Chronicle of the Middle East and North Africa

Islamic Banking Sees Rapid Expansion in Gulf Region Amid Rising Risks

While Islamic banking has grown tremendously in the Arab world, further legislation to diversify its tools and improve trust in them is still predicted.

Islamic Banking
A woman walks past a branch of Dubai’s Islamic Bank in the Gulf Emirate. AFP PHOTO/KARIM SAHIB

Ali Noureddine

This article was translated from Arabic.

The overall value of Islamic bank assets surged by more than 200 percent from $1.2 trillion in 2012 to $4 trillion by the end of 2022.

According to the Arab Monetary Fund, the majority of this expansion has been centered in the Arab region, which accounts for 55 per cent of global Islamic financial activity. The Gulf Cooperation Council countries alone account for half of the world’s Islamic banking assets and are home to 11 of the world’s top 20 Islamic banks.

The data also shows that Islamic banks’ assets in Arab countries have now surpassed 18 per cent of the total assets held by Arab banks. This indicates that Islamic finance has emerged as a significant rival to traditional banking in several Arab countries, notably in the Gulf.

In particular, the proportion of Islamic banks’ assets compared to the total assets of banks has increased to 45 per cent in Kuwait, making it the Arab country with the highest reliance on Islamic finance. Saudi Arabia and Qatar follow in second and third place, with Islamic banks accounting for approximately 26 per cent of the total assets of banks in the two countries.

Meanwhile, the percentage of banking assets that are Sharia-compliant approached 20 per cent in the United Arab Emirates, 17 per cent in Bahrain, 16 per cent in Djibouti and Jordan, and 15 per cent in Tunisia. These comparisons exclude Sudan, which relies primarily on Islamic banking to manage the entirety of its banking sector.

In brief, the Islamic finance sector has experienced significant growth in recent times, both in terms of its size and its relative significance compared to conventional banks in Arab countries.

Additionally, Islamic banks have made substantial strides in improving the quality of their products, as well as the regulatory framework governing their operations. These developments have played a key role in bolstering public trust and confidence in the stability of Islamic banks.

Despite significant expansion and development, the topic of Islamic banks remains a source of contention in many Arab countries. Some claim that these entities are only a means of simulating traditional banking procedures while circumventing existing restrictions.

According to critics, Islamic banks do not provide a separate financial or banking model. Even international agencies, such as the International Monetary Fund, have expressed concerns regarding Islamic banks’ methods and risks, as well as their compatibility with modern banking systems.

In contrast, some argue that Islamic banks provide innovative and novel financial alternatives for individuals who wish to comply with Islamic law principles. Some experts even see Islamic banking services as an evolving financial paradigm that mitigates numerous risks associated with conventional banking methods.

History of Islamic banks

As is commonly known, the work and financing models of traditional banks in Western countries have evolved over the course of several centuries, accompanied by corresponding legal and regulatory frameworks. However, it wasn’t until 1963 that the first attempt to establish a Sharia-compliant bank was made in Islamic societies.

Previously, jurisprudence scholars identified significant contradictions between Islamic law principles that prohibit usury, which involves dealing with interest, and bank business models that generate profits from the difference between interest paid to depositors and interest received from borrowers.

Consequently, banking in the Arab region was limited to the services offered by local or foreign conventional banks, as there were no Islamic financing models available.

In 1963, Dr. Ahmed El-Naggar, an Egyptian economist, pioneered the provision of Islamic financing services through an experiment known as “savings banks.” The concept involved setting up a network of banking branches that accepted savings from residents of Egyptian villages, with the condition that the branches would finance the projects of farmers, artisans or industrialists within those villages.

Compliant with Sharia principles, the branches did not provide financing in the form of interest-based loans but rather through contributions and partnerships that entitled them to a percentage of the project profits. Depositors did not receive interest payments but instead received a portion of the branches’ profits.

After six years, the experiment proved successful with over 53 “savings banks” branches established and approximately 85,000 Egyptian citizens subscribed.

However, the expansion of private financial institutions through these branches contradicted the socialist ideology embraced by Gamal Abdel-Nasser’s regime, ultimately resulting in the state assuming full control of the branches and merging them with the state-run and state-owned traditional banking system.

As a result, the first experiment aimed at reconciling Sharia law with banking activity concluded six years after its inception.

In 1971, the Nasser Social Bank was established in Egypt as a state-owned public entity. The bank was not permitted to engage in interest-based transactions, either through taking or giving, under the statute that defined it at the time and instead focused on developmental and social activities.

While the bank’s operations were in accordance with Islamic law’s prohibition on interest, this experience wasn’t representative of an Islamic capitalist profit-making enterprise, as modern-day Islamic banks are.

In 1972, the concept of Islamic banking gained momentum when a conference of foreign ministers from Islamic countries recommended the establishment of an international Islamic bank to serve the financial needs of these countries. As a result, the Islamic Development Bank was founded in 1974 with the aim of providing international development finance while adhering to Islamic law.

However, the bank’s services were initially restricted to governmental and strategic projects, which impeded the growth of Islamic banking services for companies and individuals in the countries that benefitted from the bank’s services.

The first sustainable, profitable and integrated experience for Islamic banks emerged in Dubai with the establishment of Dubai Islamic Bank in early 1975. Subsequently, other Islamic banks emerged in the United Arab Emirates and neighboring Gulf nations, leveraging the surplus generated from oil exports and the consequent accumulation of savings in the region.

The conservative social norms prevalent in these societies further aided the development of Islamic banking, as it aligned with their efforts to reconcile the quest for financial services with adherence to the tenets of Islamic law.

The activity of Islamic banking has not only experienced growth in the Gulf countries, but also in various other countries including Jordan, Lebanon, Algeria, Turkey, Malaysia and Egypt at different times.

One of the major factors contributing to the expansion of Islamic finance services has been the establishment of Islamic banks by conventional banks, enabling the Islamic banking sector to capitalize on the capital and expertise of established traditional banks that are already operating in the market.

Application of the Islamic banking model

Islamic law prohibits the payment or receipt of interest.

For this reason, the services of Islamic banks are based on a set of tools that enable Islamic banks to provide or receive money from customers in a sustainable and lucrative manner, without explicitly and directly providing interest. Examples of these tools include:

Murabaha contract:

This is an Islamic financing model in which the Islamic bank purchases a particular commodity, such as a car, house or household appliances, on behalf of the customer using its own funds. The bank then sells the commodity to the customer at a marked-up price that includes a certain profit margin.

The customer can pay for the commodity through convenient payment arrangements, such as monthly, quarterly or annual installments, without incurring any interest charges. This system provides customers with a way to obtain financing for their purchases without relying on traditional bank loans, while the bank profits from the margin generated by the buying and selling process.

Murabaha is a popular financing strategy used by Islamic banks to help businesses wishing to expand have access to financial services to pay, for example, the purchase of equipment. The Islamic bank buys the equipment and sells it to the client at a deferred payment price that can be paid in installments, with a profit margin added to the commodity’s price.

Mudaraba contract:

This financing technique is used by Islamic banks to provide funding to owners of productive or commercial projects. This contract allows an Islamic bank to finance a specific project undertaken by an individual or organization in exchange for the bank recuperating the value of the financing as well as a set percentage of the project’s revenues.

As a result, rather than providing finance as a loan with interest, the bank becomes a partner in the project’s profits. The contract’s terms may be tight, containing certain requirements and guarantees that ensure the bank recovers the entirety of the funding supplied.

Musharaka contract:

Similar to the Mudaraba contract, the bank provides funding for a project and becomes a partner in the profits. However, in the Musharaka contract, the bank has more authority to intervene in decisions and oversee the project’s management.

Additionally, the bank shares ownership of the institution itself. Unlike the Mudaraba contract, the bank also assumes responsibility for any losses that may arise from its participation, rather than seeking to recover its full investment later.

Lease-to-own contract:

Islamic banks provide this financing option as an alternative to standard home loans. The Islamic bank initially owns the residential property and rents it to the consumer for an extended period of time, which can last several decades.

The customer pays the bank rent, which includes a profit margin until the property is entirely paid off. The bank transfers ownership of the property to the customer once the payments are completed. This strategy substitutes the usual method of repaying a mortgage in installments, which is typically given by traditional banks.

Although Islamic banks do not offer conventional debit or overdraft accounts due to their strict prohibition of interest, customers can still benefit from credit card services, such as prepaid cards, for a fee.

Furthermore, unlike conventional banks, Islamic banks cannot offer set interest rates on deposits. Instead, they pay consumers a monthly or annual percentage of the earnings made through investing their assets in various financing programs.

A debate about the risks and problems of application

Islamic banks continue to be the subject of numerous debates regarding their role and operational risks.

Some critics argue that the fixed profit margins achieved by Islamic banks through contracts such as Murabaha transactions or lease-to-own agreements merely reproduce the principle of interest adopted by conventional banks.

From this vantage point, Islamic banks’ services are viewed as a way to avoid the concept of interest in form without abandoning it in content. Others raise concerns about Islamic banks’ credit risks, notably their usage of partnership contracts, which might burden them with the duty of project management and profitability.

Others, on the other hand, emphasize the benefits of Islamic banks, which may help avoid certain hazards inherent in traditional banking. Unlike conventional banks, Islamic banks do not provide their depositors with fixed, long-term interest rates. Instead, they agree to pay a share of the profits generated from the investment of funds.

This allows Islamic banks to circumvent the dangers associated with interest rate changes, which can result in low-interest rates on bank assets that are lower than the interest provided to depositors.

While Islamic banking model has clearly grown tremendously in the Arab world, particularly in the Gulf States, it is still in its infancy. Further banking legislation and regulations targeted at diversifying Islamic banks’ tools and improving trust in them are predicted in the future years.

Furthermore, it is expected that significant improvements will be made in how Islamic banks manage the risks connected with their operations, and apply lessons learned from previous years.

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