Assignment on Challenges faced by Islamic Banking System

            Islamic Banking system is gaining credibility in different countries due to its interest free and profit and risk sharing mechanism. The sharia compliant banks follow ethical and moral standards which are derived from QURAN and SUNNAH. Islamic shariah model of banking system is attracting the customer due to its Riba free system. Islamic banks also survived the Global Financial Crisis of 2008-2011 which showed how powerful the sharia complaint system is. Islamic financial model is not only attracting the Islamic countries but the west too. Some western Banks have also started offering Islamic banking services in the form of Islamic Windows. These Islamic Windows perform according to Sharia Law. Islamic banking is gaining strength in Muslim countries due to the support of their local government. While in western countries the reason of the popularity of Islamic institutions is due to its sharia compliant model which offers interest free banking. The demand for Islamic banking is increasing in western countries. But there is still large number of people who don’t know how the Islamic banking system works and how it is better than the traditional banking system. There is the issue off Islamophobia after September 11, 2001 as well which is keeping people reluctant to enter into Islamic financial system.The products offered by the Islamic Banks are sharia compliant and offer interest free solutions. These differ from conventional banks which offer loans at high interest rates and with strict returning policies. The Islamic banking system was required to purify the interest-based banking system that was prevailing in the whole world. Interest based banking system makes the rich people richer and poor people poorer. Islamic banking system on the other hand promotes interest (Riba) free financing which is according to the rules of QURAN and SUNNAH. Islamic banking is based on second surah of the QURAN where it is specified that ALLAH declares war against those who take Riba or charge interest (QURAN 2:278-279).

Islamic Financial System of Challenges faced by Islamic Banking System

            Islamic banking system consists of following institutions:

1.      Islamic Banks: Islamic windows of commercial banks, Central bank, Islamic windows of western banks

2.      Islamic Financial Institutes: Leasing financial institutes, housing finance companies, private capital funds, charity and religious rites focused Institutes

3.      Islamic Insurance: takaful

4.      Islamic financial capital market and its stakeholders

5.      Sharia Compliant payment system, screening system, Internet banking, accounting system, rating companies, education and research institutes

Difference in Islamic and Western Banking

            The Islamic banking system due to its humble nature has rapidly growing worldwide. It is gaining the attention of International financial community. The Islamic banking system model is same in terms of receiving deposits and advancing loans. It is the approach that makes it unique and beneficial for the economy. Islamic banks receive deposits from well earning people and gives loan to companies that are suffering from lack of investments. The loan is given on risk sharing and partnership basis. The deposits are also interest free. The bank shares the loss if it happens with the company and does not hedge the investments. The Islamic bank relies on the success of the business plan of its potential client. The bank analyses the business plan of its client and makes contract of partnership in profit or loss. This model ensures that the finance is given to real production rather than speculative endeavours.

            Islamic banking system operates according to Muslim Law and follows the QURAN and SUNNAH. There are some things which are prohibited (HARAM) in Islamic banking or economic activity which are as follows:

Riba of Challenges faced by Islamic Banking System

            Riba is an Arabic word which means increase or growth. In Islam it means unjustified amount in borrowing or lending money above the amount of loan whether conditional or unconditional. In Islamic banking world Riba is synonymous with interest rate. It includes interest on loans, bonds, deposits with fixed interest rates. Riba and Usury both are same and prohibited in QURAN: “But ALLAH has permitted trade and has forbidden Riba” (2:275). In Islamic banking money cannot be traded for money and delayed transaction is also prohibited. Islamic banks make joint venture with their client and the profit and loss from the investment or resale cost of investment is shared between them at an agreed profit margin.

Gharar of Challenges faced by Islamic Banking System

            In Arabic gharar means uncertainty. Gharar is defined in the Islamic financial world as contract that involves uncertainty. The contracts like forwards, futures, swaps and insurance that contains uncertainty falls into this category. Gharar contracts are usually vague and does not explicitly specify the terms and conditions. This contract also contains one side advantage at the loss of the other party. Due to this nature of the contract gharar is considered to be HARAM in Muslim Law.

Maysir of Challenges faced by Islamic Banking System

            Maysir in Arabic means gambling. Gambling or speculative contracts are explicitly considered HARAM in Muslim Law. Gambling also takes advantage of the uncertainty and huge amount of money can be lost or gained with betting. That’s why Islamic banks prohibit schemes like lottery and other similar contracts.

Halal Investment of Challenges faced by Islamic Banking System

            Halal investment means investment which is done in halal things. It is prohibition to invest in haram things like production of alcohol, pork, tobacco, black money, prostitution, pornography, drug trafficking, sorcery etc.

Challenges in Islamic Banking of Challenges faced by Islamic Banking System

            Islamic banking system is governed by the Shria Boards. Sharia Boards consists of religious scholars that analyse the product in the light of QURAN and SUNNAH to be Sharia Compliant. The challenge that the Islamic banks are facing that there is no central body that regulates the Sharia Law and because of it there is inconsistency in jurisdictions imposed by Islamic scholars. Although Islamic banking system has grown rapidly in recent years it also introduced some complexities in banking system and how to handle Islamic banking globally. There is a need of central Sharia Board that regulates Islamic banks on a global level. There is lack of harmony between Islamic scholars. Islamic banking although growing rapidly but still it is a new concept for many people. Early adopters are reluctant to switch, and some think it is the same as conventional banking system. Islamic banks are also facing serious competition from commercial banks which are operating long before there was concept of Islamic banking.

Difficulty in Attracting Depositors of Challenges faced by Islamic Banking System

            Islamic banks have focused their research on making interest free products but there is less research done on the product model itself. If the product being offered doesn’t posses’ financial benefits the customer will not be interested. In order to compete with modern banks, Islamic banks needs to devise its products in a way that attracts entrepreneurs and investors. Islamic banks need to make investment plans that are sustainable and cater to the needs of start-ups and young entrepreneurs. Islamic banks biggest hurdles are interest-based banks and stock market. There are also those people who just don’t want to take risk and earn profit on their savings. In a world where interest-based banks are prevailing Islamic banks needs to up their game in products department to remain competitive.

Extra Management Required

            Due to profit and loss sharing nature of products of Islamic banks they are required to analyse the business plan of its clients which requires extra budget for managing. Islamic banks must periodically monitor the project they are financing. They are required to make sure that the project is sustainable and profitable. This poses a risk of getting lots of projects that are not profitable, and the bank can face serious loses.

Simple Loan of Challenges faced by Islamic Banking System

            People who require loan for non-commercial purposes and loans that are required for personal needs can not benefit greatly from Islamic banks. Islamic banks which have limited funds will not be able to meet the requirements of these customers. Islamic banks majorly operate on profit and loss sharing model and this restricts them to offer pure simple loan without any risks. Depositors who are looking for profit on their savings without the risk of loss cannot benefit from Islamic banks. If the banks offer such saving account, they do not give profit on the same level as commercial banks.

Long Term Projects of Challenges faced by Islamic Banking System

            Long term projects or projects that show their returns in three or four years are not deemed suitable for Islamic banking. Islamic banks have to pay profit on their deposit every year, so they require large no of projects with quick returns. It restricts the Islamic banks in growing in large scale industrial sectors.

Need for Research of Challenges faced by Islamic Banking System

            Islamic banking system needs a proper centralized Sharia Board system that regulates the whole Islamic banking system. There is a need of harmony between scholars and to streamline the sharia compliant process. There are still complexities present in Islamic banking system even though they have been in the market for quite some time.

Use of Media of Challenges faced by Islamic Banking System

            Islamic banking system is still not utilizing the power of media. Commercial banks are using the power of media to strengthen their network. Islamic banking needs to be promoted on a global level. Although recently the trend has been seen in Islamic banks, but it still needs more marketing strategies to be able to remain competitive.

Conclusion of Challenges faced by Islamic Banking System

            In conclusion If a Saudi Islamic financial institution wants to establish its roots in west than it must make changes in its products that attract the western market. Islamic banks should focus on improving their products and offer solutions that are interest free and offer compelling benefits to the customers of west.