Islamic Banking and Finance Contributions to Economic Development of a Country

Islam prohibits riba because riba deprives justice and discourage people from undertaking real economic activities. Riba makes people putting hopes for reward rather than putting efforts to earn it. People with excess funds keep the money in the bank and earn interests. Banks lend the money they receive from depositors (surplus people) to borrowers (deficit people) and earn interests. Banks and surplus people, by having money excess money and lend it to the deficit people, are able to grow their money because of interest. The situation of the money grows from money through interest is the main core of conventional banking and finance systems. There is no additional increase of production in the economy. Although the system itself is growing (because of the payment of interest plus the principle amount), but the real economic activity actually did not take place.

The core proposition of Islamic finance draws from its inherent features and the values that it brings to the economy, and the tremendous potential that it offers in supporting sustainable economic growth and in safeguarding financial stability. These core propositions are derived from the Shariah, which dictates that Islamic financial transactions must be supported by underlying productive activities. This Shariah ruling ensures a close link between financial transactions and the real economy of a country.

Islamic banking and finance is strongly against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy of the country.

This decade has witnessed a dramatic transformation of the Islamic financial landscape. It has been marked by sustained rapid growth and the widening of its geographical reach, resulting in more diverse Islamic financial institutions and the generation of a wide spectrum of innovative products, particularly in the high-growth segment of the sukuk market. In this decade, Islamic finance has also evolved from being domestic-centric to become increasingly internationalised. In this dynamic environment, the scope of the Islamic finance business has expanded from simple retail and trade financing to include private equity, project finance, sukuk origination and issuance, as well as fund and wealth management products. This demonstrates that Islamic banking and finance has moved up its roles from a financial intermediary and financial market to be part of financial system of the country.

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth.

In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

The developments in Islamic finance have gained greater prominence in terms of their potential to improve financial stability outcomes, and most notably by the vital contribution that they make towards restoring the foundations for finance that supports sustainable economic growth, and bringing with it immense benefits to the real economic development and to the well-being of society of the country.

References:

1. Saiful Azhar Rosly (2005), Critical Issues on Islamic Banking and Financial Markets, Kuala Lumpur, Dinamas Publishing.
2. Abdul Ghafar Ismail (2010), Money, Islamic Banks and the Real Economy, Singapore, Cengage Learning.
3. Governor Zetty Akhtar Aziz's Speech at the Islamic Development Bank (IDB) Regional Lecture Series on Islamic Economics, Finance and Banking: “Finance and the Real Economy: Fostering Sustainability”, (2002), Jakarta.

Journal / Article Review: A Comparative Study of the Returns on Mudharabah Deposit and on Equity in Islamic Banks

By Authors:

Abdou Diaw and Abdoulaye Mbow (International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia

Journal / Article Review:

This write is trying to review and analyze a research paper on “A Comparative study of the returns on Mudharabah deposit and on equity in Islamic banks”. The article is co-written by Abdou Diaw and Abduulaye Mbow of the International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia. As the paper title specifically mentioned, the aim of the authors are to compare the return on investment in the both type of instruments that are mudharabah deposit and equity in the Islamic banks.

The research was conducted based on samples collected from nine Islamic banks of seven countries. The source of samples although seems very small but actually represents a significant portion of the total global Islamic banking institutions as they are the major players in their own countries. The chosen countries where the banks operate are the early adopters and leading players of Islamic finance and banking systems.

The authors highlighted that mudharabah contract and equity share same profile in terms of risk but are different on how they are rewarded. This is very true if we look at the actual return rate Islamic banks give to its mudharabah account holders. This has raised a question of fairness and transparency to those depositors who bear the risk of losing their capital investment. They also tried to discover how the adoption of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) accounting treatment for mudharabah deposit affects on this account.

In finding the comparative results, the authors employed the risk-return framework and regression analysis method on a set of data from selected Islamic banks. The methodologies employed are suitable in testifying the theory of risk-return on Islamic investment products by using the regression analysis. The calculations obtained were used to compare the percentage of Return between the Mudharabah Deposit (ROMD) and Return on Equity (ROE).

The authors have a clear understanding on the relationship between risk and return which has a positive relationship. For example, an investment in mudharabah account exposes the investors to either profit or loss depending on the performance of the business ventures. The same principle applies to equity investment. The investment with similar risk profile should yield comparable return. Thus, both types of investments should receive same treatment in terms of the return on investment. They also made the understanding on the study easier for those who do not have fundamental knowledge in Islamic finance by relating the risk profile in investment from pure finance viewpoint. That is to justify reasonable expectations from depositors for similar returns on Mudharabah deposit and equity.

But the authors did not find any proof in their research that the Islamic banks upheld this principle. They found out that the average returns on Mudharabah deposit are corresponding with the local interest rates. As generally practiced, the normal conventional deposit receives interest based on local interest rate as the benchmark. The finding has caused a great concern especially for those who expect a higher return for their mudharabah deposit whereas the conventional saving accounts are riskless since the offering banks guarantee both return and principle. Consequently, this situation may affect the attractiveness of mudharabah deposit in Islamic banks as compared to conventional deposits.

As the writers pointed out the similarities in terms of risk profile between mudharabah deposits and equity from the finance theory’s on risk return did not applicable at Islamic banks in this research. Two investments were rewarded differently. The ROE behaved in as similar fashion of the theory but the ROMD seemed to mirror the local interest rates.

There is an interesting observation by the writers on the effect of lower return from mudharabah investment that could cause large fluctuations and frequent movement of the funds in the banking system namely the Islamic banks and consequently give a negative effect on economy where fund stability is crucial for country’s payment system. A deep thought will be more plausible for Islamic banking to offer Wadiah type deposits rather than mudharabah if the lower return persist which is unfair to mudharabah account holders.

The authors’ study on comparison of return on investment in mudharabah and equity was actually not new. There were some other empirical works conducted that compare the return on these two types funds. Rosly and Zaini (2008) compared ROMD and ROE for six Malaysian Islamic banks in 2005 which found that ROE was higher than ROMD that exhibits a behavior similar to that of conventional-fixed deposit. Fixed deposit also used local interest rate as the benchmark to determine the return rate.

Sundarajan (2005) went a step further by examining the relationship among the returns on investment accounts, the returns on bank deposits generally in the banking system, the return on assets (ROA) and equity, and the level of risks. His analysis showed that in practice there is a considerable smoothing of returns on investment account despite wide divergences in risk, and hence very little risk sharing with investment. The “smoothing element” of return seems validated by the research paper authors when they found some Islamic banks have established two types of reserve namely the profit equalization reserve (PER) and the investment risk reserve (IRR). These two reserves could be the contributing factors why returns on mudharabah deposit are always lower than equity.

The result of the research showed that the ROE in the sample tend to be at least two times higher than the ROMD, even though the risk is similar in many aspects. There was also no signicant difference, in respect to the return on mudharabah and equity, between those banks following AAOIFI standards and those who do not.

This research should be followed by a more deep study on creation of an Islamic investment product other than mudharabah deposit that meet the risk and return theory and at the same time practiced as well as observed by Islamic banks. If an investment portfolio is exposed to higher risks, then it should be given higher returns. This is because there are portion of investment communities who are willing to put in their money for more return as long as the investment is Shariah compliant, free from usury and permissible.

Reviewed by: saupee

Islamic Finance: Time Value of Money, Islamic and Conventional Perspectives

ISSUE:

Some scholars in Islamic economics argued that the concept of time value of money is a key to the door or riba which is prohibited in Islam. However, some scholars are of the opinion that time value of money is a concept valid in Islamic economics. What are your opinions on this issue?

DISCUSSION:

Islam prohibits riba because riba deprives justice and discourage people from undertaking real economic activities. Profit earned from money that is loaned to debtor is considered as interest or usury. Riba gives a picture that money itself can earn profit (in the form of interest) by lending it to who needs it. The Quran forbids the charging of interest or riba on money lent. There are general consensus among Shariah economic scholars that riba is not only restricted to usury but encompasses interests as well.

Legally, from the Islamic belief, riba is strongly condemned by Allah. Allah said in the Quran “O you who believe, do not consume riba with redoubling and protect yourself from God, perchance you may be blissful.” (Al-Imran: 130). Islam does not recognize the earning from interest or riba derived from loan/borrowing activity was a fair business transaction.

Capitalist economic considers money as commodity and a resource for production. Therefore it has value or cost which is determined by several factors such as time preference for consumption, production opportunities and inflation. Thus, time preference embodies the concept that money to grow its value in future from the current time. This concept is called Time Value of Money.

The Time Value of Money (TVM) concept says that time has value. The principle of this concept is that money at present time is worth more than the same amount in the future due to its potential earning capacity. For example, person X who has money and does not use it either for real-economic investment activities or commercial trading, but lend it to other person Y payable in a year with 10% interest. Instead of reaping profit from business, X’s money grow 10% at the end of the year because Y has to pay X the principal plus 10% interest. The concept regards that the payment of interest is to compensate X for the opportunity loss he could get if he were to invest on other project. This means money borrowed for a period of time must pay rent. According to the Quran, this form of value of money is riba and sinful to anyone to take or give it.

Contradict to the TVM concept of the capitalist economy, Islam regards money could not grow because of time factor from lending activities. In Islam, money should be used for productive economic activities such as buy and sell or trade so that there is a circulation of money. The money will have to pay zakat (an Islamic type of zakat) if it left idle in save. An increase of value due to interest is prohibited but allowed if it derived from trade. Allah said “Allah has permitted trade and has forbidden interest” (Al-Baqarah: 275).

However, the time value of money is not ruled out in Islamic financial perspective as long as it is not part of lending relationship in which it is claimed as a predetermined value (Ahmad and Hassan, 2004).

Unlike conventional belief that regards money as a medium of exchange and commodity, Islamic economy defines money as the medium of exchange not the commodity. Money has no value in itself but represent a value for the commodity.

The concept of time value of money in Islamic finance is that called the Positive-Time-Preference (PTP). The consumption and production activities take time and to calculate the time value of money based on the real time that used for the activities as we known as ex-post in modern economics. The concept of PTP is supported by majority of Shariah scholars that the price for cash sale and credit sale can be varied. The example of the difference of price for cash and credit sale can be seen in Salam contract which price paid in advance for future delivery of good is less than cash and carry price.

Time is considered as a valuable economic resource that can be explained into two positions (Batcha, 2009):

(1)        Opportunity cost of postponing current consumption for future consumption; and

(2)       Opportunity cost of not being able to invest funds in productive activity.

Thus, compensation should be made for utility or possibility of earning a profit on funds.

In line with the Quran and Hadith teachings, Islam encourages people to pay their debts more than the amount borrowed which is purely voluntary as a token of gratitude and the incremental amounts denoted that Islam’s acknowledgement of PTP (Ayub, 2004).

In explaining the recognition of time value of money from Islamic perspective is that the compensation (conventional finance called ‘interest’) cannot be contractually predetermined because there is no certainty (gharar) in any outcome and the compensation is derived from the trading transactions that is ‘profit’ or out of courtesy by the borrower.

Based on the explanations above, majority of Islamic economist believe that economic agents in an Islamic economy will have a positive time preference and there will be indicators available in the economy to approximate the rates of their time preferences, generally determined by the preference in an Islamic economy, as made in a number of studies on investment behavior in the Islamic perspective (Ayub, 2007).

The important conclusion view is Islam is time value of money is acceptable in respect of the pricing assets and their usufruct. It is not acceptable with regard to any addition to the principal of loans or debts. Valuation of credit period based on the value of the goods or their usufruct is different from the conventional concepts of ‘opportunity cost’ or the ‘time value’ (Ayub, 2004).