Recent Developments In The Theory And Practice Of Islamic Banking And Finance

Humayon DarLoughborough University

References

El-Gamal, M. A. 2000 A Basic Guide to Contemporary Islamic Banking and Finance. ONLINE RESOURCE

http://www.ruf.rice.edu/~elgamal/files/primer.pdf

Al-Jarhi, M. A. and Iqbal, M. 2001 Islamic Banking: Answers to Some Frequently Asked Questions. Jeddah: IRTI.

Lecture Plan

Introduction Models of Islamic banking and

financeEarlier modelsLater models

PracticePre-19801980-19901990 onwards

Lecture Plan …

Recent developments Change in thinking/emphasis Future Conclusions

Introduction

Banking and finance in commensurate with the Shariah – Islamic lawShariah-compliant banking?Halal banking?

Introduction…

Banking and finance as an integral part of an Islamic economic systemBanking and finance to achieve

policy objectives of an Islamic system?

Social Banking?

Introduction…

Spread all over the world Over 50-75 countries About 250 Islamic financial

institutions $200-$800 billion in size Average annual growth of 15%

How Did It All Start?

It is a modern banking style: post-1950 phenomenon

Egypt (1963), Malaysia (1963) and Pakistan (1965)early experimentation

Malaysia stands outPakistan and Egypt left behind

The Middle East as a hub of Islamic Finance

What Was The Initial Thinking?

Ills of interest highlightedinterest-based financial system: a cause of under-development

Need for an Islamic alternativesocio-economic development, equity and justice etc emphasised

Idea of social or community bankingMit Ghamr was a social bank

What Was The Initial Thinking?

Development motive was at the heart of Islamic banking thinkingIslamic Development Bank (1974)

Modelling Islamic Banking And Finance

Modelling of Islamic banking shifted the emphasis from social banking to profit loss sharing and profit-motive

Two-Tier Mudaraba Modelprofit motive emphasised

Conventional banking style was adopted as a way forwardprivate banks or special Islamic banks (1974 - )

Practice …

Murabaha or fixed-return modes dominatedPLS marginalised

Idea of social/ community/ development banking faded away

Era of Islamic commercial bankingearning profit as opposed to charging interest

Practice…

Anglo-Saxon model of banking Profitability as a yardstick of

success

Current Issues

Transition from interest-free paradigm to asset-based paradigm

Pricing of Islamic financial products Screening principles for investing in

equity and stocks

Current Issues…

Financial innovation Regulation of Islamic financial

services Towards a theory of Islamic financial

firm

Interest-Free Versus Asset-Based

Interest-free banking was a hallmark of Islamic finance pre-1990 emphasis

Institutionalisation of Murabaha post-1990 phenomenon

Return on asset-backed financial assets is acceptable

An Example!

I need £100,000 for a business venture for a period of one year.

I have got two options1. Borrowing at a rate of interest of

7%2. Going Islamic way

First is not acceptable to my Shariah AdvisorWhat about the second?

Option 2

My advisor issues securities worth £100,000 on my house

The securities are sold to a third party with a buy-back clause of one year

The buyer then rents the house to me for one year on a rental equivalent to 7% of the stocks’ worth (£100,000)

Option 2…

Is it acceptable?

YES…

This is what we do in securitisation!!!

What’s The Difference?

Option 1 involves Riba while Option 2 involves trade

Probably rightBut…Are they really different?Yes…Probably not…

Options 1 And 2 Compared

Option 1 Pure monetary

phenomenon Return on money –

riba

Straight forward

Cheap

Option 2 Trade of a physical

item is involved Return on

investment in property – rental

Involves some sort of innovation

Costly

But Are They Really Different?

Option 1 Return on money

Option 2 Return on

securities

There are Other Ways…

Party C Party B

Party A

$100 (cash)

$105 (credit)£100 cash

Result

Asset-based financing has become a hallmark of Islamic banking and finance in the 21st century

Pricing Of Islamic Financial Products

Interest remains relevant Benchmarking with LIBOR, KLIBOR Positive correlation between

interest and prices of Islamic financial products

Normally a “mark-up” over the benchmarked interest

Consequently…

Demand for Islamic finance remains sluggish at a grassroots level

Islamic finance’s focus remains on the so-called “captive market”

Islamic finance as an elitist phenomenon

Is it supply-driven?

Principles Of Islamic Investing

Investing in stocks in a Halal/ Islamic way

Dow Jones and FT Islamic Indices Full details available on the

respective websiteshttp://www.djindexes.com

http://www.ftse.com/indices_marketdata/ground_rules/global-islamic-ground-rules.pdf

Islamic investment/ mutual fund industry

Financial Innovation

Strong need for financial innovation for further growth in Islamic finance

Securitisation Sukuk structures

The Ijara Sukuk

Islamic Issuer SPV Islamic Investors

Sells the assets

Certificates of participation

Cash

Lease agreement

Rental payments

Rental payments/coupons

Buys back the assets at maturity

Re-imbursement of 100% of the issue price at maturity

Direct recourse

The Mixed Assets Sukuk

Islamic Ultimate Borrower SPV Islamic Investors

Certificates of participation

Cash

Transfer of leased assets or to be

leased to issuer (2)

Transfer of Murabaha Deals (1)

Fixed payment of the return on the

assets

Direct recourse

Purchase of the assets

(1+2)

Regulation of Islamic Financial Services

Separate regulatory framework for Islamic finance is considered a necessity

AAIOFI IFSB

Towards A Theory Of The Islamic Financial Firm

Definition(s) Objectives Analysis

Future Of Islamic Finance

Not much different from conventional finance

Need for re-direction Need for genuine innovation Future lies in Islamic homelands and

not in the Western financial centres

Conclusion

Thank you