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Introduction
The financial institutions that are mostly found in the Middle East and specifically in Saudi Arabia are predominantly referred to as Islamic Banks. Islamic bank is a term used to define financial institutions that are governed by tenets of Islamic laws and regulations. The Islamic banking system is quite different from the financial practices of mainstream banks. Generally, Islamic Banking differs from other forms of banking systems in various aspects particularly the interest-free banking and lending system which is going to be one of the main focuses for this study.
Although Islamic banks are not in the mainstream the impact they have on the world financial market is significant. By 2003 the General Council for Islamic Banks and Financial Institutions approximated the number of operational Islamic banks worldwide to be not less than 250 fully fledged financial institutions with operations in more than 50 countries and a combined annual turnover of US$300 billion (Hassan). At the time Islamic banking share market for financial transactions was also estimated at 15%, over the years we can only assume that this share has significantly increased as well as the number of new financial institutions.
Basically, Islamic banking is similar to mainstream banking in practice and in most other routine functions, however, it differs in areas that pertain to interest on loans, cash deposits profit and loss sharing which are the unique features of the banking system that sets it apart from other mainstream financial institutions (El-Gamal).
The Islamic laws that govern the issues that involve finance are collectively referred to as Fiqh al-Muamalt, which describes the profit and loss sharing principles that are used by Islamic banks among others.
Islamic Banks Concept of Lending and Cash Deposits
The Islamic banks approach lending is very unconventional in that the bank does not give out the loan to a borrower per se, but instead acquire the asset on behalf of the borrower who is then supposed to institute repayment to the banks in installments; this is usually referred as Murabaha when the loan is made towards the mortgage (El-Gamal). Another unique feature of Islamic banking pertains to its approach to lending; it does not set out uniform interest rates to all clients but rather customize interest rates to match the company’s financial performance. This means clients that have high-profit returns are charged more, a concept defined by the floating rate interest on loan system (El-Gamal). These values and features of Islamic banking are the backdrops in which we are going to analyze the unique role that Islamic Banks undertake as far as lending and cash deposits are concerned.
To understand the role that Islamic Bank serves in financial matters that involve lending and cash deposit it is important to understand the major functions of a typical Islamic Bank. The functions of Islamic banks go beyond the mainstream banking functions in that an Islamic bank doubles up as a trader, investor and consultant with mandates that go beyond the traditional profit maximization concept (Hassan).
As such the distinct nature of Islamic banking has advantages that arise as a result of its financial transactions and which are also its disadvantages. The major feature of Islamic banking is confined to the bank’s concept of Profit and Loss Sharing (PLS), in this arrangement the banks depositors are strictly speaking not creditors to the bank per se, but rather very similar to shareholders who stand to absorb a certain percentage of the bank’s losses as outlined in the banking contract (Hassan). This means that depositors in an Islamic bank are actually the bank’s shareholders rather than their creditors as is the case for conventional banks. This would therefore mean that the role of the bank in this arrangement is that of an investor who is responsible for investing the customer’s cash deposit wisely. The implication of this arrangement is that Islamic banks are more insulated from financial losses that emanate from depositors’ capital than their conventional counterparts.
The features that are inherent in the Islamic banking system are both disadvantages and advantages to the bank. The Islamic bank’s contract for example between the banker and the depositor provides for risk sharing between the two parties including other elements that protect the depositor from non-procedural banking operations that can result in losses. Even though a depositor in an Islamic bank is usually regarded as an investor who cannot lay claim to their cash deposit in case of financial losses, the Islamic banking regulations provide for fiduciary risk. Fiduciary risk is where a bank is obligated to compensate the depositor with full deposited funds or face legal actions in such a case where the losses have been determined to have been caused by the bank’s negligence. Closely associated with this type of risk is Displaced Commercial Risk, a form of risk that Islamic banks are exposed to whenever they move to top up the depositors “perceived profit sharing”, to be at par with interests that the other banks are offering at the time (Hassan 2004).
This type of risk occurs because Islamic banks are essentially investors for their customers which is a duty that requires them to provide depositors with a form of dividends from any profit that the banks incur. This is despite the fact that the bank profits might not be sufficient to provide for such percentage but which they are compelled to pay or face depositor’s financial sabotage. In order to do this, the bank has to re-allocate the bank shareholders’ funds by toppling their profit-sharing obligations to cover the shortfall. Indeed, the current way in which Islamic banks calculate CAR is an indicator of their unique banking system such as the failure of the banks to charge interest rates to their customers. Because of Ijarah or Murabaha, the bank has adopted a form of a matrix format to calculate CAR at any given time during the various stages where a borrower is servicing the loan. More so the bank risk changes from price risk to credit risk, a feature that must be incorporated in CAR calculations (Hassan).
The importance of CAR in Islamic bank financial transactions is of great importance because both lending and deposits are central features of this concept. This is because CAR enables a bank to ensure that its capital base assets are at a minimum of 8 percent of its assets. The rule of thumb that applies is lending of $12 for every single dollar of the bank’s capital, this is what is referred to as Capital Adequacy Ratio (CAR) or at other times Capital to Risk Assets Ratio (CRAR). The purpose of calculating capital adequacy is to ensure that a bank is not exposed to financial risks that are caused by the lending policy of the institution. In many countries including Saudi Arabia government regulations requires the financial institutions to comply with the minimum acceptable level of Capital adequacy which is the other reason why banks need to establish the CAR which ultimately influences the bank’s lending and deposit policies.
Another unique feature of financial products that are found in Islamic banks is referred to as Sukuk; Sukuk is the equivalent of what the universal banks refer to as bonds, but which does not provide for fixed interest rates or indeed any form of interest at all (Hassan 2004).
Because of the lending approach of Islamic banks, Basel I capital adequacy guidelines which is a universal framework on financial regulations have failed to provide a workable framework that can apply in the case of Islamic banks because of their peculiarity. Nevertheless, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has adjusted the CAR calculations to allow their applications by Islamic financial institutions and thereby strengthen their financial stability. In addition, the new Basel II new guidelines have provided for these adjustments to an extent; for instance, the new guidelines expanded the form of risks that can be calculated to include credit risk, price/market risk, therefore, enabling Islamic banks to calculate CAR for Risk Weighted Assets (RWA). This is an anomaly that also interferes with CAR calculations which analysts have suggested be addressed by having the depositor’s capital shifted to the numerator so that it can be factored together with the tier I and tier II capitals.
Islamic banks are therefore able to calculate most forms of credit risks using the standard approach method, but there are other cases where credit risk calculations do not apply such as in Musharaka and Mudaraba. In such cases, the banks normally apply specialized lending guidelines that are outlined in Basel II such as the “supervisory slotting method” or the “equity position risk in banking book method” (Timberg). Despite this, Islamic banks continue to face challenges and unique risks as well, for example, the Sharia Compliance Risk (Timberg). This is a form of risk faced only by Islamic banks which includes financial losses encountered due to financial transactions that arise from non-recognition of specific sources of income or losses associated with compliance to the banking system. The importance of these guidelines that are mentioned here is because they further the Islamic bank’s core mandate competently.
Conclusion
In an analysis of the roles of Islamic banks in lending and depositing cash, it is important to note that Islamic banks’ greatest risk is caused by the bank’s unique feature of the Profit and Loss Sharing (PLS) system. On another hand, it can be argued that Islamic banks lending ideology that does not charge any interest rate to borrowers is a disadvantage in that it is a form of incitement that attracts dubious borrowers with no intention to repay the money. As a result, Islamic banks are more likely to post high numbers of credit defaulters compared to other conventional banks. It is, therefore, necessary to institute precautionary measures that will act as a deterrent to potential defaulters of loans that have been given out by the banks.
References
El-Gamal, M. Islamic Banking Corporate Governance and Regulation: A call for Mutualization, 2005. Web.
Hassan, M. Issues in the Regulation of Islamic Banking: The case of Sudan, 2004. Web.
Timberg, A. Risk Management: Islamic Financial policies. Islamic banking and its Potential Impact, 2000. Web.
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