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JRF
9,1 Development in Islamic banking:
a financial risk-allocation
approach
40
M. Mansoor Khan
Centre for Regional Engagement, University of South Australia,
Mount Gambier, Australia and
M. Ishaq Bhatti
Department of Economics and Finance, School of Business,
La Trobe University, Melbourne, Australia and
International Centre for Education in Islamic Finance (INCEIF),
Kuala Lumpur, Malaysia

Abstract
Purpose – The core objective of this paper is to direct worldwide attention towards the unparalleled
development in Islamic banking, its infrastructures and supporting institutions in recent years. This
paper articulates the case for Islamic banking in a very comprehensive and effective manner. It depicts
Islamic banking as a growing discipline adding more ethical, competitive and diversified tools and
systems into global finance. It highlights the paradigm, theory and practice, achievements, pitfalls and
future prospects of Islamic banking.
Design/methodology/approach – The paper deals with the Islamic paradigm of borrowing,
lending and investment. It presents the conceptual model and practice of Islamic banking. It covers
other related issues over the recent development of Islamic banking across the globe.
Findings – The paper observes that Islamic banking has made unprecedented progress over recent
years. The Middle East, South Asia and the Indian Subcontinent have emerged as hubs of Islamic
banking. Western conventional regulators and investors and other agents have also shown a greater
interest in and a receptive attitude towards Islamic banking. Despite all this, Islamic banking has been
facing some core problems and challenges that will have deep impacts on its future growth and
development.
Research limitations/implications – The paper deals with concepts, information and other facts
on Islamic banking that are not supported by any statistical analysis and empirical evidence. Thus
this paper may be regarded as being subjective in its real essence.
Originality/value – The paper educates Western market players about Islamic banking tools and
systems in their own language so as to bridge the gap between conventional and Islamic banking
disciplines. It suggests that Islamic banking is an equity-based system with conventional features. It
makes an important point – that the main players from both the Islamic and conventional streams
have a good opportunity to pool their expertise and resources to come up with better solutions in
business, investment and finance.
Keywords Banking, Ethical investment, Islam
Paper type Research paper

The Journal of Risk Finance

Vol. 9 No. 1, 2008 The authors are grateful to the Editor, anonymous referees, and A. Zaini from the International
pp. 40-51 Centre of Education in Islamic Finance (INCEIF), Malaysia, where the final version of this paper
q Emerald Group Publishing Limited
1526-5943
was completed. They are grateful to INCEIF for its hospitality. The authors bear sole
DOI 10.1108/15265940810842401 responsibility for any errors.
1. Introduction Development in
The conceptual development of Islamic banking gained momentum after the
mid-1940s. Islamic scholars such as Qureshi (1946), Ahmad (1952), Uzair (1955),
Islamic banking
Maududi (1961), Al-Arabi (1966), Siddiqi (1967) and Al-Sadr (1974) made significant
contributions to the evolution of the Islamic banking model. The huge influx of
petrodollars from the late 1970s provided a strong impetus to the development of
several Islamic banks in the Middle East. Other Muslim countries established their 41
own Islamic financial institutions over time. Islamic banking has made steady progress
over recent decades. In recent years it has emerged as the fastest-growing segment of
global finance due to consistently high oil prices in international markets and other
favourable socio-political factors. It is flourishing in Africa, Asia, Europe and North
America. There are about 300 Islamic financial institutions across 70 countries, holding
capital investments worth US$500-800bn, with an average annual growth of 15 per
cent (Arekat, 2006). It has been estimated that Islamic banking will have a market
value of US$4 trillion by 2010 (Cader, 2007). It is expected to capture about 40-50 per
cent of the total savings of 1.3 billion Muslims worldwide within the next eight to ten
years (Alam, 2006).
There has been an unprecedented growth and deepening of Islamic banking
products – sukuks or Islamic bonds, takaful or Islamic insurance services, equity
funds, hedge funds, assets and wealth management, risk and liquidity management,
real estate and corporate finance. Malaysia is the largest issuer of sukuks, worth more
than US$32bn (Alvi, 2006). Sukuks constitute about 85 per cent of the Middle Eastern
capital market – US$13bn of them have been issued there with an average growth rate
of over 45 per cent during 2002-7 (Islamic Finance News, 2006b). The Middle East and
Asian regions will primarily rely on sukuks to meet their US$1.5 trillion infrastructure
needs over the next five years (Khaleej Times, 2007). There are more than 250 takaful
companies worldwide. In 2005 they managed premiums worth US$2bn, which are
expected to grow to US$7.5bn by 2015 (Gulf News, 2006). Presently more than 350
Islamic equity funds, including the Dow JonesSM Islamic Fund (IMANX), manage
assets in excess of US$4bn with an annual growth rate about 15-20 percent (Islamic
Finance Training, 2007). There has been promising growth in the Islamic banking
infrastructure over recent years.
Islamic banking has received increasing support in recent decades in the Middle
East. Bahrain has emerged as the biggest hub of Islamic banking worldwide. The
persistent boom in the Middle Eastern economies may deliver US$18 trillion or more in
additional revenues over the next five years, and at least 60 percent of this additional
income might find its way into Shariah-compliant banking and investments (Graham,
2006). The Islamic banks’ deposits in GCC countries are expected to be worth more
than US$110bn by 2010 (Abdulmalik, 2006). Malaysia is the second biggest hub of the
Islamic banking and finance world. In 2006, Islamic banking assets constituted 11.8 per
cent of total assets in the Malaysian banking sector, with a growth rate of over 27 per
cent in the last ten years. The Malaysian government is targeting a 20 per cent market
share for Islamic banking by 2010 (International Herald Tribune, 2007). Islamic
banking assets represented 1.8 percent of total Indonesian banking assets in 2005.
Bank Indonesia has formulated a ten-year roadmap to ensure a 6 per cent market share
for Islamic banking by 2011 (Harisman, 2006). Singapore has plans to become the
major trading centre for sukuks, property funds, hedge funds, etc. There are six Islamic
banks in Pakistan, holding a 2.2 percent share of the total banking market with assets
JRF worth US$1.3bn. Islamic banking deposits are expected to grow to US$13bn,
constituting ten percent of total banking deposits in Pakistan by 2014 (Al-Refai, 2006).
9,1 In Bangladesh, at the end of 2005 six Islamic banks held 13 per cent of total banking
deposits and 15 per cent of total investments (Rana, 2006).
The United Kingdom (UK) Financial Services Authority (FSA) has been showing a
more receptive attitude towards Islamic banking. A number of financial institutions
42 such as the Islamic Bank of Britain, the European Islamic Investment Bank, HSBC
Amanah and Lloyds TSB offer Islamic banking and insurance products to Muslims in
the UK, while LARIBA, University Islamic Financial, Guidance Financial Group,
Shariah Capital and others deliver Shariah-compliant products and services to
Muslims in the USA. United Muslims Financial Ontario has recently started to offer
Islamic mortgage services to Canadian Muslims. The Muslim Community Co-operative
Australia (MCCA) and APV Sydney Finance provide Islamic financing in property and
real estate to Australian Muslims. Furthermore, a significant number of Western
financial institutions such as ABN AMRO, Citibank and Goldman Sachs have formed
partnerships with Islamic players to promote Islamic banking in European and
Western markets. The main players from both Islamic and conventional streams may
pool their expertise and resources to devise more ethical and efficient solutions in
business, investment and finance.
This paper explores the modern Islamic banking world. The structure of the
remainder of the paper is as follows. The next section briefly describes the Islamic
banking paradigm. The third section elaborates the theory and practice of Islamic
banking worldwide. The fourth section deals with core problems and challenges facing
Islamic banking, and the final section provides concluding remarks.

2. The Islamic banking paradigm

Islamic banking is primarily an equity-based system featuring zero-based interest,
share economy, equity participation, joint ventures, mutual funds, leasing, innovation
and a promising rate of return. Islamic banking replaces interest-based intermediation
with profit and loss sharing (PLS) and interest-free intermediation. It does not
subscribe to the conventional criteria of funding on the basis of borrowers’
creditworthiness and strong collateral. Therefore, bad projects with strong collateral
seeking bank credit cannot substitute for good projects bearing weak collateral. In
other words, Islamic banking promotes a market-based mechanism wherein available
investment alternatives are appraised on their merits in terms of bringing marked
improvements to the allocation and distribution of wealth and resources (Ahmed, 1994;
El-Ghazali, 1994).
The ban on interest payments and receipts and the levy of zakah (a tax deduction of
2.5 percent on Muslims’ wealth that remains idle or unused by business and
investment throughout the Islamic calendar year) leave little scope for capitalists to
retain funds for profiteering, which could seriously handicap the desirable and natural
flow of funds into the market. However, capitalists are absolutely free to choose the
right time for investment and the most efficient investment avenues. Zakah is paid by
Muslims only to secure spiritual purification and to meet their religious and social
responsibilities towards their poor fellow human beings. Furthermore, Islamic banking
utilizes existing wealth to produce more wealth, goods and services. In the competitive
Islamic economy, the prices of goods and services show a declining trend because the
supply of goods and services constantly increases through innovation and competitive
entrepreneurship. Since the return on capital is based on its actual productivity and Development in
outcomes, credit creation and monetary expansion policies have less inflationary
impacts on the economy (Zarqa, 1983; Chapra, 1985).
Islamic banking
It is a unique feature of Islamic banking that it does business with weaker groups
and the poor. It specializes in financing small and medium-sized business enterprises to
promote sustainable economic growth with justice. It embraces the social and religious
responsibility to mobilize charitable funds and donations from its shareholders, clients 43
and others to help needy and disadvantaged groups in the community. In other words,
Islamic banking plays a similar role to mutual funds in the conventional financial
world. A number of mutual funds in the Western world, such as Vanguard,
demonstrate a genuine interest in meeting their ethical and social responsibilities. They
openly hold social responsibility funds for initiating general welfare projects. However,
it may be noted that Islamic banking abstains from indulging in unethical and
antisocial activities based on interest, gambling, speculation, films, pornography, wine
making and selling, and suchlike.
Some Western economists have found a cure for growing economic problems such
as unemployment, inflation and recession in reconfiguring the modern economy on a
risk-sharing basis. The latest version of a risk-sharing economy – share economy –
has been presented by Martin Weitzman, whose vision of share economy was hailed as
the “best idea since Keynes” by the New York Times. Weitzman (1984) was addressing
the growing problems of unemployment, recession and inflation in the US economy –
that is, recurrent bouts of stagflation. He contended that the heart of these problems lay
in the paying of fixed wages to workers and employees. During recessions, company
sales, revenues and profits fall but wages and salaries remain almost unchanged.
Companies try to control their fixed costs by downsizing their production and
employees. This may cause higher unemployment, spiralling wage rates and
inflationary trends in the economy. Weitzman argued that, if employees agree to take a
fixed percentage share in the company’s revenues and profits instead of a fixed salary,
these problems can be effectively resolved. They may earn a high income when the
company is making good profits, and a low income when profits are poor. These
variable income arrangements will provide greater job security to employees. With the
burden of fixed wage payments removed from their backs, companies may hire a far
greater number of workers than they do under the existing fixed wages set-up, which
may bring record low unemployment.
Islamic banking, however, perceives the root cause of the underlying problems to lie
in allowing a predetermined return on capital and its speculative use, gambling and
other fictitious activities in the market. Booming economies cause inflationary
pressure, and consequently interest rates rise. Given that debt constitutes a significant
share of corporate finance, the increasing cost of borrowing reduces companies’ profits
and revenues and obliges them to cut their production and numbers of employees. The
lower demand for or oversupply of labour in the market reduces overall wage rates. In
the given context, the Islamic economy based on the sharing of risk between the
financier and the borrower or entrepreneur may offer more effective solutions to
problems such as the business cycle, unemployment, and inflation.

3. Islamic banking instruments: theory and practice

The Islamic banking model primarily relies on the instruments of mudarabah (joint
venture) and musharakah (equity participation) to eliminate interest from the financial
JRF sector and economy. Other interest-free instruments such as murabaha (deferred
payment sale), ijarah (leasing), bai salam (advance payment) and bai istisna
9,1 (procurement engagement) are also used to enhance the practical scope, diversification
and risk management capabilities of the Islamic banking system.

3.1 Profit and loss sharing (PLS) instruments

44 Islamic scholars treat PLS instruments – i.e. mudarabah and musharakah – as a
central pillar of the Islamic banking model. In mudarabah banking, the Islamic bank
accepts funds from depositors under risk-sharing arrangements. The Islamic bank
either directly invests these funds in profitable investments or extends them to
entrepreneurs on a risk-sharing basis. The Islamic bank shares the profit or loss made
on mudarabah ventures with its depositors. In musharakah banking, the Islamic bank
contributes the depositors’ funds to a joint enterprise with the client (an entrepreneur).
Generally, the Islamic bank allows the client to manage all the affairs of a musharakah
business. The Islamic bank and the client mutually share the profit or loss made on the
musharakah investment.
Table I reflects that on average 6.34 percent of total financings by Islamic banks in
the sample were based on PLS instruments (mudarabah and musharakah) during
2004-2006. The sample comprises big banks in the IBF industry and so may reflect a
general trend in using PLS modes across the board. The weighted average use of PLS
instruments by the top ten Islamic banks, representing about 50 percent of the Islamic
banking industry, was up to 17.34 percent of their total financing operations during
1994-1996 (Ahmad et al., 1998). It may be noted that the use of the PLS system has
fallen by an average of 11 percent in the Islamic banking industry since the mid-1990s.
The practical scope of PLS instruments has always been limited by operational
difficulties and business ethics constraints. Islamic banks find that most projects
submitted by their clients for PLS financing are bad, risky and with over-optimistic
profit forecasts. They lack the regulatory frameworks, standard procedures, expertise
and tools to assess the viability of PLS investment proposals. They find the cost of
monitoring PLS projects prohibitive. Furthermore, the inefficient tax system, high rate
of illiteracy, low accounting standards and the practice of keeping a double set of
accounts on the part of the majority of business people have proved to be formidable
obstacles to the practical implementation of the PLS system in Muslim countries
(Ghafoor, 1999; Khan, 2003; Khan and Bhatti, 2006). Bashir (1999) observed that
Islamic banks cannot reflect the returns on Islamic financial products on a PLS basis
due to the absence of depositors’ insurance and effective regulations in the Islamic
banking sector. Any genuine attempt by Islamic banks to adopt the PLS system would
prompt their depositors to withdraw their funds, precipitating a credit crunch in the
entire Islamic banking industry. Islamic banks are bound to follow conventional
policies, which fully guarantee customers’ deposits and fixed returns on them. In
simple terms, the PLS system is not practised in Islamic banking in either spirit or
letter.

3.2 Murabaha (deferred payment sale): theory and practice

Under the murabaha arrangement, the client makes a promise to buy specified goods
from the Islamic bank on a deferred payment basis. The Islamic bank purchases goods
from the original supplier and sells them on to the client after adding its own profit
margin. The legality of murabaha could not be established from the primary sources of
 Total investment and Bai salam/bai
Name of Islamic bank financing PLS Murabaha Ijara istisna

Al Rajhi Bank (31 December 2006) 23,884,600 NTa/nil 14,079,797 9,112,761 577,134
(58) (38) (2.42)
Albaraka Bank Bahrain (31 December 2006) 391,124.766 27,525.244 289,071.426 42,187.279 1,000b
(7.03) (73.90) (10.79) (0.25)
Bahrain Islamic Bank (31 March 2005) 662,978.83 43,443.109 406,148.59 38,401.69 NTa/nil
(6.55) (61.26) (5.79)
Bank Islam Malaysia Berhad (30 June 2006) 2,439,612.057 20,464.736 404,956.463 90,560.104 181,803.455
(0.84) (16.60) (3.712) (7.4)
Bank Muamalat Malaysia Berhad (31 December
2006) 1,477,251.957 161.837 308,670.702 376,889.715 106,125.800
(0.0109) (20.89) (25.51) (7.18)
Dubai Islamic Bank (31 December 2006) 11,044,826c 1,653,457 9,248,383 1,644,437 1,212,546
(14) (83.73) (14.88) (10.98)
Gulf Finance House (31 December 2005) 1,248,904 61,015 725,677.00 NTa/nil NTa/nil
(4.88) (58.10)
Kuwait Finance House (31 December 2005) 15,433,653 NTa/nil 8,253,477 2,076,735 1,745,666
(53.50) (13.45) (11.31)
Qatar International Islamic Bank (31 December
2004) 1,288,308 6,242.03 1,007,448 60,120.6 42,787.4
(0.485) (78.19) (4.66) (3.32)
Entire banking sector of Pakistand (31 December
2006) 1,079,594.693 182,786 435,271 322,417 9,108.68
(17) (40) (30) (2)
Average percentage 6.34 54.42 16.31 5.60
Notes: aNT, not traceable. bBai salam investments in sukuk salam (bond). cGross total of Islamic and financing assets and investments is taken.
Furthermore, the investments in properties are also based on Islamic modes, but not included in the table, because there are no details over their break-ups
on the basis of given modes. dIslamic Banking Bulletin February 2007, State Bank of Pakistan, Karachi. Figures given in parentheses are percentages
Source: Summary data taken from the annual reports of the respective Islamic banks
Islamic banking

Islamic banking industry

($US, thousands)
musharakah), murabaha

salam modes in the

(mudarabah and
The application of PLS

ijara and bai istinna/bai

(deferred payment sale),
45

Table I.
Development in
JRF Islamic Shariah, i.e. the holy Quran and Sunnah. The early Islamic jurists, such as
Imam Malik (796) and Imam Shafi (820), approved murabaha sales but they did not
9,1 refer to the increase in price in the case of deferred payment. Subsequently, certain
other Islamic jurists, such as Sarakhsi (1091), Marghinani (1197) and Nawawi (1277),
allowed the seller to charge a higher price in the deferred payment sale by
characterising it as a normal trade practice (Saadullah, 1994; Vogel and Hayes, 1998).
46 Contemporary Islamic scholars have mixed opinions about the murabaha banking
system. The majority of them have strong reservations about it because of its close
resemblance to conventional banking practice.
Table I provides empirical evidence that on average murabaha represented 54.42
percent of the total financing and investment portfolios of ten Islamic banks during the
period 2004-2006. The weighted average use of murabaha by the top ten Islamic banks,
representing 50 percent of the Islamic banking industry, was 65.66 per cent of their
total financings during the period 1994-1996 (Iqbal, 1998). This implies that Islamic
banks have been determined to rely heavily on murabaha in carrying out their
financing and investment operations.
The practice of murabaha financing grossly violates Shariah principles. Islamic
banks insure murabaha goods against the risks of damage, destruction and theft, and
impose all such costs on their clients (Bashir, 1999; Warde, 2000). They use interest
rates to fix returns on murabaha contracts. They assign higher returns on murabaha
contracts with longer periods, just as conventional banking does. They follow the rule:
pay now, pay less principal. They recover fines and additional charges from clients
who delay murabaha loan repayments. Furthermore, they unlawfully recover losses
from clients who breach their promises to buy murabaha goods. Thus, Islamic banks
earn almost risk-free returns on their murabaha investments (Homoud, 1994; Ghafoor,
1999).

3.3 Ijarah (lease financing): theory and practice

The features of Ijarah financing are very similar to those of conventional lease
financing. But unlike in the conventional lease contract, Shariah holds the leaser
responsible for all damage, repairs, insurance and depreciation of the leased asset. The
leaser should also bear the risk of uncertainty attached to the useful life of the leased
asset. Islamic financial institutions mostly rely on leasing, known as Ijarah wa iqtina,
for meeting financing needs in the real estate, retail, industry and manufacturing
sectors. Leasing enjoys strong support from Shariah scholars and bears a close
resemblance to conventional leasing (Iqbal, 1998; Warde, 2000). Table I shows that
leasing was used by ten Islamic banks on average for 16.31 percent of their total
financings during the period 2004-2006.

3.4 Bai salam (advance payment) and bai istisna (procurement engagement)
Bai salam and bai istisna are forward sale contracts in which the seller pays in advance
the price of goods that are to be delivered to him at a specified future date. Bai salam
was widely practised in the Arabian agricultural sector long before the dawn of Islam.
These instruments are best suited to meet the financing needs of the farming and
manufacturing industries in the Islamic economy. Shariah stipulates that the terms
and conditions of bai salam and bai istisna contracts, such as price, quantity and
quality of goods, should be clearly determined without involving any features of
interest, gharar (speculation) or dubious sale (Iqbal, 1998). Table I shows that ten
Islamic banks carried out on average 5.60 percent of their total financing operations by Development in
relying on bai salam/bai istisna during the period 2004-2006.
Islamic banking
4. Problems and challenges for Islamic banking (banks)
Islamic banking is still highly nascent when compared with conventional banking. It
has been facing a range of problems and challenges. Islamic banks are haunted by the
chronic problem of excess liquidity. They carry about 40 percent more liquidity than 47
their conventional counterparts because there is a serious dearth of long-term
Shariah-compliant investment tools and avenues (Hakim, 2002). They commit 95
percent of their funds to short-term ijarah, murababah and musharakah instruments
(Islamic Finance News, 2006a). In 2002, four major Islamic banks established the
Liquidity Management Centre (LMC), which has been engaged in developing a
secondary liquid market for Islamic bonds, government securities, equities, mutual
funds and other instruments. Other institutions such as the Bank of Malaysia, the
Islamic Chamber of Commerce and Industry (ICCI), the International Islamic Financial
Market (IIFM) and the Dubai International Finance Centre (DIFC) have been working
to find effective solutions to the liquidity problem.
Islamic banks observe and follow many and varied accounting standards and
practices. Some of them follow International Accounting Standards (IAS), others
adhere to standards issued by Accounting Auditing Organization for Islamic Financial
Institutions (AAOIFI), and small ones adopt accounting standards prevalent in their
local markets. Even financial managers and researchers become very confused over the
heterogeneity in accounting practice and disclosure in Islamic banks. In fact, Islamic
banks should simply provide relevant and reliable information to stakeholders about
their responsibilities in the financial, social, environmental and religious arenas
(Sultan, 2006). It may be noted that AAOIFI and Islamic Financial Services Board
(IFSB) have been working over the years to develop universal accounting and auditing
practices for Islamic banks. AAOIFI has developed more than 63 accounting standards
for the guidance of and adoption by 130 member institutions, representing 30
countries.
There is a serious shortage of competent Shariah experts in the Islamic banking
industry. Only a small group of Shariah experts is serving on several Shariah boards
of Islamic banks worldwide. Majid Dawood, a London-based consultant on Shariah
compliance, pointed out that Shariah experts earn as much as US$88,500 per year per
bank (Matthews, 2005). In some cases, they charge up to US$500,000 for advice on
large capital market transactions (Tett, 2006). On the other hand, Shariah scholars at
small Islamic banks have little insight into the complexities of present-day financial
markets. Islamic banks should build up a strong base of research and training to
develop a corps of Shariah experts of high moral and professional integrity. They
should also establish a central Shariah board and an external audit committee to
provide a truly independent scrutiny of the Islamicity of their operations.
Islamic banks face another crucial challenge to improving their risk management
strategies and corporate governance. Presently they are extremely exposed to all sorts
of risks, such as those relating to interest rates, liquidity and non-payment. Sukuk
issues entail risks involving interest rates, foreign exchange, credit and Shariah
compliance (Hobson, 2006). Islamic banks cannot use conventional risk management
techniques and tools because they are based on interest, gambling and speculation,
which are prohibited by Shariah. In the given context, good governance can greatly
JRF help to streamline the organizational structure of Islamic banks on a more efficient and
democratic basis. Bank Negara Malaysia, International Islamic Rating Agency (IIRA),
9,1 IFSB and other supporting bodies have been pushing very hard for the development of
prudential regulations and systems related to risk management, capital adequacy and
corporate governance at Islamic banks.
Islamic banks have a very unsatisfactory record for R&D and innovation. The
48 majority of Islamic banks are small and cannot afford to develop their own or joint
R&D facilities. Only big Islamic banks are engaged in some kind of serious R&D
activity. As a result, there has been a huge flight of indigenous oil wealth from the Gulf
countries to Western financial markets. Sheikha Lubna Al Qasimi, Minister of
Economy, UAE, pointed out that at present about 80 per cent of the US$1.8 trillion of
private wealth of the Gulf countries is invested abroad because there are not enough
Islamic-friendly investment opportunities in the region (UAE Intereact, 2006). Islamic
banks should take very, very seriously the challenge of coming up with a full array of
genuinely distinctive, innovative and competitive products.
With their poor record in R&D, Islamic banks rely heavily on conventional banking
tools and systems to carry out their day-to-day operations. It is no secret that they use
the London Inter-bank Offered Rate (LIBOR) market interest rates, discounting tables
and time value of money techniques to fix PLS ratios and returns on their murabaha
and other investments (Homoud, 1994; El-Ashker, 1995; El-Diwany, 2006). Haron and
Ahmad (2000), amongst others, have provided empirical evidence that Islamic banks
use conventional profitability theories in determining returns on their products.
Moreover, sukuks are issued on the basis of LIBOR. For example, the yield on Qatar
Global Sukuks is calculated on the basis of LIBOR on dollar funds plus 0.4 per cent per
annum. There is mounting pressure on Islamic banks to develop genuinely Islamic and
innovative products and to stop imitating the conventional practice.
It is matter of great concern that the legal and regulatory frameworks, systems,
products, and terminologies of Islamic banking are still very complex and
unstandardized. IFSB, international rating agencies and other major players have
been working hard to develop uniform regulations and systems of Islamic banking and
to improve its credibility, transparency and disclosure. Furthermore, the majority of
Islamic banks operate within conventional environments. They now enjoy good
support from conventional banking and regulatory systems. Bahrain and Malaysia
have excelled at establishing entirely independent nationwide legal, regulatory and
financial frameworks for Islamic banking operations, and other Muslim countries may
follow suit. A number of supporting bodies, including the Dubai Financial Services
Authority, IFSB and Malaysia’s Securities, have been working with conventional
banking authorities to resolve regulatory issues related to Islamic finance practice.
These developments may drive Islamic banking towards greater financial and Shariah
disciplines, sophistication and integration with international financial markets.
Last but not least, there has been an acute shortage of human capital resources in
the Islamic banking industry. Islamic banking personnel are largely drawn from
conventional banking. They are neither properly trained nor devoted to learning and
practising Shariah-compliant banking. They are interested only in eliminating interest
from Islamic banking operations without realising the true objective behind this
exercise. Major Islamic banking training institutions such as the Institute of Islamic
Banking and Insurance, Islamic Finance Training, and the International Centre for
Education in Islamic Finance (INCEIF) organize frequent and numerous training
sessions, conferences, colloquiums and workshops, but this is not helping to develop Development in
Islamic banking personnel with financial-cum-Shariah competence. It is high time that
the Islamic banks made substantial investments in human resources development and
Islamic banking
training and research faculties. Internally groomed human resources can only add real
value and solutions to the current issues and challenges facing Islamic banking.

5. Summary and conclusions 49

Islamic banking refers to Shariah-compliant tools and mechanisms to replace
interest-based financial intermediation with the risk-sharing and interest-free
paradigm. It primarily relies on equity modes to conduct its affairs. This ensures
the most efficient, ethical and equitable use of economic resources of the polity. Islamic
banking relies on PLS modes, namely, mudarabah and musharakah as major, and
murrabah, ijarah, bai salam, bai istisna as secondary, instruments to perform lending,
borrowing and investment functions.
Islamic banking emerged from Middle Eastern horizons after the mid-1970s and has
flourished over the past three decades in Muslim countries. In recent years, it has made
breakthroughs and advances in more than 70 countries in Africa, Asia, Europe and
North America due to spiralling oil prices worldwide and other favourable factors. It
has found fertile soil in the Middle East, Southeast Asia and the Indian Subcontinent.
Among others, takaful, sukuks, Islamic equity funds and wealth management are the
fastest growing segments of Islamic banking and finance. Increasing numbers of
Western financial institutions have been engaging in Islamic banking to bring
innovation and diversity into their operations and to attract petrodollar investments
and a Muslim clientele worldwide.
Despite making good progress, Islamic banking has been facing teething problems
and challenges. Islamic banks need to improve their liquidity, corporate governance
and risk management techniques. They are expected to develop domestically
compatible and internationally competitive Islamic accounting standards and
practices. They are required to build up their Shariah faculties and regulatory
frameworks under common and universal principles. They should take R&D activities
very seriously and develop a wide spectrum of truly Islamic and innovative products.
Islamic banks are required to replace the overwhelming use of murabaha financing
with PLS financing. They are also urgently required to respond to the growing crisis in
human resources management. The problems and challenges of Islamic banks cannot
be effectively dealt with unless the leadership of Islamic banking becomes truly
committed and competent. In a nutshell, it is yet to be substantially proved that Islamic
banking offers more efficient and ethical solutions in the contemporary financial world.

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Corresponding author
M. Mansoor Khan is the corresponding author and can be contacted at: mansoor.khan@
unisa.edu.au

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