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Understanding Islamic Banking

Understanding Islamic Banking
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Islamic banking is a participative form of banking and is quite diffrent from conventional banking..

Islamic banking is a participative form of banking, this type of banking activity is consistent with the principles of Islamic law and its practical application through the development of Islamic economics. Sharia prohibits the fixed or floating payment/acceptance of specific interest or fees (known as Riba) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also Haraam (forbidden).

Modern Islamic banking – Background

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 the late forties, followed by a more elaborate exposition in 1950. In the Islamic community a need for commercial banks with a banking system based on the concept of Mudarabha (profit and loss sharing) was conceived. 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 early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the 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. The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image—for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamar in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in country.

In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, currently, is still in business in Egypt. In 1975, the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services. Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed according to The Economist. This represents approximately 0.5% of total world estimated assets as of 2005. According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010. The Vatican has put forward the idea that “the principles of Islamic finance may represent a possible cure for ailing markets.”

Principles

Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital. Because Islam forbids simply lending out money at interest (Riba), Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to avoid this problem.

The basic technique to avoid the prohibition is the sharing of profit and loss, via terms such as :

i. profit sharing (Mudharabah),
ii. safekeeping (Wadiah),
iii. joint venture (Musharakah),
iv. cost plus (Murabahah) and
v. leasing (Ijar).

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 bank’s 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 Murabahah.

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).

An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank’s share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party’s current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.

There are several other approaches used in business transactions. 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 labour 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 the lender to monopolize the economy.

Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. Islamic Banking and Finance Database provides more information on the subject.

In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. However, in practice, this is not the case, and no examples of 100 per cent reserve banking are observed.

Largest Islamic banks

Shariah-compliant assets reached about $400 billion throughout the world in 2009, according to Standard & Poor’s Ratings Services, and the potential market is $4 trillion. Iran, Saudi Arabia and Malaysia have the biggest sharia-compliant assets. In 2009 Iranian banks accounted 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’s Al Rajhi Bank, Bank Mellat with $39.7 billion and Bank Saderat Iran with $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 Banker published 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.

Understanding Islamic Banking
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