Origin and development of Islamic Banks

Major experiments of exercising the Islamic principles into financial transactions have started with the setting-up of the Mit-Ghamr Saving Association in a small Egyptian village called Mit-Ghamrfrom 1963 to 1967 (Iqbal and Molyneux, 2005). Moreover, in 1962, another Islamic implication was a saving organization, called Tabung Haji,

located in Malaysia for Muslims who are willing to perform pilgrimage to Mecca (IFSB, 2007).

The Mit-GhamrSaving Association derived the concept from German saving banks. It used to hold small savings, mainly through interest-free saving accounts, from the rural areas (Ariff et al., 2012). Nevertheless, depositors willing to invest in productive sectors were entitled to small, short-term, and interest-free loans as incentives (Iqbal and Molyneux, 2005). They were allowed, also, to withdraw their savings on demand. Moreover, investment accounts, based on the profit and loss sharing concept, began to finance particular projects of entrepreneurs (Iqbal and Molyneux, 2005).

In 1976, Mit-GhamrAssociation was succeeded by the first interest- free bank, called Nasser Social Bank. The main purposes of the public-owned Nasser Social Bank were social including providing interest-free loans to the poor and needy borrowers, scholarships to students, and micro-credits to small projects based on the profit and loss sharing model (Iqbal and Molyneux, 2005). In 1975, a group of businessmen founded the world’s first Islamic commercial bank, the Dubai Islamic Bank (DIB), in Dubai in the United Arab Emirates (UAE) (Iqbal and Molyneux, 2005).

The major significant development in the history of Islamic banking occurred when the Islamic Development Bank (IDB) was founded in 1975. The IDB is a multilateral development financing organization originated to promote the economic and social development of the member countries and Muslim communities in compliance with the principles ofShari'ah (Islamic Development Bank, 2013). The IDB was initiated as an international financial foundation following the announcement of purpose resulted from a conference of Islamic countries’ ministers of treasury held in Jeddah- Saudi Arabia, in December 1973 (IDB, 2013). The announcement was approved by the representatives of twenty-three countries which were members of the Organization of the Islamic Conference (OIC) (Hassan and Lewis, 2009). The IDB started to operate in 20thof October 1975 following an opening meeting of the Board of Governors of the IDB that occurred in Riyadh, Saudi Arabia (Iqbal and Molyneux, 2005).

The industry grew progressively over the 1980s, but it is not until the early 1990s that the demand for the investments and loans that are in compliance with the Shari'ah

principles began to rise drastically. Over this term, Islamic banking developed into a feasible financial intermediary. Also, numerous Shari’ah-compliant financial instruments were issued. The period was distinguishable by the opening of a vast number of privately owned Islamic banks operating under different socio-economic circumstances. Moreover, three countries including Pakistan, Iran and Sudan, expressed their intention to remove interest from their total banking system to comply with Shari’ah principles (Iqbal and Molyneux, 2005). Currently, Iran has a banking system that is entirely Islamic and Shari’ah complied. Several global banks like HSBC, Citibank and more have also opened Islamic windows and started to offer

Islamic financial instruments. This was considered clear recognition and acceptance of the Islamic financial intermediation by international organizations, International Monetary Fund (IMF), and World Bank (Iqbal and Molyneux, 2005). The amount of assets managed under Islamic finance has been estimated increasing from US$ 150 billion in the mid-1990’s to around US$ 2 trillion in 2014 (The Economist, 2014). On the other hand, Islamic banking is still considered to be a growing industry and needs more time to be corresponding to the well- developed conventional financial intermediary in spite of significant growth and solid performance (Ariff et al., 2012). It has made considerable progress towards that end, but there are still several challenges that it has to confront. Numerous unresolved theoretical issues and operational problems, mainly related to the poor regulation and corporate governance of Islamic banking system, may constrain further growth and effectiveness of the industry. Hence, the Islamic banking industry is still at an evolutionary stage, it has scored a number of successes, but a lot more needs to be achieved.

Table2.1 Difference between Islamic & conventional banks' financial instruments Deposit Mechanism

Al WadiahCurrent Deposit Bank promises to return the deposits in full and the depositors do not receive any payment from the profit or other return

Current Deposit

It is equivalent to Al Wadiahcurrent deposit

MudarabahSavings Deposit Bank invests the savings at its own risk, but ensures to return the entire deposits full return and to share any profit.

Savings Deposit

Bank safeguards deposits provided by customers in return for interest payment. The depositors are capable to withdraw the held amount.

MudarabahTerm Deposit Savers share the profit and loss resulting from the projects financed by the bank. Consequently, they are not eligible to deposit’s withdrawal and do not receive any interest. The return is based on the actual profits generated from the investments operated by the bank.

Fixed or Term Deposit

This account is opened frequently for a definite term. Depositors obtain different interest rates for different terms of fixed deposits. Usually, the savers cannot withdraw the funds from these accounts. However, withdrawals might be allowed in special situations.

Investment Mechanism

Murabahah

The customer requests the bank to provide funds to his specific requirement or project. The bank then notifies the particular customer about the markup the bank would like to receive. Then, the final cost is paid through installments. The ownership of the asset remains with the bank before selling it to the customer.

Cash Credits

The bank permits the borrower to request cash beyond the limit of the credit by issuing cheque. Interest charges are based on the day-to-day balance of the account.

Overdrafts

The bank lets the borrower overdraw amounts of money greater than his credit balance but defined to a specific limit.

Source: extracted from different sources, i.e.; Noman (2002), Alam (2003), Hussein (2004), Kamali (2007), and Ahmad and Hassan (2007), modified.

Table 2.1: Difference between Islamic & conventional banks' financial instruments continued Deposit Mechanism

Bai'-Salam

It is a sale of commodity to bedelivered on a future date for cash price. Payment is made in advance to the seller who makes in return the delivery of commodity of defined specification on a precise due date. Usually, the items traded under this mode consist of agricultural products.

Purchase or Discount of Bills

A customer makes an agreement with the bank by initiating a Letter of Credit which assures that the bank will pay the customer’s bill on a particular date and beyond in return for pre-determined interest return. If the bill found to reach well prior the mentioned, the bank might buy the bill, if requested, on discount.

Qard al Hassan

It is an interest-free loan that contributes socially in financing profitable activities.

Loans

A loan is a requested amount of funds paid in advance to a borrower. The sum can be re-paid in full at a definite time or by pre-agreed installment. Interest is applied usually on such type of transactions.

Musharakah

In this type of Islamic financial contract, one or more entrepreneurs seek financing of a project from an Islamic bank. The latter provides the funds and is able to participate in the management of the given project. The profits or losses are shared among parties corresponding to a pre-agreed ratio or as per the capital contribution.

Mudarabah

It represents a contractual agreement between two parties. One party provides the necessary funds whereas the second party offers the expertise and management. The profits are distributed based ion pre-agreed proportion, whereas only the financier absorbs the losses.

Ijarah

It is equivalent to operating leases (Sale- leaseback/Lease-buyback) or financing leases (lease-purchase). The investor rents a given project or asset for a definite amount and over a specific period of time. The ownership of the asset is kept with the investor during the transaction where he sustains all the expenses which are related to the asset’s ownership. On the other hand, the lessee has to cover fully the costs resulting from utilizing the asset. In the case of a lease-purchase, each payment presents a portion of the final price of purchase and transfer of ownership of the asset.

The bank is not permitted to apply any additional charges on the client in case of delay in payment of the rentals since it is assumed to be a Riba. However, Islamic jurists have reached a solution that is the defaulted customer could be requested to make a payment to charity

Conventional Leasing

It is a contractual agreement between landlord and tenant for leasing a specific asset. The lessor maintains the ownership of the given asset which the lessee uses for a definite term in return for a series of rental fees. During the period of the transaction, the ownership of the leased property goes to the lessee. In case of default, the lessee incurs charges as penalties. Buying the given asset at a discounted price at maturity should not be an option included in the contract. At the expiry of a contract, the underlying asset should have a different value from the initial value of lease. The lease rate is based on market rate of interest.

Source: extracted from different sources, i.e.; Noman (2002), Alam (2003), Hussein (2004), Kamali (2007), and Ahmad and Hassan (2007), modified.