Islamic Banking Operations and Trade Finance
Banks traditionally offered current and saving accounts because of the benefits such products availed for depositors; a check book, typically associated with a current account for instance, is a must for all types of businesses. Further, current and savings accounts are classified as “low cost deposits”, i.e. they either bear no interest rates or comparatively low interest rates. This means that banks gain higher profit margins upon lending said funds. In consumer finance the interest rates could be as high as 11%. It is for this reason that banks strategically pursue sources of low cost deposits.
The most attractive source of low cost deposits is Islamic Banking. Deposits under this domain are totally free of interest. This explains the reason for which global banks are investing large amounts to attract Islamic Accounts. The HSBC have a whole Islamic Banking Division and so is the SAMBA (CitiBank in Saudia). They are even offering a whole range of retail, corporate and trade finance products under their Islamic Banking brands like “Amanah” for the mere purpose of attracting interest free (low cost) deposits that can be lent later on at prevailing interest rates to make higher profit margins. Of course, according to the Shari’a principles, a dedicated Muslim must not deal with those banks that directly or indirectly charge interest (riba) from or pay interest to their customers. In principle, a Muslim who does not accept riba but banks with a financial institution that deals with riba, is in the same position as that Muslim who directly accepts interest. Hence, a devout Muslim must not deal with any bank that offers conventional banking products. To demean this rule, global banks have gone as far as employing the so called Shariá Boards that constitute of groups of 6 or more Muslim sheiks (O’lama: Islamic banking experts) who placed hundreds of fatwa’s (religious interpretations) to make dealings with them legitimate according to Islamic values. Although they were not so convincing, yet they managed to built their Islamic banking business. Their success is solely attributed to the failure of genuine Islamic Banks to offer the Muslims services at standards adequate to secure their rights and protect their interest, especially with regard to trade finance and investment transactions.
Hence, if a genuine Islamic bank was able to operate at standards parallel to those adopted by international banks, it becomes imperative on all devout Muslims to deal with such a bank rather than dealing with conventional banks.
In graincon.com previous article on Islamic Banking, the domain’s volumes, transactions and trends were highlighted. In this article, I will discuss the general principles applying to Islamic banking operations and trade finance.Trade finance operations under Islamic banking are identical to conventional banking operations. The LCs rules of practice for example equally apply to import LCs issued or export LCs advised under both conventional and Islamic banking. Same are risk management issues, excluding interest rate risks of course. Whilst on the subject of interest in the Islamic context, it is useful to define this term.
In Arabic language, people are accustomed to translate interest to “Riba” (fayedربا أو فائض ) which is a word meaning “surplus” or “additional”. In the abstract, the logic of forbidding interest in all types of banking transactions is avoiding the burden of debt on parties in circumstances where the underlying transaction or relationship does not yield the desired results. Hence, this in essence is a unified commercial and social code aimed at protecting citizens whilst at the same time facilitating trade and financial transactions instead of basing the whole relationship on the strict legal principles of contract (offer and acceptance) that encapsulates all commercial transactions. Uniquely designed as it is, the Islamic Banking transactions are based on an adjustable principle of fairly sharing profit made or loss incurred, rather than fixing a price on the loan or the deposit. In the later case, a borrower who fails to pay the interest of a loan granted by his bankers may well face legal suit that would add extra financial burden on him; a matter forbidden under the principle of fair dealing in Islam.It remains to say that the difference between Islamic and conventional banking trade finance lies solely in the methods of finance. Conventional banks provide import and export lines to facilitate the trade transaction for their customers. The case is not so in Islamic Banking where the banks enter into a partnership with the merchant by subsidizing the transaction on the Murabaha basis i.e. they purchase the goods at a certain price and resell it again at a higher price to the merchant where the difference in the purchase and selling prices represent the bank’s profit. The merchant then can settle the value of the transaction after a preset period of time.
It is worthwhile noting that under Islamic Banking, the underlying transaction itself has an effect on the legitimacy of the LC. For example, an LC covering the import or export of alcoholic drinks, explosives, pigs, bikinis, drugs, erotic movies, or other similar material that may not have acceptable social effects is forbidden in Islamic Banking.In financing trade, Islamic banks may also use one of the following two major principles i.e. musharakah and mudarabah. The dictionary meaning of the Arabic word Musharakah is partnership or contribution in a venture where both the buyer and the bank put up capital. The dictionary meaning of the Arabic word Mudarabah is plunge and it is a technical term used to describe the situation where the bank provides the technical skills and management needed to conclude the transaction accurately whilst the customer provides the investment.
Another main principle in Islamic Banking is Ijarah or lease. This is literally identical to the concept of leasing in conventional banking. The bank purchases the equipment or any other type of assets and the customer rents it for a specific period of time during which periodic instalments are made as lease and at the end of the period the asset becomes the property of the lessee where the bank transfers the ownership to the lessee.In essence, the Islamic banking trade finance services are traditional banking products redesigned to conform with the rules and principles of the Sharia. Murabaha is the most commonly used form of Islamic trade financing, which as explained earlier, is a form of partnership where the bank pays in full or part the value of the goods for its customer who in turn agrees to share the profits generated from sales with the financier, in simpler words, the bank purchases the goods and the borrower sells them. Of course the bank would allow the borrower a grace period adequate to sell the goods and repay dues.
In conclusion, Islamic banking is mainly based on profit-and loss-sharing partnerships; the essence of musharakah and mudarabah, to finance trade. Under musharakah, the bank pays part of the capital. One partner buys out the other partner's share over time. Under Mudarabah the client provides the capital and the bank contributes the skill and efforts to make the transaction a success. The distinctive feature of these types of financing is that the financier becomes a trader as well and takes possession of goods, something that traditional bankers prefer not to do.
The modern conventional banking has developed over long historic periods of time as a consequence of changing social and economic needs of people. It is based on laws and rules of economics and finance where the management of value is in the heart of the decision on the sort of banking services to choose. For example interest rates on deposits are correlated to annual inflation rate which in turn is the result of interacting factors of production and market forces (demand and supply). Hence banking is an advanced science based on solid laws rather than theories. For Islamic banking to blossom solidly, there has to be a mechanism that takes into account all such factors and soundly convert the traditional interest rates into equivalent fixed fees to ensure that the value of the investment is maintained undiminished. Many Muslim bankers actually argue that the current principles of Sharia are not fixated and may change with the changing global financial environment. Hence an adoption of traditional banking principles by Islamic banks is not only possible, but is actually perceived by the majority of the Muslims in the Arab world.
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