could be used as an alternative to LIBOR, and LIBOR equivalents. 30 The problem is that there is no central, global Islamic authority that officially regulates what is permitted by religious principles ("hallal") and what is forbidden ("haram"). Islamic financial institutions are usually consulted by a religious consortium that interprets the Quran, the Hadiths, and the Prophet's life story (Sunnah). Examining the almost 1400-year-old texts for modern compatibility is not always easy for the Islamic legal scholars and the interpretations differ from case to case. In the meantime, there is a very extensive literature on the Law of the Islamic financial system, but a uniform, overarching legal instrument is not in sight. Aggravating to the fact are the various different Islamic nations with all their differing and deviating regulations that are all but codified or at least unanimous. It is noteworthy that nearly all Islamic countries have central banks with benchmark rates, apart from Iran. Decisive incentives for Investment in Islamic Banking are the ever increasing market shares and the sheer volume of Islamic wealth. According to the Association of Arab Banks, the total Islamic wealth of a total of 265 institutions amounts to around 260 billion, the financial investments amounts to about 400 billion and the banks assets are about 202 billion dollars. The branch is growing by 15% a year. "The number of Islamic banks and investment funds has risen to more than 270, with assets of 260 billion dollars and deposits of more than 200 billion dollars," declared Saleh Kamel, chair of the General Council of Islamic Banks and Financial Institution 31.

16 References: 1 ellschaft NA-1-NA.html M. N. Siddiqi,1988. 'Islamic banking: theory and practice', in M. Ariff (ed.)

17 8 ez3saqlmk7ee and mic_finance.html

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