In the system of Islamic banking, there are no provisions for interest institutions. This is because Shari’ah laws prohibits taking of interest. The Muslim laws contrasts taking of interest with unlawful gains. Islamic financial institutions operation model therefore is opposed to the debt financing strategy employed in conventional banking system. Debt financing model demands for insurance deposit to shield the bank from possible financial losses. An Islamic financial institution is not allowed to indict any prearranged return on deposit finances in advance. The bank however participates in sharing the yield that may result from deposited amount in the proportion of the defined ratios. Islamic financial institutions also pursue risk in investment on the same fixed ratios (Ali, 2011).
This paper aims at showing how Islamic banks contend with conventional banks in regard to specific financial areas highlighted in the respective parts of the paper. The first part provides a general overview of how the Islamic banks transact with conventional banks; part two provides Islamic banks stand in regard to dealings in foreign exchange; the third part shows how Islamic banks deals with confirmation letters of credit; while part four shows the practices of Islamic banking in consideration of exchange of discounted bills and commodity based deals.
Dealings with foreign banks
Islamic banks and financial institutions practicing international financial dealings need to maintain deposits with correspondent foreign banks abroad to handle the confirmation activities of letters of credit. The customary practice employed by other banks is maintaining overdraft facilities with correspondent institutions to handle their requirements in the short run. Interest accrues on the overdraft on daily basis. When the overdraft requested is significantly large, the lending bank may indict a commitment fee on the later to cover the costs of making the financial resources available upon the request of the customers. This arrangement limits foreign dealings of Islamic banks with conventional correspondent banks since they would be required to pay interest for overdrafts meant to cover their abroad financial obligations. Islamic banks hence choose to maintain deposits with correspondent banks to cover the foreign demands of their customers. This is because there is no sufficient number of Islamic banks across the world where they can provide correspondence services to each other without charging interest (Hanif, 2014).
Amin, Isa & Fontaine (2013) indicates that some Islamic banking institutions developed arrangements to solve the issue with foreign correspondent banks. This is where the Islamic banks agree with particular conventional banks in foreign nation to give them non-interest loans in their preferred currency to meet the demands of their customers. However, the Islamic banks exercising such arrangements enter into agreements with the foreign banks that the advanced loan shall be cleared within a fortnight. This is to mean that, the Islamic banks wish to clear the loan in the same day it is awarded. Wajdi & Irwani (2007) indicates that in some instances, the Islamic banks open accounts with foreign banks which are non-interest on a mutual agreement that these accounts will be used in case of overdraft requisitions. The overdrafts are hence deposited in these accounts upon requisition by the Islamic bank. The Islamic bank under this arrangement clearly indicates that it would not pay any interest to the correspondent bank in case the prevailing circumstances make it indebted.
One of the major challenges to foreign dealing among Islamic banks even in countries operating Islamic banking systems is differences in banking principles and regulations. Islamic banks in different countries interpret things differently making it difficult for efficient cross-border transactions with other banks of the same caliber. For instance, the Islamic bank in Malaysia and Iran interpret deposits differently. This may be observed as a potential limitation to foreign dealings between the two Islamic banks (Ali, 2011). The Iranian Islamic bank treats deposit as interest free loan (qard hasan). According to this banking principle all deposits received are handled as non-interest loans by the bank from the depositor. This automatically grants the bank to use deposited funds on its own will and risk without consulting the depositor whilst the depositor do not enjoy any returns from the bank. The bank owes the creditor only the principal funds deposited but not any returns from the banks ventures with the money. On the other hand, the Malaysian bank treats deposits as trust (am_nah). All deposits are hence maintained in a trust account rather than a current account. The bank has to request permission from the depositor before committing the deposited funds (Amin, Isa & Fontaine, 2013).
Nature of relationship between central bank and the Islamic banks in respective countries also influences their foreign dealings. Islamic banks always adhere to the regulations of the central banks in their respective countries. The relationship between these banks and the central banks is however in different countries. For instance in Iran and Pakistan, the central bank has set an organ called the central Islamic bank whose role is to supervise the operation of the Islamic banks and make sure they adhere to the laws and regulations of the banking industry. In Malaysia, Turkey, the UAE and Jordan, the government has established foundations which regulate and supervise activities of the Islamic banks as separate from the other banks. This factor also serves a limitation in foreign dealings among Islamic banks due to lack of standard regulations. Some countries however, Islamic banks pursuing their central banks to acknowledge Islamic banking principles. In the case of Iran for example, the Islamic bank is pushing the central bank to make adjustments in its conventional supervisory procedures in order to make them suitable for Islamic banks. In Turkey, Islamic banks are pushing for recognition by central bank as the last resort sanctuary in case of financial woes as well as allowing them to make foreign dealings in equal measure to the conventional banks (Yudistira, 2003).
It is also noticeable that some Islamic banks make arrangements with foreign banks that the free interest overdraft be placed on reciprocal basis. This is where the Islamic bank agrees not to charge any interest on the credit balance of the foreign bank, where that bank is also required not to receive any interest on the deposits of the Islamic bank. In other instances, the Islamic banks are awarded interest free overdrafts by foreign banks. These banks do not hold a margin of the amount lend. In other instances, some correspondent banks only agree to provide overdraft facilities at a margin. The major challenge faced by Islamic banks while making foreign dealings is inconsistencies in banking principles with correspondent banks. In some countries however, some legislations have been adjusted to allow and promote international dealings in some of the Islamic banks’ products. In the UK for example, legislation has been attuned international trading of Islamic bonds (Hasan & Dridi, 2010).
Foreign Exchange Dealings in Islamic Financial Institutions
Confirmation of letters of credit Islamic financial institutions
Discounted Of Bills Of Exchange and Commodity Based Deals