Problem Solving Paper Example on Islamic Banking

Islamic banking is based on the policies stipulated in the holy book of the Islamic religion known as Quran). The Islamic banks are guided by the various principles that make them different and distinct from the conventional banks. For instance, in Islamic banking system, there is a limit to the interest rates that the banks, can use. This is achieved through the principle of Riba that deals with the Islamic concepts regarding interest. Therefore, Riba principle aims at limiting the amount of interest that an Islamic bank can impose. Developing the Islamic banking and financial institutions was considered unachievable task a few decades ago. Today, Islamic banking system has become a great and viable financial approach that attracts many investors even from the conventional sector. Islamic banking system was developed by the Muslim scholars with the aim of addressing the religious limitation of receipt and payment of interest alongside many other practices that were considered unethical in the Islamic religion. The fundamental laws of Islamic banking system are recorded in the laws of Islamic transaction or as it are known in Muslim, Mulamalath.

1.2. Statement of Problem

Carrying out a business has been a huge risk in Maldives following the political turmoil that has existed in the past few years. The domestic financial institutions have not been able to attract investors from outside the country. The economic hard lines created by the poor business environment have reduced the morale for investors from outside the country to invest in the country with currently Maldives having only 13 Islamic financial institutions due to the high rate of poverty (Muneeza, 2014). Further, due to the increased poverty rate in the region that has led to inadequacy in the infrastructure the economic opportunities and social services for the financial institutions have been a great deterrence.

1.3. Hypothesis

Due to the increased economic activities in Maldives in the past few years that have enhanced its GDP growth and economic development in general, it is evident that the Islamic financial institutions may also improve their activities within the country. Therefore, this paper hypothesizes that despite the challenges that the Islamic banking sector is experiencing in Maldives there is still a window for improvement due to the opportunities such as free trading space and connection with the outside world.

1.4. Literature Review

The economic environment in Maldives has not been favorable for business for many years until the successful presidential election in 2013. The 2013 presidential election was the first successful step towards reconciling the political turmoil issues that have been experienced in Maldives for decades (Morrison, 2013). However, this does not mean that there were no economic activities in the country. According to Muneeza (2011), Maldives largest source of income is tourism and construction industries that have contributed to the economy significantly. However, the banks have also contributed to the economy in a great way even though their impact may not be directly experienced due to the challenges that hinder their development. Despite the challenges, in the past few years the Maldivian banks have also experienced a tremendous growth in the various segments of the financial market industry due to the opportunities created especially with the change of the new constitution in 2008 that opened up the international market way for the financial institutions in Maldives (Morrison, 2013). The economists have argued that the financial systems with the legal origins of the Islamic banking system can experience economic growth because it is supported by the prominent mechanisms or provisions of the law (Ali, 2007). But, the Islamic banking system can also be suppressed by the same policies or provisions of the law. However, to understand the challenges and opportunities facing the Islamic banking in Maldives, it is important to understand the historical origin of the banking system in the Muslim countries as one way to discuss the introduction of the Islamic banking.

The Islamic banking system emerged as a result of the Muslims feeling sidelined from the conventional financial systems (Haron & Azmi, 2009). Therefore, they formed their own systems that could respond to their needs effectively. According to Usman (2004), since the Islamic banking products are in compliant with the Islamic Shariah laws, the financial institutions and banking systems were constructed on various philosophies that were derived from the Quran. The principle of Riba is based on the Islamic philosophy that no one should take advantage of another persons suffering (Albaraka, 2017). The Islamic banking system has received international prominence due to its resilience regarding the financial crises as it guided by the legal principles outlined in the Quran, Shariah policies that emphasize mainly on the real assets and risk sharing mechanisms (Ali, 2007). Development of Islamic banking and financial institutions in Maldives has been inhibited by the hostile political climate that discouraged investors from other countries. Even though the country attained its independence from the British colonial power in the 1960s, very little development could be witnessed in Maldives by 2008 when the new constitution was enacted and even until 2013 before the Presidential election (ADB, 2015). However, enactment of the new constitution and subsequent successful presidential election in 2013 contributed significantly to the favorable business atmosphere that businesses now enjoy in Maldives (Sambajee & Dhomun, 2015).

2. Introduction to Islamic Banking

As Iqbal and Mirakhor (2011) explain the modern conventional banking systems that exist in the Islamic states like Maldives are as a result of the colonization. These banks were established to support the mining, agricultural, and manufacturing activities of the colonizers (ADB, 2015). The banks were established by the foreigners who wanted to expand their foreign-owned industries in the colonies. However, the development that was brought about by the foreigners seemed to sideline the Muslim natives who formed a large portion of the population (Muneeza, 2011). As a result of being left out of the banking system due to voluntary self-exclusion and religious beliefs, the majority of the Muslims felt that their financial needs were not fulfilled. Therefore, this inadequacy led to less saving by the Muslims and eventually contributed to a liquidity problem. In their desire to meet their financial needs that would comply with their religious beliefs, the Muslims introduced products that were in compliance with their religion, Shariah law. Therefore, they thought that the conventional banks could meet their banking needs. As a result, the Islamic banking system was introduced to help fill the gap that the conventional banks could not fill (Kettell, 2011).

3. Principles of Islamic Banking

Islamic banking is derived from various important components like risk-sharing, stability, and innovation that have contributed greatly to the sectors improvement. However, there are other components such as limited liquidity that may be considered detrimental to the growth of the Islamic banking sector (Tunay, 2016). The principles of Islamic banking systems are derived from the holy book Quran.

3.1. Riba Principle

Riba is a principle that prohibits the gain of interest in the Islamic financial institutions. This is one of the factors that led to the formation of Islamic banking system. The Muslims in the Islamic states saw that the conventional banking system that was established and managed by the foreigners or colonialists was mainly focused on making profits through interest (Albaraka, 2017). As a result, the Muslims felt that their needs were not satisfied by such banks; thus, the formation of banks that do not focus on making a profit but helping the customers. Albaraka (2017) asserts that the Riba principle is guided by the following sub-principles: the wealth gets the return without necessarily incurring any risk or effort; irrespective of the outcome of the economic activity, the person given the money must return the money to the lender; finally, taking advantage of the issues or challenges that others are facing is discouraged and considered unjust. Riba, according to the Islamic states that practice it, is considered to be a greater sin than even committing adultery or eating certain unwanted foods such as pork.

3.2. Gharar Principle

Gharar is another principle in the Islamic banking that prohibits Muslims from participating or engaging in uncertain or ambiguous financial transactions. According to this principle, any person willing to make financial transaction must agree with the other party to create a proper control environment over the business. According to Albaraka (2017), the Gharar principle also dictates that both parties should share complete information to enable them to share profit and loss equally as well.

3.3. Zakat Principle

Zakat is another principle of Islamic banking that includes a property tax that allows a balanced distribution of wealth across the Islamic society. This principle dictates that a fair amount of Zakat is deducted from the accounts of any person carrying out a transaction during the holy month of Ramadan (Albarka, 2017). The collected amount is then distributed to the neediest or poor in the society.

3.4. Shared Risk and No Investment Principles

Apart from the Riba, Gharar, and Zakat principles, there are also other important principles that are considered critical in the Islamic banking. For instance, shared risk principle that dictates that both parties involved must carry the burden of risk equally to improve the economic activity in the given Islamic state (Albaraka, 2017). Gambling principle is another key aspect of Islamic banking that prohibits obtaining wealth through ambiguous means like participating in gambling. Further, the Islamic banking principle of no investment prohibits any form of investment of industries that are harmful to the society or considered a threat to the societal social responsibility such as pornography, prostitution, alcohol, pork, and drug industries (Halimatusadiyah, 2015).

4. Fundamentals of Islamic Banking and Finance

The Islamic banking theory explains that every contract must be backed by the underlying asset or investment activity which demonstrates a direct relationship between the financial market and the economic activity (Iqbal & Mirakhor, 2011). Therefore, the Islamic banking model has significantly improved the spread of real asset-based financing principles in various countries. It is also considered the ideal alternative for the financing of infrastructure projects. As a result, the Islamic banking systems can also contribute to the development and economic growth in a given country by creating a favorable business environment for achieving a more integrated approach to economic development (Johnson, 2013).

The success stories regarding the Islamic banking systems in other states like Singapore can be an example that can be replicated in emerging markets like Maldives. Despite the challenges in the market especially the emerging markets like Maldives, Islamic banking and finance is envisaged to be a significant contributor to the Maldivian economy as it remains an emerging field in the banking system worldwide (Morrison, 2013). The unique tenets or principles of Islamic banking system makes more appropriate towards achieving development and economic growth in Maldives. According to Ibrahim (2017), th...