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Constraints of Islamic Banking
  By: Hamid Sultan Dawoodi
   
 
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The growth of Islamic banking is based on religious grounds. As Riba (usury, interest) is forbidden in Islam in all forms and intent and the focal point of Islamic banking/finance is on the prohibition of interest. Equality and justice in the society is the core basis of prohibition of interest which is evident from the Holy Qur'an, Ahadith and Fiqh.The structure of Islamic finance is based on a web of contracts, such as contracts of partnership, services and future sales. However, Islamic banking system is based on profit and loss sharing. Business of banking is exposed to different risks as the borrowing or lending of money involved in it. Whereas, the Islamic banking sector is in no way immune to risks but this sector confronts with new and unique risks as a result of its unique asset and liability structures.

The contracts (Musharakah, Mudaraba, Murabaha, Salam, Istisna and Ijarah) in Islamic finance are exposed to operational, credit, market and liquidity risks along with risks, which are specific to Islamic finance like Shariah arbitrage, issues of contracts and documentation. . Here some of the risks specifically to Islamic Banking are discussed. First start with Sharia risk, which is related to the structure and functioning of the Shariah boards at the institutional and systemic level.
   
 

Risk-related to Shariah is of two types; the first is due to non-standard practices in respect of different contracts in different jurisdictions and the second is due to failure to comply with Shariah rules.

There is a diversity of opinion as to whether particular practices or products are Shariah-compliant, meaning thereby some products and services may be approved as being Shariah-compliant by some Shariah scholars but not by others. Different adoption of Shariah rules sometimes results in differences in financial reporting, auditing and accounting treatments by Islamic banks. Islamic banks/financial institutions are exposed to the risk of non-compliance with the Shariah rules and principles determined by the Shariah board or the relevant body in the jurisdiction. The nature of the relationship between the bank and the investor is not only of an agent and principal, but also based on an implicit trust between the two that the agent will respect the desires of the principal to fully comply with the Shariah.This relationship distinguishes Islamic banking from conventional banking and is the sole justification for the existence of the Islamic banks. In case the bank is unable to maintain this trust and the bank's actions lead to non-compliance with the Shariah, the bank is exposed to the risk of breaking the confidence of the investors.

   
 

Breaching the trust and confidence of the investors can lead to dire consequences, including the withdrawal and insolvency risk. Therefore, the bank should give high priority to ensuring transparency in compliance with the Shariah and take necessary actions to avoid any non-compliance. It is very much important that the products should gain approval from the Shariah boards on Shariah compliance before its launch. It is equally important for Islamic banks and Islamic financial institutions to recognise that Shariah compliance is a continuous process which means their products and services are adequately monitored.

Effective monitoring of Shariah compliance by Islamic institutions may involve reinforcing more remote Shariah boards oversight through the internal Shariah audit process and by developing expertise within the institution.Secondly, legal risk may arise through uncertainty in laws, regulations and legal actions in terms of capacity and enforceability issues, as well as the legality of financial instruments and exposure to unanticipated changes in laws and regulations. Legal risk often stems from uncertainty in laws, regulations, or legal actions and will even affect a transaction which is properly documented. Such uncertainties in law resultantly interpret some transactions not according to the Shariah. Another problem relating to this aspect is that some institutions are not capable of delivering judgements related to the Shariah.

Judges in non-Shariah courts for instance rarely receive proper training of Shariah, therefore, it is too much to expect that their decisions will reflect the Shariah principles.

The legality of Islamic financial instruments is also one of the common legal risks faced by Islamic banks. Due to the absence of recognisable laws pertaining to Islamic financial instrument, some transactions might be deemed illegal by law even though Shariah allow such transactions. For instance the restriction on investor (sahibul maal) to have recourse to the general patrimony of the Mudarib in the case of Modaraba financing. The biggest issue which might arise from the legality of an Islamic financial instrument is the probability of selective enforceability. As an Islamic financing structure usually involves several financial instruments, the illegality in parts of the instrument used in the transaction may result in that only the favourable terms in a contract is enforced.

The problem with selective enforceability is that most of Shariah compatible financing is conducted through a web of contracts and if any part of such a web fails to function or only part of the web is enforced, the integrity of the whole system in terms of Shariah compatibility might be compromised. Legal capacity is another element of legal risk that affects the operation of Islamic banks, whereas legal capacity is defined as the legal authority to enter into a contract. The consequence of non-existence of any legal capacity is that the contract is deemed ultra vires, and is therefore unenforceable. The common avenue to mitigate the legal risk in Islamic banking transactions is through employing structured financing. The idea of structured financing is to use documentation to create particular legal effects. Another way to reduce the legal risk is by codifying the Islamic principles.

The absence of such codification will risk any Islamic contract being interpreted in the light of a conventional commercial code or civil code. Mitigation of legal risk can also be managed through creation of supporting legal institutions. Finally, a risk related to reputation, where the irresponsible actions or behaviour of management will damage the trust of the bank's customer. The irresponsible behaviour of a single institution could taint the reputation of other banks in the industry. The Islamic financial services industry is a relatively young industry, and a single failed institution could give a bad name to other banks that are not engaged in negligent behaviour. Close collaboration among financial institutions, standardisation of contracts and practices, self-examination, and establishment of industrial associations are some of the steps needed to mitigate risk of reputation.

Risks and returns are strongly related to Islamic financial products. The unique structure of Islamic financial products exposes them to different types of risks at different stages of Islamic contracts. Since the Islamic financial contracts are more complex than the conventional ones however, such types of contracts are facing additional challenges.

Therefore, Islamic banks are more prone to risk as compared to conventional banks. Institutions that are offering Islamic financial products or formulate deals based on Islamic financial contracts are exposed to credit, operational, business, market, and liquidity risks, along with the risk of non-compliance with Shariah rules and Islamic contract laws. Such risks may result in major financial losses and excessive disruptions in the financial institutions' performance. In terms of managing the mentioned risks to Islamic banks/financial institutions, they should define a risk management framework of measuring, monitoring, assessing, evaluating, controlling, and managing their associated risks. As the Islamic banking system is facing great difficulties to develop strongly even in the Muslim countries, there is a need of clear and strong decisions by the Shariah scholars and the governments of Muslim countries regarding its implementation.

The Islamic financial system cannot be developed or enforced by the stroke of a pen but the enforcement of a true Islamic banking system requires a true Islamic society as well as tremendous improvements in existing systems and procedures, innovations in Islamic banking services and products, development of skills and expertise, training of banks' personnel and amendments in the relevant laws, including banking laws. The risks and challenges to Islamic banking/financial system will have to be tackled systematically and unanimously in an organised manner keeping in view the spirit of the Sharia.


 
 
 
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