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Essay: Challenges faced by Islamic commercial banking

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The banking sector is a pivotal contribution to the economy of any country. The performance of the banking sector at a given time is usually a barometer of the level of economic development in a country. Over the years, there has been a transformation of banking from traditional brick and mortar banking to electronic banking (Machogu & Okiko, 2015). Quantum leaps in the advancement of modern technology have created paradigm shifts in the offering of banking instruments, products, and services. The development of electronic banking can be traced to the 1970s. Electronic banking is proving to be a hot cake with the banking institutions as well as clients of banks due to the fact that it facilitates the provision of ubiquitous banking services. Its convenience and sheer transaction speed greatly endears electronic banking to the stakeholders in the banking industry. Electronic banking manages quick processing of transactions that could otherwise take many hours or days through the traditional brick and mortar banking. Electronic banking embraces various technologies that include landline telephone, mobile telephone, and smartphones; direct bill payment electronic funds transfer technology; and internet banking. It is impossible to completely do away with brick and mortar banking. Brick and mortar banking services are offered at the headquarters, branches, and banking agents of banks. Brick and mortar banking can offer the services that are dispensed through electronic banking. However, in most cases, brick and mortar banking offers services that cannot be conveniently offered through electronic banking such as asset financing, evaluation of loans, safe keeping of precious items, processing of large amounts of cash, physical deposit and withdrawal of cash for both corporations and individuals, and the dispensation of foreign exchange currency.

There are different types of banking institutions that offer different services. Banking institutions can be broadly categorized into central banks, savings banks, industrial banks, investment banks, land development banks also known as agricultural banks, indigenous banks, cooperative banks, online banks, consumer banks, exchange banks, and commercial banks. Central banks are fully government-owned institutions that execute the monetary policies of the government that control the quantity of currency circulating in the local economy in order to correct inflation or deflation. The central banks are provide banking services to other banks, receive mandatory cash deposit reserves from banks on behalf of the government, act as the lender of last resort, and establish the base lending interest rates in the case of countries whose economic systems are modeled on the conventional Western banking and finance system. Savings banks are usually established to promote a culture of savings among the members of the public. The savings banks mobilize savings from members and lend loans on favorable terms to their members. Industrial banks are banks that usually specialize in funding long-term projects that require huge initial capital outlays for corporations. In addition, the industrial banks offer loans to companies to meet their growth and expansion needs. In some cases, the industrial banks raise cash by issuing shares and debentures. Investment banks, also known as wholesale banks, are a special type of banking institutions that provide financial services to companies and governments that wish to raise money from members of the investing public. Investment banks are critical in ensuring that initial public offers of ordinary shares as well as other classes of shares are successful. Investment banks perform a myriad of services that include advisory services, provision of large amounts of loans through merchant banking to corporations that wish to raise capital through financial leverage of debt. Moreover, the investment banks act as intermediaries in the brokering of mergers and acquisitions for their client companies. What is more, many investment banks run their own trading floors from where they buy and sell shares on behalf of their clients. In addition, the investment banks manage investment schemes like unit trusts and pension funds. Land development banks – are also referred to as land mortgage banks or agricultural banks – majorly provide banking services that are focused on aiding the development of land as well as growth of the agricultural sector. Indigenous banks are a type of banks found in some countries that collect deposits from the members of the public and lend loans to the deserving out of their own funds as well as the cash reserves raised through the deposits collected from the members of the public. The indigenous banks are usually popular in the rural areas and small towns of some less developed countries. Cooperative banks are formed with the aim of advancing the economic and financial interests of their members. Members who have purchased the units of ownerships known as shares own the cooperative banks. In many countries, the cooperative banks – which are also known as cooperative societies or credit unions – are formed under the Cooperative Societies Act or an act of parliament with a similar name. There are special restrictions on the nature of services offered by cooperative banks as well as the ownership and governance of such banks. For instance, in order to prevent the economic interests of the members, the national laws of some countries prohibit a member from owning more than 5% of the total share capital of a cooperative bank. Cooperative banks are formed by like-minded individual who come together to have a common platform of advancing their economic interests. The cooperative banks serve such people as employees of a certain large corporation or governmental entity, farmers, self-help groups or people serving in the same profession. Online banks are a relatively new type of banking institutions that offer banking services to their customers strictly over the internet or through similar related technologies such as mobile banking. The striking feature of online banks is the absence of physical brick and mortar premises that can dispense banking services to their customers. In some cases, online banks offer their services on non-discriminatory terms to people living beyond the borders of the countries in which they are headquartered. Consumer banks are a relatively new type of banking institutions that are found in some developed countries. Consumer banks chiefly purpose to offer loans to their members to purchase consumer goods like motor vehicles, entertainment systems, electronics, televisions, air conditioners, cookers, furniture, and washing machines. Exchange banks majorly provide foreign exchange related services to individuals and corporations. Exchange banks perform an assortment of services that include discounting of foreign bills of exchange, funding of import and export, buying and selling commodities like gold and silver, and facilitating the transfer of money from one country to another. Commercial banks – are also referred to as retail banks or high street banks – provide a myriad of banking services to individuals and corporations. The banking services provided by many modern commercial banks vary from bank to bank as some commercial banks provide services that are disseminated by other classes of banks under the watchful eye of the central banks and other regulators in their countries of operation. The services provided by many contemporary commercial banks include the receipt of salaries and wages into the salary or current accounts of their clients from their employers; issuance of check book and provision of checking facilities; provision of physical credit cards and debit cards as well as facilitating the execution of the services associated with these cards; provision of over-the-counter cash withdrawal services; provision of automated teller machine services; provision of overdraft facilities; provision of loan facilities; stock market brokerage services; deposit of savings; provision of bank guarantees; provision of direct debit facilities; provision of standing order facilities; provision of insurance brokerage services; and asset management services. In many countries of the world, the popular types of banks are the commercial banks. The ubiquity of commercial banks stems from a myriad of factors that include the large product and service offering of these banks, extensive areas covered by the commercial banks, as well as the convenience of the products and services offered by the commercial banks.

One popular classification method of commercial banks groups commercial banks into conventional Western commercial banks and Islamic commercial banks. While the nature of the services offered by Islamic commercial banks and conventional Western banks is somewhat similar, there are fundamental differences in the essence of the instruments, products, and services offered by the two types of commercial banks.

Islamic Commercial Banks

Islamic commercial banking institutions operate under the principles of the Shari’ah that is sourced from the Holy Quran and the teachings of Prophet Mohammed (peace be upon him). For a many scores of years, the conventional Western banking institutions dominated the field of commercial banking (Swartz, 2010). The practice of commercial banking sufficiently appealed to the Muslim religious conscience to the point that the adherents of the Islamic faith sought to develop Shari’ah compliant alternatives of the services offered by the conventional Western banking institutions (Swartz, 2010). Islamic commercial banks majorly sprung up and thrived during the oil boom of the 1970s. Rising oil revenues were channelled through Shari’ah compliant banking institutions and this led to massive expansion and development of the Islamic commercial banking sector. The moral values that are rooted in the Shari’ah give the Islamic commercial banks more social significance. In as much as the formation and operations of Islamic commercial banks are predicated on the Shari’ah, the Islamic commercial banks serve both Muslims and non-Muslims alike since the ethical message of Islamic banking and finance is universal (Santoso, 2016). Over the years, many Islamic commercial banks have registered consistent financial stability with very few banks going under as compared to the case of conventional Western banking (Swartz, 2010). The financial stability of Islamic commercial banks is largely attributed to moral conservatism, avoidance of speculation, and the tendency of Islamic commercial banks to link themselves to the real economic sector (Santoso, 2016).

Stark Differences between Islamic Commercial Banking and Conventional Western Banking

Some of the most striking features of Islamic commercial banking, that are predicated on the provisions of the Shari’ah, include the prohibition of riba; prohibition of participating in financial undertakings that involve speculation on events that may or may not occur; prohibition of dealing in Haram items such drugs, alcohol, and pork; prohibition of gambling; existence of profit sharing and risk sharing arrangements; and the existence of an underlying asset in every transaction.

Riba

Interest (Riba) is outlawed in all Shari’ah compliant transactions. Payment or receipt of interest is regarded as one of the most grave sins according to the Quran (Abedifar, 2015). The Holy Quran unequivocally outlaws usury since the charging of interest in money would change money into an object of commerce (Al-Zuhayli, 2003). Money ought to be treated as an instrument of measuring the value of a commodity or as a store of value (Zahra, 1970). Therefore, the payment of interest on money is forbidden since it does not lead to value addition on the money. The earning of interest on money is considered to be an accrual of unearned income. The sharing of profits and losses arising from financial and economic transactions carried out on the real assets is allowed. The essential structural buildups of the financial products and services offered by Islamic commercial banking institutions is based on profit and loss sharing mechanisms that aim to provide the highest rate of return on investment while reducing the underlying risk.

On the other hand, interest is the bedrock of the conventional Western banking and finance system. Interest denotes compensation made to the providers of funds. It is composed of the risk free rate of return and risk premium. The risk free rate of return is a compensation made for the passage of time and is usually pegged upon the interest on the treasury bills issued by the central government or the currency board in countries that have a dual banking and finance system or where the conventional Western banking and finance system dominates the economy. The risk premium represents the compensation made to the provider of funds for the risks inherent in the normal operations and ordinary course of events associated with the financial instrument, product, or service in question. The bone of contention that Shari’ah compliant commercial banking harbors with the conventional Western commercial banking is that the primordial model of conventional Western banking and finance starts at the proposal to pay monetary compensation to the provider of funds for the passage of funds without any wealth creation activity that is backed and based on real assets taking place.

Risk

Islamic commercial banking recognizes and treats risk as per the provisions laid out in the Shari’ah. The Shari’ah advocates for the sharing of risk in lieu of risk transfer. In the conventional Western commercial banking, the better part of the risk incident on the loans offered to customers is transferred to the borrowers by the lending institutions. Risk transfer is open to abuse by the lending institutions. Risk transfer is more prone to contravening the principle of equity.

Real Economy vs. Financial Economy

Islamic commercial banks exclusively concern themselves with the real economy whereas the conventional Western commercial banks chiefly focus on the financial economy. Islamic commercial banking is strictly hinged upon the real economy. The real economy is made up of tangible revenue generating assets such as land, property, equipment, housing, production plants, and goods (Hassan, 2010). The real assets circulating in Islamic commercial banking can be traded for profit and leased. The profits earned can be distributed to the owners of the commercial banks or shared between the commercial banks and their clients depending on the nature of the trading agreement. In the real economy, that the entire Islamic commercial banking activities place in, people are employed to drive the creation of tangible goods and service thus making real contribution to the economy. All the financial instruments, products, and services that are exchanged in the Islamic commercial banking sytem are at all times based on real assets and backed by real assets. Islamic commercial banking deals with reality and not just items that can be attributed to be mere abstractions that exist in the minds of the participants and not as true things in the real world.

In the financial economy, money is treated like a commodity. Moreover, many participants in the financial economy engage in the trade of paper-based financial assets. The holding period of paper-based financial investments in the conventional Western commercial banking and finance system has significantly reduced from at least eight years in the 1960s to usually a period that on averages ranges from between a few months time to less than three years in most cases (Hassan, 2010). Usually, the financial economy in the environment of conventional Western commercial banking environment co-exists with the real economy. However, the financial economy products nothing that is real and tangible since it is for the better part paper-based (Hassan, 2010). The entire financial economy fundamentally revolves around tradabe paper-based instruments and products that have monetary values that rise and fall based upon the changing perception that people accord such paper-based financial instruments and products in the absence of real assets in most cases (Hassan, 2010). There are some serious inherent fundamental and structural weaknesses in the financial economy upon which conventional Western commercial banking is hinged upon. For instance, instead of the participants embarking on undertaking trading activities that are based and backed by real tangible assets, they place valuation based on gambles or probablistic models that are interest-based. In doing so, they place financial commitments, that span a wide assortment of products and services, on events that may or may not happen in the real world. In some cases, the commitments are made through the use of high leverage which is a double-edged sword that has the potential of significantly boosting the profits earned by a large factor, or severelly magnify the losses earned by the factor of leverage. The predorminant practice in the financial economy is for the players to take advantage of inflated price increases of the underlying paper-based assets. Such practices are in actual sense a form of betting. What is more, such practices are expressly outlawed by the Shari’ah. In the field of conventional Western commercial banking, some forms of factoring, invoice discounting, and the buying and selling of debtors involve trade in the financial economy since they deal with the buying and selling of classes of assets that are actually paper-based and do not make significant contributions to the real economy per se.

Islamic Commercial Banking vs. Conventional Banking

The Nature of Contractual Commercial Agreements, Products, and Services Offered by Islamic Commercial Banks

Ijarah

The conventional Western commercial banking closest equivalent of Ijarah is the hire-purchase method of financing. In an Ijarah arrangement, an Islamic banking and finance institution purchases an asset and makes it available for use to its clients. A customer is allowed to use the asset for a fixed period while making periodic rental payments. Full ownership is vested with the customer after the pre-agreed rental payments are successfully settled in their entirety.

Under the structure of Ijarah, there is the Ijarahwaiqtina commercial banking model based on either the Ijarahwaiqtina contract or the Ijarahmuntahiyabiltamlik contract that is an effective alternative to the conventional Western hire-purchase method (Alam, Noreen, Karamat, & Ilyas, 2011). The major structural difference between the Ijarahwaiqtina and the conventional Western hire purchase method is the absence of the interest factor in the Ijarahwaiqtina.

Murâbaḥah

In the Murâbaḥah Islamic banking and finance arrangement, an Islamic commercial bank purchases an asset to sell it to a customer at a price that includes a markup. Clients get to use the assets as they make periodic payments to the bank until they clear their outstanding amounts. Murâbaḥah’s matches a similar financing arrangement in the conventional Western world that is populary passed as asset financing. However, since Murâbaḥah is Shari’ah-compliant, there is no interest included in the periodic payments. The interest that would be paid by a customer in a conventional asset financing setting is represented by the difference between the asset purchase price and the selling price.

Mudarabah

Mudarabah is a special type of partnership whereby one partner (an investor) deposits his money with another partner (an entrepreneur). The entrepreneur then invests the money in a Halal commercial undertaking intent on making profits. The net gains arising from the business venture are shared amongst the partners according to a pre-determined ratio. Losses arising from the commercial undertaking are solely borne by the investor. An investor-entrepreneur relationship exists between an Islamic commercial banking institution and its client. Islamic commercial banking institutions offer various product offerings that are based on Mudarabah.

Musharakah

Musharakah is a type of partnership whereby all partners contribute capital to the partnership venture. One of the partners may actively manage the partnership undertaking; or all of them may participate in the management of the partnership; or the partners may appoint a third party to manage the business on their behalf. Shari’ah provides that an active/working partner should get a higher profit share than a sleeping/ non-working partner (Ajagbe & Brimah, 2013). Profits arising from the business venture are shared according to a pre-determined ratio. Losses are shared on a pro-rata basis according to capital contribution. The conventional match for Musharakah is a joint venture. Islamic commercial banking institutions form contractually binding Musharakah partnership arrangements with their customers to facilitate the acquisition of the desired assets.

Financial Products and Services Offered by Islamic Commercial Banks

Islamic commercial banks offer have an aggregate product and service offering that is composed of a hybrid of products and services purely identifiable with commercial banks as well as other products and services that may be typically offered by other classes of banks. Islamic commercial banks have multiple product and service offerings in order to better serve the interests of their owners as well as the financial and economical needs of the immediate and wider socioeconomic orders in which they operate.

The types of the financial products and services offered in Islamic commercial banking include fall into the following broad categories:

  • business financing
  • cashline
  • leasing and hire purchase
  • trade finance
  • bridging finance
  • equity finance
  • electronic banking
  • cash management
  • wealth management
  • corporate deposit placements
  • corporate cash withdrawal facilities
  • phone banking
  • bank guarantee
  • Islamic export refinance
  • bill purchase
  • current account facilities
  • savings account facilities
  • certificate of Islamic investment
  • Dollars (or foreign currency) Mudarabah certificate
  • periodic Mudarabah certificate
  • special Musharakah certificate
  • term deposit account facilities
  • joint pool accounts
  • diminishing Musharakah
  • export Musharakah
  • import financing
  • elite banking
  • usance financing
  • parallel Salam financing
  • bancassurance
  • safety deposit
  • letter of credit
  • encashment of checks
  • payroll processing
  • electronic funds transfer
  • balance confirmation
  • investment account facilities
  • syndicated financings and Sukuk
  • charity account services (Bank Islam, 2013; The State Bank of Pakistan, 2009; Arab Banking Corporation, 2017)

It should be noted that Islamic commercial banks offer their products and services to both Muslims and non-Muslims.

The Nature of Financial Instruments, Products, and Services offered in Conventional Western Commercial Banking

All the products offered in the conventional Western commercial banking system are interest-based. Interest is included in the quantity of the amount of funding lent to borrowers in order to compensate the lending conventional Western banking institution for assuming the risks associated with lending money to the borrower. Interest calculations take into consideration the principle amount and time period. Nearly all loan repayments in form of installments include a portion of the principle as well as a component of interest. In the early periods of repayment immediately following the obtaining of the loan amount from the lending conventional Western commercial banking institution, the component of interest in the periodic repayments made by the borrower is usually high in order factor in the element of unpaid loan amount. In addition, at the early periods of loan repayment, the element of principle in the installments is mathematically speaking low. As the periodic payments near towards the end life of the payment of the loan, the interest component in the periodic installments subsides as the unpaid loan amount nears extinguishment. In the late phases of loan repayment, the element of principle in the periodic installments increases. Loans offered in conventional Western commercial banking can be repaid either through equal fixed periodic installments or through variable reducing balance repayments that have a fixed amount of principle amount below which the amount of installment cannot fall below in any period and interest rate payments that reduce as the amount of the unpaid loan amount reduces.

The Products and Services Offered in Conventional Western Commercial Banking

According to The Bank of Guyana (2017), the products and services offered by conventional Western commercial banks include:

  • deposit/investment accounts e.g. savings accounts, fixed (term) deposits, special investment accounts, corporate/personal checking accounts, and foreign currency accounts
  • credit facilities e.g. loans/mortgages, overdrafts, and bonds
  • trade financing (export/import trade financing) through letter of credit, bill discounting, invoice financing, bills for collection, bank guarantee and confirmations, and inventory financing
  • foreign trade financing through draft/money orders negotiation, electronic funds transfers, and traveler’s checks
  • night deposit facilities
  • safety deposit boxes
  • payroll processing
  • card services like issuance and processing of credit cards (local and foreign) and debit cards
  • automated teller machines
  • point of sales terminals
  • telephone banking
  • payment of utility bills
  • internet banking
  • manager’s checks
  • letter of introduction
  • balance confirmation (audit queries)
  • credit enquiries letters
  • standing orders
  • encashment of checks/withdrawal of funds from accounts

Islamic Commercial Banking and Conventional Western Commercial Banking: Dominance in the International Stage

While Islamic banking and finance is the fastest rising component of the global banking and finance system, conventional Western commercial banking dominates the scene of international commercial banking as compared to Islamic commercial banking. The growth momentum of Islamic commercial banking is expected to keep pace in the short term as well as over the long term due to a myriad of factors that include growth in religious consciousness, the China effect, favorable changes in legal and regulatory environment in many countries, economic growth, increased demand for moral and ethical banking and finance, and fundamental stability of the wider Islamic banking and finance system. However, in order for Islamic commercial banking to gain significant mileage and dislodge conventional Western commercial banking’s international dominance, the Islamic commercial banking sector needs to address a myriad of bottlenecks that put brakes on its accelerated growth and development that include inadequate standardization; inadequate skilled manpower in the sector; lack of awareness; diseconomies of scale; legal and regulatory issues; liquidity issues; and the risk of exposure to real estate.

Recommendations for Islamic Commercial Banking

In order to counteract the challenges standing in the way of Islamic commercial banking, the industry needs to effect a raft of measures. The solutions to the challenges are aimed at increasing the international as well as the national footprint of Islamic commercial banking.

The Islamic commercial banking sector needs to undertake massive standardization of its business processes as well as the documentation used in transactions in order to stimulate local and international growth of the industry. There is lack of an internationally recognized gold standard professional qualification for Islamic commercial bankers. It is of imperative importance for the field of Islamic commercial banking to pursue the development of an internationally recognized professional qualification in order to develop the quality of manpower by augmenting the level of professionalism in the sector. Many, at the individual and corporate level, are not aware of all the products and services offered by Islamic commercial banks. It is crucial for Islamic commercial banks to undertake massive campaigns aimed at increasing the level of awareness about the nature and types of products and services that they offer. Many Islamic commercial banks are exposed to risks stemming from exposure to the real estate sector. In order to mitigate against these unique risks, it is of significant importance for Islamic commercial banking institutions to diversify their activities to other areas of the economy.

Summary and Conclusion

While Islamic commercial banking and conventional Western banking offer products and services that are similar on the surface, there are a number of fundamental differences between the two. Islamic commercial banking is predicated on the principles laid out in the Shari’ah while conventional Western banking is guided by secular man-made laws. The entire sector of Islamic commercial banking offers products and services that interest-free whereas interest is the basis of nearly all the products and services offered in conventional Western banking. Islamic commercial banking operates on the basis of risk sharing whereas conventional Western commercial banking places a premium on risk transfer. All the transactions carried out in the Islamic commercial banking are asset-based and asset-backed whereas a good number of the transactions effected through the conventional Western banking system are paper-based. Islamic commercial banking has grown in leaps and bounds over the years. In order for the system of Islamic commercial banking to sustain its robust growth trajectory, it is of imperative importance for the industry to address its teething bottlenecks. There is still a lot of room for improvement of Islamic commercial banking as compared to conventional Western banking that is nearing its saturation point.

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