Thirty Years of Islamic Banking

Islamic banking started on a modest scale in the early 1970s and has shown tremendous growth over the last 30 years. What started as a small rural banking experiment in the remote villages of Egypt has now reached a level where many mega-international banks are offering Islamic banking products. The practice of Islamic banking now spreads from East to West, all the way from Indonesia and Malaysia towards Europe and the Americas. The size of the industry that amounted to a few hundred thousands of dollars in 1975 had reached hundreds of billions of dollars by 2004.

Banks are the most important financial institutions in a modern economy. They perform some very important functions for society and in this process significantly influence the level of economic activity, the distribution of income and the level of prices in a country. Although initially the major function of banking was to mobilize savings and transfer them to entrepreneurs, over time they have come to perform a number of other functions as well. In addition to offering their services for safe custody of money and other valuables, they also offer current account facilities, easy transfers of money, letters of guarantee, payment of utility bills, and loans for consumer durables and investment. As a result of developments such as credit cards, automated teller machines (ATMs), repurchase accounts, and so on, it has become very easy to make payments through banks. Therefore, in a modern economy, a very large part of current incomes are deposited with the banking system. Due to the facilities mentioned above, people do not need to physically withdraw their money nearly as much as they used to. As will be discussed later, this phenomenon enables the banks to ‘create’ money on their own. This feature increases banks’ influence over an economy. The functions that the banks perform are very important, and an Islamic economy cannot operate without these functions. Consequently, Islamic scholars have dealt with the theoretical foundations of banking activities with a view to finding alternatives.

Islamic banking, like any other banking system, must be viewed as an evolving system. No one disputes that there is a definite desire amongst Muslim savers to invest their savings in ways that are permitted by the Islamic Sharī‘ah. Nevertheless, they must be provided with ḥalāl returns on their investments. Islamic scholars and practical bankers took up that challenge and have made commendable progress in the last 30 years in providing a number of such instruments. However, the concepts of Islamic banking and finance are still in their early stages of development and Islamic banking is an evolving reality for continuous testing and refining of those concepts.

From a very early stage in Islamic history, Muslims were able to establish a system without interest for mobilizing resources to finance productive activities and consumer needs. The system worked quite effectively during the heyday of Islamic civilization and for centuries thereafter. As recorded by Professor S. D. Goitein, partnership and profit-sharing rather than interest-based borrowing and lending formed the basis of commerce and industry in twelfth and thirteenth centuries in the Mediterranean region.¹ However, as the centre of economic gravity shifted over the centuries to the Western world, Western financial institutions (including banks) became dominant and the Islamic tradition remained dormant. In recent years, however, there has been a significant revival of interest in developing a modern version of the historic Islamic financial system in the wake of Muslims’ desire to stay clear of interest.

There are several aspects of a firm’s operations that need to be watched by financial managers, who commonly use many ratios. In this chapter we employ some of these ratios to evaluate the performance of Islamic banks. For this purpose, the same sample of twelve Islamic banks as was chosen for the analysis in Chapter 4 will be employed. We will attempt to evaluate Islamic banks with respect to their soundness, prudence, effectiveness in the use of funds, economy and profitability.

This chapter provides an overview of the literature that deals with measuring bank efficiency and shows recent empirical evidence that has sought to compare cost and profit efficiencies of Islamic and conventional banks. The first part of the chapter deals with the main methodological issues associated with estimating bank efficiency and outlines the main parametric and non-parametric approaches currently used in the literature. It then goes on to discuss features of the bank production process and finishes off with a review of recent studies that compare the banking sector efficiency of Islamic banks in GCC countries, Egypt, Jordan, Turkey and Sudan. Other studies that solely focus on Islamic banks are also briefly discussed. The main finding from this (albeit recent and limited) literature is that Islamic banking as a production process is almost always found to be more cost and profit efficient than conventional banking. This is perhaps due to the lower funding costs and loan-loss levels in Islamic banking as compared with other types of banking operation. This phenomenon, amongst others, may explain why we continue to see high growth rates of Islamic banking practice internationally.

As mentioned in Chapter 4, serious research work of the past half-century has established that Islamic banking is a viable and efficient way of financial intermediation. A number of Islamic banks have been established during this period under heterogeneous, social and economic conditions. Recently, many conventional banks, including some major multinational Western banks, have also started using Islamic banking techniques. All this is encouraging. However, the Islamic banking system, like any other system, has to be seen as an evolving reality. This experience needs to be evaluated objectively and the problems ought to be carefully identified and addressed. In this chapter we review some of the challenges being faced by Islamic banks.

Thirty years ago Islamic banking was considered wishful thinking. However, serious research work since then has shown that Islamic banking is not only feasible and viable, it is an efficient and productive way of financial intermediation. A substantial number of Islamic banks have also been established during this period. The successful operation of these institutions is sufficient to show that Islamic banking offers an alternative method of commercial banking. The fact that many conventional banks, including some major multinational Western banks, have also started using Islamic banking techniques is further proof of the viability of Islamic banking. However, Islamic banking is still a nascent industry and has a long way to go before being on par with other well-developed models of financial intermediation. From a niche market it has to earn the status of a mature international industry. This requires that Islamic banks take a critical look at their activities, correct their mistakes, identify their long-run comparative advantage and exploit it to the fullest possible extent. In the long run, for its viability and survival, Islamic banking has to rely on its strengths as an alternative model of financial intermediation, rather than on the sympathies of its clients or government support.

The Islamic financial industry as well as the Islamic theory of finance has made significant progress. Having noted the challenges facing the industry in Chapter 7 and identified the potential areas of growth in Chapter 8, in this chapter we turn our attention to some theoretical issues that need to be further researched in order to provide continued support to the practice of Islamic banking.

Islamic banks emerged on to the financial scene in early 1970s. During the last 30 years the Islamic financial industry has shown remarkable progress both from a theoretical and practical perspective. Even though Islamic banks emerged in response to market needs of Muslim clients, they are not religious institutions. Like other banks, they are profit-seeking institutions. However, they follow a different model of financial intermediation. The most important distinguishing feature of the Islamic banking model is the use of risk-sharing modes of finance. Islamic scholars working with practical bankers have developed a number of such modes, including muḍārabah, mushārakah, murābaḥah, salam, istiṣnā‘, leasing and ṣukūk. Salient features of all of these modes have been discussed in this book. In the Islamic theory of contracts of exchange, the general rule is that of permission. Every contractual arrangement is permissible unless expressly prohibited by Sharī‘ah. There are very few prohibitions. Basically, these are covered under two categories: ribā and gharar. These terms have been described in detail. Based on the Islamic theory of financial contracts, guidelines for Islamic financial engineering have been derived. These can be summarized in what we have called the four Cs of Islamic financial engineering: consciousness, clarity, capability and commitment:

Consciousness: the parties should consciously and willingly agree on the conditions of contract without compulsion or duress. An implication of this is that any agreement made in a state of unconsciousness (such as under the influence of intoxicants or imposed by force is not valid).