The concept of Islamic financing came to being in the late in the last century. It developed out of concerns by the Islamic communities over the extensive emphasis of interest rates in the inevitable and constantly widening financial sector. Across the world it was almost impossible to conduct business without engaging financial institutions.
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The Islamic community as guided by the religion’s holy book Quran is against the concept of interest rates. Riba, as the Quran refers to interest rates should not be paid for money deposited in a bank or on loans issued. This being the case, the idea of Islam faithful using the conventional banking system was clearly against their faith.
The most important difference between the western banking system and the Islamic system is the no interest principle. This however does not imply free financing as there are modalities in which financing extended bears profits to the financiers.
Instead of charging interest rates, the institutions seek to establish relationships with their clients with the aim of engaging in trade rather than pure financing. Under the western model of banking, a client just walks into a bank fills out forms whose truth is verified and a decision on how eligible the client is for a loan is reached.
It can never be clear what the money ends up doing. However in the Islamic model, the relationship established between the client and the institutions enables the bank to engage in trade in conjunction with the client. In other words, unlike the western model, the Islamic bank has an identifiable stake in the transaction being facilitated using the loan money by the client.
This effectively enables the institution to engage in the trade for goods and services as opposed to trade in money. The bank establishes an arrangement on how the expected returns will be shared between itself and the client.
For example instead of giving out a loan for a car, the institution requires the client to identify the car to be bought, afterwards the bank pays for the car and the client repays the bank at a predetermined premium on an installment basis.
Also in case of a business, the bank and the client come to an agreement on how to share the expected profits likely to emerge from the activity being undertaken jointly.
Rather than loan out money to a home buyer in the form of a conventional mortgage, the Islamic bank buys the property and leases it to the buyer thus receiving monthly installment up to the time the money used plus a predetermined fixed profit is repaid and the property shifts ownership to the buyer (Ambah, 2008, par6).
In addition, the model of banking encourages socially responsible investing and adopts a more holistic evaluation the person taking up finance to ensure that the intention is good and that the money does not deviate from the intended.
The three common platforms for Islamic lending include: modaraba which involves participation financing meaning that the client is integrated in the process: morahaba which involves the process of financing goods meant for resale and Ijara which involves the finance for leases.
The global financial crisis which started in the US late in the year 2007 has dealt a huge blow to the financial sector across the world. Having started in the housing markets in US, which are highly dependent on credit financing the crisis spread to other parts of the world including those extensively, applying the Islamic banking model like Bahrain.
Proponents of the Sharia compliant banking system argue that due to the strict rules applied in the model and the close relationship between the client and the financial institutions, the Islamic model of banking has proved to better and more resilient in times of financial crisis.
The close relationship enables firms to obtain extra expertise on financial management from the bank while the bank is better able to supervise the use of its funds hence significantly reducing the level of risks associated with the western banking model.
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Despite these assurances there was significant distress among the Islamic financial institutions as a result of the crisis. In Bahrain, the Kingdom had to inject about $35 billion despite the fact that the country hosts the International Islamic Financial Market (IIFM).
However it is clear among experts that most of the problems facing the Islamic finance institutions are not much related to the effectiveness or otherwise of the model but rather the fact that the great power wielded by the western systems which were almost crippled.
The immense integration caused significant tremors in the Islamic system as stock prices slumped and the real estate sector responsible for a huge percentage of business was shrinking.
Also, the model is still consider to be in its early ages of application and more needs to be learnt through experience in order to keep such financial crisis at bay in the future (Rocks, 2008, par6).
What is most clear is the fact that the model presents a better platform to manage risk and increase the responsibility of the institutions over its own funds. The financial crisis in the west shook the confidence of everyone. The fact that not one Islamic bank went under as a result of the crisis is a clear indication of the resilience of the model.
Excessive risks are limited in the model and the application of derivatives and other such instruments largely responsible for the collapse of banking and non-banking financial institutions is not applicable. The inbuilt principles greatly protect the Islamic finance from the collapse observed in the west (Al-Hamzani, 2008, par4).
Despite the many advantages associated with the model, there are some serious constraints which limit the efficiency. However, this inefficiencies lie in the ability of the model to fully meet the funding requirements of a country and remain optimal.
First, there is the need to establish much closer relationship with the client than in conventional banking. The application of this requirement especially in the west is a real challenge due to the highly help privacy principals applied.
On the other hand, the principles requiring sharia compliance may be prohibitive to business requiring greater autonomy in operations.
Despite the problems facing the model many more people have recognized the fact that the model is based on much stronger fundamentals as opposed to the western financial models. Indeed it offers a better regulatory framework as well as better risk management.
Many experts have identified the model as a remedy for avoiding financial crisis as witnessed lately. Among the Muslim population which account for about 20% of the entire population, the model has already extensively penetrated across the world.
In countries like Bahrain, Dubai Saudi Arabia and other Arab countries, the model has been extensively used to successfully raise huge sums of money by big companies dealing in oil and other costly projects.
Inevitably, the resilience displayed by the model during the crisis is bound to attract more countries to apply the model and give incentives to even more countries to allow its application (Chapra, 2009, par4).
In countries like the UK there is already significant interest among firms to explore the idea of Islamic banking. Among the Arab nations, the rate of penetration is very high.
As the model continues to evolve some of the rigidities in interpretation of the Sharia law are continually being progressively dealt with in different countries and in different ways with a view of customizing the model to fit to an even greater scope of financing.
In Bahrain, Malaysia, Indonesia and Dubai, the model is highly accepted and is poised to take over the financial sector as there have been signs of a decline in activities among the local conventional bankers (Hajdukovic, 2010, par3).
A lot still needs to be done to convince the non-Muslim world of the benefits of the model despite the ever deeply entrenched suspicion of the Muslim especially after the 9/11. However, the success of the model in the recent years and its resilience in times of crisis means that it is now poised to grow at an even higher rate.
In the late 1990’s the model was only applied in the middle east but today, Islamic banks have managed to spread to western Nations such as the UK and are now aggressively engaging the African continent.
Even the IMF concedes that the model is better and more responsible in comparison to the conventional model and has endorsed it as a viable model if finance.
The big global financial and accounting consultants such as KPMG and Delloitte have special departments dealing with the model and have developed capacities to guide their clients. This being the case it is clear that Islamic finance will expand and gain more acceptances across the world as time goes on.
Al-Hamzani, M. 2008. Islamic Banks Unaffected by Global Financial Crisis. Web.
Ambah, F., 2008. Islamic Banking: Steady in Shaky Times: Principles Based on Religious Law Insulate Industry From Worst of Financial Crisis. Washington Post Foreign Service. Web.
Chapra, M. 2009 The Global Financial Crisis: Can Islamic Finance Help Minimize The Severity And Frequency Of Such A Crisis In The Future? Web.
Hajdukovic, D. 2010. Industry specialists debate impact of global financial crisis on Islamic finance. Arabian business.com. Web.
Rocks, D. 2008. Islamic Finance: safer than Wall Street? Bussinessweek. Web.