Islamic banking is the new phenomenon in modern economics, it presents as an effort and the belief of ‘Ulama and Islamic economist as a solution towards interest-based conventional economic. Islamic banking is defined as non-interest banking. To answer the question on How Shariah-compliant is Islamic banking, we will observe the three areas; Philosophical fundamentals, Product development, and Shariah compliance monitoring.
The goal of the Islamic economic system is to achieve the Maqashid Shariah. Its purpose is to fulfil the Islamic legal maxim (al-qawaid al-fiqh) that reflects the spirit of Islamic law. The underlying principle of fiqh mua’amalat related to commerce and transaction is permissibility (ibahah) which maintains that every activity in the economy is permissible and avoid prohibited activities. Islamic banks must obey the Islamic principles of the economic system which is the prohibition of Gharar, Riba and Maysir. Meanwhile, conventional banks are purely implementing interest (riba) on their financial services. As the Qur’an has mentioned the prohibition of riba in Surah Ali Imran verse 130;
According to the research by Qian & Velayutham in 2017, the different philosophies of the bank lead to different financial outcomes. Their study does not reveal which bank has good performance, but based on their philosophies, banks have different competitiveness, consequences and challenges.
Undeniably, Islamic banks are business units in nature that operate in the competitive market. The financing needs of the consumer are also dynamic. Therefore, Islamic banking products are evolving to meet the current market needs. The Islamic financial institutions frequently use the traditional Islamic contracts namely equity and debt base.
1- Equity instruments are partnership-based contracts of mudharabah and musharakah, while debt instruments arise from the sale transactions.
2- Some contracts include in the fixed income debt such as murabahah (cost-plus or mark-up sale), bai-muajjal (price deferred or credit sale), salaam (object deferred or pre-paid sale), istisna (construction/manufacturing contract) and ijarah (leasing contract).
Utilising these pure contracts can not cater for the needs of the contemporary financial markets and institutions. Therefore, Islamic banks need to create a new set of instruments that can cope with contemporary finance.
In the product development of its product, Islamic banks would utilise one dominant contract and multiple supporting contracts. For example, in the murabahah financing contract, a bank must first buy the asset before selling it at a markup price. This product includes the promise of the client to purchase the asset; the agency contract whereby the client appoints the bank to buy the asset from the vendor; a sale contract between the vendor and the bank, and a sale contract between the bank and the client. However, although murabahah creates debt, it is contractually different from interest (riba). The debt raised from a credit sale contract is coming from the real transaction.
In the event of default, the bank cannot charge an additional amount as done with compound interest in the case of the loan contract. However, Shariah scholars allow charging a penalty for delays in payment to mitigate the risk given the condition that it is must be donated for charity.
Some critics might arise in the development of Islamic banking products which claim to be shariah-compliant but imitate conventional banks. From an economic point of view, the objective of Islamic banks is to restructure products that have similar risk-return features to conventional products. In addition, from the legal perspective, the Islamic bank products used several legitimate Islamic contracts to produce the banking product similar to conventional products. However, this can sometimes result in products that are Shariah-compliant in form but not in substance and some scholars call it as hilah in Islamic finance.
Shariah compliance monitoring
Third, the establishment of the Shariah board to monitor the implementation of Shariah compliance guidance. It is important to ensure that all regulations are in place to support the growth of Islamic finance.
The purpose of the establishment of international standard-setting bodies such as the Islamic Financial Services Board (IFSB) and Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) is to guide the corporate governance and shariah compliance of Islamic financial institutions.
The IFSB is an international standard-setting organization that promotes the soundness and stability of Islamic banking. This includes issuing global prudential standards and guiding principles in the areas of capital adequacy, corporate governance, risk management, and transparency, among others. It issues Sharia-compliant standards, holds conferences and seminars, and provides guidance and supervision. Meanwhile, the AAOIFI prepares accounting, auditing, governance, ethics and shariah standards for the Islamic financial institutions (IFIs).
In conclusion, Islamic banking is trying to provide the Shariah-compliant solution of interest-free financial services. The obligation of Islamic banks to obey the Islamic principle has brought them to face many challenges. Such product development through contract restructuring was taken to fulfil the financing needs. However, this might also generate issues on imitating conventional banks and some issues related to Shariah compliance. Therefore, Shariah advisory board and the international standard-setting bodies are established to oversee the practices of Islamic banks which are in line with Shariah principles.
To read more about Islamic Finance related topics, please click here and visit our academy.
Besides, feel free to sign up for our free stock screening services at musaffa.com.