International Finance
Banking and Finance Magazine

Islamic Finance: Pioneering Ethical Banking

IFM_ Islamic Finance
Ethical banking and Islamic finance acknowledge the value of interacting with stakeholders, such as clients, investors, and the community

Islamic banking’s incarnation began with ground-breaking efforts in Egypt in the early 1960s. The Mit-Ghamr Islamic Saving Associations (MGISA) gathered Muslim investors’ savings and gave them profits that did not violate Shari’ah law.

In its first three years of operation, the MGISA drew a flood of deposits that increased by over 100%. Later, the Pilgrims Fund Corporation (PFC) allowed Malaysian Muslims to progressively save and invest in securities that complied with Shari’ah to cover their expenses during the Hajj time (pilgrimage). The PFC had over $12 billion in deposits and eight million account customers in 2012. Islamic banking began in the late 1970s with only a few institutions and small sums. Still, it has steadily expanded over the following 20 years, with total assets reaching over $2 trillion at the 2014 end.

The founding of the Islamic Development Bank (IsDB) in 1975, which came soon after the formation of the first significant Islamic commercial bank, the Dubai Islamic Bank, in the United Arab Emirates, was a turning point for Islamic banking. Similar banks were founded due to the latter’s success, including Kuwait Finance House and Faisal Islamic Bank in Sudan, founded in 1977. In Pakistan, initiatives to bring the financial system into compliance with Shari’ah principles date back to the late 1970s.

The legal framework was then changed in 1980 to permit the operation of profit-sharing financing businesses compliant with Shari’ah and the beginning of bank financing using Islamic instruments. Countries like Iran and Sudan too made similar reforms.

With the rapid expansion of Islamic financing, the financial infrastructure, including entities that create rules and regulate the industry, has also kept up. Although it is still challenging to standardise Islamic goods across nations, international organisations that set standards have been established to direct business activities globally.

The Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has published Shari’ah-compliant accounting, auditing, and financial reporting standards since 1991. The Islamic Financial Services Board (IFSB), created in Malaysia in 2002, provides directives and regulations.

Additionally, it encourages the appropriate regulatory agencies to implement these standards and directives. Bahrain’s International Islamic Financial Market (IIFM) received a mandate in 2001 to create regulations for Islamic financial instruments.

Based in Malaysia, the International Islamic Liquidity Management Corporation (IILM) recently began issuing short-term Shari’ah-compliant financial instruments to facilitate cross-border Islamic liquidity management.

The main goal of this article is to give readers a general introduction to Islamic finance, explore the significant macroeconomic ramifications of its global expansion, and offer a wide-ranging viewpoint on crucial aspects of Islamic finance and ethical banking.

Islamic finance’s link with ethical banking

Despite appearing to be two different ideas, Islamic finance, and ethical banking have many of the same ideals and guiding principles. This is especially true when encouraging moral and ethical financial behaviour. Strict guidelines on what is permissible by Sharia serve as the foundation for Islamic finance, and these guidelines are inextricably interwoven.

One way to conceptualise Halal, or permitted activities, is within the context of ethical investing. It ensures that all financial transactions adhere to Islamic law’s tenets of social responsibility and sustain ethical standards. Investments in healthcare, renewable energy, and socially responsible enterprises that help society are examples of activities that adhere to Islamic principles.

Contrarily, haram, or prohibited activities according to Sharia, forbids investment in immoral and dangerous activities, including gambling, alcohol, tobacco, and weapons—all of which are also classified as haram.

The Islamic financial system also encompasses social justice and charitable giving. Both ideas, officially known as social justice and redistribution, focus on transferring wealth through required charity (Zakat) and voluntary giving (Sadaqah) to empower disadvantaged sections of society.

Ethical banking and Islamic finance acknowledge the value of interacting with stakeholders, such as clients, investors, and the community. They work to develop lasting partnerships and ensure that the interests of all parties are considered. This is the main factor driving Islamic finance’s rapid growth. According to the ICD-Refinitic Islamic Finance Development Indicator, the industry will be worth $6 trillion by 2026, up from its current value of $4 trillion.

Sustainable business practises are already top of mind for Islamic banks’ retail clients. According to a 2022 Islamic Finance Council UK poll, 90% of retail consumers think their banks offer goods supporting the UN’s Sustainable Development Goals. If attained, 70% of clients would likely use their bank’s products more frequently.

Stylised data about Islamic banking

By mid-2014, there were $1.9 trillion in assets related to Islamic finance worldwide (ADB and IFSB, 2015). The industry is primarily based in the Middle East and North America (MENA) region, with the GCC countries making up 96% of this region’s population (excluding Iran), and its share is approximately 75% of the total. The estimated value of these assets at the end of 2014 is also greater than $2 trillion. Since the global financial crisis of 2008, the Islamic finance sector, including Islamic capital markets, has grown by an average of 17.5% (Ernst and Young, 2015).

Most expansions occurred outside the MENA region in nations with larger Muslim populations, while the GCC nations were primarily responsible for the industry’s rise in the MENA region. In particular, from 2009 to 2013, the Islamic finance sector expanded by an average of 43% in Indonesia and 19% in Turkey.

Despite the ongoing expansion of sukuk and other Shari’ah-compliant financial assets like Islamic funds and takäful, Islamic banks still dominate the Islamic financial sector. Despite making up less than 1% of all banking assets globally, Islamic banking assets make up around 80% of the entire assets of the Islamic finance sector. In 2013, Iran accounted for about 38% of the assets in Islamic banking, and Saudi Arabia and Malaysia combined for about 29%.

Around 410 Islamic financial institutions operated globally as of the end of 2013, including the ultimately Shari’ah-compliant banking systems in Iran and Sudan. These Islamic banks primarily came into existence in the 1980s and 1990s. Islamic banks operate in nations including Nigeria, South Africa, Nigeria, Switzerland, and the United Kingdom. Islamic banking has recently expanded to Africa, Europe, and North America.

Central European and American banks (including Citibank and HSBC) are running Islamic banking windows to capitalise on this quickly growing industry. Even considering the post-2008 global financial crisis period, the Islamic banking sector grew at an average annual pace of nearly 17% from 2009 to 2013. This ongoing expansion is evidence of the industry’s resiliency.

Islamic banking had developed to a systemic level in nine nations by the middle of 2013. These nations, which both have 100% Islamic banking, are Iran, Sudan, Bahrain, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates, according to the IFSB’s data on banking assets.

Based on the survey, nearly 70% of the organisations that provide Islamic banking services are “standalone” Islamic banks, with the remaining 30% being conventional banks that offer Islamic banking services through “windows.” Islamic banks coexist with regular banks, except in Iran and Sudan, intensifying competition in the financial sector.

Despite Islamic banking’s extensive reach, the sector’s assets are still heavily concentrated in a limited number of nations. Iran, Kuwait, Malaysia, Saudi Arabia, and the United Arab Emirates together account for 80% of all Islamic banking assets globally.

Important products

The spirit of Islamic finance is closest to PLS financing. Compared to non-PLS finance, its fundamental tenets of equality and participation and its close relationship to actual economic activity support a more equitable distribution of revenue, resulting in a more effective use of resources. PLS finance comes in two flavours: Musharakah and Mudarabah. The purest type of Islamic financing is known as Musharakah, which is a profit-and-loss sharing partnership.

It is a joint partnership agreement where two or more partners contribute money to fund a project or hold real estate or other portable assets permanently or on a declining basis.

Among all Islamic financing methods, Musharakah partners bear the most risk and have the most potential for gain. They have the right to participate in management. Losses are split proportionately to capital commitment, while revenues are allocated according to predetermined ratios.

A profit-sharing and loss-bearing agreement known as a Mudarabah is one in which one party provides funds (the financier as principal) while the other party, the Mudarib or entrepreneur, acts as the other party’s agent and contributes work and managerial skills to make a profit.

The mutual agreement governs the profit split, but losses, if any, are entirely the financier’s responsibility unless they are the consequence of the mudarib’s carelessness, misbehaviour, or violation of the conditions of the contract. Because the Mudarib manages the company and the financier cannot influence management, mudârabah is frequently referred to as a sleeping partnership.

However, stipulations may be stipulated to ensure better management of funds. Mudarabah contracts are also utilised for the management of mutual funds. Islamic banks primarily employ Mudarabah financing to raise capital.

Islamic and conventional banking

Many contend that despite variations in the business models of conventional banks and Islamic institutions, the effectiveness of both banking systems was similar. However, the financial crisis has altered the narrative. Recent research (such as Rashwan, 2012 and Hasan and Dridi, 2011) demonstrates that the profitability of Islamic banks declined more than that of conventional banks during the crisis, primarily due to inferior risk management procedures and financial crisis spillovers to the real economy. Islamic banks in affluent nations appear to be more efficient than those in less developed countries, despite evidence from worldwide showing both the cost and profit efficiency of Islamic banks are increasing. These nations’ established regulatory frameworks, more evolved human capital, and improved risk management procedures may help to explain this in part (Tahir and Haron, 2010).

Islamic banks have certain risks besides those familiar to conventional financial firms. While setting them apart from traditional banks, the Shari’ah-compliant character of their assets and liabilities exposes them to comparable market, credit, liquidity, operational, and legal risks.

Notably, conflicting opinions among religious experts on whether or not particular financial arrangements comply with Shari’ah can put Islamic banks at risk of doing so. Additionally, operational variations between nations lead to various permitted financial products, increasing legal confusion in cross-border Islamic economic activity. Islamic financing is also vulnerable to significant judicial risk because clients can seek redress in both Shari’ah courts, which make decisions on a case-by-case basis, and conventional courts.

Furthermore, Islamic financial institutions might face commercial pressure to offer competitive rates of return higher than returns on the assets they are financing. Shareholders might have to give up some or their entire share of profits to reduce the risk of funds withdrawal. Such vulnerability to the rate of return risk gives rise to displaced commercial risk, a risk specific to Islamic banks. Finally, equity risk is created when Islamic banks participate in Musharakah and Mudarabah partnerships as lenders of funds, and they share in the commercial risk of the activity being financed.

For Islamic banks, mark-up risk typically comes in at the top. A 2001 Islamic Development Bank (IsDB) report states that Islamic banks are more vulnerable to mark-up (interest rate) risk when investing in fixed-income securities like istisna’ and Murahabah. According to the research, operational, liquidity, credit, and market risks rank second to mark-up risks for these banks.

Riskier investments than Murahabah and Ijarah are profit-sharing investment accounts (PSIA), declining Musharakah, Mudarabah, Salam, and Istisna.

Islamic banks employ a range of prudential reserves to reduce risks. The purpose of PER is to level off profits for investors that own investment accounts (IAH). These reserves are not included in equity capital; instead, they are supported by setting aside a percentage of gross income before the bank’s profit share is subtracted. After assigning the PER, the Islamic bank can fund the IRR, which is used to offset future investment losses for account holders. IRR is paid as a percentage of the income sent to investors. IRR are not included in the bank’s equity capital because they are a part of IAH’s equity. Last but not least, fiduciary risk reserves (FRR), funded by a portion of the profits paid to the bank before the payment of dividends to shareholders, are significantly less frequent and less well-known than PER and IRR.

Islamic banks employ traditional risk management techniques, but additional risk-reducing instruments are required to handle their particular risk exposures. Islamic banks use internal rating systems, risk reporting, internal control systems, external audits, maturity matching, and GAP analysis, which are standard instruments that do not violate Shari’ah. However, the distinctive features of Islamic financing, including the wide range of tools used as funding sources and uses, necessitate the creation of new strategies, institutional arrangements, and procedures to advance risk management practises further and address risks specific to Islamic finance.

These prudential buffers raise issues with corporate governance. Investment account customers typically need more control over the usage of the PER and IRR and, in some cases, need to be made aware of the Islamic bank’s processes for keeping these reserves. However, IFSB guidelines impose restrictions on disclosure requirements on displaced commercial risks and smoothing practises. Additionally, the formation of resources that will likely be advantageous to someone else in the future may have a detrimental impact on an investor with a short-term time horizon. IRR might encourage bank management to take on too much risk, resulting in a moral hazard like deposit insurance.

Islamic financial institutions would benefit from more Shari’ah compliance standards. In contrast to conventional banking, where a single set of global standards aids agents in identifying hazards related to the bank’s operations, Islamic financial institutions frequently struggle to provide globally recognised Islamic instruments to their clients. Harmonising disparities in the Shari’ah compliance of various devices will lessen uncertainty and promote industrial growth, even though it may be challenging to standardise multiple interpretations of some religious issues among jurisdictions and scholars. The AAOIFI and IFSB have offered some Shari’ah criteria and governance recommendations in this vein.

The way to ethical banking

Financial institutions working to integrate their operations with environmental goals, social responsibility, and moral values are likely to see continuing expansion, innovation, and collaboration.

These values are already present in Islamic banking, which puts the latter in a prime position to take the lead in providing ethical goods and services. In this regard, any discussion of ethical banking must address the operations of Islamic banks in both developed and developing markets.

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