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Islamic Banking System and its role in global financial market (essay writing)

Created: 1 month ago | Updated: 1 month ago
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Islamic Banking System and its role in global financial market

Islamic Banking System

  • The Islamic banking system is an important component of Islamic finance.
  • Islamic finance has unique features because its foundation is laid on the principles and rules of Islamic law (shariah).
  • Shariah states that everything is owned by Allah and man has only been permitted to use it. Accordingly, the use of funds is governed by several regulations.

Feature of Islamic banking

  • The most essential feature of Islamic banking is the prohibition of interest (riba).
  • Islamic banks neither charge nor pay interest in a conventional way where the payment of interest is set in advance and viewed as the predetermined price of credit or the reward for money deposited.
  • Islamic law accepts the capital reward for loan providers only on a profit and loss-sharing basis, working on the principle of variable return connected to the actual productivity and performances of the financed project.
  • Another important aspect of Islamic banking is its entrepreneurial feature. The system is focused not "only on financial expansion but also on physical expansion of economic production and services." In practice, Islamic banks have concentrated on investment activities such as equity financing, trade financing and real estate investments.
  • Islamic banks are profit-driven institutions just like conventional banks, but they manage all their activities in accordance with shariah.

Short history of Islamic banking

  • Early experiments in this sector were undertaken in 1963 in Egypt and Malaysia.
  • Without any references to Islamic principles (for fear of political repercussions), Ahmad El Najjar established the first Egyptian savings bank based on no-interest and profit-sharing principles.
  • Muslim Pilgrims Savings Corporation was the first Islamic financial institution in Malaysia. It was set up to help people save for performing hajj. Today, Malaysia is the biggest issuer of Sukuk (Islamic bonds) worldwide and one of the main promoters of regimentations and innovation in the Islamic banking system.
  • The first genuine Islamic banks were not launched at the national level. Instead, during the 1970s, a number of these banks were established on a more local level in the Middle East and North Africa.
  • The very first Islamic bank was Nasser Social Bank, which started to operate in Cairo in 1972.
  • It was followed by Dubai Islamic Bank in 1975, and Faisal Islamic Banks was established in 1977 in Sudan and Egypt.
  • The second step in the evolution of the Islamic banking system was to take the system to an international level by creating the first Islamic international financial institution, the Islamic Development Bank, in 1973.
  • The third step came with the transformation of entire national banking systems into shariah-compliant systems. This is currently the case in Iran, Pakistan and Sudan.

Islamic Banking System in global financial market

  • Islamic banks operate mainly in Muslim countries, but currently they are also operating outside these countries. For instance, the United Kingdom has become the most important location for Islamic financial activity outside the Muslim world.
  • Today, approximately 53 countries have Islamic banking institutions, and at least 70 countries have some sort of Islamic financial services.
  • Almost without exception, the major multinational banks presently offer a broad range of shariah-compliant financial products and services. The largest Islamic banks are located in Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates).
  • The size of Islamic banks around the world was estimated to be close to $850 billion at the end of 2008 and is expected to grow by around 15 percent annually.
    While Islamic banking remains the main component of the Islamic financial system, the other elements, such as Takaful (Islamic insurance companies), mutual funds and Sukuk (Islamic bonds and financial certificates), have witnessed strong global growth, too.
  • According to a reliable estimate, the Islamic financial industry now amounts to over $1 trillion. It is estimated that the system could double in size within a decade if the past performances are continued in the future.

Returns in Islamic Banking System

  • In the decade prior to the financial crisis, the shariah-compliant financial system had quite exceptional returns.
  • Assets doubled almost every two years, and net income doubled every year. There were some institutions with a posted return on equity of more than 30 percent and in some cases even more than 40 percent. They were also able to earn an average return on assets reaching 10 percent.

Islamic Banking System and global financial crisis

  • Even if these figures are not exceptional compared to those posted by conventional financial institutions between the years 2000 and 2007, they are quite remarkable if we consider the timeframe and the dynamics of the Islamic financial system's evolution.
  • The first stage of the global financial crisis, during 2007 and 2008, favored the Islamic banking system compared with the conventional system.
  • According to a recent IMF study, Islamic banks performed better than conventional ones in 2008 in terms of profitability, credit and asset growth.
  • The Islamic banks' profitability crunch was less than 10 percent, whereas the conventional banks' profitability slumped more than 35 percent in 2008 compared with 2007.
  • The IMF study reported that Islamic banks have maintained stronger credit growth compared to conventional banks in almost all countries and in all years, suggesting that the system has great potential for further market-share expansion and a possible contribution to market stability through the available credit.
  • The same trend was maintained on the assets side, which was less affected by deleveraging and grew on average more than twice that of conventional banks during the period of 2007 to 2009.
  • While conventional finance is largely debt-based and allows for risk transfer, Islamic financial intermediation is asset-based and focuses on risk sharing.
  • Prohibition on excessive leverage and on risk transfer according to shariah principles made the system more resilient, less exposed and thus protected from the impact of toxic assets and derivatives' effects that triggered the global financial crisis.
  • The Islamic banking system's features make its activities more closely related to the real economy.
  • This reduces its contribution to excesses and bubbles, but it also makes it more exposed and vulnerable to the second wave of financial crisis: the real economic downturn.
  • Islamic banks lent a large part of their funds to the consumer sector and invested in assets that proved in time to be illiquid, sharing the losses of their activity with the stakeholders. According to the IMF study, Islamic banks' larger decline in profitability in 2009 was due to weaknesses in risk-management practices, mainly associated with high degree of concentration on, or greater exposure to, one sector and/or borrower.
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<p style="text-align:center;">Export trade means selling goods and services to other countries. It is very important for a country’s economic growth, as it brings in foreign money, creates jobs, and promotes international relationships.</p>

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