M Sair Mehdi

Bbhm-f19-104

BBA-5A

Submitted to: Mam Uzma Kashif

Significance

Although there are differences between Islamic banking and "conventional" banking,
there are some fundamental principles that apply equally to both. In particular, rigorous
risk management and sound corporate governance help to ensure the safety and
soundness of the international banking system. In the light of the growing importance of
Islamic banks and Sharia-compliant financial innovation, the increasing integration of
Islamic financial services into global financial markets serves to strengthen this
point.The Basel II framework improves the risk sensitivity and accuracy of the criteria for
assessing banks' capital adequacy. This framework is fundamentally about stronger and
more effective risk management grounded in sound corporate governance and
enhanced financial disclosure, the importance of which has been underscored by the
recent problems that have arisen in the banking industry worldwide. The guidance
provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the
realisation of these global goals. It will support the establishment of resilient financial
market infrastructures and sound and robust core Islamic financial institutions operating
according to safe and sound risk management practices.

As an associate member of the IFSB, the BIS has been actively supporting the IFSB's
mission and initiatives since the Board began operations in 2003. The Basel Committee
on Banking Supervision, which is hosted by the BIS, is increasingly looking beyond its
membership to enhance cooperation with non-member countries and organisations with
related interests and similar goals. The Committee's outreach to non-member countries
is part of an initiative to promote the development of sound supervisory practices and to
accommodate the growing importance and sophistication of non-member banks.The
BIS and the Basel Committee have been strong supporters of the IFSB through
participation in IFSB working groups, such as the capital adequacy group, and by
providing speakers for conferences and other events. I believe that the active and
productive dialogue between the Basel Committee and the IFSB will continue to benefit
both of our organisations. Professor Rifaat and members of the Basel Committee's
Secretariat have recently held fruitful discussions, and continue to strengthen the
cooperation between the IFSB and the Committee.In my remarks today, I will not
address the specifics of Islamic finance and how it differs from conventional banking.
Instead, I would like to focus on two elements of banking supervision that Islamic and
conventional banking have in common. That is, appropriate levels of risk management
and corporate governance, which help to ensure the safety and soundness of the
international banking system.

As I am sure you heard yesterday and will also hear today, there has been significant
growth in Islamic financial services in recent years and there is every reason to expect
that this growth will continue at a rapid pace. Clearly, there is expanding demand for
these products, and a closely associated desire on the part of banks, including non-
Islamic banks, to provide Islamic financial services.

Although it is still modest in size relative to conventional retail banking, Islamic retail
banking is rapidly becoming more visible. This is particularly true in the Middle East and
Asia Pacific regions, where a number of Islamic banks and banking units have been
opened in recent years. There are also Islamic banks and asset managers in key
international financial centres of the United Kingdom and the United States.The growth
in Islamic finance is also visible in the expanding range of services and products that
comply with the basic precepts of Sharia law. One example is the burgeoning global
market interest in Islamic bonds - Sukuks - many of which are increasingly being issued
and bought outside the Islamic world. This suggests that non-Islamic investors in
general are becoming comfortable with Sukuks. The broadening appeal of Islamic
finance is also evident in the move by large international banks and other private sector
financial institutions to provide Islamic financial services. This includes the
establishment of exchange-traded funds that are screened to ensure their conformity
with Islamic investment principles, as well as offering "takaful" - or Islamic
insurance.Although the elements that are usually emphasised at conferences like this
are differences between Islamic banking and "conventional" banking, there are some
fundamental principles that apply equally to both. For example, I can point to the
necessity of strong corporate governance, rigorous risk management and sound capital
adequacy requirements as essential ingredients to ensure the safety and soundness of
any financial system. The increasing integration of Islamic financial services into the
global financial fabric only strengthens this point.

Role

The prohibition of interest in Islam and the aspiration of Muslims to make this
prohibition a practical reality in their economies, have led to the establishment of
Islamic financial institutions IFIs. As a result, Islamic finance has grown in response to
demand, especially from the Middle East’s Gulf region. This approach to economics,
and particularly to commercial exchange, has gained traction in recent decades. In
fact, a robust and widespread movement has arisen to position Islamic finance and
IFIs globally as viable competitors to conventional finance and banking. In great part,
the cause of this change lies is traditional supply and demand. The worldwide
resurgence of Islamic teaching has driven demand for Islamic finance and for the
 creation of Islamic financial institutions.3 Islamic finance is a demand-driven entity
whose customers are both the Muslim population and non-Muslims.4 This demand has
created its own supply to fill the market gap. This chapter explores the role of profit-
and-loss sharing (PLS) in IFIs for economic development, and how that role differs
from conventional finance.Finance is a branch of economics concerned with providing
funds to individuals, businesses, and governments. Finance allows these entities to use
credit instead of cash to purchase goods and invest in projects. For example, an
individual can borrow money from a bank to buy a home or an industrial firm can raise
money through investors to build a new factory. Governments can issue bonds to raise
money for projects. Finance plays an important role in the economy. As banks, credit
unions, and other financial institutions provide credit, they help expand the economy by
directing funds from savers to borrowers. Islamic finance has been practiced in some
form since the inception of Islam, its practice in modern financial markets became
recognized only in the 1980s, and began to represent a meaningful share of global
financial activity only around the beginning of this century. In recent years, significant
interest in Islamic finance has emerged in the world's leading conventional financial
centers, including London, New York, and Hong Kong, and Western investors are
increasingly considering investment in Islamic financial products. The organizing
principle of Islamic finance in an Islamic economy is transaction based on exchange,
where real asset is exchanged for real asset. By focusing on trade and exchange in
commodities and assets, Islam encourages risk sharing, which promotes social
solidarity. The features of an Islamic economy will change the behavior of society.
There will be greater consultation; hence there will be no impulsive-compulsive reaction
in financial dealings. At the same time, the labor force in an Islamic economy will work
under a rule of trust and full understanding of contracts and obligations. Workers also
share in the gains achieved through the risk, based on productive efforts, which is a
better incentive system than a fixed wage. Workers will be treated with respect, which
reflects the importance of human dignity in Islam. This paper is organized as follows:
chapter one discusses the epistemological roots of conventional and Islamic finance.
Chapter two provide a perspective of conventional modern economists. Chapter three
provides a brief taxonomy of the foundational Islamic market principles and evaluates
them in the context of institutional and behavioral economics in the context of Knightian
uncertainty. Chapter four accounts for finance and development in Islam from a
historical perspective. Chapter five discusses the evolution of the concept of economic
development. Chapter six provide an Islamic perspective on financial inclusion and
argue that the core principles of Islam place great emphasis on social justice, inclusion,
and sharing of resources between the haves and the have-nots. Chapter seven
addresses financial inclusion. Chapter eight provide insight into Islam's perspective on
social safety sets and social insurance. Chapter nine examines Islamic capital markets
in a global context. Chapters ten examines the problems of primary and secondary
aspects of the conventional stock markets and their critiques of corporate governance.
Chapter eleven give a realistic view of the current state of affairs in Organization of
Islamic Conference (OIC) countries. Chapter twelve addresses key economic policy
challenges in the context of the Islamic economic and financial system.

Importance
Islam is not only a religion in the ordinary sense of the word, but a complete system of
life. While other religious codes provide guidance only for the relation between man and
his Creator, Islam guides man in his relationship with God and gives him the norms
which govern his temporal existence, since Islam is concerned with the spiritual,
political, social economic, moral and all other material aspects of the human being.

Islamic banking is banking or banking activity that is consistent with the principles of
Islamic law (Shariah) and its practical application through the development of Islamic
economics. Shariah prohibits the fixed or floating payment or acceptance of specific
interest or fees (known as Riba or usury) for loans of money. Investing in businesses
that provide goods or services considered contrary to Islamic principles is also Haraam
(forbidden). While these principles were used as the basis for a flourishing economy in
earlier times, in the late 20th century that a number of formal Islamic banks were formed
to apply these principles to private or semi-private commercial institutions within the
Muslim and Non-Muslim Communities.

The growth of the Islamic finance industry was remarkable in the last decade and in
certain parts of the world its growth is extraordinary. According to Ernst & Young’s
inaugural World Islamic Banking Competitiveness Report 2011, Islamic banking assets
with commercial banks globally will reach US$1.1 trillion in 2012, a significant jump of
33% from their 2010 level of US$826 billion. The Islamic banking assets in the Middle
East and North Africa (MENA) region increased to US$416 billion in 2010, representing
a five year Compound Annual Growth Rate (CAGR) of 20% compared to less than 9%
for conventional banks and these Islamic banking assets are expected to reach to
US$2.8 trillion by the year 2015. As new geographies open up to Islamic banking, the
MENA Islamic banking industry is expected to more than double to US$990 billion by
2015.Based on estimates of the International Monetary Fund (IMF) (2010), there are
more than 390 Islamic banks and institutions spread across 75 countries. Based on the
Islamic Development Bank records, the average annual growth rate of Islamic financial
institutions assets during the period 1995-2010 was estimated to be within the range 10-
15%. The main reason for the growth stem from a number of sources:Muslims
worldwide are starting to use Shari’ah compliant products that were not previously
available to them;- Due to the increase in oil wealth of the Muslim nations in the Middle
East and their decision to use Shari’ah compliant products, western governments and
 conventional financial institutions are considering using Islamic Finance Due to their
escalating competitiveness and focus on ethics, Islamic products are attracting not only
Muslims but non- Muslims as well. Islamic Finance has no way to leave in any time
soon as Islam is the fastest growing religion in the world and is the second largest
religious group in the UK, USA and France.The GCC countries account for nearly 56
percent of the total Islamic banking assets. Based on Mckinsey projections, by 2015,
more than half of financial services provided are expected to become Shari’ah
complaint in the GCC countries.

Objective

Islami banking has been defined in a number of ways. The definition of Islamic bank
approved by the General Secretarial of the OIC is staled in the following manner. “An
Islamic bank is a financial institution whose status, rules and procedures expressly state
commitment to the principle of Islamic Shariah and to the banning of the receipt and
payment of interest on any of its operations.” Dr Shawki Ismail Shehta viewing the
concept from perspective of an Islamic economy and the prospective role to be played
by an Islamic bank therein opines that “It is therefore, natural and, indeed, imperative for
an Islamic bank incorporate in its functions and practices commercial investment and
social activities, an institution design to promote the civilized mission of an Islamic
economy.” Dr. Ziaul Ahmed says, “Islamic banking is essentially a normative concept
and could be define conduct of banking in consonance will the ethos of the value
system of Islam.”

It appears from the above definitions that Islamic banking is a system of financial
intermediation that avoids receipt and payment of interest in its transactions and
conducting operations in a way that it helps achieving the objectives of an Islamic
economy. Alternatively, this is a banking system whose operation is based on Islamic
principle transactions of which profit and loss sharing (PLS) is a major feature ensuring
justice equity in an economy. That is why Islamic banks are often known as PLS-banks.

Conventional banking is essentially based on debtor-creditor relationship between

depositors and the bank in the one hand and between the borrowers and the bank on
the interest is considered as the price of credit, reflecting the opportunity cost of money.
Islam, on the other hand, considers loan to be given or taken, free of charge, to meet
contingency and that the creditor should not lake any advantage of the borrower. The
money is lent out on the basis of interest, more often it happens that it leads to some
kind of injustice. The first Islamic principle underlying such kinds of transactions is that
“deal not unjustly and ye shall not be dealt with unjustly”. Hence, commercial banking in
an Islamic framework is not based on debtor-creditor relationship.The second principle
regarding financial transactions in Islam is that there should not be any reward without
risk-taking. This principle is applicable both to labor and capital. As no payment is
allowed to labor unless it is applied to work, no reward for capital should be allowed
unless it is exposed to business risks.Thus, financial intermediation in an Islamic
framework has been visualized on the basis of the above principles. Consequently
financial relationships in Islam have been participatory in nature. Several theorists
suggest that commercial banking in an interest-free system should be organized on the
principle of profit and loss sharing. The institution of interest is thus replaced by a
principle of participation in profit and loss. That means, a fixed rate of interest is
replaced by a variable rate of return based on real economic activities. The distinct
characteristics which provide Islamic banking with its main points of departure from the
traditional interest-based commercial banking system are: (a) the Islamic banking
system is essentially a profit and loss sharing system and not merely an interest-free
(Riba) banking system; and (b) investment (loans and advances in conventional sense)
under this system of banking must serve simultaneously both the interest of the investor
and those of the local community. The financial relationship as pointed above is referred
to in Islamic jurisprudence as Mudarabah.