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Islamic Banking: A Brief Summary of the Industry

Islamic Banking: A Simple Definition
The core concept of Islamic banking, also commonly known as interest-free banking,
is based on basic ethical standards along with one key difference; Muslims are not
allowed to pay or receive interest. Business activities are encouraged as well as
making profit, however, Muslims cannot participate in any activities involving
interest in any shape or form. As such, financial instruments have been developed by
Islamic financial institutions to satisfy these requirements. For example, instead of
debt financing, equity financing is used. Instead of borrowing to finance the purchase
of equipment, leasing tools were developed. Instead of a fixed interest rate on a
savings account, Islamic banks offer a share of the banks profit as a return on deposits
(which have been around 5% annually1) or place funds in short-term commodities
trading accounts.

Brief History2
Islamic banking, as an institution, has only been around for 25 years but that is not to
say that interest-free banks have not been tried before. There was one in Malaysia in
the mid-forties and another in Pakistan in the late-fifties. Neither survived. In 1962
the Malaysian government set up the “Pilgrim’s Management Fund” to help
prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-
Ghamr in Egypt was very popular and prospered initially and then closed down for
various reasons. However, this experiment led to the creation of the Nasser Social
Bank in 1972. Though the bank is still active, its objectives are more social than
commercial.

The early seventies, on the other hand, saw the institutional involvement. Conference
of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the
Egyptian study in 1972, First International Conference on Islamic Economics in
Mecca in 1976, International Economic Conference in London in 1977 were the result
of such involvement. The involvement of institutions and governments led to the
application of theory to practice and resulted in the establishment of the first interest-
free banks. The Islamic Development Bank, an inter-governmental bank established
in 1975, was born of this process.

The first private interest-free bank, the Dubai Islamic Bank, was also set up 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. In the
same year the Kuwaiti government set up Kuwait Finance House.

Twenty-five years since the establishment of the first Islamic bank, more than 150
Islamic financial institutions have come into being3. Though many are in Muslim
countries, there are some in Western Europe as well as North American and Asia.

1
Based on Kuwait Finance House data (www.kfh.com)
2
Abdul Gafoor, A.L.M. Interest-free Commercial Banking, Islamic Banking , 1995.
3
Institute of Islamic Banking & Insurance – www.islamic-banking.com.
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What’s behind today’s interest in Islamic Banking?

As economies of Muslim countries became richer (i.e. the Persian Gulf countries)
along with the migration of educated Muslims to western countries, Muslims’ interest
in their faith grew. Today, the Islamic banking system manages over $100 billion and
is said to be growing at 12%-15% annually4. Global financial institutions have
recognized this trend and are capitalizing on the attractive niche market. Some of the
western banks that have established dedicated Islamic banking subsidiaries or have
substantial dealings in the field include, Citibank, Bank of America, Commerzbank,
Deutche Bank, Merrill Lynch, ABN AMRO, BNP Paribas, Pictet & Cie, UBS,
Standard Chartered, Barclays, HSBC, Royal Bank of Canada and Brown Brothers
Harriman.

Demand for Islamic Banking Services

Islamic banks have come along way in a relatively short time and have captured a
significant market share from their conventional rivals. Penetration rates of Islamic
banking services in Muslim countries range from 5% in Malaysia to 12% in Saudi
Arabia to 30% in Kuwait5.

It is anticipated that the Islamic banking industry will be responsible for managing at
least 40-50% of the total savings of Muslims worldwide in 8 to 10 years.

It is important to note that Islamic banks tend to focus on their local markets while
western institutions such as Merrill Lynch target the high-net-worth segment. There
are no real global players in the field. There are no retail Islamic banks in OECD
countries. Also, Islamic banks do not have the in-house expertise to develop Sharia-
compliant products and thus, seek financial engineering expertise from western
institutions.

Types of Products and Services Offered by an Islamic Bank

Generally speaking, all Islamic banks agree on the basic principles. However,
individual banks differ in their application. These differences are due to several
reasons including the laws of the country, objectives of the different banks, individual
bank’s circumstances and experiences, the need to interact with other interest-based
banks, etc. The following will describe the salient features common to all banks.

1. Deposit accounts
All the Islamic banks have three kinds of deposit accounts: current, savings and
investment.

- Current accounts
Current or demand deposit accounts are virtually the same as in all conventional
banks. Deposit is guaranteed.

4
Institute of Islamic Banking & Insurance – London (www.islamic-banking.com)
5
Independent study conducted by PSI Global, a UK-based consulting firm, 1999.
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- Savings accounts
Savings deposit accounts operate in different ways. In some banks, the depositors
allow the banks to use their money but they 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 others, 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 accounts
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. Capital is not guaranteed. Some Islamic banks structure these accounts to act
like a Certificate of Deposit (CD) where funds are lock in for a period of time and
profits are paid out at maturity (refer to appendix for actual returns on Al Baraka
investment accounts).

2. Modes of financing
Banks adopt several modes of acquiring assets or financing projects, but they can be
broadly categorized into three areas: investment, trade and lending.

- Investment financing
This is done in three main ways:
a) Musharaka(venture/equity financing) where a bank may join another entity to
set up a joint venture, both parties participating in the various aspects of the
project in varying degrees. 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.
b) 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 proportion, but when a loss occurs the total
loss is 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.
c) Financing on the basis of an estimated rate of return. Under this scheme, 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. In case a loss is suffered the bank will take a share
in it. A good example to highlight this, though they do not act exactly the
same, are corporate bonds. The investor receives a fixed rate of return. If the
company makes more money the bondholder still receives the same amount,
however, if the company runs into financial trouble, the bondholder will share
in the loss.

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- Trade financing
This is also done in several ways. The main ones are:
a) Murabaha (Cost-Plus Financing) a contract of sale 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. For example: a customer 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 then sells it to the customer for $15,000. The
bank charges a mark-up because it is willing to accept installments (i.e. over
60 months) instead of one lump sum payment. The mark-up is profit since the
bank acted as a middleman; no money was lent, a product was 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.
b) Leasing where the bank buys an item for a client and leases it to him for an
agreed period and at the end of that period the lessee pays the balance on the
price agreed at the beginning an becomes the owner of the item. Several US
investment banks have expressed interest in securitizing Islamic leases.
c) 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.
d) 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
certain time for an agreed price.
e) Letters 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
Main forms of Lending are:
a) 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.
b) 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.
c) Overdrafts also are to be provided, subject to a certain maximum, free of
charge or for a small fee.

It is important to note that Islamic banks are not active in lending, as defined by a
conventional bank, due it’s nature of being interest-based. What lending forms were
mentioned above are not a complete list of the various modes of the lending.
However, the point being made is that lending in an Islamically acceptable form is not
very profitable to the bank, so they must resort to other “lending” related practices,
such as leasing and mark-up transactions (a.k.a. Murabaha). Islamic bonds, where
the rate of return is fixed but not guaranteed, are increasingly becoming popular as
financial engineers continue to develop acceptable non-interest related products.
Malaysia and Bahrain are currently developing a global Islamic bond market.

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3. Services
Other banking services such as money transfers, bill collections, trade in foreign
currencies at spot rate etc. where the bank’s own money is not involved are provided
on a commission or charges basis.

Shortcomings in current practices

In the previous section the current practices were listed under three categories:
deposits, modes of financing (or acquiring assets) and services. There seems to be no
problems as far as banking services are concerned. Islamic banks are able to provide
nearly all the services that are available in the conventional banks. The only
exception seems to be in the case of letters of credit where there is a possibility for
interest involvement. However, some solutions have been found for this problem --
mainly by having excess liquidity with the foreign bank. On the deposit side, judging
by the volume of deposits both in the countries where both systems are available and
in countries where law prohibits any dealing in interest, the non-payment of interest
on deposit accounts seems to be no serious problem. Customers still seem to deposit
their money with Islamic banks.

Islamic banking in non-Muslim countries

The modern commercial banking system in nearly all countries of the world is mainly
evolved from and modeled on the practices in Europe, especially that in the United
Kingdom. The philosophical root of this system revolves around the basic principles
of capital certainty for depositors and certainty as to the rate of return on deposits. In
order to enforce these principles for the sake of the depositors and to ensure the
smooth functioning of the banking system, Central Banks have been vested with
powers of supervision and control. All banks have to submit to the Central Bank
rules. Islamic banks which wish to operate in non-Muslim countries have some
difficulties in complying with these rules. These issues are highlighted below.

Certainty of capital and return

While the conventional banks guarantee the capital and rate of return, the Islamic
banking system, working on the principle of profit and loss sharing, cannot, by
definition, guarantee any fixed rate of return on deposits. Thus the basic difference
lies in the very roots of the two systems. Consequently countries working under
conventional laws are unable to grant permission to institutions which wish to operate
under the Profit-and-Loss scheme to function as a commercial bank. Two official
comments, one from the UK and the other from the US suffice to illustrate this.

Sir Leigh Pemberton, the Governor of the Bank of England, told the Arab Bankers’
Association in London in 1984 that:

! It is important not to risk misleading and confusing the general public by allowing
two essentially different banking systems to operate in parallel;
! A central feature of the banking system of the United Kingdom as enshrined in
the legal framework is capital certainty for depositors. It is the most important
feature which distinguished the banking sector from the other segments of the
financial system;

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! Islamic banking is a perfectly acceptable mode of financing but it does not fall
within the definition of what constitutes banking in the UK;
! The Bank of England is not legally able to authorize under the Banking Act, an
institution which does not take deposits as defined under that Act;
! The Islamic facilities might be provided within other areas of the financial system
without using a banking name.

In the United States, Mr Charles Schotte, the US Treasury Department specialist in

regulatory issues has remarked in 1985:

There has never been an application for an Islamic establishment to set up either as
a bank or as anything else. So there is no precedent to guide us. Any institution that
wishes to use the word ‘bank’ in its title has to guarantee at least a zero rate of
interest -- and even that might contravene Islamic laws.

Note that these comments where made in the eighties when Islamic banking was still
a mystery to most central bankers. Today, the Federal Reserve in the US and the
Bank of England seem more receptive to Islamic banking practices as they have seen
it’s market acceptance and growth. Some prominent Islamic bankers are confident
that the US will grant an Islamic banking license within the next two years. As such,
there are groups currently working on establishing an Islamic banking presence in the
US.

Tax regulations
Another important consideration is the tax procedures in non-Muslim countries.
While interest is a ‘passive’ income, profit is an earned income which is treated
differently. In addition, in trade financing there are title transfers twice -- once from
seller to bank and then from bank to buyer -- and therefore twice taxed on this account
decreasing the profitability of the venture. The Director of the International Islamic
Bank of Denmark said that tax laws pose the greatest difficulty for Islamic banks in
most OECD countries.

For more information contact:

Failaka International Inc. ■ Tel/Fax: +1 (209) 391-4248 ■ Web: www.failaka.com