ISLAMIC BANKING CONCEPTS.

ISLAMIC BANKING – Origin and Definition

The origin  of Islamic banks as major players in the financial domain was in the early 1970’s. But the rules and regulations governing the Islamic banking system has been present in the world for more than centuries.

The main pillar of Islamic banking is the forbiddance of Riba  ( interest).

The principles that govern the Islamic  banking environment are based on common sense and basic rules and regulations. These sort of simple rules are the base of a legion of religions in the world including Islam

Even in non Muslim literature, in the great western classics the Old and New testaments interest was evil. The 19^th century writers such as William Shakespeare and others  repeatetedly  raised their voice against  interest and money lenders.Famous writers such as  Charles Dickens have also brought up the bestiality and evil side of taking interest, and championed the equal distribution of money among all classes. Famous Indian authors such as Rabindranath Tagore, Munshi Premchand, Sarat Chandra  also showed the dark side of the society due to prevalence of interests.

"Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euro money Publication, 1997)

During the middle ages Islamic finance was hugely popular and was widely accepted and practiced. It helped in furthering the trade and business in the Muslim world. The Islamic merchants began to play a very important role in the European region (Mediterranean, Spain and Baltic States) .The middle east countries started playing a very important role in the trading scenario due to its location and soon became an important trading and business hub thus increasing the importance of Islamic banking and financing. It  is also strongly believed that  European financiers and businessmen improvised upon numerous theories, concepts and techniques based upon the system of Islamic banking and finance .

Around 1975-76 Islamic banking was revitalized due to the increase in the financial strength of Muslims especially  from the middle eastern oil producing nations.This sudden boost in the economy demanded a business model which followed the rules and regulations according to Islam. The increasing importance given to ethics and core value systems also gave a huge push to the Islamic banking and financial sector.   

The Shariah law clearly marks a demarcation amongst what is legal or halal and what is illegal or haram.The law has numerous rules which a devoted Muslim is supposed to follow .It restricts taking interest, pork , gambling , pornography etc..

 Islamic banking  adheres to this norms and helps in the maturity of the Islamic economy.

Few of  the prominent features which form the base of the Islamic banking and financial procedures are as follows:

Islam says that economic activity can be pursued on items which do not harm society or morality.It bans delving into businesses which are haram, that is not doing good for society or morals.

Islam asks an individual not to amass his riches or consume it carelessly. It asks for hard earned money to be spent wisely and carefully.

The rule of Zakat helps people to participate in the well being of the society by distributing ones surplus wealth to the deprived and the needy. Thus trying to bring about  an equality among the masses.

The main goal of the Islamic economic system is social justice and equality. It tries to be fair for one and all.It helps in promoting individual enterprise and also controls the economic system in a fair and equal manner.

 In the Islamic financial system the financial institutions become a partner in business. The utilization of the funds from the institution by a business house or an enterprise is on a profit and loss sharing basis. Gain from the business as well as losses earned due to the business are shared equally by the institutions and the enterprise. But this does not mean that the investments by the financial institutions are speculative. Before investing money a thorough investigation is carried out on the risk factors associated with the business. Feasibility of the project and necessary risk management principles are rightly undertaken to undermine the effect of loss.

Investing in Islamic financial institutions may provide more profit and less risk because the financial institution has its own interest as it acts as a partner.

The progressive theory of profit and loss sharing for financial transactions also helps in demarcating between good, bad and moderate performances by various businesses.

A fresh perspective

The theories and concepts regarding Islamic financing system sent a ripple down the existing financial system base on capitalist values. People used to the existing financial system thought that a system and financial institutions based on a no interest regime could not survive. A financial system based on ethics and human values was equivalent to a dream who were immersed in a valueless capitalist economic system.. People questioned the relationship between values, ethics and finance.

But with people slowly paying more importance to moral values, beliefs and ethics in society has hit the existing financial system which is based on capitalistic methods. Conventional financial maneuvers such as taking high interests on loans, forcefully occupying premises if loans are not paid, mishandling of defaulters are being seen as on the wrong side of the law. The financial institutions are being harassed by human rights member and new rules and regulations benefiting the client. Clients are reluctant to deal with institutions which do not give importance to moral values and ethics. Investment by financial institutions in unethical activities and activities detrimental to society are not received well by clients. Islamic banking has created a portal to invest ethically and in a valuable way to the society, thus increasing its adoption. Socio-demographic trends have been the catalysts for continued growth in Islamic banking and finance. The high rate of population growth in the world-wide Islamic community has been supported by growing affluence, particularly across Asia. With this growth, customers are seeking Islamic banking and finance products that will provide opportunities to invest and borrow according to Islamic ethical principles defined in Sharai’ah law, while still offering the benefits of diversification and a full range of banking products.

Islamic banking is continuing to grow rapidly due to the importance that it gives to moral beliefs and society. The Shariah law is driven by value and good for man kind, hence gaining popularity not only among Muslims but also from non Muslim communities. New investment models and business tools are being developed by Islamic financial experts which are not only hundred percent shariah compliant but highly profitable too.This tools or investment vehicles can be used both by muslim and non muslim alike.

Islamic finance has become a global business spanning Asia, the Middle East, and the Western world. Islamic banking is not limited onlyto the muslim nations in the middleast but cover a vast area spanning USA, Europe, and the far east. Today, more than four hundred and fifty plus Islamic banks are operating from China to USA, having funds  under management greater than one trillion US dollars. Coventional foreign banks(e.g., HSBC, standard Chartered Bank, Grindlays, Citibank, etc.), are dealing in Islamic products through their Islamic Units in U.K, Germany, Switzerland, Luxembourg, etc. Islamic funds are also gaining popularity and momentum in Europe and USA.

 According to industry estimates, Islamic financial assets have already reached the $300 billion mark, and are expected to reach $1 trillion by 2010 as customers turn to Islamic finance as a socially-responsible banking alternative.

Performing the same financial intermediation as conventional banks, Islamic banks act in accordance with revenue-sharing principles, and structure transactions so as to avoid paying or receiving interest.

Islamic banking services include a broad range of profit-sharing, safekeeping, leasing, cost-plus financing and joint venture agreements. Innovative new technology solutions have enabled banks to meet the increased demand for these services. Now, virtually

every product and service offered by conventional financial institutions has a Sharai’ah-compliant equivalent, from loans to mutual funds, and from electronic payment systems to stock indices.

Recent Trends

All the Islamic banks follow the basic rule of no interests, but each of them have applied it differently. The  difference mainly arises due to the  due to the different laws in different countries, size of the banks, goals of the banks and the type of customer it deals with, the competition it is getting from the foreign interest based banks and several other reasons.

Some of the important aspects common to all the interest free banks are discussed  in brief below:

Deposit Accounts consist of current, savings and investment. Accounts.

• Current/Demand Deposit accounts

      Similar to normal banks, gives  a guaranteed deposit.

• Savings accounts

There are multiple ways by which Savings deposit accounts can be operated. The money from the depositors can be invested after taking required permission from the depositor. But the bank has to promise to return the full amount back to the depositor.  No fixed profit is promised by the financial institutions to its customers .The savings accounts have stringent conditions to number of withdrawls and minimum balance.But certain accounts which are  used for investments have less strict conditions.The return on capital is not ensured  but banks invest carefully  in  marginally low risk-free short term projects.

• Investment account

It is a form of fixed deposit account where deposits are held for a fixed tenure  and a profit or loss sharing margin is accepted by both the parties i.e the financial institutions and the customer. Capital return is not guaranteed.

• Modes of financing

Mainly differentiated under 3 broad based criteria’s: trade, investment and lending.

• Trade financing

Some of the different ways in which trade can be financed are

a) Mark-up price: In this case the bank purchases an item from a seller on behalf of the customer and the customer has to repay the bank the price plus a profit which was agreed before hand. The customer has the benefit of repaying the money later to the bank.

b) Letters of credit: The bank assures the import of a good on behalf of the client. The agreement is based on marked up price or on the basis of profit sharing on sale of the items.

c) Hire-purchase: the financial institution will hire a good/item to the customer on a rent and tenure agreed earlier.At the end of the tenure  the customer gets the right of ownership on the hired good/item.Its like a rental and at the end of the rental time the good is handed over to the customer. 

d) Sell-and-buy-back:  In this process the bank will purchase an item from the customer and give him money for it.The condition will be that the customer will buy back the item on a predecided price after some pre agreed time.

e) Leasing : the bank will lease an item to the customer for a pre agreed period and then the customer will pay the balance of the price for the item and be the owner of the item.

• Investment financing can be done by three main ways:

a) Musharaka: Its like a joint venture. The financial institution will participate in the project along with the enterprise.The terms and conditions for profit/loss sharing are finalized beforehand.The bank may slowly come out of the project after recovering its investment and earning some profit.

 b) Mudarabha : In this process the technology, resource management, labour management, expertise is provided by the enterprise whereas the job of the bank is to provide full financial support.The sharing of profits are finalized before hand but if a loss occurs then the total loss is endured by the financial institution.

 c) Financing on the basis of an estimated rate of return: The bank will finance the project under the assumption that the project will generate a minimum rate of return which will help in repaying the banks investment.If the rate of return is more than the rate of return estimated by the bank then the enterprise will gain from the excess profit.If the rate of return is lower than the expected return then the bank will accept that only.The bank will share if any loss is endured in the project,.

• Lending

The different forms of lending are:

 a) No interest  is levied on the loan but the loan comes with a service charge.The interest costs are covered through the help of this service charge.The service charge is predetermined by the Shariah committee in the bank .This service charge varies from bank to bank.

b) Loans which do not bear interest or service charge.This are known as No-cost loans.According to the rule each bank is expected to set aside a part of their funds to serve the society.No-cost loans are provided to the needy and deprived people for setting up small businesses, farming , fishing etc.

 c) free of charge overdrafts are provided up to a certain limit.

• Services

Different services such as bill collections,forex,money transfers etc are provided on a  basis of commission or charge.