Home Articles Current Issues in the Practice of Islamic Banking

Current Issues in the Practice of Islamic Banking

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Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

Islamic banking started in earnest in the 1970s with personal initiative of the
concerned Muslims to address the problem for riba. Things soon began to change in the late seventies and in the early eighties with recognition at the state level for the need to develop riba-free financial system in Iran, Sudan, Pakistan and Malaysia. In the meantime, Islamic bankers also organized themselves through International Association of Islamic Banks. This was
soon followed by establishment of AAOIFI for achieving standardization in Islamic
banking practices.

The current position is that there are more than 200 Islamic financial institutions
all over the world with investment funds in excess of $250 billion.

 Some issues are identified here that may help consolidation and growth of Islamic banking.

Standardization is urgently needed in the following respects: (1) vocabulary of
Islamic financing, (2) financial instruments and their documentation and (3) pricing
formulas for Islamic financial products.

Financial Instruments and Their Documentation: It is difficult to think of “identical” documentation for all Islamic financial institutions in lieu of a given Islamic financial instrument. This is because practical concerns may vary from institution to institution, practical needs may not always be the same, and, last but not least, door for financial innovation in emergent situations will always remain open.

Any financing operation by an Islamic bank will involve accommodation of interests
of the bank’s principals, the bank staff and the fund-seekers. These concerns are
addressed mainly through “pricing” of the financial products.

Islamic financial model is feasible. There is no question about this. In fact, with the
availability of more financing modes than those recognized at present.

It may be more versatile and efficient. But it faces problem of general acceptability. This is
mainly due to unfamiliarity with the various Islamic modes of financing. This problem
is likely to be solved over time. But pace of development of Islamic banking can be
expedited through the following: (1) public education campaigns, (2) inclusion of
Islamic banking concepts in school curriculum, (3) making Islamic financing course a
part of business administration programs and (4) offering full-fledged degree
programs in Islamic financing. There is already some are in progress.

Training of Banking Professionals in the Use of Islamic Financial Products Practically this was done through delegating authority for the Shari’ah matters to the respective Shari’ah Boards, absolving Islamic bankers of their responsibility in Shari’ah violations. Of course, in principle, Shari’ah Boards have the authority to impose their viewpoint. But logistic considerations do not permit timely vetting and/or monitoring of all banking operations.

In view of the above, it will be more fruitful if the following approach is adopted:

(1) The Islamic financial instruments should be properly and fully developed,
accommodating all relevant factors.

(2) Principals of Islamic banks should set economic and Shari’ah parameters
for providing bank financing.

(3) Bank officials at the branch level should be given full freedom for making
routine financing decisions, of course, in the light of the abovementioned
parameters.
(4) There should be both random and regular, either biannual or annual,
Shari’ah audit of all financing operations.

The prospects of Shari’ah compliance should be enhanced through  introduction of penalties for the bank staff and Shari’ah-rating of the bank.
The above approach shall be needed in any case for expediting Islamic banking at
the retail level Establishment of Real Market Links Trading modes of financing require contact with suppliers in the case of murabahah financing and marketing channels for disposing of merchandize produced in the name of financial institutions under salam financing. Similar considerations also arise in other Islamic financing modes, for example, leasing. Standing arrangements with suppliers and marketing agencies can considerably reduce transaction costs and Current Issues in the Practice of Islamic Banking  The prohibition of indexation for inflation of loans and debts
can make the matters worse in inflationary regimes. In an Islamic environment, these problems will have to be addressed at several levels.
Measures available to Islamic banks may include careful evaluation of financing
requests (including credit rating of the clients), proper pricing of Islamic financial
products, effective covering contracts and efficient machinery for enforcement of
contracts. Notwithstanding these, however, as the financial system grows in size,
institutions specializing in recovery of debts would be needed. Factors leading to
their emergence are likely to be economies of scale enjoyed by such institutions and
potential reduction in recovery costs for the financial institutions.
There is also need for redefinition of legal rights of the creditors. For example,
debts may be recognized as first charge on the assets of the debtors as soon as
they become due. Of course, a margin may be given for Shari’ah-recognized basic
personal needs of the debtors.

Risk Management -Choice of an appropriate financial instrument available in the Islamic setup Pricing of Islamic financial products -At present Islamic banks are working in many Muslim countries without proper legal cover. Of course, Iran, Sudan and Malaysia are exceptions.

In general, legislative needs for Islamic banking can be minimized by legislating
the Shari’ah principles and the Shari’ah restrictions for contracts, while leaving
practical details for adjudication by the courts.

Nevertheless, attention will also have to be paid to the following and similar other points.

Murabahah financing means purchase and resale, i.e. two trading transactions.
This need not be seen as such for sales tax purposes because Islamic banks do not
buy things under financing for their personal needs. Registration requirements
associated agreements need to be simplified as the associated costs may impede
lease financing. There is also need for special legal cover in order to facilitate and
implement musharakah (partnership) agreements by Islamic banks.

Adjudication of recovery of bank receivables is presently interest-based. Its alternatives need to be developed and provided for in the law.

One issue that will continue to be relevant in the foreseeable future is prospect of
Islamic banks working in the prevalent interest-based framework. It is obvious that
Islamic financial instruments and their documentation and accounting requirement
would be different. Therefore, the room for putting Islamic financial norms into
practice in the existing framework would be limited. This, in turn, implies that Muslim
countries should consider providing separate legal cover for Islamic financing.

Further Shari’ah Research. This is both important and sensitive matter. Its importance is self-evident. The long fiqhi tradition of last fourteen centuries warrants utmost care for any fresh attempts.

We respectfully draw attention to the following points.
Is it not that, notwithstanding complexities in the transactions and the institutions
that developed after the first century of Islam, in particular last two hundred years,
the transactions as well as institutions represent derivatives of those prescribed in
the Qur’an and Sunnah? Should the argument on various matters be developed in
the light of the principles laid down in the Qur’an and Sunnah? Is there not a need
review and reaffirm the received doctrines through a systematic and integrated
analysis of the vast Hadith sources compiled in the 3rd Century after Hijrah?

A consideration of above points is very likely to be fruitful for expeditious
development of Islamic financial paradigm, as also for making it a living reality.
Emergence of Islamic banking has provided a golden opportunity for unifying the
fiqh. Moves are already underway to look for common ground and to define common
fiqh for all Muslims

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