The
Islamic banks face a number of challenges. First, they have not yet
been successful in devising an interest-free mechanism to place their
funds on a short-term basis. They face the same problem in financing
consumer loans and government deficits. Second, the risk involved
in profit-sharing seems to be so high that most of the banks have resorted
to those techniques of financing which bring them a fixed assured return.
As a result, there is a lot of genuine criticism that these banks have not
abolished interest but have in fact only changed the nomenclature of their
transactions Khan (1989). Third, the Islamic banks do not have the
legal support of central banks of their respective countries (except in
Pakistan and
Iran), which exposes them to great risks. Fourth, the Islamic banks
do not have the necessary expertise and trained manpower to appraise,
monitor, evaluate and audit the projects they are required to finance. As
a result, they cannot expand despite having financial
liquidity.
The future
of Islamic banks hinges, by and large, on their ability to find a viable
alternative to interest for financing all types of loans. They should
recognize that their success in abolishing interest has been only partial
and they have yet to go a long way in their search for a satisfactory
alternative to interest. Simultaneously, Islamic banks need to improve
their managerial capabilities by training their personnel in project
appraisal, monitoring, evaluation and performance auditing. Moreover, the
future of Islamic banks also depends on developing and putting into
practice such accounting standards which provide timely and reliable
information of the type that the Islamic banks would require for
profit-sharing, rent-sharing or for cost-plus financing. These standards
are yet to be developed. The Islamic banks would have to work hard to
pursue their clients to accept these standards so that a reliable
information base is established (Khan 1994, pp.80-81).
2.
ISSUES AND PROBLEMS
The
implementation of an interest-free banking raises a number of questions
and potential problems if seen from the macro and micro operational point
of view. A partial list of the issues confronting Islamic banks
includes:
Issues
related to Macro Operation
·
Liquidity
and Capital
·
Valuation
of Bank Assets
·
Credit
Creation and Monetary Policy
·
Financial
Stability
·
The
Ownership of Banks
·
Lack
Capital Market and Financial Instruments
·
Insufficient
Legal Protection
Issues
Related to Micro Operation of Islamic Banks
·
Increased
Cost of Information
·
Control
over Cost of Funds
·
Mark-up
Financing
·
Excessive
Resort to the Murabaha Mode
·
Utilization
of Interest Rate for Fixing the Profit Margin in Murabaha
Sales
·
Financing
Social Concerns
·
Lack of
Positive Response to the Requirement of Government
Financing
These are
some of the immediate problems confronting policy makers and regulators.
Of course, it has to be kept in mind that these issues are at their
elementary level of discussion. Much work has to be undertaken in terms of
procedures, infrastructure and allowing a new framework to develop and
mature. The ensuing analysis should make some these issues clearer, but
the progress so far has been less than substantial.
ISSUES
RELATED TO MACRO OPERATION
Liquidity
Islamic
banking stands for the use of money as a medium of exchange. Conventional
banking, on the other hand, emphasizes the need for maintaining liquidity
and hence requires an adequate amount of reserves. Basic principle of
Islamic banking being PLS-based financing and thereby having been exposed
to increased risk, it would conceivably require higher liquidity and
reserves. This is because of its nature of investment in assets having
lesser divisibility and reversibility. That means, reserve ratios for
interest-free banking are to be calculated on the basis of risk
calculation in various forms of investment.
The
complex problem in measuring liquidity is that liability management in the
conventional banking system has been gradually replacing asset management
to fund liquidity needs. At present, no such facilities exist under the
Islamic banking system. As a result, these banks have to depend on their
central bank to supply cash. The liquidity ratios required by the banking
laws on demand and time deposits differ from country to country. In some
countries, the supervisory authorities reserve the right to impose
different ratios on different banks according to their location. At
present, the liquidity ratio is 35% of demand and time liabilities in
Pakistan (Mangla
& Uppal 1990, pp.194-95).
The
existing operations of conventional bank's lending activities for definite
maturity are based on the doctrine of 'anticipated income theory,' where
bank loans are not self-liquidating in the sense of 'commercial loan
theory.' These loans are paid off out of the future earnings of the
borrower, and are liquid according to their nature, guarantee, and
marketability. Since Islamic banks are not based on the same principle,
but are investing in assets represented by commodities, shares in
companies or working capital of companies, the theoretical probability of
these assets becoming liquid is more difficult to ascertain than in
conventional banks. Also, greater fluctuations in the liquidity ratio due
to the still largely agrarian nature of these economies will significantly
affect the ability of Islamic banks to provide credit to private sector.
This requires special attention when fixing liquidity ratios for each type
of deposit and each kind of investment in order to allow a degree of
liquidity higher than conventional banks (Ibid).
With
regard to the elements comprising the liquid assets of Islamic banks, it
would be necessary to allow these reserves to be held in the form of
financial instruments. Similarly, the bank capital requirements under
Islamic banking would be higher to protect the depositors against
unexpected losses, if any, on the investment portfolios. Increasing the
requirement of legal and loss reserves could provide additional safety
cushion.
Valuation
of Bank's Assets
It is
argued that Islamic banks may suffer a loss of value of its assets in the
absence of a fixed positive rate of return. Further, without the provision
of insurance Islamic banks may face trouble in making their system stable
and avoiding liquidity crises. So far, under Islamic banking, no such
insurance system exists.
Theoretically,
Islamic banks are likely to face a dual risk: (a) the 'moral' risk due to
lack of honesty and integrity on the part of the borrower of funds in
declaring a loss, (b) the 'business' risk arising from unexpected market
behaviour. The deposits under a profit and loss sharing system are
conceptually more akin to a mutual fund's share certificate. These
deposits would share in both the realised as well as unrealised gains and
losses on the investment of Islamic banks. Typically under current
Generally Accepted Accounting Principles, the investment portfolio is
adjusted to market values in investment companies. An upward adjustment of
the assets account requires an offsetting credit to either revenue or
unrealised capital increment. Unrealised capital decrement requires
recording of an unrealised loss on long-term equity securities as a contra
item in stockholder's equity.
The
problem associated with proper valuation of Islamic banks' assets has
important implications from the point of view of bank safety and bank
regulation. Any specification of reserve or provision requirements laid
down by the regulatory agencies will have to consider how far the gains
(losses) on banks' investments are passed on to the depositors. If in the
extreme case, these gains and losses are fully reflected in the value of
the deposits, the banks probably would be passing on all the risks to
their depositors.
Another
problem in determining the profit or loss to be distributed to the
depositors of the Islamic banks relates to the periodic evaluation of
their assets, especially in case of long term investments, such as
Mudaraba, or Musharaka. In the case of participation term
certificates (PTCs), market values could be observable if an active market
in these instruments exists. Such a market for the PTCs is not fully
developed in countries experimenting with the interest free banking
system. The value of long-term investments would fluctuate with the
changes in the expected cash flows as well as the opportunity cost of
capital. In the absence of an active market in these investments, the
valuation process could be very imprecise and costly.
Credit
Creation and Monetary Policy
It
is of the general perception that most of the traditional policy
instruments of the central bank are said to remain largely unaffected
under Islamic banking. These include: minimum cash reserve requirement,
liquidity requirement, overall credit ceilings on lending activities of
these banks, mandatory targets for providing finance to specific sectors,
and moral suasion. Of course, equating the goals of monetary policy in
Islamic banking to those of the free market economies would not be fair
since there is a significant difference in emphasis of the two systems to
economic values and socio-economic justice.
Monetary
policy under Islamic banking assigns a somewhat passive role to money.
Chapra opines that the central bank should adjust the money stock to keep
pace with the secular growth of output. In his view the control of money
supply can be accomplished by regulating the high powered money at the
source. He suggested two alternatives. The first is to impose a 100%
reserve requirement on the commercial banks, thus permitting the central
bank to create credit, which will be channeled through commercial banks on
a Mudaraba basis. The second alternative is to allow banks to
create deposits. Given the Islamic emphasis on re-distributive justice,
this may result in either nationalizing the commercial banks or forcing
the banks to pass on to the state the net income arising from 'derivative'
deposits after allowing for the share of the commercial banks. Under this
alternative, he suggests a 15-20% statutory reserve requirement on only
demand deposits without extending it to cover deposits, which constitute a
part of equity in an Islamic economy. This alternative has its own
conceptual problems of dividing 'net income' among the shareholders,
depositors, and the state. Also, since the deposits will be invested in
the long-run projects, which are likely to be more profitable, this
scenario will pose greater liquidity constraints (Ibid, p.197).
M. S. Khan
(1986, pp.1-27) divides the sources of funds into demand deposits and
investment deposits and places a 100% reserve requirement for the first
category of deposits. Such a restriction would reduce the power of banks
to create credit. As investment deposits are used for risk-bearing
activities, no reserve requirements are needed.
Al-Jarhi
(1980, pp.85-118) proposed a model which he calls a "Productivity-Based
Financial and Monetary Structure" in which the central bank creates a fiat
money through "sale and purchase of central deposit certificates" instead
of issuing interest-bearing government securities. According to Jarhi the
expansion in money must be justified by a possible contribution to real
balances. The growth of money must go with the real growth of the economy.
There are no fractional reserves in the model. The central bank issues
certificate as liabilities and holds loan accounts and deposits in member
banks. The banks hold assets in the form of cash, equity shares, PLS
accounts, and leasing accounts; while their liabilities consist of
non-interest bearing demand deposits, investment deposits and certificates
issued to their customers. Thus, in Jarhi's model, the indirect link
between financial and goods market established by the financial
intermediaries is replaced by direct participation of banks in productive
investment projects. The growth and the past behavior of inflation provide
the central bank with necessary information on the expansion or
contraction of money supply.
The
consequences of Jarhi's model are as follows: (a) there is no discount
rate as a policy tool in such an economy. An economy-wide elimination of
discount rate will entail profound structural changes, focusing on social
justice in the light of existing economic conditions. In the absence of
interest rate, and for the purpose of discounting future income streams
for project evaluation, some mechanism in an Islamic economy must serve as
a discount factor. (b) Monetary policy becomes closely intertwined with
the development policy of the economy. Therefore, his suggested policy
questions the emphasis on the stabilization policy followed by
conventional central banks in post-war period. (c) The above emphasis
tends to encourage lending of funds on the basis of profitability of
investment projects rather than solvency and credit worthiness of the
borrower in the debt finance case. This would require trained banking
personnel and expertise in project feasibility, evaluation and appraisal
by the commercial banks, which may lead to increase monitoring costs for
Islamic banks.
There is a
recurring emphasis in Islamic banking literature on 100 percent reserve
requirements. Though this permits the central bank a direct control of
money stock, the emphasis is more pointed in favor of Islamic equity and
against the notion of 'hidden subsidy' involved in the generation of
'derivative' deposits in the interest based banking system. Accordingly,
credit creation is confined to the central bank, which extends credit to
commercial banks on a basis.
The
fractional reserve system versus 100% reserves would have different policy
implications. Under the former system, banks would have the ability to
draw profits on funds that they have exerted no productive effort. Such
earning is against the original spirit of Islamic banking. One solution
may lie in the nationalization of commercial banks, which has already
occurred in most of these countries. As regards the latter, we have a fair
amount of theoretical insight from the western literature but do not have
any valuable empirical observations on the operations of 100% reserves
even in countries that have adopted Islamic banking. These Islamic banks
are still operating under fractional reserve system. Hence, the operation
of monetary policy under 100% reserves system needs further
research.
In
summary, according to the principle of Islamic banking private banks
should not have the power to create money, that money creation should be a
power reserved for the government or its central bank.
Financial
Stability
Conventional
banking system based on the fractional reserve system has built-in
instability as illustrated by western economists such as Hayek (1933),
Mintz (1950), Fisher (1930) and Freedman (1957). The instability arises,
as argued by them, from the lack of synchronization between the decisions
of commercial banks and the central bank thereby resulting in
destabilizing forces. Modern banking based on interest issues fixed
value liabilities to its depositors. In the absence of deposit insurance
the value of assets can fall below its fixed liabilities, resulting in
bankruptcies. In the worst scenario, the welfare of each depositor
depends on the action of other depositors (Kaufman 1986, pp.69-77). For
example, if one of the bank's major borrowers defaults and a financial
panic is triggered, each depositor will try to withdraw funds as soon as
possible. This negative externality generated by the depositors can cause
instability in the banking system. The provision of deposit insurance has
reduced the problem of financial panics, but it has at the same time led
to inefficiency in the intermediation process.
By that
reasoning, lack of insurance coverage is considered to be a problem for
Islamic banks. It is presumed that depositors in Islamic bank, due to fair
of capital and or profit losses in the event of having no insurance
coverage, would not remain with the Islamic banks. Muslim economists argue
that under Islamic banking, because there are no fixed liabilities,
depositors feel encouraged to remain in the bank when it suffers a decline
in the value of its assets. Hence, there is no externality created, it
does not require the provision of deposit insurance. However, it would
need some provision of insurance against fraud and theft in Islamic
banking.
The
Ownership of Banks
The
ownership issue of Islamic banks relates principally to distributional
impact on the society. Particularly, credit creation power of commercial
banks with fractional reserve ratio has been the point of debate, which
has raised the question as to whether the ownership should be with public
or private hand. The issue is still seems to be unresolved. Commercial
banks in Pakistan are required to maintain fractional reserves and they
are in private sector. On the other hand, all commercial banks in Iran are
nationalized. Further research is required in this regard to come into
conclusion.
Lack of
Capital Market and Financial Instruments
Islamic
banks working under conventional banking framework in different countries
lack capital market and instruments for investment of their surplus
liquidity. Availability of Islamic capital market and instruments help
growth of these banks otherwise they are constrained. Growth of Islamic
capital market and financial instruments also helps creating environment
for government financing.
Insufficient
Legal Protection
A
comprehensive system of Islamic banking requires legal protection. That
means a thorough review of all relevant laws having a bearing on banking
business is needed. Laws relating to companies, commerce, investment and
the courts and legal procedures need to be reviewed and reformulated to
suit the requirement of the efficient functioning of Islamic banks. It is
not acceptable that company law continues to talk about bonds and interest
while ignoring participation deeds and profits. Investment promotion laws
should accommodate rules regulations which permits Islamic banks to apply
their profit/loss sharing modes so that they can participate in
partnership businesses either in the form of or Musharaka or direct
investment.
ISSUES
RELATED TO MICRO OPERATION
Increased
Cost of Information
Muslim
scholars generally agree that monitoring cost as well as cost of writing
and enforcing contracts would be higher in Islamic banking than in the
interest based system. This is because, with Musharaka, the bank
finances the working capital of a business venture taking a quasi-equity
position in the economy. In financing, a management company is formed
which floats a negotiable security, or the bank may completely finance a
project within the scope of its charter. Moreover, since the economies of
countries implementing Islamic banking are generally characterized by
market and informational imperfections, further persistence of these
problems will increase the cost of information. This higher cost of
information could be major setback in effective implementation of the PLS
system.
Control
over Cost of Funds
Interest
based banks maximize their profit subject to cost of funds as it is in a
position to know in advance, with a reasonable degree of certainty, the
amount of profit it may earn in the short term. Through the use of hedging
it can also determine the level of profits in the long run. Under the PLS
system, on the other hand, there is no such scope to know the cost of
funds beforehand. The depositors are paid a portion of bank's profits the
volume of which is extremely uncertain. In this situation if profit rate
expected by the depositors is not realized, the Islamic banks could face
greater uncertainty in their profit base.
Ideally,
Islamic banks are expected to calculate their rate of return on PLS
deposits periodically. The usual practice is that the deposits are
weighted to reflect differences in their maturity. Banks prepare a six
monthly summary account of its operations and send it to the central bank,
which determines the individual PLS rate to be paid by each bank. In spite
of that individual banks are allowed to marginally deviate from the
proposed rate of return. In sum, it can be argued that Islamic banks have
no control over the cost funds.
Mark-up
Financing
There is
wide apprehension that little difference can be found between mark-up
practiced by Islamic banks and conventional banks. However, though not
considered strictly interest-free by many Muslim scholars, mark up was
seen by the banks as a tool to facilitate the transition to Islamic
banking without disrupting the system. Because the ultimate objective of
Islamic banking is toward investment-oriented long-term financing, the
transition from mark-up to equity finance would also require a larger
spread between rates of return to the banks and to their
depositors.
It has
been argued by a number of writers that real substitute of interest in an
Islamic financial system is the mode of profit/loss sharing along with
Qard Hasana. While the other techniques like Murabaha,
Bai-Muajjal, Ijara and Ijara wa Iqtina can not be of equal
significance in achieving Islamic socio-economic objectives (Ahmad 1994).
The reasoning employed is as follows. Islam disallows the interest system
because intrinsically it is a highly inequitable system. The feature that
makes the interest based system inequitable is that the provider of
capital funds is assured a fixed return while all the risk is borne by the
user of these capital funds. Justice demands that the provider of capital
funds should share the risk with the entrepreneurs if he wishes to earn
profit. Financing techniques like Murabaha, Bai-Muajjal, Ijara
and Ijara wa Iqtina, which involve a pre-determined return on
capital, can not be regarded as commendable substitutes for interest, and
should only be used when absolutely needed.
Excessive
Resort to the Murabaha Mode
The
repeated criticism against Islamic banks, which is valid in many counts,
is that it takes recourse to excessive use of Murabaha mode in
financing investment. Yet it is not a violation of Shariah as long
as the Murabaha contract is correct from Shariah viewpoint
and is free from intentional or nominal deception.
The
objection is from two groups of people. The first group considers Murabaha
to be the same as pre-determined rate of return i.e., rate of interest.
But this is not true. Murabaha is different from interest-based mark up as
the former has to satisfy the following requirements. First, it is
necessary that profit margin (or the mark up) the bank is charging must be
determined by mutual agreement between the parties concerned. Secondly,
the goods in question should be in physical possession of the bank before
it is sold to the client. Thirdly, transaction between the bank and the
seller should be separate from the transaction between bank and the
purchaser. There should be two distinct transactions. That is why Islamic
banks effect a Murabaha transaction in two stages using two separate
contract forms. The first form is a request to the bank through which the
client informs the bank of his intention to carry out the transaction. In
this contract, the client promises to buy goods from the bank. It should
also be noted that a promise is not legally enforceable. Hence the client
has a right to change his mind and the bank runs the risk of losing the
money it has invested in this particular transaction. The second
contract deals with the sale of goods by the bank to the client on
deferred payment basis, the terms and conditions of which are clearly
spelled out in the contract form. Unfortunately, the bank violates the
condition that the goods should be in physical possession of the
bank.
Utilisation
of Interest Rate for Fixing the Profit Margin in Murabaha
Sales
It is also
criticized that Islamic banks utilize the interest rate as a criterion for
fixing the profit margin in the Mudaraba sales. To be fare there is
no known way of avoiding the alleged link up as long as Islamic banks
coexist with traditional banks. Still Islamic banks must avoid exceeding
the prevailing interest rate or exploiting the clients through accounting
methods as employed by some banks (Homoud 1994, pp.74-75).
Financing
Social Concerns
Islamic
banks are accused of following the same course of line as pursued by
conventional banks as regards financing of social aspects. These banks are
usually found to be interested in extending credit facilities to
well-established commercial establishments, which often obtain credit
facilities from both conventional as well as Islamic banks without real
commitment or attempt to free themselves from the prohibited means of
finance. In this way, Islamic banks have in general become a figure that
is added to the number of traditional banks, which do business in the
country concerned. No clear prescription has so far emerged on the role of
Islamic banks in the promotion of new projects needed by the society as
follows:
·
Enabling
those who have no property, providing employment opportunities to all
categories of people;
·
Demonstrating
the impact of Islamic investment on the solution of the unemployment
problem; and,
·
Assisting
the state in confronting these ever-increasing
problems.
Moreover,
Islamic banks did not pay much attention to the development of banking
services in some socially desirable directions, except in very rare cases.
The entire realm of the management of estates, trusts and orphanages,
etc., has remained outside the area of interest of Islamic banks, in spite
of the fact that a number of western banks have, since the sixties, begun
establishing specialized departments foe Estates and Trusts.
Lack of
Positive Response to the Requirement of Government Financing
It
is a well-known fact that the modern state is always in need of funds and
resources to implement useful projects, such as the provision of schools,
roads, electricity and water and telecommunication services. Generally,
governments resort to issuance of treasury bills with interest in
accordance with the form used by conventional banks. Islamic banks are
required to enter into this field so as to prove their ability to play
their role in the financing of projects in a manner that conforms to the
Islamic system through the issuance of deeds of Musharaka,
advance-sale, Salam and such other forms that satisfy the need s of
the state for financing and, at the same time, benefit from investment of
their idle liquid surpluses.
Failure of
Islamic Banks to Establish Co-operation among Themselves
In spite
of good intentions, Islamic banks are blamed for their lack of
open-mindedness to one another, a state of affairs that obstructs the
achievement of mutual co-operation among them. This is in spite of the
persistent endeavors of the Islamic Development Bank to bring them closer
to one another and unify their stands. Following examples are enough to
prove the point:
·
Not
all-Islamic banks are members of the International Association of
Islamic Banks. The Association has neither been able to unify their
regulations, nor build bridges of confidence and promote understanding
among them.
·
The idea
of establishing a "Bank of Islamic Banks" is still a mere idea, although
there is an urgent need for its establishment. As a result of its
absence, Islamic banks have lost hundreds of millions with the collapse
of the BCCI.
·
Islamic
funds continue to sneak out by hundreds of millions into investment
houses doing business in the West while the Muslim world remains thirsty
for investment resources.
·
Funds of
expatriates from Islamic countries do not find their way back to their
own countries to contribute to the development of their original
homelands.
·
Trade
among countries of the Muslim world is completely paralyzed as the
Islamic financing system goes along with the traditional trend in
financing imports from foreign countries without giving any preference
to products of the Muslim world. Only the Islamic Development Bank has
been paying due attention and care to the need for preferential
treatment for the products of Muslim countries.
ISLAMIC
BANKS OPERATING UNDER CONVENTIONAL BANKING SYSTEM
Problems
faced by Islamic banks operating under conventional banking framework have
been identified in a recent study are as follows (Ibid).
Failure of
Islamic banks to finance high-return projects
Islamic
bank fails to appropriate high profit from high-return projects since the
owners of these projects prefer borrowing from conventional banks where
cost of borrowing turns out to be lower. That means, only the projects
with rates of return equal to or below the market rate of interest are
left with the Islamic banks. At this situation, Islamic banks are not able
to invest on the projects having rates of return below the prevailing rate
of interest thereby limiting their capacity to utilize investment
opportunity to the level of their conventional counterpart. This leads to
limiting the application of profit-loss-sharing modes such as
Mudaraba and Musharaka. In other words, Islamic banks, at
that situation, switch over to other modes of financing such as
Murabaha, hire purchase, leasing, etc.
Sacrifice
of allocative efficiency
Allocative
efficiency of Islamic bank, if it is truly a profit-loss-sharing bank, is
built-in to its financing mechanism. But failing to finance high return
projects in a situation when entrepreneurs switch over from Islamic banks
to conventional banks to avoid high cost borrowing allocative efficiency
of an Islamic bank is not likely to be in the desired level. Profitability
of projects being the ideal device of efficient resource allocation, at
this situation, does not apply to Islamic banking system as it,
considering the rational behavior of the borrower, takes recourse to modes
other than profit-loss-sharing. This situation continues as long as
Islamic banks operate side by side with the conventional banks. Experts
are very much worried about this situation of Islamic banking. Up till now
no effective policy prescription is available to the Islamic banks to
ameliorate the situation.
Loss of
distributive efficiency
It has
also been found that distributive efficiency of Islamic banking is lost
when an Islamic bank starts operation under conventional banking
framework. Any shift from profit-loss-sharing modes leads the system break
the direct relationship between the incomes of the entrepreneurs, the bank
and the depositors. The inefficiency of conventional banking about
distribution is neither influenced nor modified by the introduction of
Islamic banking in the economy.
CONSTRAINTS
FACED BY ISLAMIC BANKS IN BANGLADESH
Constraints
faced by Islamic banks in Bangladesh are analyzed as below.
Problem
with legal reserve requirement
Islamic
banks in Bangladesh have to keep 10% of its total deposits as liquidity.
Of this, 5% is required to be kept in cash with Bangladesh Bank and the
rest 5% is to be kept either in approved securities or in cash (in case of
problem with securities) with Bangladesh Bank. Legal reserve requirement
for conventional banks is 20%. They have to keep 5% in cash with
Bangladesh Bank and the rest 15% is invested in Bangladesh Bank approved
securities. Traditional banks can earn interest on their deposits with
Bangladesh Bank but Islamic banks can not since they cannot receive
interest as earning. Compared to interest-based traditional banking,
Islamic banks, in this case, are in disadvantageous position. However,
Islami Bank Bangladesh Limited has been receiving interest against its
deposit with Bangladesh Bank and crediting it to its Sadaqa fund
since 1993. It should be noted that the interest earning are not
considered as bank income and added to profit. The proceeds are spent on
welfare activities.
Lack of
opportunities for profitable use of surplus funds
Conventional
banks can invest their excess liquid amount in approved securities and or
in other bank in crisis. Islamic banks cannot take this opportunity due to
the existence of interest element in the transaction process.
Apprehension
of liquidity crisis and possibility of liquidity surplus
Islamic
banks have to be more cautious and vigilant in managing their funds since
it can not resort to call money provision at times of fund shortages or
crisis. As a result Islamic banks may have always left with a sizeable
amount of cash as liquidity surplus. Conventional banks can borrow in the
form of call money among themselves even at an exorbitant rate of
interest.
Problems
in capital market investment
Conventional
banks can invest 30% of their total deposits in shares and securities.
Islamic banks have their problem in this case as they avoid any
transaction based on interest. Following examples may be cited for
illustration. (a) Islamic banks do not purchase shares of companies
undertaking interest-based business; (b) Shares of companies taking loan
from commercial banks on interest are not also purchased by Islamic banks;
and, (c) Islamic banks can not purchase shares of companies involved in
businesses not approved by Shariah.
The above
restrictive environment in the capital market of Bangladesh has limited
substantially the investment opportunities for Islamic banks and hence the
avenues of lawful earning. In the absence of Islamic money and capital
market these banks cannot obtain funds from capital market at times of
need.
Absence of
inter-bank money market
In spite
of five Islamic banks have been functioning in Bangladesh, inter-bank
money market within Islamic banks has not yet taken place. Of course,
except Islami Bank Bangladesh Limited and Al-Baraka Bank Bangladesh Ltd.,
rest of the Islamic banks have launched their operations very recently not
exceeding even two years with hardly more than two branches. Still these
banks can take initiative to form a money market among themselves. This
may help minimising particularly the call money problem they are suffering
from beginnings.
Predominance
of Murabaha financing
Predominance
of Murabaha financing in the portfolio management of investment funds by
the present day Islamic banks of Bangladesh has been a hot agenda of
debate. One study shows that Islami Bank Bangladesh Limited, Al Arafah
Bank and Social Investment Bank Limited have used 54%, 76% and 65%
respectively of their investment funds by resorting to Murabaha mode
(Hoque 1996, p.9). Murabaha though considered as a Shariah approved mode,
the Islamic economists have traditionally prescribed for its limited
application. Due to legacy of traditional banking, lack of appropriate
legal protection and standard accounting practice in business, Islamic
banks in Bangladesh find Murabaha financing as suitable and Mudaraba and
Musharaka as extremely difficult to apply.
Depression
of Profit
Traditional
banks can meet up loss arising from delay in repayment by the clients
through charging compound interest. Islamic banks cannot do that. What it
does it realises comprehension at the rate of profit. But the compensation
so realised is not added to the profit income rather credited to
Sadaqa account i.e., amount meant for social welfare activities.
This depresses profits of Islamic banks. This may place Islamic banks
relatively in weaker position in terms of profitability compared to
conventional banks.
Moreover,
Islamic banks are to make a compulsory levy equivalent to 2.5% of its
profit earned each year and credited to Sadaqa account, which also
depresses banks' profitability. This is unlikely the case with
conventional banks.
Absence of
legal framework
Amendment
of old laws and promulgation of new laws conducive to efficient operation
of Islamic banks are sin qua non for its healthy growth. Countries
introducing Islamic banking should create an enabling environment for
Islamic banks by modifying existing laws and regulations. Islamic banks in
Iran and
Pakistan have their legal supports. Pakistan has
provided legal support to float Participation Term Certificate and conduct
Mudaraba transaction by replacing "The legal Framework of
Pakistan's Financial and Co-operative System" on June 26, 1980. The
Banking Tribunal Ordinance and The Banking and Financial Services
(Amendment of Laws) Ordinance were passed in 1985 by amending seven Acts
such as the Partnership Act, The Banking Companies Ordinance, the Wealth
Tax Act, the Federal Bank Co-operation Act, the Income Tax Ordinance, The
Registration Act and Capital Issues, 1974.
Absence of
Islamic insurance company
Banking
and insurance have to go hand-by-hand in matters of trade and business in
order to protect investments of banks against unforeseen hazards and
catastrophes. Unfortunately, Islamic banks have to depend on
interest-based insurance companies in the absence of Islamic insurance
companies.
FUTURE
POLICY DIRECTIONS
It is
evident from the research findings (Akkas 1996) that Islamic banking could
be the most efficient system if it were allowed to operate as a sole
system in an economy. However, when it starts operation within the
conventional banking framework, most of its efficiencies are lost. The
study demonstrates that it is not the inherent shortcomings of Islamic
banking system that is responsible for its relative inefficiency. Rather
it is the continuation of legacies of the conventional banking system that
jeopardizes an efficient operation and functioning of Islamic banks in the
economy. The policy implication is not that Islamic banks should never be
floated within the conventional banking framework. Rather it is the
conventional banking system whose operational mechanism needs to be
reviewed into PLS-system considering beneficial impact of the
latter on the economy. However, as long as Islamic banks are to operate
within the conventional banking framework, the recommendations under the
following heads may be taken note of.
Banking
Philosophy
There
seems to be a gap between the ideals and actual practice of Islamic banks.
In their reports, booklets, bulletins and posters these banks express
their commitment to striving for establishing a just society free from
exploitation. The present study shows that a little or no progress has
been achieved so far in that regard. Though this failure is attributed
mainly to the pervasive influence of conventional banking system itself,
lack of vigilance of the promoters of Islamic banking in realizing the
objective is no less to blame. The shortcomings need to be identified.
Particularly, it has to be seen whether there is any scope to open up
alternative avenues to arrest the causes of efficiency erosion. There
should be a thorough review of policies that have been pursued by these
banks for about a decade, and points of departure have to be identified to
redesign their course of action. This is a very crucial issue because of
the fact that people at the mass level find very little difference between
the banking operations of Islamic banks and that of their
conventional counterparts. Until and unless a quick change in policy
followed by clear actions takes place, the credibility that Islamic banks
have achieved so far may be tarnished away very soon.
The first
action that deserves immediate attention is the promotion of the image of
Islamic banks as PLS-banks. Strategies have to be carefully devised so
that the image of Islamic character and solvency as a bank is
simultaneously promoted. The following strategies are suggested for
immediate application:
(a)
Pilot
schemes in some very selected areas should be started to test innovative
ideas with profit-loss -sharing modes of financing as major component.
This type of scheme may be experimented both in urban and rural areas.
The strategy will serve as a ready reference that Islamic banks are in
the process of transforming themselves as PLS-banks. Side by side, they
will gain experiences from real situation as to the problems that might
come up while implementing profit-loss-sharing modes on trial and error
basis.
(b)
Islamic
banks should clearly demonstrate by their actions that their banking
practices are guided by profitability criterion thereby establishing
that only Islamic banking practices ensure efficient allocation of
resources and provide true market signals through PLS-modes.
(c)
Islamic
banks should continuously monitor and disseminate through various media
the impact of their operations on the distribution of income primarily
between the bank and the other two parties: the depositors and the
entrepreneurs and then on different income groups of the society. These
presuppose establishment of a fully equipped research academy in each
Islamic bank.
Stepping
up for Distributional Efficiency
The task
is more challenging for Islamic banks, as they have to promote their
distributional efficiency from all dimensions together with profitability.
Islamic banks, step by step, have to be converted into profit-sharing
banks by increasing their percentage share of investment financing through
PLS-modes. The Islamic banks, to do that, can be selective in choosing
clients for financing under PLS-modes.
Islamic
banks should establish a direct functional relationship between the income
of the bank and that of the depositors and between the income of the bank
and that of the entrepreneurs. The relationship improves with the share of
bank financing under PLS-modes increases. Islamic banks should immediately
take measures to revert the trends of resource transfer from both
low-income groups to high-income groups and from rural to urban areas.
This is extremely important from the viewpoint of their banking philosophy
as well as for their tacit commitment for distributional equity. They
should develop a monitoring mechanism by which distributional impact of
their banking operation could be traced out and necessary policy can be
formulated to continuously improve the equity situation. Banking
inequality index developed in the present study might be useful for this
purpose particularly in the case of inter group transfer of incomes.
The Islamic banks should
actively consider utilization of rural potentials from both efficiency and
equity grounds in the context of the present-day socio-economic conditions
of Bangladesh. Strong
commitments and stepping up through experiment and implementation of
innovative ideas are the appropriate ways to do that.
Promotion
of Allocative Efficiency
The
Islamic banks can improve their allocative efficiency by satisfying social
welfare conditions in the following manner. (a) They should allocate
a reasonable portion of their investible funds to social priority sectors
such as agriculture (including poultry and fishery), small and cottage
industries and export-led industries such as garments, shrimp cultivation,
etc. (b) When the percentage shares of allocation of investible funds are
determined, profitability of the projects should be the criterion for
allocating loanable funds. The criterion would be best satisfied if more
and more projects were financed under PLS-modes.
CONCLUSIONS
Islamic
banks can satisfy most of the efficiency conditions if they can operate as
a sole system in an economy. Conventional banking, on the other hand, does
not satisfy any of the efficiency conditions analyzed in the present
study. However, when Islamic banks start operation within the conventional
banking framework, their efficiency goes on decreasing in a number of
dimensions. The deterioration is not because of Islamic bank's own
mechanical deficiencies, rather it is the efficiency-blunt operation of
the conventional banking system that puts a negative impact on the
efficient operation of Islamic banks. This does not mean that the survival
of Islamic banks operating within the conventional banking framework is
altogether threatened. Evidence from Bangladesh indicates that Islamic
banks can survive within the conventional banking framework by switching
over from PLS to trade related modes of financing.
Even
under the conventional banking framework Islamic banks can operate with
certain level of efficiency by applying in a reasonable percentage the
PLS-modes - the distinguishing features of Islamic banking. This has been
possible in some countries of the Muslim world where the management of
Islamic banks was cautious about possible impacts of every policy measure.
Particularly, the management of these banks was judicious in selecting
sectors or areas as major of their operations. Sudan Islamic Bank is a
typical example in this respect. Islamic banks in Bangladesh have much to
learn from experience of this successful bank.
Having
been considered the pro-efficiency character of Islamic banking and its
beneficial impacts on the economy, government policy in Muslim countries
should be in favor of transforming conventional banking system into
Islamic banking.
