FREE ESSAY ON ISLAMIC BANKING

ISLAMIC BANKING

INTRODUCTION
The basic concept of Islamic banking which is also known as 'interest-free banking' is
based on basic ethical standards with just one main difference- Muslims are not allowed
to pay or receive interest. This does not mean that business activities or making a
profit are not encouraged, they are but as long as they don't involve interest in any
form. To fulfil this purpose, financial instruments have been introduced by the Islamic
financial institutions to satisfy these requirements. An example that can be seen is that
equity financing is used instead of debt financing. Furthermore, instead of giving a
fixed interest rate on the savings account, Islamic banks offer a share of the bank's
profit, as a return on deposits and this is around 5% annually.
HISTORY
The modern banking system was introduced into the Muslim countries in the late 19th
century when most of these countries were performing that well economically as well as
politically. These banks founded branches in the capital cities of major Muslim countries
to cater their business needs. However, the branches were limited to the capital cities
and the other surrounding cities were totally ignored by the banking system.
Nevertheless, most local businesses still refrained from engaging with these "commercial"
banks, mainly for religious reasons. The reason behind this is that banks operate on the
basis of charging interest, a concept totally forbidden by Islam.
As time went by however, it became challenging to avoid commercial banks. They were more
efficient in certain banking aspects such as money transfers and current accounts, but
borrowing loans and opening saving deposits were still avoided due to the prohibited
interest issue.
As the second half of the 20th century has witnessed, any business-related transaction
almost always involves a bank and hence, avoiding the modern banking system has become
virtually impossible. Banks extended into local communities and thus, forced themselves
into almost every kind of business and their related transactions. This is when many
Muslim intellectuals recognized the need for an Islamic banking system that will serve
the needs of Muslims from the business point of view and at the same time respecting the
codes of Islam.
Islamic banking as an institution has been around for 25 years but interest-free banks
have also been tried before. There was one such bank in Malaysia in the mid-forties and
one in Pakistan in the late fifties. Neither of them survived. The early seventies saw
the institutional involvement. The Islamic Development Bank, an inter-governmental bank
was established in 1975. The first private interest-free bank, the Dubai Islamic Bank was
also setup in 1975 by a group of businessmen from several countries. Two more private
banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan.
Twenty-five years since the establishment of the first Islamic bank, more than 150
Islamic institutions have come into existence. Though most of these are in Muslim
countries, there are some in Western Europe as well as in North America and Asia.
PRINCIPLES OF ISLAMIC BANKING
The Islamic banking system follows certain, yet simple, rules set by the Qur'an and the
Shari'ah (Islamic law), which if deviated from the system becomes un-Islamic. These are
summarized as follows: 
1. Any predetermined payment or benefit over and above the actual amount of principal is
prohibited: 
Islam allows only the type of loan in which interest of any form is not charged. Interest
in this case is in either monetary form or other beneficiary forms such as using the
borrower's property, etc. in return for the lent money. In other words, any type of
benefit received by the lender from the borrower in return for lending the money is
prohibited. This is different however from the concept of 'profit-sharing' which will be
explained next. This is different from the typical loan types of commercial banks which
impose interest on loans in some form or the other.
2. The lender must share in the profits or losses arising out of the enterprise for which
the money was lent:
One of the basic concepts of Islamic banking is to share profits as well as losses. In
this way, the lender and borrower become partners rather than creditor and debtor. The
incentive behind this is to make both parties involved to equally share risk of the
outcome, regardless of the transaction at hand. In modern days, since an Islamic
institution is the intermediary, it shares the risks as well as profits with the
borrowers and lenders. This differs obviously from the traditional banking system which
imposes and collects an interest rate on the loan regardless of the success or failure of
the borrowers' businesses. This system puts all the risk on the borrower which at many
times can be hectic and merciless. 
3. Making money from money in Islam is not acceptable: 
Money can only be used as a medium of exchange, i.e. to determine the value of an item.
It in itself does not have value and therefore should not be used to generate more money,
via fixed interest payments, simply by being put in a bank or lent to someone else. Only
human effort and taking risk in starting and managing a venture are the means of
generating money. In other words, money should be used as a form of debt rather than
being capital, and this debt should not be allowed to generate interest. For this reason,
Muslims are encouraged to purchase goods and services rather than accumulating it and/or
earning interest on it, whether by depositing it in interest-based banks or lending it to
people for benefits in return. 
4. Uncertainty, risk or speculation (gharar) is also prohibited:
The Islamic banking system allows only transactions in which the results are known and
determinable. The parties involved in the transaction have perfect knowledge of what they
will receive from the other party. Therefore, no uncertainty, risk, or speculation are
allowed into the transaction. A guaranteed future profit on the basis of uncertain gains
is also prohibited. Also, no additional amount on and over the principal amount can be
charged on the basis of inflation. The rationale behind the prohibitions is the wish to
protect the weak from exploitation. This directly states that investment derivatives such
as options and futures are considered as un-Islamic and so are forward foreign exchange
transactions because of the predetermined future benefits and gains.
5. Investments should be utilized only in practices or products that are not forbidden,
or even discouraged, by Islam:
Money supplied under the Islamic system cannot be used to trade in alcohol, for example.
Also, a loan cannot be used to finance the construction of a nightclub, casino, etc. The
modern practice of inter-banking lending at a predetermined rate is also prohibited.
CURRENT PRACTICES OF ISLAMIC BANKS
Generally speaking, all interest-free banks agree on the basic principles of Islamic
banking. However, individual banks differ in their internal characteristics, functions,
and services. These differences arise as a result of the country's laws, the citizens
needs, and the individual bank's objectives and experiences. Despite this, Islamic banks
have the following aspects in common: -
 Deposit Accounts:
All Islamic banks have 3 types of deposit accounts: current, savings and investment.
While the number of current accounts has steadily declined, savings and investment
accounts have proliferated. The reason for this is due to the increasing confidence of
savers and investors in Islamic banking.
Although the current accounts are the same as in conventional banks, the savings account
operates in a different manner. In some banks, the depositors allow the banks to use
their money but the obtain a guarantee of getting the full amount back from the bank.
Banks adopt several methods of inducing their clients to deposit with them but no profit
is promised. In other banks, savings accounts are treated as investment accounts but with
less stringent conditions as to withdrawals and minimum balance. Capital is not
guaranteed but the banks take care to invest money from such accounts in relatively risk
free short-term projects. As such lower profit rates are expected and that too only on a
portion of the average minimum balance on the ground that a high level of reserves needs
to be kept at all times to meet withdrawal demands. 
Investment deposits are accepted for a fixed or unlimited period of time and the
investors agree in advance to share the profit or loss in a given proportion with the
bank.
In addition to the above deposit accounts, some Islamic banks have additional accounts as
follows:
- Trust Deposits: These deposits are not subject to any conditions for drawing or
depositing. The bank may use such deposits at its own risk and responsibility in respect
of profit or loss.
- Joint Investment Accounts: These are deposits received by the bank from persons who
desire to participate with the bank in multilateral and continuous investment operations.
Such deposits receive a certain percentage of the annual net profits realized. The way of
investing these funds is left to the bank's discretion. 
 Means of Financing:
Banks adopt several means of acquiring assets or financing projects and these can be
categorized in three areas: investment, trade and lending.
Investment financing:
This is done in three different ways:
1. Musharaka (venture/equity financing) where a bank may join another entity to setup a
joint venture, both parties participating in the various aspects of the project in
varying degree. Profits and losses are shared in a pre-arranged fashion. The venture is
an independent legal entity and the bank may withdraw gradually after an initial period.
2. Mudarabha (trust financing) where the bank contributes the finance and the client
provides the expertise, management and labor. Profits are shared by both the partners in
a pre-arranged fashion, but when a loss occurs, it is completely borne by the bank. This
type of contract is also used in fund management where the fund manager is the mudarib
who is entrusted to manage clients' money.
3. Financing on the basis of an estimated rate of return. Here, the bank estimates the
expected rate of return on the specific project it is asked to finance and provides
financing on the understanding that at least that rate is payable to the bank. If the
project ends up in a profit more than the estimated rate, the excess goes to the client.
If the profit is less than the estimate, the bank will accept the lower rate. If a loss
occurs, the bank takes a share in it.
Trade Financing:
This is also done in many ways. They are:
1. Murabaha (Cost-Plus Financing): a contract between the bank and its client for the
sale of goods at a price plus an agreed profit margin for the bank. The contract involves
the purchase of goods by the bank, which then sells them to the client at an agreed
mark-up. Repayment is usually in installment. This type of financing is very commonly
used for various installment related financing needs. As an example, we can look at a
customer who wants to finance a car purchase for $10,000 but cannot afford to pay the
full amount now. The bank buys the car on the customer's behalf and sells it to the
customer for $15,000. The bank charges a mark-up because it is willing to accept
installments (over 60 months) instead of one lump sum payment. The mark-up is profit as
the bank acted as a middleman; no money was lent, a product was only bought and sold. If
the customer decides to pay off the entire amount next month or at the end of the 60th
month, he will still owe the same amount.
2. Leasing where the bank buys an item for a client and leases it to him for an agreed
period ad at the end of that period the lessee pays the balance on the price agreed at
the beginning and becomes the owner of that item.
3. Hire purchase where the bank buys an item for the client and hires it to him for an
agreed rent and period and at the end of that period the client automatically becomes the
owner of the item.
4. Sell-and-buy-back where a client sells one of his properties to the bank for an agreed
price payable now on condition that he will buy the property back after a certain time
for an agreed price.
5. Letter of Credit where the bank guarantees the import of an item using its own funds
for a client, on the basis of sharing the profit from the sale of this item or on a
mark-up basis.
Lending:
The main forms of lending are:
1. Loans with a service charge where the bank lends money without interest but they cover
their expenses by levying a service charge. This charge may be subject to a maximum set
by the authorities.
2. No-cost loans where each bank is expected to set aside a part of their funds to grant
no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and
to needy consumers.
3. Overdrafts are also provided and are subject to a certain maximum. Free of charge or
small fee.
It should be noted that Islamic banks are not active in lending like conventional banks
because they are not interest based. The point to be noted is that lending in an
Islamically acceptable form is not very profitable to the back and they therefore have to
resort to other 'lending' related practices, such as leasing and mark-up transactions.
Islamic bonds are becoming very popular and Malaysia and Bahrain are currently developing
a global Islamic bond market.
 Services:
Other banking services such as money transfers, bill collections, trades in foreign
currencies at spot rates etc, where the bank's own money is not involved are provided on
a commission or charges basis. Many Islamic banks provide traditional banking services to
the extent that Shari'ah and the local government rules and regulations permit for
example, they receive OPEC surplus funds and trade Eurocurrencies.
SHORTCOMINGS OF THE ISLAMIC BANKING SYSTEM
Islamic banks are able to provide almost all the services that are provided by other
common banks. However, the only exception seems to exist in the case of letters of
credits where there is a possibility of interest being present.
There have been, however, some other major difficulties involved with Islamic banking
that are mentioned as follows:
1. Shortage of experts in Islamic banking - The supply of trained or experienced bankers
has lagged behind expansion of Islamic banking. The training needs not only affect Arab
domestic banks (both Islamic and non-Islamic) but also foreign banks. Academic
institutions, international organizations, and translation firms must respond to the need
by organizing training materials, lectures and workshops.
2. Absence of accounting and auditing standards pertinent to Islamic banks - Uncertainty
in accounting principles involves revenue realization, disclosures of accounting
information, valuation, revenue and expense matching etc. Thus, the results of Islamic
banking schemes may not be adequately defined, in particular, the profit and loss shares
attributed to depositors.
3. Lack of uniform standards of credit analysis - Islamic banks have no appropriate
standard of credit analysis, especially for profit-and-loss-sharing (PLS) schemes.
Similarly, there is a widespread training need involving related aspects such as
financial feasibility studies, monitoring of ventures and portfolio evaluation.
4. Potential conflicts with central banks - Islamic banks have been established as
separate legal entities and therefore their relationship with central banks and/or other
commercial banks is uncertain. Problems may be complicated when an Islamic bank is
established in a non-Muslim nation and is subject to the nation's rules and regulations.
5. Potential conflict between domestic banks, foreign banks and Islamic banks - It seems
that domestic and foreign banks will experience continuing difficulty in adopting Islamic
banking practices, including the PLS scheme, until they become more confident of the
results of investing ventures.
6. Lack of deposit insurance system - The lack of such a system becomes of a greater
concern because Islamic banks have standard measures of reserve requirements or liquidity
ratios.
7. Legislation - The depositors' funds are one of the basic asset acquiring methods of
Islamic banks. The existing banking laws, however, do not permit banks to engage directly
in business enterprises using these funds. Therefore new legislation and banking laws
need to be established.
8. Re-training of staff - The bank staff will have to acquire substantial knowledge and
skills for new procedures to operate the Islamic banking system. This seems to be a very
time consuming process as a large number of persons have to be re-trained.
9. Taxation - The bank is comparatively a big business and thus needs to disclose its
profits and losses every year. The Government requires banks to perform an audit for its
financial statements and determine the result of the operations. Once this is done, the
taxation authorities commence to claim the taxes due from the bank.
10. Uneasy questions of morality - The practices in use by the Islamic banks have aroused
questions of morality. Some argue that the practices that involve interest have simply
changed names to appear in an interest-free manner. It is questionable whether the
Islamic banking system is truly adopted by Islamic banks and institutions or not.
CONCLUSION
Islamic banking is a new system yet it has already been implemented many Muslim and a few
non-Muslim countries. Despite the successful acceptance there are problems which are
mainly in the area of financing. 
Islamic banks, however, can eliminate the doubtful forms of financing and offer a clean
and efficient interest-free banking. This can be put into effect by making use of only
two forms of financing -- loans with a service charge and Mudaraba (or participatory
financing) -- both of which are fully accepted by Islam. Such a system will create a
competitive advantage where Islamic banks and conventional banks both co-exist. In
addition, Islamic banks will have no difficulty in establishing and operating in
non-Muslim countries.
Mudaraba is a unique feature of Islamic banking, and can offer responsible financing to
socially and economically relevant development projects. This is an additional service
Islamic banks offer over and above the traditional services provided by conventional
commercial banks.
Therefore, Islamic banks have the potential to compete with perhaps even outperform the
common commercial banks that are currently available if they follow the Shari'ah rulings
and put it in effect.