Financial Sphere in Islamic Countries - Essay Example

Islamic Finance Islamic finance and banking was launched as a significant practice in the financial field almost 30 years ago and has grown from a marginal industry to raise hope in a situation that was getting desperate. It may be defined as a finance system that conforms to Islamic law, also known as Sharia, although the definition does not imply that is it limited to Muslims or Islamic countries (Rammal & Zurbruegg 86). Islamic finance is guided by ethical concepts prescribed by Sharia in relation to money and capital and the association between profit and risk as well as the social obligations of financial institutions. It has grown into a global and cosmopolitan financial system, committed to a text that may be accessed by all people. Being open to innovation, the system has been able to effectively compete with the conventional financial system by offering a wide range of financial products suiting numerous customer needs. Serving as an alternative to the conventional financial system, Islamic finance has been forging a more functional link between activities of real economy that generate value and the financial activities which facilitate it. This paper will discuss ways in which Islamic finance can be considered as an alternative to conventional finance and why it is a viable alternative. Governance and Regulation Although it is governed by the same fundamental monetary policies as conventional banking, the key and most significant distinguishing factor is the requirement of a strict adherence to a code of ethics (Zepeda 52). At the microeconomic level, Islamic finance is regulated by Sharia supervisory boards, or Sharia scholars at the least, who are responsible for approving and reviewing financial products and practices for compliance with Sharia guidelines. At microeconomic levels, the key regulatory authorities and institutions are located in Malaysia and Bahrain as the largest segments of the Islamic finance’s market are predominantly found in those jurisdictions. Among the leading organizations that set standards of the system are the Accounting and Auditing Organisation for Islamic Finance (AAOIFI), Malaysia Accounting Standards Board (MASB) and Islamic Financial Standards Board (IFSB). AAOIFI is based in Bahrain while MASB and IFSB are in Malaysia (Zepeda 53). Islamic Finance as an Alternative to Conventional Finance The conventional finance system has been described as being innately unstable mainly due to being based on interest and debt as well as using the credit multiplier to leverage itself while creating debt excessively. It is characteristic of government rules and regulations, insurance schemes and treatment of tax to promote contracts that are based on debt in conventional finance rather than those involving sharing of the risks (Zepeda 48). As such, a finance system founded on debt encourages the transfer of risk while the gains of sharing risks are underused. Islamic finance offers an alternative to conventional finance to those seeking to integrate values and ethics into financial services as a positive development that also promotes social justice. The alternative can best be viewed from the two perspectives through which the system has evolved. First, the system has eliminated interest-based finance, also known as riba, as per the guidelines of Sharia. It is also from this principle that the nature of capital is held exclusively as a medium of exchange since it has no attached intrinsic value. Second, it has developed a comprehensive range of low-risk financial products that aim at giving depositors, shareholders and regulators the same level of confidence. Although most of the products are debt-based and resemble the instruments used in conventional finance, they bear a distinguishing feature in the way they promote entrepreneurship; do not support speculative behavior; preserve property rights; advocate for sharing both returns and risks; and keep contractual obligations transparent (Mahlknecht 71). In this manner, the system has not only appeased most of the stakeholders, but also the industry of financial and banking services itself. The financial services that make it possible to view Islamic finance as an alternative to conventional finance may be detailed as below: Interest (riba) From these two perspectives, people seeking an alternative to interest-based finance have an option. Fundamentally, any predetermined, fixed, positive rate attached to the maturity and principal amount is prohibited. Further, the principal amount is guaranteed regardless of the investment’s performance (Mahlknecht 69). However, this does not mean that there is no profit on capital or rate of return, since the earning and sharing of the profit is encouraged by the system. In other words, profit is symbolic of the generation of wealth by innovative entrepreneurship and is determined ex post. On the other hand, interest is an accrued cost regardless of the business’ results capable of generating wealth even if losses are incurred by the business and is determined ex ante. In this sense, riba is in reference to the compensation a borrower pays the lending institution for the capital used in a given duration. Uncertainty and Risk (gharar) In this system, customers who do not wish to engage in gambling-like transactions are offered an alternative because of the prohibition of contractual risks and uncertainties, also known as gharar (Timur 623). One party cannot sell services and goods that they are not able to deliver to the other, or goods that they do not own. In the same way, no contract may be entered into basing on the conditions of an event that is unknown. The nature and price of the goods in the transaction are detailed and both parties must agree to them. It is through the agreement that the gambling aspect of a contract, which exists in conventional finance in services such as insurance, is eliminated. The regulating authorities have developed standard financing modes and instruments as alternatives to those that have existed before in conventional finance by applying an adherence to Islamic law to them. The instruments may be categorized into those that are associated with liquidity management and financing working capital; equity; asset finance; and fixed income investment as described below. Asset Finance In this category, there are two instruments; ijara and diminishing musharakha. Essentially, ijara is the equivalent of leasing in conventional finance and applies mostly in property purchase such as land and homes (Timur 621). A financial institution buys the borrower’s preferred asset and leases it to them for an agreed time duration and payable rent that goes towards the purchase price of the property. Musharakha represents an arrangement of joint venture via a contract of equity participation. In musharakha, distribution of ownership depends on the shares of each partner and losses incurred or profits made are shared. Diminishing musharakha as used in asset finance is a hybrid technique that has aspects of both musharakha and ijara. First, this concept conforms to the risk-sharing tenets of Sharia, and then it incorporates variable return rates and bears a credit profile accepted by most institutions of conventional finance. Liquidity Management and Financing Working Capital These two financial services provided through murabaha and istinaa. Murabaha is a cost-plus financing instrument that affords customers to make deferred payments. Unlike the conventional lending of money to customers by banks, under murabaha, the bank buys commodities as requested by the customer, who in turn buys from the bank at a marked up price as they agree (Kadri 23). This makes it a functional alternative to obtaining working capital. Istinaa targets long term projects, such as construction, and when applied together with murabaha, it facilitates the sale of a product before its actual existence. However, this should not be viewed as a gambling-like transaction, because a building to be constructed will definitely come to be and no speculation is involved. Equity The concepts of musharakha also apply to equity investments where property may be owned by multiple partners and returns shared according to shares of partners. Further, it also incorporates mudarabah. In mudarabah, a segment of the partners may contribute the full capital requirement, while another segment offers management services. Here, customers are offered an alternative to own shares in projects even if their contribution is other than financial. However, even if the sharing of profits is agreed before the initiative takes off, only the contributors of financial capital bear the losses (Kadri 23). Fixed Income Investment This is mainly characterized by sukuk, which is a bond or investment certificate that is representative of an impartial interest in a pool of assets generating capital returns. The investment originates from securitization process as it applies in conventional finance, where assets are acquired by use of special purpose vehicles. The investors, who are the sukuk holders, distribute the returns among themselves. In this way, large institutions, even governments, have an affordable alternative to raising funds for large projects, such as infrastructure. In Islamic finance, the debt markets of conventional finance are replaced by securities markets that are securitized through their asset link (Kadri 16). This represents a significant alternative to conventional finance because the Islamic securitization is in the form of an investor’s right of ownership over the assets which are securitized. The conventional financial system can accommodate multiple ownership levels, essentially providing no recourse to investors but, on the other hand, Islamic finance strict requirements have been upheld for clear rights of ownership for all investors (Warner 117). It then becomes clear that this feature provides an alternative of stability because trading of the underlying asset cannot be carried out over and again which, in the event of liquidation, would produce a cascading effect. Being debt-based, underlying assets in conventional finance bear implicit guarantees on of principal. Conversely, the Islamic finance system’s securitization has been proposed to be based on the sharing of risks, which implies that the underlying asset’s market value would determine the principal return. This is in opposition to the way the market prices of security reflects the market value rather than the underlying asset’s market price in conventional finance. Islamic Finance as a Viable Alternative to Conventional Finance Institutions of Islamic finance have proven their worth in the way they have filled the gaps left open by conventional finance by launching innovative programs that complement their growth. Based on an ethical foundation and the link to resurgence of modern civilization in Islam, the system is proving to be viable even to persons who do not practice Islam. It bears the capacity to create links between real economy and finance. Profit is justifiably shared through innovations like Musharakha and Mudaraba, which symbolize partnership and equity participation. Islamic finance is also made viable by the notion of sharing profits and risks instead of transferring risk as is the case of conventional finance. For instance, murabaha commits to trade with a mark-up and facilitates short-term financing similar to purchase finance in conventional finance (Warner 120). However, the viability is that banks can buy assets from sellers and agree on the resale mark-up with buyers, without any interest on the loan. This curbs the exchange of contemporary money for future, prospective money, promising to reduce the borderless expansion of credit and reduce speculation. This characteristic also makes it more suitable for an economic platform that is globalizing, where conventional finance systems have not achieved enough trust from communities faced with financial difficulties (Rosly 84). In Islamic finance, there is the concept of a segmented market, where products are based on Sharia principles and the market is made up of customers willing to abide by the concepts of their religion. Every transaction is based on the perspective of sharing profit and loss, with returns differing depending on the performance of a financial institution. Customers can take part in profit sharing in more equitable ways than getting predetermined returns. Unlike conventional banking where having a bad credit history locks one out of participating in financial products and initiatives, Islamic finance does not automatically bar such persons from participation. Instead, financial institutions look at more considerations to determine an individual’s eligibility to further credit or contract. Islamic finance is set apart from conventional banking and the basis behind it is that God owns all the wealth in the world, over which man is only a trustee (Warde 23). Humans, therefore, have an obligation to manage the wealth in accordance with the commands of Allah that prohibit activities which do not promote justice. One major reason for imposing Islamic ethics and law on finance is to encourage and advocate social justice, since Islam is considered to be inseparable from social justice. Islamic finance is founded on the nucleus perspective that prohibits the practice of usury, which means lending money to earn interest, also known as riba. Sharia law defines it as an excess compensation that lacks due consideration. Therefore, this underlying factor redefines finance from the Islam view point. However, it does not expressly preclude an agreed return on investment by the transacting entities, where all reference to interest only make up standards for the return on investment for the purpose of transparency. What that means is that interest is not used in the transaction, although capital is not only given to investors without a return. This idea arises from the fact that Islamic law does not recognize money as having intrinsic value, instead, only as a measure of value whose use is not supposed to be paid for (Warde 28). This makes Islamic finance an asset based industry, in opposition to the currency based conventional finance system, where investments are designed on the ownership or exchange of assets, with money acting only as a medium of payment to materialize transactions. Islamic finance is developed to conform to Sharia law as defined by the Quran and serves the visions and interests of the Muslim community by offering financing modes acceptable to their faith (Bodhi 9). On the other hand, conventional finance is based on secular practices of the respective nations that practice it and the creditor-debtor relationship between the customer and the bank, where the consideration between a banker and a borrower is interest. The opportunity cost for money in conventional finance is also mirrored in the interest. Islamic finance does not put in place restrictive measures in economic activities. Instead, it directs the industry towards responsible and moral activities that place God before monetary gains while benefiting others, especially the poor. This is achieved by allowing free market economies in which the market decides supply and demand, unlike conventional finance where supply and demand are largely decided by secular government rules and regulations. Furthermore, the secular guidelines in conventional finance consent to trading of all instruments of finance, including derivatives that are prohibited in Islamic finance. Therefore, it is relevant consider Islam as not forbidding the accumulation of wealth; rather, it promotes the awareness of shared responsibility for the hardships the poor go through. This is replicated in one of the five pillars (obligatory acts) of Islam also known as zakat, which obliges people to give part of their wealth to the cause of charity. Therefore, large scale implementation of the principles of Islamic finance in the financial markets has the capacity to result in advantageous investments through which people with different financial capabilities may benefit. Such rewards can lead to considerable stability on levels ranging from regional to national and global (Sait & Lim 63). Islamic finance can be conclude as a viable alternative to conventional finance because of the way it has promoted simplicity and transparency as it has worked towards linking financial markets and economic activities. It is attributed by the notion that organizations and persons taking part in activities of financial products are viewed as partners in their transactions, rather than borrowers and lenders. Works Cited Bodhi, Bhikku. Right Speech, Right Action, Right Livelihood. Mumbai: Buddhist Publication Society, 2012. Print. Kadri, Sadakat. Heaven on Earth: A Journey Through Sharia Law. London: The Bodley Head Mahlknecht, Michael. Islamic Capital Markets and Risk Management. London: Risk Books, 2009. Print. Rammal, H., & Zurbruegg, R. “Awareness of Islamic Banking Products among Muslims: The Case of Australia.” Journal of Financial Services Marketing, 12.1 (2007-03): 83–102. Print. Rosly, Saiful A. Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Investments, Takaful and Financial Planning. New Jersey: AuthorHouse, 2006. Print. Sait, Siraj & Lim, Hilary. Land, Law and Islam. New York: UN-HABITAT. Print. Timur, Kuran. “The Absence of the Corporation in Islamic Law: Origins and Persistence.” American Journal of Comparative Law, 53.4 (2005-09): 612–649. Print Warde, I. Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press, 2000. Print. Warner, Bill. Sharia Law for Non-Muslims. London: CSPI, 2011. Print. Zepeda, Rodrigo. “Enhancing Islamic Finance through Risk Benchmarking.” The Capco Institute Journal of Financial Transformation, 9.38 (2013-10): 74-99. Print. Read More