CAIRO: In today’s hyper-competitive business and financial world, Islamic financial systems are witnessing an unprecedented growth. However, many scholars, researchers and academics are currently accusing the system of creating confusion. Issues like participation of Islamic banking in the stock exchange markets, mortgage and the overall operation of Islamic financial systems, particularly in western societies, tend to create a considerable dilemma among interested parties.
Economic, business and financial experts have different views regarding the issue. Interpreting the system as interest free tends to create confusion. Thus we need understand the basics.
Historically, Islamic finance was practiced in the Muslim world throughout the Middle Ages, fostering trade and business activities with the development of credit. Islamic merchants became indispensable middlemen for trading activities. In fact, many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.
The term Islamic financial system appeared in the mid-1980s coinciding with the current account surpluses of oil-exporting Islamic countries. But its continued growth in the face of eroding oil revenues reflects the influence of other factors, such as the desire for sociopolitical and economic systems based on Islamic principles and a stronger Islamic identity. Factors such as the introduction of broad macroeconomic and structural reforms – in financial systems, the liberalization of capital movements, privatization, and the global integration of financial markets allowed for the expansion of Islamic finance.
In brief, Islamic finance follows Sharia where all forms of interest are forbidden. Under Sharia, risk sharing is important. Making money from money, such as charging interest, is usury and therefore not permitted. In Islamic banking, the customer and the bank share the risk of any investment on agreed terms, and divide any profits between them. Wealth should be generated only through legitimate trade and investment in assets. But investment in companies involved with alcohol, gambling, tobacco and pornography is strictly off limits.
The main categories within Islamic finance are: Ijara, Ijara-wa-iqtina, Mudaraba, Murabaha and Musharaka.
Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period.
Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract.
Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit.
Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis.
Musharaka is a investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested.
On one hand, the system can be fully appreciated only in the context of Islam s teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state. Besides focusing on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole.
Islamic financial systems encourages risk-sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts. It prohibits the payment and receipt of any predetermined guaranteed rate of return, thus closing the door to the concept of interest and the use of debt based instruments.
An Islamic financial system can be expected to be stable owing to the elimination of debt-financing and enhanced allocation efficiency such a system will be stable since the term and structure of the liabilities and the assets are symmetrically matched through profit-sharing arrangements, no fixed interest cost accrues, and refinancing through debt is not possible. Allocation efficiency occurs because investment alternatives are strictly selected based on their productivity and the expected rate of return.
Entrepreneurship is encouraged as entrepreneurs compete to become the agents for the suppliers of financial capital who, in turn, will closely scrutinize projects and management teams. Generally speaking, the main aim of Islamic finance systems is meant to be the promotion of Socio-economic justice, equitable distribution of income and wealth and a broad-based economic well-being with full employment and optimum rate of economic growth.
However, on the other hand, the system has been accused of creating confusions particularly when it comes to issues like mortgage, Islamic banking, stock exchange markets and many other practicalities and challenges that face the implementation of the system. Let us take the example of Muslims living in western societies, those communities live in a constant dilemma.
Under Islamic law, you cannot lend or borrow at a rate of interest, they cannot get a mortgage to buy a house, and they are not allowed to participate in stock exchange transactions unless these transactions are filtered according to Sharia. Thus, following the strict law of Islam becomes challenging in the western Muslim communities where it is extremely difficult to follow such practices. One can say it’s a necessary evil.
In the case of a mortgage for example, many wealthy Muslims in western societies are still living in rented properties because mortgage rules doesn’t comply with their religious beliefs and Islamic lifestyle. Recently banks, such as HSBC, Lloyds TSB in England for example, became aware of that need and initiated a home-loan program for Muslims to cater for their needs. With Islamic mortgages, the bank might buy a 90 percent share of the home while the homebuyer buys 10 percent. The homebuyer borrows nothing, but pays a rent instead, only some of which will go straight to the bank.
The rest goes towards gradually buying the bank out of its share of the property. One might argue that this system is very much like the other companies, yet there is one difference that is supposing he failed to pay and we re going to sell the house. If I am a bank, a Muslim bank, lending to a Muslim, sharing with him, I am not going to sell the house in the way that it is sold now, by putting it in an auction and selling it at the easiest and the fastest price
Even in the most developed part of the Islamic financial systems that is Islamic banking, we find that specialized Islamic banks have been traditionally well positioned to attract deposits from Muslims, yet generally lacked the technical ability to invest efficiently. This gap has been bridged by the services of Western banks that swiftly and efficiently deploy funds into Islamic-acceptable channels. But this has often meant lower returns for Islamic investors owing to the second layer of intermediation.
This trend is changing. Islamic banks are becoming resourceful and are going global, in part owing to their increased integration with international markets.
Islamic financial markets are challenged by the lack of liquidity-enhancing instruments, thus eliminating a large segment of potential investors. In this regards, the issue of Islamic funds can be confusing to some. There are three types of Islamic funds: equity, commodity, and leasing. Equity funds, the largest share of the Islamic funds market, are the same as conventional mutual funds but with an Islamic touch that requires a unique filtration process to select appropriate shares.
The filtration process ensures that the mode, operation, and capital structure of each business the fund invests in are compatible with Islamic law, eliminating companies engaged in prohibited activities and those whose capital str
ucture relies heavily on debt financing (to avoid dealing with interest). For this reason, companies with a negligible level of debt financing (10 percent or less) may be selected, provided that the debt does not remain a permanent feature of the capital structure. Moreover, the absence of liquidity instruments, such as bonds and other marketable securities, is another challenge in case of liquidity gaps occurring.
In Egypt, as in many other Islamic countries, the Islamic financial market is operating far below its potential. Existing banking regulations are based on the Western banking model. We live in a market economy that is driven and manipulated by interest. The banking sector is supported and regulated by the central bank. One could see this kind of support in terms of discount rates on loans given by the central bank to commercial banks in times of need.
Unfortunately, Islamic bank do not enjoy such privileges since many Islamic banks work under operational procedures different from those of the central banks. Although stock markets in emerging Islamic countries such as Egypt, Jordan, and Pakistan are active, they are not fully compatible with Islamic principles.
An Islamic financial system needs sound accounting procedures and standards. Western accounting procedures are not adequate because of the different nature and treatment of financial instruments. The development of a regulatory and supervisory framework that would address the issues specific to Islamic institutions is needed to enhance the integration of the Islamic financial systems in the international markets. In sum, from my point of view limitations of the system should be fully addressed before we can judge its efficiency.
By Dr Doaa Khairy Mohsen, (PhD. MBA, BSc).Business Management consultant specialized in issues of organizational behavior, management reform, Economic development in the MENA region, with particular interest in the Arab world & GCC Studies.