One of the maincharacteristic of Islamic finance is the principle of debt-free financing.
Charging any type of interest is prohibited under Islam because they considerthat it is unethical to earn money on someone else’s debt. It is considered as oneof the haram activities because it is like making money by harming someoneelse. The banks which run on this ideology are funded by non-interest bearingcurrent accounts which are either benevolent loans or safe keeping contracts. Theyare also funded by profit sharing investment accounts in which they receive apart of the profit earned by the loan bearer. This type of framework is verydifferent than conventional type of banking as conventional banks survive bymaking money from the interest they charge from their defaulters. Islamic financialinstitutions follow the model of profit and loss sharing.
It is anothercharacteristic of Islamic banking which works on the principle of profitsharing and loss bearing which is also known as ‘Mudarabah’. In this scenario, thefinancier or the investor provides capital whereas the beneficiary provides theskills 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 theinvestor.
The investor does not interfere in the management of the operation otherwiseit is considered a breach of contract. In the second case, there is equity likefinancing of the operation where profits and losses are shared equally known as’Musharakah’. This profit sharing model is often considered as a win-winsituation because the loan bearer is not actually taking a loan but is in apartnership with the bank. The investor or the partner will share both theprofits and the losses. It is a greater amount of risk for the banks but it isalso greater amount of profits at the same time.
The loan bearer on the otherhand can feel more debt-free and can actually focus on making profits insteadof thinking about repaying the bank. Based on the Hofstede’scultural dimensional theory, it can be seen that most of the Islamic countriesare high on uncertainty avoidance and masculinity. Islamic culture is ahigh-context culture. Islamic banking works on the principle ‘Do not sell whatyou 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 tothese type of conditions, Islamic banking is considered to be asset basedbanking. Islamic banks tend to havehigh amount of liquidity, but at the same time, they suffer from lack of highquality liquid assets complied by Shari’ah.
There is a big question in order tohave a regulatory body for the compliance and regulation of these Islamicbanks. There is a need of this regulatory body as there is no supervision tothese banks and some small scale banks take advantage because of this reason.There is a need to develop methodologies for their asset management, analysisof their risk taking capability and vulnerability. The international monetaryfund has introduced some standards to govern these banks. One such body isaccount and audit association of Islamic financial institutions. Another thingis ‘sukuk’, which are asset based financial securities. They are certificatesof value representing assets which provides the investor a proof of ownershipof the asset. The Islamic banks tend to face more risk because theirinvestments are physical whose return is uncertain.
These banks are moreresilient to sudden shocks than conventional banks due to the gharar considerationswhich prohibits them from creating investments in super risky and toxic assets.Islamic banks have showna great amount of growth in the past decade. Stats show that the amount ofassets owned by Islamic banks grew by double digit rates in the past decadefrom 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 growthpatterns, it is clear that most of these assets are limited to the gulfcountries. The growth is mainly due to the strong demand from Muslimpopulations and tremendous growth of industry in the developing countries.Islamic banks have great potential to contribute even more towards the growthof these countries as research shows that investment by these banks in theprivate and the public sector has helped boom various economies in the pastsuch as Pakistan and Syria.
A big section of the Muslim population isunderserviced by conventional finance – only 24 percent of adults have bankaccount and 7 percent have access to formal financing, compared to 44 percentand 9 percent, respectively, for non-Muslim populations (Demiguc-Kunt, Klapper,and Randall 2013). The characteristics of risk sharing makes these types ofbanks 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 alsorapidly increased since 2006, although its diversification is still going on invarious African and middle eastern countries.
If we compare Islamicbanks to conventional banks based on their growth and profit, before the periodof the recent global recession, both types of banks were not significantlydifferent. After the financial crisis, the profitability of Islamic financeslowed down in comparison with the conventional banks due to the low riskmanagement policies. But the recent studies show that Islamic banks are on arise in both the profit and efficiency. These banks are way more advanced inthe developed countries than in other countries due to the same reason ofbetter risk management policies of these countries.
Islamic banks face theirown 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 yearsthey might be a better option than the conventional banking system.