From a humble beginning in the 1960s in Egypt, Islamic banking has witnessed a significant development in terms of growth and size. With 15-20% growth annually, Islamic banking has widened its horizons to all major parts of the world and is now operating in more than 75 countries. Although the first commercial Islamic bank was established in 1975, the idea of having Islamic banking started way before that. CHOWDHURY SHAHED AKBAR attempts to explore the origin and development of Islamic banking.
The theoretical work
Although the basic foundation and principles of Islamic banking and finance were drawn from the Quran, Sunnah and contemporary practices of financing during the pre-Islamic and Islamic era, the theory of Islamic banking as a new phenomenon started to appear during the 1940s through to the 1960s, in Urdu, Arabic and English.
In the pre-Islamic era financing principles were either Riba-based or Mudarabah and Musharakah-based. Since interest (Riba) is prohibited in Islam, the jurists of the early-Islamic period closely examined the features of Mudarabah and Musharakah and developed a detailed framework of juridical opinion in regard to these two types of arrangement to make them fully compatible with Shariah. The abundance of juridical opinions of these two types of arrangement actually laid the foundation of the modern Islamic banking theory and the earlier scholars in modern times discussed the possibility of Islamic banking on the basis of these very principles.
Among the earliest proposals for Islamic banking was one made by Qureshi (1946) in his book ‘Islam and theory of interest’. He suggested that both an Islamic bank and an entrepreneur can create a partnership. However, his notion of partnership was unclear as he suggested that capital will be provided by one party and work will be done by the other party while profit and loss will be borne by both parties. Ahmed (1952) in his book ‘Economics of Islam’, reiterated the same view with the proposal of establishment of Islamic banks on the basis of a joint stock company with limited liabilities. He held the view that customers could deposit their capital on the basis of partnership. Later contributions including those of Uzair (1955), Irshad (1964) and Al-Arabi (1966) also suggested that Mudarabah should be the main principle for Islamic banking.
Siddiki (1985; published in the Urdu language in 1968) provided an elaborate theoretical foundation of Islamic banking and a detailed framework of financial intermediation. He proposed an Islamic banking mode on the basis of Mudarabah and Musharakah and classified the operations of Islamic banking into three categories: service-based fees, commission and other fixed charges; financing on the basis of Mudarabah and partnership; and services provided free of charge.
Chapra (1985) proposed the concept of Islamic banking on the same profit and loss sharing (PLS) basis and for the first time he promoted the idea that Islamic financial institutions are investment institutions rather than typical financial institutions. His idea of banking was in line with the proposal of earlier scholars and provided a much more fertile ground for PLS arrangements in the banking models. He further developed the idea that Islamic banks should serve the public interest rather than individual or group interest. Hence, they should play a social welfare-oriented role rather than a profit-maximizing role.
The above discussion indicates that PLS-based models such as two-tier Mudarabah were examples of the application of the fundamental principle for banking in the earliest theory. However, practitioners of Islamic banks, especially in the Arab world, did not see much scope in this model and it was also challenged by scholars in terms of its application in modern banking systems as it lacks the ability to provide financing for consumer goods and goods supplied to government and industry, etc. Therefore, during the 1970s and 1980s, a significant development occurred in terms of proposing other principles that are Shariah compliant on one hand and capable of meeting the demands of growing customers who wanted the same sort of products they used to get from conventional banks on the other. The most significant development during that period was the introduction of sale-based principles. Based on Quranic verses (2:275) which clearly distinguished Bai (trade) and Riba (interest) – the two very common transactions in the pre-Islamic era – and comments from various Shariah scholars in this regard, it was concluded that Bai can be spot or deferred. The Fiqh scholars mentioned the following five forms of deferred sales which became the cornerstone of non-PLS-based principles in Islamic banking and granted added capacity to Islamic finance to offer liability-creating financing or debt-based financing:
Salam – in this type of sale, the price is paid at the time of contract and the object of the sale becomes due as debt in kind.
Muajjal – the object of sale is delivered at the time of contract but the price becomes due as debt.
Istisnah – the price is paid at the time of contract and the object of the sale is manufactured and delivered later.
Ijarah – sale of the usufruct of the assets in exchange of periodic rentals.
Murabahah – sale with a known profit which may or may not create debt.
From theory to reality
While the first theoretical works began in the 1940s, the experimental works in this regard did not start until the 1960s. In 1963, the Mit-Ghamr Islamic Savings Bank (MGISB) started in Egypt which is regarded as the first Islamic bank in the world. However, a number of scholars such as Wilson, Traute and Siddiki pointed out that a number of interest-free savings and loans societies were reported to have been established in the Indian subcontinent during the 1940s. According to Traute (1983) and Wilson (1983), an attempt was made to establish an Islamic bank in the late 1950s in a rural area in Pakistan, though this had no lasting impact.
On the 25th July 1963, a pioneering experiment in the form of MGISB, started in the county of Mit-Ghamr in Egypt. The purpose was to mobilize idle savings of the majority of the Muslim Egyptian population without violating the laws of Shariah and to provide them with Halal returns on their savings as well. The experiment proved quite successful and the savings mobilization was impressive. It came to an end in February 1967 after only three and a half years due to political reasons beyond its control.
In 1963, Malaysia established the Pilgrims Fund Corporation or Tabung Haji, which started operations with the objective of enabling Malay Muslims to save gradually for expenditure incurred during their Hajj (pilgrimage) and to facilitate active and effective participation in investment activities that are permissible in Islam through their savings.
In 1973, the Phillipine Amanah Bank was also established to enable Muslims to meet some of their financial needs without involving interest.
Establishment of IDB
During the 1970s institutional involvement began and IDB was established. It was founded in 1973 by the finance ministers at the first Organization of the Islamic Conference with the support of the king of Saudi Arabia at the time and began its activities on the 20th October 1975 in Jeddah, Saudi Arabia. Its initial share capital was supplied by its member countries. The main objective of IDB is to foster economic development and social progress of member countries and Muslim communities individually as well as jointly in accordance with the principles of Shariah.
Commercialization of Islamic banks
In 1975, the first private commercial Islamic bank, Dubai Islamic Bank, was established by a group of Muslim businessmen from several countries. In 1977, Faisal Islamic Bank was established in Egypt and Sudan. During the same year, Kuwait Finance House was set up by the Kuwaiti government.
Within 10 years since the establishment of Dubai Islamic Bank, more than 50 Islamic banks came into being not only in Muslim countries but also in some of the European countries. Currently, global Islamic banking assets constitute 75% of more than US$1 trillion in the Islamic finance market. Islamic banking has widened its horizons to all major parts of the world and is now operating in more than 75 countries. The countries which are witnessing increasing growth in this sector are: Malaysia, Iran, Bangladesh, Pakistan, Indonesia and countries of the GCC i.e. Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. Moreover, a number of western countries are now concentrating on Islamic banking. In the UK, along with Islamic windows, a fully-fledged Islamic bank named Islamic Bank of Britain has been set up. To tap into this growing market, large conventional banks have opened Islamic windows including HSBC, Barclays, BNP Paribas, Citigroup, Deutsche Bank, Standard Chartered and the Royal Bank of Scotland.
Islamic banking at the state level
Efforts have been made to introduce Islamic banking at the state level as well. Pakistan first ‘Islamized’ its banking system between 1979 and 1985 through a series of ordinances issued by the federal government and a number of circulars issued by the State Bank of Pakistan. Iran introduced usury-free banking laws in 1983 and nationalized all banks in the country. Sudan launched Islamic banking in 1984 and made the entire financial sector Islamic in 1989. Malaysia introduced Islamic banking in 1983 by introducing the Islamic Banking Act. Malaysia’s effort in this regard is unique as it introduced a dual banking system which was the first of its kind. The Indonesian government established Bank Muamalat in 1994 – the first Islamic bank in the country.
S&P (2012) estimates that over 2011-15, the growth rate for Islamic banking will be about 20% annually. This growth can be expected due to various reasons. Firstly, Islam is the world’s second largest religion after Christianity with over 1.0-1.8 billion comprising 20-25% of the world population while most estimated figures point to a population of 1.5 billion Muslims worldwide (www.adherents.com). This huge population has welcomed Islamic banking due to religious obligations.
Secondly, Islam provides a framework that shapes the moral and ethical behavior of a growing number of investors in Islamic banking. There has been a trend of investing in socially responsible investments in the major financial market over the last decade. In the US alone, from 1997 to 2000, the size of socially responsible investments doubled from US$1.19 trillion to US$2.16 trillion (Hakim & Rashidian, 2002). Islamic investment resembles socially responsible investment as both prohibit investment in business activities that are detrimental to people. This resemblance has granted added capacity to Islamic investment to penetrate into the human conscience and the reality of shifting towards Islamic investment is gaining momentum. Thirdly, the chronic financial crisis of conventional banking across the globe infused the need of looking for an alternative system that can protect investors from the crisis. The world observed the advantage of Islamic banking during the recent financial crisis.
However, Islamic banking is not without its challenges. It faces many disputes and clashes due to the existence of a dual system in society. These need to be addressed properly so that the clashes can be minimized and challenges can be tackled. Therefore, the future success of Islamic banks will not only depend on the size or outreach, but also on how conducive the regulatory and supervisory framework is for Islamic banks to reach their full potential.
Chowdhury Shahed Akbar is working in Southeast Bank in Bangladesh and has a postgraduate degree in Islamic banking, finance and management from the UK. He can be contacted at [email protected] .