Study On Islamic Banking And Financial Stability Finance Essay - Free Essay Example

Sample details Pages: 12 Words: 3534 Downloads: 8 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? When examining the Islamic bank soundness relatively to conventional banks, it is imperative to provide to the reader an accurate description of the Islamic banking system. For that reason, the present chapter is dedicated to present the basic characteristics of the Islamic banking system that make it different from the traditional one. Hence, the chapter will be divided into two sections; the first one deals with a presentation of the Islamic banking system. It highlights its fundamental aspects: origin, basic assumptions and theoretical framework. Moreover, it provides a brief explanation of the common Islamic banking products. In the second section, I am concerned to emphasize the importance of ensuring banking stability. Furthermore, I give an overview of the literature focusing on the role of Islamic banks in maintaining financial stability. Section I.1: An Overview on Islamic Banking Islamic banking operates in accordance with Islamic law called Shariah. The principle sources of these rules are the Quran and the recorded sayings and actions of the prophet Mohammed (Peace Be Upon Him) followed by the consensus (Ijmaa) and the analogy (Qias). Islamic banking is characterized by several fundamental aspects. They consist mainly of the prohibition of interest and gambling and the incorporation of the risk sharing principle. Then, Islamic financial transactions should be linked with real economic transactions. Further, Islamic financing and investments are limited to the lawful activities. Finally, Islamic banking transactions seem to be inspired from the ethical and moral values. (Hassan and Lewis, 2007; Visser, 2009) Islamic bankers need to understand these principles in order to provide Shariah compliant products and services. Hence, Islamic banks must employ a Shariah Board to verify their compliance with Islamic transaction rules. In what follows, we will explain the key features of Islamic banking and describe the basic Shariah compliant contracts. I.1.1 Islamic Banking Principles The prohibition of Riba (interest and usury): According to the Islamic religious scholars, there are two types of riba cited in the Quran and in the traditions of prophet Muhammed (PBUH) riba alfadl and riba alnasia. Riba alfadl refers to an excess or an increase paid in a direct exchange of commodities that follows to unequal exchange. While, riba alnasia refers to a positive, fixed and predetermined rate of return on loan, claimed by the lender as a reward for waiting (Zaher and Hassan, 2001; Visser, 2009). Many argue that riba alnasia corresponds effectively to the modern interest. The banning on riba is based on a number of verses from the Quran such as Al-Baqara (2: 274-280), Ali-Imran (3:130) and Al-Rum (30:39). To explain the rationales behind the injunction of interest, we should know that money, in the Islamic perspective, is considered as a medium of exchange and a way of defining a value of assets, properties and labor. Consequently, money has not a value on itself and it is not a commodity. Thus, considering interest as a price of money is rebutted in the Islamic economic theory. Additionally, Islamic law prohibits interest even if it is claimed as the productivity of capital. Muslim scholars deem that it isnt a valid argument to justify its rightness, since it is paid on capital and required independently of the capital productivity results. Undoubtedly, this is not in contrary to Islamic banking principles aims in investing and increasing wealth. But, Shariah rules dont allow an increase of money via a fixed rate simply by keeping it in a deposit account or lending it. In fact, wealth should not rise without taking risk or making physical or mental effort. Finally, and regarding the argument that rate of interest corresponds to the discount rate, Islamic religious scholars argue that the latter should not be predetermined. Only the future economic conditions are allowed to determine the time value of money. To sum up, Islamic laws prohibit investments in all financial projects and instruments that guaranteed a fixed and predetermined rate of return. (Khan 1988; Pal, 1994; Zaher and Hassan, 2001) The prohibition of Gambling and Gharar: Because of the inequity, injustice, enmity and hatred between parties that could result from gambling and bets, Quran forbids such activities: Al-Baqara (2:219) and Al-Maida (5:90). The banning of gambling may be justified by the excessive risk and uncertainty of gains. But, taking risk with hope of winning is essential for human life. Besides, Islamic transaction rules allow Mudharabah  [2]  despite that involves a great risk. Consequently, assuming that injunction of gambling is related with uncertainty of gains is unacceptable. Siddiqi (2001) argues that gambling is taking risk deliberately which is not necessary in economic activity. While, Al- Suwailem (2000) suggests that the payoff structure makes the difference. He claims that Shariah principles prohibit Muslim persons to engage in a zero -sum game with uncertain payoffs. In such game, the preferences of each player are in direct opposition. So, the one partys payoff increases only if the other partys payoff decreases. There is no possibility of cooperative game (that both parties can win). Therefore, Islamic rules on transactions prohibit risk which is a channel to make one party profit at the detriment of the other (Ibn Taymiah in Al- Suwailem, 2000). The basic motive for the prohibition of gambling is the imbalance between rights and obligations of each party. This fundamental rule should be applied to the modern financial arrangements in order to see their legitimacy in the Islamic economic theory  [3]  . Profit and Loss Sharing (PLS): The interest-free banking system is based on the risk sharing principle (known also as Profit and loss Sharing). This means that the capitals owners and the entrepreneur share profi t and loss equally. In fact, capital provider can earn a return only if it accepts to bear loss when the project fails (Hassan et al, 2003). Hence, Zaher and Hassan (2001) argue that Islamic financing is similar to the equity financing. Unlike conventional banks, Islamic banks act as a partner rather than a lender. Moreover, the notion of interest rate is henceforth substituted by the profit and loss sharing ratio. As mentioned in Hasan (2008), the PLS ratio reflects the ratio by which profits or losses of a business are shared. It is usually expressed as a percentage of the total profits. According to the International Association of Islamic Banks  [4]  (1995), PLS system is adequate to establish congruence between social values and economic growth. In fact, PLS system guarantees more equitable distribution of wealth between contractual parties since the return depends on the real capital productivity. Thereby, it gives no way to the exploitative contracts. In addition, t he PLS structure eliminates conflict of interest problems. All partners contribute as expected to ensure business ventures success. Furthermore, PLS mechanism increases the volume of investments and employment relatively to the interest financing regime. The latter makes feasible and acceptable only venture whose expected return is higher than the debt cost. Hence, PLS regime makes the investment opportunities equally evaluable to entrepreneur with productive idea. Linkage with real economy: One of the major pillars of the Islamic finance theory is the integration of the financial and real sectors. In fact, all Islamic financial transactions should be associated with real economic transactions. Indeed, there is no place to debt-based assets in Islamic finance. (Mirakhor and Zaidi, 1988; Zaher and Hassan, 2001; Siddiqi, 2006) Investing in (Halal) lawful activities: Islamic banks should not invest in industries prohibited by Shariah such as: alcoholic beverage, pornography and p ork. Adequacy with ethical and moral values: Islamic finance isnt concerned only with the economic and financial aspects of the transactions. It takes into consideration social, ethical, moral and religious aspects. Financiers have to increase wealth without using ruses and involving gharar or information asymmetry. Indeed, Islamic finance takes care of fairness, equity and justice among the members of society. There is no separation between spiritual or social values and businesss aims. (Zaher and Hassan, 2001) More than prohibition of interest and gambling, Islamic transaction rules prohibit Muslims to engage in contracts that involve: fraud and deception (Ghobn), coercion (Ikrah), and exploitation of need (Bayal Mudtarr). Further, they forbid business consisting in withholding supplies of essential goods and services with an attention to raising prices (Ihtikar) or raising price by manipulating false bids (Najsh). Finally, Shariah interdicts contracts with lack of informati on about the commodity (quantity, priceÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦) that may lead to dispute among parties (Jahl  mufdi  ila  al-niza) (Siddiqi, 2001). I.1.2 Basic Islamic Banking Contracts The central role of Islamic banks is to perform financial intermediation with regard to the banking Shariah rules. Islamic banks collect funds from capital surplus agents in the form of investment and demand deposits. Then, they channel it to the capital deficit agents using interest-free financing instruments. I.1.2.1 Interest-free financing instruments To satisfy clients financing requirements, Islamic banks have developed multiple interest-free financing techniques based on two principles: Profit and Loss Sharing and Markup principles. (Zaher and Hassan 2001; Hassan et al, 2003) Under PLS principle, Islamic banks use two major instruments Mdurabah and Musharakah. Mudharabah (Trusty finance contract or principal/agent partnership): bank provides the e ntire capital needed to finance a project while the entrepreneur offers his labor, expertise and management. The profit is shared between them on a greed ratio while the financial losses are exclusively borne by the bank. The liability of the entrepreneur is limited only to his time and effort. However, if the negligence or mismanagement of the entrepreneur can be proven he may held responsible for the financial losses incurred. At the end of the period stipulated in the contract, the bank receives the principal only if the project suceed. Bank cannot request collateral to reduce credit risk but it may do it in order to decrease moral hazard problems. Mudharabah is usually employed in short term investment projects and in trade and commerce. Musharakah (Equity partnership): bank enters into an equity partnership with one or more partners to jointly finance a project. Profits and losses are shared strictly in proportion to the capital contribution. Unlike in Mudharabah contract, t he bank can exercise the voting rate and monitor the management. Musharakah is usually employed to finance long term investment projects. Under Markup principle, Islamic banks use, among others, Murabaha and Ijara transactions. Murabaha: the bank purchases a tangible asset at the request of its client. Then, it sells to it at a predetermined price that covers the original cost and an agreed profit margin. Ijara (leasing): it is similar to a conventional leasing. The bank purchases an asset and leases it to a customer. The ownership remains with the bank or it is gradually transferred to the entrepreneur in a rent and purchase scheme. According to Zaher and Hassan (2001), the rent paid cannot be considered as an interest because it is applied to tangible and durable goods and for its wear and tear. Islamic banks can make also charitable loan (Qard Hassan) which is zero- return loan. Banks are allowed to charge the borrowers a service fee to cover the related administra tive expenses. This fee must not be associated with neither the loan amount nor the maturity. I.1.2.2 Deposits accounts Islamic banks collect funds through two main categories of deposits: demand deposits and investment deposits. (Ahmed, 1993) Demand deposits (Current accounts or Amanah): deposits that yield no return and repayable on demand at par value. Banks can use demand deposits at their own risk. The profits resulting from the employment of funds accrue to the bank, unless, the total loss is borne only by the bank. Investment deposits (unrestricted Mudharabah): unlike the demand deposits, the PLS investment deposits are not considered as a liability because neither the principle nor the return are guaranteed. Depositors, in this case, are like partners but without voting right. Depositors share the banks net profit according the PLS ratio stipulated in the contract. Investment deposits cannot be withdrawn at any time but only on maturity and in the best case. T wo theoretical models of Islamic bank have been suggested based on the structure of assets and liabilities: Two-tier Mudharabah and two windows models. (Mirakhor and Zaidi, 1988; Sundararajan and Ericco, 2002; El- Hawary, 2007) Two-tier Mudharabah model: it is characterised by the full integration of banks assets and liabilities. On the liability side, bank collects funds in the form of unrestricted Mudarabah (investment deposits) and it acts as an entrepreneur / agent. Depositors and shareholders, in this case, share the overall banks profits on an agreed ratio. Bank is also permitted to accept demand deposits that yield no return but charging service fees. Depositors are aware that the bank will use their demand deposits to finance risk bearing projects On the asset side, bank enters into restricted Mudharabah with an entrepreneur as a provider of capital. Bank shares the net projects profit according to an agreed percentage only when the project wins. The two-tier Mudhar abah model does not require any specific reserve on both investment and demand deposits. Khan (1987) supposes that, contrary to investment deposits, demand deposits should require reserve because they cannot absorb the bank loss. Two windows model: It is very rare in practice. The liability side is divided into two windows: investment deposits and demand deposits. Depositors choose from the beginning the type of deposits. Bank uses only investment deposits to finance risk bearing investments. However, demands deposits are kept intact as Amanah and cannot be used. Therefore, banks must apply a 100% reserve on the demand deposits and 0% reserve on the investment deposits. Section I. 2: Islamic Banking Stability In addition to the financial intermediation function of banks, Islamic and conventional banks have to provide further services that fulfil countrys needs and respond to the globalization requirements. In particular, they offer services that facilitate national and inte rnational payment flows and currency exchange. Moreover, banks may invest and trade for their own accounts. Accordingly, the role of bank in the economy depends on the degree of the financial markets development. Albeit, in highly developed financial markets, banks are not the only institutions that provide liquidity and produce financial information necessary for intermediation. Banks remain at the heart of the economic activity because they are considered as a fulcrum for monetary policy implementation (Mirakhor and Zaidi, 1988; Lindgren et al, 1996). Consequently, macroeconomic stability requires a sound banking system. In fact, banks provide a microeconomic channel for the implementation of some monetary policies. Whereas, vulnerable banks are less responsive to market signals and may impede the monetary transmission. As a result, unstable bank constrain the policy choices and break the linkage between policy instruments and their performance in the economy (Lindgren et al, 1 996). For these reasons, banks owners and managers, banking supervisors and government should be adequately insured for banks financial soundness. Lindgren et al (1996) define bank soundness as the ability of the bank to withstand adverse events such as bank run, major policy changes, financial sector liberalization and natural disaster. So, it reflects the bank capacity to be solvent and remain so under difficult economic conditions by means of their capital and reserve accounts. In the present study, my focus is on analysing the role of Islamic banking in maintaining financial stability. More precisely, we will analyse the Islamic banks financial soundness relatively to conventional banks. I.2.1 Islamic Banks  Strengths According to Bryant (1980) and Diamond and Dybvig (1983), traditional banks are inherently unstable since they are deposit-taker institutions. In fact, under ordinary circumstances, banks do not expect that all depositors demand their money back at the same time. This depends on their individual needs of liquidity. Thereby bank can make loans over long horizons even if all depositors have the right to withdraw at any time, by keeping a small amount of cash in hand. Unless the individual expenditures needs are largely uncorrelated, depositors attempt to withdraw their money simultaneously. In such situation, bank cannot pay all the depositors quickly because of its illiquid assets (business, mortgage loans). It pays the first in line while the last one will be left with nothing  [5]  . This uncertainty about banks ability to repay immediately can lead to a bank run situation. Therefore, due to the maturity mismatch between assets and liabilities, healthy banks are potentially vulnerable to bank panics. However, many argue in line of Khan (1987) that the theoretical models of Islamic banks can successfully fill the failure of conventional banks in maintaining stability. In fact, Islamic banks should separate investment funds from the demand deposits and must apply 100% reserve on the latter. Banks can either sell currency or Government Investment Certificate. Hence, demand deposits cannot participate in the creation of money because depositors dont wish to share bank risks. They want to keep it intact in order to pay their expenditures. Therefore, maintaining 100% reserve removes the risk of bank panics and promotes the payment system efficiency. Khan (1987) has explained that Islamic banking model isnt unfamiliar with the economic literature; Simons (1948) and Friedman (1969) have already suggested a similar banking model to avoid bank run. The PLS principle plays also a critical role in keeping financial stability. As a financial intermediary institution between capital surplus and capital deficit agents, Islamic banks channel investment deposits into PLS loan (Mudharabah and Musharakah). Given that neither the principal nor the return of the investment deposits are guaranteed, any loss occu rred on the asset side is totally absorbed on the liability side. Thus, if the value of assets decreased, the value of the liabilities decreased respectively. Therefore, the PLS principle allows the bank to maintain its net worth under difficult economic situations. (Khan, 1987; Ahmed, 2002; Syed Ali, 2007; Cihak and Hesse, 2008) Finally, Ahmed (2009) argues that the prohibition of Riba and the linkage with the real economy principle could prevent the financial crises. In fact, financial assets and derivatives based on other debt financial assets cannot be traded. So, there is no place for speculative behaviour that leads to instability like what is happen in the last U.S subprime crisis. I.2.2 Islamic Banks  Weaknesses Unfortunately, Islamic banks may lose their comparative advantages against their counterparts due to the deviations of the current practices from the theoretical model. In particular, the mimicking of conventional banks may raise multiple risks that a re not assumed to be for Islamic banks. The first deviation is in the composition of balance sheet. In a typical Islamic bank, more than 80% of total assets are fixed income and short term maturity assets. While, only 20% are dedicated to long term and risk sharing investments. El- Hawary (2007) and Greuning and Iqbal (2008) claim that the dominance of less risky, low return assets deprives the bank of the benefits of the portfolio diversification, as Mudarabah and Mushrakah contracts are more profitable. Analysts explain this behaviour by the fact that sale based transactions are less associated with moral hazard and adverse selection problems than PLS investments (Siddiqi, 2006). In fact, the latter need additional effort to capture good investment opportunities and to analyse projects adequately. Besides, Islamic banks cannot request for collateral to reduce credit risk. Thus, risk sharing investments require a high level of confidence and transparency between investors, bank s and depositors. The second divergence with the Islamic banking theory is in the income distribution. In some cases, the Islamic banks distribute profits to the investment depositors even when they accrue loss, so the profits are paid out of equity. This phenomenon is the displaced commercial risk (El- Hawary, 2007; Greuning and Iqbal, 2008). Therefore, the current practices dont make a clear differentiation between shareholders and investment account holders rights. Finally, Islamic banks may not fully respect Shariah principles in their activities. Such behaviour makes them vulnerable to risks normally born by the conventional counterparts. In particular, Malaysian Islamic banks have introduced innovative products that seem to be Shariah compliant, whereas they are similar to the conventional contracts. For instance, they allow the sale of debt arising from sale-based transactions. Moreover, Chong and Liu (2009) claim that Malaysian banks are not very different from traditi onal banks in the adoption of the PLS principle. Conclusion In this chapter, I described the main distinctive features of Islamic banking and the frequently used contracts. This is in order to explain how Islamic banks can perform their financial intermediation function effectively without paying and receiving any interest. Then, I presented a literature review on the Islamic financial stability which supposes that Islamic banks could bring more stability to the international financial system. In fact, the PLS principle applied on investments deposits and the 100% reserve on demand deposits make Islamic banks less vulnerable to bank panics (khan,1987). Moreover, Ahmed (2009) claims that the banning on riba and the asset backing principle could, in some way, prevent financial crisis. Never the less, many argue that the deviations of current practices from the Islamic banking model and providing services which are not fundamentally different from conventional ones reduce the Isl amic banks capacity in taking financial stability. So, Islamic banking soundness is closely related to the well application of the Islamic transactions rules. But this is requires a joint effort by the participants (bankers, depositors, investors, shareholders, governments). To be strong, Islamic banks need robust institutional and regulatory infrastructures to support their work. For instance, they need legally recognized institutions to ensure their efficient functioning, and to monitor compliance of their services with Islamic banking principles. In the following, I will try to analyse empirically the Islamic banks soundness relatively to conventional banks using two different approaches. The first one is a non parametric analysis of the different indicators of financial soundness (chapter two). The second approach is based on an econometric model testing three hypotheses (chapter three). Don’t waste time! Our writers will create an original "Study On Islamic Banking And Financial Stability Finance Essay" essay for you Create order