ISLAMIC FINANCE Opportunities and Challenges

ISLAMIC FINANCE Opportunities and Challenges

One of the most prominent aspects of Islam is that it attempts to moralize every walk of life. All social institutions (religious, political, economic, educational, recreational and legal) are structured in such a way that the enabling societal conditions are provided where an individual’s as well as a society’s collective advancement is ensured within strong moral precepts. The same is the case with economic institution of Islam that seeks equitable distribution of resources, end of economic exploitation, mainstreaming of marginalized segments of society and elimination of poverty with its moralized fundamentals of economy and finance.

Islamic finance refers to the provision of financial services as per Islamic jurisprudence (Shariah). Shariah bans all forms of Riba (interest) whether on commercial loans or on personal ones, gambling and short sale, and also prohibits all business activities that maybe harmful to society such as trade of alcohol and other such drugs. Fair treatment and sanctity of honour are, in principle, important pillars of the Islamic finance. The whole edifice of Islamic finance has been underpinned by the real economic activities and it implies that investments are made in tangible properties and businesses, and the risk associated with investments is shared by all parties involved.

As per Islamic viewpoint, money is only a way of determining the value of something; it has no value itself. So, generating more money by simply saving money in banks or lending it to someone on interest is not allowed. Islamic banks are funded by non-interest current account as well as profit-sharing investment accounts where the investor receives ex-post profit (based on actual results rather than forecasts) that is determined by the profitability of banks or the pool of assets financed thereby. Traditional means of earning money in conventional banking systems like loans, mortgage and charging interest on them are avoided in Islamic finance. The Shariah-compliant banks use the depositors’ money to acquire assets and share any profit earned thereupon with the depositor. So, Islamic banks do not engage in lending but these banks deal with sales, lease, profit-and-loss-sharing financing and fee-based services. All transactions, transfers, ownerships and purchases are made in real goods among the parties and the return hinges on the profitability of underlying transactions. The principal amount is not guaranteed and instead of interest, the debtors provide predetermined and periodic payments to the banks based upon expected profits earned from investments.

Islamic finance reveals itself in many different forms and hues. Broadly speaking, economic activities based on Islamic finance can be classified into three categories:

1. Debt-like financial products such as sales that could be with markup, or deferred payments, are known as Murabahaha. These products can be in the form of purchases with deferred delivery of products which is called as Salam for basic products and Istisna for manufactured products. Sukuk bonds can also be placed under this category of which Ijara is the most common type that is Islamic finance’s version of leasing. Ijara is asset-based leasing in which the issuer transfers the ownership of some tangible assets to bondholder and pledges to give predetermined rent to the bondholder until the maturity of bond.

2. Another category is profit-and-loss-sharing financial products. These are further of two types: (a) Profit-sharing and loss-bearing known as Mudarbah; and (b) profit-and-loss sharing known as Musharkah. Under Mudarbah arrangement, the financier (whether bank or investor) provides capital and beneficiary provides labour and skills. In this arrangement, profit is shared and loss is borne by the financier. As name indicates Musharakah is arrangement under which two parties have equity-like financing of projects and they share profits and losses.

3. The third form of Islamic finance provides different services such as safe-keeping contracts as current account known as Waliah or agency contract known as Wakalah used for market transactions. In addition, equity market, investment funds, insurance (Takaful) and micro-financing are other services provided in Islamic banking.

Islamic finance or Islamic banking is fast-emerging as a parallel to the conventional banking system. It has been expanding at the rate of 10 to 12 percent and its total assets, at present, are valued nearly US$ 1.9 trillion. The fast-growing importance and relevance of Islamic finance is mainly due to the following factors:

1. It provides unique opportunities of extending the banking services to OIC member states whose majority populations are under-served and excluded from safety nets provided by the conventional banking system. The abject poverty, untapped natural and human resources and religious tendency to avoid interest-based economic activities make Islamic banking a profitable sector for developing and underdeveloped Muslim countries. So interest-free banking system should be the choice of majority of Muslim population.

Islamic finance has the potential to foster financial inclusion, especially for those who are reluctant to undertake economic activities due to religious and cultural reservations associated with conventional banking system. This would result into equitable distribution of resources and availability of untapped human resource, thus ensuring inclusive development on sustained basis.

Risk-sharing feature and prohibition of speculation can be instrumental in avoiding the systemic risks associated with conventional financial management. The principles of risk-sharing and asset-based financing help promote better risk management by both financial institutions and customers and this results into increased stake for both parties and their cautious approach translates into relative stability.

The emphasis of Islamic finance on real economies ensures macro- and microeconomic stability as equity and investment in real business help promote stable and productive banking system and financial capital does not lead to artificially bloated asset prices. Thus the overall element of uncertainty is eliminated and investors continue to make investments.

Asset-based financing and risk-sharing features mean that Islamic financing would prove helpful for small and medium enterprises (SMEs) and it can help promote investment in public infrastructure. SMEs play a critical role in the elimination of poverty and empowerment of downtrodden segments of society. In addition to risk-sharing, the strong link of capital to the collateral indicates that Islamic banking is well suited to SMEs, and especially Sukuk (Islamic bonds) have shown their importance in the realm of infrastructure finance as it is helpful in supporting investment and economic growth led by SMEs.

Islamic finance or Islamic banking is founded on strong ethical precepts. The underlying ethical precepts provide an important basis for high level of ethical conduct, governance and customer protections. The moralized concept of finance adds another distinction to this system as conventional financial system believes in ruthless race of increasing wealth without any regard for the legitimacy or illegitimacy of sources of income.

Financial Crisis 2008 or Global Financial Crisis proved the resilience of Islamic finance to withstand the recession. The resilience of Islamic banking resides in its emphasis on doing business in real economy. Islamic banking was less exposed to the toxic assets that contaminated the global financial system. As per an IMF report, the asset quality and capitalization of Islamic finance are better than those of the conventional banking system.

The humanitarian approach of Islamic finance is also a unique feature of this system. Different financial instruments such as Zakat and Waqf (charitable endowment) can generate resources on sustained basis to eliminate poverty and other social ills such as illiteracy and unemployment. Particularly Zakat, which is collected for mitigating the sufferings of the poor and the needy.

Despite the advantages and opportunities provided by Islamic finance, it is facing multiple challenges that have hindered the full exploitation of its potential.

Islamic finance is unique form of financial system that necessitates corresponding supervision and regulation. The most daunting challenge Islamic finance is confronting today is the one posed by regulatory and supervisory frameworks that are designed for conventional banking system, not for Islamic finance. This is the reason of relatively slow-paced development of this system. In addition to non-conducive regulatory environment, near- absence of innovation is also proving a mighty roadblock in the way of Islamic finance.

There are very few Muslim countries that have developed full-fledged Islamic deposit insurance scheme with premium invested in Shariah-compliant assets. The safety nets and resolution framework to ensure the resolution of disputes remain underdeveloped. Furthermore, the tax and regulatory mechanism of majority of Muslim countries is proving counter-productive for Islamic financing and it is operating where legal rules, financial infrastructure and access to safety nets and liquidity are absence.

Monetary policy formulation for Islamic finance and its implementation are facing constrains due to scarcity of Shariah-compliant monetary instruments and Islamic scholars with expertise in money transmission mechanism. The absence of consensus on different Islamic Finance’s products and instruments among different schools of thought is further hindering the outreach of Islamic banks.

It is general tendency on the part of experts to structure the Islamic banking on the pattern of conventional banking system with a few modifications. This results into the same risks factors (market, credit and operational) that plague the conventional banking and people begin to consider Islamic banking as the other side of same coin. So, people show lack of interest in this banking. In addition to these, Islamic finance is facing structural problems as well. One of them is as to how to counteract the devaluation of paper currency without interest. The Islamic scholars have yet to solve this issue.

Although Islamic banking is facing multi-faceted problems, its potential cannot be ignored. That’s why both the World Bank and the IMF are offering financial and technical assistance for Islamic financing. The World Bank has introduced investment projects that use Islamic financing. World Bank treasury issues varieties of Islamic instruments such as Sukuk and International Financial Corporation has issued $100 million worth trust certificate. IMF has played very determinant role in the establishment of Islamic Financial Service Board and it is providing assistance and training to assist countries seeking to strengthen regulatory and supervisory framework of Islamic banking. Apart from global financial institutes, national governments are also investing in Islamic investment. UK government’s issuance of Sukuk Bond is such an example.

Islamic financial system is unique because its underlying philosophy seeks to end poverty and economic exploitation. It is provision of interest-free financial services. It reveals itself in different forms and has huge potential to bring about massive transformation in the lives of the people of developing and underdeveloped countries. It offers many opportunities and advantages as compared to the conventional banking system. Although it is confronting many challenges, the presence of strong legal institutions that protect property rights and ensure enforcement of contracts, the standardization and harmonization of regulations across the countries and reforms in national tax, monetary and fiscal policies would go a long way in erecting the edifice of Islamic finance on sustained basis. The enactment of appropriate, enabling environment that is characterized by effective partnership and level playing fields is also imperative in reaping the rich fruit produced by Islamic financial system.

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