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PROJECT REPORT ON ISLAMIC BANKING

Constraints & obstacles in Islamic banking

INSTITUTE OF MANAGEMENT SCIENCES


University of Baluchistan

Submitted by Mr. Umar Javaid


Enrolment no 2008-A32
MBA (banking & finance)

Submitted to Sir Zia Ul Hassan


Dedication

I dedicate this report to my parents


Whom unwavering faith in me
Has been the driving force in my life
Their unconditional love and prayers
Remain my unremitting source
Of strength

(Umar Javaid)
S.N CONSTRAINTS & OBSTACLES IN ISLAMIC BANKING Pg#
O

Chapter 1
1 Introduction & Objectives 4

2 History and Present Status of Islamic Banking around the World 5-6

Chapter 2
3 Problems Faced By Islamic Banking In The World 7

4 An Overview on the Review of Problems 8

5 The problem of forward contact/booking of foreign currency 9

6 Portfolio Management 10

7 The Regulatory environment   11

8 Use of Advanced Technology and Media & Absence of Liquidity Instruments 12

9 Need for Professional Bankers 13

10 Blending of Approach of Islamic Scholars with the Approach of the Conventional Banker 14

Chapter 3
Problems of Islamic Bank Operating under Conventional Banking System

11 Failure of Islamic banks to finance high-return projects 15

12 Sacrifice of allocative efficiency 15

13 Sacrifice of allocative efficiency 16

Chapter 4
Problem Specific to Islamic Banking in Pakistan
14 Absence of Islamic Money Market 17

15 Absence of Suitable Long-term Assets 17

CONTENTS
16 Shortage of Supportive and Link Institutions 18

17 Organizing Relationship with Foreign Banks 18

18 Long-term Financing 18

19 Conclusion 19

20 Recommendations 20-
21
Executive summary

As per the requirement for the degree of MBA course of institute of management

sciences university of Baluchistan I am submitting a report on Islamic banking

(topic =constraints & obstacles in Islamic banking)

This report is based on the experience and knowledge which I got from the

course of Islamic banking

In the first chapter I have discussed about the introduction of Islamic banking

The story begins with the history of Islamic banking and incorporation of Islamic

development bank

In second chapter I have discussed the major problems faced by Islamic banks

globally the goal of this chapter is to cover and explain different sort of problems

faced by Islamic banks globally.


In third chapter I have discussed comparative analysis of conventional and

Islamic banks , the goal of this chapter is to analysis different advantages and

disadvantage of conventional and Islamic banks

In fourth chapter I focused the main problems of Islamic banks operating in

Pakistan.

In last I have given some concussions and personal recommendations as how

Islamic banks bank industry can improve its performance .

CONSTRAINTS & OBSTACLES IN ISLAMIC BANKING


Introduction

An Islamic Bank is a financial institution that operates with the objective to


implement and materialize the economic and financial principles of Islam in the
banking arena.

The Organization of Islamic conference (OIC) defined an Islamic Bank as “a


financial institution whose statutes, rules and procedures expressly state its
commitment to the principles of Islamic Shariah and to the banning of the receipt
and payment of interest on any of its operations.”

According to Islamic Banking Act 1983 of Malaysia, an Islamic Bank is a “company


which carries on Islamic Banking business....... Islamic Banking business means
banking business whose aims and operations do not involve any element which is
not approved by the religion Islam.”

Objectives
The objective of Islamic Banking is not only to earn profit, but to do good and
bring welfare to the people, Islam upholds the concept that money, income and
property belong to Allah and this wealth is to be used for the good of the society.

Islamic Banks operate on Islamic principles of profit and loss sharing and other
approved modes of Investment. It strictly avoids interest which is the root of all
exploitation and is responsible for large scale inflation and unemployment.

An Islamic Bank is committed to do away with disparity and establish justice in


the economy, trade, commerce and industry; build socio-economic infrastructure
and create employment opportunities.

History and Present Status of Islamic Banking around the World

The History of Islamic Banking

The History of Islamic Banking can be divided in to two parts. First When it still
remained an Idea, Second-When it became a reality-by private initiative in some
counties and by law in others.

Islamic Banking as an Idea

The scholar of the recent past in early fifties started writing for Islamic Banking in
place of Interest Free Banking. In the next two decades Islamic Banking attracted
more attention.

Early seventies saw the institutional involvement. Conference of the Finance


Ministers of the Islamic Countries was held. The involvement of institutions and
Government led to the application of theory to practice and resulted in the
establishment of the Islamic Banks. In this process the ‘Islamic Development
Bank (IDB)’ was established in 1975.
The coming into being of Islamic Banks

The first private Islamic Bank, the ‘Dubai Islamic Bank’ was also set up in 1975 by
a group of Muslim businessmen from several countries.  Two more private banks
were founded in 1977 under the name of ‘Faisal Islamic Bank’ in Egypt and
Sudan. In the same year the Kuwaiti Government set up the ‘Kuwait Finance
House’.

In the ten years since the establishment of the first private commercial bank in
Dubai, more than 50 Islamic Banks have come into being. Though nearly all of
them are in Muslim countries, there are some in Western Europe as well: in
Denmak, Luxembourg, Switzerland and the UK.

In most countries the establishment of Islamic banking had been by private


initiative and was confined to that bank.. In Iran and Pakistan, however, it was by
government initiative and covered all banks in the country. The Governments in
both these counties took steps in 1981 to introduce Islamic Banking.
PROBLEMS FACED BY ISLAMIC BANKING IN THE WORLD

Twenty-five years ago Islamic banking was considered a wishful thinking.


However, serious research work of the past two and half decades has shown that
Islamic banking is a feasible and viable way of financial intermediation. A number
of Islamic banks have also been established during this period under
heterogeneous social and economic milieu. The successful operation of these
institutions and the countrywide experiences in Pakistan, Iran, Sudan and partly in
Malaysia are sufficient to show that Islamic banking offers an alternative method
of commercial banking.

The commendable achievements during the last twenty years should not lead us
to ignore the problems that Islamic banking is facing, and there is no dearth of
those. While many problems are a result of the inappropriate environment in
which Islamic banks are working, there are others which have arisen from the
practices of Islamic banks themselves.
Most of the Islamic Banks operate on Bai- Murabaha, Bai Muazzal, Bai- Salam,

Istisna, Hire Purchase/ Leasing mode of Investment i.e. Islamic Banks always

prefer to run on markup/ guaranteed profit basis having Shariah coverage. For

this reason some times the conventional Economists and General people fail to

understand the real difference between Islamic Banking and conventional

Banking.

An Overview on the Review of Problems


The Islamic banks face a number of problems.

 First, they have not yet been successful in devising an interest-free


mechanism to place their funds on a short-term basis. They face the same
problem in financing consumer loans and government deficits.

 Second, the risk involved in profit-sharing seems to be so high that most of


the banks have resorted to those techniques of financing which bring them
a fixed assured return. As a result, there is a lot of genuine criticism that
these banks have not abolished interest but have in fact only changed the
nomenclature of their transactions. (Example while financing use of
conventional KIBOR, and fixed profits + variable in monthly mudarbah
certificates issued by Meezan bank LTD.
 Third, the Islamic banks do not have the legal support of central banks of
their respective countries (except in Pakistan and Iran), which exposes
them to great risks.

 Fourth, the Islamic banks do not have the necessary expertise and trained
manpower to appraise, monitor, evaluate and audit the projects they are
required to finance.(comparatively to conventional banks like MCB) As a
result, they cannot expand despite having excess liquidity. The future of
Islamic banks hinges, by and large, on their ability to find a viable
alternative to interest for financing all types of loans. They should recognize
that their success in abolishing interest has been at least partial and they
have yet to go a long way in their search for a satisfactory alternative to
interest. Simultaneously, Islamic banks need to improve their managerial
capabilities by training their personnel in project appraisal, monitoring,
evaluation and performance auditing. Moreover, the future of Islamic
banks also depends on developing and putting into practice such
accounting standards which provide timely and reliable information of the
type that the Islamic banks would require for profit-sharing, rent-sharing or
for cost-plus financing. These standards are yet to be developed. The
Islamic banks would have to work hard to pursue their clients to accept
these standards so that a reliable information base is established. They
should introduce their own bench mark for deciding profit sharing other
then the conventional KIBOR.

The problem of forward contact/booking of foreign currency

The value of US Dollars ($), Pound Sterling, Euro and others are not fixed in
Pakistan; they are fluctuating from time to time. Most of our imports and exports
are made in USD and USD being a strong currency always moves upward and the
exporters are in better position than the importer in our country. In Pakistan
Forward Booking is required to check the exchange fluctuation for import of
heavy/project Machineries where it take long time say one year or six months to
produce the same.
But due to the restrictions of Shariah we can not cover the risk of Exchange
fluctuation by forward contract as Forward Booking is not permitted by Shariah.
As per Shariah, currency, transaction is to be made under certain terms and
conditions laid down for “sarf” by Shariah, such as spot possession of both the
currencies by both the parties which is not available in forward Booking. It is also
prohibited to deal in the forward money market even if the purpose is hedging to
avoid loss of profit on a particular transaction effected in a currency whose value
is expected to be declined.  This problem requires a solution by Shariah experts

Unfamiliarity with the Islamic Banking System

The first problem is that despite the growth of Islamic banks over the last 30
years, many people in the Muslim and non-Muslim world do not understand what
Islamic banking actually is. The basic principle is clear, that it is contrary to Islamic
law to make money out of money and that wealth should accumulate from trade
and ownership of real assets. However, there does not appear to be a single
definition of what is or not an Islamic-banking product; or there is not a single
definition of Islamic banking. A major issue here is that it is the Shariah Councils
or Boards at individual Islamic banks that actually define what is and what is not
Islamic banking, and what is and what is not the acceptable way to do business,
which in turn can complicate assessment of risk for both the bank and its
customer. More generally, the uncertainty over what is, or is not, an Islamic
product has so far prevented standardization. This is difficult for regulators as
they like to know exactly what it is, they are authorizing. It is also an added
burden on the banks that have to educate customers in new markets.

Portfolio Management

The behavior of economic agents in any country is determined partly by past


experience and present constraints. The Islamic banks are still growing in
experience in many countries. Regarding constraints, Islamic banks in different
countries do not freely choose arrangements, which best suit, their need. As a
result, their activities are not demand-oriented and do not react flexibly to
structural shifts in the economic setting as well as to changes in preferences It is
known to the bank management that a certain portion of the short-term fund is
normally not withdrawn at maturity; these funds are used for medium or long-
term financing. However, a precondition for this maturity transformation is that
the bank be able to obtain liquidity from external sources in case or unexpected
withdrawals. Islamic banks, without having an interest-free Islamic money and
capital market, have no adequate instruments to meet this pre-condition for
effective maturity transformation. On the other hand, Islamic banks can enhance
term transformation if there is an interest-free bond market or a secondary
market for Islamic financial papers. Adequate financial mechanism still has to be
developed, without which financial intermediation, especially the risk and
maturity transformation, is not performed properly.

The Regulatory environment  

The relationship between Islamic banks and monetary authorities is a delicate


one. The central bank exercises authority over Islamic banks under laws and
regulations engineered to control and supervise both traditional banks. Whatever
the goals and functions are, Islamic banks came into existence in an environment
where the laws, institutions training and attitude are set to serve an economy
based on the principles of interest. The operations of Islamic banks are on a profit
and loss share basis (PLS), which actually does not come fully under the
jurisdiction of the existing civil laws. If there are disputes to be handled, civil
courts are not sufficiently acquainted with the rationale of the operations of
Islamic Banking. Regarding the protection of depositors, Islamic Banks are
required to let the authorities know the difference between money paid into
current accounts and money paid into investment accounts. Islamic banks
operate in two broad types of deposits:
a)    Deposits which cover transaction balance. These have a 100 percent
reserve requirement and completely safe, thus satisfying the needs
of risk averters.

b)    The PLS or equity account, in which depositors are treated exactly
as if they were shareholders in the bank. There is no guaranteed rate
of return or nominal value of the share.

In non-Muslim counties (i.e., the countries with less than 50% Muslim population)
the central banks are very stringent in granting licenses for Islamic banks to
operate. In order to be established in those countries Islamic banks must also
meet the additional requirements of other government and non-government
authorities.

Absence of Liquidity Instruments

Many Islamic banks lack liquidity instruments such as treasury bills and other
marketable securities, which could be utilized either to cover liquidity shortages
or to manage excess liquidity. This problem is aggravated since many Islamic
banks work under operational procedures different from those of the central
banks; the resulting non-compatibility prevents the central banks from controlling
or giving support to Islamic banks if a liquidity gap should occur. So the issue of
liquidity management must come under active discussion and scrutiny by the
authorities involved is Islamic banking

Use of Advanced Technology and Media

Many Islamic banks do not have the diversity of products essential to satisfy the
growing need of their clients. The importance of using proper advanced
technology in upgrading the acceptability of a product and diversifying its
application cannot be over emphasized. Given the potentiality of advanced
technology, Islamic banks must have to come to terms with rapid changes in
technology, and redesign the management and decision-making structures and,
above, all introduce modern technology in its operations. Many Islamic banks also
lack the necessary expertise and institutional capacity for Research and
Development (R & D) that is not only necessary for the realization of their full
potential, but also for its very survival in this age of fierce competition,
sophisticated markets and an informed public. Islamic banking cannot but
stagnate and wither without dynamic and ongoing programmes. In addition,
Islamic banks have so far not used the media appropriately.

Even the Muslims are not very much aware that the Islamic banking is being
practiced in the world. Islamic banks have not ever used an effective media to
publicize their activities. The authorities concerned in Islamic banks should
address these issues on a priority basis.        

Need for Professional Bankers

The need for professional bankers or managers for Islamic banks cannot be over

emphasized. Some banks are currently run by direct involvement of the owner

himself, or by managers who have not had much exposure to Islamic banking

activities, nor are conversant with conventional banking methods. Consequently,

many Islamic banks are not able to face challenges and stiff competition. There is

a need to institute professionalism in banking practice to enhance management

capacity by competent bankers committed to their profession. Because, the


professionals working in Islamic banking system have to face bigger challenge, as

they must have a better understanding of industry, technology and the

management of the business venture they entrust to their clients. They also have

to understand the moral and religious implications of their investments with the

business ventures. There is also a need for banking professionals to be properly

trained in Islamic banking and finance. Most banks’ professionals have been

trained in conventional economics. They lack the requisite vision and conviction

about the efficiency of the Islamic banking.      

Blending of Approach of Islamic Scholars with the Approach of the

Conventional Bankers

Bankers, due to the nature of their jobs have to be pragmatic or application-


oriented. There is and will be tendency in the bankers practicing in Islamic banks
to mould or modify the Islamic principles to suit the requirement for transactions
at hand. Additionally, being immersed in the travails of day to day banking, they
find little time or inclination to do any research, which can make any substantial
contribution to the Islamic banking. Islamic Scholars active in researching Islamic
Banking and finance, on the other hand, typically have a normative approach, i.e.
they are more concerned with what ought to be. A very few of them are
knowledgeable about banking or the needs of the customers.
Problems of Islamic Bank Operating under Conventional
Banking System

Failure of Islamic banks to finance high-return projects

Islamic bank fails to appropriate high profit from high-return projects since the
owners of these projects prefer borrowing from conventional banks where cost of
borrowing turns out to be lower. That means, only the projects with rates of
return equal to or below the market rate of interest are left with the Islamic
banks. At this situation, Islamic banks are not able to invest on the projects having
rates of return below the prevailing rate of interest thereby limiting their capacity
to utilize investment opportunity to the level of their conventional counterpart.
This leads to limiting the application of profit-loss-sharing modes such as
Mudaraba and Musharaka.

In other words, Islamic banks, at that situation, switch over to other modes of
financing such as Murabahah, hire purchase, leasing, etc.

Sacrifice of allocative efficiency

Allocative efficiency of Islamic bank, if it is truly a profit-loss-sharing bank, is built-


in to its financing mechanism. It is not possible to achieve the desired level of
allocative efficiency when entrepreneurs switch over from Islamic banks to
conventional banks to avoid high cost borrowing. Profitability of projects being
the ideal device of efficient resource allocation, at this situation, does not apply to
Islamic banking system as it, considering the rational behavior of the borrower,
takes recourse to modes other than profit-loss-sharing. This situation continues as
long as Islamic banks operate side by side with the conventional banks. Experts
are very much worried about this situation of Islamic banking. Up till now no
effective policy prescription is available to the Islamic banks to ameliorate the
situation.

Loss of distributive efficiency

It has also been found that distributive efficiency of Islamic banking is lost when
an Islamic bank starts operation under conventional banking framework. Any shift
from profit-loss-sharing modes leads the system break the direct relationship
between the incomes of the entrepreneurs, the bank and the depositors. The
inefficiency of conventional banking about distribution is neither influenced nor
modified by the introduction of Islamic banking in the economy.
Problem Specific to Islamic Banking in Pakistan

Absence of Islamic Money Market

In the absence of Islamic money market in Pakistan, the Islamic banks cannot

invest their surplus fund i.e., temporary excess liquidity to earn any income rather

than keeping it idle.(how ever in Pakistan SBP issue SUKOOK bonds) Because all

the Government Treasury Bills, approved securities and Pakistan Bank Bills in

Pakistan are interest bearing. Naturally, the Islamic banks cannot invest the

permissible part of their Security Liquidity Reserve and liquid surplus in those
securities. As a result, they deposit their whole reserve in cash with state

Bank.where SBP invest these funds islamicaly under supervision of Shariah board

and gives the profits to these banks. Similarly, the liquid surplus also remains

uninvested. On the contrary, the conventional banks of the country do not suffer

from this sort of limitations. As such, the profitability of the Islamic banks in

Pakistan is adversely affected.           

Absence of Suitable Long-term Assets

The absence of suitable long term assets available to Islamic banks is mirrored by
lack of short term tradable financial instruments. At present there is no equivalent
of an inter-bank market in Pakistan where banks could place, say, over night funds,
or where they could borrow to satisfy temporary liquidity needs. Trading of
financial instruments is also difficult to arrange when rates of return are not known
until maturity.Obviously, these factors place Islamic banking in Pakistan at a
distinct disadvantage compared to its conventional banking counterpart.

Shortage of Supportive and Link Institutions

Any system, however well integrated it may be, cannot thrive exclusively on its
built-in elements. It has to depend on a number of link institutions and so is the
case with Islamic banking. For identifying suitable projects, Islamic banking can
profitably draw the services of economists, lawyers, insurance companies,
management consultants, auditors and so on. They also need research and training
forums in order to prompting entrepreneurship amongst their clients. Such support
services properly oriented towards Islamic banking are yet to be developed in
Pakistan.

Organizing Relationship with Foreign Banks

Another important issue facing Islamic banks in Pakistan is how to organise their
relationships with foreign banks, and more generally, how to conduct international
operations. This is, of course, an issue closely related to the creation of financial
instruments, which would be simultaneously consistent with Islamic principles and
acceptable to interest-based banks, including foreign banks

Long-term Financing
Islamic Banks stick very closely to the pricing policies of the government. They
can not benefit from hidden costs and inputs, which elevate the level of prices by
certain entrepreneurs without any justification. On the other hand, Islamic banks as
financial institutions are even more directly affected by the failure of the projects
they finance. This is because the built in security for getting back their funds,
together with their profits, is in the success of the project. Islamically, it is not
lawful to obtain security from the partner against dishonesty or negligence, both of
which are very difficult if not impossible to prove.               

Conclusion
Islamic banks can satisfy most of the efficiency conditions if they can operate as a
sole system in an economy. Conventional banking, on the other hand, does not
satisfy any of the efficiency conditions analyzed above. However, when Islamic
banks start operation within the conventional

banking framework, their efficiency goes on decreasing in a number of


dimensions. The deterioration is not because of Islamic bank's own mechanical
deficiencies; rather it is the

efficiency-blunt operation of the conventional banking system that puts a


negative impact on the efficient operation of Islamic banks. This does not mean
that the survival of Islamic banks operating within the conventional banking
framework is altogether threatened. Evidence from
Bangladesh indicates that Islamic banks can survive within the conventional
banking framework by switching over from PLS to trade-related modes of
financing. Even under the conventional banking framework Islamic banks can
operate with certain level of efficiency by applying in a reasonable percentage the
PLS modes – the distinguishing features of

Islamic banking. This has been possible in some countries of the Muslim world
where the management of Islamic banks was cautious about possible impacts of
every policy measure. Particularly, the management of these banks was judicious
in selecting major sectors or areas of

their operations.

Recommendations
In order to operate in global markets effectively, it is desirable that the size
of operations of Islamic banks be substantially increased. In this regard, serious
consideration should be given to mergers. Islamic banks have to increase their
size as well as form strategic alliances with other banks. It will also be useful to
build bridges between existing Islamic banks and those conventional banks that
are interested to do banking on Islamic principles.

To promote teaching, training and research in Islamic banking and finance and to
produce and disseminate authentic information on their activities with a view to
develop new Islamic financial products, it is proposed that Islamic banks
strengthen their cooperation with the assistance of the Islamic Research and
Training Institute.

With a view to broaden the equity base of the economies of Muslim countries, it
is desirable to establish institutions dealing more in equities. These include
mutual funds, unit trusts, pension plans etc. It would also be desirable to
encourage businesses through macro-economic policies to increase the use of
equity finance and decrease their reliance on debt. Until Islamic countries do not
opt for a complete Islamic banking system, it is necessary to enact some laws to
facilitate the operation of a mixed system. In this context, one of the most serious
problems being faced by Islamic banks is the lack of proper legal framework to
deal with cases of delayed payments and bad loans expeditiously. Since Islamic
banks cannot charge interest on the delayed debts, they face a bigger risk of
default as well as loss in income. These considerations, among others, necessitate
that special laws for the introduction and practice of Islamic banking be put in
place.

Another important policy issue relates to tax treatment. Under the conventional
system, interest paid by corporations is treated as a tax-deductible expense. Similar
treatment must be given to the dividends paid out by financial institutions. It is
proposed that an autonomous Board for shari’ah supervision of Islamic banks, may
be constituted. In addition, there is also a need for Central banks in Muslim
countries to consider the special nature of Islamic banking and devise suitable
international standards for major control variables similar to the Basle Committee
for Banking Supervision.
There is an urgent need to increase the supply of scholars with dual specialisation
in shari'ah and finance. In order to meet this need, it is recommended that
courses may be introduced for shari'ah scholars in economics and finance.
Similarly, courses in shari'ah especially designed for economists and financial
experts may be initiated

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