08/11/2015 By Omar Mustafa Ansari and Faizan Ahmed Memon | Islamic Finance news

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Is Islamic banking really ‘Islamic’?In this era of development and growth in Islamic finance and banking, that question invariably arises at forums. While on theone hand we celebrate the achievements of Islamic banking, on the other, we should not ignore other relevant issues andobjections in order to ensure that the indus­try has a strong foundation.

We should first try to understand the objectives of Islamic banking, which are:1. To provide Shariah compliant and prudent banking opportunities; hence providing an opportunity to Muslims to do theirbanking transactions in a halal manner. In other words, this is just an effort to avoid riba and other prohibited elements presentin commercial and banking transactions, in order to ensure that we do nothing that is haram; and 2. To achieve the goals and objectives of an Islamic economic system.

Given the circumstances, the Islamic banking industry is making all efforts to ensure the first objective is achieved, while thesecond, although no less important, does not appear to be a priority in current­day Islamic banking.

History of Islamic bankingModern banking was introduced in Muslim countries at a time when they were politically and economically enslaved by thewestern world. Major western banks established their branches and subsidiaries in Muslim countries and territories to fulfillrequirements of foreign business.

The Muslim community generally avoided foreign banks for religious reasons but with the passage of time, it becameincreasingly difficult to engage in trade and other activities without making use of commercial banks. Even then, a large numberof Muslims confined their involvement to transactions such as current accounts or 100% cash margin letter of credits.Borrowings from commercial banks or placement of the access funds and saving accounts were strictly avoided by practicingMuslims in order to keep away from dealing in interest, which is prohibited by Islam.

However, due to the higher volume of cross­border transactions and other socio­economic forces demanding more involvementin national economic and financial activities, avoiding transactions with conventional banks soon became impossible. Localbanks were established in Muslim countries (including adopting names like Muslim Commercial Bank (MCB Bank)) on thesame lines as the interest­based foreign banks and they began to expand within the country. Governments, businesses andindividuals had no option but to deal with the banks.

This state of affairs drew the attention and concern of Muslim intellectuals, which gave emergence to contemporary Islamicbanking. By the middle of the last century, many Muslim countries had begun efforts to adopt the Islamic economic and bankingsystem — although scholars, economists and experienced bankers had different ideas on how to go about doing so. Thoseexperiences paved the way for modern Islamic banking.Nowadays, it is common to see Islamic financial institutions (IFIs) even in European countries and the US. They are especiallyprominent in Pakistan, the GCC countries, Malaysia, Sudan and Iran.

Islamic banking is a weak industry in terms of resources, knowledge bases, knowledgeable human resource capital, availabilityof commercial options, state support, as well as community support, in respect of the sincerity of stakeholders. Unfortunately,certain weaknesses in the industry have not only been singled out by its critics, they have also been severely criticized even byits sup­porters. As a consequence, there is a divergence of opinion among various quarters including certain “revolutionary”Islamic movements, certain “rigid” and “hardcore” religious scholars, and “idealistic” and “utopian” Islamic economists.

There are two facets as to whether Islamic banking is really Islamic. The first is that as a transaction performed in the name ofIslamic banking appears to be similar to that done by a conventional financial institution, thus creating doubt in people’s minds,on what grounds can we call it Islamic? A majority feel that Islamic banking merely involves a change in name and documentsand in fact, is no different from conventional banking.

The second facet, which deals with the socio­economic factors associated with the overall Islamic financial system, is moreimportant.

By Omar Mustafa Ansari and Faizan Ahmed Memon

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Merely a change in name?The most common argument against contemporary Islamic banking is that there is “no difference at all” between conventionaland Islamic, that it merely involves a change in name and documents. The second, which is in fact an offshoot of the firstargument, is that even in Islamic banking, the most common products used, e.g. Murabahah, Musawwama, Salam, Istisna,diminishing Musharakah and Ijarah Muntahia Bittamleek, are on a fixed­return basis. Even the Musharakah­ and Mudarabah­based products are engineered such that the profits are “virtually fixed”.

One should realize that unless we can distinguish an Islamic bank from a conventional bank, it would be difficult to rely on thesame. Islamic banks make the effort to ensure that their products are similar to conventional ones in all aspects, even if for thatpurpose they have to incorporate a few provisions that are not considered good or are considered Makrooh. In addition, theirendeavors are focused on minimizing risk through every possible scenario and accordingly, the essence of Islamic financewhich is based on risk taking is lost.

It will be observed that most IFIs market their products on models that are similar to those used by conventional banks. As anexample, an Ijarah Muntahia Bittamleek transaction introduced by an IFI might be similar to a finance lease offered by aconventional leasing company, save for Takaful/insurance cost, which in Shariah is to be borne by the lessee and accordingly,the same is built into the rentals.

The basic reason behind this similarity is to ensure three objectives. The first one, which can be considered the more important,is to provide a level playing field to ensure the survival of IFIs in the financial landscape. The second is to ensure shareholdersand depositors of IFIs are not deprived of returns, preferably equivalent to that in conventional banks. And the third is to avoidarbitrage among Islamic and conventional financial systems which may be exploited by a few big guns to take advantage of thepricing difference between the two parallel financial systems. For such reason, time value of money concept is used forperformance measurement and pricing of financial products.

More importantly, in some areas, there is little difference between haram and halal. For example, only by uttering the name ofAllah Almighty upon an animal at the time of slaughter makes it halal and permissible while not doing makes it haram or by justa few words of acceptance in Nikah (solemnization of marriage), in the presence of a few, a man and woman become halal foreach other. Similarly, if a transaction can be engineered in such a way that it becomes Shariah compliant, we should notconclude that the same is haram only because of its similarity to interest­based financing.

It is also pertinent to note that since the Islamic financial services sector is still at infancy stage, it is not easy to come up with anew financial tool just for the sake of complementing its conventional cousin. For example, where running finance and overdraftis used as a financing tool, in Islamic banking, this takes the form of Istijrar with Murabahah or Musharakah­based runningfinance. Similarly, where finance leases are used, we have the Shariah compliant Ijarah Muntahia Bittamleek or diminishingMusharakah. These are only two examples, but the tally is practically very high and for each interest­based financial productexcept for those explicitly haram, more than one alternate has been engineered.

The objective of this discussion was to emphasize that merely an amortization schedule similar to the one offered by aconventional bank is not a basis for declaring a halal product as haram. If a pricing model or the similarity of a cash­flow modelalone makes the transaction haram, what about a conventional loan offered at a price that is much higher or much lower thanprevailing market rates for which the pricing model and the cash­flow model are not similar to those generally applied in theindustry? Does anybody think that such dissimilarity will make it halal? Accordingly, under Shariah principles, it can beconcluded that it is the substance of a transaction that makes it halal or haram, and not a pricing model used to price thetransaction or the cash­flow model used for the payments and repayments in monetary terms.

Socio­economic effectsThe second most significant argument by certain Islamic economists and certain Islamic revolutionary movements concerns thesocio­economic factors of Islamic banking. They feel that since Islamic banking is also based on profit motive and in its presentform, it generally works on a “virtually fixed” return basis, the same cannot contribute anything positive towards the socio­economic changes that Islam desires. This is a crucial question and we believe every conscientious Muslim will have the sameconcerns albeit reaching different conclusions.

Nobody can argue that virtually fixed­return­based banking, while Shariah compliant, is not what has been desired by Islam asa complete way of living. In addition, modern­day Islamic banking emphasizes consumer finance as compared to financing theSME sector, agricultural sector, and more importantly, on microfinance; hence, it is not contributing enough towards the “justand equitable monetary system” that Islam needs.

Having due regard for these arguments, the Islamic economic system is not something that can work in isolation from thegeopolitical and legislative system. Society’s attitude towards the injunctions of Islamic Shariah in personal and collectivematters is another factor. Accordingly, if in an economy most businessmen are not honest about presenting the financialstatements of their businesses in a fair manner, it would be difficult to introduce a profit­ and loss­sharing­based financialsolution.

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The complete transition to an Islamic economic system is possible when — and only when — overall consensus is reached onthe practical application of Shariah in all facets of human life, including governmental, political and legislative structures.

Despite such an unsatisfactory and rather discouraging attitude towards the application of Islamic Shariah, it should be notedthat such a situation does not relieve a Muslim of the applicability of Shariah principles, but rather increases his responsibilitiesin that it becomes his duty not only to try to abide by all applicable Shariah requirements in his personal capacity but also to puthis energy into the improvement of such a system. The responsibilities of the Muslim ummah as a whole (or of the state) cannotbe expected to be borne by a single sector only.

Is it heela banking?From the Shariah perspective, a heela is an option utilized to disobey the divine guidance through engineering thecircumstances and playing with the facts and intentions. The foundation of the Islamic finance industry has been built using thepillars derived from the Holy Quran, Sunnah and Fiqh. It is worth noting that a heela is mostly applied in the “execution of”rather than the “designing of” a transaction. In other words, application of heelas in Islamic banking is not a weakness in thetheories of Islamic banking, but actually is a matter of misuse/misinterpretation of basic Shariah guidance in respect of variousShariah compliant financial transactions.

Accordingly, to support the growth of Islamic banking and finance on the right footing, we need to strengthen the Shariahcompliance mechanism. In addition, in the longer run, we need to eliminate the Islamic financial products which have thepotential of misuse.

Halal to use interest rate as a benchmark?Critics, including scholars and economists, allege that most IFIs, while providing financing by way of any of the halaltransactions, determine their profit rate on the basis of the current interest­rate benchmarks prevailing in the conventionalmoney market. Scholars believe that by applying these benchmarks, the Islamic banking industry makes their transactions“similar” to interest­based transactions and as a consequence, these transactions become doubtful from a Shariah point ofview.

It may be worthwhile to take a look at the arguments by the Islamic banking fraternity for a better understanding of the pricingissue. They generally give the following examples: Suppose you enter a supermarket in the UK and see that the pork, the beefand the halal beef are all being sold for ₤2 per kg. Do you think that this similarity in price or the fact that these products arebeing sold under the same roof renders the halal beef as haram?

Or, in the same store, you notice that they use the same weighing scale for all three types of meat. Do you think that using thesame scale will render the halal beef as haram? If not, then we should better understand the principle that it is the substanceand legal form of the transaction that makes it halal or haram and not its pricing, rate or the cash­flow model or the institution, oreven the environment that offers such transaction.

This issue, however, needs to be addressed by the government as well as the market players. A strong Islamic interbankmarket will, InshaAllah, provide us opportunities to develop our own benchmarks for Islamic banking operations.

Islamic versus conventional banksAnother strong argument against Islamic banking is against dealing with conventional banks. These dealings are of two typesi.e. sharing of services and commercial transactions. As far as services are concerned, these encompass the Islamic bankassisting customers of the foreign businesses or helping their customers transfer money from safe channels. For theseservices, the remuneration or expense of Islamic banks connotes a service charge, which is allowed by Shariah jurists,although they recommend that such interaction should be avoided wherever IFIs are available.

The second argument which is stronger concerns the commercial transactions with conventional financial institutions. Thesetransactions generally relate to the treasury side of the bank, whereby either the IFIs place their excess liquidity with theconventional banks or obtain financing from them to meet their own liquidity requirements. For placement of funds withconventional banks most Islamic banks in Pakistan use commodity Murabahah or they invest in certain “halal assets” of theconventional financial institutions. On the other hand, they normally obtain financing from the conventional banks on the basisof profit and loss sharing, although the profit rates are once again “virtually fixed”.

Although most Shariah scholars would have no objections to these transactions, nobody can say that it is a must to avoid allsuch transactions. For this purpose, however, we need to strengthen the Islamic interbank market and to provide more liquiditymanagement options to the IFIs. These could be in the form of strong Shariah compliant government securities and a stablecapital market with plenty of halal investment options. All dealings with conventional financial institutions should be limited tothe necessities which reach the extremes of compulsion.

There are those who have serious doubts on the honesty and integrity of IFIs. They feel that these banks are using the term“Islam” to make an extra buck as compared to the conventional banks. On the financing side, their charges are higher than

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conventional banks. In other words, the internal rate of return on Islamic financial products is higher than the conventionalproducts.

On the contrary, it is observed that on the deposit side, they pay less than conventional banks. In addition, it is generallyobserved that the expected rates, as well as the actual rates of return offered by these financial institutions, are almost thesame as (generally slightly less than) the rates being offered by conventional financial institutions.

A justification against the first argument is that since IFIs are subject to the commodity risk, asset destruction and holding risksand the price risk, as well as their relevant costs e.g. Takaful expenses, in addition to the risks and costs that a bank faces, theyare justified in their demand i.e. a higher internal rate of return. Nevertheless, financial experts have generally felt that even ifthese factors are considered, the pricing by these banks is on the higher side.

On the other hand, in a profit and loss­based model, it is agreeable that they assign weightage to different types of deposits in amanner that the total return on investment and financing pools is allocated among various depositors and the bank (working asa partner). Even then, it is generally noted that IFIs are paying less than the market.

We can only hope that in the near future, with increasing competition in the Islamic banking industry, this effect will minimizebecause of market forces except to the extent of pricing against actual additional risk elements.

Marketing approach of IFIsAnother valid argument is the marketing approach being used by these financial institutions, which adversely affects the publicreliance on this mode. People raising objections on the marketing approach of IFIs have two grounds. The first one is thegeneral marketing approach being applied by a few IFIs which include advertisement and other publicity materials includinginvolvement of women and traditional marketing and advertisement styles for promotion of “Islamic” banking business.

Second is the marketing strategy in which sometimes it is felt that false statements are made for promotional purposes. Anexample is the claim by a leading Islamic bank that all its day­to­day activities are monitored by its Shariah adviser. Justimagine, if it is humanly possible, a part­time Shariah adviser overseeing all day­to­day activities of a full­fledged bank with anumber of branches even located at other cities.

Another example is the claim by an Islamic mutual fund that it is the first of its kind in the country, whereas another fund hadoperated in the country about a year earlier to subscription for such mutual fund.

Generally, upon entering the branch or office of an IFI, you won’t feel it is that much different from a conventional bank. Somehave ventured the opinion it should look like a sacred place instead of a commercial office. They feel management may havegone overboard with the furniture, decor and publicity, which apparently is against the injunctions of Islam. And their impressionis reinforced when taking into account the overall environment, the attitude of personnel and most significantly, there are femaleemployees who do not wear the hijab or even “appropriate attire” (in line with the dress code of a Muslim woman as defined byShariah). Although a few “moderate­enlightened” Muslims will not see credibility in this objection at all, nevertheless, it shouldbe borne in mind that a common Muslim cannot digest “Islamic” banking while he feels that other factors of business are notreally Islamic.

We can’t argue with these objections as these have due weightage and the management of IFIs should take these objectionsseriously. However, we should not forget that the prime objective of Islamic finance is to ensure that “financial” matters are dealtwith in line with Islamic Shariah. In other words, environment does not make anything haram. Needless to say, from a Shariahperspective, one can always buy a halal product from a store where everything else is haram although the same needs to beavoided if other options are available.

Islamic bankers don’t know Islamic bankingThis argument, once again, has key significance from the perspective of the overall control environment of these banks withregard to the applicability of Shariah principles. Particularly, it is astonishing when you deal with an Islamic banker who knowsvery little about Islamic banking, but unfortunately, this is not uncommon. The main reason is that most IFIs have hiredconventional bankers and generally there is no or very little consideration to ensure that they are well versed with the Shariahrequirements with regard to the modes of finance being used by these banks. Similarly, the IFIs do not spend enough onresource­building for Shariah compliance and training of their staff, in comparison to what they spend on marketing.

Having trained “Islamic bankers” and performed Shariah compliance reviews, we may safely conclude that this objection is notwithout substance. This, accordingly, is a strong indicator that the IFIs should allocate more resources to staff training andShariah compliance.

Another objection concerns the appointment of Shariah boards and advisers. People have largely noted that the majorcontribution in this field in Pakistan is limited to a small group of jurists, most of whom are related to a single family and theirpupils (a single religious university).

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Another question is that generally the honorariums, consultancy fee and other benefits offered to such jurists by the IFIs inPakistan and abroad are quite high and may jeopardize their independence. In addition, they appear to be the only ones whoare wholly and solely responsible for Shariah compliance. They approve the products, review the transactions and in the end,they perform the Shariah audit themselves. This gives rise to a conflict of interest (without casting any doubt on their personalindependence and integrity).

Those familiar with the business and operations of Islamic finance disagree with this observation because the contribution ofthese people to the industry as a whole is remarkable and they deserve more than that. The general concept that a “Moulvi”should be paid the minimum for his life is not justifiable. If you are benefiting from their efforts, knowledge and skills, then theyshould be justifiably rewarded.

Having said that, the writers submit that the opinions of jurists from other schools of thought should also be sought and theyshould necessarily be provided opportunities to enter the field. For this purpose, the proposition from the State Bank that a juristshould not be allowed to hold more than one remunerative position as a Shariah adviser or member of a Shariah board is agood one. This will ensure fresh blood which will eventually improve the overall Shariah compliance in the field as well as helpthese institutions to innovate fresh products.

There are also claims that IFIs use conventional insurance. This is a valid objection. It was a real issue that according to legalrequirements, as well as derived from real “compulsion”, the banks were required to obtain insurance coverage fromconventional insurance companies and this practice was allowed by the Shariah advisers to the extent of compulsion only. Thissituation, Alhamdulillah, has changed following the introduction of Islamic insurance, or Takaful, in Pakistan.

Unfortunately, some IFIs still have not begun to offer Takaful. To date, three Takaful companies and a family Takaful companyhave commenced operations in Pakistan and now this lame excuse of compulsion cannot apply anymore. It’s high time that theState Bank and the Shariah advisers take steps to ensure that the IFIs do not patronize any conventional insurance companyeither in respect of owned assets or against assets held under security.

Should we still prefer Islamic banking?In conclusion, one may say that we are required by our religion to implement a complete Islamic way of living in our individualand collective lives and the society and the government as well. The Islamic banking and financial system is part of such asystem and is not construed to be applicable in isolation while other laws and customs repugnant to the Shariah requirementsare still in force.

However, for our own benefit, in order to avoid interest by ourselves with a view to providing interest­free opportunities to ourbrothers and sisters in Islam, we should promote and support Islamic banking and finance in the country to the best of ourability. We should not try to pull the legs of an infant who is just trying to take his first step towards a long journey. However, weshould try to ensure that he commences his journey the right way, on a strong footing.

Such form of Islamic banking may not be perfect, but can provide us a reprieve from interest­based transactions for now, andmight support us in augmenting a truly Islamic financial system. More appropriately, it will serve us well when we are in aposition to implement the complete Islamic way of living. Omar Mustafa Ansari is a chartered accountant by profession, and currently partner of the Islamic financial services group atFord Rhodes Sidat Hyder & Co (a member firm of Ernst & Young Global Limited). Faizan Ahmed Memon is manager ofIslamic financial services at the same firm.Omar has vast experience in audit, Shariah compliance and providing related services to the Islamic finance industry inPakistan, and is the author of Managing Finances — A Shariah Compliant Way. Faizan has worked on Shariah audits andproduct development. He was previously a Shariah coordinator and Shariah auditor at a leading Islamic bank.

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