Week 3: A Framework of the Islamic Financial System – Part 1

Week 3: A Framework of the Islamic Financial System – Part 1

“Introduction, Strategic Role & Service of Financial Institutions … The Working of Commercial Banks … The Working of Investment Banks & NBFIs … Working of Financial Markets and Operations of an Islamic Bank … Macroeconomic Impact”
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Summaries

  • Week 3: A Framework of the Islamic Financial System - Part 1 > Introduction, Strategic Role & Service of Financial Institutions > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > The Working of Commercial Banks > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > The Working of Investment Banks & NBFIs > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Macroeconomic Impact > Unit
  • Week 3: A Framework of the Islamic Financial System - Part 1 > Islamic Investment Banking > Unit

Week 3: A Framework of the Islamic Financial System – Part 1 > Introduction, Strategic Role & Service of Financial Institutions > Unit

  • Hello and welcome to the chapter”A Framework for Islamic Financial System.
  • Financial institutions such as commercial and investment banks, micro-credit institutions, savings and loans institutions, they act as intermediaries linking the saving surplus units and the saving deficit units.
  • Financial institutions charge a rate of return from the fund users, and give part of the return to the fund owners, and they retain the excess of the amount deposited for themselves.
  • On completing this chapter, you’ll be able to explain the strategic role of the financial institutions in society, describe services and benefits that these financial institutions provide to society, explain how commercial banks and investment banks essentially work, explain the nature of non-banking financial institutions and the financial markets, describe the primary characteristics of an Islamic financial system, and describe the basic operations of an Islamic bank.
  • You’ll be able to identify the most suitable organizational model for an Islamic bank, describe the two types of deposits that the Islamic investment banks can provide, explain how deposit may be managed by Islamic bank, identify the appropriate modes of financing for which Islamic banks can invest upon in diverse sectors, and recognize the difference between the profit and loss sharing, and exchange contracts approaches used by Islamic banks to generate return.
  • Describe the advantages and disadvantages of profit or loss sharing approaches adopted by Islamic banks, explain the types of services the Islamic investment banks can provide, the characteristic… Now we like at the strategic role of financial institutions in society.
  • It coordinates and standardizes the services of international banks and financial institutions at a global level.
  • Developmental financial institutions, they operate in dual mode as a banking and non-banking institution.
  • They organize and they facilitate the funding of syndicated loans, and also they provide a lot of financial advisory services.
  • Financial institutions, they provide a variety of services and enjoy the benefits due to the size and nature of services they offer.
  • Financial intermediaries benefit from certain advantages, primarily the economy of scale and the economy of scope, leading to the lower fixed cost per transaction, owing to their specialization and in use of specialized equipment, the reduction in financing cost due to stronger capability in obtaining the credit information crucial to the financial transactions, easy access to borrowers’ sensitive and crucial financial information due to their history of exercising discretion in financial dealings, and production of financial merchandise at lower cost when compared with that for the individual consumers.

Week 3: A Framework of the Islamic Financial System – Part 1 > The Working of Commercial Banks > Unit

  • Most commercial banks undertake the following functions: obtaining deposits with checking facilities, funding short and medium term loans, for overdrafts, discounting bills and commercial papers, they provide advances against securities for business and households, financing long-term mortgages and investing their depositors’ funds, offering merchant banking and exchanging the foreign currency and money.
  • Other types of accounts such as savings, term deposits, notice deposits, certificates of investment or commonly known as the certificate of deposits, are fee-based deposits and hence they do earn a return.
  • Let us look into more detail now about deposits and liabilities.
  • The main types of deposits are current accounts, which are maintained by corporate clients and individuals to avail credit facilities.
  • These are accounts where the funds are locked for a fixed period of time and carry a fixed rate of interest.
  • Term deposit receipts or TDRs, are issued on at par and are discounted value and they grow in value at the given time frame.
  • Advanced profit paying products are accounts where the expected profit is discounted and paid in advance, comparable to a term deposit receipt issued at discount.
  • These deal with deposit of money for an agreed period and for a fixed rate of return or at a rate concurrent with the activities in a capital market.
  • They provide productive loans, are offered for trade and commerce and housing.
  • Consumption and consumer durable loans are offered for household items and automobiles.

Week 3: A Framework of the Islamic Financial System – Part 1 > The Working of Investment Banks & NBFIs > Unit

  • As general investors do not conform with the investments of the size required for small and start-up companies.
  • Investment banks mobilize medium and long-term finance for the closed or open-ended funds by issuing certificates of investment and they offer assured dividend accounts without checking facilities.
  • Certificates of investment holders avail pre-agreed interest income and dividend at a certain rate for a period of deposit.
  • They do facilitate the raising of funds for business and commerce directly from the saving surplus entities or households.
  • These non-bank financial institutions, they finance various sectors in the economy, such as discount houses, leasing companies, venture capital companies, asset management and fund management companies, and insurance companies.
  • Non-bank financial institutions assist business and industry through direct intermediation between the savers and the investors.
  • Some non-bank financial institutions actually deal in real estate as well and they manage property and other finances to earn fixed and variable returns, like interest or dividends.

Week 3: A Framework of the Islamic Financial System – Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit

  • Financial markets in the conventional framework comprise of money and capital markets.
  • Money markets is based on receipts and payments of interest on short-term lending and borrowing and trading in short-term debt instruments.
  • Capital markets is based on dealing in medium- and long-term debt instruments, medium- and long-term equity-based transactions, as well as foreign exchange trade.
  • Financial markets are further divided into the primary and the secondary markets.
  • Islamic financial institutions or IFIs perform the same functions of an intermediary between the surplus and deficit units.
  • The main difference between an Islamic institution and a conventional one is the dealing in interest, which is replaced by dealing in a number of other alternative financial instruments which do not generate interest per se.
  • Islamic financial institutions can retain the ownership right of assets and thus are responsible for the liability of a loss which is born by them.
  • An Islamic bank is a banking institution that takes deposits and performs all banking activities except interest-based borrowing and lending.
  • On the other hand, commercial banks with shared capital charge for all the services they provide.
  • Banking activities can be categorized activities for mobilizing funds and investing funds.
  • An Islamic bank shares its net profit with the customers based on the size and the maturity value of their deposit.
  • Investing of the funds: On the assets side, deposits in the investment accounts may be invested through actual partnership in a business where the bank makes profit-sharing investments or in interest-free modes, which are in accordance to the principle of Shari’ah, such as advancing funds on a profit and loss sharing basis or purchasing assets at a fixed return basis.

Week 3: A Framework of the Islamic Financial System – Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit

  • Let us now look at the organizational model for Islamic Bank.
  • The three organizational models that a bank can adopt according to their span of activities are; Universal Banking Model, the Bonafide Subsidiary Model where all the subsidiaries have their own capital and separate operations, and thirdly, the Bank Holding Company Model, where a bank holds separate organizations owned by it for different activities.
  • Examples include investment banking, Murabaha, or trade transactions and commercial banking.
  • The first two models, Universal Banking and Bonafide Subsidiary Models, may not be best suited for Islamic banks due to the nature of their operations.
  • The best suited model for Islamic Banks is the Fully Owned Subsidiaries Model.
  • If they establish a number of subsidiaries for various types of operations like investment banking, commodity trade-based banking, lease-based banking, Istisna’a-based banking, and the normal commercial banking.
  • The modes available to Islamic banks or their subsidiaries in order of preference would be, Musharakah or equity participation, Mudarabah, profit-sharing and loss-absorbing, three Ijarah, four, Bai Mu’ajjal or Liz’mn Mu’ajjal which is a mode of trading in real goods and sale contracts with a deferred payment.
  • Islamic Banks must innovate techniques in order to mobilize deposits and safeguard depositors from loss.
  • The two types of deposits offered by Islamic Banks are Current Deposits and Saving Deposits.
  • Banks shall guarantee the principal amount of the deposits, and banks and the depositors shall agree at the time of the account opening whether the bank is allowed to use the money in its business or not.
  • The characteristics of this Saving Deposits in Islamic Banks are all remunerative deposits In Islamic Banks including saving deposits shall be accepted on a profit and loss sharing basis.
  • Risk-prone deposits are treated as part of the bank’s equity and involve a weightage system on a daily product basis.
  • Let us assume that the bank launches the following deposit tenors: three months, six months, and one year.
  • The bank undertakes the business with these funds from the pool and the profit earned is shared between the partners in the agreed ratio.
  • Assuming that the profit-sharing ratio between the bank and the pool was set at 50% each and the bank deploys 10,000 U.S. dollars into the pool funds for one month, and it generates a profit of $1,000 at the end of that month.
  • In the case of unrestricted investment accounts, the bank is free to use the deposits for any Shar ́ah compliant financing.

Week 3: A Framework of the Islamic Financial System – Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit

  • Islamic banking practice is open to utilizing all rightful modes, including those based on shirkah, which is a partnership arrangement, trade or lease, finance trade, industry or budget deficit through domestic and foreign sources.
  • Banks should manage diversified portfolios and select proper modes to avoid risks.
  • Some of the common modes are musharakah or mudarabah, murabaha, musawamah, assalam, istisna’a, ijaraha and istijrar.
  • For trade and industry, the appropriate modes of financing to use and their purposes are as follows: murabaha, installment sale and leasing, and assalam.
  • These modes are suitable for trade, purchasing of raw materials and inventory.
  • In the agriculture and forestry industry, the appropriate modes of financing to use and their purposes are as follows: murabaha and assalam.
  • Ijarah Muntahia Bittamleek, assalam and murabaha modes are also suitable for tube wells, tractors, trailers, farm machinery and transport that include fishing boats.
  • Diminishing musharakah or rent sharing is best suited for storage and other farm construction, like sheds for animal fencing, etc.
  • Operating ijarah and assalam is specific to land development, and assalam and Musaqah is best suited for orchards, nurseries and forestries.
  • For consumer finance, the appropriate modes of financing to use and their purposes are as follows: Murabaha, leasing and interest-free loans are provided for personal finance, for consumer durables.
  • Wakala and murabaha are suitable for cash financing through charge and credit cards.
  • Ijarah Muntahia Bittamleek and murabaha are the alternatives for auto finance, and murabaha, diminishing musharakah and rent sharing are suitable for house finance or mortgages.
  • The treasury operations in Islamic banks also must use Sharia compliant modes for their liquidity management and their investments.
  • Islamic banks may sell, purchase Sharia compliant money and capital market instruments such as stocks and sukuk.
  • For public sector financing, the appropriate modes of financing to use and their purposes are as follows: Government and public sector enterprises can purchase equipment or utility-generating assets through mudarabah or musharakah certificates.

Week 3: A Framework of the Islamic Financial System – Part 1 > Working of Financial Markets and Operations of an Islamic Bank > Unit

  • The majority of scholars believe that Profit-and-Loss Sharing which encompasses musharakah, mudarabahand and their variants are the main instruments that can replace the interest based system.
  • The idea of replacing interest by a profit-sharing arrangement in the relationship between the depositor and the bank, and the arrangement between the bank and the client business was first debated during the period 1940s to the 1960s, and it gained considerable approval in the 1980s and 1990s.
  • Islamic Banking and Finance should rely on profit sharing contracts to achieve the objective of economic justice, efficiency and stability of the economic system Mudarabah, shirkah or the acquisition of shares of joint stock companies is the best form of financing.
  • Exchange Contracts for instance and deferred prices are more relevant to Islamic financial institutions and equally legitimate as per Qur’anic injunctions.
  • The substitution of an interest-based system by a profit-sharing system raises a number of fundamental, theoretical, practical, and policy questions.
  • The key questions are; What theoretical framework forms the basis of Islamic Banking and Finance? Will the Islamic system be more or less stable than the conventional interest-based system? What effect will the adoption of an interest-free Islamic system have on important macroeconomic variables such as saving and investment? And will monetary policy have a role to play in such a system? Let’s look more closely at the theoretical framework for applying profit-and-loss sharing approach in Islamic Banking.
  • Islamic Financial System is a complete system that replaces the interest-based transactions with a form of profit-and-loss sharing.
  • In contrast in the traditional system, either the bank or the government guarantees such deposits which often lead to the need for intervention in times of crises.
  • Research in the stability of an Islamic Banking System has shown the following; that an equity-based Islamic system may be better able than the interest-based banking system to adjust to banking crises.

Week 3: A Framework of the Islamic Financial System – Part 1 > Macroeconomic Impact > Unit

  • On the macroeconomic impact of profit sharing system, research findings suggest that in a fully Islamic system, the cost of monitoring would be minor and equity participation arrangement will be superior to the interest-based system.
  • There is not full consensus on this matter, which is highlighted by some other research, which would suggest that a profit sharing arrangement between the lender and the investor as in Islamic finance system may actually increase the monitoring cost, and thus could have an adverse effect on the supply of credit and consequently on investments.
  • By implementing a legal and institutional framework based on Shari’ah, Islamic nations can facilitate contracting and safeguard the terms of contracts.
  • A Mudaraba, for example, serves as the source of business conducted by the combination of funds and financial expertise.
  • Mudaraba Sukuk can be issued to raise funds and fortify trading and industrial activities.
  • Shirkah-based or profit and loss sharing modes can be used for short, medium, and long-term project financing, import financing, pre-shipment export financing, working capital financing, and the financing of all single transactions.
  • Special purpose vehicles or SPVs manage such assets as trusts or funds for their own benefit, as well as for the Sukuk holders.
  • In practice, the most popular forms of Islamic financing are Murabaha and Ijara, and not the equity-based instruments, Mudaraba and Musharaka.

Week 3: A Framework of the Islamic Financial System – Part 1 > Islamic Investment Banking > Unit

  • Islamic investment banks handle a portfolio for institutions, corporate clients, high net worth individuals and pooled investment mediums, such as unit trusts and mutual funds.
  • Asset management, a major aspect of investment banks, comprises of equity funds, real estate funds and alternative investments in ijarah and of a sukuk.
  • The opportunities for Islamic asset management are open and closed end mutual funds, the availability of equity benchmarks and leasing companies involved in asset backed financing.
  • Their services relate to venture capital and corporate finance, includes syndication finance, project finance and transactions in the capital markets.
  • Their services include equity issues such as IPOs, office for sale and rights issues, private placements, strategic reviews, financial restructuring, acquisitions, divestments, mergers and joint ventures.
  • Syndicate financing is a large financing facility granted to key industrial and trading companies and are lead managed by a bank of a strong base.

Return to Summaries.

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