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Islamic Banking Vs Conventional Banking

Islamic banking is based on the principles of Islamic economics — an economic framework in accordance with Islamic law (Sharia'h). There are two types of Islamic economics:

Caliphate , the Islamic form of government representing the political unity and leadership of the Muslim world (Islamic political framework) Assuming the political framework is non-Islamic, therefore, seeking to integrate some prominent Islamic tenets into a secular economic framework

Caliphate is the absolute Islamic rule, thus the economy focuses on distribution of resources in order to meet the basic and luxurious needs of individuals in society, and the state has a clear role in policing, taxation, managing public assets, and ensuring the circulation of wealth. Such a political framework in its true form does not exist in today's world. Assuming non-Islamic political framework simply proposes two main tenets: no interest can be earned on loans and socially responsible investing. This is the way conventional banking is Islamized—the first step towards an Islamic economic framework. Modern day Islamic scholars and academics have developed various modes of Sharia'h complaint financing that are designed to work within the prevailing capitalist economic framework. In order to achieve this balance numerous concessions have been afforded to financial institutions that would not apply if a viable interest free economic system existed. The intention behind making these concessions is to encourage the evolution of this type of alternative system.


Islamic Banking Vs Conventional Banking

Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Sharia’h) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called riba. Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam. Islamic finance has been gaining momentum on a global scale for the last 30 years. Many Islamic Banks have sprung up over the last few years. These changes are occurring both in Muslim and in western countries, and are driven by a global trend amongst Muslims to become more observant of their faith. It might have been the reason why Islamic Banking emerged, however, today Islamic Banking is sought by Muslims and non-Muslims due to the benefits it offers. Industry size is currently estimated at more than $400 billion, with projected growth of 15% per annum. Financial institutions around the globe are trying to keep pace with the growing demand for Sharia’h compliant products and services.

Islamic Banking Global Scenario
Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15percent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have


Islamic Banking Vs Conventional Banking

developed significantly and therefore, they are also participating in the money and capital market transactions. In Malaysia, Bahrain and a few other countries of the Gulf, Islamic banks and financial institutions are working parallel with the conventional system. Bahrain with the largest concentration of Islamic financial institutions in the Middle East region, is hosting 26 Islamic financial institutions dealing in diversified activities including commercial banking, investment banking, offshore banking and funds management. It pursues a dual banking system, where Islamic banks operate in the environment in which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for Islamic banks as for conventional banks. Bahrain also hosts the newly created Liquidity Management Centre (LMC) and the International Islamic Financial Market (IIFM) to coordinate the operations of Islamic banks in the world. To provide appropriate regulatory set up, the BMA has introduced a comprehensive prudential and reporting framework that is industryspecific to the concept of Islamic banking and finance. Further, the BMA has pioneered a range of innovations designed to broaden the depth of Islamic financial markets and to provide Islamic institutions with wider opportunities to manage their liquidity. Another country that has a visible existence of Islamic banking at comprehensive level is Malaysia where both conventional and Islamic banking systems are working in a competitive environment. The share of Islamic banking operations in Malaysia has grown from a nil in 1983 to above 8 percent of total financial system in 2003. They have a plan to enhance this share to 20 percent by the year 2010. However, there are some conceptual differences in interpretation and Shariah position of various contracts like sale and purchase of debt instruments and grant of gifts on savings and financial papers. In Sudan, a system of Islamic banking and finance is in operation at national level. Like other Islamic banks around the world the banks in Sudan have been relying in the past on Murabaha financing. However, the share of Musharaka and Mudaraba operations is on increase and presently constitutes about 40 percent of total bank financing. Although the Islamic financial system has taken a good start in Sudan, significant problems still remain to be addressed. Like Sudan, Iran also switched over to Usury Free Banking at national


Islamic Banking Vs Conventional Banking

level in March 1984. However, there are some conceptual differences between Islamic banking in Iran and the mainstream movement of Islamic banking and finance. Owing to the growing amount of capital availability with Islamic banks, the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals particularly in the Middle East region. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. These projects, inter alia, include power stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the leading centre for Islamic finance in the Middle East region. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures. The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool assets to develop and promote Shariah compliant tradable instruments for Islamic banking industry. The arrangement is seen as a major boost for industry’s integration in the global financial system and should set the pace for commodity-trading environment in Bahrain. BMA has also finalized draft guidelines for issuance of Islamic bonds and securities from Bahrain. In May 03, the Liquidity Management Centre (LMC) launched its debut US$ 250 million Sukuk on behalf of the Government of Bahrain. National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that has all the benefits of a regular credit card. The card does not have a credit line and instead has a prepaid line. As such, it does not incur any interest. Added benefits are purchase protection, travel accident insurance, etc and no interest, no extra fees with no conditions, the card is fully Shariah compliant. It is more secure than cash, easy to load up and has worldwide acceptance. This prepaid card facility is especially attractive to women, youth, self employed and small establishment employees who sometimes do not meet the strict requirements of a regular credit card facility. Saudi Government has also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector and opened it for foreign investors.


Islamic Banking Vs Conventional Banking

Islamic banks have also built a strong presence in Malaysia, where Standard & Poor's assigned a BBB+ rating to the $600 million Shariacompliant trust certificates (called sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank licences to foreign players. The Financial Sector Master plan maps out the liberalisation of Malaysia's banking and insurance industry in three phases during the next decade. It lists incentives to develop the Islamic financial sector and enlarge its market share to 20 percent, from under 10 percent now. A dedicated high court has been set up to handle Islamic banking and finance cases. In United Kingdom, the Financial Services Authority is in final stages of issuing its first ever Islamic banking license to the proposed Islamic Bank of Britain, which has been sponsored by Gulf and UK investors. The United States of America has appointed Dr. Mahmoud El Gamal, an eminent economist/expert on Islamic banking to advise the US Treasury and Government departments on Islamic finance in June 2004.

Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit over the cost, which is stipulated in advance.


Islamic Banking Vs Conventional Banking

Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.

A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.

Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former.


Islamic Banking Vs Conventional Banking

Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.

It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna'a can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways.

Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.

A form of partnership where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.


Islamic Banking Vs Conventional Banking

Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Barring this, Bai Salam covers almost everything, which is capable of being definitely described as to quantity, quality and workmanship

Islamic Banking Issues
Users of Islamic financial services assign primary importance to Sharia'h compliance of the services they use. It is understandable that Sharia'h noncompliance entails a serious operational risk and can result in withdrawal of funds from and instability of an Islamic bank, irrespective of its initial financial soundness. Sharia'h compliance is hence a serious matter for an Islamic bank, in addition to its compliance with other regulatory requirements.

Lack of standard financial contracts and products can be a cause of ambiguity and a source of dispute and cost. In addition, without a common understanding of certain basic foundations, further development of banking products is hindered.

An appropriate legal, institutional and tax framework is a basic requirement for establishing sound financial institutions and markets.


Islamic Banking Vs Conventional Banking

Islamic jurisprudence offers its own framework for the implementation of commercial and financial contracts and transactions. Nevertheless, commercial, banking and company laws appropriate for the enforcement of Islamic banking and financial contracts do not exist in many countries.

Islamic banks have over 60 % excess liquid funds which cannot be properly utilized due to non-availability of Sharia'h Compliant products and instruments. The competitiveness and soundness of financial institutions depend on the availability of efficient financial products. Islamic banks urgently need Sharia'h compliant products to meet a number of pressing needs.

Conventional Banking
Conventional banking is based on the principle that the more you have, the more you can get. In other words, if you have little or nothing, you get nothing. As a result, more than half the population of the world is deprived of the financial services of the conventional banks. Conventional banking is based on collateral. Conventional banks look at what has already been acquired by a personConventional banks go into ‘punishment’ mode when a borrower is taking more time in repaying the loan than it was agreed upon. They call these borrowers “defaulters”. When a client gets into difficulty, conventional banks get worried about their money, and make all efforts to recover the money, including taking over the collateral. In conventional banks charging interest does not stop unless specific exception is made to a particular defaulted loan. Interest charged on a loan can be multiple of the principal, depending on the length of the loan period.


Islamic Banking Vs Conventional Banking

Islamic Banking Vs Conventional Banking
Best Answer - Chosen by Voters The main difference between Islamic and conventional banking is that Islamic teaching says that money itself has no intrinsic value, and forbids people from profiting by lending it, without accepting a level of risk – in other words, interest (known as "riba") cannot be charged. To make money from money is prohibited – wealth can only be generated through legitimate trade and investment. Any gain relating to this trading are shared between the person providing the capital and the person providing the expertise. At Islamic Bank of Britain, we generate all our profit through sharia’a compliant trading and investment activities. We then share the profits with our customers at a pre-agreed ratio. In order to share profits you must hold one of our savings or investment accounts There are two major difference between Islamic Banking and Conventional Banking: 1. Conventional banking practices are concerned with "elimination of risk" where as Islamic banks "bear the risk" when involve in any transaction. 2. When Conventional banks involve in transaction with consumer they do not take the liability only get the benefit from consumer in form of interest whereas Islamic banks bear all the liability when involve in transaction with consumer. Getting out any benefit without bearing its liability is declared Haram in Islam. While the basics of what the business is are the same, the term refers to operating the business within Islamic law. The main thing that effects this business under that law is that Islam prohibits the charging of interest. Certainly a problem in modern banking!


Islamic Banking Vs Conventional Banking

However, what is considered to be interest has different definitions by different Islamic scholars...some say it can only be considered on gold and silver...but paying back the same weight as you borrowed (the same weight of paper money for example), is not interest. Like in all religious things, there would seem to be some conflict and differences between followers that may seem strange to outsiders. So basically, modern Islamic banking may take many forms, each of which strives to adhere to it's understanding of Islamic law.

Islamic banks playing role in Economic Development of the Country
Islamic banking is unique, but by no means anomalous. It is neither at odds with nor incomparable to conventional banking. Is it possible to contrast the two models? I-They are both financial intermediations. A financial intermediary is the institution that acts as a middleman between cash surplus units (savers) and deficit spending units (users of fund). It is quite obvious that the main function of conventional banks is financial intermediation. However, there are those who would like to think that there is no such thing in the Islamic economic system as financial intermediation and that an Islamic bank can only be “sufficiently” Islamic if it can operate like a trader, one who buys and sells goods and commodities. The financial intermediary in conventional banking is a “borrowerlender” institution. Since such institution will not survive unless it at least covers expenses, then an income must be generated from such arrangement. This is where interest appears. An Islamic bank, on the other hand, is based on a multi-tier Mudarabah. A Mudarabah is a partnership in profit where capital and management may joint together to create value. The income accruing to the Islamic financial intermediary is coming out of profit not from interest. The root of such a conception is the fact that Shari'ah doesn’t distinguish between a seller being a trader or a final intermediary, unlike positive law where civil law is different from commercial law. In Shari'ah all people stand against one legal code.


Islamic Banking Vs Conventional Banking

II-A case in mind is Murabaha. There are those who say if an Islamic bank does Murabaha any other form but the traders way of doing things it will not be permissible from Shari'ah point of view, and an Islamic bank would be in their view a “dubious” conventional bank. They say: since it is never the intention of the bank, to own there assets and hold on to them then, such bank is not sufficiently Islamic. According to this viewpoint, an Islamic bank must have huge warehouses and elegant stores full of goodies for sale. This is not valid and those who think so miss two important points: Intention is of no consequence on the permissibility or otherwise of any exchange contract in Shari'ah. In an authentic Hadith, the Prophet (PBUH) showed one companion how to substitute a usurious transaction by another non usurious to reach the same purpose, He (PBUH) didn’t object to the intention nor that he nullified the contract on the basis of intention. Rather he corrected the form of contract. If the anatomy of the contract is in line with Shari'ah requirements, then the transaction is acceptable. Hence, if bank actually buys and then sells, with ownership passing from seller to buyer and that the subject of contract is a good or commodity then the transaction is correct. In conventional banking the subject of contract is money hence any increase is usurious. III-The way conventional banks render financial intermediation is very simple. They borrow money and lend money. Both assets and liabilities are one form of lending. Islamic banking function in a rather “elaborate” (not perplexing) way. They have to continuously innovate to satisfy the needs of their clients. It is because of this we see Murabaha, Musharakah, Mudarabah, Istisna’a, Salam to name just a few Islamic modes of finance. This makes the job of an Islamic banker “not all roses”, but certainly a more interesting one. IV-A conventional banker is a risk manger. He is concerned with all kind of credit, market, interest rate, legal and other risk factors. An Islamic banker should be just as concerned. However, there is one added risk for the Islamic banker, this is what we may call “Shari'ah


Islamic Banking Vs Conventional Banking

disobservance risk”. Risk analysis refer to the forces that may cause the outcome of investment to be sub optimal. Certainly an Islamic investor earning non-permissible income is an outcome that is most undesireous, and it may cause the value of his investment to be reduced. V-Contrary to popular opinion, being concerned about time value of money is a similarity not a difference between Islamic and conventional banking. There is no basis for the current thinking that Shari'ah doesn’t allow the attachment of monetary value to time in the contracts exchange. The contract of Salam and differed-payment sales fly in the face of this argument. It is only in loans that Shari'ah requires that no time value of money is considered (but replaced by great rewards in the hereafter). VI-A major difference, however, remains in the handling of delinquency and default. When a borrower delays payment of debt, interest will accrue on his delayed portion. Unless, such borrower defaults and become incapable of paying back his debt, such interest will compensate the conventional bank for lost business. This can’t be done in Islamic banking as this is considered usurious. Clearly, this is a disadvantage from two aspects: Firstly, an Islamic bank will not have the opportunity in a Murabaha transaction for example, to be compensated for lost profit. But more importantly, it increases significantly, the Murabaha risks. Since bank clients are rational people who will seize an opportunity when they see one, they will always delay payment. One major Ijtihad of contemporary Shari'ah scholars, is to allow the Islamic bank to impose penalties. Rather than accrue such penalties as income, and hence become usurious, they are disposed off to charity. This way the pressure will mount on the debtor to pay in time, without falling into Shari'ah impressibility.

Operational Challenges and Prospects
Both the theory of Islamic banking and the rapid expansion of Islamic banks recent years have demonstrated the viability and feasibility of non-interest-based operations. This must be surprising to those who believed that banks and financial systems could not operate in a modern economy without reliance on an interest rate mechanism.


Islamic Banking Vs Conventional Banking

Indeed, experience has shown that Islamic banks are powerful means of mobilizing resources. Operationally, however, both the Islamic financial systems in the three countries that have adopted it as well as individual Islamic banks face challenges that need to be addressed. The most important among these challenges is the fact that, while it has been relatively easy to create a system in which deposits do not pay interest, the asset portfolios of Islamic banks do not contain sufficiently strong components that are based on profit-sharing. The main reasons for this are: (a) lack of a legal and institutional framework to facilitate appropriate contracts as well as mechanisms to enforce them; and/or (b) lack of appropriate menus containing a broad range and a variety of maturity structures of financial instruments. Consequently, a relatively strong risk perception has become associated with profit-sharing methods in particular and Islamic banking in general. This, in turn, has led to concentration d asset portfolios of the Islamic banks in short-term and trade-related assets with inimical effects on investment and economic development. The problem is exacerbated by the fact that Muslim countries, as is the case in much of the developing world, suffer from a lack of deep and efficient capital and money markets that can provide the needed liquidity and safety for existing assets. The absence of suitable longterm instruments to support capital formation is mirrored in the lack of very short-term financial instruments to provide liquidity. a. The challenges facing individual Islamic banks Impressive as the growth record of individual Islamic banks may be, the fact is that at present, those banks have mostly served as intermediaries between the financial resources of Muslims and major commercial banks in the West. In this context, this has been a oneway relationship, so far. There is still no major Islamic bank that has been able to develop ways and means of intermediating between Western financial resources and the demand for them in Muslim countries. It also appears that individual Islamic banks face difficulties in fund placement because they have had a major bias towards short-term, secured, low-return but liquid investments. The challenge for these institutions stems from motivational and technical factors. Motivationally, their basic aim appears to have been that of demonstrating the viability of Islamic banking without taking too many risks. Admittedly, this is a noble and a very important objective,


Islamic Banking Vs Conventional Banking

however, although they have succeeded in this effort and have managed to create a market niche for Islamic banking, they do not seem to have achieved the market depth that could ensure long-term profitability and survival. This stems from the fact that they appear to be far behind in technical innovations and financial market developments that in recent years have revolutionized finance and capital markets. There is no evidence that these banks have made any large investment in research and product development, nor is there any evidence that new financial products developed in recent years, particularly in equity derivatives, have been utilized to any significant degree by the major Islamic banks. This is unfortunate because the market opportunities that these banks have been able to develop, to allow funds from Islamic communities to be placed in Islamically permissible portfolios, can and will be exploited by more efficient and innovative Western financial institutions that already have or will discover this market niche. While there is considerable room for competition and expansion in this field, the long-term survivability of individual Islamic banks will depend on how rapidly, aggressively, and effectively they can develop techniques and instruments that would allow them to carry on a twoway intermediation function. They need to find ways and means of developing marketable Shari‘ah-based instruments by which asset portfolios generated in Muslim countries can be marketed in the West as well as marketing Shari’ah-based Western portfolios in Muslim communities. b. The challenge of adopting an Islamic financial system The most important challenge for Islamic banking is in its system-wide implementation. At present, many Islamic countries suffer from financial disequilibria that frustrate attempts at wholesale adoption of Islamic banking. Financial imbalances in the fiscal, monetary and external sector of these economies cannot provide fertile ground for efficient operation of Islamic banking. Major structural adjustments particularly in fiscal and monetary areas are needed to provide Islamic banking with a level playing field. Additionally, adoption of a legal framework of property ownership and Contracts that would clearly specify the domain of private and public property rights as well as stipulation of legally enforceable rights of parties to contract that fully reflect the requirements of the Shari’ah, are necessary to allow an operational framework conducive to efficient operation of Islamic banking.


Islamic Banking Vs Conventional Banking

An Islamic financial system can be said to operate efficiently if, as a result of its adoption, rates of return in the financial sector correspond to those in the real sector. In many Islamic countries fiscal deficits are financed through the banking system. To lower the costs of this financing, the financial system is repressed by artificially maintaining limits on bank rates. Thus, financial repression is a form of taxation that provides governments with substantial revenues. To remove this burden, government expenditures have to be lowered and/or revenues raised. Massive involvement of governments in the economy makes it difficult for them to reduce their expenditures. Raising taxes is politically difficult. Thus, imposing controls on domestic financial markets becomes a relatively easy form of raising revenues. Under the above circumstances, it is understandable why governments would have to impose severe constraints on private financial operations that can provide higher returns to their shareholders and/or depositors. This makes it very difficult for Islamic banks and other financial institutions to realize fully their potential. For example, Mudarabah companies that can provide higher returns than the banking system would end up in direct competition with the banking system for deposits that are used for bank financing of fiscal deficits. While Muslim countries may, for legitimate reasons, opt for an Islamic financial system, for the economy as a whole to benefit fully from the operations of such a system, it is necessary that (a) government expenditures are fully rationalized, (b) revenues from taxation, and those derived from property legitimately placed within the government domain by the Shari’ah, are raised to meet the expenditure needs the government, (c) the financial sector is liberalized so that returns to this sector reflect returns to the real economy, (d) equity markets are developed to allow financing of investment projects outside banking institutions, and, finally, (e) the structure of the banking system should be such as to allow strong banking supervision and prudential regulation commensurate with the risks involved in various transactions.* To accomplish the last objective, the banking structure can be tiered in accordance with principal Islamic financial transactions. It is reasonable to assume that risks involved in Musharakah or Mudarabah financing, are different from those involved in trade-type financing. It follows, therefore, that prudential regulations of these transactions should be different.


Islamic Banking Vs Conventional Banking

Motivating Factors for Islamic Banking
Motivation and renewed interest in Islamic finance industry stems from its strong economic, financial and social considerations, backed by its unique features. Most significant is its appeal to add to financial diversity and innovation being skewed towards: (i) Asset backed and equity based transactions, which promote entrepreneur friendliness and consideration of project viability Equitable distribution of risks and rewards among the stakeholders; inculcating market discipline and higher ethical standards given its emphasis on non-exploitation and social welfare.



In the wake of high Asian domestic savings rates and build up of the region’s foreign exchange reserves as well as oil surpluses of Middle East in the last few years, Islamic finance is now also emerging as a way to wealth management, both of richer nations and high net worth individuals.