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Islamic Banking Situation

Categories Bank, Banking, Economics, Islam

Essay, Pages 10 (2437 words)



Essay, Pages 10 (2437 words)


This chapter is based on the introduction given lately and the research problem presented in the introduction and the previous studies that have been done within these constructs. It provides the reader with a literature review concerning the research area. There are useful contributions expressed by so many authors about Interest-free banking. The major reason for people to look for the banking alternative is that the conventional system has some problems and may suddenly cause instability to the economy at some point in time (Loo, 2010).

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The most basic flaw which is attached to the interest-based banking system is that the crisis is embedded in the conventional banking system and as long as the economies are dependent on the conventional banking system especially its interest-based banking system then the economies may delve into crisis at some point of time (Almossawi, 2001). However, Islamic banking that based on Shariah laws that prohibited interest (riba) in the transaction will not depend on the interest and will not cause the probable crisis in the economy (AbdulJalil & Rahman,2013).

With this issue, many conventional banks start to offer IFB services to capture the demands and needs of the Muslim as well as Non-Muslim customers. Concepts and definition of IFB, the definition of interest or riba, IFB Service Models, source of fund IFB, Investment deposits can have various deposit arrangement options; Principles of Islamic Banking Service and Functional roles Islamic banks play literature will be discussed. In the end the previous studies on the area were presented.

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In this study, the contribution was reviewed to show the challenges and prospects of IFB for resource mobilization in Ethiopia commercial banks Case Study of Jimma Town.

Concepts And Definition Of Islamic Banking

Many scholars give various meanings to this IFB. It refers to a system of banking or banking activity that is consistent with the principles of the Shari’ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasize moral and ethical values in all dealings have wide universal appeal. Shari’ah prohibits the payment or acceptance of interest charges for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.

According to Yahiya Abdul-Rahman, (2010), Islamic banking defined as conventional banking minus the word interest with a new contract that does not include the word interest and that is structured in a convoluted version of buy/sell, in which the seller changes ownership to the bank and then the bank sells it to the eventual buyer. Many participants in Islamic banking business thought, with good intentions, that these guidelines made the contract Islamic. Islamic banking according to Sandrararajan, (2011) consists of mobilizing funds through noninterest-bearing deposits and through investment deposits based on “profit-sharing and loss-bearing” contracts and channeling these funds to finance permissible (under the Sharifah law ) investments activities, using various forms of Islamic finance contracts. Islamic banking as described according to Yahiya Abdul-Rahman, (2010) it is a brand of banking that is socially responsible and is community-based in both spirit and intent. This brand of banking is the manifestation of Judeo-Christian-Islamic values. In addition to this Islamic banking does not discriminate, because discrimination in service and financing and in dealing with others is a major sin in all Abraham faiths. Islamic banking is a system of banking that mobilizes saving on the basis of profit and loss sharing that is considered to be fairer and more conducive to measurement and development. Owing to the growing demand by the Muslim population in Western countries and also to the increasing interest of Islamic investors to diversify geographically their portfolios, conventional banks are increasingly becoming interested in entering the market of Islamic financial products. (Hassen and Lewis, 2007)

Interest-free Banking Situation in Ethiopia

Ethiopia’s Growth and conversion Plan (GTP) is the guiding document for all-rounded development efforts including the transformation of the banking industry in a way that addresses strategic interests of the business community, as the case may be, to achieve the commitments of the Millennium Development Goals. One of these instruments is the authorization of Interest-free Banking convention in the country primarily to satisfy economic reasons and other reasons in the process. Accordingly, the government of Ethiopia through the NBE has taken constructive step, which was of course after continuous pushing and pulling forces from notational and international stakeholders in authorizing and issuing a regulatory provision for Interest-free Banking under the umbrella of the conventional banking, on October 1, 2011 through the NBE. It is regarded as a constructive action in facilitating access to both conventional and or alternative banking conventions based on religious, social, economical, and cultural motives of the community in recent years.

As per this provision, all commercial banks that are licensed to engage in the CB are privileged to engage in IFBW business through CB branch offices only after securing an independent license for the convention, which is subject to fulfillment of terms and conditions set out thereof. The IFB business as per the provision refers to the banking business in which mobilizing or advancing funds is undertaken in a manner consistent with Islamic finance principles and mode of operation that avoids receiving or paying interest and the IFBW refers to a unit or window within a conventional bank exclusively offering IFB (Kerima, 2015)

Definitions of Riba or Interest

The word Riba means a surplus, increase or addition, which correctly interpreted according to the Shariah expressions, implies any excess compensation without due consideration (consideration does not include the time value of money).

This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars. There are two types of Riba identified to date by these scholars, namely “Riba a Nasiyah” and “Riba al Fadl”.

Classification of Riba

  • The first and primary type is called Riba a Nasiyah or Riba al Jahiliya.
  • The second type is called Riba al Fadl, Riba a Naqd, or Riba al Bai.

Since the first type was specified in the Quranic verses before the sayings of the Prophet (PBUH), this type was termed as Riba al Quran. However, the second type was not understood by the Quranic verses alone but also had to be explained by the Prophet (PBUH), it is also called Riba al Hadees

Interest is a component of the banking concept. According to Mohammed and Mahdi, (2010) interest is one of the most effective factors for deciding to deposit in the banking system. Herald and Heiko, (2009) also mentioned interest as one of the determining factors for commercial bank deposit and it is an important element of Islamic economic society. All covers the meaning to load additional money on funds lent to the borrower. As such it is fundamental to understand Islamic economics to have a fair idea about IFB.

Kahn, (1986) also defines an interest-based, or traditional, banking system is symmetrical, with interest being paid and charged for the use of funds. In addition to this Iqbal and Mirkahor, (2011) interest simply refers to the “premium” that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in the duration of the loan. Interest is a contractual instrument by which the lender collects a predetermined interest added to the principal amount it has lent out. The principal amount can be money, gold, silver, or fungibles including wheat, barley, dates, etc (Qasaymeh, 2011)

Prohibition of Interest

Prohibition of interest is any unjustifiable increase of capital, whether, in loans or sales, it is the central tenet of the system. More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal that is, guaranteed regardless of the performance of the investment is considered interest and is prohibited. (Iqbal and Mirkahor, 2011)

The prohibition of interest is not exclusive to Muslims. The origin of norms in Christianity prohibits interest. It is said in the Bible:

“Thou shalt not lend upon usury to thy brother, usury of money, usury of victuals, usury Of anything that is lent upon usury” (The Holy Bible

(King James Version) Old Testament, Deuteronomy 23: 19 183)

Islamic Banking Window Service

According to Juan Sole, (2007), An Islamic banking window is simply a window with a conventional bank via which customers can conduct business utilizing only sharia compatible instruments. Sanusi (2011) defines the Islamic banking window as a business model in which conventional banks offer Islamic banking products and services from their existing branch network. In short, the Islamic banking window refers to a situation whereby a conventional banking system provides some of the Islamic banking products or services. In other words, it can be seen as a banking system that meets up only the profit, loss, and risk-sharing principle of Islamic banking for some of its products. (Audu and Mikafilu, 2014).

Subsidiary/Branch Islamic Banking Service

The Commercial bank offers shariah-compliant products and services in the specific branch. It is a semi-independent office of a bank engaging in banking activities such as accepting deposits or making loans at facilities away from a bank’s home office. This branch banking established when the main bank feels there is a potential of concentrated customers are found in the area want to serve these customers. (Akmel, 2015)

Full-Fledged Islamic Banking Service

Once a conventional bank has operated an Islamic window for some time and has gathered a sizeable customer base for its Islamic banking service activities, it may decide to establish an Islamic subsidiary or even fully convert into a full-fledged Islamic bank. By following either of these two routes, the bank may benefit from economies of scope and concentration of knowledge and expertise. The bank will be able to offer a wider range of Shariah-compliant banking products than through the Islamic window alone. For example, it may be better equipped to fully engage in Islamic investment banking activities, such as underwriting Sukuk (bond) issuances or managing Shariah-compliant investment and hedge funds or to manage its own treasury and money market operations.(Sole, 2007)

Sources Of Funds For Islamic Banks

The institution of Islamic banking forms a cornerstone required to create an Islamic financial environment. Islamic banking plays a vital role in the economic development of Islamic societies by facilitating the mobilization and allocation of dormant savings, which used to be intentionally kept out of interest-based financial channels. Islamic banking institutions utilize various mechanisms for mobilizing funds from the general public, depending on the institution’s organization, geographic location, market strategy, capital resources, and charter. (Delwin A. Roy, 1991:438) Islamic banks are deposit-taking institutions but do not pay interest on deposits. Their sources of funds classified as either includes shareholder investments, savings accounts, current accounts, and investment accounts. The source of funds in Islamic banks can be used for borrowing by corporate investors to fund specific projects. (Bala et.al (2009: 24)

Shareholder Funds

An Islamic bank may raise initial equity funds by following the principles of musharaka (equity participation) under this principle, the capital owners enter into a partnership with the bank by contributing equity in return for a share of banks profit or loss on the basis of predetermined ratio. (Bala et.al (2009: 23)

Wadiah Saving Accounts

Islamic banks offer saving account with an aim of drawing in and persuading depositors to enjoy this safe-keeping facility. Bank customers normally choose saving accounts because of fulfilling precautionary motives (Haron & Wan-Azmi, 2008)

Islamic banks practice the principle of Wadia in operating customer saving account. The bank may request permission to use customer funds deposited in these accounts as long as these funds remain within the bank’s discretion. The bank does not share with the customer profit earned from the use of customer funds deposited in these accounts funds but does guarantee the customer deposits. The bank, however, rewards the customer with a gift as a token of its appreciation for being allowed to use the funds. (Bala et. al (2009: 25)

The situation is very different in Islamic banks. Here too the depositor’s first aim is to keep his savings in safe custody. Islamic bankers divide the conventional savings account into two categories. Savings account and investment account. The investment accounts operate fully under the PLS scheme capital is not guaranteed, neither is there any pre-fixed return. Under the savings account the nominal value of the deposit is guaranteed, but they receive no further guaranteed returns. Banks may consider funds under the savings accounts too as part of their resources and use it to create assets (Abdul-Gafoor, 1995:14)

This is a theory. In practice, however, the banks prefer, encourage and emphasize the investment accounts. This is because since their assets operate under the PLS scheme they might incur losses on these assets which losses they cannot pass onto the savings accounts depositors on account of the capital guarantee on these accounts. In the process, the first aim of the depositor has pushed aside and the basic rule of commercial banking capital guarantee is broken (Abdul-Gafoor, 1995:14)

It is suggested that all Islamic banks guarantee the capital under their savings accounts. This will satisfy the primary need and expectation of an important section of the depositors and, in Muslim countries where both Islamic and conventional banks co-exist, will induce more depositors to bank with the Islamic banks. At the same time, it will remove the major objection to establishing Islamic banks in non-Muslim countries. Siddiqi, (1980:219.)

Current Accounts

The current account is a deposit account that can be used for business or personal purposes and like a saving account. Account-holders are not guaranteed and return for keeping their funds with the bank, but they may be rewarded a gift. The primary distinction between the current account and the saving account is that the minimum balance limits and withdrawals are more flexible for current accounts. Bala et.al, (2009: 25) In addition to this according to Haron & Wan-Azmi, (2008) current accounts also known as checking accounts, meaning cheque is used to make several types of payments.

Current accounts are demand deposit accounts kept with the bank on custodial arrangements and are repayable in full on demand. Current accounts are based on the principle of Wadia (trust or safekeeping) or Amanah (trust), creating an agency contract for the purpose of protecting and safekeeping the depositor’s assets. (Iqbal and Mirkahor, 2011:154)

Cite this essay

Islamic Banking Situation. (2019, Dec 11). Retrieved from https://studymoose.com/chapter-two-example-essay

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