RISK ANALYSIS FOR ISLAMIC BANKS – Book Sample
Principles and Development of Islamic Finance
Islamic finance is a rapidly growing part of the financial sector in the Indeed, it is not restricted to Islamic countries and is spreading there is a sizable Muslim community. More recently, it has caught the attention of conventional financial markets as well. According to some estimates, more than 250 financial institutions in over 45 countries practice some form of Islamic finance, and the industry has been growing at a rate of more than 15 percent annually for the past five years.
The market’s current annual turnover is estimated to be $350 billion, compared with a mere $5 billion in 1985.1 Since the emergence of Islamic banks in the early 1970s, considerable research has been conducted, focusing mainly on the viability, design, and operation of “deposit-accepting” financial institutions, which function primarily on the basis of profit- and loss- sharing partnerships rather than the payment or receipt of interest, a prohibited element in Islam.
Whereas the emergence of Islamic banks in global markets is a significant development, it is dwarfed by the enormous changes taking place in the conventional banking industry. Rapid innovations in financial markets and the internationalization of financial flows have changed the face of conventional banking almost beyond recognition.
Technological progress and deregulation have provided new opportunities, increasing competitive pressures among banks and non-banks alike. The growth in international financial markets and the proliferation of diverse financial instruments have provided large banks with wider access to funds. In the late 1980s, margins attained from the traditional business of banking diminished. Banks have Principles and Development of Islamic Finance
- Institutions offering financial instruments and services compatible with the principles of Islam are emerging rapidly in domestic and international financial markets.
- The basic framework for an Islamic financial system is a set of rules and laws, collectively referred to as Shariah, governing economic, social, political, and cultural aspects of Islamic societies.
- Prohibition of riba —a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales”—is the central tenet of the system. Such prohibi- tion is applicable to all forms of “interest” and therefore eliminates “debt” from the economy.
- Efforts to develop financial intermediation without interest started in the 1960s. Several Islamic banks were established in the 1970s, and their number has been growing since then.
- The last decade has witnessed rapid developments in the areas of financial innovation, risk man- agement, regulation, and supervision.
responded to these new challenges with vigor and imagination by forging ahead into new arenas. At the same time, markets have expanded, and opportunities to design new products and provide more services have arisen. While these changes have occurred more quickly in some countries than in others, banks everywhere are developing new instruments, products, services, and techniques. Traditional banking practice—based on the receipt of deposits and the granting of loans—is only one part of a typical bank’s business today and often the least profitable.
New information-based activities, such as trading in financial markets and generating income through fees, are now a major source of a bank’s profitability. Financial innovation has also led to the increased market orientation and marketability of bank assets, which entail the use of assets such as mortgages, automobile loans, and export credits as backing for marketable securities, a process known as securitization.
A prime motivation for innovation has been the introduction of prudential capital requirements, which has led to a variety of new financial instruments. Some instruments are technically very complicated and poorly understood except by market experts, while many others pose complex problems for the measurement, management, and control of risk. Moreover, profits associated with some of these instruments are high and, like the financial markets from which they are derived, are highly volatile and expose banks to new or higher degrees of risk.
These developments have increased the need for and complicated the function of risk measurement, management, and mitigation (control assessment).
The quality of corporate governance of banks has become a hot topic, and the approach to regulation and supervision has changed dramatically. Within an individual bank, the new banking environment and increased market volatility have necessitated an integrated approach to asset-liability and risk management.
Rapid developments in conventional banking have also influenced the reshaping of Islamic banks and financial institutions. There is a growing realization among Islamic financial institutions that sustainable growth requires the development of a comprehensive risk management framework geared to their particular situation and requirements.
At the same time, policy makers and regulators are taking serious steps to design an efficient corporate governance structure as well as a sound regulatory and supervisory framework to support development of a financial system conducive to Islamic principles.
This publication provides a comprehensive overview of topics related to the assessment, analysis, and management of various types of risks in the field of Islamic banking. It is an attempt to provide a high-level framework (aimed at non-specialist executives) attuned to the current realities of changing economies and Islamic financial markets. This approach empha- sizes the accountability of key players in the corporate governance process in relation to the management of Islamic financial risk.
PRINCIPLES OF ISLAMIC FINANCIAL SYSTEMS
The Islamic financial system is not limited to banking; it also covers capital formation, capital markets, and all types of financial intermediation and risk transfer. The term “Islamic financial system” is relatively new, appearing only in the mid-1980s. In fact, earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either “interest-free” or “Islamic” banking. However, interpreting the Islamic financial system simply as free of interest does not capture a true picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating social justice, risk sharing, the rights and duties of individuals and society, property rights, and the sanctity of contracts.
An Islamic economic system is a rule-based system formulated by Islamic law, known as Shariah. The Shariah consists of constitutive and regulative rules according to which individual Muslims, and their collectivity, must conduct their affairs. The basic source of the law, in Islam, is the Qur’an, whose centrality in Islam and influence on the life of Muslims cannot be overemphasized. Its chapters constitute the tissues out of which the life of a Muslim is tailored, and its verses are the threads from which the essence of his or her soul is woven.
It includes all the necessary con- stitutive rules of the law as “guidance for mankind.” However, it contains many universal statements that need further explanation before they can become specific guides for human action. Hence, after the Qur’an, the Prophet Muhammad’s sayings and actions are the most important sources of the law and a fountainhead of Islamic life and thought.
The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. Whereas the conventional financial system focuses primarily on the eco- nomic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, which seek to enhance equality and fairness for the good of society as a whole.
The system can be fully appreciated only in the context of Islam’s teachings on the work ethic, distribution of wealth, social and economic justice, and role of the state. The Islamic financial system is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. This closes the door to the concept of interest and precludes the use of debt-based instruments.
Given an understanding of the role of institutions, rules, the law, and ideology of Islam, one can make the following propositions regarding the economic system:2
- The foremost priority of Islam and its teaching on economics is justice and equity. The notion of justice and equity, from production to distri- bution, is deeply embedded in the system. As an aspect of justice, social justice in Islam consists of the creation and provision of equal opportu- nities and the removal of obstacles equally for every member of society. Legal justice, too, can be interpreted as meaning that all members of society have equal status before the law, equal protection of the law, and equal opportunity under the law. The notion of economic justice, and its attendant concept of distributive justice, is characteristic of the Islamic economic system: rules governing permissible and forbidden economic behavior on the part of consumers, producers, and govern- ment, as well as questions of property rights and the production and distribution of wealth, are all based on the Islamic concept of justice.
- The Islamic paradigm incorporates a spiritual and moral framework that values human relations above material possessions. In this way, it not only is concerned about material needs but also establishes a balance between the material and spiritual fulfillment of human beings.
- Whereas conventional thinking focuses on the individual, society, or community and appears as a mere aggregate having no independent sig- nificance, the Islamic system creates a balanced relationship between the individual and society. Self-interest and private gains of the individual are not denied, but they are regulated for betterment of the collectivity. Maximizing an individual’s pursuit of profit in enterprise or satisfaction in consumption is not the sole objective of society, and any wasteful con- sumption is discouraged.
- The recognition and protection of the property rights of all members of society are the foundation of a stakeholder-oriented society, preserving the rights of all and reminding them of their responsibilities.
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