Introduction
In the past two decades, the number of the Islamic banks has experienced a high demand. The key driver of the expansion has been globalization and the emerging wealthy countries in the Middle East (Chachi, 2005). In addition, during the financial crisis reported in Europe and other parts of the world, Islamic banks remained stable and depicted the ability to hedge out the risks that affected many financial institutions (Asutay, 2010). As a result, the Islamic finance system has drawn a lot of global interest. The system has gained acceptance in many parts of the world. Ahmed (2009) defined Islamic financial as a system of finance based on principles of Islamic banking, and that operates under the ethics of Islamic teaching. The following paper is a literature review of the legitimacy of financial risk management in Islamic banking. The literature will focus on the essential tenets of Islamic banking.
Islamic Financial System
The Islamic financial system is a concept, which gained global prominence in the mid-1980s (Ahmed, Rehman & Saif, 2010). Many businesspersons and leading European financiers adopted the core Islamic finance techniques, principles and instruments. A study conducted by Blay & Kuehn (2004) established that the primary tenet that defines the Islamic financial system is interest-free. The principle is based on Islamic teaching, which does not allow payment or receipt of interest. The principle advocates for sharing of duties, risks and property rights (Hamwi, 2009). The Islamic financial system does not cover the banking sector only; it includes other financial areas such as stock markets and financial intermediaries.
In the typical interest financial system, the aim is to make profits based on contracts that exploit opportunities that bring back interest for the money invested in the contract (Jobst, 2007). The basis for the contracts is speculation on financial markets. However, a study conducted by Saeed (2005) found that the core tenet of the Sharia teaching is that unfair contracts based on speculations are not enforceable. The Islamic financial teaching places a lot of emphasis on the social justice and spiritual values (Wilson, 2007). The Quran does not draw boundaries between life of a Muslim and the financial dealings hence there is no separation of state and the religion (Ahmed, 2009). El-Qorchi (2005) noted that the interest-free system that makes it unlawful to receive and pay interest bars the people in the financial system from financial practices with the aim of earning interest. The implication for the practice free system is that it ensures that the system is risk aversive as the parties to the system share profits and losses (El-Qorchi, 2005).
Vogel and Hayes (2008) found that the implication is that there is no predetermined gain in the financial system. The Sharia law that guides the no interest principle prohibits maximization of shareholders wealth, a common feature of the western banking system (Vogel & Hayes, 2008). Aggrawal and Yousef (2000) found that the sharing of the losses and the equitable distribution of the profits and losses serve as a risk aversive strategy that cushions the financial system from danger that is posed by accumulation of interest for few wealthy individuals. According to Aggrawal and Yousef (2005), the return on capital in the sharing of contract profits is based on the productivity. The system ensures that the allocation of capital is efficient. In addition, the basis of productivity as the factor to determine the returns on capital leads to equitable wealth distribution; hence, even wealth distribution (Wilson, 2007). The equitable distribution is unlike the interest financial system in which wealth distribution in which capital invested dictates the interest.
Islamic finance system reduces speculation found in the interest financial markets. According to Kazimi (2000), the interest-free principle does not imply that Islamic financial system shuns investments. Kazimi (2000) stated that the Islamic finance system allows investors to trade in the stock markets guided but guided by principles of sharing. In a similar a study, Chapra (2000) found that the Islamic financial system prevents the inflationary pressures by ensuring that money supply does not overcome the goods supplied in the market. The process thus ensures that the price of the commodities is relatively stable. The ability of the system to check on the inflationary pressures implies that the financial system has a great role in underpinning the stability of an economy.
Conclusion
The literature points to the fact that the principle of sharing plays a crucial role in curbing risks. The interest free principle allows equitable sharing of the productivity; hence, ensures that it puts checks on stability of a given economy. The sharing of the productivity points to the social aspect and the religious alignment of the financial system. However, the literature emphasizes the social aspect. The literature does not provide the legitimacy that informs the sharing of productivity. The inadequate literature on the legitimacy fails to explore the superiority of the financial security that relates to risk sharing. Globalization has led to the adoption of the Islamic financial system principles across the globe. As the financial world adopts the tenets of the system, there is a need for further research to investigate the legitimacy of financial risk management in Islamic banking.
References
Aggrawal, K. and Yousef, G. (2000). Islamic banks and investment financing. Journal of Money, Credit, and Banking, 32 (1), 93-120.
Ahmed, A., Rehman, K., & Saif, M. (2010). Islamic banking experience of Pakistan: Comparison of Islamic & conventional banks. International Journal of Business Management, 5(2), 137-144.
Ahmed, H. (2009). Financial crisis, risks and lessons for Islamic finance. ISRA International Journal of Islamic Finance, 1(1), 7-32.
Asutay, M. (2010). Islamic banking and finance and its role in the GCC and the EU relationship: Principles, developments and the bridge role of Islamic finance. Dubai: Gulf Research Center.
Bley, J., & Kuehn, K. (2004). Conventional versus Islamic finance: Student knowledge and perception in the United Arab Emirates. International Journal of Islamic Financial Services, 5(4), 104-115.
Chachi, A. (2005). Origin and development of commercial and Islamic banking operations. Islamic Economics, 18 (2), 3-25.
Chapra, U. (2000). The future of economics: an Islamic perspective. Journal of Economic Behavior and Organization, 27 (1), 151-157.
El-Qorchi, M. (2005). Islamic finance gears up. Finance and development, 42(4), 46-49.
Hamwi, B. (2009). Islamic finance: a growing international market. Thurnderbit International Business Review, 41 (5), 407-420.
Hassan, M. K., & Kayed, R. N. (2009). The global financial crisis, risk management and social justice in Islamic finance. ISRA Journal of Islamic Finance, Forthcoming.
Jobst, A. (2007). The economics of Islamic finance and securitization. Journal of Structured Finance, 13 (1), 6- 27.
Kazimi, A. (2000). Islamic financial instruments. Journal of Islamic Banking and Finance, 11 (1), 42-45.
Saeed, A. (2005). The moral context of the prohibition of Riba in Islam. American Journal of Islamic Social Sciences, 12, 4, 496-517
Vogel, F. E., & Hayes, S. L. (2008). Islamic law and finance: Religion, risk, and return. International Financial Law Journal, 16 (1), 4-21.
Wilson, R. (2007). The Islamic financial system: Islamic banking, finance and insurance- a global overview. Journal of Islamic Studies, 18(1), 152-156.