Question

Discuss 4 challenges faced in the development of an Islamic financial system.

Answer 1

Islamic banking, also known as non-interest banking, is a banking system that is based on the principles of Islamic or Sharia law and guided by Islamic economics. Two fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors. Islamic law prohibits collecting interest or "riba".

Islamic banking is grounded in Sharia, or Islamic, principles and all bank undertakings follow those Islamic morals. Islamic rules on transactions are called Fiqh al-Muamalat. Typically, financial transactions within Islamic banking are a culturally distinct form of ethical investing.

Profit and Loss Sharing and its problems

To earn money without the use of charging interest, Islamic banks use equity participation systems. Equity participation means if bank loans money to a business, the business will pay back the loan without interest, but instead gives the bank a share in its profits. If the business defaults or does not earn a profit, then the bank also does not benefit.

Liquidity

For the survival of any banking and financial system, Liquidity position is a very important factor, the Islamic banking and finance is not an exception as well. The ability to convert assets into cash or a cash equivalent quickly in an emergency when their depositors need them without incurring large losses with a competitive rate of return on funds. Conventional banks are able to borrow and lend by using the interbank lending market borrowing to meet liquidity requirements and investing for any duration including very short periods, and thereby optimize their earnings.

Late payments/Defaults

Since the Islamic finance prohibits collection of interest or riba, the control and management of late accounts has become a serious problem. In the conventional finance the late payment or default is discouraged by the accumulating interest and penalizing. Since the payer does not feel any binding for the late payment, it continues to do so, as it does not involve any cost for them. Islamic banks face a serious problem with late payments.

Inflation

In simple term, the interest so collected by the banks is the compensation for the erosion of value of the funds with effluxion of time. The Islamic banks have not imitated conventional banking and are truly lending without interest or any other charges. Whether and how to compensate lenders for the erosion of the value of the funds from inflation, has also been called a problem "vexing" Islamic finance.

Concentrated ownership

Concentration of ownership is another danger to the stability of Islamic banking and finance, three or four families own a large percentage of the industry. This concentration of ownership could result in substantial financial instability and possible collapse of the industry if anything happens to those families, or the next generation of these families changes their priorities. Similarly, the experience of country-wide experiments has also been mostly on the initiatives of rulers not elected through popular votes.