Why Islamic Banking and Finance?

Financial systems are crucial for the efficient allocation of resources in a modern economy. The main role played by financial intermediaries are asset transformation, conduct of orderly payments, brokerage and risk transformation. They not only channel resources from capital surplus agents (generally households) to capital deficit one (business) but also allow international smoothing of households’ consumption and business expenditure, enabling both firms and households to share risks.

Conventional financial system is capitalist financial system, which is based on certain principles, like rational economic man, positivism, and say’s law. Despite doing well the above jobs, most of the time these institutions make negative impact on the economy. Because rather than lending helping hand to the economy, these financial intermediaries cause financial shocks which naturally affect the entire economy of the globalised world. If we look at the history of these shocks (financial crises), we would come to know that more than 100 crises occurred in last four decades. The main causes of these crises are market indiscipline, moral decline and some illegal practices like interest, speculation and gambling.

Today in the name of economics and finance only efficiency and wealth creation become the key concepts. Capitalism creates a national frame of mind which, having destroyed the moral authority of so many institutions. The purpose of financial intermediaries is profitability and self interest, for which they can do anything whether it is the exploitation of moral values of human beings or their livelihood.

The entire world had fallen victim to the financial crises or we can say global meltdown of 2008-09. After that the world has started searching for an alternative, which should be based on just, equity and interest-free system. Then there is one name which clicks the mind, and that is Islamic finance.

The term “Islamic financial system” is relatively new, that appeared only in the mid-1980s. This system is not limited to banking; it also covers capital formation, capital markets, and all types of financial intermediaries and risk transfer. It prohibits the receipt and payment of interest but is supported by other principles of Islamic doctrine advocating social justice, risk sharing, the rights and duties of individuals and society, property rights and sanctity of contracts.

The foremost priority of Islam and its teaching on finance is just and equity. As mentioned above, the main purpose of financial intermediaries in conventional system is to earn high profit and self interest. Islam does not deny it; rather they are regulated for the betterment of society. Maximising an individual pursuit of profit in enterprise or satisfaction in consumption is not the sole objective of society, and thus any wasteful consumption is discouraged.

Second thing, as mentioned above, is market indiscipline, which is one of the causes of financial crisis. Market indiscipline refers to the existence of any other factor considered impermissible by the Shari’ah such as fraud, cheating, monopoly practices, coalitions and all types of combinations among buyers and sellers, under selling, speculative hoardings and bidding of prices without the intention to purchase. In the Islamic financial system, the Shari’ah protects all such practices which are illegal like unjust and unfair dealing, riba, maysir, gharar and speculation. Islamic finance was practised predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities with development of credit. In fact, many concepts, techniques and instruments of Islamic finance were later adopted by European financiers and businessmen. The first commercial bank was established in 1974 in the United Arab Emirates, followed by an establishment by Islamic Development Bank in 1975.

By the early 1990s the market gained enough momentum to attract the attention of public policymakers and institutions interested in introducing innovative products. Some of the noteworthy developments like AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institution), IFSB (Islamic Financial Services Board), which was established with the help of IMF (International Monetary Fund), took on the challenge and started working in the area of regulation, risk management and corporate governance. Further progress was made in developing capital markets. Islamic asset-backed certificates, sukuks, were introduced in the market. Different structures of sukuks were launched successfully in Bahrain, Malaysia, and other financial centres, several equity funds based on Shari’ah compatible stocks emerged. Dow Jones and Financial Times launched Islamic indices to track the performance of Islamic equity funds.

Since the return on the asset depends on the bank’s ability to invest the funds at a higher rate than that promised on the liability side, and this rate is unknown, it can lead to classical risk management problem of mismatch between assets and liabilities. In contrast, in Islamic banks there is no predetermined accounts, and depositors are expected to share the profit and loss incurred on asset aside of the bank; so there is no problem of asset and liability mismatch. Islamic finance contributes to the stability of financial system. Several institutions were established to create and support a robust financial system, including the international Islamic financial markets, the international Islamic rating agency, the general council of Islamic banks and financial institutions, and the arbitration and reconciliation centre for Islamic financial institutions.

STRUCTURE OF FINANCIAL STATEMENTS OF ISLAMIC BANKS

For Islamic financial institutions, the nature of financial intermediation, including the function of banking, is different from that of conventional financial institutions.

Theoretical balance sheet of an Islamic bank based on maturity profile:

Theoretical balance sheet of an Islamic bank based on functionality:

Today, Islamic finance is no longer leading financial centres of the world. With the recent wave of high revenues in the Middle East, demand for Shari’ah compliant products on both the purchase and sale sides has increased sharply. It is expected that as leading market makers embrace and begin to purchase Islamic finance, the market will grow further, and new products and services will be introduced in near future.