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Finance Essay on Islamic Banking: An Alternative Social & Ethical Way



Write a finance essay on the topic “Islamic banking: as an alternative social and ethical banking”


The study developed in the finance essay investigates the feasibility of Islamic finance and banking as an alternative social and ethical banking in the modern day 21st century. Key highlights include a comprehensive definition and the role of divine guidance alongside the rule of permissibility differentiating between halal and haram transactions. Various prohibitions relating to interests, frauds and ambiguity have also been discussed along with a comparison between Islamic finance and conventional Western banking systems. Products of Islamic finance have also been incorporated including the likes of Musharakah, murabah and ijarah based on their social and ethical implications. Additionally, the study comprehensively discusses the role of contracts such as Wadiah, Hiwala, Kafalah and others that indicate towards the level of social and ethical positions of the Islamic banks. Pricing transactions such as BaiBisamanAjil and Bai Salam are discussed in the light of their role in Islamic banks to ensure protection of rights of all the parties involved. Besides this, the role of Shariah board in regulating the banking and finance has also been discussed along with their current status in different countries. Additionally, future Islamic banking problems and issues that might occur include the reduced profitability for over dependence on Mudharabah and Musharakah financing.

Islamic banking refers to the banking system that has been established in accordance to the laws of Shariah, where money is considered to be devoid of any intrinsic value. Theoretically speaking, Islamic banking differs from conventional banking systems in terms of prohibitions on drawing interests. As of today, the system is prevalent in over 60 countries across the world, with Asia and the Middle East being the hubs of Islamic banking at the global level. Estimates show that by the end of 2014, roughly $2 trillion in circulation was compliant to Sharia laws, representing around 1% of all assets in the world (Hassan and Aliyu, 2018). The current study would include a comprehensive understanding of Islamic Banking following the rule of permissibility, prohibitions of Islamic Banking such as Riba, Gharar and others. Additionally, its connection with the components of western baking and their coexistence along with Islamic banking products, contracts, pricing transactions, regulation and future of the Islamic banking have also been discussed critically in details.The current study presents an argument that forms the foundations of Islamic banking enables the system to be a suitable alternative to ethical and social banking in the 21st century.


Definition of Islamic banking
Islamic banking, also referred to as Islamic finance, can be defined as the set of banking activities that are in line with the laws of Sharia and based towards the practical application of Sharia laws with regards to developing Islamic economics. Various concepts are entailed within Islamic banking, where the primary underlying idea is that money cannot be treated as a commodity. According to the works of Rasulevet al., (2020), Islamic banking is widely considered to be the cornerstone of Islamic revivalism, with advocates emphasizing on how the system is meant to prevent ‘inflation, unemployment, exploitation and poverty’. While its criticisms involve the lack of a method to share profits and losses and ethical investments, the system has gained prominence in recent decades owing to its viability to reduce economic burdens. As the population of Muslims increase within Europe and the rest of the world with a simultaneous decrease in monetary supply and opportunities, Islamic funds are gradually coming to be viewed as an important element to bring about economic prosperity. As stated by Laarab (2019), Luxembourg, for example, has emerged as one of the leading geographic regions with regards to Islamic funds and transaction systems that adhere to the laws of the Sharia. The Islamic banking system was predominantly a response to the rise of European power and Western influence on the global banking ecosystem, where money was commoditized to a large extent. The movement is believed to have gained momentum during the late 1940s, with notable scholars such as NaeemSiddiqui, Muhammad Hamidullah and others forwarding the proposition of interest free banking.

Rule of permissibility
The terms ‘halal’ and ‘haram’ refer to permissibility based on the principles covered in the Holy Quran. Halal refers to anything that is permissible or lawful as per the Quran, while haram refers to anything that is not permissible or lawful as per Quranic provisions. Various aspects that are considered to be critical components of a conventional banking system are considered as haram or prohibited in the banking system, with the most prominent example being that of riba or usury. In addition, Halwiet al., (2019) argue that ambiguity in contracts or gharar is also prohibited along with the concept of maysir, which broadly translates into gambling or wagers. Riba is considered as increments that are not justified, with the Quran even containing specific provisions as to how those that charge interests cannot be considered as law-abiding within the Shariat. There are also several aspects that are prohibited in case where the existence is proved, and these include concepts like tahdeed or threats, ghalat or mistakes, zulm or injustice, khedaa or deception and istighlal or deception. Monopoly is also an important area of prohibition within Islamic law, which is referred to as Ihtikar (Johan and Hussain, 2019). Fraudulent activities and blackmailing that are aimed at securing unjust gains are also considered as haram in Islamic finance. In terms of the ramifications, the rule of permissibility is the founding principle of Sharia law in with regards to an absence of tests that are clear and authoritative. Halal and Haram, while seemingly binary, exist on the basis of a ranking system, where the objective is to definitively classify something as halal or haram based on the degree of permissibility. While aspects such as ‘riba’ or ‘gharar’ are outright prohibited, other concepts such as ‘zulm’ or ‘ghalat’ are prohibited in case they are definitively present and communicated.

Prohibitions under Islamic banking
The aforementioned prohibitions are critical to the depiction of Islamic finance as being an alternative to ethical and social banking, where the primary objective is to ensure social justice and economic development in an equitable manner. As per the views of Zakariaet al., (2017), the Islamic Code of Conduct is also relevant in this regard, which plays an important role in ensuring a general sense of direction within financial activities and transactions that are based on ethics and Islamist values. For instance, the concept of riba or usury is considered as haram in all of its aspects due to the unjustified nature of the increment derived from lending or borrowing money. Similarly, the concept of gharar or ambiguity in contracts is present to prevent contractual uncertainties and limiting the occurrences of deceptions and risks. Maysir or gambling exists within Islamic finance with the sole objective of extending the argument that all money must be earned though genuine effort and hard work and cannot involve a game of chance by any means. The prohibitions and their social value are also in line with the ideology that all the natural resources in the world inclusive of human life is, in essence, a trust from Allah (Usai, 2017). Islamic principles establish that the prohibitions are in place to protect and conserve the resources while ensuring that future generations are also allowed to utilize the resources in an effective manner.

Western and Islamic banking systems
Discussing the co-existence of Islamic banks and the Western banking system, the purposes of the two are similar with the major difference being the operations of Islamic banks in accordance to the welfare principles contained within Islam. According to the works of Bitaret al., (2018), the banking paradigm between the two systems is relatively focused towards ensuring that communities around the world are able to access banking and financial services in an unrestricted manner. While Western banking systems are based on customary laws and man-made principle, Islamic finance is based on the principles contained in the Quran and the Shariah law. The approach to liabilities and risks within the two systems are also different, especially in terms of how Islamic banks are bound to absorb all the liabilities when transacting with their customers. Contradictorily, Mosteanu(2017) argues that Western banking systems operate with the objective of generating profits, where the benefits are taken from the customers in the shape of interests and surcharges. Despite the differences, there are numerous similarities with regards to deposits, financing methods, investments and other banking activities. Profit and loss sharing principles are the major reasons as to why the two systems appear to be distinctively different from one another. The pros of Islamic finance include the lower risk factor and stability in return, while the cons include the need for a higher degree of transparency and governance. Similarly, the exploitative nature of the Western banking systems is a major drawback, while the pros include high growth capabilities, transparency and strong governance.

Islamic banking products
Islamic banking systems are gradually gaining market share at the expense of Western systems. This has been fuelled by the presence of numerous Islamic banking products with the most notable being the musharakah or joint venture for fixed assets, murabah or hire purchase of goods and ijarah or blessings. Musharakah refers to the joint partnership agreement where the partners are entitled to a share of profits and losses (Warnindaet al., 2019). The social and ethical aspects surrounding musharakah is predominantly aligned with preventing profiteering from lending, where the financier of a project is allowed to retain a portion of the profits based on a predetermined ratio. It is an element of shirkah al-amwal, which refers to the principle of sharing and is aimed at preventing exploitation by the rich and wealthy. Similarly, murabah or murabaha is associated with cost plus financing, where the seller and the buyer agree to a specific cost and markup when dealing with an asset. It is an acceptable from of credit sale and does not constitute usury. The social and ethical implications of the concept are linked to reducing the risk for the individual and placing the risk on the institution, thus ensuring better creditworthiness within transactions. In addition, Wahlaet al., (2018) argue that the concept of ijarah is linked to usufructs of assets, where an asset is transferred onto a person for a rent. It enables equitable distribution of goods and assets, where individuals and economically weaker communities can access items that otherwise would have been difficult. It is aligned with the welfare principle contained within Islam and the Quran.

Islamic banking contracts
Looking forward to the definition of Wadia, Hiwala, Kafalah and Rahn, Komijani and Taghizadeh-Hesary(2018) mentioned that the deposit of assets or funds with any Islamic bank for safekeeping of the property is considered as Wadia. In order to come into an agreement with the bank depositors need to come under a contract namely Wadiah YadDhamanah with the banks. Under this contract, the depository or the banks ensure returning of the property deposited by the common people; this defines the ethical means if integrating the rules and regulations for sake of transparent dealing. Therefore, any individual that comes under this contract can safely deposit their money or asset that is kept safely and the person can withdraw his or her money according to the requirements. Hiwala is another term that can be defined as the transfer of debts from one person wheel to the other person or the muhal alaihi with regards to the order and benefit of the creditors. Agreement from both the parties is required for the contract termination which is a socialized way of protecting the rights of both the parties. Kafalah is also a contract which is formulated for conjoining the guaranteed by the guarantor. Through this contract Islamic banks guarantees services with regards to the financial transactions including guarantee from the banks, shipping guarantees and standby credit letters as well (Alamet al., 2017). Kafalah assures both the parties (the importer and the exporter) receive the agreed due amount that was decided at the initial stage. When it comes to the completion and settlement of debt, Rahn guarantees the process. In certain circumstances, the collaterals can be ignored or layer off at the time of default. There is subtle resemblance of western baking with the Islamic baking with regards to lending capital and making money. The western banking focuses on non-predatory lending and ethical rendering of the investment just as it could be found in the context of Islamic banking.

Pricing transactions in Islamic banking
The pricing transactions include BaiBisamanAjil, Bai Salam and others that are said to exist when the banks are selling properties and goods to the buyer with deferred payment facility. On the other hand, banks can also buy property where the payment is done immediately though the goods or the products are delivered in future. One of the advantages of these transactions are there will be no hidden charges or cost that may change the price of the properties bought. Therefore, this highlights the ethical considerations that are defined by the transparency kept between the buyer and the seller where both the parties would enjoy their rights as per the rules and regulations (Ahmedet al., 2018). Another advantage is it nullifies the uncertainty components or Gharar that makes the transactions more socially effective. There would be a certain time limit that the customers would be aware of; this indicates towards the social banking aspects of the Islamic banks as customers would not be deprived of the transaction facilities they are entitled to by the bank. However, the disadvantages of these transactions are following: the rationale behind these transactions is allowing Salam to fulfill the need instantly; therefore, these transactions can convert into meaningless ones if this certain purpose is not served (Stoika, 2019). Therefore, it may reduce the capability to render social means to the transactions. Another disadvantage of these transactions is only properly defined and quantified properties can be purchased and paid for which often leads to confusion and rather leads to lowered transparency of the measurement of the property for settling the price. This reduces the ethical positioning of property investments in Islamic finance and is a major area of criticism today.

Authenticity of Shariah boards
As mentioned by Haridanet al. (2018), Islamic Banks are required to incorporate the objectives Shariah and need to consider the importance of Axioms. This helps in bridging the gap between the ideals and the realities in harmonizing the Islamic banking and financial dealings globally. The verdicts that are in parallel line with Shariah lead to the authenticity of the transactions in the contexts of Islamic banks. In this regard, the members of the Shariah board are needed to be the scholars who have in depth knowledge of the principles and objectives of Shariah. The members are also expected to be insulated against the moral hazard and have exemplary level of integrity. However, it is criticized by different authors based on the questionable outcome of hiring the Shariah board members by the banks. Ulfietal.(2020) argues that this is responsible for creating confusion and conflict of interest as some decisions might not align with the objectives of Shariah, whereas those can be effective for the profit generation of the banks. However, banks following the regulations or objectives of Shariah are required to maintain certain level of transparency in banking transactions overcoming the profit generation motive.

Practice of Islamic banks in Pakistan, Malaysia, UAE and the UK
The ‘islamisation’ of banking and finance in Pakistan include some judicial changes, decrees of Zakat, Ushr and others. This has led to effective redistribution of land to the country people who are poor. Therefore, elimination of Riba takes place as defined with regards to the loans and security as interest charge is paid. General Muhammad Zia-ul-Haq was the person advancing a program abiding the banking law of Pakistan and islamization of banking in Pakistan with regards to the principles of Shariah rules (Maulanet al., 2020). There are 16 banks that are operating in Malaysia under Islamized rules of banking. On the other hand, Shariah based products are also offered by non-bank intermediaries that are offered under “Malaysia Building Society Berhad(MBSB)”. This has registration with the “Cooperative Commission of Malaysia (SKM)”. The “National Shariah Advisory Council” is responsible for advising Bank Negara Malaysia with regards to the Shariah rules to be followed by these institutions. Additionally, they also advise the institutions regarding the product and service transactions. Skilled and certified personnel are appointed in the banking and finance sector that are provided by a dedicated university“International Centre for Education in Islamic Finance (INCEIF)”. UAE is pioneer in Islamic banking where the first commercial bank has been established in 1975 as Dubai Islamic Bank. UAE possess the 32% of the global Islamic banks which leads to hold the second rank in the indicator of global Islamic banking. Also, the Islamic banks in UAE have 19% of the banking assets as compared to the conventional banks. However, the recent data also suggests that a slight downfall in the growth percentage (8.90%) could be perceived in the year 2019 (Riazet al., 2017). A number of central bank committees are regulating the operations of banking sector in UAE. UK can be referred as a leader in western context for banking and finance. Western countries that operate Islamic banks include UK, Australia, France and others among which UK operates the highest number of banks. The Islamic finance could be identified to play a crucial role in the infrastructure development in UK. A range of supportive government policies have also improved the ethical and social transaction with the sphere of operation.

Future of Islamic banking
It could be identified that the mode of financing has the potential to affect the profitability of the Islamic banks in future both direct and indirect manner. The variables risk and cost-efficiency indicates the indirect impact of the banking modes and operations. As mentioned by Ariff(2017), the higher level engagement with Mudharabah and Musharakah financing would lead to high level of risk in crediting also which is responsible for reducing the profitability of the banks. However, in the GCC countries Mudharabah and Musharakah financing is observed to play a positive role where it increases the ration of profitability by improving capitalization ratio. This also leads in operating in a cost effective manner. Hassan and Aliyu(2018), suggests to the managers to focus on risk-taking and cost efficiency. If the countries operating Islamic banks do not revise the regulatory policies, it would increase collusion and would reduce the social and ethical effectiveness of banking. Participation in the profit and loss would also be imperative to the improvement of the processes and tactics t enhances the profitability of these banks. Moreover, it can be suggested to use financing based on profit-margin which would reduce the credit risk in future.

The objective of Islamic banks is to bear the risk, while Western principled banks look to eliminate risks when engaging in a financial transaction. The very foundation of Sharia law is that ethics must supersede economics. Business ethics are a central component of the laws contained in the Shariat, with the core values aligned with fairness, dignity, loyalty, justice and integrity. On the other hand, it is also identified that small banks suffer while integrating Shariah via hired experts or members with regards to the uncertainty and inconsistency in decision making. UAE plays a pioneering role on promoting Islamic banking.

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