Islamic Banking And Financial Stability Finance Essay

When analyzing the Islamic bank soundness comparatively to conventional Bankss, it is imperative to supply to the reader an accurate description of the Islamic banking system. For that ground, the present chapter is dedicated to show the basic features of the Islamic banking system that make it different from the traditional 1.

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Hence, the chapter will be divided into two subdivisions ; the first one trades with a presentation of the Islamic banking system. It highlights its cardinal facets: beginning, basic premises and theoretical model. Furthermore, it provides a brief account of the common Islamic banking merchandises.

In the 2nd subdivision, I am concerned to stress the importance of guaranting banking stableness. Furthermore, I give an overview of the literature concentrating on the function of Islamic Bankss in keeping fiscal stableness.

Section I.1: An Overview on Islamic Banking

Islamic banking operates in conformity with Islamic jurisprudence called “ Shariah ” . The rule beginnings of these regulations are the Quran and the recorded expressions and actions of the prophesier Mohammed ( Peace Be Upon Him ) followed by the consensus ( Ijmaa ) and the analogy ( Qias ) .

Islamic banking is characterized by several cardinal facets. They consist chiefly of the prohibition of involvement and gaming and the incorporation of the hazard sharing rule. Then, Islamic fiscal minutess should be linked with existent economic minutess. Further, Islamic funding and investings are limited to the lawful activities. Finally, Islamic banking minutess seem to be inspired from the ethical and moral values. ( Hassan and Lewis, 2007 ; Visser, 2009 )

Muslim bankers need to understand these rules in order to supply Shariah compliant merchandises and services. Hence, Islamic Bankss must use a Shariah Board to verify their conformity with Islamic dealing regulations.

In what follows, we will explicate the cardinal characteristics of Islamic banking and depict the basic Shariah compliant contracts.

I.1.1 Islamic Banking Principles

The prohibition of Riba ( involvement and vigorish ) : Harmonizing to the Islamic spiritual bookmans, there are two types of riba cited in the Quran and in the traditions of prophesier Muhammed ( PBUH ) riba al’fadl and riba al’nasia. Riba al’fadl refers to an surplus or an addition paid in a direct exchange of trade goods that follows to unequal exchange. While, riba al’nasia refers to a positive, fixed and preset rate of return on loan, claimed by the loaner as a wages for waiting ( Zaher and Hassan, 2001 ; Visser, 2009 ) . Many argue that riba al’nasia corresponds efficaciously to the modern involvement. The censoring on riba is based on a figure of poetries from the Quran such as Al-Baqara ( 2: 274-280 ) , Ali-Imran ( 3:130 ) and Al-Rum ( 30:39 ) . To explicate the principles behind the injunction of involvement, we should cognize that money, in the Islamic position, is considered as a medium of exchange and a manner of specifying a value of assets, belongingss and labour. Consequently, money has non a value on itself and it is non a trade good. Thus, sing involvement as a monetary value of money is rebutted in the Islamic economic theory.

Additionally, Islamic jurisprudence prohibits involvement even if it is claimed as the productiveness of capital. Muslim scholars deem that it is n’t a valid statement to warrant its rightness, since it is paid on capital and required independently of the capital productiveness consequences. Undoubtedly, this is non in contrary to Islamic banking rules ‘ purposes in puting and increasing wealth. But, Shariah regulations do n’t let an addition of money via a fixed rate merely by maintaining it in a sedimentation history or loaning it. In fact, wealth should non lift without taking hazard or doing physical or mental attempt. Finally, and sing the statement that rate of involvement corresponds to the price reduction rate, Islamic spiritual bookmans argue that the latter should non be predetermined. Merely the future economic conditions are allowed to find the clip value of money.

To sum up, Islamic Torahs prohibit investings in all fiscal undertakings and instruments that guaranteed a fixed and preset rate of return. ( Khan 1988 ; Pal, 1994 ; Zaher and Hassan, 2001 )

The prohibition of Gambling and Gharar: Because of the unfairness, unfairness, hostility and hatred between parties that could ensue from chancing and stakes, Quran forbids such activities: Al-Baqara ( 2:219 ) and Al-Maida ( 5:90 ) . The forbiddance of gaming may be justified by the inordinate hazard and uncertainness of additions. But, taking hazard with hope of winning is indispensable for human life. Besides, Islamic dealing regulations allow Mudharabah[ 2 ]despite that involves a great hazard. Consequently, presuming that injunction of gaming is related with uncertainness of additions is unacceptable.

Siddiqi ( 2001 ) argues that chancing is taking hazard intentionally which is non necessary in economic activity. While, Al- Suwailem ( 2000 ) suggests that the final payment construction makes the difference. He claims that Shariah rules prohibit Moslem individuals to prosecute in a zero -sum game with unsure final payments. In such game, the penchants of each participant are in direct resistance. So, the one party ‘s final payment increases merely if the other party ‘s final payment decreases. There is no possibility of concerted game ( that both parties can win ) . Therefore, Islamic regulations on minutess prohibit hazard which is a channel to do one party net income at the hurt of the other ( Ibn Taymiah in Al- Suwailem, 2000 ) . The basic motivation for the prohibition of gaming is the instability between rights and duties of each party. This cardinal regulation should be applied to the modern fiscal agreements in order to see their legitimacy in the Islamic economic theory[ 3 ].

Net income and Loss Sharing ( PLS ) : The interest-free banking system is based on the hazard sharing rule ( known besides as Net income and loss Sharing ) . This means that the capital ‘s proprietors and the enterpriser portion net income and loss every bit. In fact, capital supplier can gain a return merely if it accepts to bear loss when the undertaking fails ( Hassan et al, 2003 ) . Hence, Zaher and Hassan ( 2001 ) argue that Islamic funding is similar to the equity funding. Unlike conventional Bankss, Islamic Bankss act as a spouse instead than a loaner. Furthermore, the impression of involvement rate is henceforth substituted by the net income and loss sharing ratio. As mentioned in Hasan ( 2008 ) , the PLS ratio reflects the ratio by which net incomes or losingss of a concern are shared. It is normally expressed as a per centum of the entire net incomes.

Harmonizing to the International Association of Islamic Banks[ 4 ]( 1995 ) , PLS system is equal to set up congruity between societal values and economic growing.

In fact, PLS system guarantees more just distribution of wealth between contractual parties since the return depends on the existent capital productiveness. Thereby, it gives no manner to the exploitatory contracts. In add-on, the PLS construction eliminates struggle of involvement jobs. All spouses contribute as expected to guarantee concern venture ‘s success. Furthermore, PLS mechanism increases the volume of investings and employment comparatively to the involvement funding government. The latter makes executable and acceptable merely venture whose expected return is higher than the debt cost. Hence, PLS government makes the investing opportunities every bit evaluable to entrepreneur with productive thought.

Linkage with existent economic system: One of the major pillars of the Islamic finance theory is the integrating of the fiscal and existent sectors. In fact, all Islamic fiscal minutess should be associated with existent economic minutess. Indeed, there is no topographic point to debt-based assets in Islamic finance. ( Mirakhor and Zaidi, 1988 ; Zaher and Hassan, 2001 ; Siddiqi, 2006 )

Investing in ( Halal ) lawful activities: Muslim Bankss should non put in industries prohibited by Shariah such as: alcoholic drink, erotica and porc.

Adequacy with ethical and moral values: Islamic finance is n’t concerned merely with the economic and fiscal facets of the minutess. It takes into consideration societal, ethical, moral and spiritual facets. Financiers have to increase wealth without utilizing artifices and affecting gharar or information dissymmetry. Indeed, Islamic finance takes attention of equity, equity and justness among the members of society. There is no separation between religious or societal values and concern ‘s purposes. ( Zaher and Hassan, 2001 )

More than prohibition of involvement and gaming, Islamic dealing regulations prohibit Muslims to prosecute in contracts that involve: fraud and misrepresentation ( Ghobn ) , coercion ( Ikrah ) , and development of demand ( Bay’al Mudtarr ) . Further, they forbid “ concern dwelling in keep backing supplies of indispensable goods and services with an attending to raising monetary values ( Ihtikar ) or raising monetary value by pull stringsing false commands ” ( Najsh ) . Finally, Shariah interdicts contracts with deficiency of information about the trade good ( measure, priceaˆ¦ ) that may take to challenge among parties ( JahlA mufdiA ilaA al-niza ) ( Siddiqi, 2001 ) .

I.1.2 Basic Islamic Banking Contracts

The cardinal function of Islamic Bankss is to execute fiscal intermediation with respect to the banking Shariah regulations. Muslim Bankss collect financess from capital excess agents in the signifier of investing and demand sedimentations. Then, they channel it to the capital shortage agents utilizing interest-free funding instruments.

I.1.2.1 Interest-free funding instruments

To fulfill client ‘s funding demands, Islamic Bankss have developed multiple interest-free funding techniques based on two rules: Net income and Loss Sharing and Markup rules. ( Zaher and Hassan 2001 ; Hassan et Al, 2003 )

Under PLS rule, Islamic Bankss use two major instruments Mdurabah and Musharakah.

Mudharabah ( Trusty finance contract or principal/agent partnership ) : bank provides the full capital needed to finance a undertaking while the enterpriser offers his labour, expertness and direction. The net income is shared between them on a greed ratio while the fiscal losingss are entirely borne by the bank. The liability of the enterpriser is limited merely to his clip and attempt. However, if the carelessness or misdirection of the enterpriser can be proven he may keep responsible for the fiscal losingss incurred. At the terminal of the period stipulated in the contract, the bank receives the principal merely if the undertaking suceed. Bank can non bespeak collateral to cut down recognition hazard but it may make it in order to diminish moral jeopardy jobs. Mudharabah is normally employed in short term investing undertakings and in trade and commercialism.

Musharakah ( Equity partnership ) : bank enters into an equity partnership with one or more spouses to jointly finance a undertaking. Net incomes and losingss are shared purely in proportion to the capital part. Unlike in Mudharabah contract, the bank can exert the vote rate and supervise the direction. Musharakah is normally employed to finance long term investing undertakings.

Under Markup rule, Islamic Bankss use, among others, Murabaha and Ijara minutess.

Murabaha: the bank purchases a touchable plus at the petition of its client. Then, it sells to it at a preset monetary value that covers the original cost and an in agreement net income border.

Ijara ( renting ) : it is similar to a conventional leasing. The bank purchases an plus and leases it to a client. The ownership remains with the bank or it is bit by bit transferred to the enterpriser in a rent and purchase strategy.

Harmonizing to Zaher and Hassan ( 2001 ) , the rent paid can non be considered as an involvement because it is applied to touchable and lasting goods and for its wear and tear.

Muslim Bankss can do besides charitable loan ( Qard Hassan ) which is zero- return loan. Banks are allowed to bear down the borrowers a service fee to cover the related administrative disbursals. This fee must non be associated with neither the loan sum nor the adulthood.

I.1.2.2 Deposits histories

Muslim Bankss collect financess through two chief classs of sedimentations: demand sedimentations and investing sedimentations. ( Ahmed, 1993 )

Demand sedimentations ( Current histories or Amanah ) : sedimentations that yield no return and repayable on demand at par value. Banks can utilize demand sedimentations at their ain hazard. The net incomes ensuing from the employment of financess accrue to the bank, unless, the entire loss is borne merely by the bank.

Investing sedimentations ( unrestricted Mudharabah ) : unlike the demand sedimentations, the PLS investing sedimentations are non considered as a liability because neither the rule nor the return are guaranteed. Depositors, in this instance, are similar spouses but without voting right. Depositors portion the bank ‘s net net income harmonizing the PLS ratio stipulated in the contract. Investing sedimentations can non be withdrawn at any clip but merely on adulthood and in the best instance.

Two theoretical theoretical accounts of Islamic bank have been suggested based on the construction of assets and liabilities: Two-tier Mudharabah and two Windowss theoretical accounts. ( Mirakhor and Zaidi, 1988 ; Sundararajan and Ericco, 2002 ; El- Hawary, 2007 )

Two-tier Mudharabah theoretical account: it is characterised by the full integrating of bank ‘s assets and liabilities. On the liability side, bank collects financess in the signifier of unrestricted Mudarabah ( investing sedimentations ) and it acts as an enterpriser / agent. Depositors and stockholders, in this instance, portion the overall bank ‘s net incomes on an agreed ratio. Bank is besides permitted to accept demand sedimentations that yield no return but bear downing service fees. Depositors are cognizant that the bank will utilize their demand sedimentations to finance hazard bearing undertakings

On the plus side, bank enters into restricted Mudharabah with an enterpriser as a supplier of capital. Bank portions the net undertaking ‘s net income harmonizing to an agreed per centum merely when the undertaking wins.

The two-tier Mudharabah theoretical account does non necessitate any specific modesty on both investing and demand sedimentations. Khan ( 1987 ) supposes that, contrary to investing sedimentations, demand sedimentations should necessitate modesty because they can non absorb the bank loss.

Two Windowss theoretical account: It is really rare in pattern. The liability side is divided into two Windowss: investing sedimentations and demand sedimentations. Depositors choose from the get downing the type of sedimentations. Bank uses merely investing sedimentations to finance hazard bearing investings. However, demands sedimentations are kept integral as “ Amanah ” and can non be used. Therefore, Bankss must use a 100 % modesty on the demand sedimentations and 0 % modesty on the investing sedimentations.

Section I. 2: Muslim Banking Stability

In add-on to the fiscal intermediation map of Bankss, Islamic and conventional Bankss have to supply farther services that fulfil state ‘s demands and respond to the globalisation demands. In peculiar, they offer services that facilitate national and international payment flows and currency exchange. Furthermore, Bankss may put and merchandise for their ain histories.

Consequently, the function of bank in the economic system depends on the grade of the fiscal markets development. Albeit, in extremely developed fiscal markets, Bankss are non the lone establishments that provide liquidness and bring forth fiscal information necessary for intermediation. Banks remain at the bosom of the economic activity because they are considered as a fulcrum for pecuniary policy execution ( Mirakhor and Zaidi, 1988 ; Lindgren et Al, 1996 ) . Consequently, macroeconomic stableness requires a sound banking system. In fact, Bankss provide a microeconomic channel for the execution of some pecuniary policies. Whereas, vulnerable Bankss are less antiphonal to market signals and may hinder the pecuniary transmittal. As a consequence, unstable bank constrain the policy picks and interrupt the linkage between policy instruments and their public presentation in the economic system ( Lindgren et al, 1996 ) .

For these grounds, bank ‘s proprietors and directors, banking supervisors and authorities should be adequately insured for bank ‘s fiscal soundness. Lindgren et Al ( 1996 ) define bank soundness as the ability of the bank to defy inauspicious events such as bank tally, major policy alterations, fiscal sector liberalisation and natural catastrophe. So, it reflects the bank capacity to be solvent and remain so under hard economic conditions by agencies of their capital and modesty histories.

In the present survey, my focal point is on analyzing the function of Islamic banking in keeping fiscal stableness. More exactly, we will analyze the Islamic Bankss ‘ fiscal soundness comparatively to conventional Bankss.

I.2.1 Islamic Banks’A Strengths

Harmonizing to Bryant ( 1980 ) and Diamond and Dybvig ( 1983 ) , traditional Bankss are inherently unstable since they are deposit-taker establishments. In fact, under ordinary fortunes, Bankss do non anticipate that all depositors demand their money back at the same clip. This depends on their single demands of liquidness. Thereby bank can do loans over long skylines even if all depositors have the right to retreat at any clip, by maintaining a little sum of hard currency in manus. Unless the single outgos demands are mostly uncorrelated, depositors attempt to retreat their money at the same time. In such state of affairs, bank can non pay all the depositors rapidly because of its illiquid assets ( concern, mortgage loans… ) . It pays the first in line while the last one will be left with nil[ 5 ]. This uncertainness about bank ‘s ability to refund instantly can take to a bank run state of affairs. Therefore, due to the adulthood mismatch between assets and liabilities, healthy Bankss are potentially vulnerable to bank terrors.

However, many argue in line of Khan ( 1987 ) that the theoretical theoretical accounts of Muslim Bankss can successfully make full the failure of conventional Bankss in keeping stableness. In fact, Islamic Bankss should divide investing financess from the demand sedimentations and must use 100 % modesty on the latter. Banks can either sell currency or Government Investment Certificate. Hence, demand sedimentations can non take part in the creative activity of money because depositors do n’t wish to portion bank hazards. They want to maintain it integral in order to pay their outgos. Therefore, keeping 100 % modesty removes the hazard of bank terrors and promotes the payment system efficiency. Khan ( 1987 ) has explained that Islamic banking theoretical account is n’t unfamiliar with the economic literature ; Simons ( 1948 ) and Friedman ( 1969 ) have already suggested a similar banking theoretical account to avoid bank tally.

The PLS rule dramas besides a critical function in maintaining fiscal stableness. As a fiscal intermediary establishment between capital excess and capital shortage agents, Islamic Bankss channel investing sedimentations into PLS loan ( Mudharabah and Musharakah ) . Given that neither the chief nor the return of the investing sedimentations are guaranteed, any loss occurred on the plus side is wholly absorbed on the liability side. Therefore, if the value of assets decreased, the value of the liabilities decreased severally. Therefore, the PLS rule allows the bank to keep its net worth under hard economic state of affairss. ( Khan, 1987 ; Ahmed, 2002 ; Syed Ali, 2007 ; Cihak and Hesse, 2008 )

Finally, Ahmed ( 2009 ) argues that the prohibition of Riba and the linkage with the existent economic system rule could forestall the fiscal crises. In fact, fiscal assets and derived functions based on other debt fiscal assets can non be traded. So, there is no topographic point for bad behavior that leads to instability like what is happen in the last U.S subprime crisis.

I.2.2 Islamic Banks’A Weaknesses

Unfortunately, Islamic Bankss may lose their comparative advantages against their opposite numbers due to the divergences of the current patterns from the theoretical theoretical account. In peculiar, the mimicking of conventional Bankss may raise multiple hazards that are non assumed to be for Muslim Bankss.

The first divergence is in the composing of balance sheet. In a typical Islamic bank, more than 80 % of entire assets are fixed income and short term adulthood assets. While, merely 20 % are dedicated to long term and hazard sharing investings. El- Hawary ( 2007 ) and Greuning and Iqbal ( 2008 ) claim that the laterality of less hazardous, low return assets deprives the bank of the benefits of the portfolio variegation, as Mudarabah and Mushrakah contracts are more profitable. Analysts explain this behavior by the fact that sale – based minutess are less associated with moral jeopardy and inauspicious choice jobs than PLS investings ( Siddiqi, 2006 ) . In fact, the latter need extra attempt to capture good investing chances and to analyze undertakings adequately. Besides, Islamic Bankss can non bespeak for collateral to cut down recognition hazard. Therefore, hazard sharing investings require a high degree of assurance and transparence between investors, Bankss and depositors.

The 2nd divergency with the Islamic banking theory is in the income distribution. In some instances, the Islamic Bankss distribute net incomes to the investing depositors even when they accrue loss, so the net incomes are paid out of equity. This phenomenon is the displaced commercial hazard ( El- Hawary, 2007 ; Greuning and Iqbal, 2008 ) . Therefore, the current patterns do n’t do a clear distinction between stockholders and investing history holders rights ‘ .

Finally, Islamic Bankss may non to the full esteem Shariah rules in their activities. Such behaviour makes them vulnerable to put on the line usually born by the conventional opposite numbers. In peculiar, Malayan Islamic Bankss have introduced advanced merchandises that seem to be Shariah compliant, whereas they are similar to the conventional contracts. For case, they allow the sale of debt originating from sale-based minutess. Furthermore, Chong and Liu ( 2009 ) claim that Malayan Bankss are non really different from traditional Bankss in the acceptance of the PLS rule.


In this chapter, I described the chief typical characteristics of Islamic banking and the often used contracts. This is in order to explicate how Muslim Bankss can execute their fiscal intermediation map efficaciously without paying and having any involvement. Then, I presented a literature reappraisal on the Islamic fiscal stableness which supposes that Islamic Bankss could convey more stableness to the international fiscal system. In fact, the PLS rule applied on investings sedimentations and the 100 % modesty on demand sedimentations make Muslim Bankss less vulnerable to bank terrors ( khan,1987 ) . Furthermore, Ahmed ( 2009 ) claims that the forbiddance on riba and the plus backup rule could, in some manner, prevent fiscal crisis. Never the less, many argue that the divergences of current patterns from the Islamic banking theoretical account and providing services which are non basically different from conventional 1s cut down the Islamic Bankss capacity in taking fiscal stableness.

So, Islamic banking soundness is closely related to the well application of the Islamic minutess regulations. But this is requires a joint attempt by the participants ( bankers, depositors, investors, stockholders, authoritiess… ) . To be strong, Muslim Bankss need robust institutional and regulative substructures to back up their work. For case, they need lawfully recognized establishments to guarantee their efficient operation, and to supervise conformity of their services with Islamic banking rules.

In the undermentioned, I will seek to analyze through empirical observation the Islamic Bankss soundness comparatively to conventional Bankss utilizing two different attacks. The first 1 is a non parametric analysis of the different indexs of fiscal soundness ( chapter two ) . The 2nd attack is based on an econometric theoretical account proving three hypotheses ( chapter three ) .


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