Evolution of Islamic Financial System
Evolution of Islamic Financial System
Evolution of Islamic Financial System
Islamic finance has become a major global industry with over 300 institutions
involved in both Muslim countries and international financial markets. Assets
managed in accordance with the Islamic law are worth over $200 billion,
including financing facilities made available by banks and investments by
mutual funds that have been screened for shariah compliance.1 Just three
decades ago even the strongest advocates of Islamic finance could not have
envisaged that such progress would have been possible in the context of an
international financial system that was dominated by western interest based
methods of financing.
Although Muslim owned banks were established in the 1920s and 1930s,
such as Bank Misr of Egypt and the Arab Bank of Palestine, these institutions
adopted the same practices as their European owned competitors and
interest based dealings prevailed. It was only during the 1950s that a group of
Pakistani economists and finance specialists sought to explore how traditional
Islamic financing techniques could be used for modern commercial
transactions. In 1958 a small rural co-operative bank was set up in West
Pakistan, with a group of landlords depositing and obtaining funds on a
mudarabah profit sharing basis.
1
The International Association of Islamic Banks estimated the assets of Islamic banks as
$137 billion in 1996, which included all Iranian banks. Allowing for five percent per annum
growth, a very conservative estimate, this figure becomes $174 billion for 2001. There are in
addition the funds managed in accordance with the sharia law by conventional banks,
possibly amounting to $20 billion and using Islamic Banker and fund reporting data around $6
billion in Islamic managed funds.
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and handicrafts, but they are best classified as micro-financing institutions
rather than commercial banks.
Almost one third of the trade financing by the IDB has been for oil imports, as
one of the original aims of the new institution was to assist poorer Muslim
countries without oil resources to pay for their essential imports, especially
after the oil price rises of 1973-74. In recent years trade financing has
involved a diverse range of commodities including industrial intermediate
goods ($3.2 billion), vegetable oil ($900 million), refined petroleum products
($769 million), fertilisers, phosphoric acid and potash ($465 million), rice and
wheat ($459 million) and cotton ($367 million). All these figures refer to
cumulative financing over the 1975-1999 period.
Project finance has become increasingly important for the IDB in recent years,
with much of the funding provided through leasing, (ijara) hire purchase (ijara
wa-iqtina) and advance purchase financing, (istisna). Almost one third of
project finance has been for public utilities such as power generation plants,
electricity transmission, and water treatment and distribution facilities with
over $1.5 billion used in this way over the 1995-1999 period. Social projects
account for a further quarter of the total, including schools and hospitals, with
around $1.2 billion disbursed over the 1995-1999 period. Other project
funding over the same period was for transport and communications ($1
billion), industry ($850 million) and agriculture ($800 million).
The IDB has encouraged the governments of its member states to pass
legislation to allow Islamic commercial banks to operate, and has advised
about regulatory issues and the use of Islamic financial instruments. The IDB
has also several schemes designed to support Islamic commercial banks,
notably the Unit Investment Fund and the Islamic Banks Portfolio for
Investment and Development. Under these schemes securities have been
issued backed by the leasing and hire purchase assets (ijarah muntahia
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bittamleek) of the IDB. These securities can then be purchased by Islamic
commercial banks, which increased IDB funding, but at the same time means
the banks have secure liquid assets that provide a modest return. Between
$100 million and $200 million is raised in this way annually.
Other institutions have become equally successfully, with the Kuwait Finance
House and the Qatar Islamic Bank accounting for over 20 percent of bank
deposits in their respective markets. The Jordan Islamic Bank has 62
branches throughout the kingdom from Irbid in the north to Aqaba in the
South, 695,000 account holders and over 1,400 employees.
Islamic banks have been extremely successful at the retail level, as they have
a special customer appeal, by being able to satisfy financial needs, while at
the same time assuring their clients that their transactions and assets are
being undertaken in compliance with shariah law. Clients in most Muslim
countries have a free choice whether to use conventional or Islamic banks,
but large numbers have chosen the latter because of their religious
convictions. The names and reputations of the scholars on the shariah boards
seems to be one factor influencing client choice, especially initially when
Islamic banks first open, but over time, as the banks have established
reputations as solid financial institutions, name and brand image have
become important.
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modest incomes who did not hitherto use banks. The Malaysian and
Indonesian Islamic banks are also examples of this kind of operation, with
large numbers of small retail depositors.
4
Islamic economists welcomed the spread of Islamic banking, but there was
criticism of the banks’ excessive reliance on short-term murabahah financing.
There was relatively little long term funding of projects that might contribute
more to development and a lack of partnership financing. To counter these
criticisms many Islamic banks, having built up confidence through murabahah,
were prepared to offer their clients longer-term finance, usually through ijarah,
which was a leasing contract, or in some cases through ijarah muntahia
bittamleek, a hire purchase contract. This became popular in the 1980s and
remains important. Such financing applied to purchases of major items of
capital equipment, where the goods themselves served as collateral, and the
payment was by instalment, usually monthly or quarterly, up to a period of 5
years.
Where projects were financed, istisna’ was used, whereby the bank made
advances which could enable suppliers to be paid at each stage of the
project. This method was strongly supported by one of the leading Islamic
economists, Muhammad Anas Zarqa, a Syrian scholar, who believed it was
suitable for the financing of large-scale infrastructure developments.
Islamic banks which received most their funds through current account
deposits, on which no return was payable, were often accused of accepting
free money and making profits for themselves out of virtually risk free
operations. Questions were still asked if Islamic banking was different only in
the legal designation of the financing instruments used or if it really was a real
alternative to conventional banking.
Similar criticisms were also made of the Islamic investment fund movement
that emerged in the 1980s and 1990s. These funds were criticised for
investing mostly in the West rather than in the emerging stock markets of
Muslim countries, with investment decisions influenced largely by risk
assessment rather than any notion of Islamic solidarity. Nevertheless those
who manage the funds see parallels with the western ethical finance
movement, as although the criteria for acceptable investments differ from
what is halal under shariah law, there has been much scope for a cross
fertilisation of ideas over managerial practices.
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Some of the largest Islamic financial institutions, notably the Al Rajhi Banking
and Investment Corporation, provided extensive foreign exchange services at
competitive rates, but others were more expensive and bureaucratic with
respect to such business.
From the 1980s Islamic retail banks expanded their personal financing
facilities, with for example the Kuwait Finance House offering a car purchase
scheme. As state financed housing banks and real estate development funds
could no longer meet the demand for housing loans in most Arab countries,
Islamic banks expanded into this area, with houses being purchased on
behalf of clients who repaid the bank through rental payments related to the
initial value of the property. Islamic banks also provided additional
transactions instruments, with the Kuwait Finance House for example offering
a debit card to current account holders that was accepted internationally in
retail outlets taking Visa payments.
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The pioneering Malaysian market
Malaysia has in many respects seen the most ambitious development of
Islamic banking in terms of the range of products offered. The Central Bank,
Bank Negara Malaysia, is committed to encouraging the development of the
Islamic finance industry, and has developed instruments and assets that have
facilitated the industry’s expansion. Bank Islam Malaysia Berhad was the first
institution to be established under the Islamic Banking Act of 1983. On 17th
January 1992 it was sufficiently strong to be floated on the Kuala Lumpur
Stock Exchange. By 2000 it had a paid up capital of $244 million, and total
assets of almost $1.8 billion, making it the fourth largest Islamic financial
banking institution globally. It had a network of 80 branches throughout
Malaysia with 1,200 employees.
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Development of Islamic securities markets
An Islamic securities market makes liquid asset holding more profitable for
Islamic banks and reduces reliance on inter bank deposits. As Islamic banks
cannot hold short-term interest yielding assets such as treasury bills because
of the prohibition of interest under the Shariah Islamic law, they have always
had a problem in profitably managing their liquidity.
The first attempt to overcome this problem was taken by Bank Negara
Malaysia in July 1983 after the first Islamic bank in Malaysia began
operations, as it was realised that Bank Islam Malaysia could not hold
government securities or treasury bills which paid interest. Therefore non-
interest bearing paper was issued, Government Investment Certificates and
Government Investment Issues. Bank Islam Malaysia could acquire these
certificates, which represented a beneficial loan (Qard Hassan) to the
government. There was no pre-determined rate of interest on these securities,
rather instead the rate of return would be declared by the government at its
“absolute discretion”. A dividend committee was established to regularly
declare the rates, the committee comprising representatives of the Ministry of
Finance, Bank Negara, the Economic Planning Unit and the Religious Affairs
Section of the Prime Minister’s Office. There was no fixed formula for
determining the rate of return, the stress being on qualitative rather than
purely quantitative considerations. Those setting the return considered a
range of indicators including macroeconomic conditions, the inflation rate and
the yield for similar instruments.
The investor bank in the MII scheme does not know in advance what the
actual profit will be, as it depends on the gross profit of the investee bank. The
profit sharing ratio is however agreed in advance, and the principal is repaid
at the end of the loan period. To increase certainty further Bank Negara
introduced a minimum benchmark rate on February 2nd 1996, which is the
prevailing rate on Malaysian government investment issues plus a spread of
0.5 percent. Investee banks are not obliged to declare profit shares based on
this benchmark, rather it is a guide to investor banks to the sort of return they
can reasonably expect, and therefore can be taken into account in the
negotiations on the profit sharing ratio.
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On June 13th 2001 the Bahrain Monetary Agency offered for the first time in
the Gulf government bills that were structured to comply with the shariah
Islamic law. The bills were worth $25 million, and were in the form of three-
month paper, referred to as Sukuk Salam securities. Although the Malaysian
government has offered Islamic bonds since the 1980s as already indicated,
governments in the Gulf have been forced to borrow in international markets
rather than locally because of Islamic objections to trading in debt and interest
based securities. Governments have issued paper that the local commercial
banks have held to maturity, but not traded. This however restricts the liquidity
of bank assets, and makes it more difficult for the government to raise finance
directly from the public.
With its new Sukuk Salam Securities Bahrain has overcome this problem, by
providing a fixed return, equivalent to 3.95 percent at an annualised rate, for
the first Islamic bill issue, which is not based on interest. The return has been
calculated in relation to the real benefit the government expects to obtain on
the funds, rather than with reference to market interest rates. The first
securities matured on September 12th, and a new issue was launched, a
process that will be repeated every three months.
Bahrain hosts the High Council for Islamic Banking that has taken over from
the Jeddah based International Association of Islamic Banks. The Islamic
Development Bank spearheaded the establishment of the Council, and its
membership of Islamic banks is growing rapidly. The Islamic Development
Bank has also chosen to locate its Infrastructure Fund in Bahrain because of
the island’s position as an Islamic financial centre. The Infrastructure Fund is
a private equity fund that is being managed by the Emerging Markets
Partnership of Bahrain. The Islamic Development Bank has agreed to set up
an International Islamic Rating Agency that will be located on the island. This
agency will rate Islamic securities that should help ensure their international
acceptability. Islamic and conventional banks that purchase and hold such
securities will have a clear indication of the risks involved. This should enable
them to compare risks versus returns for different categories of Islamic
securities, increasing transparency and the potential efficiency of the market.
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Establishment of national Islamic banking systems
In most Muslim countries Islamic banks have been established alongside
existing conventional banks so that there is a choice of financing methods,
with those who wish to manage their affairs in compliance with shariah law
able to do so, but no obligation on all bank clients to follow this example. Two
Muslim countries have introduced more comprehensive Islamic legislation
however with the ambitious aim of ensuring that all domestic financial
transactions comply with the shariah. The two countries are Iran and the
Sudan, with Pakistan also planning to Islamise its entire financial systems.
In Iran’s case in the aftermath of the Islamic revolution of 1979 there was an
ambitious plan to apply the shariah law in the financial sphere, but the
revolution itself undermined the stability of the existing banks, resulting in the
state taking over control in order to maintain depositor confidence rather than
because of ideology. Once a degree of stability was re-established, the state
drafted Islamic banking legislation, and following consultation with those in the
industry, the government implemented Islamic banking legislation in 1983. All
banking operations were henceforth to be conducted in accordance with
Islamic law, with no interest based transactions permitted. Deposits were
accepted on a wakala basis, and financing was provided through murabahah
mark-up trade finance, leasing and beneficial loans. Transactions with foreign
banks outside Iran were still conducted on the basis of interest but this was
seen as a necessary pragmatic approach forced on the authorities because of
international circumstances beyond their control. Open market operations
involving the central bank and the commercial banks were also conducted
using discount rates as a proxy for interest, but this was viewed as a technical
issue, rather than a practice that would have any implications for practising
Muslim clients of the banks.
Difficult economic conditions prevailed in Iran in the period after the Islamic
banking law was passed in 1983, as there was a continuing decline in oil
prices and disruption to oil production, and most other industrial sectors of the
economy, as a result of the war with Iraq. The adoption of Islamic operations
did not appear to be a handicap for the major banks, as they survived the
economic recession and continued financing business, although the level of
deposits and financing was depressed. Bank Melli continued as the dominant
Iranian bank, with Bank Mellat, Bank Saderat and Bank Tejarat as the major
second tier banks, although Bank Sepah, the smallest of the banks, expanded
its share of deposits. Bank Sepah is the only bank in Iran to have a shariah
board and shariah advisors, but most of its financing is for real estate. In
contrast Bank Melli is mostly involved in trade and industrial financing, but
although its assets exceed $20 billion, twice the size of the largest Arab
Islamic Bank, the Al Rajhi Banking and Investment Corporation, many
observers outside Iran have doubts about its Islamic banking credentials.
Deposits are placed on a wakala basis, the returns being set by Bank
Markazi, the Central Bank. Around 11 percent of financing involves
musharakah and 6 percent leasing. There is no murabahah financing
however, but much of its trade financing is nevertheless different from that
offered by conventional banks. Iran’s banks have been nationalised since the
revolution, but there are now plans to privatise, starting with Bank Saderat.
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There are already two recently established private Islamic banks in Iran, Bank
Karafa and Bank Eqtesad-e-Novine or Modern Economic Bank, both of which
function more like the Islamic banks on the Arab side of the Gulf rather than
as Iran’s state owned banks.
The progress made in the Zia years was not sustained during the Butto years,
as although the Pakistani Peoples Party did not attack Islamisation directly, it
stifled the business sector and much private economic activity, which made it
difficult to generate the profits to sustain the Islamic profit and loss sharing
operations. Furthermore corruption, always a problem in Pakistan, became
endemic, with businesses having to make illegal payments to politicians,
political parties and bureaucrats if they were to stand any chance of winning
government contracts or speed up import clearance. The Butto administration
was not entirely responsible for these developments, but they must bear some
responsibility. With the overthrow of the Butto government in 1996 and the
election of Nawaz Sharif more progress was hoped for, especially as the
International Institute of Islamic Economics in Islamabad was invited to
produce a blueprint for an Islamic financial system in the country and the
elimination of riba. This was written under the chairmanship of Sayid Tahir
and published in 1999. On December 23rd of that year, the Supreme Court,
under Justice Khalil-ur-Rahman, recommended that that the system should be
implemented by 30th June 2001. The government of General Musharraf was
cautious over this ruling, as there was opposition to its implementation by
conventional bankers, notably from those in the United Bank. They argued for
a five-year delay in implementing the law on riba free banking until December
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31st 2005, but the Supreme Court has only authorised a one-year delay until
30th June 2002.
Apart from their Islamic character of the modaraba companies, the main
attraction for founding the companies was the tax exemptions granted. No
companies tax was payable for the first 3 years of operation, and for the
following 2 years only half the full rate of 25 per cent was payable. Although
the modaraba companies got off to a slow start, with only 2 founded in 1985
and a further 2 in 1987, by 1991 there were 30 companies. This was the peak
year for their establishment, with 15 modaraba companies founded. By 1995
there were 52 companies, but there have been no new companies set up
since then, reflecting the recession in Pakistan and the depressed state of the
stock market. By November 2001 only 37 remained active, but approval is
being sought from the Religious Board of Pakistan and the Securities
Commission to allow modaraba companies to issue Islamic term finance
certificates that will be comparable to the Islamic bonds issued in Malaysia. If
permission is granted, this should help revive the modaraba companies.
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By the 1990s there were 25 banks providing Islamic financing in the Sudan
the largest institution being the state owned Agricultural Bank and the second
a former conventional institution, the Omdurman National Bank. The
Sudanese Islamic Bank and the Faisal Bank had become relatively small
players in the local market for financial services, although the Tadamon
Islamic Bank had grown relatively. All of the banks would have grown more if
the Sudanese economy had performed better, but the country has suffered
from civil strife, relatively high levels of military expenditure, drought, heavy
external indebtedness and sanctions imposed by the United States. The
economy has improved since 1996 however, with an end to the drought and
increased agricultural production. Gross domestic product growth has
averaged 5.5 percent, and inflation has fallen from 133 percent to 16 percent.
Economic conditions are much better than for many years to facilitate the
expansion of Islamic finance. The Bank of Sudan, the central bank, has
issued with the help of the International Monetary Fund, Islamic government
certificates, which are used for liquidity management purposes.
The consequence has been a series of mergers, such as that between the
Faisal Islamic Bank of Bahrain and the Islamic Investment Company of the
Gulf, and the subsequent creation of the Shamil Bank, a much larger
institution. The International Investor of Kuwait, headed by Adnan Al Bahar,
and the Dallah Albaraka Group, headed by Sheikh Saleh Kamel, agreed to
merge their operations as part of a $300 million deal. The Investment Banking
expertise of the International Investor combined with the retail reach of Dallah
Albaraka should create a formidable new force in the industry. There is little
doubt that with its loyal customer base and track record of providing profitable
financial products, the Islamic banking industry is well positioned to weather
the present downturn in global markets, and take advantage of the upturn
when it arrives.
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Arabian Monetary Agency told Islamic banks and Islamic subsidiaries of
conventional banks operating in the Kingdom to use AAOIFI standards. To
date AAOIFI has issues eighteen accounting standards, four auditing
standards, four governance standards, five shariah standards and four
shariah rules, in addition to a code of ethics. Increasing convergence in
Islamic financial practice will undoubtedly increase client confidence in the
industry and facilitate inter-bank transactions between shariah compliant
institutions.
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