ISLAMIC BANKING

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shariah (Islamic rulings). Shariah prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims. Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shariah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. The principle source of the Shariah is The Quran followed by the recorded sayings and actions of Prophet Muhammad (pbuh) the Hadith.

Origin
The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions. Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.

Islamic Banking Principles

The Shariah prohibits the payment of charges for the renting of money for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community. "While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.

Basis of Islamic Banking

In order to be Islamic, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law. Another Islamic principle is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks.

Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways: 1. Debt-financing (the western loan system). The businessman borrows the capital from the capitalowner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction. 2. Mudarabah (the Islamic way, or PLS). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit. The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah. There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship: (i) Both parties agree on the ratio in which profits will be shared between them. (ii) The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort. (iii) Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work. Mudarabah is the basis of modern Islamic banking on a two-tier basis. 1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds. 2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager. Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views

true profit as a return for entrepreneurial effort and objects to money being placed on a pedestal above labour, the other factor in production. As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely nominal share based on the prevailing interest rate. Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit. The records of banks that have been involved in PLS show that they have usually provided higher returns to their depositors than those who have used such transitory instruments as cost-plus and leasing. PLS is thus the real goal of Islamic banking.

Credit in Islamic Banking

The term Al-Itiman is correctly used by economists to denote the meaning of the banking term credit. In some dictionaries, the following meanings are given under the term credit: It is the belief held by people that a certain person is wealthy. The author of the dictionary adds: It is an obligation created by the bank for one who demands from it that he be permitted to use a particular asset on account of the confidence reposed in him with respect to it. This exactly is the meaning of itiman. It is incorrect to state that itiman means granting a loan. Itiman is the confidence reposed by the bank in someone before it is prepared to grant a loan or provide a guarantee. Accordingly, loan is dependent on this confidence and is a result of it. Guarantee is part of what is termed credit in banking jargon and is based on the same confidence. In some banking dictionaries, it has been defined as the ability to raise loans and purchase goods in return for a promise to pay in the future. There are others who have defined it as mans confidence in man. CREDIT RISK AND ITS IMPORTANCE The risks faced by banks in their operations are of many types: interest risk, exchange rate risk, trade risk (or market risk), political risks, and risks that represent changes in the value of tangible assets and goods, etc. Credit risk is deemed to be the most important type of risk faced by a bank in its relationship with the owners of wealth. It is related to the ability of a debtor to repay at the time appointed for repayment and in accordance with the conditions stipulated in the contract. If the debtor fails to abide by his obligations, it leads to a loss for the creditor and, therefore, becomes a risk for the bank. The existence of credit risk is not dependant on direct financing by the bank, like bank loans. The bank also faces this type of risk in guarantees and acceptance paper when the originator of the financial instruments owned by the bank is unable to meet his obligations (as in the case of bonds). So is the case in other indirect financing operations. Therefore, prudent bank management includes strict and detailed regulations specifically for credit risk with the purpose of managing it in a suitable manner. Conventional banks face credit risk in almost all of their operations, because the relationship between the banks and those who transact with them is that of a debtor with a creditor in all cases. Islamic banks also face this form of risk in most of the

modes of financing that they use. It is well known that murabahah, istisna, and installment sale are sales with delayed payment thus generating debts in the accounts of the banks. The fundamental form of risk in all these contracts is credit risk. Salam gives rise to a commodity debt rather than a cash debt, but it also involves credit risk. Mudarabah and musharakah, on the other hand, are contracts of participation, and the funds given by the bank to entrepreneurs are not liabilities. Yet, these two also bear a credit risk in two ways. First, in the case of tort or negligence, the entrepreneur is liable to guarantee the capital which means a debt liability. Second, when the capital of mudarabah or musharakah are employed in a deferred sale, which is what takes place in most mudarabas, the owner of capital (rabb al-mal), the bank in this case, bears an indirect credit risk. This risk pertains to the ability of the counter parties to repay. Those who deal with Islamic banks observe that the cost of financing on average is greater than the cost of financing by conventional banks. For example, compare the cases of two persons. One borrows on interest from a conventional bank a sum of 100,000 riyals for a period of three years with which he buys a car costing 100,000 riyals. The other buys the car himself on the basis of murabahah with installments running over a period of three years. The second person will most likely, bear greater costs than the former. This means that the excess amount charged due to delayed payment in murabahah is more than the interest on loan. Islamic banks do not deny this, but they respond by saying that their operations carry higher credit risks. When the relationship between the return and the credit risk is directly proportional, it is natural that the cost of Islamic financing be higher for bearing such risk. This is an issue that needs examination and consideration because it gives rise to direct effects on the ability of the banks to remain competitive and the effects on the policies of central banks in supervising and directing Islamic banks.