One of the main
characteristic of Islamic finance is the principle of debt-free financing.
Charging any type of interest is prohibited under Islam because they consider
that it is unethical to earn money on someone else’s debt. It is considered as one
of the haram activities because it is like making money by harming someone
else. The banks which run on this ideology are funded by non-interest bearing
current accounts which are either benevolent loans or safe keeping contracts. They
are also funded by profit sharing investment accounts in which they receive a
part of the profit earned by the loan bearer. This type of framework is very
different than conventional type of banking as conventional banks survive by
making money from the interest they charge from their defaulters.
institutions follow the model of profit and loss sharing. It is another
characteristic of Islamic banking which works on the principle of profit
sharing and loss bearing which is also known as ‘Mudarabah’. In this scenario, the
financier or the investor provides capital whereas the beneficiary provides the
skills or the labor. There are two types of cases in this, in the first case,
the profits are shared by both the parties but the losses are beard by the
investor. The investor does not interfere in the management of the operation otherwise
it is considered a breach of contract. In the second case, there is equity like
financing of the operation where profits and losses are shared equally known as
‘Musharakah’. This profit sharing model is often considered as a win-win
situation because the loan bearer is not actually taking a loan but is in a
partnership with the bank. The investor or the partner will share both the
profits and the losses. It is a greater amount of risk for the banks but it is
also greater amount of profits at the same time. The loan bearer on the other
hand can feel more debt-free and can actually focus on making profits instead
of thinking about repaying the bank.
Based on the Hofstede’s
cultural dimensional theory, it can be seen that most of the Islamic countries
are high on uncertainty avoidance and masculinity. Islamic culture is a
high-context culture. Islamic banking works on the principle ‘Do not sell what
you do not own’ which means that things like short selling are prohibited. For example,
one cannot lose his/her property except on the basis of his/her right. Due to
these type of conditions, Islamic banking is considered to be asset based
Islamic banks tend to have
high amount of liquidity, but at the same time, they suffer from lack of high
quality liquid assets complied by Shari’ah. There is a big question in order to
have a regulatory body for the compliance and regulation of these Islamic
banks. There is a need of this regulatory body as there is no supervision to
these banks and some small scale banks take advantage because of this reason.
There is a need to develop methodologies for their asset management, analysis
of their risk taking capability and vulnerability. The international monetary
fund has introduced some standards to govern these banks. One such body is
account and audit association of Islamic financial institutions. Another thing
is ‘sukuk’, which are asset based financial securities. They are certificates
of value representing assets which provides the investor a proof of ownership
of the asset. The Islamic banks tend to face more risk because their
investments are physical whose return is uncertain. These banks are more
resilient to sudden shocks than conventional banks due to the gharar considerations
which prohibits them from creating investments in super risky and toxic assets.
Islamic banks have shown
a great amount of growth in the past decade. Stats show that the amount of
assets owned by Islamic banks grew by double digit rates in the past decade
from US$250 billion in 2004 to an estimated US$1.9 trillion at the end of 2014
(Ernst & Young 2014; IFSB 2014; Oliver Wyman 2009). Inspite of these growth
patterns, it is clear that most of these assets are limited to the gulf
countries. The growth is mainly due to the strong demand from Muslim
populations and tremendous growth of industry in the developing countries.
Islamic banks have great potential to contribute even more towards the growth
of these countries as research shows that investment by these banks in the
private and the public sector has helped boom various economies in the past
such as Pakistan and Syria. A big section of the Muslim population is
underserviced by conventional finance – only 24 percent of adults have bank
account and 7 percent have access to formal financing, compared to 44 percent
and 9 percent, respectively, for non-Muslim populations (Demiguc-Kunt, Klapper,
and Randall 2013). The characteristics of risk sharing makes these types of
banks very well suited for the financing of various types of startups and SME.
The presence of sukuk has shown great value in the field of investments,
infrastructural financing and economic growth. The issuance of sukuk has also
rapidly increased since 2006, although its diversification is still going on in
various African and middle eastern countries.
If we compare Islamic
banks to conventional banks based on their growth and profit, before the period
of the recent global recession, both types of banks were not significantly
different. After the financial crisis, the profitability of Islamic finance
slowed down in comparison with the conventional banks due to the low risk
management policies. But the recent studies show that Islamic banks are on a
rise in both the profit and efficiency. These banks are way more advanced in
the developed countries than in other countries due to the same reason of
better risk management policies of these countries. Islamic banks face their
own risk in compliance with the Shari’ah and use conventional risk measures.
The overall development of these banks is on such a rise that in a few years
they might be a better option than the conventional banking system.