Issues Related to Macro operation
Conventional banking emphasizes the need for maintaining liquidity and hence requires an adequate amount of reserves. Basic principle of Islamic banking being PLS-based financing and thereby having been exposed to increased risk, it would conceivably require higher liquidity and reserves. This is because of its nature of investment in assets having lesser divisibility and reversibility. That means, reserve ratios for interest-free banking are to be calculated on the basis of risk calculation in various forms of investment.
The complex problem in measuring liquidity is that liability management in the conventional banking system has been gradually replacing asset management to fund liquidity needs. At present, no such facilities exist under the Islamic banking system. As a result, these banks have to depend on their central bank to supply cash. The liquidity ratios required by the banking laws on demand and time deposits differ from country to country. In some countries, the supervisory authorities reserve the right to impose different ratios on different banks according to their location. Islamic banks are investing in assets represented by commodities, shares in companies or working capital of companies, the theoretical probability of these assets becoming liquid is more difficult to ascertain than in conventional banks.
Valuation of Bank’s Assets
Theoretically, Islamic banks are likely to face a dual risk
the ‘moral’ risk due to lack of honesty and integrity on the part of the borrower of funds in declaring a loss
The ‘business’ risk arising from unexpected market behavior.
The deposits under a profit and loss sharing system are conceptually more akin to a mutual fund’s share certificate. These deposits would share in both the realized as well as unrealized gains and losses on the investment of Islamic banks. Typically under current Generally Accepted Accounting Principles, the investment portfolio is adjusted to market values in investment companies. An upward adjustment of the assets account requires an offsetting credit to either revenue or unrealized capital increment. Unrealized capital decrement requires recording of an unrealized loss on long-term equity securities as a contra item in stockholder’s equity.
The problem associated with proper valuation of Islamic banks’ assets has important implications from the point of view of bank safety and bank regulation. Any specification of reserve or provision requirements laid down by the regulatory agencies will have to consider how far the gains (losses) on banks’ investments are passed on to the depositors. If in the extreme case, these gains and losses are fully reflected in the value of the deposits, the banks probably would be passing on all the risks to their depositors.
Credit Creation and Monetary Policy
It is of the general perception that most of the traditional policies instruments of the central bank are said to remain largely unaffected under Islamic banking. These include: minimum cash reserve requirement, liquidity requirement, overall credit ceilings on lending activities of these banks, mandatory targets for providing finance to specific sectors, and moral suasion. Of course, equating the goals of monetary policy in Islamic banking to those of the free market economies would not be fair since there is a significant difference in emphasis of the two systems to economic values and socio-economic justice.
Monetary policy under Islamic banking assigns a somewhat passive role to money. Chapra opines that the central bank should adjust the money stock to keep pace with the secular growth of output. In his view the control of money supply can be accomplished by regulating the high powered money at the source. He suggested two alternatives.
The first is to impose a 100% reserve requirement on the commercial banks, thus permitting the central bank to create credit, which will be channeled through commercial banks on a Mudaraba basis.
The second alternative is to allow banks to create deposits. Given the Islamic emphasis on re-distributive justice, this may result in either nationalizing the commercial banks or forcing the banks to pass on to the state the net income arising from ‘derivative’ deposits after allowing for the share of the commercial banks.
Conventional banking system based on the fractional reserve system has built-in instability. The instability arises, from the lack of synchronization between the decisions of commercial banks and the central bank thereby resulting in destabilizing forces. Modern banking based on interest issues fixed value liabilities to its depositors. In the absence of deposit insurance the value of assets can fall below its fixed liabilities, resulting in bankruptcies. In the worst scenario, the welfare of each depositor depends on the action of other depositors.
By that reasoning, lack of insurance coverage is considered to be a problem for Islamic banks. It is presumed that depositors in Islamic bank, due to fair of capital and or profit losses in the event of having no insurance coverage, would not remain with the Islamic banks. Muslim economists argue that under Islamic banking, because there are no fixed liabilities, depositors feel encouraged to remain in the bank when it suffers a decline in the value of its assets. Hence, there is no externality created, it does not require the provision of deposit insurance.
The Ownership of Banks
The ownership issue of Islamic banks relates principally to distributional impact on the society. Particularly, credit creation power of commercial banks with fractional reserve ratio has been the point of debate, which has raised the question as to whether the ownership should be with public or private hand. The issue is still seems to be unresolved. Commercial banks in Pakistan are required to maintain fractional reserves and they are in private sector. On the other hand, all commercial banks in Iran are nationalized. Further research is required in this regard to come into conclusion.
Lack of Capital Market and Financial Instruments
Islamic banks working under conventional banking framework in different countries lack capital market and instruments for investment of their surplus liquidity. Availability of Islamic capital market and instruments help growth of these banks otherwise they are constrained. Growth of Islamic capital market and financial instruments also helps creating environment for government financing.
Insufficient Legal Protection
A comprehensive system of Islamic banking requires legal protection. That means a thorough review of all relevant laws having a bearing on banking business is needed. Laws relating to companies, commerce, investment and the courts and legal procedures need to be reviewed and reformulated to suit the requirement of the efficient functioning of Islamic banks. It is not acceptable that company law continues to talk about bonds and interest while ignoring participation deeds and profits. Investment promotion laws should accommodate rules regulations which permit Islamic banks to apply their profit/loss sharing modes so that they can participate in partnership businesses either in the form of or Musharaka or direct investment.
Issues Related to Micro Operation
Increased Cost of Information
Monitoring cost as well as cost of writing and enforcing contracts would be higher in Islamic banking than in the interest based system. This is because, with Musharaka, the bank finances the working capital of a business venture taking a quasi-equity position in the economy. In financing, a management company is formed which floats a negotiable security, or the bank may completely finance a project within the scope of its charter. This higher cost of information could be major setback in effective implementation of the PLS system.
Control over Cost of Funds
Interest based banks maximize their profit subject to cost of funds as it is in a position to know in advance, with a reasonable degree of certainty, the amount of profit it may earn in the short term. Through the use of hedging it can also determine the level of profits in the long run. Under the PLS system, on the other hand, there is no such scope to know the cost of funds beforehand. The depositors are paid a portion of bank’s profits the volume of which is extremely uncertain. In this situation if profit rate expected by the depositors is not realized, the Islamic banks could face greater uncertainty in their profit base.
Ideally, Islamic banks are expected to calculate their rate of return on PLS deposits periodically. The usual practice is that the deposits are weighted to reflect differences in their maturity. Banks prepare a six monthly summary account of its operations and send it to the central bank, which determines the individual PLS rate to be paid by each bank. In sum, it can be argued that Islamic banks have no control over the cost funds.
There is wide apprehension that little difference can be found between mark-up practiced by Islamic banks and conventional banks. However, though not considered strictly interest-free by many Muslim scholars, mark up was seen by the banks as a tool to facilitate the transition to Islamic banking without disrupting the system. Because the ultimate objective of Islamic banking is toward investment-oriented long-term financing, the transition from mark-up to equity finance would also require a larger spread between rates of return to the banks and to their depositors.
It has been argued by a number of writers that real substitute of interest in an Islamic financial system is the mode of profit/loss sharing along with Qard Hasana. While the other techniques like Murabaha, Bai-Muajjal, Ijara and Ijara wa Iqtina can not be of equal significance in achieving Islamic socio-economic objectives (Ahmad 1994).
Excessive Resort to the Murabaha Mode
The repeated criticism against Islamic banks, which is valid in many counts, is that it takes recourse to excessive use of Murabaha mode in financing investment. Yet it is not a violation of Shariah as long as the Murabaha contract is correct from Shariah viewpoint and is free from intentional or nominal deception.
People think Murabaha to be the same as pre-determined rate of return. Murabaha is different from interest-based mark up as the former has to satisfy the following requirements. First, it is necessary that profit margin (or the mark up) the bank is charging must be determined by mutual agreement between the parties concerned. Secondly, the goods in question should be in physical possession of the bank before it is sold to the client. Thirdly, transaction between the bank and the seller should be separate from the transaction between bank and the purchaser.
Utilization of Interest Rate for Fixing the Profit Margin in Murabaha Sales
It is also criticized that Islamic banks utilize the interest rate as a criterion for fixing the profit margin in the Mudaraba sales. To be fare there is no known way of avoiding the alleged link up as long as Islamic banks coexist with traditional banks. Still Islamic banks must avoid exceeding the prevailing interest rate or exploiting the clients through accounting methods as employed by some banks.
Financing Social Concerns
No clear prescription has so far emerged on the role of Islamic banks in the promotion of new projects needed by the society as follows:
Enabling those who have no property, providing employment opportunities to all categories of people;
Demonstrating the impact of Islamic investment on the solution of the unemployment problem; and,
Assisting the state in confronting these ever-increasing problems.
Moreover, Islamic banks did not pay much attention to the development of banking services in some socially desirable directions, except in very rare cases. The entire realm of the management of estates, trusts and orphanages, etc., has remained outside the area of interest of Islamic banks, in spite of the fact that a number of western banks have, since the sixties, begun establishing specialized departments foe Estates and Trusts.
Lack of Positive Response to the Requirement of Government Financing
It is a well-known fact that the modern state is always in need of funds and resources to implement useful projects, such as the provision of schools, roads, electricity and water and telecommunication services. Generally, governments resort to issuance of treasury bills with interest in accordance with the form used by conventional banks. Islamic banks are required to enter into this field so as to prove their ability to play their role in the financing of projects in a manner that conforms to the Islamic system through the issuance of deeds of Musharaka, advance-sale, Salam and such other forms that satisfy the need s of the state for financing and, at the same time, benefit from investment of their idle liquid surpluses.
Failure of Islamic Banks to Establish Co-operation among Themselves
In spite of good intentions, Islamic banks are blamed for their lack of co-operation among them. This is in spite of the persistent endeavors of the Islamic Development Bank to bring them closer to one another and unify their stands. Following examples are enough to prove the point:
Not all-Islamic banks are members of the International Association of Islamic Banks. The Association has neither been able to unify their regulations, nor build bridges of confidence and promote understanding among them.
The idea of establishing a “Bank of Islamic Banks” is still a mere idea, although there is an urgent need for its establishment. As a result of its absence, Islamic banks have lost hundreds of millions with the collapse of the BCCI.
Islamic funds continue to sneak out by hundreds of millions into investment houses doing business in the West while the Muslim world remains thirsty for investment resources.
Funds of expatriates from Islamic countries do not find their way back to their own countries to contribute to the development of their original homelands.
Trade among countries of the Muslim world is completely paralyzed as the Islamic financing system goes along with the traditional trend in financing imports from foreign countries without giving any preference to products of the Muslim world.
Constraints Faced by Islamic Banks
Constraints faced by Islamic banks in Bangladesh are analyzed as below.
Problem with legal reserve requirement
Islamic banks in Bangladesh have to keep 10% of its total deposits as liquidity. Of this, 5% is required to be kept in cash with Bangladesh Bank and the rest 5% is to be kept either in approved securities or in cash (in case of problem with securities) with Bangladesh Bank. Legal reserve requirement for conventional banks is 20%. They have to keep 5% in cash with Bangladesh Bank and the rest 15% is invested in Bangladesh Bank approved securities. Traditional banks can earn interest on their deposits with Bangladesh Bank but Islamic banks can not since they cannot receive interest as earning. Compared to interest-based traditional banking, Islamic banks, in this case, are in disadvantageous position. However, IBBL has been receiving interest against its deposit with Bangladesh Bank and crediting it to its Sadaqa fund since 1993. It should be noted that the interest earning are not considered as bank income and added to profit. The proceeds are spent on welfare activities.
Lack of opportunities for profitable use of surplus funds
Conventional banks can invest their excess liquid amount in approved securities and or in other bank in crisis. Islamic banks cannot take this opportunity due to the existence of interest element in the transaction process.
Apprehension of liquidity crisis and possibility of liquidity surplus
Islamic banks have to be more cautious and vigilant in managing their funds since it can not resort to call money provision at times of fund shortages or crisis. As a result Islamic banks may have always left with a sizeable amount of cash as liquidity surplus. Conventional banks can borrow in the form of call money among themselves even at an exorbitant rate of interest.
Problems in capital market investment
Conventional banks can invest 30% of their total deposits in shares and securities. Islamic banks have their problem in this case as they avoid any transaction based on interest. Following examples may be cited for illustration. (a) Islamic banks do not purchase shares of companies undertaking interest-based business; (b) Shares of companies taking loan from commercial banks on interest are not also purchased by Islamic banks; and, (c) Islamic banks can not purchase shares of companies involved in businesses not approved by Shariah.
The above restrictive environment in the capital market of Bangladesh has limited substantially the investment opportunities for Islamic banks and hence the avenues of lawful earning. In the absence of Islamic money and capital market these banks cannot obtain funds from capital market at times of need.
Absence of inter-bank money market
In spite of five Islamic banks have been functioning in Bangladesh, inter-bank money market within Islamic banks has not yet taken place. Of course, except Islami Bank Bangladesh Limited and Al-Baraka Bank Bangladesh Ltd., rest of the Islamic banks have launched their operations very recently not exceeding even two years with hardly more than two branches. Still these banks can take initiative to form a money market among themselves. This may help minimising particularly the call money problem they are suffering from beginnings.
Predominance of Murabaha financing
Predominance of Murabaha financing in the portfolio management of investment funds by the present day Islamic banks of Bangladesh has been a hot agenda of debate. One study shows that Islami Bank Bangladesh Limited, Al Arafah Bank and Social Investment Bank Limited have used 54%, 76% and 65% respectively of their investment funds by resorting to Murabaha mode (Hoque 1996, p.9). Murabaha though considered as a Shariah approved mode, the Islamic economists have traditionally prescribed for its limited application. Due to legacy of traditional banking, lack of appropriate legal protection and standard accounting practice in business, Islamic banks in Bangladesh find Murabaha financing as suitable and Mudaraba and Musharaka as extremely difficult to apply.
Depression of Profit
Traditional banks can meet up loss arising from delay in repayment by the clients through charging compound interest. Islamic banks cannot do that. What it does it realises comprehension at the rate of profit. But the compensation so realised is not added to the profit income rather credited to Sadaqa account i.e., amount meant for social welfare activities. This depresses profits of Islamic banks. This may place Islamic banks relatively in weaker position in terms of profitability compared to conventional banks.
Moreover, Islamic banks are to make a compulsory levy equivalent to 2.5% of its profit earned each year and credited to Sadaqa account, which also depresses banks’ profitability. This is unlikely the case with conventional banks.
Absence of legal framework
Amendment of old laws and promulgation of new laws conducive to efficient operation of Islamic banks are sin qua non for its healthy growth. Countries introducing Islamic banking should create an enabling environment for Islamic banks by modifying existing laws and regulations. Islamic banks in Iran and Pakistan have their legal supports.
Absence of Islamic insurance company
Banking and insurance have to go hand-by-hand in matters of trade and business in order to protect investments of banks against unforeseen hazards and catastrophes. Unfortunately, Islamic banks have to depend on interest-based insurance companies in the absence of Islamic insurance companies.