Wednesday, November 30, 2011

Information Disclosure in Islamic banks

1) Information disclosure in general

A bank discloses their financial and other information, aimed at providing a broad and reasonably up-to-date view of the bank through annual reports. Major groups of the reports users are ⒜ Shareholders; ⒝ Account holders and depositors (clients of the bank); ⒞ Borrowers and others who transact with the bank; and ⒟ Regulatory bodies.

Information disclosure leads to transparency and supervision and regulation of the banking sector. Moreover, it gives banks stability in consequence, despite the fact that almost all banks’ activities face a variety of risks. For that reason, major global financial institutions such as the World Bank and IMF’s Financial Sound Indicators system have emphasized the importance of transparency and disclosure as one of the core components of bank stability because transparency which arises from greater disclosure by banks will further benefit the financial system as a whole, by reducing the doubts and it provides an essential foundation to a more stable and efficient financial system.

2) Information disclosure in Islamic banks

Not only in conventional banks but also in Islamic banks, truthful and relevant disclosure of information is necessary and Islamic banks, which avoid Gharar and follow Mudarabah principle, are encouraged to make more extensive disclosure since it shows banks’ strategies and relevant risks and also assists depositors and other investors to make well-informed decisions on where to put their money.

Islamic banks apply a Shariah and legal framework which ensures effective risk management practices, adequate financial disclosure and governance to their information disclosure. This leads them to have a strong financial system by including these components as follow: ⒜ Performance Overview; ⒝ Statement of Corporate Governance; ⒞ Directors’ Report; ⒟ Statement by Directors; ⒠ Statutory Declaration by Director or person responsible for reparation of financial statements of the reporting institution; ⒡ Auditors’ Report; ⒢ Shariah Committee’s Report; ⒣ Balance Sheet; ⒤ Income Statement; ⒥ Statement of Changes in Equity showing either all changes in equity or changes in equity other than those arising from capital transactions with owners and distributions to owners; ⒦ Cash Flow Statement; and ⒧ Accounting Policies and Explanatory Notes.

This form of information disclosure based on a Shariah and legal framework has increased the reliability of the Islamic financial system and strengthened the incentives for banks to maintain sound banking practices. Besides, it provides both the supervisory authorities and the public with better information of a bank's strategies and risks including Islamic banks’ special risks.

1) Reserve Bank of New Zealand, “Your bank's disclosure statement: what's in it for you?”
2) Nafis Alam & Prof. Bala Shanmugam, “Promoting Transparency in Islamic Banks”, THJ Jan/Feb 2007 edition
3) Luca Errico & Mitra Farahbaksh, “Islamic Banking: Issues in Prudential Regulation and Supervision”, IMF Working Paper, March 1998
4) Islamic Banking and Takaful Department of Bank Negara Malaysia, “Guidelines of Financial Reporting for Licensed Islamic Banks”
5) Mohamed Abdelhamid, “Islamic Banking”, Department of Economics in Carleton University, September 2005

Friday, November 4, 2011

What is Riba?

Although Islamic finance is playing a more and more important role in the world, I even didn't know what is different between conventional and Islamic banks. I thought it was not my business as I'd never seen any Islamic bank in Korea.

Things are always changing though. I happened to come to Malaysia and this country is closely connected with Islamic banks. It's time I needed to know at least what it is!

I asked my Thai friend if she knew anything about it and she said there's something different in their interest system. I found out later that it was about riba, which is one of the most crucial concepts in Islamic finance.

Then what is Riba?

Literally, riba means ‘excess’ or ‘increase’ in the Arabic language, which is also thought to be ‘effortless profit’ in the Islamic terminology and translated into ‘interest’ in English. However, riba is so much more than what I mentioned above in fact. There are a number of opinions about the definition of riba, depending on scholars, and the meaning seems to be too general and indefinable, so we are going to have a look at it from the different angle in order to get a better understanding of what riba is by explaining 1) why riba is prohibited in Quran and 2) why a profit in the Islamic banking is not riba.

1) why riba is prohibited in Quran

In the conventional economics, a loan is considered a means to make greater economic benefits. That is why the lender returns to the borrower more and better than the quantity borrowed in compensation for the time value of their money.

However, it is assumed that those who are in difficulties borrow a loan to get out of the situation in the Islamic economics. In other words, what Quran prohibits is not ‘riba’ itself but the worse result which can be happened to the borrower not being able to pay back. This is the reason why riba is not accepted in Quran.

2) why a profit in the Islamic banking is not riba

Nevertheless, a profit called interest in the western banking still exists in the Islamic banking and it is one of the vital sources which allow the Islamic bank to run the business smoothly. Then why is the profit in the Islamic banking not riba?

While the borrower has to take the risk of the lender by paying them the interest in the conventional economics, the borrower and lender share not only the profit but also the risk as a partner in the Islamic economics. Moreover, either a product or a service must be delivered in Islamic banking transactions so that the profit is not riba anymore, but just a profit from their investment in the partnership.

It is true that the definition of riba has similarities to interest in some ways but we can find the certain differences between them and when the reasons, why riba is prohibited in Quran and why a profit in the Islamic banking is not riba, are taken into account, we can get a better understanding of the definition of riba.