Islamic Banking

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Islamic banking with reference to ADCB

Transcript of Islamic Banking


The project is based on the study of Islamic Banking. An Islamic concept of banking which is based on profit & loss sharing and forbids interest (Riba) and thus is totally different than the conventional banking which is based on interest.

As dealing in interest has been forbidden In Islam this type of banking has been very popular in the Muslim populated countries like those in Middle East and has also grown interest in Europe & America although in India it is still in the embryonic stage.

The project gives details on why Islamic banking is practised, the history of Islamic banking when it started and also describes the tools on which the banking system operates like Mudarabaha, Musharaka, Wadia, Ijarah, Istisna etc. The project also speaks about Equity funds & its application while being in the constraints of islam, and also sheds some light on Taqaful the Islamic way of insurance which can act very similar to the present insurance concept of insuring human lives and commodities while being in the boundaries of Sharia.

To see all these Islamic financial techniques working in practice a study on ADCB AMANAH was made. ADCB AMANAH is a global financial division of ADCB Group working on Islamic principles and serving to the needs of people in Middle east, Europe, USA & some Asian countries ( not available in India).ADCB Amanah has developed very competitive financial services compared to conventional banks by using various Islamic financial techniques. It has also developed Islamic Credit Cards which are one of there popular products. ADCB Amanah is also considered to be one of the banks strictly following the Islamic Sharia and has a board of Islamic scholars on its panel to take care of its activities.

Islamic banking was chosen as a project to know the best of it and also to introduce this rather alien topic to masses here.

Chapter 1: Introduction

Islamic banks appeared on the world scene as active players over two decades ago. But "many of the principles upon which Islamic banking is based have been commonly accepted all over the world, for centuries rather than decades". The basic principle of Islamic banking is the prohibition of Riba- (Usury - or interest).Since the mid 1970s Islamic banks have been growing at a very fast rate. This banks were not only established in the countries were Islam is the major religion like Egypt, Syria , Jordan ,United Arab Emirates, Bahrain ,Kuwait Tunisia & Malaysia. But also in the United Kingdom, Denmark & Philippines where it is a minority religion. An International Islamic bank, The Islamic Development Bank, whose share holders are the members of the Organisation of Islamic Conference (OIC), acts as the sponsor of Islamic banking and finance in the wider Muslim world. This is in addition to the efforts made in the early 1980s by Pakistan and Iran to transform the entire financial systems to interest- free (Islamic) systems.The Islamic Banking institution is a new and constantly evolving concept. In relation to the Western way of banking, the Islamic Banking system is free of interest. One might wonder what the incentive to lend money would be. Others may not understand what benefits could be had by putting their savings into a bank account. While Muslims do not believe in charging or earning interest, they have developed a very complex alternative that is being implemented all over the eastern world. Started from just an idea, this new way of banking quickly spread through the Muslim countries, and has continued to expand all over Europe and Asia. Although the system is proving to the West that it can work, it is still trying to iron out some of the inefficiencies that it currently has. Once the system is more efficient, it will be better able to provide its members with a stock market that works in the same efficient way as it does here in the West. While a basic tenant of Islamic banking - the outlawing of Riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.

1.1The Basic PrincipalIslamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).All Islamic Banks have three kinds of deposit accounts: current, savings, and investment. In the case of current accounts, the deposit is guaranteed. In terms of savings accounts, they can be dealt with in a number of ways. In some, the banks are allowed to use the depositors money but they are guaranteed to get the full amount back from the bank. In others, it is thought of as more of an investment type account. The capital is not guaranteed, but the money is invested in low-risk securities, which could also provide a profit. For an investment account, deposits are accepted for a fixed or unlimited period of time. The investors in these types of cases agree in advance to share with the bank their profit or loss. Their capital is not guaranted.Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. 1.2 Largest Islamic banksShariah-compliant assets reached about $400 billion throughout the world in 2009, according toStandard & Poors Ratings Services, and the potential market is $4 trillion.Iran,Saudi ArabiaandMalaysiahave the biggest sharia-compliant assets. In 2009Iranian banksaccounted for about 40 percent of total assets of the world's top 100 Islamic banks.Bank Melli Iran, with assets of $45.5 billion came first, followed by Saudi Arabia'sAl Rajhi Bank,Bank Mellatwith $39.7 billion andBank Saderat Iranwith $39.3 billion.Iran holds the world's largest level of Islamic finance assets valued at $235.3bn which is more than double the next country in the ranking with $92bn. Six out of ten top Islamic banks in the world are Iranian. In November 2010,The Bankerpublished its latest authoritative list of the Top 500 Islamic Finance Institutions with Iran topping the list. Seven out of ten top Islamic banks in the world are Iranian according to the list.

1.3Difference between Islamic banking and Conventional banking

Lets first discuss about the Conventional banking. Conventional banking does not follow one pattern. In Anglo-Saxon countries, commercial banking dominates, while in Germany, Switzerland, the Netherlands, and Japan, universal banking is the rule. Naturally, then, a comparison between banking patterns becomes inevitable.

Commercial banking is based on a pure financial intermediation model, whereby banks mainly borrow from savers and then lend to enterprises or individuals. They make their profit from the margin between the borrowing and lending rates of interest. They also provide banking services, like letters of credit and guarantees. A proportion of their profit comes from the low-cost funds that they obtain through demand deposits. Commercial banks are prohibited from trading and their shareholding is severely restricted to a small proportion of their net worth. Because of the fractional reserve system, they produce derivative deposits, which allow them to multiply their low-cost resources. The process of bank lending is, however, subject to some problems that can make it inefficient. Borrowers usually know more about their own operations than lenders. Acting as lenders, banks face this information asymmetry. Because borrowers are in a position to hold back information from banks, they can use the loans they obtain for purposes other than those specified in the loan agreement exposing banks to unknown risks. They can also misreport their cash flows or declare bankruptcy fraudulently. Such problems are known as moral hazard. The ability of banks to secure repayment depends a great deal on whether the loan is effectively used for its purpose to produce enough returns for debt servicing.

Even at government level, several countries have borrowed billions of dollars, used them unproductively for other purposes and ended up with serious debt problems. Banks can ascertain the proper use of loans through monitoring but it is either discouraged by clients or is too costly and, hence, not commercially feasible. Hence, why the purpose for which the loan is given plays a minimal role in commercial banking. It is the credit rating of the borrower that plays a more important role.By contrast, universal banks are allowed to hold equity and also carry out operations like trading and insurance, which usually lie beyond the sphere of commercial banking. Universal banks are better equipped to deal with information asymmetry than their commercial counterparts. They finance their business customers through a combination of shareholding and lending. Shareholding allows universal banks to sit on the boards of directors of their business customers, which enables them to monitor the use of their funds at a low cost. The reduction of the monitoring costs reduces business failures and adds efficiency to the banking system.

Following the above logic, many economists have given their preference to universal banking, because of its being more efficient. Commercial banks are not allowed to trade, except wi