Both the theory of Islamic banking and the rapid expansion of Islamic banks recent years have demonstrated the viability and feasibility of non-interest-based operations. This must be surprising to those who believed that banks and financial systems could not operate in a modern economy without reliance on an interest rate mechanism. Indeed, experience has shown that Islamic banks are powerful means of mobilizing resources. Operationally, however, both the Islamic financial systems in the three countries that have adopted it as well as individual Islamic banks face challenges that need to be addressed.
The most important among these challenges is the fact that, while it has been relatively easy to create a system in which deposits do not pay interest, the asset portfolios of Islamic banks do not contain sufficiently strong components that are based on profit-sharing. The main reasons for this are:
(a) lack of a legal and institutional framework to facilitate appropriate contracts as well as mechanisms to enforce them; and/or
(b) lack of appropriate menus containing a broad range and a variety of maturity structures of financial instruments.
Consequently, a relatively strong risk perception has become associated with profit-sharing methods in particular and Islamic banking in general. This, in turn, has led to concentration d asset portfolios of the Islamic banks in short-term and trade-related assets with inimical effects on investment and economic development. The problem is exacerbated by the fact that Muslim countries, as is the case in much of the developing world, suffer from a lack of deep and efficient capital and money markets that can provide the needed liquidity and safety for existing assets. The absence of suitable long-term instruments to support capital formation is mirrored in the lack of very short-term financial instruments to provide liquidity.
The challenges facing individual Islamic banks
Impressive as the growth record of individual Islamic banks may be, the fact is that at present, those banks have mostly served as intermediaries between the financial resources of Muslims and major commercial banks in the West. In this context, this has been a one-way relationship, so far. There is still no major Islamic bank that has been able to develop ways and means of intermediating between Western financial resources and the demand for them in Muslim countries.
It also appears that individual Islamic banks face difficulties in fund placement because they have had a major bias towards short-term, secured, low-return but liquid investments. The challenge for these institutions stems from motivational and technical factors.
Motivationally, their basic aim appears to have been that of demonstrating the viability of Islamic banking without taking too many risks. Admittedly, this is a noble and a very important objective, however, although they have succeeded in this effort and have managed to create a market niche for Islamic banking, they do not seem to have achieved the market depth that could ensure long-term profitability and survival. This stems from the fact that they appear to be far behind in technical innovations and financial market developments that in recent years have revolutionized finance and capital markets. There is no evidence that these banks have made any large investment in research and product development, nor is there any evidence that new financial products developed in recent years, particularly in equity derivatives, have been utilized to any significant degree by the major Islamic banks. This is unfortunate because the market opportunities that these banks have been able to develop, to allow funds from Islamic communities to be placed in Islamically permissible portfolios, can and will be exploited by more efficient and innovative Western financial institutions that already have or will discover this market niche.
While there is considerable room for competition and expansion in this field, the long-term survivability of individual Islamic banks will depend on how rapidly, aggressively, and effectively they can develop techniques and instruments that would allow them to carry on a two-way intermediation function. They need to find ways and means of developing marketable Shariah-based instruments by which asset portfolios generated in Muslim countries can be marketed in the West as well as marketing Shariah-based Western portfolios in Muslim communities.
The challenge of adopting an Islamic financial system
The most important challenge for Islamic banking is in its system-wide implementation. At present, many Islamic countries suffer from financial disequilibria that frustrate attempts at wholesale adoption of Islamic banking. Financial imbalances in the fiscal, monetary and external sector of these economies cannot provide fertile ground for efficient operation of Islamic banking. Major structural adjustments particularly in fiscal and monetary areas are needed to provide Islamic banking with a level playing field. Additionally, adoption of a legal framework of property ownership and Contracts that would clearly specify the domain of private and public property rights as well as stipulation of legally enforceable rights of parties to contract that fully reflect the requirements of the Shariah, are necessary to allow an operational framework conducive to efficient operation of Islamic banking.
An Islamic financial system can be said to operate efficiently if, as a result of its adoption, rates of return in the financial sector correspond to those in the real sector. In many Islamic countries fiscal deficits are financed through the banking system. To lower the costs of this financing, the financial system is repressed by artificially maintaining limits on bank rates. Thus, financial repression is a form of taxation that provides governments with substantial revenues. To remove this burden, government expenditures have to be lowered and/or revenues raised. Massive involvement of governments in the economy makes it difficult for them to reduce their expenditures. Raising taxes is politically difficult. Thus, imposing controls on domestic financial markets becomes a relatively easy form of raising revenues. Under the above circumstances, it is understandable why governments would have to impose severe constraints on private financial operations that can provide higher returns to their shareholders and/or depositors. This makes it very difficult for Islamic banks and other financial institutions to realize fully their potential. For example, Mudarabah companies that can provide higher returns than the banking system would end up in direct competition with the banking system for deposits that are used for bank financing of fiscal deficits.
While Muslim countries may, for legitimate reasons, opt for an Islamic financial system, for the economy as a whole to benefit fully from the operations of such a system, it is necessary that
(a) government expenditures are fully rationalized,
(b) revenues from taxation, and those derived from property legitimately placed within the government domain by the Shariah, are raised to meet the expenditure needs the government,
(c) the financial sector is liberalized so that returns to this sector reflect returns to the real economy,
(d) equity markets are developed to allow financing of investment projects outside banking institutions, and,
(e) the structure of the banking system should be such as to allow strong banking supervision and prudential regulation commensurate with the risks involved in various transactions. To accomplish the last objective, the banking structure can be tiered in accordance with principal Islamic financial transactions. It is reasonable to assume that risks involved in Musharakah or Mudarabah financing, are different from those involved in trade-type financing. It follows, therefore, that prudential regulations of these transactions should be different.
My Comment
The above is an excerpt of an article that was written by Dr Abbas Mirakhor, a well known expert in the field and the said study was presented at the International Monetary Fund in 1997.
The article got me thinking on the following issues :
1) The academics especially in the field of Islamic banking and finance had on numerous occasions conducted studies and shared their findings to the world on the challenges and/or issues faced, but what significant impact(s) has/have been made out of the studies?
2) To be able to see the effect/impact of a new financial system, the full backing of the government is needed, however, despite the yearly forums/meetings etc, the progress is deemed to be slow. Yes, there’s a lot of “hoo-haa” on the tremendous increase in the Islamic banking growth the world over, but the significant increase is due to the growth in Murabahah (cost-plus) products and not on Mudarabah or Musharakah investment products.
This means that the Islamic banking industry is merely imitating the conventional products – easy means to show growth in a short span of time.
3) Even the financial fraternity (the auditors, the bankers etc) in the Muslim countries are having problems to follow the AAOIFI standards on presentation of the accounts of Islamic financial institutions, then how could comparison be made on the performance of these banks ?
A lot of industry experts (or so they called themselves) argued on the need for standardization, as even without one, the industry has shown great potential for growth. Yes, based on the history so far, certain fiqh issues/matters can be opened for interpretation/discussion, however, we cannot neglect the fact that if the Islamic banking industry is to be at par with its conventional counterpart, it needs to have a minimal standardization in the following areas :
a) Accounting practices and presentation (which I believe the IFSB and AAOIFI have both done a very good job so far). However, the fact remains that most Islamic countries fail to adopt the standards and still prefer to use other standards like the case of Malaysia, the Islamic banks are still using the standards issued by MASB and IFRS.
b) Basic standards for development of new financial products so that these products can be accepted and acknowledged by all Muslim countries. It is quite weird and funny to develop an Islamic product that is only accepted in certain parts of the world only.
Read the full article by the learned author and think about it...you may find that there are other issues that warrant some attention from the practitioners.....
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