The aim of this research project lies on the study of principles and activities that define the Islamic banking system, allowing the latter to be more efficient and more equitable. The performance evaluation is made on the basis of four models that govern the activities of the Islamic banks. The first model is based on the Muhammad (deposit, Investment funds); the second concerns the Muhammad for the deposit only while for the investment we need the Muskrat: The third model is based on the Muhammad for deposits but introduces the debt and quasi-debt instruments (Maharajah, Assists, Salaam, Ajar The fourth model is based on
Muhammad for deposits and Matriarch on the assets side. Results show that the first model Is more efficient than the others, particularly the third which is paradoxically largely adopted. The fourth Is not recommended for Its negative Impact on trade. Keywords: Islamic banking, Islamic finance, muskrat, ajar, maharajah, ribs. Shari compliance, Muhammad, 1. Introduction Islamic finance covers the whole of the financial and legal techniques allowing the financing with goods or services In accordance with Shania requirements. Islamic finance Is provision flagrance services under Islamic law (or Share) principles.
It was established as an alternative to conventional financial institutions mainly to provide Shari compatible investment, balancing, and trading opportunities. The Islamic financial industry is growing continuously ever since the first institutions started operating during the early Seventies. Today, it is received with significant interest and It has made great strides: the Industry has experienced a dramatic growth and transformation. Islamic finance has become a rapidly expanding phenomenon In ten Muslim Ana non-Muslim world Ana a serious competitor to conventional financing.
Although it remains still very concentrated in the Middle-East and South-east Asia, it has developed surprisingly quickly in the United States and in Europe. The paper was financially supported by Pushchair for Islamic Banking Studies at Imam University, Riyadh, Saudi Arabia. International Research Journal of Finance and Economics – Issue 65 (2011) 146 Islamic finance, in agreement with Islamic law, is based on the principles of the prohibition of interest (Ribs) also called usury, the prohibition of Gharry (risk, uncertainty), the prohibition of Massif (speculation), the prohibition of unethical use f funds, and he profit-and-loss sharing.
Based on these principles, Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari. Islamic bank is an institution which receives deposits and leads all banking activities except the collection and payment of interest. Islamic bank incites all the parts with a transaction to share risk and profit-and-loss. We can compare the Islamic banks depositors to investors or to shareholders, who receive dividends when the bank makes a profit or lose part of their economies if business makes a loss.
Islamic finance stands for a system of equity-sharing and stake-taking. It operates on the principle of a variable return based on actual productivity, on the performance of the projects and on the quality of the projects, specific or general, individual or institutional, private or public, to devise an efficient and equitable system of profiteering. Prohibiting of Ribs is not against earning money objective. Islam is not against the earning of money. In fact, Islam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another.
The principal contracts used by an Islamic bank are: Muhammad, muskrat, maharajah, ajar, salaam and assists… On the basis of these different Islamic financial modes, we find four models which direct the Islamic banks activities. The first model is based on Muhammad in both sides: on the assets side (Muhammad contract with entrepreneur) and on the liability side (Muhammad contract with depositors). The Second model is based on Muhammad on the liability side and Muskrat on the assets side.
The third model is based on Muhammad on the liability side, but is introduced debt and quasi-debt instruments on the assets did (Maharajah, Assists, Salaam, Sahara… ). The fourth model is based on Muhammad on the liability side and Metadata on the assets side. The comparison of the four models enables us to highlight advantages and the disadvantages of each model. This paper explores the importance of Islamic finance as an alternative system of financial intermediation (section 2) and derives the principles and the contributions of Islamic finance (section 3).
In this paper, we analyze the principal financial models uses Day an Islamic Dank (Stetson 4) Ana we study Ana compare performance AT ten our models governing the activity of Islamic banks by highlighting the advantages and the disadvantages of each one (section 5). 2. Islamic Finance as Financial Intermediation Financial intermediation is defined as the process of channeling funds embroiled from the surplus sectors of the economy (savers), towards the deficit sectors (investors) by the intervention of a specific agent called financial intermediary.
Financial intermediaries accept money from savers or investors and loans those funds to borrowers, thus providing a link between those seeking earnings on their funds and those seeking credit. Financial intermediaries include savings and loan associations, building and loan associations, savings banks, commercial banks, life insurance companies, credit unions and investment companies. The role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them.
The emergence of financial intermediaries is thus result from imperfections in the capital market (Leland and Pyle (1977), Diamond (1984), Diamond (1991)). Financial intermediaries exist to solve or reduce market imperfections (such as: differences in the preferences of lenders and borrowers (in terms of size, authority, liquidity, risk), presence of transaction costs, shocks in consumers’ consumption and asymmetric information (both adverse selection and moral hazard).
Several theories have been developed to explain how financial intermediaries reduce/solve these market imperfections. They are the theories of: theory of asset transformation, transaction costs reduction, liquidity insurance and informational economies of scale and delegated monitoring. 147 Asset Transformation Financial intermediaries play a major role in transforming particular types of assets into others. Borrowers’ needs are a long-term capital and permanent capital and the series of many lenders are a high degree of liquidity in their asset.
Financial intermediaries simultaneously satisfy both borrowers’ needs and desires’ lenders by the process of asset transformation. They transform the primary securities issued by firms into the indirect securities required by lenders (Gurgle and Shaw (1960); Fame (1980)). Specifically, they issue liabilities (deposit claims) with the characteristics of low risk, short-term, high liquidity, and use a proportion of these funds to acquire the larger size, high-risk and illiquid claims issued by firms.
To reconcile the conflicting acquirement of lenders and borrowers, financial intermediaries undertake four main transformations: maturity transformation (by making long-term loans and funding them by issuing short-term deposits), size transformation (by collecting the small amounts made available by lenders and parceling them into the larger amounts required by borrowers), liquidity transformation (by transforming deposits with high liquidity and low risk to loans with higher risk and illiquid) and risk transformation (by transforming risky loans (assets) into virtually rissoles deposits ) Banks transform rolls Day mulling ten rolls AT loss on can Uninominal non, diversifying risk and pooling risks.
Transaction Costs The existence of financial intermediaries is Justified by the presence of transaction costs: financial intermediaries reduce transaction costs by developing branch networks and information systems, which enable lenders and borrowers to avoid the need to seek out a suitable counterpart on each occasion, by providing standardized products, by using tested procedures. Financial institutions are able to reduce transaction costs by taking advantage of economies of scale (The unit cost of the contract per loan is such smaller for the bank than for an individual who has a loan contract drawn up when undertaking direct lending), of economies of scope (Economies of scope are essentially concerned with deposit and payment services: deposits are the legal- financial claims by which banks both collect funds to sustain their lending activities, and satisfy the request of payment instruments) and of expertise (is essential to providing low-cost liquidity services).
Liquidity Needs A key role of financial intermediaries is to provide insurance against liquidity shocks that eliminates idiosyncratic liquidity risk and aggregate liquidity risk, as postulated in the liquidity insurance theory also known as consumption smoothing theory (Diamond and Divvy (1983)). This liquidity insurance will appear by the fact that financial intermediaries will propose to depositors checking accounts remunerated and the possibility of withdrawing their deposits on demand. Banks allow consumers to deposit funds that they can withdraw when they have liquidity needs. This liquidity provision allows banks to accumulate funds that they can use to lend to firms to fund long term investments. Banks must manage their liquidity so that they can meet the liquidity needs of their depositors. Liquidity functions of banks affect investment and growth at different stages of economic development.
Asymmetric Information: Adverse Selection and Moral Hazard Second reason Justifying the existence of the intermediaries financial is the reduction of information and asymmetries of information costs. The new theory of financial intermediation is concentrated on ex- ante problems of asymmetry of information (adverse selection) and ex-post problems of asymmetry of information (moral hazard). International Research Journal of Finance and Economics – Issue 65 (2011) 148 Adverse selection is the problem created by asymmetric information before the transaction occurs. It arises when the potential borrowers who are most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out loans. Thus adverse selection increases the probability that bad credit risks will get loans.
As a consequence, lenders may decide not to give any loans, even to good credit risks. Adverse selection meets in all situations where information had by a type of agent is not observable by another agent on which it is dependent. Adverse selection is thus a form of ex-ante opportunism. Adverse selection appears in banking intermediation when borrowers has more information on the quality of his project that the lender. So lender cannot distinguish the “goods” and “bad” Dowers (Lemons problem Day Croaker (II/U)). Resolution AT adverse selection implies that full information on the borrowers should be provided to the lenders (Leland and Pyle (1976)) and lenders selects good borrowers (screening).
Private production and sale of information, government regulation, and financial intermediaries reduce and solve the adverse selection problem. Especially financial intermediaries like banks produce more accurate valuations of firms and are able to select good credit risks thanks to their expertise in information production. Financial intermediary develops an expertise in order to be able to manage asymmetric information problems which continue to arise throughout financing relation. One particular advantage of banks in information production is that they can have information about potential borrowers from the transactions on their bank accounts.
By acquiring funds from depositors and lending them to good firms, banks earn Geiger returns on their loans than the interest paid to their depositors. Asymmetric information theory offers a convincing explanation of the existence of financial intermediaries. Moral hazard is the problem that occurs after the transaction is made. Moral hazard thus appears in all situations where an individual seeks for example to maximize his utility function to the detriment of other individuals on which it is dependent. It is in that a form of ex-post opportunism. Therefore, once agency relation is established, post-contractual risk appears in the form of Moral hazard. This last also finds its source in informational uncertainty but this one relates from now on to the behavior of the agent.
Moral hazard occurs when principal cannot observe agent actions at least two reasons: control costs of agent actions are higher and/or principal is not able to measure perfectly agent actions by observing results because its actions do not determine completely the results. Len banking context, moral hazard is the risk (hazard) that the borrower will engage in activities that are undesirable (immoral) for the lender. These activities potentially reduce the arability that the loan will be repaid. Again, the consequence is that lenders may decide not to make any loans. Investors are more likely to behave differently when using borrowed funds rather than when using their own funds. 3. Islamic Finance Principles A bank is considered a liquidity provider and a controller of capital utilization.
Islamic bank also completed these two functions: it collects the financial resources for a better allocation in the various investment projects according to principles of Shari. The latter is based on several sources including Quern, Width of the Prophet and also Zamia or Fish which represents Islamic Jurisprudence based on a set of laws derived from Islamic scholars. The basic principles of Shari are: the prohibition of interest, the prohibition of speculative behavior and gambling, prohibition of unethical use of funds (investment in illicit activities (harm)), equity (sharing of profit and loss between the parties to a transaction) and the obligation to lean all financial transactions in real economic activity… 49 International Research Journal of Finance and Economics – Issue 65 (2011) 1 Prolonged AT Interest a or ODL Ion AT Interest Is ten mall Iterance teens Islamic finance and conventional finance. Islamic banking is based on the principle of prohibition of interest or also known as В« usury В». This is explicitly stated in the Quern and Width explained the rules of legitimate trade. This width has detailed six products called “Arabia”: gold, silver, wheat, corn, dates, and salt. Any exchange of identical product (cons gold golden wheat against wheat) with a benefit to a person constitutes a usurious transaction, except as regards the benefits resulting from the exchange of products of different nature (cons golden wheat).
Also, NY surplus from a transaction not based on real assets and previously owned by the seller is unlawful (harm). This category loan contracts. Specifically, bank credits whether consumer loans or business credits are considered illegal. Prohibition of interest is explained by the fact that interest is generated by the passage of time. For cons, indirect compensation through revenue from property or activity is not prohibited by Shari. 3. 2. Prohibition of Speculative Behavior and Gambling Prohibition of interest is not the only key point of difference between Islamic finance and conventional finance. Islamic banking differs from conventional finance in terms of speculation (Massif) and uncertainty (Gharry).
One of the principles of Islamic banking is the prohibition of speculative behavior and gambling. Therefore, any element of speculation or uncertainty is prohibited by Shari. Islamic finance is to avoid conflicts with major speculative behavior or at least significantly reduce the risk of conflict. It also serves to support the criticisms of some conventional financial practices such as speculation, derivatives contracts and conventional insurance that have elements of Gharry and Massif which are unethical to Islam. . 3. Prohibition of Unethical use of Funds (illicit activities (harm)) Shari prohibits unethical use of funds (illegal and illicit activities).
Islamic finance is a form of responsible finance excluding certain industries and involving filters ethical, social and environmental. Islamic finance portfolio excludes companies whose products or practices do not meet the criteria advocated by the fund. The ethical investment funds exclude companies involved in tobacco, liquor, gambling, weapons, nuclear power and armaments among others (Wilson, 1997). Islamic finance also rejects all transactions hat should not be marred by defects such as ribs or gharry. 3. 4. Equity (sharing of profit and loss between the parties to a transaction) Third principle states that both sides of transaction are forced to share profits and losses.
This principle based on equity dictated by Shari shows that Islamic finance is participatory finance: Profits and losses must be shared between creditor and debtor, instead of being concentrated on one side. Islamic finance has a particular view on sharing risks and profits between different stakeholders in a financial transaction. Shari calls for a fair haring of profit and risk between the investor (lender) and the entrepreneur (borrower), whatever the form of financing used. 3. 5. Obligation to lean all financial transactions in real economic activity Islamic finance appears with this principle in the service of the real economy: financial transactions are systematically linked to real assets.
This is an absolute necessity for lean asset to any financial transaction. International Research Journal of Finance and Economics – Issue 65 (2011) Figure 1 : I en Twelve principles AT Islamic 150 Prohibitions Prohibition of Ribs Commands Sharing of profit and loss Tolerance Prohibition of speculative behavior and gambling Obligation to lean all financial transactions in real economic activity Prohibition of unethical use of funds 4. Basics techniques of Islamic Finance On the liability side, funds are raised primarily on the basis of a contract Muhammad. On the assets side, Islamic banks provide the financing with the use of various contracts in accordance with the requirements of Shari.
Investments can be undertaken using profit sharing modes of financing (Maturated and Muskrat) and fixed-income modes of financing like Maharajah (cost-plus or mark-up sale), installment sale (medium/long term Maharajah), Assists/ Salaam (object deferred sale or prepaid sale) and Sarah (leasing). 4. 1 . Islamic Instruments on the Liability Side (Deposits) In Islamic banks, relationship between Islamic banks to their depositors is based on the principle of sharing profits or losses. This means that the bank gives no commitment to provide a fixed income and determined in advance. The relationship between Islamic banks and their depositors is not a conventional relationship between creditor and debtor. It is a relationship where both parties share risks and profits. Islamic banks make all the services (which are not contrary to Islamic Jurisprudence) offered by conventional banks.
But Islamic banking intermediation presents specific aspects about the fundraising. The liability of Islamic banks is formed by shareholders and current accounts and investment deposits. Therefore, on the liabilities side, there are demand deposit accounts (Checking accounts) that are considered interest-free loans (Card al-Has), and therefore they are guaranteed. Demand deposit accounts allow the account holder to receive a check book, have a safe place for their money, they can 151 Lateran easily, at any tale, wilt Creole cards or deed t a I cards. I nose mean appose do not take the risks of banking. Depositors pay administrative costs and management at the bank for services provided by it.
Figure 2: Muhammad applied to investment deposits and accounts Depositors’ profits Investment fund Sharing of profit Shareholders’ profits Midrib’s Management fee Expertise and funds management Depositors Participatory investment accounts Figure 2: Muhammad applied to investment deposits and accounts Islamic Bank We also find that all funds raised are in the form of Muhammad. In this latter case, he Islamic bank acts as a manager of investment against depositors whose funds fall under the category of investment deposits. Islamic bank shares its net earnings with its depositors in proportion to the amount at each deposit. Depositors are considered in this case Arab al-mall (capital providers). They must be informed once the date of deposit of the distribution of profits with the bank. Islamic banks are called Muhammad. They manage the investment deposit accounts also called participatory investment accounts or Profit and Loss Sharing Accounts (PLEAS). The losses incurred by depositors, except “operational risk”. . 2.
Islamic Instruments on the Assets Side 4. 2. 1 . Muhammad In accordance with the principle of sharing of profits and losses, Muhammad is a form of passive participation treated as a limited partnership or a corporation. In a Muhammad financing, only the bank (Arab al mall or capital provider) provides capital while the client (Muhammad or entrepreneur) manages the business. Muhammad brings its experience and expertise, manages the activity or business under and provide the labor needed to use these funds and does not guarantee the capital invested and the realization of profit. The bank cannot interfere n the day-to-day running of the business. Any profit is shared.
The client is not paid a salary, and if he or she does not make a profit, the client loses all the time and effort expended on the venture and the bank absorbs losses. The distribution of profits and losses is fixed in the contract. International Research Journal of Finance and Economics – Issue 65 (2011) Figure 3: Muhammad on the assets side Return on capital and profits less expenses of management of Muhammad 152 cap tall Tort mum Entrepreneur nard Capital provider (Muhammad) Activity determined in advance Activity left open Investment project Islamic bank (Arab al mall) Return on capital and profits Capital for Muhammad 4. 2. 2.
Muskrat In muskrat (a form of active participation), both bank and client contribute capital and agree to a profit-sharing ratio (profit or loss). Specifically, Islamic banks have developed the permanent muskrat (The Bank participates in the equity of a project and receives a share of profit on a pro-rata basis. The period of contract is not specified) and diminishing muskrat (antiquities: In this form of muskrat, equity participation and sharing of profit on a pro-rata basis is allowed. It also includes a method by which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants. ).