Summary Note on Islamic Banking and Finance

Interest Free (Islamic) Banking is a banking business in which mobilizing or advancing of funds taken in accordance with Shari'ah (Islamic law) and Islamic Finance Principle and mode of operation that avoids receiving or paying interests (National Bank of Ethiopia, 2011). Shari'ah shall mean a way or path. In Islam Shari'ah refers to the divine guidance and laws of rules and principles supplemented by the juristic interpretations of Islamic scholars.

I. Historical Background

Islamic Banking began to emerge as early as the religion because its principles were primarily derived from the Quran. During the time of the Prophet there was a man by the name al-Zubayr al-Awwam who took the role as a bank, and kept the deposits for other people (Hamoud, 1985). According to Islamic economists Choudhury and Malik, a full fledged Islamic economic system was existed under Caliph Umar (634-644 CE). By the tenth century, Islamic law had supported credit and investment instruments that were as advanced as anything in the non-Islamic world (Timur Kuran, 2005). Furthermore, a number of economic concepts and techniques were applied in early Islamic banking (Brian Kettell, 2011), these include;

► Partnership (Mufawada, limited partnerships, or Mudaraba),

► Bills of exchange,                                  ► Transaction accounts,

► Forms of capital (al-Mal),                      ► Promissory notes,

► Capital accumulation (Nama al-mal),    ► Cheques, and

► Loaning, ledgers and assignments,      ► Trusts (Waqf) 

The modern history of Islamic financial institutions can be traced to the establishment of a saving institution based on profit sharing was Mit Ghamr Local Saving Bank in Egypt in 1963. followed by the establishment of the first Islamic Bank i.e. Dubai Islamic Bank in the UAE) in 1975. Two years before, the Islamic Development Bank (IDB), an Inter-governmental institution aimed to foster the economic  and social development of its member countries, was also established in 1973 in Jeddah, Saudi Arabia

Since then, more and more Islamic Financial Institutions had began established in different countries such as Faisal Islamic Bank of Sudan in 1977, Bahrain Islamic Bank in 1979 (Bahrain),  etc. Subsequently, ethical Banks and financial institutions, based on Islamic principles, spread in countries where muslims are minorities, such as UK, Luxemburg, Denmark, Australia, India  and the United States. Today  (Western) Citibank, Merill Lynch, HSBC, Barkley’s offering Islamic Financial services. IB Britain, Lariba (America) were established.

Some other IFIs like Accounting and Auditing organization for IFI (1991)  and IF services Board (IFSB) (2002) were established in Bahrain and Malaysia respectively after recognizing the need for Islamic Financial Standards and to disseminate the prudential and supervisory standards  and core principles that are in compliance of Shari'ah.

II. Principles of Islamic Banking and Finance

Islamic banking has more far reaching purposes than conventional banking, and has the guiding principles for Islamic finance which include: fairness, justice, equality, transparency, and the pursuit of social harmony (Nizam Yaquby) , although others describe these virtues as the natural benefits of following Shari'ah. Usmani, argues that Islamic principles should include the fulfillment of the needs of the society giving preference to the products which may help the common people to raise their standard of living,

To be consistent with the principles of Islamic law and guided by Islamic economics, the current progress of Islamic banking and finance forbids a variety of activities, some not illegal in secular states. These include:

• Giving or Receiving interest. All forms of interest are riba and hence forbidden. 
• Investing in businesses involved in activities that are forbidden (haraam). These include things such as selling alcohol or pork, or producing media such as gossip columns or pornography. 
• Participate in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future is maisir and forbidden in Islamic finance. 
• Both maisir and gharar as they tend to rule out derivatives, options and futures.

III. Forms of Islamic Financial Institutions 

Internationally, based on the legal framework for these countries and other Islamic financial institutions, there are four forms or models available to provide Interest Free (Islamic) banking services. All four models have different characteristics based on the rules and regulation adopted by the central banks in the various countries.

1. Window Model

Interest Free Banking Window shall mean separate units within a conventional bank that exclusively offer Interest free services. This means that the Window in the bank is the only window in which the free bank account is placed. There are no other regular banking services in this window and interest-free banking customers will only use this window. In this window, free bank customers can provide financial services, including money exchange, money exchange, COPIA services, domestic delivery and receipt and all other services.

Today, countries with high interest free banking have used this model to provide a great boost to the service after the service was well-received. In the same way, banks in the Middle East, Europe, the United States, and Africa also serve as window services.

2. Dedicated Branch Model

It is the same way as the window model provides, with the exception that the branches do not offer the bank's exclusive banking services, but only provide a free bank account that is authorized by Shari'ah. According to this method, the subsidiary is responsible for the bank's own banking service, which is operated with the same banking system, with various manpower and permanent equipment.

3. Subsidiary Model Under the existing Bank

It is organized under the common bank and is only awarded to Shari'ah authorized service providers, and the model is different from that of the normal bank. In other words, this branch model has its own unique operating system, organization, policy, etc., and is responsible for the overall operation of the main bank.

4. Fully Fledged Model

There are new banks that allow banks to pay interest-free banking in various countries, some of which will replace the existing bank to full interest on free, bond-free banking. On the other hand, banks with banks that provide interest-free, interest-free banking services in the various countries, and banks in the country are still banking.

IV. Shari’ah Supervisory/ Advisory/Consultant Board

Compliance with Shari'ah law is the underlying reason for the existence of Islamic finance, Islamic banks (and conventional banking institutions that offer Islamic banking products and services) should establish a Shari'ah Supervisory/Advisory/consultant or as the case maybe to advise them on whether their products comply, and to ensure that their operations and activities comply with Shari'ah principles.

The Shari’ah encompass all business activities, financial contracts, and transactions. Hence every Islamic financial institution is required to establish a Shari'ah Committee /Board that shall comprise persons with appropriate qualifications and experience in Shari'ah. Shari'ah Supervisory/Advisory/consultant body is an independent body of scholars and specialists in Islamic transactions appointed  by the Bank to ensure all products and services; related policies and agreements are in compliance with Shari'ah rules and principles.

Some of the Major Responsibilities of Shari'ah Advisory Board

• Ensures all products and services, related policies, draft agreements and general framework of the Islamic Banking are in compliance with Shari'ah rules and principles;
• Before launching any new products and services, the related policies and agreements shall be duly inspected by the Shari'ah Consultant;
• Comments on the Bank's annual financial statement in respect of its Shari'ah compliance;
• Accesses all records, documents and information from all sources including professional advisers and  Islamic Banking employees in discharge of his duties;
• Reviews the operations of the Islamic Banking  on periodic basis in coordination with officials responsible for Shari'ah compliance to ensure that all the products and services being offered by the Bank conform to the injunctions of Shari'ah.
• The legal Attorney and auditor of the Bank may seek advice on the Shari'ah matters from the Shari'ah Consultant who will provide such advice accordingly

V. Standard Setting Institutions

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), has been publishing standards and norms for Islamic financial institutions since 1993. By 2010, it had issued 25 accounting standards, seven auditing standards, six governance standards, 41 Shari'ah standards and two codes of ethics. (By 2017 it had issued 94 standards in the areas of Shari’ah, accounting, auditing, ethics and governance) Although it is an independent body, its "pronouncements on the acceptability or otherwise of contractual structures in relation to Islamic financial instruments are to be viewed in the same vein as regulatory edicts. Its standards are mandatory for Islamic financial institutions in Bahrain, Sudan, Jordan and Saudi Arabia, and recommended for other Muslim countries and Islamic financial institutions according to Muhammad Akram Khan. Established in Algiers in 1990, its original name was Financial Accounting Organization for Islamic Banks and Financial Institutions. It later moved its headquarters to Bahrain.

VI. Interest Free Banking Products, Services and Contracts

Banking products: Banking makes up most of the Islamic finance industry. Banking products are often classified in one of three broad categories, two of which are "investment accounts

1. Profit and loss sharing modes:  profit-loss sharing (PLS) is the primary mode of finance replacing interest-based loans, where financier and the user of finance share profits and losses, are based on contracts of partnership.

1.1. Mudarabah Deposit: means a partnership in which the customer (Rabb-ul-Maal) provides the deposit/capital and the Bank ("Mudarib") provides its expertise and skill in relation to the investment of such capital.

1.1. Musharakah (joint venture) is also a profit and loss sharing partnership, but one where investment comes from all the partners,

1.2. Diminishing Musharaka: Musharaka al-Mutanaqisa, (literally "diminishing partnership"), is a popular type of financing for major purchases such as housing.

2. Asset-backed financing Modes: Asset-backed or debt-type instruments (also called contracts of exchange) are sales contracts that allow for the transfer of one commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money. Include: mark-up (Murabahah), Leasing (Ijara), Salam - cash advances for the purchase of agricultural produce, Istisna'- cash advances for the manufacture of assets etc.

3. Contracts of Safety and Security, Service Mode: These contracts are intended to help individual and business customers keep their funds safe. These Include wadi’ah safe-keeping contracts  for current deposits called checking accounts, Wakalah - agency contracts, Hawala - literally means transfer or trust etc.

4. Deposit side of Islamic banking Islamic banks also offer "demand deposits", i.e. accounts which promise the convenience of returning funds to depositors on demand, but in return usually pay little if any return on investment and/or charge more fees. Eg. Qard, Wadiah and Amanah

5. Non-banking finance: Most Islamic finance is in banking, but non-banking finance which are also fast-growing, and as of 2013 represented about one-fifth of total assets in Islamic finance. These include:

5.1 Sukuk (Islamic bonds) are financial certificates developed as an alternative to conventional bonds.

5.2 Takaful (Islamic insurance)Takaful, sometimes called "Islamic insurance", differs from conventional insurance in that it is based on mutuality so that the risk is borne by all the insured rather than by the insurance company.

5.3 Islamic creditcards: there are credit cards claiming to be Shari'ah-compliant. These generally following one of a number of arrangements:

5.4 Islamic funds: are professionally managed investment funds that pool money from many investors to purchase securities that have been screened for Shari'ah compliance.

5.5 Islamicderivatives: Contracts or combinations of contracts for derivatives include swaps and options:

6. Microfinance: The products used in Islamic micro-finance may include some of those mentioned above like those qard al hassan, musharaka, mudaraba, salam, and others. 

VII. Challenges and Opportunities of Islamic Banking

Opportunities

• Existence of Large Market Size: Ethiopia has more than 30 million Muslims, this offers huge opportunities to exploit. Beside, Islamic  banking  is not meant for Muslims only  but non Muslims  may  also  need  the  benefit  of  it,

• Gaining diplomatic advantages: with  introduction  of  Islamic  banking,  Ethiopian  government  will  certainly gain  diplomatic  advantages  to  make  financial  dealings  with  Muslim  dominated  nations especially  to  attract  trillion  dollars  market  from  the  gulf  countries

• Enriched Islamic legal system which make easy to create an ethical, sustainable, environmentally and socially responsible system (according to Abayomi A. Alawode);

• Easy to integrate conventional banks with Islamic banking and finance industry (Munawar Iqbal and Philip Molyneux);

• Drawing new customers and money into banking, rather than taking existing customers and their money away from conventional banking, (Laurent Gheeraert).

• Creating a less risky form of finance (according to Zeti Akhtar Aziz and others), by forbidding speculation, so that, for example, the excesses that led to the global financial crisis of 2007–2008 are avoided . The profit and loss sharing products decreases bank's risk (Ibrahim Warde)

Challenges

• Low levels of public awareness: poor understanding  about its operations both in the Muslim and non-Muslim communities/customers

• Lack of Shari'ah-compliant monetary policy instruments (Lack of Supportive Institutional and Market links): support  Institutions  properly  oriented  towards  Islamic  banking are yet to be developed in many countries. In our case, Ethiopia, there are no independent and well organized Shari’ah based institutions and even, there is  no halal product certifying institutions.

• The Regulatory Challenges: The  relationship  between  Islamic  banks  and  monetary  authorities  in Ethiopia are not so close to support each other.

Most of Islamic Bank Customers complain that the system established only for the sake of collecting the money, there are no regulations set for the benefits of those groups. eg. Micro-finance institution have no rooms to support Muslim Community. The Condominium housing programs, which aimed to support the poor as equitable resource distribution strategy, did not consider the Muslim community, as it require 20% or 40% Pre saving and 80% and 60%  loan with interest. For example, the operations of Islamic banks are on a profit  and  loss  share  basis  (PLS),  which  actually  does  not  come  fully  under  the jurisdiction of the existing civil laws. Absence of well developed regulation, cooperation between Islamic and conventional financial standard-setters

• Use of Advanced Technology and Media: Many Islamic banks do not have the diversity of products essential to satisfy the growing needs of their clients.

• Research and Development (R & D): Many  Islamic  banks  also  lack  the  necessary  expertise  and  institutional  capacity  for Research and Development (R & D) that is not only necessary for the realization of their full potential, but also for its very survival in this age of fierce competition, sophisticated markets and an informed public.

• Lack of Professional Bankers: The are critical shortage of Islamic Banking Professionals that have a better understanding of industry, technology and the management of the business venture, and also have better understanding of  the  moral  and  religious  implications  of  their  investments.

• Absence of Islamic Micro-finance Institutions and Insurance Systems: this is because there is lack of policies to uplift small traders and the poor; like safety nets and resolution frameworks 

• The non-Muslim ownership of much of Islamic banking

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