ISLAMIC BANKING AND FINANCE

Dissertation: Islamic Banking and Finance in the Contemporary World

Program: Ex-PGP (2001-04), XLRI, Dubai Campus

ISLAMIC BANKING AND FINANCE

IN THE CONTEMPORARY WORLDDISSERTATION

Shakeel Ahmad (shakeeluae@gmail.com)Facilitator: Dr. H. K. Pradhan (pradhan@xlri.ac.in)

Executive Post Graduate Program (Ex-PGP) in Management

XLRI (http://www.xlri.ac.in), Dubai (http://www.xlri-dubai.net/)

Approved for submission: February 2004

Acknowledgements I am grateful to Dr. H.K. Pradhan, my guide, for his continuous encouragement that enabled this study of a subject that had remained within my heart, since early ages. His teachings of International Financial Management provided insights beyond theoretical concepts, and his friendly style inspired the quest for excellence. I am thankful to XLRI, an institution that provided me with the opportunity to pursue this post graduate study in management, for which this dissertation project was undertaken.

I take this opportunity to express my sincerest gratitude to all the members of Islamic Banking and Finance Community (IBFnet) in the Yahoogroups mailing list. Islamic finance community has worked hard in providing a wealth of resources on the internet. They deserve appreciation and rewards from no less an entity than Allah SWT Himself.

Special thanks go to Dr. Obaidullah, the IBFnets founder. This dissertation work would not have been possible without the special help and encouragement from Dr. Shahid Ebrahim it is difficult to express my special thanks for him, in a few words.

Finally, the time that I devoted on the Ex-PGP, and this project, was taken away from my family whose support acted not only as facilitator but also was a source of continuous inspiration.

Exploratory Channel:

SequenceTitlePage

1Introduction3

2Why Islamic Banking?4

3Islamic Banking and Finance (IFB) Sector, now6

4Why is Islamic Banking and Finance (IBF) creating ripples?6

6Literature Review7

7Islamic Banks10

8Brief History11

9Concepts behind Islamic Banking and Finance13

10Distinguishing Features13

11Role of Islamic Banks14

12Prohibition of Interest14

13Table-2: Comparison between Riba and Profit15

14Table-3: Differences between Islamic & Conventional Banking16

15Key Islamic Financial techniques/ Products17

16Box-1: Islamic Financial Instruments19

17Islamic Derivative Products21

18Advantages of Islamic Finance21

19Box-2: Landmark Islamic finance deal inked23

20Perceived Disadvantages of IBFs24

21Impediments to the growth of IBFs24

22Recommendations to counter Impediments to growth of IBFs36

23Latest Developments38

24Box-3: How Islamic is Bank Negaras IIMM?40

25Islamic Bonds (Sukuk) Funds41

26Box-4: Conventional Investors find Islamic Bonds attractive41

27Box-5: US$250 Government Islamic Leasing Securities42

28Box- 6: Islamic Development Bank launches bond issue worth $400m43

29Box-7: Latest Trends & Challenges45

30Box-8: Bahrain: LMC to issue $1.2b bonds46

31Rating Agencies48

32Basel II Implications49

33Important Institutions49

34Conclusion51

35References54

36Appendix-A0: Estimation of TAI for UAE59

37APPENDIX-A: Competitiveness of Banking Sector In Case of Opening Local Markets to GCC Banks59

38APPENDIX-B: Islamic Financial Institutions in the World61

39APPENDIX-C: Islamic Equity Funds in the World

68

40APPENDIX-D: The Dow Jones Islamic Market Indexes72

41APENDIX-E1: Assets, Deposits and Loans of 53 Conventional local Banks in GCC73

42APENDIX-E2: Assets, Deposits and Loans of 8 Islamic local Banks in GCC74

Introduction: To start with graphics may not be a novel idea, but if you are associated in any way with promoting deposits or instruments of a conventional bank anywhere in the world, these graphics must already have left some alarm bells ringing in your mind. 32.83% CAGR in Deposits and 24.69% CAGR in total assets over a four-year period in a country which was written off the books of financial wizards and stock-market punters after the Asian Currency Crisis. In figure1, the rapid rise can be seen not in one aspect but in all major aspects of banking and finance reinforcing the belief that the growth rate witnessed was an all encompassing one. The question that arises at this moment is whether this growth rate is sustainable. An answer to that would be premature without looking at the reasons behind this phenomenon, and whether the same success story is repeated anywhere else in the world.We will try to answer some of the above questions, and also try to see if the growth in Islamic banking and finance sector could have been better. If yes, we will try to peep into the reasons behind less than expected growth.

Much has been written by historians about the feudal lords who by virtue of charging high interest rates controlled those in desperate need to finance their survival. Financial clout led to political clout and ended up in enslaving the masses. Before the historians touched upon this exploitation of the masses, religious scriptures had already warned of usurious acts existing in the society.

In the Old Testament (King James Version), Exodus, Chapter 22, verse 25:

If you lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury.

Leciticus, Chapter 25, verses 34-36:

And if thy brother be waxen poor, and fallen in decay by thee; then thou shalt relieve him: yea though he be a stranger, or a sojourner, that he may live with thee.

Take thou no usury of him, or increase: but fear thy God; that thy brother may live with thee.

Why Islamic Banking? The New Testament also contains edicts on the same line. Thus the very mention of usury and the suggestion to avoid indulging in this act in Judaism and Christianity implies its existence in ancient times and the ills that it carried along for the society.

Despite the warning against this practice, the system prospered. Modern financial system learnt a lesson from these religious warnings and tried to adopt a system that limited the extent of usurious exploitation to a great extent. By creating a market for debt, based upon perfect competition, it propounded an end to exploitative nature of usury and thus evolved the system of interest rates which was supposed to be determined by the market forces freely competing with each other. What we see today is an expansion of the ancient feudal system into a global arena with nations facing the same plight as did individuals earlier.

From the traditional Jewish lending system of the Shylocks to the Indian feudal system, there is no need to strain our memories much. What is definitely cause for stress is the false claim of the contemporary world order to have relieved the masses of this burden of debt. Figures 2a and 2b show how countries, instead of individuals, are getting trapped into slavery. There is no doubt that Debt to GDP ratio is a robust indicator of the Debt burden of countries. If we compare the ratios that triggered the 1980s Debt crisis with the levels being experienced, now, we can see that the situation is no better, and could be enough cause for the unipolar world of the day. Despite the claim that modern interest-based system is not exploitative or usurious, because the interest rates or debt-service payments are within limits, Figures 2c and 2d provide a different picture altogether.

The transition of the world from a multipolar world order to a unipolar one has not been without pain and suffering. It is not easy to emphatically pronounce that the cause for this has been the interest-based system, but nobody should doubt that the cause has been the financial system as a whole. Interest-based system is one component of the economic system where the concept of money itself, as a worthless piece of paper carrying immense power, may be ill-conceived.

Fig-3a and 3b: Interest rates and export prices in Latin America (1972-1986)

Source: Andres Bianchi et al., Adjustment in Latin America, 1981-86, in V. Corbo, M. Goldstein, and M. Khan, ed., Growth Oriented Adjustment Programs, Washington, D.C.: International Monetary Fund and The World Bank, 1987.Similarly, the argument that low interest rates cannot cause countries to lose their sovereignty also does not hold much ground. The diagnosis of the Debt Crisis of early 80s suggests that even low interest rates (Figure-3a), acting as a trap (particularly when they are floating rate, as majority of debt was) could cause countries to come down to their knees. Flushed with funds, due to the sharp oil price increase in 1973-74 leading to booming deposits by Oil-rich countries, international commercial banks were eager to lend at lower interest rates enticing the third world to borrow more and more. The debt burden measured by Debt-to-GDP ratio (Fig-2b) is an indication of the inevitable crisis that was waiting to happen.

The urge to have a system that claims to provide a solution to such financial crises grows after every financial (monetary, exchange rate, stock market or Debt) crisis. It is not hard to understand that if the value of money carried its real worth, currency crises could be avoided. If the paper being traded in stock exchanges were actually trading at their genuine value, with no speculation, bubbles that occasionally burst would not exist. If the interest-free banking system could see the light of the day, no debt-crises would occur, as all the financing would be PLS (Profit-and-Loss S