Islamic banking, according to Lewis and Algaoud, is a financial system based on Sharia and associated ideas (23). Profits and losses are divided among the numerous stakeholders in this banking arrangement. The accumulation of interest is prohibited. The system appears to follow the idea of "no risk, no reward." Islamic banking is distinct from other types of financial transactions since it is governed by Sharia law. In the promotion of a model based on the Islamic faith, morals are adhered to. Practices that violate Sharia law are prohibited. Among them are investments in the alcohol and pork industries.
The author will present an overview of Islamic banking in this paper. The author will, among other things, assess the strengths and limitations of this system. The operation of the model will also be examined. The study will also investigate how the banking sector weathered the recent global economic crisis.
Islamic Banking: An Introduction
Islamic financial organizations adhere to religious tenets. Therefore, every financial institution must have a Sharia board (Rammal and Zurbruegg 4). Members receive training in Sharia law in order to better advise the bank. Islamic banking, in contrast to conventional institutions that lend money based on financial criteria, emphasizes investment and the "soundness" of a given enterprise. This method is also known as interest-free banking. It provides as an alternative to financial transactions based on interest. This system has become established in both Islamic and non-Islamic nations. It has expanded dramatically during the years. Some nations have even abandoned conventional banking to adopt this system.
The banking model can be traced back to the time of the Prophet Muhammad, whose wife engaged in trading. Egypt is considered the origin of the system before its diffusion to other nations. In this North African country were established the first local savings accounts (Rukhsar, Kamran, and Immamuddin 43).
Fundamentals of Islamic Banking
To achieve success in any project, a set of rules and principles must direct the actions of all involved parties. To this goal, every Islamic institution establishes an advisory council (Sharia Board). The council is open to anybody with training in Sharia law, including attorneys and religious experts.
The restriction of transactions that generate interest is the first and most essential principle of this type of banking. Muslims think that charging or receiving any type of interest is unethical. This notion is also known as Riba or Usury (Rukhsar et al. 42). When investors place a greater emphasis on the returns associated with their investments than on the welfare of their clients, they earn a substantial profit. Muslims, however, consider this technique as having a bad effect due to the investors' pursuit of self-interest. The abolition of the aforementioned riba is one of the reasons for establishing an Islamic financial system. In light of this, the borrower pays the bank simply what is owed. However, they may make additional payments as a gesture of appreciation.
Observance of ethical standards is another principle. Sharia law is utilized to decide whether or not a particular economic transaction is permissible. An further element that defines Islamic banking is liability and risk. In this scenario, it is expected that if one desires profits, they must also be willing to share risks. The majority of individuals are unwilling to participate. They are overcome by dread of losing what they already have (Banaji 53).
The final principle is concerned with moral and social ideals. The Quran encourages individuals to assist those in need. Therefore, financial institutions should strive to provide particular services to the underprivileged through charitable activities. Exemplary is the Quard Hasan. It is a sort of short-term funding given to persons in need, often for one year. The lender does not expect any return on such funds. Quard Hasan is available to anyone who want to study or pay for medical expenses. Money does not generate profits, in conclusion. It should only be used for economic development (Lewis and Algaoud 17).
Origins of Islamic Banking
In the early days of the Prophet Muhammad, banking activity were present. However, these activities were not developed sufficiently. After the establishment of conventional banks throughout Europe, interest-free banking ceased to exist. Mit Ghamr Local Savings Bank of Egypt's establishment altered the circumstances (Rukhsar et al. 63). The institution represented a fresh start for Islamic banking. It was founded in 1963. (Rukhsar et al. 63). There were two sorts of accounts available. One of them was a savings account that did not accrue interest. The second account was an investment account with profit sharing.
In nations such as Sudan, the expansion of the banking sector was linked to two 'periods.
The government's complete support was the first one. As a result of the government's withdrawal of support, the system subsequently faced a number of problems. In 1984, the government decided to convert all banking systems into Islamic institutions. As a result, there are no typical banks in Sudan today.
Dubai Islamic Bank was the first Islamic financial institution in history, according to Lewis and Algaoud (28). The establishment was founded in 1975. (Lewis and Algaoud 28). It expanded swiftly in both quantity and number. Today, more than sixty nations operate Islamic banks. The majority of them are based in Middle Eastern and Asian nations. There are no conventional banks in certain nations, such as Sudan and Pakistan, because they were all turned into Sharia institutions.
The founding of Islamic banks is primarily motivated by the promotion and development of religiously inspired financial services and products. The institutions serve as investment partners for anyone in need of capital to engage in Sharia-compliant enterprise. Following investment, the bank becomes a "part-owner" of the business. Consequently, clients live in fear of repossession, as they are in debt (Kayadibi 435). In spite of this, Islamic banking continues to be the only financial system that uses its funds to serve humankind. The institutions foster moral values because they adhere to Sharia law. They seek to improve the welfare of society's members.
Fundamental Techniques of Islamic Banking
The initial strategy is Musharaka (Banaji 65). Additionally known as equity participation. The basic principle is the division of earnings and losses (Banaji 72). The bank and the customer enter into a partnership. Both parties are entitled to business management responsibilities. It is observed that the shares owned by the parties impact the allocation of profits and losses.
Another strategy is Mudaraba (Banaji 53). Additionally, it is considered trustee financing. In Mudaraba, unlike Musharaka, the bank or investor gives all the necessary finances for a given project. After the completion of the project, the investor receives a portion of the revenues generated. There can be multiple lenders that share the profits and losses.
Murabaha or markup is another Islamic financial term. The parties involved meet and reach an agreement on the price of products and services. They eventually determine the profit margins. The agreed-upon amount is paid in installments. The transaction may involve a third party. A client may approach a bank in order to "buy" financing from the seller at a predetermined price. The client then pays interest to the bank. This practice is therefore discouraged. According to Sharia, both partners are required to share in the risk-taking. In this instance, though, the bank receives profits without incurring any financial risk (Kayadibi 434).
Ijara or lease comes last. In conventional banking systems, individuals lease property for a profit. However, this is not the case in Sharia banking. Islamic institutions can reach an agreement with a client to purchase an asset from the seller (Banaji 65). The client pays the bank in installments over a certain time period. The entire operation is predicated on profit sharing.
Islamic Banking in Malaysia
This country's system has a long history. September 1963, according to Rukhsar et al., marked the beginning of the banking model (72). In 1983, however, the first formal bank was founded. Islamic banks operate similarly to conventional financial institutions. The main distinction between them is that the former adheres to Sharia law. Malaysia was the first nation to implement two separate banking systems. Banking without interest has grown in this Asian economy. The process serves as a model for the development of international banks, such as Malaysia's Asian Finance Bank.
Islamic Capital Market is an additional component of this banking system in Malaysia (ICM). This market's growth led to the issue of Sukuk or Islamic bonds. The Kuala Lumpur Regional Centre for Arbitration was formed to address Islamic banking and finance-related issues (Kayadibi 433). In addition, educational institutes have been established to provide professionals certified to perform Islamic banking. Statistics from the Malaysian Central Bank suggest that during 2004 and 2005, the number of these banks climbed from 126 to 766. (Kayadibi 431).
Malaysia established Islamic banking as an alternative to conventional financial systems. However, mechanisms were implemented to distinguish it from traditional banks. The Islamic Banking Scheme (IBS) was created to assist businesses in offering Sharia-compliant financial solutions (Kayadibi 435). Malaysians of both Muslim and non-Muslim faiths have expressed interest in this financial system. It is acknowledged that the principles and values of the Sharia are applicable to all facets of human life. Lenders are not only investors seeking to increase their fortune, but also the borrower's friends and business partners.
The government of Malaysia is determined to establish a comprehensive Islamic financial system. Nevertheless, the system has experienced several obstacles. A small number of banks have embraced riba, which generates interest. These institutions are attacked for being unable or unwilling to comply to Sharia. As previously stated in this study, Mudarabah pushes for risk sharing. However, the majority of banks are risk-averse and profit-driven (Rukhsar et al. 48). Some non-Muslims who participate in Islamic banking disregard Sharia law. As a result, some individuals criticize Islamic banking as a means for the wealthy to amass wealth at the cost of the poor (Rammal and Zurbruegg 5).
Malaysian Islamic banking is regarded as one of the most progressive in the Muslim world (Rammal and Zurbruegg 3). To maintain this trend, however, the government should make measures to solve the issues listed above. Failure to address these obstacles could result in a situation in which the distinctions between Islamic and regular banking systems are eroded. Banking misconduct may have a negative effect on the Sharia's underpinnings. The development may alter the people's faith and belief systems. The goals of Islamic finance are distinctive and must be honored.
Islamic Banking in Pakistan
In order to meet their economic and religious requirements, Pakistanis opted to adopt a non-interest banking model. The system began operation in 1970. In 1980, though, it became more practicable. Initial efforts to promote Islamic banking were ineffective. In order to adapt the new paradigm, the state was necessary to eradicate riba. Despite this, the introduced financial system failed to fully incorporate Sharia principles, resulting in its demise. In 2001, when the government intended to promote Islamic banking, it was relaunched (Lewis and Algaoud 54). As a result of this determination, the government permitted Islamic banks to operate in the country. Additionally, conventional banks were permitted to establish independent branches selling Islamic financial products.
There are differences between Malaysian and Pakistani Islamic banking. In the former, institutions collaborate with other financial institutions. Pakistan presents a distinct scenario. All banks in this country operate according to Islamic financial law (Lewis and Algaoud 32). However, financial basics remain the same in both nations. During its embryonic phases, the banking sector in Pakistan faced similar obstacles to that in Malaysia. As an illustration, the number of these institutions was less than that of other banks.
Many individuals feel that non-interest-based banks can expand quicker than interest-based institutions. However, the dearth of certified and skilled workers hinders its expansion (Rukhsar et al. 62). People take advantage of the fact that penalties are considered a kind of interest and take a long time to pay off their obligations (Rukhsar et al. 53). To overcome this issue, late-payment penalties should not be structured to benefit the investor. Instead, they should be geared on enhancing the economy.
Effects of the Global Financial Crisis on Islamic Banking
Several causes precipitated the recent global financial crisis. They involve excessive and unrestrained bank lending over an extended period of time. The mortgage is an excellent illustration of this type of lending (Rammal and Zurbruegg 44). The crisis had a greater impact on conventional banks than on Islamic organizations. The latter demonstrated some resiliency during the trying times. Scholars feel that a lack of discipline among interest-based banks was also a significant cause of the financial catastrophe. As previously stated in this study, Sharia promotes the distribution of earnings, losses, and risks. Other banks do not observe this principle. Islam considers violation of this requirement a kind of pecuniary and moral injustice (Rammal and Zurbruegg 66).
Compared to conventional financial institutions, Islamic banks were negatively affected by the global financial crisis in terms of losses. It is a truth that interest-based banks were impacted by the economic collapse, although they did not sustain as severe losses as Islamic institutions. Despite this, Islamic banks are believed to have contributed to economic stability during the crisis. A substantial portion of their portfolio was held by consumers who were less impacted by the economic crisis (Rukhsar et al. 54). The crisis enabled Islamic banks to recognize and concentrate on system-specific difficulties.
Islamic Banking and Future Prospects
In Islam, all forms of profit-making are forbidden. This premise underpins the future of Islamic banks. Therefore, this type of financial transaction is considered interest-free banking. The system began tiny but has developed substantially over time. This approach has been established in non-Muslim nations as a result of the expansion. Non-Muslim participants are involved in these transactions (Kayadibi 438).
Malaysia is projected to remain one of the leading nations in Islamic finance in the future. Other nations, such as Sudan, have no conventional banks since they have all been converted into Islamic organizations. The primary objective of Islamic banking is to increase Sharia compliance in all facets of economic transactions. The banking system has resulted in the establishment of numerous organizations, including as schools, that provide training on Sharia law (Lewis and Algaoud 34). Future visibility of groups founded to address Islamic banking-related issues is projected to expand.
Every Islamic financial organization must comply to certain rules. A panel of Sharia-trained professionals is appointed to advise and direct the activities of these businesses (Rukhsar et al. 72). Islamic banking remained durable during the recent economic crisis because it functions differently than other financial organizations around the world. The crisis also assisted banks in identifying numerous systemic flaws. The ability to survive such crises is indicative of Islamic banking's promising future.
In conclusion, it is essential to underline Islamic banking's advantages and downsides. Profits and losses are shared equally by both parties, as interest-bearing transactions are prohibited. Due to the observance of the Sharia's rigorous laws, morality is upheld. According to the Quran, it is the responsibility of all Muslims to assist the needy. Therefore, Islamic financial institutions provide assistance to individuals in need. Therefore, banks are not solely motivated by profits (Lewis and Algaoud 22).
Similar to other business models, Islamic banking has a variety of flaws. When banks lend money, for instance, they serve as investing partners. As a result, the consumer owes the institution money and lives in fear of losing the assets the bank helped them obtain (Rammal and Zurbruegg 95). In addition, there are institutions that do not adhere to Sharia law. As a result, the institutions may be considered profitable businesses. In addition to fostering distrust, these activities undermine the Islamic religion and the principles of the Quran.
The repayment of debts is an additional big issue. This paper demonstrates that Islamic banking discourages profit-making. Given that they are not penalized for late payments, many individuals take advantage of this rule. To remedy this issue, Sharia banking institutions should devise rules for punishing such individuals.
Islam, the Mediterranean, and the Rise of Capitalism, by Jairus Banaji Historical Materialism, 15, 1 (2007), pp. 47-74. Print.
The Growth of Islamic Banking and Finance in Malaysia, by Saim Kayadibi Print Islamic Finance 1.1 (2011): 429-440.
Mervyn Lewis and Latifa Algaoud. Islamic Banking, Edward Elgar Publishing, Cheltenham, 2001. Print.
Rammal, Hussain and Ralf Zurbruegg. "Muslims' Awareness of Islamic Banking Products: The Case of Australia" Journal of Financial Services Marketing, volume 12, number 1 (2007), pages 65-74. Print.
Rukhsar, Ahmed, Siddiqui Kamran and Mufti Immamuddin. Islamic Banking in Pakistan: Difficulties and Prospects. Asian Journal of Research in Banking & Finance, Volume 3, Issue 7 (2013), pp. 42-72. Print.
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