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SWINBURNE UNIVERSITY OF TECHNOLOGY
Islamic banking in the
Middle EastHBI552 Business in Asia, Americas and
Europe
Ali Ramtoola (6932584), Srinivasa Maddula (6917542), Arcris Galang(2226219)
Prepared for Dr J Mohammad
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Executive Summary
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Contents
Executive Summary ................................................................................................ i
Contents ................................................................................................................ 2
1.Introduction ........................................................................................................ 1
The limitations to this report .............................................................................. 1
Scope .................................................................................................................. 1
2.The Middle East .................................................................................................. 2
Gulf Cooperation Council (GCC) .......................................................................... 5
Banking in the Middle East .................................................................................... 7
The history of Islamic banking ............................................................................ 7
Islamic banking in the Middle East ..................................................................... 8
Islamic banking versus conventional banking .................................................. 10
The impact of Islamic banking on the Middle East ...........................................12
Conclusion ........................................................................................................... 14
4.References ........................................................................................................ 15
Appendix A .......................................................................................................... 17
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1.Introduction
This report on Islamic banking has been commissioned by Dr Jawed Mohammed
as part of a study of the Middle East in the HBI552 Business in Asia, Americas
and Europe unit at Swinburne University of Technology.
The limitations to this report
While Islamic banks has been in existence for over three decades, their
separation from national central banking systems creates a lack of publicly
available literature on financial performance and its impact on the Middle
Eastern region made it difficult to make comparisons to conventional models.
Scope
The report is broken up into three significant sections the first defines the Middle
East region; the second explores the concept of Islamic banking, its history andhow it differs from conventional banking; and lastly what impact Islamic banking
has had on the Middle East region. The final two sections will be explored
through academic literature and with examples to provide a comprehensive view
of the subject.
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2.The Middle East
The Middle East is the region originally included in the Ottoman Empire,
spanning South-Western Asia and North-Eastern Africa and currently extending
from Libya to Afghanistan. Before first World War the British had ruled over thePalestine including all the Israel occupied countries. In 1917, a deal was struck
between the British and the Arab province Ottoman Empire to make a separate
Jewish national home in Palestine. After the World War I, the Ottoman Empire
established Israel as a separate nation with the help of central powers, with the
US playing a key role in the formation of Israeli.
The Middle East is a geopolitical and cultural term that refers to the countries
nestled between Africa and Asia. Historically, the boundaries are debated but
typically the western half of countries in the South-Eastern Mediterranean along
the Nile delta and extending through Iran. According to the International
Monetary Fund, the Middle East includes the countries of:
Afghanistan
Algeria
Bahrain
Djibouti
Egypt
The Islamic Republic of Iran
Iraq
Jordan
Kuwait
Lebanon
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Libya
Mauritania
Morocco
Oman
Pakistan
Qatar
Saudi Arabia
Somalia
Sudan
The Syrian Arab Republic
Tunisia
The United Arab Emirates (UAE)
West Bank and Gaza
Yemen
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Figure 1 - Map of Middle Eastern countrieshttp://www.globalresearch.ca/articlePictures/The%20Project%20for
%20the%20New%20Middle%20East.jpg
Despite comprising of small and numerous nation-states, there is a prevailing
collective pride in its long history as the origin of some of the worlds most
influential empires; the birthplace of monotheism; and fundamental contributions
to civilisation.
While a predominantly Muslim region, not all Middle Eastern countries have are
Islamic nations or have Islamic systems or governments. The majority of these
nation-states have Islamic Law woven in varying degrees into their legal
frameworks, showing that Islamic principles are persist in the present social state
in most of the regions nations.
Part of their culture also stems from a European influence. From the sixteenth
century through the nineteenth centuries while the Ottomans ruled most of the
Middle East, the region extensively traded goods, exchanged ideas and travellers
from Europe. This influenced the region, integrating European ideals into Islamic
legal systems. This coexistence was due in part to Europes desire to enhance
their position, but it also filled the need in Islamic trade and financial law.
The region is well situated globally to offer many dynamic trade and investment
opportunities. Primarily known as one of the largest oil and gas exporters, the
Middle East holds two thirds of the worlds oil reserves. Their governments are
attempting to reduce their dependence on oil by instituting policies attractive for
foreign investment. Middle Eastern leaders recognise the need to diversify by
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privatising traditionally state-owned assets and attract the annual $3.1 billion in
projects to realise privatisation efforts and infrastructure projects in the Middle
East (Donboli & Kashefi 2005), while coping with population growth which is
increasing faster than its economic development.
The Middle East is mostly a hot and arid climate. Agriculture is one of the keyresources for the economy as well as the dairy, textiles, leather and defence
industries. Tourism is also increasing with the provision of improved facilities
and amenities.
It is also a melting pot of various ethnic groups and uses a diverse number of
languages, the most popular being Arabic, Persian and Turkish. The region has
also been plagued by conflict with the US occupation of Iraq, the Israeli-
Palestinian conflict and the spreading fear of terrorism.
Gulf Cooperation Council (GCC)
Recognising the need to enhance regional cooperation, the GCC was established
in the early 1980s to facilitate and enhance foreign investment among the six
member states of:
Saudi Arabia
Kuwait
Bahrain
Qatar
Oman
United Arab Emirates (UAB)
Figure 2 Map of the GCC countries, http://cominganarchy.com/wordpress/wp-
content/uploads/2009/12/GCC-ap.jpg
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In banking terms, the majority of the GCC countries represent the bulk of Islamic
bank assets in the Middle East (Hasan & Dridi 2010). The banks in the GCC have
developed to be more diverse, with a mixed financial system to set them up as
mainstream financial intermediaries of the Middle East.
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Banking in the Middle East
In the 1960s and 1970s, banking in the Middle East comprised mainly of small-
sized banks serving the requirements of a limited domestic market at a time
when no local commercial banks had globalised their operation to any significantextent.
Today, the financial scene has been transformed with an increase in the size and
number of local banks, a quick expansion of banking networks and a widening of
available financial services.
Banking in the rich oil exporting countries is tightly linked to oil. While economic
policy is being used to enhance competition and raise efficiency, the sector is
relatively restricted in terms of competition. Non-oil countries are characterised
by financial institutions that rely on more diverse domestic and regional
resources. Financial liberalisation started early in these countries than the Gulfstates, with regulators introducing financial deregulation.
Banks in the Arab Middle East region earn revenues as if under conditions of
monopolistic competition. There are still heavy regulations and protective
measures imposed restricting banking in some countries. Economists and
businesses are calling for an easing on these restrictions to increase efficiency of
the system and economy while protecting domestic banks.
The history of Islamic banking
Islamic banking was a new political alliance that emerged between the rich andwealthy and Islamic law (Shariah) scholars. The relationship invigorates Shariah
scholars, influential in forming public opinion in most Muslim countries (Kahf
2004). The scholars and religious leaders have continuously spoken of the
prohibition of usury or riba, and the fact that conventional foreign banks were
based on such activity.
It was in the early 1950s to the late 1960s when Muslim economists, bankers,
Shariah scholars and political Islamists focused on the possibility of running
financial institutions without riba. They highlighted the merits of Islamic banks
to the Muslim public, but the actual establishment of these banks came from two
areas of the Muslim world, Asia and the Middle East. Conceptually, they both
involved collecting small amounts of savings from a large number of people to
invest in infrastructure or agricultural projects, or to microfinance small local
entrepreneurs.
In Asia, Malaysia was being preparing for independence in the early 1950s. The
newly emerging government supported the idea of establishing an investment
institution addressing the needs of Malays. In 1956 the Pilgrims Administration
Fund (Tabung Hajji) took shape as a financial institution that collects savings for
and invests them in accordance with Shariah. The fund was supported by
legislation requiring all Malays use the Tabung Hajji. The fund has anindependent decision-making authority, with government appointed
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management and an honorary subordination to the Prime Ministers Office. The
fund increased shares in real estate, industrial and agricultural sectors and had
initiated improvements to ideas and procedures of Islamic financing.
In the Middle East, a series of savings and investment houses known as Mit
Ghamr, were established in rural northern Egypt in 1963. This was done in atime where the current government and ruling class were sensitive to Islamic
political activity. The banks did not last long, with the houses being liquidated in
1967. The success of Mit Ghamr was in its ability to spread from small town to
small town to encourage savings from the poor of Egyptian society; which
pressured the government to fill the void when they closed. In 1971 the
Egyptian government created the first Islamic bank, the Nasser Social Bank and
was based on interest-free financing and the distribution of donation orzakat.
The bank was again supported by legislation, requiring public sector companies
to donate 2.5% of profit to the bank, as well as the administration ofzakat (El-
Gamal 2005).
Islamic banking in the Middle East
Currently, Islamic finance is one of the fastest growing segments of the global
financial services industry with assets growing over 10% per annum over the last
10 years. In 2009 the global Islamic finance industry is estimated at US$822b
(Austrade 2010).
CountryNumber/Type ofLicensed Banks Islamic banks
Offshore banks
Bahrain
21 commercial banks, 2specialised banks, 47 offshorebanks, 32 investment banks,
27 foreign bank offices
4 commercial, 14investment, 2offshore banks
47
Egypt
81 banks, 28 commercialbanks, 32 investment and
business banks, 21specialised banks
Yes None
Iran10 state-owned banks, 3
private banks
All banks mustconform to Islamic
principlesNone
Jordan
9 local commercial banks, 2Islamic banks, 5 investment
banks, 5 foreign banks, 5specialised credit institutions
2 commercial
banks None
Kuwait7 commercial banks, 2
specialised banks, no foreignbanks
One None
Lebanon68 banks (48 domestic), 14foreign banks, 8 specialised
banksNone None
Libya6 commercial banks, 18 localbanks, 3 specialised banks
Two
Oman
15 commercial banks, 3specialised banks. The
largest three banks are localcontrolling 60-70%
None None
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Qatar
15 commercial banks (7foreign). Domestic banks andQatar Industrial Bank control
88.7% bank assets
Two Yes
Saudi Arabia
11 commercial banks (3 Saudi
owned), 5 governmentspecialised credit institutions
One bank and allcommercial banks
have Islamicwindow
None
Syria1 commercial bank, 4
specialised banks all stateowned
None None
United ArabEmirates (UAE)
47 commercial banks (20locally incorporated), 1
restricted license commercialbank, 1 specialised bank, 2
investment banks
Three,conventional
banks with Islamicwindows
None
Table 1 - Creane, et al 2004, Financial sector development in the Middle East and North Africa,
International Monetary Fund, pp 27 28
As one of the most developed Islamic banking markets, the Middle East holds
almost 60% of the industrys assets. While development of the industry is
different between countries, Saudi Arabia and Kuwait are reaching maturity while
others are still experiencing some growth.
Figure 3 Size of Islamic Banking market and assets in the Middle East,
http://reports.celent.com/PressReleases/200811253/IslamicBanking.asp
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Islamic banking versus conventional banking
Exploration of the differences between conventional banking and Islamic banking
requires an understanding of where conventional banking from a capitalist
system and Islamic banking based on Shariah stand.
1. Conventional banks operate on the basis of return on investment and
profit, whereas an Islamic bank is bound to operate within the limits of the
Shariah fiqh al-Muamulaat; and abide by the laws of the holy Quran and
Hadiths.
2. Conventional banking mainly focuses on the economic and financial
features of a transaction. The Islamic system lays the same importance
on the ethical, social, religious, economic, and financial market dimensions
(Ahmed 2010).
For example a conventional bank will lend money to finance a casino, butan Islamic bank will not do so as gambling is not permissible under Islamic
law (Quran and Sunnah) and a form of uncertainty (gharar) (Ahmed 2010).
3. Conventional banks mobilise resources from deposits and passes it on to
other productive players in the economy using a rate of interest
mechanism and liquidity ratios. Depositors who have a bank account are
clients and not partners in the banks profit or loss. The relationship is of
creditor to debtor.
Islamic banks operate differently for resource mobilisation in the sense
they offer asset backed finance. They are organised as or in similarfashion to a joint stock company with the shareholders providing initial
capital, managed by shareholder representatives. Individual holders of
bank savings or investment accounts are partners in the success or loss of
the bank and as such share the realised profits with the bank in
accordance to ratios agreed upon at the time of contracting. Deposits
from clients are treated as loans to the bank, who then invest them in
Shariah compliant ventures.
Islamic banking promotes risk sharing between the investing party and the
borrower, whereby both the bank as an investor and the borrower as the
entrepreneur share the results (profit or loss) in a predetermined way .
Wherein conventional banking the risk factor is removed and normal bank
operate on the basis of credit worthiness of a client and based on his
credit rating lend him money in an equation such that the borrower or
entrepreneur is solely responsible for the risk of the venture and the bank
is assured of a fixed predetermined return.
4. Conventional banks lend money and consider it to have an intrinsic value
and expect a return on it in the form of interest and reward in the form of
private enterprise and profits. This money is traded as a commodity and
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banks lend money based on a rate of return payable as interest which
benefits the shareholders of the bank.
In Islamic banking riba is prohibited and as such all types of financial
contracts and transactions are exempt from interest, as per jurists who
base this banning or arguments of social justice, equality and propertyrights.
5. Conventional banks take into account the credit history and credit
worthiness of a client first and foremost to evaluate the suitability of a
loan, as they are more concerned that the loan (capital) and accrued
interest should be repayable on time.
Islamic banks on the other hand encourage the concept of profit and loss
sharing, wherein the bank only receives a return only in cases the project
they have financed makes a profit, thus the Islamic bank will be more
focused on the soundness and business expertise or experience of theproposed entrepreneur before deciding to invest (Iqbal & Molyneux 2005).
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The impact of Islamic banking on the Middle East
Some countries in the Middle East like Iran have moved to a full Islamisation of
their banking and financial system; while others like Bahrain has moved to a
mixed financial system; others still like Lebanon have not embraced Islamic
banking. Obviously, those countries with a predominantly Muslim population will
have a greater tendency toward Islamisation.
Bahrains mixed financial system provides a competitive advantage in
establishing it as a well-diversified international financial hub appealing to all
types of investors. Established during the Lebanese civil war, Bahrain approved
the entry of foreign banks.
The governments commitment to attracting leading financial institutions and
initiatives resulting from a merging of the two systems has meant that Bahrain is
home to important Islamic organisations like the Accounting and AuditingOrganization for Islamic Financial Institutions (AAOIFI), the International Islamic
Rating Agency (IIRA), the International Islamic Financial Market (IIFM) and the
Islamic Liquidity Management Center (ILMC). The ILMC was created to help
Bahrain Islamic banks meet short-term liquidity issues, which is common for all
Islamic banks not part of a national central banking system. This freed Bahrain
from having to hold significant cash reserves and increased growth potential.
Full Islamisation of financial systems is being held back by the smaller number of
Islamic financial instruments in comparison to conventional banks (Creane, et al
2004). This has led to the creation of non-profit & loss sharing instruments,
which bear a striking resemblance to those in conventional banking (Chong & Liu
2007). Some of these instruments include:
Murabaha is based on mark-ups, where the bank buys goods and sells
them to the customer for cost price plus a negotiated profit margin.
Ijarah is based on rents, where the bank purchases an asset for a
customer and then leases it for a fixed charge.
Bai salam is based on the idea of forward sale, where an entrepreneur
sells specific goods to a bank at a price determined at the time but with
the delivery of goods in the future.
It is because of these similarities that those who avail the services of Islamic
banks are similarly comfortable using conventional banks (Zaman 2002).
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Figure 3 Islamic and conventional banking profitability,
http://www.imf.org/external/pubs/ft/survey/so/2010/res100410a.htm
During the current economic crisis, the Islamic banks outperformed their
conventional counterparts. This was due in part to having smaller investment
portfolios, lower leverage and adherence to Shariah principles which includes the
prohibition of selling what is not owned (short-selling and like derivatives). It isbecause of this risk and profit sharing principle and gharar, that Islamic banks
are more conservative avoiding speculative investments (Austrade 2010).
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Figure 4 Islamic and conventional bank profitability, credit and assets,
http://www.imf.org/external/pubs/ft/survey/so/2010/res100410a.htm
However, Islamic banks were not completely insulated from the crisis due to
their Shariah based model requiring transactions to be backed by tangible
assets. Most of the tangible assets were real estate based, the prices of which
were affected in the downturn (Austrade 2010). It is also attributable to
concentrated exposure to a sector or borrower (Hasan & Dridi 2010)
Conclusion
While Islamic banking is enjoying double digit growth, its spread across the world
is limited with the major markets being Middle East, Malaysia and UK. The
challenges facing Islamic banking in the Middle East are:
Adopting one institutional framework and regulatory body so that it can
find greater coexistence with conventional banking (Iqbal et al 1998)
Liquidity and having access to enough a Shariah compliant secondary
market (Iqbal et al 1998)
Improving the offer of financial instruments to maximise given input usage
while complying Shariah principles (Abdul-Majid, Saal & Battisti 2009)
Adopted and universal accounting standards to meet existing business
conditions
Supportive legal and government policy to provide Islamic banks theflexibility to remain non-secular (Iqbal et al 1998)
Full Islamisation of some banking industries has effectively stifled
economic development for those countries (Chong & Liu 2009)
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Murjan, W. & Ruza, C., 2002, The competitive nature of the Arab Middle Eastern
banking markets, International Advances in Economic Research, vol 8, no 4, pp
267 273
Zaman, M.R., 2002, Assessing the nature and impact of Islamic banking and
finance, paper submitted to the 2nd
International Conference on Banking andFinance
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Appendix A
For the interest of the readers, the unique features of the conventional banking
and Islamic banking are shown in terms of a box diagram as shown below:-
Conventional Banks Islamic Banks
1. The functions and operatingmodes of conventional banks arebased on fully manmadeprinciples.
1. The functions and operatingmodes of Islamic banks are based onthe principles of Islamic Shariah.
2. The investor is assured of apredetermined rate of interest.
2. In contrast, it promotes risksharing between provider of capital(investor) and the user of funds(entrepreneur).
3. It aims at maximizing profitwithout any restriction.
3. It also aims at maximizing profitbut subject to Shariah restrictions.
4. It does not deal withZakat. 4. In the modern Islamic bankingsystem, it has become one of theservice-oriented functions of theIslamic banks to be aZakatCollection Centre and they also pay
out theirZakat.
5. Lending money and getting itback with compounding interest isthe fundamental function of theconventional banks.
5. Participation in partnershipbusiness is the fundamental functionof the Islamic banks. So we have tounderstand our customers businessvery well.
6. It can charge additional money(penalty and compoundedinterest) in case of defaulters.
6. The Islamic banks have noprovision to charge any extra moneyfrom the defaulters. Only small
amount of compensation and theseproceeds is given to charity. Rebatesare give for early settlement at theBanks discretion.
7. Very often it results in thebanks own interest becomingprominent. It makes no effort toensure growth with equity.
7. It gives due importance to thepublic interest. Its ultimate aim is toensure growth with equity.
8. For interest-based commercialbanks, borrowing from the money 8. For the Islamic banks, it must bebased on a Shariah approved
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market is relatively easier. underlying transaction.
9. Since income from theadvances is fixed, it gives little
importance to developingexpertise in project appraisal andevaluations.
9. Since it shares profit and loss, theIslamic banks pay greater attention
to developing project appraisal andevaluations.
10. The conventional banks givegreater emphasis on credit-worthiness of the clients.
10. The Islamic banks, on the otherhand, give greater emphasis on theviability of the projects.
11. The status of a conventionalbank, in relation to its clients, isthat of creditor and debtors.
11. The status of Islamic bank inrelation to its clients is that ofpartners, investors and trader, buyer
and seller.
12. A conventional bank has toguarantee all its deposits.
12. Islamic bank can only guaranteedeposits for deposit account, whichis based on the principle ofal-wadiah, thus the depositors areguaranteed repayment of theirfunds, however if the account isbased on the mudarabah concept,client have to share in a lossposition..