Islamic Banking and Finance in a Global Economy - Assignment Example

and Section # of Islamic Banking and Finance in a Global Economy The paper discusses the growth of Islamic Banking and Finance in the globalized world. Briefly I have covered the banking practices, the funds and the instruments used. The underlying principles of Islamic finance such as creation of an asset, avoidance of uncertainty and speculation, and prohibition of riba etc. The role of shariah compliant institutions and the Islamic Rating Agency for regulatory and monitory purposes is also highlighted. The Islamic financial sector has been robust in the last few years and is expected to continue a possible high growth in multiple of years to come. This growth is conspicuous from the emergence of new Shariah compliant instruments in various asset classes, ranging from equities, real estate, commodities and private equity (not bonds as interest bearing instruments are considered prohibited (haram)). Estimates suggest that since 1990, the market size of the Islamic Finance has multiplied five times from USD 150 billion to USD 900 billion in the year 2008; whereas it is expected to more than double at USD 2 trillion by the year 2010. The main markets currently involved in the Islamic finance and banking across the globe comprises mainly the active participation from the GCC countries, followed by Middle Eastern and North African countries. Slowly and gradually European states, Australia and other American states have started penetrating the market with wild growth rates. It is noticeable from the onset of Shariah compliant banking units of Citigroup (America), HSBC (Britain), and Deutsche Bank (Germany). As opposed to conventional banking, Islamic banking has its roots in the core values of the religion, Islam. Where, Islam itself is the way of life and conduct of living, the underlying theme of the Islamic Financial system is application of ethics and discipline to the banking and finance sector. It is not so simple; it does not only prohibit usury/interest (money on money), but aims at eliminating unjust behavior for the development of an equitable economy. Prohibition of interest, avoidance of uncertainty and contingency, restrictions on short selling, sharing in profits and losses are the core principles governing Islamic finance; it also places restrictions on financing sectors that engage in illegal and illicit activities – such as alcohol and tobacco, gambling, arms and ammunition, pornography and acts that are harmful for the environment. For the avoidance of all these prohibit able acts and indulgences, the community of Islamic shariah scholars have come up with products in the light of Quran and Sunnah for the purposes of making money (not interest) and channelizing the potential investments of the individuals and institutions; on the other hand for borrowers to have a source of funds. The most popular of the Islamic banking products include Murabaha, Bai Salam, Istisna, Ijara, and Mudaraba. Each will be discussed briefly to understand the spirit of the Islamic finance. Mudaraba is a cost plus transaction; in murabaha, a customer requiring a certain asset intimates to the bank. The bank purchases the asset, and sells to the customer on a cost plus basis; this price is then paid by the customer in equal installments over a certain agreed time period. The price over and above cost, takes into account the time value of money. Bai salam, another contractual instrument mainly used by manufacturing concerns to cell their produce. To fulfill their financing needs they take advance payment from the bank; the bank ultimately has the buyer to whom it sells for a higher price. The difference between the purchase and the sale price is the compensation for the purchase of goods that will be supplied later. Another similar kind of forwards sales contract is Istisna, like Bai salam it requires payment in advance from the buyer; the seller then subcontracts or manufactures the asset; Bai salam is common for general manufacturing, whereas, Istisna is common for big projects such as construction. A form of leasing instrument that is Shariah based is known as Ijara. It involves bank buying the asset on its own name and then leasing the asset to the customer for a defined time period for usage. The customer in return makes periodic payments like rental for the utilization of assets’ services. Another contract may govern for the transference of ownership of the asset to the user, if required. Another of the popular instrument in the Mudaraba, it is an investment partnership that requires sharing in both profits and losses. The bank and the business enter into a partnership contract; the bank becomes the dormant partner, who makes investment, whereas the business management is the managing partner. Both share in profits and losses in the agreed proportion. Sukuk’s are the asset backed bonds, conventional bonds are not allowed in Islam as these are interest based. But Sukuk provides partial ownership in the debt. There are various types of Sukuk, such as Sukuk Al Istisna, Sukuk Al Ijara, Sukuk Al Modaraba etc. It was imperative to go into a brief detail of the instruments to understand that Islamic banking first of all is not constrained. It has a growing range of financial products within the limitations of the Shariah. No transaction occurs without creation of an asset. The developed means of financing in the Islamic mode reflect a relatively lower risk profile, because they avoid excessive leverage and speculation. Moreover, stricter Shariah laws are imposed that imposes tighter controls and monitoring of the compliance based on permit able rules. There is an Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which regulates and governs the monitoring of the Shariah compliant instruments. A sole rating agency known as the Islamic International Rating Agency (IIRA), has been formed to provide rating services to the capital markets and the banking sector in Muslim countries; it helps bring transparency into the Islamic financial institutions. The agency is relatively new and made its onset in 2005. The IIRA has established methodologies and benchmarks for the rating of the issue or issuer. The firm acts independently of the client it provides objective opinion by assessing the timing of payment of the financial obligations. Governance system and compliance with shariah are taken into account. Moreover, on a macro level it provides view on the industries and the sectors. Conclusion and Recommendations The Islamic Finance though have grown a lot is a shorter time period, but it is still in an amateur phase and face many challenges which it needs to overcome to compete with the conventional banking system. To progress it has to break out of the niche. So far it has very limited exposure to the international investors, it is mainly popular in the Muslim countries such as GCC and other Middle Eastern and African muslim States; other global big banks have started their branch banking exclusively for Islamic financing but requires to expand its contribution and customer services to gain more recognition. So far the growth in Islamic Financial Institutions have been fueled by OPEC countries, which had their living standards improved and higher disposable incomes. They had a part of their income that needed to be channelized into productive savings. But riba was forbidden. Hence initiation of Saudi firms Dallah AlBaraka Group (1969) and Dar Al-Maal Al Islami Organization (1981) supported the initiation of Islamic banking and institutions. Then events like 9/11 also shifted priorities of Arabs and Muslims to save their investments in their own countries, another phenomenon to flourish the Islamic institutions. Another impediment to the growth of Islamic Financial Institutions is the difference in Muslim culture from the western world. The terrorist attacks in the various areas of US and other non Muslim nations have brought a bad image to the Muslims and the Islamic countries, hence the trust in Islamic financial institutions and Islamic way of life has had a shattered image and haven been viewed with doubt. Hence internationalization and globalization of Islamic finance though developed is faced with many challenges, which it needs to overcome by interacting and communicating with the world. Some of the issues the Islamic financial industry needs to work on include development and training of bankers that lag behind because of their ignorance to the Islam and Shariah. The institutions should develop rigorous accounting standards, rules for revenue and expense recognition and matching, valuation and recording of transaction entries etc. The relationship with central banks should be established, which should recognize them as individual entities, capable of developing into an industry. This will help eliminate any rivalry that may emerge because of competition being faced from the traditional commercial bank. I understand that there will take a substitution in the customers (depositors) when the industry will flourish further and that will be a threat to the commercial banks, but central banks should develop mechanisms to avoid any potential conflict. The financial innovation in this area needs to be enhanced to come up with more tailored instruments for meeting the potential demand of the depositors, both short term and the longer term. Normally, short term investment instrument development is constrained by the ability to generate assets (as we understand is the underlying theme of the Islamic finance); this needs a resolution. As necessity is the mother of invention, it is agreed that Islamic finance will take time to develop mechanisms that are purely Islamic, but it is the spirit of the management and the people that needs to be developed in sincere manner. Works Cited Garas, S.N. Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution. Bahrain. Accessed from http://www.albaraka.com/ar/media/pdf/Research-Studies/Internationalization.pdf Iqbal, Z. An Introduction to Islamic Finance: Theory and Practice. Singapore: John Wiley & Sons (Asia) Pte Ltd., 2007 Warde, I. Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press, 2000 Read More