Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
Factors Affecting Stability of Islamic Financial System
Humaira Parveen Runi
Islamic financial industry is considered as one of the rising industries at present.
In spite of the continuing aftershock of the global financial crisis, the
development of Islamic finance is a viable form of financial intermediation which
is steadily moving forward and continuing with many emerging markets and
introducing new standards with new products to attract investor and still striving
to reach the stable framework in different part of the world, starting from the
middle-east to the Muslim countries of Asia. In this paper, I would like to present
few silent but dominating factors those are playing role behind this instability.
One of the biggest challenges for Islamic financial system is its competition with
the conventional system, especially in the country with dual banking system.
This competition is forcing Islamic financial system to provide hibah to the
deposit account holder, to arrange a floating rate to the financing, etc. This is the
challenge in the product design perspective. Again from the target customers
group consists of both Muslims and Non-Muslims. So the financing as well as
depositing need is not the same for these two groups whose belief system is
different. This sort of demand, which is not Islamic by virtue, is forcing the
Islamic financial system to develop products which are getting controversial to
different majhabs.
We also find the legal system of the country is not following the Islamic rule, any
disputed issues which are referred for judicial decision are judged under civil
system. This is leading to another source of instability. The financial products,
which have been developed with Islamic principles, when judged under civil legal
system, it missed out its basics in deed. Harmonization crisis is always present
in this financial system, which needs to be addresses with a broader perspective
to reach the stability. Finally, the ethical and moral standard of the customers
restricts the institutions to be fully Shariah-compliant for the default customers by
offering them grace period or even to waive the debt.
With all these details above, this paper has discuseds about the factors affecting
the stability of Islamic financial system which is ultimately influencing the
domestic
as
well
as
global
economy.
1. Introduction:
Islamic financial industry is considered as one of the rising industries at present. It is undergoing
various progressive stages as one of the fastest growing asset classes in the world. In spite of the
continuing aftershock of the global financial crisis, the development of Islamic finance is a viable form
of financial intermediation which is steadily moving forward and continuing with many emerging
markets and introducing new standards with new products to attract investors.
Islamic financial system is based on keeping in view certain social objectives for the benefit of
human beings and society. Islam, through its various principles, guides human life and ensures free
enterprise and trade. Socio-economic justice is central to the Islamic way of life. In an Islamic
financial system, the transactions are not only for individual benefit; also it has scope of activities and
responsibilities extended to the welfare and interests of society at large, which is the basic unique
characteristics of this system.
__________________________________________________________________________
Ms. Humaira Parveen, Finance Department, IBA, Dhaka University, Dhaka, Bangladesh, email: humaira_parveen@yahoo.com,
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
2. Factors Effecting Stability of Islamic Financial System:
Almost in every country, Islamic financial system (IFS) is running in parallel with the conventional
system. Under this dual system also, IFS has also gained wide acceptance as a form of financial
intermediation throughout the world. But this industry is struggling for the stability in different
perspective. Attention has been given to the supervisory, regulatory and legal dimension and also to
the development of the financial infrastructure, the markets, the Islamic institutions and the financial
instruments. But still it is striving to reach the stable framework. And in this paper, I would like to
present few silent but dominating factors those are playing role behind this instability.
2.1 Competition with the Conventional Financial System:
With its journey of around thirty years, Islamic financial system (IFS) has already reached to the
segments of banking system, Takaful industry, capital market, money market and also the derivative
markets. Different products have been developed for all these areas in order to provide a firm base
to compete with the conventional financial system. All the contracts are getting involved from multidimensional angels to design these products.
But one of the biggest challenges for IFS is its competition with the conventional system, especially
in the country with dual banking system. But this expressive and silent competition with the
conventional system, is forcing IFS to adjust its product design, process as well as regulation to
continue its existence. For example, the prohibition of giving hibah (gift) to the deposit account
holder of Islamic Banks (IBs). If IBs do not give it, then the customers will migrate to conventional
banks with their deposit and as a result, IBs will fell short in deposit fund. In some cases, to match
with these Conventional Banks (CBs), IBs borrow fund from money market to provide hibah to the
depositors and their earning gets even lower and the ultimate result is displacement commercial risk.
Thus we can see, IBs are exposed to risk for competing with CBs, which is an external force and
without any control over that.
2.2 Basis of Competition:
Willingly or not all the Islamic financial institutions (IFIs) are facing competition with the conventional
financial institutions all over the world. But this competition is difficult to be justified as the basis of
operations of these two groups is significantly different when one group accepts the gain from money
and the other does not. But there is no way possible to avoid this competition. But IFIs should focus
more on other areas rather than their product design or to face this competition. For example, IFIs
can achieve operational excellence, distribution network, or customer service – these areas to
establish their competitive advantage in the industry in order to face the competition. The customers
have a very high ranking in all these characteristics for choosing a financial institution for their
transactions. So being firm in Shariah compliance while product designing, IFIs still can be
competitive in the industry.
2.3 Product Pricing:
Pricing is another major area that IFIs are dealing with. On the financing side, we find IBs have
introduced the floating financing rate to compete with the CBs. As per Islamic contracts rule, no
elements of contract can be changed once the contract is agreed and signed by both the parties, etc.
This is one of the biggest challenges from the product design perspective. One example, I would like
to discuss in this reference. The rate, which is set during the financing of IBs, cannot be changed
once fixed as per Islamic Contract rule. But CBs can change the rate as per the industry as well as
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
country‟s economic condition as they do not have any binding to fix the rate throughout the tenure. It
was creating pressure on IBs as they were bound to fix the financing rate even the economy was
changing the rate itself. If the rate used to go downward, then the banks are in challenge of losing
customers as their rate was higher. On the other hand, if the rate was moving upward, they are in
better position to retain the customers but losing the opportunity to earn more revenue. In nutshell,
this was raising the mismatch risk by having the fixed income streams from their financing activities
which need to be distributed among depositors at a competitive market rate, not according to their
income.
Again we find that the long-term financing of IFIs are funded by short-term deposits. Thus they lock
their profit rate through financing over a long period. So, it becomes difficult for them to provide
competitive return to the depositors. Thus this also leads the depositors to transfer their funds from
IFIs. This fixed-rate regime has resulted in a funding mismatch to the Islamic financial institutions
because their long-term financing was funded by short-term bank deposits which can give variable
returns. In recent developments, the high leverage on fixed-rate financing became a topical issue in
Islamic banking as there has been an inadequate hedging mechanism through which Islamic
financial assets could grow and be protected from exposure to fluctuations in the financing rate.
In this perspective, we find the introduction of „Islamic Variable Rate Mechanism, which has come to
Malaysia in 2002. This first variable rate financing product was developed for the Islamic banking
industry under the concept of Bai’Bithaman Ajil, or in short, BBA. The ultimate target to develop this
variable rate mechanism is to support the IFIs, especially who are operating in dual banking system
where the financing rate is in changing pattern most of the time. But with this initiative, IFIs are able
to receive the income stream from their financing products as per the market trend and can distribute
the same to the depositors in a more competitive manner. Thus they can maintain the available
deposit as well as can raise new deposits. This mechanism ultimately offer rebate to customers,
which is known as „ibra‟ and the Shariah issue comes here as to decide whether it is a right of the
customers or the freedom of the banks to decide.
2.4 Benchmark to Use:
In order to be guided to set their rate, IFIs use Base Financing Rate (BFR). It is the minimum interest
rate calculated by Islamic financial institutions based on a formula which takes into account the
institutions cost of funds and other administrative costs. Usually it is similar amongst the major
Islamic Banks. Some adjustments to the BFR are made by banks at the almost same time, though
not regularly. In Malaysia, this BFR adjustments correlate with adjustments of the Overnight Policy
Rate (OPR) which is determined by the Central Bank, Bank Negara Malaysia (BNM) during
Monetary Policy Meeting. But throughout the world, all the countries where Islamic financial system
exists does not follow this practice, rather they follow the interest rate index, e.g. country index,
LIBOR, etc. and this rise the question of criticism as well. Taking this conventional interest based
benchmarks as the base of pricing an Islamic financial product puts Islamic banks dependent on
their conventional peers. This raise a negative perception among people that there is no prudent
difference in Islamic bank products as these are also using the same interest based benchmark. The
mechanism for long-term financing could be devised on the basis of prevailing renting system
adopted by the private landlords while renting their assets/properties etc. The industry needs to work
in this area immediately to establish a standard Islamic rate index to be followed as a base by all the
IFIs all over the world.
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
2.4 Target Customer of IFIs:
The target customer of IFISs is another big challenge for achieving stability of Islamic financial
system. In general for most of the IFIs, the target customer consists of Muslim as well as NonMuslim customers. Again, there is no standard definition of Muslim customer. Being a Muslim by
birth does not necessarily mean that the person will follow all the requirement of Islam religion, will
look for Shariah-compliant products, services all the time, rather some Muslim people have other
characteristics for searching their products. For these non-observing Muslims, the services provided
by IFIs get challenged and they get forced to be competitive with the conventional financial
institutions. For meeting the requirements of this customer group, IFIs need to design their products,
which end up with controversy.
One such product is credit card. It provides a revolving credit facility within the credit limit and credit
period determined by the issuer of the card. It is a means of payment for the card holder. The card
holder is able to purchase goods and services and withdraw cash within the credit limit. Ultimately
the amount of purchase or cash withdrawal becomes cardholder‟s debt to the card issuer. The
industry has different view on the mode of credit card operation, the contract used for offering this
service, the late payment fee or the service charge. But I would like to draw the attention on the
basic need of the consumers that has created the base of offering Islamic Credit Card and the basic
requirement to have a credit card for the customers is to have a credit limit so that they can spend
when they do not have money themselves at the time of spending. But Islam does not permit this
sort of spending behaviour at all unless it is a mere necessity. A Muslim should not be vain or
attached to the ephemeral pleasures of this world. While most people allow the material world to fill
their hearts, Muslims should keep Allah (SWT) in their hearts and the material world in their hand.
In Holy Quran, Sura Al-Furqan, verse no. 67, Allah (swt) has said as follows:
"And those who, when they spend, are not extravagant and not niggardly, But hold a medium (way)
between those (extremes)"
But the product „Credit Card‟ is offering the facility to avail the spending option when customers do
not have money and they can pay it in future. This pattern of spending is not necessity in most
cases, rather it is a luxury and over spending nature. There are other facilities of having a credit card
as well, e.g. it helps customers not to carry cash, it is secure, etc. But these benefits become
secondary and availing credit facility becomes the primary reason for the customers for having a
credit card. The Muslim customers should rather avail „Debit Card‟ through which they can spend
directly from their account balance.
The same Muslim customers select the financial institutions based on their profit rate. So when they
find the conventional financial institutions are offering better rate, they shift to those institutions. For
them the rate is important, rather that Shariah compliance. In this way, to serve the target customers
who are not considering the Islam requirements as basis to meet their demands, the IFIs are facing
the competition as well pressure in their operation, products as well as process. All these are leading
them towards instability.
2.5 Legal Framework:
The stability of Islamic financial system is also challenged by the legal framework available for the
IFIs. In most countries, we find the disputed matters of IFIs are referred to civil system for the judicial
decisions. This is leading to another source of instability. The financial products, which have been
developed with Islamic principles, when judged under civil legal system, it missed out its basics in
deed. The commercial laws appropriate for implementation of Islamic banking and financial contracts
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
do not really exist; Islamic banking contracts are treated as buying and selling only. In these laws,
the provisions of Islamic transactions are defined very narrowly and specifically within conventional
limits. But to ensure the stability, we need the specific Islamic legal framework for the IFIs. To be
more specific, I would mention the requirement of Islamic courts to deal with Islamic contracts only,
Islamic financial transactions law, etc. In absence of all these, the enforcement of Islamic contracts
by the IFIs in courts may require extra efforts, costs and time as well. Besides the banking and
companies‟ laws in several countries are required to be amended to create a level playing field for
Islamic institutions. Furthermore, international acceptance of Islamic financial contracts requires
them to be Shariah compatible as well as acceptable under the major legal regimes such as
Common law and Civil law systems.
2.6 Tax System Applied:
Besides the legal framework, I would like to draw the attention towards the tax system of the country
to bring the stability in the financial system. As we know, in Islamic contract, a sale is complete only
when the ownership of the object is transferred from the seller to buyer. For certain objects, e.g.
house, land, etc. this ownership gets complete only when the tax is paid to Government. For Islamic
Banks, before selling the product, banks have to take the ownership themselves first and then sell it
to customers. So in a standard procedure, IBs have to registrar the house/land in their name and
then sell it to the customers. But while registering they need to pay the tax as well to Government.
As a result, in order to complete the Islamic contract requirement for a particular sale of house/land,
tax need to be paid twice for the same property, first by the IBs when the property is bought by them
from the seller and then by the customers, when they buy it from the IBs. Thus we find the double
taxation issue here. To avoid this double taxation, IBs allow to registrar the property at customers‟
name on the first phase and at the same time get the customers signed some other contracts e.g.
Product Sale Agreement (PSA), Product Purchase Agreement (PPA), etc. to ensure their ownership.
But this does not really fulfil the purpose of getting ownership of the property by IBs. There are
instances when we have found the civil court has given their decision saying that IBs have no
ownership on the property and it becomes a serious problem for them in case the customers default.
Neither they get the financing amount back from the customers nor do they get the right to sell the
property in deed. In order to avoid this scenario, countries need to bring changes in their tax system
which will allow that the tax need to be paid only once by the ultimate owner of the property and not
by the banks whose purchase is only to complete the Islamic contract‟s requirements. This might be
one way-out for this tax dispute.
Besides this, the penalty charges, those are realized by IFIs, are not taken as their income according
to Shariah guideline. So, Government is not earning any amount through income tax from this
amount. IFIs need to be more transparent on this fund utilization and a separate statement should be
included in the financial statement as a regulatory requirement.
2.7 Ethical Stand of the Customers:
The ethical and moral standard of the customers plays another instability source of the financial
system. Human beings are blessed with an innate sense of morality, which has served to guide them
in order to distinguish between right and wrong as well as good and evil. Although the degree to
which a certain quality is interpreted as being either good or evil may vary from person to person,
there is more or less a universal consensus regarding the classification of what constitutes a moral
deed or attribute and what does not. Thus, the ethical and moral virtues such as bravery and
truthfulness have always elicited praise, which addresses every aspect of a Muslim‟s life, from
greetings to international relations. Islam has set the highest possible standard of morality. Ethical
behaviour is the right way to behave and is choosing the right and good. Islam supports morality and
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
matters that lead to a healthy society, and stands in the way against corruption and matters that lead
to it.
But are the customers always behave on the ethical and moral standard while dealing with the IFIs?
IFIs do their necessary verification of the customers before financing through „Know Your Client‟
(KYC), field visit, etc. But it becomes very difficult for them to be certain whether customers are really
in difficulty or they are pretending, once they default.
In Holy Quran, Sura Baqara, verse no. 280, Allah (swt) has said as follows:
“And if the debtor is in a hard time (has no money), then grant him time till it is easy for him to repay,
but if you remit it by way of charity, that is better for you if you did but know.”
But IFIs cannot always follow the above instruction as customers do not present their real scenarios.
To get the benefit from the IFIs, they might present that they are in difficulty, in reality they are not.
Thus, the lack of moral and ethical standard among the customers also leads the financial system
towards instability.
2.8 Harmonization of Products:
Islamic financial industry is also getting challenged by the issue of product harmonization. The
growth of the industry is hugely affected by the lacking of consent among the Shariah scholars of
different schools of thought. This diversity has resulted in disagreements about the acceptability of
specific features of Islamic financial products. On the other hand, harmonization means establishing
universal Shariah standards to eliminate the disagreements of Shariah interpretation. There are both
parties who support as well as oppose this aspect of harmonization. One group thinks that the
harmonization will make the product development process more efficient. They argue that without
harmonization, the industry is left exposed to too many conflicts as institutions, bankers, and
consumers will look for the fatwa that suits their objectives. This group also believes that
harmonization supports the integration of Islamic financial markets into mainstream global financial
markets. On the contrary, the other group believe that harmonization will prohibit innovation. It will
also lower the effort by the financial institutions. But I believe for the new and emerging markets, who
want to introduce Islamic Finance in their financial system, harmonization will be value adding. It will
be cost effective and will also lower the risk of Shariah non-compliance. They can start with the
existing one and start research for further development. Though, AAOIFI, IFSB, and International
Islamic Financial Market (IIFM), are working here, still the controversies exist in this industry is quite
a huge and this created the instability of its own.
2.9 Concerns of Liquidity Management:
With all these mentioned areas, there is another area to be concerned that affects the stability of
financial system and it is liquidity management of IFIs. It is one of the most crucial operations for the
Islamic banks specifically. To be interconnected with the global financial system, it is now very
essential that IFIs put more focus in their liquidity management. The crisis is more on excess fund
because of limited availability of Shariah-compliant instruments in products availability to invest in
the market. Islamic banks are also criticised for not giving priority to long-term development projects
over short-term projects aimed at quick profits. The short-term structure of the Islamic banks‟ assets
is even more pronounced with the predominance of debt-based contracts or fixed return modes like
Murabahah and leasing on the asset side of Islamic banks‟ balance sheet. The structure of deposits
on the liabilities side which is not sufficiently long term further accentuates the reluctance of Islamic
banks to get involved in long-term projects, which is another cause of liquidity risk for IFIs.
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
At the same time, the lack of secondary market for the products in Islamic finance industry is another
major crisis behind instability. It makes the IFIs reluctant to invest in these products in the primary
market and result is the liquidity crisis. But having good liquidity management is a key prerequisite
for sustaining financial stability and efforts are required to have new products to be introduced to
accomplish this crisis. At the same time, countries should develop „Commodity Market‟ to support the
Islamic financial system in liquidity management.
2.10 Supervisory Framework:
Finally, I would like to draw the attention towards supervision of Islamic banks which is equally
important. At present, lack of effective prudential regulation is one of the weaknesses of the Islamic
finance industry. But for ensuring the stability, there is no other alternative other than the efficient
and effective supervision of the industry. The Government support is also another requirement for
the stability. With the controlled supervision, the industry can face any challenge very responsibly.
This supervision should also focus into the role of Lender as Last resort to ensure the safety net for
the depositors as well as IFIs for establishing a stable financial system in the economy.
In Holy Quran, Sura Imran, verse no. 104, Allah (swt) has said as follows:
“Let there arise out of you a group of people inviting to all that is good, enjoining what is right and
forbidding what is wrong. It is they who are the successful.”
All these are very much present in Malaysia, which can be taken as role model for many countries.
For instances, we can cite the Bank Negara Malaysia‟s (BNM) resolution on offering ibra by the IFIs.
As we know ibra has the question whether it is a right of the customers or a privilege to receive due
to the different opinions from different school of thoughts. To address this issue we find BNM has
given the guideline in January 2011 to grant ibra to all customers who settle his or her financing
before the end of the financing tenure. There are many other examples as well. This supervisory
authority must ensure the proper mechanism of product development, process initiation, ensuring
transparency and required information disclosure to the public in order to ensure customer protection
as guided by Shariah.
3. Conclusion:
Financial stability does not have any standard definition; rather it is a broad concept. But the
accepted key elements are the institutions, primary & secondary market, products availability, legal
system and of course the supervisory as well as regulatory control. At present Islamic financial
system is following a significant progress in the domestic level and also integrating with the global
market place with the same pace. The initiatives on the global front to position the Islamic financial
system as a dependable area of the global financial system will contribute to further strengthen the
development of the domestic Islamic financial system. So it is obvious that the stability is must for
the system in domestic as well as global perspective.
Also to ensure the sustainability of Islamic financial system, all concerned parties, both who are
providing the services and who are availing the services have much to work on for this achievement.
Islamic Finance is still at its early stage of development as stability is far away to reach. This paper
has identified few areas only for attention. But we need to be attentive on a regular basis as stability
is never stays at a guaranteed state. With all our effort, we will ensure a constant stable Islamic
financial system and will support the economy as a whole, InshaAllah.
Proceedings of 9th Asian Business Research Conference
20-21 December, 2013, BIAM Foundation, Dhaka, Bangladesh ISBN: 978-1-922069-39-9
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