Essentials of Successful Islamic Banking

By Lawai, Hussain | Economic Review, October 1994 | Go to article overview

Essentials of Successful Islamic Banking


Lawai, Hussain, Economic Review


Islamic banking, as some instances in post-communist Russia have shown, can provide business solutions even in situations where the conventional banking techniques fail to accommodate. The conventional interest-based banking is mainly a business of financial intermediation between savers and entrepreneurs. It earns its profit by borrowing at one rate of interest from those who have surplus and lending it a higher rate to those who can use it profitably.

Islamic Banking, on the contrary, is sharing the fruits of economic activity generated through intermediation of savers and investors. The reason for elimination of interest in banking transactions is its prohibition in Islam. The injunctions against interest, synonymous to riba, are explicit and the word, under various connotations of prohibition, appears several times in the Holy Quran. It extends to financing for trade and industry involved in prohibited goods and services.

Islamic banking is emerging in an era when the world is settling down to a free market economy and when phenomenal changes are taking place in the global economy. A free-market economy envisages three essential features - free trade, open capital market and minimum governmental intervention. The vagaries of protectionism and regionalism are transforming the economy to free trade and globalism. The changes could provide ample scope for the Islamic banking to grow and work in competitive environment. Requisites of Islamic Banking

Islamic banking, being an integral part of an Islamic economic system can be practiced more effectively in an environment which conforms with the tenets of Islam. Thus there are some essential requirements for a successful Islamic banking, such as:

i) Supportive Legal Framework and Swift Judicial System: An effective legal framework ensuring speedy justice is essential for a good society, it is more so for the success of Islamic banking, because its investment risk is more than that of a conventional interest-based bank as its dealings are on profit and loss basis.

ii) Disciplined Entrepreneurship: It would minimise cases of malfeasance and mismanagement. Besides, a banker must extend from being merely a financier to a role-player in business. Although a Murahaba transaction in Islamic banking does provide an opportunity to banker to share in business, the Islamic banks generally limit themselves to being an inactive partner for their credit risk only. The real entrepreneurial role of an Islamic bank needs, therefore, to be increased.

iii) Conceptual Change from Credit Risk to Overall Risk Management: While it is difficult to predict, with any degree of certainty, the operating results of an enterprise and the magnitudes of profit and loss, all the same, it seems unjust if the party providing the capital is guaranteed a fixed and predetermined rate of return, and the other party undertaking the enterprise is made to bear the uncertainty alone. Under the circumstances, an Islamic banker has not only to focus on credit risk but also to view all the business risks of the enterprises in which he has invested the banks + money.

iv) Strong Ethical Values: The Islamic economic system offers a balance between the two extremes of public or social and private or individual ownership of property. The success of Islamic banking in a society is related to the extend of acceptability of the doctrine of trusteeship and transformation of the self-interested and profit-oriented behaviour of people into an altruistic and value-oriented behaviour.

v) Supreme Sharia Council: The function of Sharia Council in maintaining Islamic banking activities in a country within the orbit of Islamic injunctions is dependent on its legal status and the extent of implementation of its opinion.

The opinions of Sharia Councils of different countries may not necessarily be uniform. There is, therefore, a need for a Supreme Sharia Council representing Muslim community all over the world to deride about various issues confronted by Islamic banks. …

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