Magoosh GRE

Islamic Banking In Saudi Arabia

| March 24, 2015

INTRODUCTION:

INTRODUCTION TO ISLAMIC BANKING:

GENERAL OVERVIEW:

It has been conceptualized that Islamic Banking refers to a financial system that is in parity with the fundamental Islamic concepts and highlight the values prevalent in the religion of Islam. These values are a pre-defined in a code of conduct called the Shariah Law that governs the Islamic way of life and. Sharia Law is influenced by the teachings in the Quran (the holy scripture followed by Muslims) and the Sunnah (teachings of the last Prophet), and is consistently practiced in all Islamic economies around the world. Sharia Law, on a general level, instructs individuals to abstain from the concept of fixed payment while simultaneously refraining from conventional banking policies and instruments that have elements of interest. Islamic law instructs its followers to avoid using interest (known as Riba) along with all classifications of conventional banking practices that are considered unethical. Therefore, business practices that are contrary to the principles of Sharia Law are termed as Haraam (forbidden). In essence, the concept of Islamic Banking differs from conventional banking system as it forbids the use of interest and relies on the transactions that are based upon tangible goods and real, measurable services. (1,2)

HISTORICAL VIEW OF ISLAMIC BANKING:

Historically, the use of interest was present in ancient Middle Eastern societies, imposed on the poor by the rich. However, with the spread of Islam, the teachings of the Quran and the Sunnah introduced a novel financial system that freed all citizens of interest (Riba) and introduced equal rights for all. Through the use of the Sharia Law in commencing businesses and transactions, various communities in the Middle Eastern region prospered and grew into an immense trading arena. Moreover, through the popularity of the Islamic banking system because of its attractive outcomes, the application and use of it spread worldwide and can now be found implemented in many western societies. (1,3)

Before 1950s, Muslims strived and succeeded in giving way to a financial system that didn’t use interest to gather capital for business transactions (5,7). The evolution of contemporary Islamic banking system can be traced back to the 20th century, when Ahmad El Najjar from Egypt, built its basic foundation by introducing a system of savings based on ‘profit-sharing’. In 1963, a number of Egyptian banks applied the profit-sharing system by investing in local trade and industry, and shared the profits with the depositors. The Egyptian community discovered sound success during the years implementing Islamic financial system, aiding to the economy’s success. Although the return of profit is relatively slower in Islamic banking, bankers found the conventional financial system more attractive as it returned higher profit returns through the use of interest. Therefore, when conventional banking surfaced in many Middle Eastern societies, it quickly rose to great popularity for businesses and investors. However, as the conventional system solely depended on interest-bearing activities, many scholars of Sharia Law dismissed it as prohibited according to the religion of Islam. (4,6)

From the period of 1950 to 1960, Muslim scholars got together in order to formulate a banking system that would be free from interest and would be based on the fundamental principles of Islam. This resulted in the formation of a model known as present day Islamic banking, which was based on two concepts. Firstly, they established profit and loss sharing contracts, known as Mudarabah; and secondly the concept of Wakalah, an investment account in an Islamic bank that would earn a flat fee for investors. (3)

Keeping this model in mind, the countries of Egypt and Malaysia were the first to produce Islamic financial institutions that were non-interest based. In 1971, Nasir Social Bank was established in Egypt that was essentially declared as ‘an interest-free commercial bank’. Later in the 1970s due to the booming oil revenues from the Middle Eastern countries, small commercial banks sprang up as they competed for the surplus funds amidst the growing popularity of no-interest banking (4,8,10). United Arab Emirates introduced the first commercial bank that was a result of private enterprise, established in 1974. This was followed by the establishment of an international financial institution by the name of Islamic Development Bank in 1975 in the city of Jeddah in Saudi Arabia. (5)

The 1980s saw rapid growth of the Islamic banking industry. One of the major developments in this period was the establishment of the Islamic Training Institute by IDB, which invested on research and development of conceptual and theoretical applications of the Islamic Banking principles. Countries like Bahrain and Malaysia supported the advent of such a system and promoted Islamic banking. This move was followed by the conversion of the banking systems to non-interest institutions in countries such as Iran, Pakistan and Sudan (3,10). Due to the phenomenal growth witnessed by other financial institutions, conventional banks began introducing Islamic windows in their institutions by offering Islamic products such as Mudarba and Musharaka, which are described later on in the report (7).

In the 1990s the growth that was witnessed earlier steadied, as governments and lawmakers were attracted by the propositions of this banking system. Through increased development in the Islamic financial system, different innovative products and services were introduced. Islamic insurance, known as Takaful, was introduced along with the introduction of Islamic equity funds (2,3,8). In the contemporary world, the Islamic banking system has established itself across the world and got is recognized as a major banking system in both western and eastern societies around the world. (4)

WHAT IS ISLAMIC BANKING?

There are certain defining characteristics that separate an Islamic financial institution from a interest-based conventional system. Firstly, Islamic financial system shares the risk of investment that translates into sharing the risk of ownership concurrently (1). Secondly, Islamic banking is based on real assets and transactions that have a certain economic purpose (2,3). Thirdly, Islamic financial system grants that fairness should be guaranteed in the execution of the agreements so that there are no dubious terms and conditions for every party involved (6). The most important of the characteristics mentioned above is that Islamic financial institutions should not involve under any circumstances, an element or a transaction based on Riba (interest), because the Islamic Financial system centers on interest-free banking. (3)

GROWTH AND DEVELOPMENT:

In order to understand the growth and development of the Islamic banking model, we need to evaluate the extent of reach of the current Islamic banking system. Islamic financial institutions have now engulfed several Muslim countries across the globe, and have begun establishing roots in many western societies. An eminent example is of the Islamic windows present in HSBC by the name of Amanah, as well as Standard Chartered Sadi in the UK.

Geographic Breakdown of Islamic AssetsFigure 1: Geographic Breakdown of Islamic Assets

 

Recent studies have established that Islamic assets have increased by 15% per annum over the past two decades (5,6). This is because Islamic economists have modeled current financial products offered by Islamic banks by adapting on to the much demanded conventional banking products to cater to and fulfill the consumer’s needs. However, they have successfully altered them to avoid the use of interest and comply with the fundamental aspects of Sharia Law. (5,9)

The current global picture of the position of Islamic banking sector is very promising. Assets under the Islamic banking management would soon cross the 1 trillion dollar mark for the very first time in 2012 (3,6,9). In 2011, the assets were valued at 840 billion dollars, which was preceded by the asset value of 400 billion dollars in 2009 (4). This shows a remarkable growth of 100% in the year 2011 and a further 25% growth in 2012. (8,11)

Total Volume of Sharia Complaint Assets in USDTable 1: Total Volume of Sharia Complaint Assets in USD

Currently, there are 300 banks and financial institutions across 50 countries that offer Islamic financial services to its consumers (1,11). Economists’ have made predictions for the unparalleled growth and demand for the Islamic banking system, forecasting a growth rate of 15% to 20% annually for the next eight to ten years (5,8). According to these statistics, the growth in the Islamic Financial sector is set to achieve a 4 trillion dollar mark from 2020 to 2022. (3,9)

ISLAMIC BANKING PRINCIPLES AND CONCEPTS:

FINANCIAL INSTRUMENTS OF THE ISLAMIC BANKING:

Following are the key financial instruments applied in Islamic banking. Some of them may seem duplicate to many products offered by conventional banks, however, they differ through the basic concept of interest-free banking that are governed by Sharia Law. (3, 7, 10)

  1. Mudharabah

Mudharabah is an agreement usually established between a capital provider and an entrepreneur, who will invest the amount in his business. Any profits generated would be shared in a pre-determined ratio, while losses incurred are borne solely by the provider of capital. This whole process of profit sharing will continue till the point that the loan is repaid.

  1. Musharakah

Musharakah is usually confused with Mudarabah as the concepts are quite overlapping. Under Musharakah, partners provide different capitals to invest in their business. The profits generated are shared according to a pre-determined ratio; however, the losses suffered are shared according to the ratio of equity participation.

  1. Murabahah

Under this financial instrument, goods are sold keeping in mind a certain profit margin that is agreed by both parties involved in the transaction. Every detail regarding the possible transaction should be elucidated to the purchaser, such as the selling price, purchase price and the profit margin. Murabahah is a fixed income loan that is used for buying assets with a profit margin involved.

  1. Wadiah and Hibah

Wadiah is an arrangement where the bank is deemed as the “safe keeper” of the funds deposited, until the depositor wishes to withdraw the amount. In such an arrangement, the bank, at its own discretion, might use these funds to invest in businesses. By doing so, the bank will provide the depositor a certain amount for the use of their funds. Hibah refers to the same procedure; however, the capital comes from savings accounts held by consumers in an Islamic banks.

  1. Qardhul Hassan

Qardhul Hassan is a loan that is extended on the basis of goodwill to the debtor where no interest is charged. The debtor is only to pay back the initial amount of the loan, without any added interest. In this situation, the debtor, in his pure appreciation of the bank’s services, can provide back an extra deposit at his own discretion without promising for it in the beginning.

  1. Takaful

Takaful is referred to as Islamic insurance, based on the underlying concept of mutual cooperation and bearing each other’s burdens. In a Takaful agreement, the policyholders pay a certain premium to each other and in return share the profits made by businesses in which their funds have been invested in.

  1. Wakalah

Wakalah is a term similar to a power of attorney. It is applied within the operations of Islamic banking where one person appoints another person to be his representative, bestowing on him the power to take transactions their behalf.

  1. Sukuk

Sukuk refers to a bond that is issued with no interest charged on it. Thus, they are in accordance to the injunctions of Islam where the basic concept is the interest of ownership by the investor or the bondholder.

  1. Ijarah

Ijarah refers to lease, wage or rent. In application to Islamic banking principles, it is the arrangement where the benefit of using a certain product is provided for a fixed charge. The bank would make available the asset or the service for a consumer to use, which they are to pay a certain fixed amount as rent until they continue using it.

Ijarah

ISLAMIC BANKING IN KSA:

ECONOMIC HISTORY:

Saudi Arabia enjoys a rich economy, due to its prosperous oil-based reserves. As the country is an absolute monarchy, government intervention is present in most of the major activities and functions of the economy. The petroleum sector alone accounts for around 45 percent of the budgetary revenues, 55 percent in contribution to the Gross Domestic Product and most importantly 90 percent to the exports of the country (8). Saudi economy was an agrarian economy that was based on agriculture before the discovery of oil in the 1930s. One of the most prominent economic acceleration came from the 1973 oil crisis, from which Saudi Arabia gained benefit in its economic growth as the GDP per capita increased by 1858%. (4, 8)

ISLAMIC BANKING SECTOR AND ITS GROWTH:

The Islamic banking sector in the Saudi Arabia is supervised and governed by Saudi Arabian Monetary Agency (SAMA) (4,8). SAMA is an independently established and operated governmental agency that is directly subject to the orders and instructions passed by the Council of Ministers. The Ministry of Finance and National Economy is in charge for matters pertaining to SAMA. (4,8)

The growth of the Islamic banking sector can be divulged from the fact that Saudi Arabian banking sector is currently the largest, when measured in terms of assets. The Al- Rajhi Banking and Investment Corporation is considered the largest Islamic Bank in the world (2,4). Currently there are 15 banks operating in the country, out of which 3 are foreign banks that have played their respective role in the growth of the banking industry in Saudi Arabia. They arethe Deutsche Bank, JP Morgan Chase and BNP Paribas. (2,7,9)

Islamic Products Growth

DIFFERENCE BETWEEN CONVENTIONAL BANKING AND ISLAMIC BANKING:

In conventional banking, money is treated like a commodity that can be sold at a price higher than its face value. However, in Islamic banking money retains its position at store value and a medium of exchange only that cannot be sold at a higher price.
Also, in conventional banking, interest is charged on the time value of capital whereas in Islamic banking profit is earned through trade of goods and services. Moreover, in conventional banking, interest is charged even when the party suffers losses. This doesn’t depict the profit and loss sharing arrangement (9, 11). In Islamic banking, in case of losses suffered, the bank will share the losses depending on the financial instrument used. Under the system of conventional banking, no agreement is made to allow for the exchange of services when dealing with the disbursement of cash finance, working capital finance or running finance. On the contrary, while disbursing cash finances under Islamic banking system, agreements regarding the exchange of goods and services must be made and followed through. While using money as a commodity, conventional banking system can lead to inflation whereas the Islamic banking contributes to the development of the economy by linking the sectors of the economy to trade activities and thus creating a link with the real assets as well. (7, 10)

COMPARING TABLE:

COMPARING TABLE

Works Cited

  1. Choudhury, M.A. Venture capital in Islam: a critical examination. Journal of Economic Studies, Vol. 28:1,2011
  2. Lewis, Mervyn, and Latifa M. Algaoud. Islamic Banking. Cheltenham, UK: Edward Elgar Print, 2001.
  3. Ghannadian, Farhad F., and Gautam Goswami. Developing Economy Banking: The Case of Islamic Banks. International Journal of Social Economics 31.8: 740-52. Print. 2004
  4. Binladen, Abdullah M. Western Banking Practices and Shari’a Law in Saudi Arabia a Thesis. 1992.
  5. Bintawin, Samar. Performance Analysis of Islamic Banking: Some Evidence from Saudi Arabian Banking. Journal of Economic Studies, Vol. 29:5, 2011.
  6. Muzaffar, Islam. Growth and Development of Islamic Banking. 2002.
  7. MAbid Ali Al-Jarhi and Munawar Iqbal. Islamic Banking: Answers To Some Frequently Asked Questions. Islamic Development Bank, Islamic Research And Training Institute, Occasional Paper No.4, 1422h, 2001
  8. Saudia Arabia Banking Sector. Global Research. 2006.
  9. International Association of Islamic Banks. Report, Cairo, Egypt: IAIB. 1998
  10. Islahi, AbdulAzim. Hennie Van Greuning and Zamir Iqbal Risk Analysis for Islamic Banks. The World Bank, Journal of King Abdulaziz University-Islamic Economics 22.1: 197-204, 2009.
  11. Chachi, Abdelkader. “Munawar Iqbal and Philip Molyneux Thirty Years Oflslomic Banking: History, Performance and Prospects.” Journal of King Abdulaziz University-Islamic Economics 19.1: 39-41, 2006.

Category: Essay & Dissertation Samples, Finance Essay Examples