Can Sharia Banking Tackle Todays Global Financial Crisis Finance Essay

Today’s global financial crisis has left many wondering where the faults actually lie. Indeed, there are many contributing factors that can be highlighted. However, in a more positive approach, it is argued that Sharia banking covers principle areas that are in almost complete opposition to conventional banking. For example, institutions do not pay interest, and they require transactions to be reinforced by real tangible assets.

The conventional banking system in place has offered a suitable medium for trade over many years. Countries have prospered with the facilities provided while few have had complaints or criticism of the system. Due to this apparently fluent and dependable system, trade had continued uninhibited until recent times.

Prior to the unfolding of the current financial crisis, there was a certain limited amount of speculations regarding whether or not the system would face any hiccups. This was a reasonable conjecture considering the financial crisis that occurred in the 1930s. This was of course limited to the U.S. economy, and was at a time when globalization and international trade had not exist the way it does today.

It is interesting to note that there have been alternatives offered to the conventional banking system, which largely consisted of a private banking method, which will be explained later in this paper. As opposed to the private banking method, many scholars began to explore the alternatives, and Islamic or Sharia Banking is one form that was deemed to be interesting enough.

Islamic Banking methods seemed to offer a fair amount of safety to users, and it appeared to be a fair and just method for borrowers. Primarily, it is the borrower’s rights that need to be safeguarded in this method of banking, as this would be a moral action and it would bring stability to the system. Borrowers would be able to trust the system, and this would only instill confidence in all users of the banking system. Moreover, this system does not agree with intangible assets. There are Quranic quotations and examples that justify this approach, which is actually quite a matter of common sense; probability, chance, etc. are factors that have to be mitigated if reliability is desired. Indeed, this is why every possible measure has been sought in Islamic banking to ensure stability and reliability, which will result in economic prosperity.

Aims:

To determine:

How Sharia banking principles can help to relieve the current economic crisis, and transform the economic system for more reliability.

How different Sharia Banking is from Conventional Banking.

Advantages Sharia Banking has over Conventional Banking 

Objectives:

To determine:

What the fundamental principles of Sharia Banking are.

Why Sharia Banking principles are believed to make global financial operations more reliable and concrete in comparison to conventional western banking systems.

Whether or Not Sharia Banking concepts can be implemented pervasively in the west.

How ripe consumers minds are in terms of being ready to receive Sharia Banking as a new banking concept.

Possible obstacles to Sharia Banking

What the fundamental principles of Sharia Banking are.

Possible obstacles to sharia banking

Problem of systems – Sharia – conservative Western – tends to be reckless – but which system best.

Sharia looks a good model right now – but a collapse of the construction industry in the gulf will show weaknesses.

Why do now have doubts about commercial banking?

Sub- prime – US housing market

UK banks

FACTIVA

Look in the Financial Times about Islamic banking

Literature Review

Why Does the World Need a Banking System?

For anything to be related, networked and linked, there needs to be some sort of medium through which operations can be carried out. For example, for the Internet to function effectively with all individuals operating from different locations, cyberspace has to exist. Similarly, for trade to take place effectively there needs to be some sort of facilitation. This facilitation is provided by banks and other financial institutions. However, there needs to be a set of norms and governing rules that allow these institutions to operate smoothly and in a just manner.

Indeed, a banking system facilitates business activities. Whether it is limited to a particular region or stretched across the globe, all those who are facilitated by it enjoy the banking system.

Indeed, a technologically well supported banking system is vital in this day and age. This is because speed and reliability are both top requirements. Businesses need to act rapidly, especially when transactions are to be made over long distances. As opposed to demand for speed today, yesteryears saw a slower pace of business and there was far less business activity. Therefore, it might be said that while speed and reliability are both required today, the banking system was still a need yesterday.

A banking system from the very beginning promised a streamlined approach to business activity. Governing laws brought safety and stability to all those involved in banking facilities. It is unthinkable what man would do for trade in the absence of a banking system. An example that might be cited is Mozambique in East Africa. It was known that people who traveled there on business or for tours had to maintain their foreign currency on them. This is because there no banks to facilitate them. This exposed them to much risk, as thugs are the generally desperate would loot or assail them. However, most parts of the developed and developing world are encompassed by the banking system, which provides them a safe means to conduct transactions.

What is Private Banking?

The term ‘private banking’ appears to directly suggest that it is a banking system that deals with the private financial affairs of individuals. It also suggests the lack of social responsibility that comes along with it. Private banking means that what an individual does in terms of banking or financial transactions is a private affair as long as it does not violate any laws. Though the idea is fundamentally one in which many individuals can invest their money and receive gains upon it as a whole, the concept of gain at the expense of another still remains. For example, when many individuals invest their money in a private bank, this money is often loaned to individuals or other financial institutions or companies that later have to return it with an additional payment [interest]. Therefore, it can be said that the individuals collectively gain interest by simply accumulating their funds in a private bank at the expense of the borrowers who have to pay interest.

Private banking is known to combine trust services, banking services, investment services, and tax services. Private banking is a term used for encompassing banking, investment and other financial services that are furnished by banks to private individuals who invest in sizable assets.

The term “private” has also been used to refer to the customer service that is given on a personal basis as opposed to mass-market retail banking. This process should not be mixed up with a private bank, as a private bank is itself a non-incorporated banking institution. While private banking was always seen as a very exclusive form of banking that explicitly catered to high net worth individuals who had liquidity exceeding $2 million, it is now possible for an individual to open an investment account with some private banks with as little as $250,000. A private banking division will include a variety of services: inheritance, wealth management, savings, and tax planning. For the affluent a high-level kind of private banking is wealth management (Mullineux & Murinde, 2003, 23-25).

Basic Tennets of Islamic Banking

There are certain principles of Islamic banking that differentiate it from traditional banking. This particularly refers to its functions. Islamic values that are mirrored in Islamic economic principles govern Islamic Finance. These are briefly described below:

There is a clear prohibition on Predetermined Payment that Exceeds an Actual Amount Of Principal Is Prohibited: Islam permits only one type of loan, which is called ‘qard-el-hassan’. This literally means ‘good loan’, and is described as one in which a lender does not levy any extra charge or interest on the principal amount.

According to Islamic Financial Principles, a Bank must share The Profits Or Losses that Result From Investment: The interest-based commercial banking system that has immense pressure is on the borrower. In contrast to this, Islamic finance is founded on the idea that the depositor, the bank as well as the borrower must shoulder the risks and the rewards that result from financing business ventures.

Generating Money Directly From Money is Not Acceptable: According to Islamic teachings, money stands for purchasing power. It should not be made use for reinforcing purchasing power (money). If it is used for this purpose, there must be an intermediate step in which it should be used for purchasing goods and services (Maurer, 2005, 41-73).

Uncertainty, Risk Or Speculation, Which is Also Known as ‘Gharar’ is Strictly Prohibited: Parties that are included in a contract should possess all required knowledge of the counter values that will be exchanged in the process of transactions. They should also be protected from uncertainty, risk and speculation. No party in a contract is allowed to predetermine a guaranteed profit, which is founded on the tenet of ‘uncertain gains’. ‘Uncertain gains’ does not permit an agreement in which the customer might repay the borrowed principal with an additional amount for inflation protection (Maurer, 2005, 41-73)

Investments are Intended to Support Practices Or Products Only That Are Not Prohibited or Discouraged By Islam: An Islamic Bank would not finance trade in alcohol. Also, real-estate finance cannot be furnished for erecting a casino. Additionally, banks cannot lend money to other banks with an interest levied.

The above principles are the complete opposite of what has been practiced in conventional banking. For example, the borrowing against assets that are not tangible, which has proved to be a flawed concept that has led to much of the global economic crisis.

Basic Description of Sharia Banking [Islamic Banking]

The basic difference between Islamic and traditional banking systems is the system of deposits followed. In an Islamic Banking system, deposits are deemed as shares. These deposits or shares do not promise nominal value (Mullineux & Murinde, 2003, 23-25).

While it may be said that ‘In Islamic finance, interest is forbidden, there are very good reasons why this is so. Interest is prohibited because of its effect. One needs to understand this effect in order to value the Islamic finance & conventional finance.

Interest by far benefits one party in a contract more than another. It is known to put one party at a clear advantage over another or others. In a contract where interest is implemented, a party is guaranteed its principal sum returned along with a significant benefit over others.

Umar Chapra, the author of ‘Towards a Just Monetary System’ asserts that from the Qur’an and the Hadith of Prophet Muhammad, guides Muslims and helps them to understand what is fair and unfair, particularly when it comes to their earnings earnings. Chapra says, “One of the important sources of unjustified earnings is receiving any monetary advantage in a business transaction without giving a just countervalue.”

To put it simply, Islamic finance is a fair system in contrast to conventional finance. It is Islamic finance aims at getting rid of unfair or exploitative financial situations, products or services. This does not only apply to loan transaction, but also to other situations that might be unfair or exploitative in the financial world.

The result of this straightforward aim is asset-based financial products that suffice as a ‘just countervalue’ for all parties involved. In An Introduction to Islamic Finance, Taqi Usmani describes asset-backed financing; it is financing that creates real assets. These can then be sold in exchange for money. As a result, it consequently earns a justified profit. This is indeed different from the concept in the conventional systems that generate money out of money (‘interest’).

In Islamic finance, there must be an asset that creates the profit, and not money alone. The formula that is prohibited in Islamic Finance is as follows: ‘Money + Interest = More Money’. As opposed to this, the formula that should be applied is as follows: ‘Money + Asset/Real factor of production = More money’.

Islamic banking has more to it than traditional banking as its products must adhere to secular laws as well as the holy Qur’an. This means that it must be suited to all countries in order to makeup a complete system that can be operated globally.

One of the main laws of Shari’ah is riba, the prohibition of interest. Also, Islamic law prohibits the use of funds for investment or purchase that may be related to pratices that it deems impermissible (haram). Alcohol consumption and gambling stand as examples. As a general rule, anything that is not defined as haram can be considered permissible (halal) under Shari’ah law. It, however, must be asserted that Shari’ah interpretations can vary according to regions where it is implemented fundamentally due to local Islamic scholars defining what is fit for particular regions. Banks that wish to offer Islamic Banking must enlist local scholars who will serve on the bank’s Shari’ah board or committee. These scholars aid the bank in designing and implementing Shari’ah-compliant bank products and processes. Large conventional banks are known to now also develop specialized functions that aim to educate employees about adherence to Islamic finance principles.

The Concept of ‘Musharakah’:

The bans against interest are founded on the Islamic idea of property that is caused by a person’s creative labor or from trade or property. Interest on money loaned is encompassed within neither of these two concepts and is thus not justified (Mullineux & Murinde, 2003, 23-25).

To resolve this problem from a legal and religious viewpoint, Islamic banking implements common terms: musharakah or co-operation for production; mudharabah or as one might put it, a silent partnership, when one party supplies the capital, the other the labor; and murabbahah or deferred/post payment on purchases, similar in practice to an bill of exchange and the most preferable Islamic banking agreement in Sudan. To decide the ban on interest, an interest-bearing overdraft would be transformed to a murabbahah contract.

Similar Operations But Different Methods in Islamic and Traditional Banking:

A great deal of Islamic banking literature says that although Islamic banks carry out mostly similar functions to that of traditional banks, their method is clearly different (Ahmad, 2000; Chapra, 2000; Iqbal and Molyneux, 2005; Iqbal and Mirakhor, 2007). To demonstrate some of the most important characteristics of Islamic banking and finance which makes it different and unique from its traditional counterparts encompass: first, Islamic banking aims at a just and fair society as dreamed of Islamic economics (Mirakhor, 2000; Warde, 2000). In accordance with this, the many restrictions (e.g. interest, gambling, undue risks, etc.) are to serve a flat playing grand to defend the interests and advantages of all participants included in market exchanges and to elevate social harmony (Ahmad, 2000; Chapra, 2000). For example, the current tradition of interest in the traditional banking system includes inequality to the borrowers since the interest on their loans must be paid regardless of the results of their business. In the same way, interest-bearing agreements can be unfair to the lenders particularly when their returns on deposits, which have been fed back by the banks to the investors, do not commence with the actual performance of the investment (Lewis and Algaud, 2001; Iqbal and Molyneux, 2005).

Second, Islamic banking is setup upon the rule of brotherhood and co-operation, which symbolizes for a system of justice sharing, risk distribution and stake holding. It encourages such sharing and co-operation between the giver of funds (investor) and the user of funds (entrepreneur) (Iqbal and Molyneux, 2005).

Third, as a system founded on ethics and morals of the Islamic law of Shariah, Islamic banking is also embodied by ethical norms and mores and social obligations (Ahmad, 2000; Mirakhor, 2000; Warde, 2000). There is a moral monitoring mechanism based on the descriptions of Halal (permissible) and Haram (prohibited and undesirable) functioning at various levels, holding the conscience of entrepreneur and firm, favouring a positive social climate for society, and giving a convenient and practical legal framework (Chapra, 1992). In accordance with this, Islamic banks can hardly financially support any project which contradicts the moral value system of Islam. For example, financing a brewery factory, a night club, a casino or other similar kinds of activities are banned by Islam or known to be harmful to society (Ahmad, 2000).

How Competitive is Islamic Banking Especially in present Era?

Within the Middle East regional participants in the Islamic banking industry have rendered inspiring financial outcomes. These banks have acted well by securing attractive financial returns regardless of their capital size. In order to make sure Islamic banks remain competitive in the face of their conventional counterparts, they need to elevate their functional capabilities in order to fulfill prospective demand for Islamic banking products and services. This requires them to redraw their current business models, turn their attention to consolidation and strategic alliances. They also need to systemize their functions by outsourcing non-core operations in order to affirm sustainable growth.

The Islamic finance industry is rapidly attaining popularity in constantly evolving environment. On one hand IFSI has performed exuberantly and on the other hand it also encounters various challenges, most of which are unique to the industry (Saeed, 1999, 24-45).

High Liquidity

Without a well-established Sharia compliant taking the place of conventional interbank money markets has posed a significant impediment to the growth of the IFSI [Institutions offering Islamic Financial Services]. It is one of the main reasons for IFSIs foregoing superfluous funds that are alternatively being channeled into conventional banking systems. Islamic investment prospects has been short-term and low risk opportunities with the lack of variety, tradable financial instruments has restricted investment opportunities.

Human Resources

In the initial phases of its development, the Islamic finance industry has had shortage of experienced professionals that has impeded its initiatives geared towards offering its valuable customers developed, innovative and excellent products (Saeed, 1999, 24-45).

Global Shari’a Compliance

At many occasions IFSIs has been soaked in issues like differing responses with respect to the Fatwas given by various Shari’a Supervisory boards. These responses emerge from differences in Shari’a opinions emerging from varied interpretation of Fiqh (Islamic jurisprudence). This emphasizes the need of developing harmony of Shari’a opinions thus paving way for advancement in product development and resultantly formation of a consistent industry.

Risk Management

IFSIs face risks such as Shari’a compliance, further legal and asset risk, fiduciary risk and displaced commercial threat. These risks elevate the need of development and establishment of more comprehensive and effective risk management framework to timely monitor and reduce them. This should not only encompass the risk management dilemmas prevailing in the IFSIs but also allowing IFSIs to affirm better rating in the global marketplace to lead them to participate with conventional counterparts.

Islamic banking and finance makes up the Islamic economic system and its very basis revolves around fairness and morality. Moral aspect, thus, is raison d’etre of Islamic banking and finance. Sincere efforts are needed in this circumstance on the model of Sudan and Bahrain. This is with regard to Musharaka, Ijarah and Salam Sukuk, and Malaysia in view of Mudarabah based Islamic money market).

Documentation of the economy, substitute income tax of the corporate sector with spending tax and reform in other pertinent laws are important requirements. A well thought out plan with steadfast and sustained efforts could lead to achievement and finally to overhauling of the economy (Lewis & Algaoud, 2001, 77-109).

Advantages of Islamic banking and finance

Along with the evolution of Islamic banking and financial institutions main changes that came about in the financial surrounding during the past few decades of the twentieth century. These include lessening in the intermediation activities and taking part in a dynamic and forceful management of investment and an incorporation of financial markets in the face of globalization.

Retract of the Glass-Steagall Act in the US Islamic finance facts gained on the foundations that financial intermediation had been established on interest. The deeper participation of banks and other financial organizations in investment administration put greater emphasis and pressure on comprehending the greater range of Islamic financial methods such as sharing profits as well as mark-up financing and the associated advantages in long term for the institution as well as the customer.

However, the need of time has transformed from what was there in twentieth century of developing methods of financial intermediation interest-free to the development of Islamic Techniques of risk management and make sure that they are free from troubles associated with traditional methods of financing (Lewis & Algaoud, 2001, 77-109).

Risk management in an Islamic Setup

Even though risk is at the center of all the activity in each and every viewpoint of the activities, particularly in business but industrialization brought risks previously unprecedented in trade and agriculture. With better periods of time and more developed period of production, the uncertainty increases. The range of the market has widened and is heading for forming a global village through which introducing new types of risk. When Islamic laws were penned many years ago years ago, the type and range of risk and unpredictability were different. However, gaining knowledge with a mixture of modern experiences allows one to remember the Shari`a objectives of justice, fairness and effectiveness.

The Prophet (P.B.U.H.) banned sale of calves that were not born. This was because there was no guarantee about the future, and there was no way of determining the results. He also banned sale of fish that was in a pond. The reason for this was the same as the one before; one cannot predict the future; one cannot be certain of the quality and quantity of the produce being sold.

The Prophet disallowed the sale of a product that has not been fully cultivated but on the other hand permitted undertaking Salam – including advance money paid against agricultural crops at the time when the agreement was made, months ahead of the real harvest. It must be said that this is advantageous to the farmer as well as to the grain-trader. It also has a permissible level of indecision included in the defined transaction.

Therefore, comprehensive information must be collected at the time of any agreement in order to obviate any mix-up between parties in time to come and loss of any on these grounds. But to protect benefits, in some of the cases, given joint consent some doubt is acceptable (Lewis & Algaoud, 2001, 77-109).

Globalized Financial Markets

The world’s financial markets with greater incorporation have initiated movements of money through national boundaries with less cost and instantaneously. This change is suitable to Islam in which there are no ideas of belief of national boundaries. In practical implementation, however, this partially took place and created obstacles for Islamic financial movement for two main reasons. The first reason is progress made in Middle East, South Asia and South East Asia who have stunted economies and where financial systems are less complicated in contrast with the developed countries. Secondly, Islamic financial institutions suffer from their small size and very few of them function in more than one country as the main players do. The situation has changed with few major conventional financial institutions taking on and introducing there Islamic Divisions/subsidiaries. But this has also made things more tedious for the older Islamic financial institutions as the same have to undergo mergers and acquisitions in order to withstand in this era of competition and speed (Lewis & Algaoud, 2001, 77-109).

Globalization has elevated the instability of almost every financial variable especially the exchange rates. It has also reduced the effectiveness of economic macro-management of the countries that venture their institutions in the direction of transformation of their existing structures into one based on mainly Islamic principles. The only method of correcting this is undertaking international agreements aimed at curbing speculation and controlling financial markets. The approach of Islamic financial motion, henceforth, deals and underscores profit-loss sharing modes of finances, commodity-linked financing such as murabaha and mitigating the role of debt in order to reduce the associated risks in today’s world (Lewis & Algaoud, 2001, 77-109).

Hindrances Towards Development/Management Of Islamic Banking

Efforts are underway to develop standards in Islamic financial products. There is pervasive acceptance for standardizing basic elements of Islamic finance including Mudaraba [limited partnerships]. Additionally, Murabaha and Ijara are also accepted. It should be known that Murabaha is a known markup price which is made known to the buyer, and Ijara is a sharia-compliant type of mortgage that has no down payment, which is similar to rent to own. There are steps taken in order to co-ordinate the activities carried out by various Shari`a advisory boards of Islamic financial institutions. These actions are primarily being taken in order to mitigate misunderstandings and rein in un-coordinated activities.

Major obstruction towards growth of IFSI is insufficient information that creates a negative outcome on the activities taken up towards its development on solid footings.

There is a lack of institutions that can carry out a rating procedure. This especially refers to the ones that should be established to carryout rating of products and institutions on the foundations of Shari`a compliance.

Regardless of the odds, few that have been mentioned above, the industry carries on to grow but at a snail-paced mainly in the Gulf countries. It has also reached the Balkans and recently independent Central Asian Islamic Republics. Shaky economic situations in these countries, are certainly causing problems in the Islamic financial institutions, and this creates hindrances for them (Lewis & Algaoud, 2001, 77-109).

Islamic Banking Drives Competition

Islamic banks had large degree of ‘monopoly’ over the financial resources of Islamically motivated clients. The conditions have been transformed with Islamic banks now facing ever increasing competition. A vital development in Islamic banking in the last few years has been the beginning of some traditional banks in that market. A precise figure of conventional banks around the world that have implemented Islamic banking techniques is hard to determine. However, some of the main players in international banking business include names like Citibank, ANZ Grindlays, Klienwort Benson, Chase Manhattan, etc. Also, there are several commercial banks in a variety of Muslim countries that offer Islamic banking services. Bank Misr in Egypt and National Commercial Bank in Saudi Arabia have both inaugurated Islamic Branches. Malaysia too allows its conventional banks to initiate Islamic Banking procedures so that they can advance into Islamic Financial Industry (Venardos, 2006, Pp 32-55).

In general, rivalry is always taken to be an affirmative phenomena stimulating expansion of any industry. It compels inefficient firms to either transform themselves in accordance with respective industry norms or move out of the way. It mitigates the costs and ameliorates services to consumers while boosting innovation and bringing in enhancements in product quality. However, IFSI that is in its early stages need to be protected from harsh, stiff and aggressive competition from conventional till the time they are capable of standing on their feet and be able to confront competition from their business counterparts.

Conventional banks have enormous benefits in contrast to Islamic banks in terms of their experience and long survival in the market. Their systems, methods, techniques of product innovations, strategic marketing and their diversification in repertoire are far superior to the corresponding functions of Islamic banks. As a result, opens up Islamic banks to an unequal rivalry and competition. Looking at the other end, such competition may be suitable for Islamic banking as conventional banks can rein in their efficiency, research data and main capabilities, complex banking and result-oriented strategies to Islamic banking. This may all result in the development of new products and facilitations of better services to customers (Venardos, 2006, Pp 32-55).

Methodology

Data Sources:

For this research, there are a wide variety of sources considered. All these together will aid one to complete the task at hand. In this research, there is a mixed approach consisting of primary and secondary sources. The researcher has to carefully consider the kinds of sources obtainable to him in order to make a precise selection.

In order to deal with the precise question [How Can Sharia Banking Be Used to Tackle Today’s Global Financial Crisis?] one has to investigate the procedures at Islamic financial organizatiuons. From these institutions, the researcher will understand more about the dynamics of Islamic Banking, and then be able to come up with a strategy that could deal today’s financial crisis.

The research will start by searching for secondary sources. This is normally what is done so that one can get an idea of what types of data can be obtained on a particular subject.

Secondary data for this researcher paper will come from a variety of records held by a variety of organizations. Since there has been a wide range of data made accessible in the shape of journals, reports and books, they will be carefully considered.

Following the compilation of secondary data, primary data will need to be obtained too.

Primary data to be collected will be attained through questionnaires. Through this method, the researcher can attain a wide range of data. It is worth mentioning that this data will be obtained at random from employees and supervisors of departments [respondents] regardless of their gender, age, etc.

An appropriate methodology that includes the role quantitative and qualitative approaches is seen as the most suitable way to research this project.

By implementing a questionnaire, the researcher aims at retaining significant primary data that will be analyzed alongside the secondary data accumulated. While secondary data will be gathered from sources like books and journals Islamic Banking, primary data will be obtained from organizations staff at a variety of Islamic Banks.

Qualitative Research

When implementing a qualitative research technique, one is in a position to can establish a highly organized and free flowing method of data from a participant’s mind. To employ this research form, a researcher must take full advantage of a questionnaire. Implementing questionnaires permits a certain degree of flexibility for a research technique. In this research paper, an interpretive approach will be implemented, which will comprise analyzing data; content analysis and statistical analysis.