What is Islamic Banking?

Islamic Finance goes back centuries, however it has recently gained world-wide recognition. With the rise in ethics, Islamic Banking bridges this gap between capitalist and socialist financial systems through the values and rules it follows.

Islamic Banking provides financial services that follow Shari’ah Islamic law and rules. This mean receipt and payment of interest is forbidden as it is seen as exploitative and each transaction needs to have an economic purpose. Fairness is very important in Shari’ah law therefore equally shared risk and benefit is emphasised. Equity financing is allowed however investment in pornography, weaponry, alcohol or other markets considered harmful to society is not. Excessive uncertainty is also forbidden, all transactions must be asset-backed. Purely monetary transactions are not allowed — activities must be anchored in the real economy. Asset-backing provision is often ignored in traditional banking, increasing the risk related to the transaction.

Islamic Finance is rapidly growing, Technavio’s market research predicts that the global market for Islamic Finance will create a CAGR of 19% until 2019. It also shows that with the growth of Islamic financing in Asian countries such as Pakistan, Bangladesh and Indonesia, the market size of Asia will be over $985 billion by 2019. While the last decade saw double- digit growth rates in the value of the Islamic finance industry, it is still a very long way from saturation.

This growth emerged in an environment where there is no fully-developed financial and economic system based on Islamic principles. Therefore it faces a number of challenges.

Firstly, regulation protecting the depositors is lacking as there is no type or level of protection assigned to Islamic banking instruments. There are also challenges on the asset side, Islamic Banks are the legal owners of all the products they sell and finance, however the disclosure of the these contracts and transparency is not yet available due to the lack of regulatory regimes.

Accreditation of the Shari’a scholars and the development of these rules to approach Islamic finance is also a limitation to this field.

Within each country, Shari’a compliance varies, some products are considered to Sharia’ compliant in Malaysia for instance may be forbidden in the UAE. There are organisations which can address this problem and standardise this, such as AAOIFI. This harmonisation will not only aid Islamic financial reporting but will additionally enable western regulators to understand and work with the Islamic Finance Industry

Despite these ethics, disputes are bound to occur and investors may not be familiar with Islamic contracts, and different court systems may handle these disputes differently depending on their legal system, such as when the dispute between Shamil Bank of Bahrain and Beximco Pharmaceuticals ended up in an English court in 2004.

Although Islamic banks use the same management tools as traditional banks, they still face unique risks. Their risk management is limited by inadequate short-term liquidity management as well being affected as the prohibition of derivative instruments. There is a need to innovate the risk measurement and monitoring process.

There is considerable scope for Islamic financial Institutions to foster innovation to face regulation challenges, create standardisation, settle disputes and identify and manage risks efficiently. There is a high expectation of increased widespread participation and many banks will continue to increase their Islamic products.

While Islamic finance industry has already established itself as a niche market, especially for Muslim customers, and has registered robust growth it faces some important issues and challenges, from regulation and standardisation to risk management. This breeds the opportunity for innovation and new business opportunities.

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