The rise of Islamic Banking

Islamic Banking by A.L.M. Abdul Gafoor

4.1.1 Interest-free banking as an idea

Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961). Muhammad Hamidullah’s 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha - profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

4.1.2 The coming into being of interest-free banks

The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House.

However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the mid-forties and another in Pakistan in the late-fifties. Neither survived. In 1962 the Malaysian government set up the “Pilgrim’s Management Fund” to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial.

In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg , Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years.

In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent ‘profit’ rate depending on the type of economic activity. Interest on deposits was also converted into a ‘guaranteed minimum profit.’ In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.

Islamic Banks: A Novelty No Longer
From Jakarta to Jeddah, 265 Islamic banks and other financial institutions are now operating in some 40 countries, with total assets that top $262 billion, according to organizers of the International Islamic Finance Forum, a semi-annual industry conference. That pot of money, the investment of which adheres to the Koran's prohibition against receiving or paying interest, has been steadily building since 1994, when Malaysia created the world's first Islamic interbank money market. Now Islamic banking has broadened its appeal well beyond the confines of faithful Muslims. Indeed, nearly one-quarter of all Islamic banking business in Malaysia is being transacted by non-Muslims.

Islamic finance was long the preserve of specialty banks that handled shariah-compliant products exclusively, such as Malaysia's top-ranked Bank Islam and Saudi Arabia's Al Rajhi Banking & Investment Corp. But Western banks, no longer content to leave the market to Islamic lenders, are competing for a slice of the business. Two years ago, Citigroup (C ) began providing Islamic mortgages in Malaysia and has begun training staffers in Indonesia and Pakistan to offer them there. It also provides Islamic mortgages in Middle Eastern countries such as the United Arab Emirates. HSBC operates Islamic banking services all over the Arab world, and they now make up about 10% of its business in Malaysia. UBS, the world's top player in wealth management, set up a stand-alone Islamic private bank last year in Dubai to cater to its wealthiest Middle Eastern clients. And no wonder. Assets held by Muslims, led by Gulf Arabs, in all banks -- Islamic and otherwise -- are estimated at $1.5 trillion and are growing 15% a year, in large part because of high oil prices.

Islamic banking
Principles
Islamic 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).
In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is similar to real-estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

There are several other approaches used in business deals. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.

And finally, Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only acceptable form of investment, and moral purchasing is encouraged. Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio.[2] However, in practice, this is not always the case.

Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral or excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).

UK's first Islamic insurance company authorised by regulator
Principle Insurance, UK's first independent Islamic insurance (takaful) company, has been authorised by the FSA (Financial Services Authority). The company will offer Shari'ah-compliant home and car insurance. The latter will be launched in the second quarter of 2008 and will be available online or over the phone.

Abdulaziz Hamad Aljomaih, the company's chairman, believes that Principle Insurance 'will go some way in altering the perception of Islamic finance in the UK, by showing that progressive, sensible and profitable businesses can be established in accordance with Islamic law'. He also states that receiving the FSA authorisation proves that 'Shari'ah-compliant financial products are not only equitable and profitable but also conform to the modern day principles of international finance, especially from a regulatory standpoint'.

Bradley Brandon-Cross, chief executive of Principle Insurance, estimates that over 500,000 British Muslims own cars and therefore, have car insurance (it is a legal requirement in the UK). However, conventional insurance 'compromises their beliefs'. By offering the country's first Shari'ah-compliant motor insurance, the new takaful company will 'remove this dilemma'.
Principle Insurance has established a Shari'ah Supervisory Committee, consisting of three prominent Muslim scholars: Shaikh Nizam Yaquby of Bahrain, Dr Mohammad Elgari of Saudi Arabia and Mufti Abdul Kader Barkatulla, who lives in the UK.

The company has been present in the UK market since 2006 under a previous name of British Islamic Insurance Holdings (BIIH). Its initial capital was around £60 million ($119 million), with over 45 per cent of the investment originating from Saudi Arabia. Other investors include organisations and individuals from GCC and Asia.
The company's long-term strategy is aimed the UK market to start with and, in due course, Europe and the countries in the Gulf region. Principle Insurance will be providing an ethical insurance alternative on a selective basis.


Islamic Banking and the Media
If people want these shows about Islamic banking to be successful then these channels must seek to bring together the professional competencies of this field to work as presenters, or at least advisers, to suggest the topics that should be tackled and recommend suitable guests. In addition, these channels should be diligent towards familiarizing hosts – if they do not belong to the field of Islamic banking – to a suitable level by enrolling them on training courses related to Islamic banking that would teach them the basics of this system.

A significant field such as that of Islamic banking, and the speed of its growth that reaches an average of 20% per year and 35% in some countries, is a huge market for advertising. It is worth television channels gaining a foothold in this market where financial, Islamic and traditional institutions that provide Islamic services are competing to gain access to target consumers by all available means with the aim of selling their services, establishing trademarks and strengthening the confidence that their customers have in them.

Perhaps an indication of the lucrative gains to be made by these channels from such programs is the success of Islamic banking articles that are published in newspapers in attracting advertisers and the fact that Islamic and traditional financial institutions that provide Islamic services compete for this.


Islamic banking needs new rules
How do you think Islamic banking will grow, globally and locally?

Islamic banking services are growing at high rates – more than 25 per cent – on the regional and global levels. Increasing numbers of investors in the GCC are pushing to create Islamic financial institutions, investment companies or Islamic insurance companies. In the UAE, we are achieving high growth rates, however, the share of Islamic banking in the UAE is still low, between 15 per cent and 18 per cent, of the total banking market and less than 20 per cent of the total banking assets. The main challenge is to create a regulatory system for Islamic banking in the country. The UAE Central Bank has not introduced a set of regulations for Islamic banking and this hinders our expansion and progress. We need such regulations to streamline Islamic banking services. Islamic financial services need regulations different from conventional banking regulations because there are essential differences between the two banking systems.

All current regulations are targeting conventional banking and the Central Bank should move quickly to introduce laws and regulations for Islamic banking because the current conventional regulations represent a major obstacle to our expansion. Despite the high growth rate in Islamic banking in the country, which reached around 30 per cent annually, our market share is still low and, with the current regulations, we will not be able to achieve 50 per cent of the market share during the next five years.

Why cannot regulations for conventional banking be applied to Islamic banking?

There is a wide gap between the basics of conventional banking and Islamic banking. Conventional banking is based on financial economy as it trades in money and their main focus is lending. It is also interest-based banking, where the banks are setting fixed interest rates for their customers regardless of whether the business of those customers achieved profits or not. Islamic banking is based on the real economy as we are not offering money. We are partners with our customers through different products.

For example Musharaka, which means sharing, is an ideal alternative to interest-based financing and plays a vital role in an economy based upon Islamic principles as the bank enters a partnership with the client. Also Ijara, which means leasing, is used for two different situations, to employ the services of a person on wages given to him as a consideration for his hired services, or as a form of investment, and also as a mode of financing. Such Islamic products mean the bank is involved in the real economy and is close to changes in the markets.

In conventional banking when a customer borrows money to finance a commercial project and offers his property as a guarantee for this loan, the bank will take over the property if the customer fails to repay and this double the losses of the customer. In Islamic banking, there are a lot of other solutions to help our customers. For example, we could enter into a partnership to own this property and also give customer the right to buy back the bank's share in the property. These factors make things easier for the customer.


Islamic banks 'are making mark'
MANAMA: A new report from a global strategic management consulting firm shows that Islamic banks are making their mark in non-Muslim countries.

The AT Kearney study reveals that these wholesale banks target a broad set of corporate, institutional and high net worth clients, both Muslims and non-Muslims.

While Sharia-compliant banking has traditionally focused on the GCC and Malaysia, there has recently been a dramatic increase in the number of Islamic banks outside the core markets, most remarkably in the UK, where the number of Islamic banks has more than doubled over the past 12 months.

At the same time, their products remain popular in their core markets, where Islamic banks consistently outgrow their conventional competitors.

"While Islamic banks in their core markets take a universal banking approach, with retail, corporate and investment banking business lines, they focus on wholesale banking in the UK," said AT Kearney Middle East manager of financial services Dr Alexander von Pock.

Assets in the Islamic banking sector grew to over $250 billion globally in 2006, according to the UK Treasury.

In the GCC, this segment expanded to 15 per cent of the total system and is expected to reach 50pc within the next few years.
The success at home enables these banks to export their business abroad, as Islamic banks from the GCC are the major shareholders behind all of the newly set-up Islamic banks in the UK.

However, the strategic approach they take on differs between them and their home countries.

"Islamic investments have often been outperforming conventional investments, hence Western, non-Muslim investors are becoming more interested in Islamic finance.

"They account for up to 40pc of buyers," AT Kearney Dubai associate director Maktoum Al Maktoum.

Maybank Banking On Pakistan Expansion
HONG KONG - While most Western banks are taking a pause from expansion to solve their credit problems at home, Malayan Banking is accelerating its acquisition ambitions, in an attempt to strengthen its regional footprint. Malaysia's biggest lender said Monday it would buy up to 20% of Pakistan's MCB Bank for $933 million, its third takeover in the region in two months.
Malayan Banking (other-otc: MLYBY - news - people ), widely known as Maybank, said in a filing with the stock exchange in Kuala Lumpur on Monday that it had agreed to buy 15% of MCB Bank, Pakistan's fourth-largest bank by asset value, for 2.17 billion ringgit ($685.5 million). Maybank also has secured the right to buy an additional 5% stake in MCB Bank for a maximum of $247 million from three other institutional investors, potentially bringing its ownership up to 20%.

[ ... ]

The deal, which will be completed by the end of June, is expected to provide an opening for Maybank to expand into Islamic banking, retail services, credit cards and small-to-medium enterprise banking in Pakistan. MCB Bank has 1,026 branches, including eight Islamic banking branches within Pakistan and six branches outside the country, with a deposit base of about. 280 billion Pakistani rupees ($4.3 billion) and total assets of around 300 billion Pakistani rupees ($4.6 billion), according to the bank's Web site.

Seeking prospects beyond its maturing home market, Maybank recently stepped up the pace of regional acquisitions. It announced last month it had agreed to acquire a 56% stake in Bank Internasional Indonesia, that nation's sixth-largest bank, from Singapore's state-directed Temasek Holdings and South Korea's Kookmin Bank (nyse: KB - news - people ) for 4.8 billion ringgit ($1.5 billion). The bank will also make a tender offer for the remaining 44.3% shares of Bank Internasional Indonesia (other-otc: PKIDF - news - people ) for approximately 3.8 billion ringgit ($1.2 billion), bringing the total value of the potential acquisition to about 8.6 billion ringgit ($2.7 billion).

What is Islamic Banking?
The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalization of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and philosophy of Islam.

Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.

Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems Haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:

While permitting the individual the right to seek his economic well-being, Islam makes a clear distinction between what is Halal (lawful) and what is haram (forbidden) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious.

While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.

While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat.

While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.