CHAPTER ONE: INTRODUCTION
1.1Background of the research subject
As a result of the financial crisis, experienced in Europe, there have been various arguments concerning trust that consumers have for conventional banking system. During the period, financial markets experienced a large downturn in customer trust. Therefore, the industry is under threat. Consumers of the banking services globally identified the worthiness of these banks and have therefore resorted to demand a more loyal relationship from the institutions. However, in today’s banking system, clients are quite reluctant on their decisions to switch to the Islamic banking system as a result of the belief that the change effort can be of great significance in the search for a more loyal and safe alternative (Imam & Kpodar 2010). In addition, there have been increases in interest for sustainable financial products which are also ethical in nature. Therefore, customers are searching for more improved financial products that provide them with revenue as well as an opportunity to make a good investment, which is worth more than profit (Akram et al, 2011).
With the current trends of globalization, forms of communication have greatly changed coupled with changes in cultural values on a global scale. This has made customers have a more open minded attitude towards new approaches of conducting business. On the other hand, financial institutions, which offer options, have become more focused on the emerging markets (Sorkin 2009). As a result, Islamic Banking has developed and become one of the most growing segments in the international banking market (Tieman et al. 2012). The development and growth of this financial institution has been perceived differently by different nations. For instance, some of the Islam dominant countries, such as Malaysia, have proved to be pioneer within Islamic finance, and have been able to develop a dual system, including both Islamic and conventional banking. This is an important approach, having many benefits, particularly when transferring Islamic banking system to the European markets, because the conventional banking system has dominated these markets, and is deeply rooted in these societies (Belder & Khan 1993).
The emergence of Islamic financial systems has resulted to a new dimension of the current economic models of financial developments. However, the worldwide feature of the banking industry today is that it is increasingly becoming turbulent and competitive. There are indications that as competition intensifies, religious factors may not be able to substantiate the growth of Islamic retail banking. The UK is the centre of Islamic finance outside the Muslim world. Islamic banking refers to a banking system which is based on the Shariah law principles, and controlled by Islamic economics (Khan & Bhatti 2008).
The basic principles of Islamic banking include profit and loss sharing. In addition, the overall Islamic financial system prohibits the collection and payment of interest. Under the Islamic law, interest collection is prohibited. In the UK, HSBC, Lloyds TSB and the United National Bank are some of conventional banks that offer Islamic bank services. This study aims at exploring Islamic banking as an alternative to the banking system in the UK, focusing on retail banking.
Wilson (2010) provides the basic underlying principles of Islamic banking to include the following; first is the prohibition of interest usury. Under the Islamic banking system, interest or usury is completely prohibited, be it simple or compound interest charge on productive or unproductive consumption loans. The other principle is profits and loss sharing (Perry & Rehman 2011). The economic agents, under Islamic finance, involved in any financial transaction must have some share from the associated profit and the transaction loss entered into. These include sharing of the profits and loss should be spelt out in terms and conditions that apply to such transactions at the onset of the business. The Islamic banks also ban on uncertainty interims and conditions of all transactions are prohibited. All the terms and conditions that of the associated with sharing of profits and loss should be comprehended by all parties involved to the financial transaction including the take off of the business. There is also prohibition of unethical investment under the principles of Islamic banking (Wilson 2010).
The Islamic banking system and the overall Islamic financial system prohibit pornography, gambling, pork-based products and financing of institutions that produce the above mentioned is discouraged. These activities are identified to result in increased social vices when allowed in the society as against the engagement of resources in productive activities. The other principle is asset banking, whereby, under this system, all assets are transformed into gold standard or its equivalents whose value do not deteriorate with time. In Islam, profit is the recognized reward for capital. In addition, the returns can be claimed in a situation where either risk or loss has been assumed or effort has been expanded. Therefore, profit is claimed by the provider of capital and wages. Clients of the Islamic bank can therefore earn income through:
- Return on capital when the capital is employed in a business venture;
- Through profit sharing when the capital or part of capital is employed in a partnership;
- Through rental earnings on an asset that has been partially financed by capital;.
As stated earlier, under the Islamic finance, the Islamic bank prohibits interest and other unethical transactions. The Islamic finance has become increasingly popular among a range of religious groups and general consumers. In London some examples of Islamic banks include the Islamic Bank of Britain, Habib Bank, QIB UK (Qatar Islamic Bank), Bank of London, the Middle East Plc and Gatehouse Bank Plc. The two major banks offering Islamic banking are "HSBC Amanah" and Lloyds TSB (Bokhari 2007).
While Islamic banking and the overall financial sector did not emerge intact from the banking crisis, it is currently considered as a viable alternative to conventional banking. Many clients have seen the benefits of Islamic banking, with its aversion to excessive risk and speculation and focus on assets; as a result it is seen as a more responsible and ethical banking option (Botts 2012). However, most of the western markets have experienced lack of trust for conventional banking; hence, there is likelihood that Islamic Banking in London will be of great significance as well as an interesting study topic (Bellalah & Ellouz 2004)
1.2 Aims and Objectives of the Research
The major aim of the study is to explore the advantages of Islamic Banking system to be considered as the best alternative to banking solutions in London. The study aims at examining the characteristics of Islamic Banking in order to promote as it the best alternative to conventional Banking in London, and possibly to boost the understanding of these banking models in the European society. In addition, the researcher intends to assess the possibility of the dual banking system, through adoption of both Islamic banking and conventional banking systems operating collaterally in London and other associated financial markets.
The study aims at comparing the efficiency and productivity of the Islamic banks with their interest based counterparts, in the delivery of banking services, in London. Previous studies have suggested that Islamic banks are profitable just like the conventional banks. The main of the study compare the benefits of Islamic banks, and the overall Islamic financial system, with other conventional banks with emphasis on retail banking, in UK.
Specific research objectives include the following:
i Discuss the theoretical framework of retail banking, in the UK
ii Understand the implications of the Islamic banks and the overall Islamic financial system on the financial sector, in UK.
iii Assess customer satisfaction with the Islamic banks and the overall Islamic financial system, in the UK.
1.3 Research Questions
The purpose of the study will be guided by the following research questions
- How have the competitive conditions of the UK retail banking sector changed since the introduction of the Islamic banks and the overall banking system, in the UK?
- What is the meaning of Islamic Banking, and what value systems are attached to the institution?
- What are the components of Islamic Banking, and is there a possibility that it can function hand in hand with the conventional banking system, in London?
- What is the best way of Islamic Banking implementation in London?
1.4 Statement of the Problem
Knowledge on Islamic banking should be developed to enable client participation in banking activities, which are safe enough and have the capacity to offer ethical alternative when compared to the traditional conventional banking. Wrong understanding and interpretation of the unique financial institution can have a negative reflection on financial institutions, which provide this type of financial services. Therefore, this may expose the entire banking system to threats, and also influence customers, who may miss the positive effects offered by the Islamic financial system. With the subsequent global financial crisis and economic recession, economists are encouraged worldwide to consider alternative financial solutions. Much attention has been focused on Islamic banking and finance as an alternative model. The contemporary phenomenal institutionalization of Islamic banking is based on the Islamic principles. These approaches involve reforms initiation and adoption of the potential useful elements such as trade and rejection and elimination of their potential harm. This is a challenging issue that may increase globally as a result of fear of Islamic culture. In addition, the uniqueness of the Islamic Banking system can be regarded as a significant element when comparing the facts that Islamic Banking has been in existence for more than three decades and the conventional banking has been in operation for many centuries. Therefore, clients may feel relaxed; for instance, most European nations have been utilizing conventional banking model which may be the main reason of having many clients being attached to this banking model; hence, hindering the ability to switch to a new banking alternative, which may boost the use of Islamic Banking products, with its interest free principles, an issue which most religions have been sidelining. However, Islamic banking can be seen as more human, because it is a financial institution, which is characterized with social responsibility as well as sustainability, and can be appealing to most clients, regardless of disparities in religious beliefs.
In most regions of the world, conventional institution of interest-based banks was not seen as the best one; hence, there is a need for an alternative form of the banking system in the UK (Adib & El-Bassiouny 2012). The main intention of interest-based banks was based on the financial intermediation economic necessity in an environment of increasing service production; it was channeled directly to the large-scale deficit units because of the persistence of serious implications of asymmetric information, manifested in the form of adverse selection, moral hazard, and transaction costs (Bhatti 2012).
The main rationale of establishing the Islamic banks and the entire Islamic financial system is political as well as economic scopes. The economic scope of the establishment of the Islamic banks and financial system arises in the context of financial systems` vulnerability in the form of financial contagion as well as the financial crisis. Based on the government support of the UK banking competition Khan and Bhatti (2008) observed that while the competitive advantage of retail banking was in line with the monopolistic form of competition, demonstrated by substantial abnormal returns, there are signs of new entrants as well as increased competition that would improve information, which would influence retail banking. The UK banking sector involves joint products or bundled services that can result to overpricing and under pricing of banking products. Even though, the entrant in the banking sector may form part of the larger banking group; most of them often specialize in products, such as mortgages, unsecured loans and credit cards. However, new entrants in the banking sector may tend to increase the competition intensity in this market niche (Fitriati 2012; Botts 2012).
1.5 Study Limitations
This study has time limitations as well as the scope of the study; hence, this has confined the researcher to Islamic Banking and financial systems.
1.6 Study Delimitations
When exploring the importance of Islamic banking and financial system, previous studies have been conducted to collect data on how conventional banking and Islamic banking can co-exist in the market. Therefore, conducting this study in the western world, with regard to London, has narrowed the scope of the study to one of the regions which demonstrated an increased level of trust in the banking system over the last decades, as a result of financial crisis. Another important aspect that made the researcher choose London for this study is due to the increased number of Muslim community in the region and an increased trend towards a multicultural society. This paper explores how Islamic banking and financial systems can be incorporated as an alternative banking system in London to promote the private individuals` lives in the society.
Furthermore, these delimitations have been discovered by the application of interviews as an instrument of data collection where participants were mainly concerned with the Islamic religion. On the other hand, this research has been conducted on a very broad discipline; however, few decisions have been made to focus on some minimal strategies of implementing Islamic financial system in London, which identified various issues, which may be considered as general guidelines instead of critical analysis which could pave way for future studies on this subject.
1.7 Structure of the dissertation project
This Dissertation work is divided into three distinct parts: the first part comprises a comprehensive background of the research topic and a literature review of the concepts and characteristics underlying Islamic banking within UK (Chapters 1 and 2); the second part comprises the research methods outline intended to be applied for the purposes of this dissertation project (Chapter 3); and the third part outlines the mains findings, conclusions and recommendations from the results of our research methods applied (Chapters 4 and 5).
Chapter One: Introduction
This chapter provides a background of the research subject, with an emphasis on the aims and objectives of the study alongside the identified research questions and statement, and concludes with the limitations and delimitations of the study.
Chapter Two: Literature Review
In this chapter the investigators provide a review of related literature with special attention to Islamic banking system compared to conventional banking system. This chapter also covers SWOT analysis of the Islamic financial system. In addition, the chapter will provide examples of regions where the institution has excelled, for example Malaysia, and where the dual banking system has been implemented. The literature review will also provide macro and micro analyses with clear examples of some western markets.
Chapter Three: Methodology
This chapter will provide the detailed analysis of the methodology employed to gather data for the study. On the other hand, the chapter will also provide the detailed examination of the implementation of the case studies chosen, as well as, description of the interviews used in the study. The researcher will then provide analysis and present the data on the issues that the Islamic Banking may experience if the banking market in London is developed. Furthermore, this will be followed by strategies, put in place and adapted for each issue.
Chapter Four: Findings and analysis
This chapter presents the findings from the analysis of the primary data and the secondary data obtained during the course of the research.
Chapter Five: Conclusion and Recommendations
This is the final chapter in this study, and it presents the conclusion derived from the study findings which are presented in the analysis, and derived from the research questions formulated to guide the study. Finally, in this section, the researcher will present appropriate recommendations for further studies on the topic under discussion.
CHAPTER TWO: LITERATURE REVIEW
In this section, the researcher describes the characteristics of Islamic banking. This chapter will involve an analysis of the Islamic religious features, which must be adhered to in order to abide by the rules and values of Islamic financial system. The researcher will discuss the differences that exist between the conventional banking system and the unique Islamic financial system. Different sources, materials, books and journals that relate to Islamic banking will be reflected in this section. General banking based on the Islamic concept will be reviewed as well. However, much emphasis will be put on the application of this banking system in the United Kingdom.
2.1 The Islamic Financial System- Background Information
Wilson (2010) argues that possibility of a financial system that would match the Islamic Sharia laws was discussed in the early 1940s; however, this notion was not implemented until the opening of a rural bank in Egypt in 1963. Tieman et al. (2012) observed that after the creation of the Islamic Development Bank (IDB) in 1975, most nations realized the importance of this financial institution and developed Islamic banking system, which later emerged as a rapidly growing segment of the international banking and capital markets. Currently, there are various Islamic Banks operating in many nations all over the world, majorly in the Muslim world, as well as, several western nations. In addition, there are many Islamic financial institutions, which have been developed in various regions of the world, such as urban cooperative credit societies, as well as different financial associations, adopted by many countries and functioning at a local level. Tieman et al. (2012) state that these financial institutions are majorly concerned with small business firms and individual households, and they sometimes deal with urban units. Therefore, it is necessary to understand the meaning of Islamic Banking. As mentioned earlier, these are institutions, which base their objectives and operations on Islamic Sharia law, which is a legal system that operates under the code of behavior derived from the Islamic teaching as provided by the holy book, Quran, and supported by traditions of Hadith, the holy prophet of Islam. According to the doctrines of the Islamic Sharia Law, there is a set of five religious features, which must be followed based on investment behavior (Tieman et al. 2012).
These doctrines are discussed below.
Based on the teaching of the holy Quran, Riba refers to any additional payment for any item, which is loaned to another party. This additional payment is seen as being equal not only to usury but to any other interest, and is considered as an unfair unproductive act, done with the main intention of exploiting other people. The teaching of Islam prohibits such payments and encourages Muslims to stay away from such acts for the sake of the society’s welfare (Hanif 2011). The holy Quran clearly states that individuals, who violate such orders, ignore the prohibitions of interest and are in conflict with Allah. The reading from the Holy Book of Quran indicates that any person, who implements usury, becomes the flesh and blood and is subjected to eternal punishment by the hell fire. Therefore, through prohibiting such additional payments, the Islam doctrine intends to inculcate a society, which is characterized with fairness and justice (Hanif 2011).
In spite of such prohibitions, it should be noted that it does not mean that capital has no cost, because it barely refers only to the predetermined pricing of capital that is seen as a crime. This means that capital owners in the Muslim world have no right to demand a fixed return rate on capital and should not seek for additional payments whatsoever, without getting involved in risk sharing, which is involved in the process. According to Imam & Kpodar (2010), the Islam doctrine states that loss and gains should be shared equally among the actors involved and the lenders should have an opportunity of having a share of the profits from any investment they financed. Therefore, sharing of the returns is an acceptable phenomenon as it is the cornerstone of the development and implementation of the Islamic banking and financial system. The difference between profits sharing and any additional payments in form of interest has made the Islamic financial systems legitimate, due to the fact that the rate of return is not considered under the Sharia law, but only the profit sharing ration, which is predetermined (Bellalah & Ellouz 2004).
Most Muslims believe that profit and loss sharing is a concept built upon the notion that any gain or loss should be shared equally between the borrower and the lender, and should be based on the parties involved irrespective on the magnitude of participation. Therefore, in Muslim banking the contracts that involve profit and loss sharing has a meaning that the financial institutions will have to establish a working relationship with the borrowing parties. According to the doctrines of the Muslims, there are two basic types of partnerships. These are the mudarada, which refers to a form of finance trusteeship, and the other form of partnership is known as the musharak, which describes a longer-term type of partnership. These types of partnerships require that financial institutions should obtain a contractual share of the profits obtained from the investment or business ventures. The main difference from profit sharing and interest in this financial system is that the ratio of profit sharing is predetermined and not the rate of interest return on the money borrowed (Akram et al. 2011).
Based on the principle of profit and loss sharing, the Islamic financial institutions are directly dealing with the profitability of the investment, in a similar manner the conventional banks are concerned with the nature of the financial institutions profitability, focusing on the risk and the potential default on the loans. The main difference is that the conventional banks are not directly influenced by the investments rate of return since there are interests which will be involved in the transactions. On the other hand, the profitability of the Islamic financial institutions is linked to the real return rate; therefore, the financial institutions must focus on the real return based on the physical investments (Akram et al. 2011).
The other major difference between the profit and loss sharing deals and the interest based agreements applied in the conventional banking systems is the attributes based on risk management, as the returns that the borrower makes to the financial institution is adjusted according the customer’s financial situation. The Islamic financial systems gather data on a regular basis concerning the financial situations of their clients in order to enable them ascertain the profit share. As a result, deals based on profit and loss sharing have demonstrated a greater ability as well as stability on the financial markets and motivates banks to appreciate the importance of long-term relationships with their customers (Bown 2005).
The Islamic financial institutions have been seen to provide a safer alternative for the clients because the banks cannot claim additional payments if the client is not able to make such payments, for example in a situation the investment go bankrupt. However, this should not be seen as the case in a situation the whereby there are cases of negligence on management, fraud, or misappropriation. This makes the client to become more focused in a long-term quest which could generate both social and economic benefits to the society instead of being concerned with issues such as servicing debt (Sorkin 2009). In addition, the concentration of a long-term relationship between the borrower and the lender in profit and loss sharing may lead into higher costs to the Islamic financial system as a result of the need for supervision on the performance of the borrowers, meaning that the Islamic financial institutions may make more investments in the managerial skills, as well as, expertise to enable them make analysis on investment projects (Sorkin 2009).