Islamic banking

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It's Instruments to reduce the effects of interest rates,comparison with day to day commercial banks.

Transcript of Islamic banking

  • 1. DISSERTATION 14395 1 A critical comparison of Instruments of Islamic banking with the commercial banks in the United Kingdom. By Mohammed Zaki Department of Finance Dissertation prepared for the partial fulfillment of the requirements for the Masters of Business Administration 19th September 2011

2. DISSERTATION 14395 2 Declaration This Dissertation is a product of my own work and is not the result of anything done in collaboration. University ID-1092227297575 Student Signature.. Date. I agree that this Dissertation may be available for reference and photocopying, at the discretion of the university of Wales institute, Cardiff. Student signature.. Date Mohammed Zaki 3. DISSERTATION 14395 3 ABSTRACT The present dissertation topic A critical analysis of Islamic banking instruments with Commercial banking in the United Kingdom has been attempted so as to analyze the basic differences in the principles of these two systems of banking. The data reveals that basically the Islamic banking operates on the principles of interest free banking with a participatory system of sharing of profits and losses with its clients. Conventional banking in Britain works on interest charging as its basis of finance. Although Islam has prohibited Riba (interest), the question still remains whether it is the same as the bank interest. There are a number of Islamic banks and Islamic Windows in commercial banks in the United Kingdom. Profit and Loss Sharing principle applies to some major instruments of the Islamic banking system such as Musharaka and Mudarabah and cost plus profit is applied to Mudarabah.It is argued that Murabaha is not entirely based on Shariah and Mudarabah though permitted has great disadvantage attached to the financier. On the Savings account there is no bank guarantee on the return of principle as per Shariah law. Critical differences between Islamic and Conventional banks on the whole reveal that profit and loss sharing system may have greater beneficiary effect upon society than interest based finance. The future of Islamic banking in the United Kingdom seem bright on account of the fact that there is a large Muslim population in Britain who want to do financial transaction preferably through Islamic banking in order to satisfy their religious principles. Further the data also reveals that Islamic banking has fared better during economic crisis in the recent past. This research recommends that in view of the benefits associated with the interest free system of banking, it may be encouraged in its true Shariah form or through a system of Binary Economy where the products are managed with out involving interest as in conventional banking. 4. DISSERTATION 14395 4 Table of Content Introduction 11-17 1.1 Purpose and main objective 12 1.2. Background and preliminary scene setting 13 1.2.1. Emergence of conventional banks in United Kingdom 13 1.2.2. Islamic banks in UK 14 1.3. Instruments of Islamic banking 15 1.4. Outlines of the subsequent chapters 17 Literature Review 18-48 2.1. Britains First Islamic Bank 18 2.2. Principles of Islamic Banking System 19 2.2.1. Practice of Interest (Riba) In Early Arabia 19 2.2.1.1. Riba Al Nasiah 20 2.2.1.2. Riba Al Fadal 20 2.2.1.3. Injunctions against Riba in the Quran 21 2.2.1.4. Ill Effects of Riba 22 5. DISSERTATION 14395 5 2.2.1.5. Comparison between Riba and Trade 23 2.3. How Does Interest Affect Us 24 2.4. Profit And Loss Sharing 27 2.4.1. Instruments of Islamic Banking 28 2.4.1.1. Deposit Accounting 28 2.4.1.2. Investment Financing 28 2.5. Critical Evaluation of Islamic Banking Instruments 35 2.5.1 Murabaha V Conventional Loans 35 2.5.2 Profit And Loss Sharing 36 2.6. Differences between Islamic and Conventional Banking 37 2.6.1. Differences in Concepts and Operations 39 2.7. Risk Management 41 2.7.1. Risks Involved In Islamic Banking 41 2.7.2. Risk Management by Conventional Banks 43 2.8 Future of Islamic Banking in UK 44 Methodology 49-54 6. DISSERTATION 14395 6 3.1. Sourcing data 49 3.2. Data collection 49 3.3. Qualitative data collection 51 3.4. Quantitative methods 51 3.4.1. To observe ethical procedure and obtain relevant data 51 3.5. Sources of secondary data collection 52 3.5.1. Advantages of quality data 53 3.5.2 .Reasons for preference 53 Data Analysis 54-67 4.1 .Equating riba with bank interest 55 4.1.1 .Critical analysis of profit and loss sharing 56 4.1.2 .Difficulty in implementation 56 4.2 .Critical review of instruments of Islamic banks 57 4.2.1. Murabaha 57 4.2.2 Diminishing Musharaka 57 4.2.3. Modarba 59 4.2.4 .Savings account 59 7. DISSERTATION 14395 7 4.4. Critical differences between conventional and Islamic banks 63 4.5. Risk management by Islamic and conventional banks 64 4.6. Future of Islamic banking in Britain 65 Conclusion 69-74 5.1. Interpretation of Shariah Law 71 5.2 Conventional Banking 72 5.3 Constrains and Challenges of Islamic Banks in the UK 72 Recommendation 75-77 Bibliography 79-86 8. DISSERTATION 14395 8 List of Figures Literature Review Figure 1-Basic Types of Growth Pattern 25 Figure 2-Constant Growth Curves 26 Figure 3-Examples of the Amount of Interest within the Normal Prices and Fees 27 Figure 4-Musharakah Contract 29 Figure 5-Profit Sharing Contract 31 Figure 6-Diminishing Musharaka 32 Figure 7- Murabaha 33 Figure 8- Global Assets of Islamic Finance 45 Figure 9-Islamic Finance by Country 46 Figure 10-Islamic Banks in UK 47 Figure11- Global Assets of Islamic Finance and Islamic Finance by Country 47 Figure12-Assets of Islamic Banks in UK 48 Data Analysis Figure 13-Before the Crisis 65 Figure 14-Initial Crisis Effect 66 Figure 15-Deepening Impact 67 9. DISSERTATION 14395 9 Figure 16-Country Wise market Share of Islamic Banking 68 Figure16.1- Global Islamic Funds Industry 68 10. DISSERTATION 14395 10 ACKNOWLEDGEMENT First of all I am grateful to the Almighty God for making me accomplish my dream of studying in London at the University of Wales. I am indeed grateful to my professor and guide Professor Jim Matthews who has very systematically guided me during the preparation of my dissertation work. His soft approach and timely guidance enabled me to go through the assignment in a methodical manner. I am very much grateful to my parents for their continued moral support and their constant prayers for my success. May the Almighty God give them health with a long life and happiness. I am thankful to my friends especially Mr. Sanjay, for helping me to adjust to the London atmosphere. 11. DISSERTATION 14395 11 INTRODUCTION Human behaviour over the ages has been guided by great religions of the world. Norms and standards have been set for man to follow a systematic way of life in tolerance, patience, perseverance and in all dealings with fellow human beings as well as with his surroundings .These standards and laws also extend to the economic areas which are the most vital aspect of human dealings. All great religious leaders and philosophers from the ancient Greece to the modern day have made a concerted effort to curb the evil of exploitation of the poor by the rich. However much, one might try to curb this monetary exploitation; this evil continues to persist in the modern society. Unfortunately feudal system of exploitation of exorbitant interest has now been extended into a global arena as a result of which many nations are facing the same plight as did individuals. Modern economists have predicted that the interest free banking would alleviate many of the existing financial problems facing mankind. The recent recession through out the world, especially in advanced countries is linked to the bad effects of interest on society. Thus according to Margrit Kennedy (1995), the reasons for the accumulations of huge debts and rise in unemployment and unrest are on account of interest and compound interest. Money should always be going into circulation rather than remaining in the possession of a few. This can be achieved by an interest free economy. Therefore it becomes necessary to examine this system now known as Islamic Banking more critically and compare it with Conventional banking. RATIONALE The principle area of research topic pertains to Islamic Banking .The most important aspect of Islamic banking system is that it is interest free and this is strictly in accordance with the Shariah which is the Islamic law. My interest in this topic is for finding the main principles of its operation as it seems to be gaining popularity among Muslims in London and would like to probe whether it could stand against competition from Conventional banking which has been in existence since a long time 1.1. PURPOSE AND MAIN OBJECTIVE: 12. DISSERTATION 14395 12 The main purpose of making this study is not only to know the critical differences but also to know the basis of its formation and popularity. The United Kingdom has been the major hub of banking system and it is but natural that Islamic banking which is comparatively a new idea has found its roots here. The main foundations are: Prohibition of Riba (Interest) Prohibition of Miser (Game of Chance) Prohibition of Haram (Illegal and unsociable activities) Payment of Zakat (Part of bank profits for charity), Sol (2007). Interest is designated as Riba in Islamic terminology and it would be necessary to explain Riba because it is based on this objection that the Islamic banks design all their products and activities. Also to detail the points based on which the scholars have come to a conclusion that Riba, the type of interest that was practiced in early Arab world, is similar to the interest as charged by the Conventional banks. Secondly, Islamic banks function on the basis of profit and loss sharing. Here the purpose would be to find its salient features, how does it applies to various instruments of Islamic banking and what is its short falls. Finally to get an over all assessment in comparing the Conventional and Islamic banking system