The time when recession was seen in Muslim countries and economically they were ebbing out; modern banking system was introduced, which was confined to capital cities because local community avoided the banks for religious reasons. The banks were established on interest based system so Muslims were abstainer. As the time went on it almost became impossible to refrain from bank interactions, this status quo incited the Muslim intellectual to lay an Islamic Banking System free of interest (riba).
The Islamic banking and Conventional banking is different in many ways.
Islamic banking is based on SHARIAH rules while conventional is based on debtor-creditor relationship. Principles on which Islamic Banking focuses on are:
- Riba Free transactions
- Avoidance of economic activities involving oppression
- Avoidance of economic activities involving speculation
- Introduction of Zakat, Islamic tax
Islamic law considers that a loan should be issued or borrowed free of charge. In Islamic Banking the creditor should not take any vantage of the borrower.
Money lent out on interest basis usually leads to inequity.
In conventional banking the investor is sure of interest based profit, in contrast Islamic Banking believes in PLS scheme that is Profit and Loss sharing scheme.
Lending money and getting it back with compounded interest is the common practice of conventional banking, Islamic banking focuses on participation in the partnership business because the status of the relation in conventional banking is of creditor-debtors while in Islamic banking it is more of partners, investors and traders.
Again as the relation in conventional banking is of creditor-debtor, this guarantees a fixed income so they give little importance of where the money is invested.
A conventional bank accepts all its deposits while in Islamic banking system it guarantee deposits on deposits accounts based on Al-Wadiah principle.
Looking into more details about Islamic banking accounts and why it is not practiced.
All Islamic banks have three types of accounts
This works as it works in conventional banking.
It acts in different ways in different banks. In some banks the depositor is allowed to take back a limited amount of money. In this account no profit is promised, they are similar in nature with investment accounts but have low stringent conditions. Capital is not guaranteed but banks take serious interest in investing this money in short term and relatively risk free projects.
They are accepted as fixed and long term, the investors agree in advance to share the profit or loss in a fixed proportion as agreed with the bank.
The modes of financing are
The investment and trade are modes of finance that usually does not trouble the investors or the bank.
The lending is done in 3 ways.
Loans with a Service Charge
The bank lends money at no interest but usually cover their expenses by having some service charges.
- No Cost Loans
The bank set aside a part of their fund to help out the needy customers, entrepreneurs, small farmers, producers and etc.
They are also provided free of charge.
It is based on the principal of no pain and no gain. You cannot gain any capital until and unless you do not share the risk involved in it. The capital provider or RABBULMAL invests through a borrower MUDARIB.
In this type the financing is done through equity participation. The partners or shareholders use the capital in any joint venture where the profit and loss is shared by both parties on a pre agreed formula.
In this type of transaction the bank buys an asset or behalf of its customer. The bank then adds a markup to the costing price which the customer pays at a certain fixed rate. This sounds more like the interest based conventional banking but the bank does have a certain risk in buying that asset from the seller and then again selling again to the buyer and they are liable if any thing goes wrong in this process because they are the owner of that particular asset.
They are charged higher prices for deferred payments but they are regarded as trade not as loans.
As far as the services are concerned, Islamic banking system provides you with all the facilities and service that conventional banking does.
The main problem for both the bank and customers lies in area of financing.
Bank lending is still in practice limited to either no cost loans including overdrafts or loans with only service charges. These type of loans bring zero income to the bank so they do not lean towards such approaches.
They are left with investment financing, which in Islamic banking system can be done through Profit and Loss Sharing (PLS) basis. This is the place from where main income comes and from where account holders are expecting a return.
It’s the PLS scheme which roots the problem in going for Islamic banking.
Theoretically the PLS scheme is very superior to conventional banking system but in real life implication this is not that golden as it seems to be.
The main issues are that participating on PLS basis involves time consuming complicated procedures, requiring experience and expertise. The bank lacks the experience and expertise and they do not want to indulge in long term projects because the investment is tied for long period and this would prompt higher risk.
Small businesses are a major part of country’s productive sector and a form of bank clients. There lie some problems in providing them with the necessary financing under PLS scheme.
Traditional banks do perform when large medium and long term loans are granted. Doing such detailed evaluation of investment to set PLS scheme like calculating the rates of return is beyond the orbit of conventional banking. Yet no consensus is been made on these principles due to unparallel nature of task along with huge amount of research work and need for experienced person to carry out them.
Another problem is that it needs a legal and tax framework. Islamic system offers its own framework that needs to be implemented. Islamic banks have over 60% liquidity which cannot be properly utilized due to non availability of shariah products and instruments.
Islamic banking concept is still immature in terms of implementation. It has some problems but main problem lies in financing.
Replacing Arabic terminology like ‘Ijara’ with leasing and ‘Mushraka’ with equity participation will lead to a greater understanding of Islamic banking system.
With little adjustment in their practice it can get rid of burdensome and doubtful financing terms and come up with a clean interest free based banking system.
Islamic bankers have sought are trying to avoid excessive risk by Murbaha, ijara, baisalam and other means.
All the above discussion does elaborates that Islamic banking is not a temporary phenomenon there are signs that they are here to stay long and prosper in a good way.
The Dow Jones Islamic market index does also indicates towards this growth of Islamic banking system.
Upcoming time this will not only attract Muslims but also the non Muslims, not for interest contradiction but for means of new financial networks that could gain more profits. One more thing that Islamic banking focuses is on the viability of project and evaluating periodically unlike the conventional banking where they only the size of collateral.
A project that is good but low in collateral size might be turned down by conventional banking but Islamic bank would grab it on PLS scheme.
This particularly plays a very important role in development of a country because here the Islamic bank acts as a catalyst. Currently the Islamic bank is focusing more on the short term projects which are least risky because for long term project they lack the expertise and they do not have any secondary market for financial market instruments and no back up institutional structure.
A solution could be to make specialized Islamic financial institutions such as Murabaha bank, Mudaraba bank and Mushraka bank which would compete with each other so they could provide the best possible services.
“There is always a difference between principles and practice”