Friday, February 11, 2011

The Islamic Banking System

 I have always been curious about the Islamic banking system. The notion of no interest rates intriguers my curiosity to know more about how it works and what are the differences between the Islamic economics and the secular economic system when it comes to money and banking. After the recent financial crisis, and the collapse of the subprime market, I started wondering if that type of dysfunctionality in the banking system would happen in an Islamic banking model. The main discussion here would be the risk in the Islamic banking system and how it is managed, but also how is the Islamic banking system implemented in a global economy where the norm is the use of interest rates at secular banking systems around the world, but also in Muslim countries where there is a co-existence between the two models.
The Islamic economy is founded on the concept of banning Al Ribba, which is the arabic word that defines the notion of interest rates. This financial practice is totally prohibited even if interest rates are very low. The first Islamic bank was founded in Egypt in 1963 by the economist Ahmad Al-Nagar. The Islamic economy today has taken a different aspect. In fact, today we are talking about a whole new theory of “Islamic economy”. It consists of different elements, some are dictated by the religious texts, and others are developed by Islamic economists:
·         Increase in wealth: in Islamic economy, money is not considered as an asset itself. It is used in the business cycle to create surplus.  This aspect explains the prohibition of interest rates. The money holder is supposed to invest his money in activities that generate revenue. If that money holder decided to invest in activities that will offer interest payment, he will be less likely to be interested by the business his money is invested in.
·         The government: It plays the role of supervisor and moderator in the economy. Its power relies in the line between the capitalist laisser-faire and the socialist system. The government orients the economic indicators towards more profitable activities providing elements needed to have a constant economic growth.
·         Equitable distribution of wealth through giving zakat, charity of 2.5% of accumulated annual wealth to the less fortunate.
In the banking system, the risk management is highly relevant and important. This importance is emphasized by the existing interdependence between the different financial institutions of a country. The bankruptcy of a bank, although of small size for instance, can affect the stability of the overall banking system and affect the economic growth on the national level as well as on the international level. Thus, it is crucial to have an efficient risk management in the banking system. In order to attain this objective, the financial institutions of the country have to have a well developed model for risk management and a knowledge of the type of risks presented by certain assets or investments. There are different types of risks relates to the traditional banking system and they are: Capital risk, Credit default risk, market risk and liquidity. The agreement of Bale in 1988 introduced the concept of relative weight of risks to assets. This agreement has also required banks in the developing countries that have international transactions to hold a minimum capital in their reserves. The question that arises from this agreement is that whether Islamic banks are adopting the terms of this agreement. It is not easy to answer this question because of the difference in characteristics between a secular and Islamic bank. Therefore, it is important to familiarize ourselves with the particular characteristics discussed above. The credit default risk might pose a problem for Islamic banks. In fact, in the Islamic model, the rescheduling of the loans unpaid cannot happen therefore it might encourage some borrowers to delay their payments voluntarily. Also Islamic banks are not allowed to have transaction in the derivative market because it is against the Sharia law. Therefore, it is not evident for Islamic banks to decrease the risk by using this method. But again, the Islamic banking system can take different forms depending on the country where it is operated. For instance, in Turkey the return to depositors in Islamic banks is very similar to the return in traditional banks and that is due to the channeling of the deposits into bonds and securities that offer interest, which might not be acceptable in other countries like Pakistan. Because there isn’t a common ground of agreement on one Islamic banking theory, it is often hard to regulate this sector. The concept of no interest is definitely agreed upon but the terms by which each Islamic bank operates might differ depending on the government and on the target customers.
The third risk is the market risk. It is the risk related to the evolution of the economy, taxes, inflation, and interest rates. In fact, the market risk affects all goods and securities. Islamic banks, along with secular banks, are exposed to the market risk, although one might think the opposite because Islamic banks don’t charge interest rates. However, as mentioned previously, the returns as quite similar and that means that the interest rates in the market do, in fact, affect the return on deposit in Islamic saving accounts. Kuran (1995) explains that by the investment of the deposited money in Islamic banks in the different bonds that bear interest.  However, Islamic banks usually avoid investing in risky assets.
The risk can also be explained by the use of the concept of LIBOR as a reference to their financial transactions. It causes them to be exposed to the risk of the change in the interest rates of LIBOR. LIBOR is a benchmark interest rate index used to make adjustments to adjustable rate mortgages. Moreover, when there is increase in the rate of LIBOR, the banks are exposed to even more market risk. Because the banks have to take into consideration the distribution of the benefit margin to the deposit account holders, give larger profits to the new deposit account holders, while the deposits were made at a lower rate on the long term, as in the case of Al Murabaha.
Al Murabaha is a form of transaction in the Islamic banking system. It might be considered a form of loan but again with no obvious interest rate. The bank basically buys the product(s) that their account holder needs, and then sell it to him at a marked price while transferring the ownership as the customer makes payments. One might see no difference between this practice and the interest rate used in secular banks. However, the difference lies in the fact that Islamic banks would be responsible for any loss or damage in the property, although the ownership of the banks to the good might not last long enough to put the bank at risk.
In addition to that, any increase in the interest rates of bonds would also be reflected in the beneficiary margin without leaving the opportunity for banks to reevaluate their equivalent assets, because price is already fixed and based on the previous year. That is to say that, unlike many people think, Islamic banks cannot avoid the risk of the change in interest rates.
Secular banks have put in place regulations and tools that help manage the risk of the market, for instance the concept of option contract. While for Islamic banks, the Muslim scholars haven’t yet made a unanimous statement about what kind of measures can be taken by the government to limit the market risk in the Islamic banking system. Islamic countries are reluctant to regulate the Islamic banking based on the secular measures, because of the different characteristics but also because it should be based on the charia law which needs the confirmation from the Muslim scholars and Muslim economists who are knowledgeable of both the religious texts and its interpretation and the macroeconomics.
            The last risk discussed is the liquidity risk. This risk arises when the banks have treasury difficulties, and that it is unable to pay its obligations on time or to finance its operating expenses. A good management of assets is in fact crucial for any bank, Islamic or secular, that want to be able to stay on the market and conduct its activities with less risk.
There are many factors that can be to the origin of the liquidity risk, as mentioned by Hassoune (2007). The first element consists of the importance of the banks liabilities, having illiquid liabilities without the need to sell those liabilities, because again the charia law prohibits the sale of liabilities in the stock market.
Another issue, and probably the most evident one, is that there is no organized and audited Islamic monetary market, which makes it difficult for Islamic banks to raise capital efficiently and in short amount of time. Therefore when Islamic banks want to make an emergency loan from the Federal Reserve, for example, they will have to accept the actual interest rate in use for that period of time, which without doubt would be reflected upon the activities of the Islamic bank in one way or the other.
The last factor would be the fact that most Islamic banks rely heavily on the current accounts, which again have a great risk of withdrawal at anytime. Islamic banks are also not prepared to face this kind of risk. Like mentioned before, there is no last minute lender for Islamic banks unless they accept to borrow with interest rate.
Today, with the frequent change in expectations of the households, the last factor might pose problem for Islamic banks, in case there are negative expectations about the Islamic banking model, many of the money would be withdraw leaving the banks with less liquidity and no interest-free lender.
                                                                                                                   Sara Amiri

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