Attitudes towards Islamic finance

CHAPTER - 2

LITERATURE REVIEW

Islamic economics and finance have failed to confine the interest of western writers, and it has developed in separation from its western counterpart. It can be put right this deficiency by giving references to support for the prohibition of interest in Western literature, the creation of business cycles in capitalist economies and the facts on attitudes towards Islamic finance.

In Islam banking and finance interest is prohibited because it is based on principle called (shariat) which is prohibited interest on loan, interest charged on loan is with out effort so this is a reason that it is prohibited. Islam gives many reasons about the prohibition of interest some of them are that. The first reason is asceticism from expenditure is not a justification of rewards. The Second reason is that interest rates are no moral foundation. Third is that there is difference between money and capital. Islam redefined the relationship between creditor and debtor, the creditor are those who provide funds and becoming a partner in the project , in entrepreneurship they take risk activity and share the profit it a pre-agreed point, but not charge a fixed return as in the conventional banks. The creditor and debtor equally shares the profit and loses.

In Islamic countries the new banking system is based on Islamic economic principles, which is growing with fast developing. Now the government is giving consideration to this new banking system, and it is important because of the high growth of investment amount in the Islamic banks. This system is important due to growth of investment amount in Islamic banks. The developments in Islamic banking system have encouraged many studies. But, it has given little important to application of modern finance theories to Islamic banks. Islamic economic principles are characterize by the use of managerial techniques and models advanced in the conventional financial framework. Islamic banks principles based on the Islamic Law (Shariat). The Islamic banks principles are different from conventional banks. The conventional banks is charging fixed interest rates while Islamic banks use profit sharing principles (PLS) through its two accounts: Musharaka and Mudaraba.

Al-Sultan (1997) create a model which shows the effect of the profit and loss sharing (PLS) principle on the commercial loan market in the Islamic interest-free banks operating alongside with conventional banks. Islamic banks operate on a set on principle based on Islamic laws (Shariat). Many Islamic countries have Islamized their whole financial banking system like Iran, Pakistan, and Sudan.

There are complete Islamized banking system in Indonesia, Malaysia, Bangladesh, Brunei, Jordan, Kuwait, and the United Arab Emirates. Though, there are also a large numbers of Islamic banks in Turkey, Egypt, and Bahrain. The most prohibited thing in Islamic law is the prohibition of interest or usury Khan (2006) noted that in interest rate and usury are same thing. Both are replaced by other forms of benefits as described in Aryan (1980). Shehab (1999) describe a case in which he shows that Islamic banks are different from conventional banks.

Interest Rate and Islam

Islamic Economic system is based on mutual sharing of receipts and risks to prevent a un-equality among the people. For this argument it have different point of view on interest rate or Riba which are explain in the following segment.

The treatment of interest rates or Riba in Western literature

In Islamic economic system interest is prohibited in Islam, In Islamic banks in the place of interest base product, it uses a profit/loss sharing (PLS) financial instrument. Not only is the prohibition of interest rate unique in Islamic literature but also prohibited in religious and not religious literature over many decades ago. Western literature gives many arguments about the prohibition of interest in term of the relationship between interests, use of money, the cause of work effort and social division. Historically, interests were opposed on grounds of social divisions as recommended by the Old Testament loans without interest. Lending on interest is blame worthy action but it is evidently justified. Jewish and Christian also against the interest rate ((Stein, 1956, p.142). A borrower need money so they get it with interest from the lender because he need money and lender want to become worthy, the borrower also pay interest plus the capital and it have in huge tension. It is inequality to charge interest on the capital (Philo, De specialibus legibus, 2.74- 77; cited in Maloney, 1971, p.105). Judaeo-Christian thought over the centuries have recognized economic brotherhood and sharing of risks (Dar and Preley (1999). Christian teaches that love thine enemy which are the prohibition of interest. In western literature interest is prohibited because income on the lone is without effort. Brunner (1937) regards interest as encourage a 'parasitical existence' literature. Aristotle said that money is a medium of exchange and not a store of value. Others researchers have blamed about interest that interest is creating instability and economic fluctuation. The justification of interest claims on the bases on the state of 'time is money but it is unwarranted to justify discount through positive time preference.

Interest rates and the business cycles

There are a strong relationship between interest rates and instability of macroeconomic through the capitalist economy, inflation and unemployment etc. There are difference between money rate of interest and normal interest rates that the previous are determined by monetary forces in the loan able funds market, e.g. first in banks there is a credit creation and money supply growth but latter on they have determined by the profitability of investment.

(Adam Smith, 1904, p.337). Adam Smith said that when quantity of money is increase so it will increase the prices level but it can not affect the rate of profit and it also can not affect the interest.

(Mill, 1826, p.646) said that a business can make most error because he thinks that when the quantity of money change so it always change the interest rate.

Wicksell (1935) suppose the full employment in his model which he developed. Hayek (1939) can study the Wicksellian cumulative process in terms of fluctuations in employment over the cycle. The Hayek conclusion was different from the Wicksell's conclusion. These two authors' theories were supported by the "financial instability hypotheses, which give reason that interest rates create instabilities.

Keynes (1936) criticizes the role of interest rates and bank credit in the cyclical process.

Klein (1965) argues that when the normal rate of interest rate increases the money rate of interest so the investment increased and vice versa and the difference of opinion between the two rates is responsible for price movements.

There is a 'tradition' in western economic literature, not exploited by Islamic scholars, which blames interest rates and associated bank credit expansion and contraction for many of the economic evils of our time.

Keynes (1936) was explaining that in reality how people behave in this world. Neoclassical macroeconomics had specified that a rational people can think for his own interest only and not for the whole society or the world. Now in the modern economy everyone think about her self, but in Islamic economic theory, people, and governments can think about the welfare of the whole society, as described in the Quran. But, in reality, Now Muslims do not behave which is said in the Islamic economic theory and in Quran. It has necessary in western economics to understand the behavior of Muslims and know start research about the balance between Islamic theory and practice.

The Islamic scholars also need to search the behavior of Muslims about Islamic banking system and free interest rate and get instruction from the western theory which is exploiting the difference between the perfect Islamic system and the current opinion of Muslims around the world.

The interest rate and Islamic banking

Islamic banking system is based on the Islamic law (shairat) principles. The Quran give permission about trade but prohibited the usury and the interest rate. For these principles the Islamic banking system is different from the western conventional banking system.

Quran prohibited the usury because if there is inequality about the distribution of profit between the entrepreneurs and investor, there will be difference between the poor and the richer. So Islam says that there are equally distribution of profit between the investor and the entrepreneurs. However, it is unfair to guarantee a return on the capital and give a loan on that situation in which the lender can not make any effort. For this the Islamic bank can create profit and loss sharing account PLS.

In Business operations the Islamic banks give idea that they can charged fixed rates on their services which they provide and also there business operation, the Islamic bank get fund by create interest-free current account just like the western banking system can create or by a profit sharing basis account.

The particular principles in Islamic banks are that investors will get share in bank profit and losses but in western banking system they will charge fixed interest rate. The holder also get share in the bank profit and losses in the short and long term basis. (Khan, 2007).

The long term deposit has a higher profit and loss sharing ratio because the long term deposit contains high risk. To get high profit share, the depositors will keep their funds it the end of the contracted period which he promise to the banks. This feature show the banks to a high liquidity risk if losses are expected. For this reason the banks have to give notice before withdrawals.

Funds are used in both profitable and non-profitable issues. The profitable uses means that they invest in trade or give loan on profit sharing basis and the non-profitable uses means that they give loan to the customer and the entrepreneurs it an interest-free rate. (Usmani, 2000).

Profitability in Islamic banking

The first Islamic bank which is based on the concept of interest-free banking was established by Mit Ghamr saving bank in 1963 at the Nile delta of Egypt and now Islamic bank is growing rapidly with size and number of players, and now more that 50 countries the Islamic institutions can work in Muslim, Arabic countries and elsewhere, e.g. Islamic banking, system international holding in Luxembourg (1978) and Daral-Mal in al-Islam in Switzerland (1981), etc. Notwithstanding the present of conventional banks in Islamic countries, now these countries also starting encourage the interest-free operations in Islamic banks.

Conventional banking systems are concentrating on an order to find the infuence affecting the profitability of banks. Brucker (1970) said that high concentration give high interest on a business loan and also led to high profitability. Sudan and Guan (1997) they made a relationship among profitability, interest rate and market share in Islamic banks. Dual banking systems are that systems in which both conventional banks and Islamic bank can work.

Islamic banks unique features are PLS principle which is based on a partnership Musharaka (joint venture) or Mudaraba (partnership on the business but investor can not take part on the management). In Islamic banks are more account like Murabaha or leasing contract (Ijara). However, conventional banks can not offer these account and they operate there account on interest base. (Bashir, Darrat and Suliman, 2003).

The Islamic banking activity is same like conventional banking activity. Banking activity like foreign exchange transactions, domestic and international transfers, letter of credit and proving safe custody, But the difference is that the Islamic bank operates with the principle of no interest of PLS principle. And they share the risk with the borrower (Metwally, 2003).

Khan (2007) showed that Islamic bank have higher degree of stability than the conventional banks. Islamic banks based on the profit and loss sharing (PLS) principle which consists on high risk and high return.

The PLS account is based on risk-sharing, which allow the Islamic bank to invest in long-term project because is consist on high-risk which give high return and due to this the economy also growing. (Chapra, 1992; Mills and Presley, 1999).

The foundations of Islamic banking

Islamic banking is based on Islamic law "Shariat". The Islamic law is based on four business principl, which are profit and loss sharing (PLS), fixed charges and free charges. The other principles are based on the nature of Islamic operations. In PLS, there are two varieties of principles, namely: Mudaraba or profit sharing and Musharaka or participatory financing.

The PLS principle is applied through

  • The Musharaka can be defined as that the both parties contribute the capital in the business and divide the profit and loss at a pre-determined proportions.
  • The Mudaraba can be defined as that the supplier provide the fund for the business and the entrepreneur can use it in the project and they both agree at a portion of profit. In case if the entrepreneur doing loss, then the supplier bears the investment loss and the entrepreneur loss his time and effort.
  • The mark-up principle is applied through many activities. The best known is the Murabaha in which the bank can buy a good for his customer and resells to it the customer which consist the original cost plus the profit margin in which the bank and the customer agree on the contract.

The first principle is based on profit and loses sharing "PLS "and the Mudaraba. this two principles defined as that the agreement between the two parties, one is the supplier and the other is entrepreneur. The supplier doing investment in the business and the entrepreneur can use this fund in a project and they agreed a portion of profit in the project. If entrepreneur doing loss in the business, the suppliers can loss is investment and entrepreneur can loss it time and effort. (Khan, 2006).

Another contract applying the mark-up principle is the leasing (Ijara contract) which can be defined as that the bank buy an asset to the customer and then give it to the customer it lease for a certain period of time at a fixed rental charge. If the client need the assets then they purchases it form the bank. And after some time the leasing price is less and it the time of the end the assets is fully converted it the name of the customer. (Nienhaus, 2003).

The other principles is Wadiah (safekeeping) and Rahn (pledge).The depositor keep money with the bank in account and whenever the depositor need it, he can with draw his amount any time the bank can keep the depositor money safe and bank give him a reward as a gift .The reward is in only in case if the bank have profit. (Ibid).

The nature and characteristics of the Islamic theory of the firm

The Islamic bank main objective is to fulfill welfare of the Muslim as described in Islamic law (Shariah). Islamic bank follow the Islamic ethical principal shariah. Islamic law against maximize of wealth in the society. Prohibition of act, causes of bad thing and give more important to the private benefit over the social benefit, Islamic law against these things.

All firms in the world they want that there firms can maximize the profit and as well as welfare (Falah). Islamic firm is bound to follow the ethical values of shariah, and the essential principle is the principle of economic trusteeship, which says that the major object of the Islamic firm will not to maximize the profit but it is important to do good to please God. Finally, a separate analysis must be applied to corporate Islamic finance because interest is prohibited in financial transactions (Metwally, 2003).

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