Question

(B) Report on the evolution, function and the essence of Islamic banks and financial institutions?

Answer 1

Islamic Banks

Islamic Finance is the subject of growing interest as it provides an alternative banking system to the world economy. Islam considers trade a very important component of economic development and, therefore, the notion of investing finance in an ethical way is essential. On the one hand, interest is forbidden in Islam; on the other hand, the management of investment is a must, so Islam has developed an alternative financial system which encourages the promotion of trade without interest. In this system, therefore, risk is shared rather than being transferred while taking the business transactions into consideration

In all societies, there is a need to transfer funds from savers to investors because it is frequently the case that savers are not the same as who have the ability to explore profitable investment opportunities. This function may be performed either directly, through securities markets or indirectly, through the process of financial intermediation.

The importance of financial intermediation can be seen by the fact that in most countries this process accounts for around two-thirds of new investment (Ahmad,1998). Financial intermediation enhances the efficiency of the processes of saving and investment by reducing transactions costs and eliminating the mismatches inherent in coordination between the different needs of the surplus and deficit units of an economy. Since savers and investors usually differ, they require a considerable amount of information about each other, and this is not freely available.

Therefore, the process of channeling funds from savers to investors involves transaction costs. Moreover, because of asymmetric information, it also gives rise to the problems of adverse selection and moral hazard.

Islamic Banks and Financial Institution.

Financial intermediaries can benefit from economies of scale and hence reduce the transactions costs of transferring funds from surplus units to those in deficit. For the same reason, they are also in a better position to tackle the problems arising from the problem of asymmetric information. Similarly, the process of financial intermediation removes some of the mismatches between the two sides in terms of the choices, maturity terms and the amount of necessary funds. Those with surplus funds are often households who save relatively small amounts whereas the deficit units are often firms who need access to relatively large amounts of financial resources.

Financial intermediaries remove this size mismatch by collecting small savings and packaging them in such a way so as to make them available in a form that is more suitable to the needs of the users. In addition, users of funds in general need them for relatively long-term deployment, which cannot be met by individual suppliers. This creates a mismatch between the maturity and liquidity preferences of individual savers and the users of funds (Davar, 1999). The financial intermediaries resolve these conflicts by pooling small funds.

There are also differences between the risk preferences of small suppliers and large users of funds. It is often considered that small savers are generally risk averse and prefer safer placements whereas the users of funds are generally more adventurous and will deploy the funds in riskier projects in the expectation of securing higher returns. The mismatch between the risk preferences of suppliers and the users of financial capital implies that direct financing may be of only limited use. The role of the intermediary again becomes crucial in this process. They can reduce this risk substantially through portfolio diversification. Furthermore, small savers are unable to gather information about investment opportunities in an efficient manner.

Financial intermediaries are in a much better position to collect such information, which plays such a crucial role in securing the success of an investment. People undoubtedly require access to banking services. Since the banking services are needed but interest is prohibited in Islamic economies, the Muslim countries cannot simply do away with banking on account of the element of interest because of the vital role which banking does plays in the development of the economy. Therefore, such economies have to find alternative ways of performing various banking functions. It is this challenge that provides the rationale for Islamic banking. The role and functions of banks, briefly outlined above, are indeed extremely useful and socially desirable but, unfortunately, the modern economy performs these functions with the help of interest, which plays a central role in each of these functions. Islamic financial intermediations