Islamic Banking Vs Conventional Banking

however, although they have succeeded in this effort and havemanaged to create a
market niche for Islamic banking, they do notseem to have achieved the market d
epth that could ensure long-termprofitability and survival. This stems from the
fact that they appear tobe far behind in technical innovations and financ
ial marketdevelopments that in recent years have revolutionized finance andcapi
tal markets. There is no evidence that these banks have made anylarge investment
in research and product development, nor is thereany evidence that new financia
l products developed in recent years,particularly in equity derivatives, have be
en utilized to any significantdegree by the major Islamic banks. This is unfortu
nate because themarket opportunities that these banks have been able to develop,
toallow funds from Islamic communities to be placed in Islamicallypermissible p
ortfolios, can and will be exploited by more efficient andinnovative Western fin
ancial institutions that already have or willdiscover this market niche.While th
ere is considerable room for competition and expansion in thisfield, the long-te
rm survivability of individual Islamic banks will dependon how rapidly, aggre
ssively, and effectively they can developtechniques and instruments that wo
uld allow them to carry on a two-way intermediation function. They need to find
ways and means of developing marketable Shariâ ah-based instruments by which assetpor
tfolios generated in Muslim countries can be marketed in the Westas well as mark
eting Shariâ ah-based Western portfolios in Muslimcommunities.
b. The challenge of adopting an Islamic financial system
The most important challenge for Islamic banking is in its system-wideimplementa
tion. At present, many Islamic countries suffer fromfinancial disequilibr
ia that frustrate attempts at wholesale adoption of Islamic banking. Financial i
mbalances in the fiscal, monetary andexternal sector of these economies cannot p
rovide fertile ground forefficient operation of Islamic banking. Major structura
l adjustmentsparticularly in fiscal and monetary areas are needed to provide Isl
amicbanking with a level playing field. Additionally, adoption of a legalframewo
rk of property ownership and Contracts that would clearlyspecify the domain of p
rivate and public property rights as well asstipulation of legally enforceable r
ights of parties to contract that fullyreflect the requirements of the Shariâ ah, are
necessary to allow anoperational framework conducive to efficient operation of
Islamicbanking.
16

Islamic Banking Vs Conventional Banking

An Islamic financial system can be said to operate efficiently if, as aresult of

its adoption, rates of return in the financial sector correspondto those in the
real sector. In many Islamic countries fiscal deficits arefinanced through the
banking system. To lower the costs of thisfinancing, the financial system is rep
ressed by artificially maintaininglimits on bank rates. Thus, financial repressi
on is a form of taxationthat provides governments with substantial revenues. To
remove thisburden, government expenditures have to be lowered and/or revenuesrai
sed. Massive involvement of governments in the economy makes itdifficult for the
m to reduce their expenditures. Raising taxes ispolitically difficult. Thu
s, imposing controls on domestic financialmarkets becomes a relatively easy
form of raising revenues. Under theabove circumstances, it is understandable wh
y governments wouldhave to impose severe constraints on private financial operat
ions thatcan provide higher returns to their shareholders and/or depositors.This
makes it very difficult for Islamic banks and other financialinstitutions to re
alize fully their potential. For example, Mudarabahcompanies that can provide hi
gher returns than the banking systemwould end up in direct competition with the
banking system fordeposits that are used for bank financing of fiscal deficits.W
hile Muslim countries may, for legitimate reasons, opt for an Islamicfinancial s
ystem, for the economy as a whole to benefit fully from theoperations of such a
system, it is necessary that (a) governmentexpenditures are fully rationalized,
(b) revenues from taxation, andthose derived from property legitimately placed w
ithin the governmentdomain by the Shariâ ah, are raised to meet the expenditure needs
thegovernment, (c) the financial sector is liberalized so that returns tothis s
ector reflect returns to the real economy, (d) equity markets aredeveloped to al
low financing of investment projects outside bankinginstitutions, and, finally,
(e) the structure of the banking systemshould be such as to allow strong banking
supervision and prudentialregulation commensurate with the risks involved
in varioustransactions.* To accomplish the last objective, the banking structu
recan be tiered in accordance with principal Islamic financialtransactio
ns. It is reasonable to assume that risks involved inMusharakah or Muda
rabah financing, are different from those involvedin trade-type financing. It
follows, therefore, that prudentialregulations of these transactions should
be different.
17

Islamic Banking Vs Conventional Banking

Motivating Factors for Islamic Banking

Motivation and renewed interest in Islamic finance industry stems fromits strong
economic, financial and social considerations, backed by itsunique features.Mos
t significant is its appeal to add to financial diversity andinnovation being sk
ewed towards:
(i) Asset backed and equity based transactions, whichpromote entrepreneur friend
liness and considerationof project viability(ii) Equitable distribution of risks
and rewards amongthe stakeholders;(iii) inculcating market discipline and highe
r ethicalstandards given its emphasis on non-exploitationand social welfare.
In the wake of high Asian domestic savings rates and build up of theregionâ s foreign
exchange reserves as well as oil surpluses of MiddleEast in the last few years,
Islamic finance is now also emerging as away to wealth management, both of rich
er nations and highnet worth individuals