Islamic Banking Vs Conventional Banking however, although they have succeeded in this effort and h a v e managed to create a market

niche for Islamic banking, they do n o t seem to have achieved the market depth that could ensure long-termprofitability and survival. This stems from the fact that they appear tob e f a r b e h i n d i n technical innovations and financial m a r k e t developments that in recent years have revolutionized f i n a n c e a n d capital markets. There is no evidence that these banks have made anylarge investment in research and product development, nor is thereany evidence that new financial products developed in recent years,particularly in equity derivatives, have been utilized to any significantdegree by the major Islamic banks. This is unfortunate because themarket opportunities that these banks have been able to develop, toa l l o w f u n d s f r o m I s l a m i c c o m m u n i t i e s t o b e p l a c e d i n I s l a m i c a l l y permissible portfolios, can and will be exploited by more efficient andi n n o v a t i v e W e s t e r n f i n a n c i a l i n s t i t u t i o n s t h a t a l r e a d y h a v e o r w i l l discover this market niche.While there is considerable room for competition and expansion in thisfield, the long-term survivability of individual Islamic banks will dependo n h o w r a p i d l y , a g g r e s s i v e l y , a n d e f f e c t i v e l y t h e y c a n d e v e l o p techniques and instruments that would allow them to carry on a two-w a y i n t e r m e d i a t i o n f u n c t i o n . T h e y need to find ways and means of developing marketable Shariahb a s e d i n s t r u m e n t s b y w h i c h a s s e t portfolios generated in Muslim countries can be marketed in the Westa s w e l l a s m a r k e t i n g S h a r i a h b a s e d W e s t e r n p o r t f o l i o s i n M u s l i m communities. b. The challenge of adopting an Islamic financial system The most important challenge for Islamic banking is in its systemwidei m p l e m e n t a t i o n . A t p r e s e n t , m a n y I s l a m i c c o u n t r i e s s u f f e r f r o m financial disequilibria that frustrate attempts at wholesale adoption of I s l a m i c b a n k i n g . F i n a n c i a l i m b a l a n c e s i n t h e f i s c a l , m o n e t a r y a n d external sector of these economies cannot provide fertile ground forefficient operation of Islamic banking. Major structural adjustmentsparticularly in fiscal and monetary areas are needed to provide Islamicb a n k i n g w i t h a l e v e l p l a y i n g f i e l d . A d d i t i o n a l l y , a d o p t i o n o f a legalframework of property ownership and Contracts that would clearlyspecify the domain of private and public property rights as w e l l a s stipulation of legally enforceable rights of parties to contract that fullyr e f l e c t the requirements of the Shariah, are necessary to allow anoperational framework conducive to efficient operation of I s l a m i c banking. 15

Islamic Banking Vs Conventional Banking An Islamic financial system can be said to operate efficiently if, as aresult of its adoption, rates of return in the financial sector correspondto those in the real sector. In many Islamic countries fiscal deficits aref i n a n c e d t h r o u g h t h e b a n k i n g s y s t e m . T o l o w e r t h e c o s t s o f t h i s financing, the financial system is repressed by artificially maintaininglimits on bank rates. Thus, financial repression is a form of taxationthat provides governments with substantial revenues. To remove thisburden, government expenditures have to be lowered and/or revenuesraised. Massive involvement of governments in the economy makes itd i f f i c u l t f o r t h e m t o r e d u c e t h e i r e x p e n d i t u r e s . R a i s i n g taxes ispolitically difficult. Thus, imposing controls on d o m e s t i c f i n a n c i a l markets becomes a relatively easy form of raising revenues. Under thea b o v e c i r c u m s t a n c e s , i t i s u n d e r s t a n d a b l e w h y g o v e r n m e n t s w o u l d have to impose severe constraints on private financial operations thatc a n provide higher returns to their shareholders and/or depositors.T h i s makes it very difficult for Islamic banks and other f i n a n c i a l institutions to realize fully their potential. For example, M u d a r a b a h companies that can provide higher returns than the banking systemw o u l d e n d u p i n d i r e c t c o m p e t i t i o n w i t h t h e b a n k i n g s y s t e m f o r deposits that are used for bank financing of fiscal deficits.While Muslim countries may, for legitimate reasons, opt for an Islamicfinancial system, for the economy as a whole to benefit fully from theo p e r a t i o n s o f s u c h a s y s t e m , i t i s n e c e s s a r y t h a t ( a ) g o v e r n m e n t expenditures are fully rationalized, (b) revenues from taxation, andthose derived from property legitimately placed within the governmentdomain by the Shariah, are raised to meet the expenditure needs thegovernment, (c) the financial sector is liberalized so that returns tothis sector reflect returns to the real economy, (d) equity markets aredeveloped to allow financing of investment projects outside bankingi n s t i t u t i o n s , a n d , f i n a l l y , ( e ) t h e s t r u c t u r e o f t h e b a n k i n g s y s t e m should be such as to allow strong banking supervision and prudentialr e g u l a t i o n c o m m e n s u r a t e w i t h t h e r i s k s i n v o l v e d i n v a r i o u s transactions.* To accomplish the last objective, the banking structurec a n b e t i e r e d i n a c c o r d a n c e w i t h p r i n c i p a l I s l a m i c f i n a n c i a l transactions. It is r e a s o n a b l e t o a s s u m e t h a t r i s k s i n v o l v e d i n Musharakah or Mudarabah financing, are different from those involvedi n t r a d e - t y p e financing. It follows, therefore, that p r u d e n t i a l regulations of these transactions should be different. 16

Islamic Banking Vs Conventional Banking Motivating Factors for Islamic Banking Motivation and renewed interest in Islamic finance industry stems fromits strong economic, financial and social considerations, backed by itsunique features.Most significant is its appeal to add to financial diversity and innovationbeing skewed towards: (i)Asset backed and equity based transactions, w h i c h promote entrepreneur friendliness and considerationof project viability( i i ) E q u i t a b l e d i s t r i b u t i o n o f r i s k s a n d r e w a r d s a m o n g the stakeholders;( i i i ) i n c u l c a t i n g m a r k e t d i s c i p l i n e a n d h i g h e r e t h i c a l standards given its emphasis on non-exploitationand social welfare. In the wake of high Asian domestic savings rates and build up of theregions foreign exchange reserves as well as oil surpluses of MiddleEast in the last few years, Islamic finance is now also emerging as away to wealth management, both of richer nations and high