Islamic Monetary and Financial Economics have Insisted that Universal Banking

Islamic banks are unique institutions that draw their characteristics from Islamic Shariah, several centuries of traditions, and contemporary economic thinking and banking practices. By every measure, it is an innovation when compared to conventional banking. Yet, it is not far removed from the finance and banking industry, as it shares several common characteristics with contemporary practices.

Some specialists in Islamic monetary and financial economics have insisted that universal banking is one of the main components of Islamic banking. Islamic banks provide finance to enterprises through either sharing directly in the net results of their activities or financing their purchases of assets, goods and services on credit. We can therefore expect Islamic banks to hold equity in corporations and sit on their boards of directors. They use the information obtained from their vantage point to reduce risk from information asymmetry and to fine-tune their finance directed to the same corporations. In addition, they can trade in goods and services, provide Islamic insurance, and operate in financial markets. In other words, they operate like universal rather than commercial banks (Al-Jarhi, 2003).

The practice of universal banking is generally accepted as part of Islamic banking, but not commonly followed by Islamic banks. Islamic finance was an old practice that was generally forgotten for sometimes and gradually replaced by conventional banking. Perception of Islamic banking started as an old painting covered with dust and superimposed images. But, it is gradually and slowly coming clearer over time. A lot of literature has come out during the last quarter of a century to put some clarity into the old picture. 

In addition, Islamic banking as a concept has come back in the twentieth century while the banking and finance environment is highly sophisticated and current practices are well entrenched. We do not therefore expect novel ideas to be accepted on purely religious basis, reasoning must be made as rigorously as possible. Every part of Islamic banking must be rationalized in a way that would make sense both to bankers and economists.

Universal banking has been practiced in only few countries, mainly Germany, Belgium, Italy, Japan and few others. Such practice continued while the dominant Anglo-Saxon world has set commercial banking as a standard practice within a heavily regulated environment. Therefore, universal banking must be justified, using the economics yardstick. The literature has grown immensely on universal banking during the last decade. Many writers have come up with justifications for universal banking and many others have expressed opinions that varied from mere doubt to outright hostility. It required a lot of sifting to find the main justifications behind universal banking.

This paper tries to put forward the case of universal banking as a part of Islamic banking. A large amount of literature is surveyed that comes from banking theory, macroeconomic and monetary theory as well as empirical studies about banking practices. The conclusion is that universal banking on its own is a sound practice that can offer developing countries special advantages. Such a conclusion is rather important because many of the Islamic countries where believers in Islamic banking reside are developing. It would therefore be helpful to see that Islamic banking as it contains universal banking would give a helping hand in the process of development that would not be easily obtained from conventional banking.

The paper is divided into seven parts. The first part summarizes the perspective of universal banking from the vantage point of the banking theory. The second part surveys the Gerschenkron- Schumpeter’s thesis of the role of universal banking in economic development. The third part presents a survey of the European experience regarding universal banking from two vantage points: that of Fohlin and of Da Rin and Hellmann. The fourth part summarizes an interesting debate between Fohlin and Temin on the role of universal banking in the industrialization of Europe.

The fifth part presents the Da Rin and Hellmann model of big-push model and catch-up economy that can be considered to be the main contribution of macroeconomic theory to the topic on hand. The sixth part considers universal banking as a practice that would come out of deregulation under the practice of integrated financial services provision (IFSP) or integrated banking. We can therefore visualize universal banking taking many shapes each of which has its own pros and cons. The seventh and last part summarizes the findings related to universal banking and how it reflects on Islamic banking as a whole.

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The Challenge for Islamic Law was to Create Financial Contracts

While Islamic legal tradition has a long history, commercial law related to the contemporary financial system is at the developing stage compared to the civil and common legal traditions. The paper discusses the adaptability features of Islamic commercial law for contemporary financial settings and puts forward some suggestions to develop the Islamic legal system that can facilitate the growth of Islamic finance. 

While civil law can be called the law of the legislators and common law the law of the judges and lawyers, Islamic law can be characterized as the law of scholars. As the scholars consider both the immutable divine sources of law (Shari[ah) along with the human interpretation of these (fiqh), the development of Islamic jurisprudence can be considered a combination of the procedures found in the civil law and common law systems.

The challenge for Islamic law was to create financial contracts from traditional nominate contracts to meet the modern day needs of financial markets and intermediaries. Recent history of the growth of the Islamic financial sector is an indicator of the adaptability of Islamic law to changed situations. Given the principle of permissibility, Islamic commercial law can evolve as long as the limits imposed by Shari[ah are not traversed. 

The adaptability features of source of law and legal justification for Islamic law were closely examined. While contemporary Shari[ah scholars and jurists have done an admirable job of modifying the classical nominate contracts into financial contracts, there still remains a lot of work to be done to make Islamic commercial law relevant to modern day needs. To enable this, there is a need to develop Islamic law, keeping in mind the maqasid al-Shari[ah and the existing technology and environment.

While Islamic law can evolve based on a rich source of body of legal theory and rulings, other elements of the legal infrastructure like laws and statutes, harmonizing the Islamic rules related to financial dealings, and dispute settlement institutions are still weak in many countries. The adaptability features of Islamic law has to be complemented with the strengthening of the legal infrastructure to ensure the development of a comprehensive Islamic financial sector. Given the noble objectives of Islamic law, its evolution can help produce an alternative financial system that can benefit not only Muslims, but humanity at large.

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Islamic Law Related to Commercial Transactions in Light of Contemporary Financial System

A large literature has discussed the role of law and legal institutions on financial development. One of the important determinants of financial development is adaptability of law to changing conditions. Adaptability underscores the formalism of laws and the ability of legal traditions to evolve. Specifically, legal systems that adapt efficiently to the contracting needs of the economy foster development of the financial system. 

Empirical studies have compared the adaptability features of the civil and common law countries and found that more flexible legal systems can explain the status and development of the financial system. While most studies on the effect of legal system on financial development are related to variants of the civil and common law regimes, there is no attempt to discuss the status of Islamic law on finance. This research will fill this void. The paper first aims to examine the main features of Islamic law and identify its adaptability characteristics, and then discusses the scope of developing a sound legal infrastructure related to financial sector development.

A legal system comprises the legal order and legal regime (Kornhauser 2001). While the order consists of the legal norms of the system as expressed in the constitution, statutes, administrative regulations, juridical decisions, etc., the legal regime represents the existing legal institutions like legislatures, administrative agencies, courts, etc. Elements that support the proper functioning of the legal system can be termed as infrastructure institutions. These include appropriate laws enacted by legislature, courts for implementing the laws, etc. The financial structure of a modern economy is composed of the financial markets and intermediaries (Santomero and Babbel 2001). Financial development, therefore, signifies efficient functioning of the markets and intermediaries in providing the financial needs of the economy.

The question of adaptability of the law to changing circumstances is vital to the development of Islamic financial system. Issues like legal formalism, dynamism, and the efficiency with which laws can adapt to changing circumstances will determine to a large extent how this sector will grow in the future. The scope of this paper is, however, narrow. This study does not deal with the whole body of law or the legal system. While the main focus of the paper is the adaptability of law, some aspects of the legal infrastructure related to the financial sector development are also discussed.

While Islamic law encompasses various subject matters like rituals, family, inheritance, criminal, constitutional, fiscal, etc. the focus of this paper is on injunctions on commercial transaction (Islamic commercial law) only, as it is this law that is relevant to financial growth. The paper is organized as follows. Section 2 discusses the nature and adaptability features of the civil and common law traditions. While Section 3 outlines the sources and evolution of Islamic law, Section 4 analyzes its adaptability features. In Section 5, some recommendations related to the legal infrastructure institutions that may facilitate growth of the Islamic financial sector are provided. The last section concludes the paper.

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Islamic Banks are Relatively Inefficient in Containing Costs

This paper investigates relative efficiency of the Islamic banking industry in the world by analyzing a panel of banks during the period of 1995-2001. Both parametric (cost and profit efficiency) and nonparametric (data envelopment analysis) techniques are used to examine efficiency of these banks. Five DEA efficiency measures such as cost, allocative, technical, pure technical and scale efficiency scores are calculated and correlated with conventional accounting measures of performance. The results indicate that, on average, the Islamic banking industry is relatively less efficient compared to their conventional counterparts in other parts of the world. The results also show that these efficiency measures are highly correlated with ROA and ROE, suggesting that the efficiency measures can be used concurrently with conventional accounting ratios in determining Islamic bank performance.

The average cost efficiency (stochastic cost frontier) is 73.5%, whereas the average profit efficiency (profit efficiency frontier) is 84.4%. Although Islamic banks are relatively inefficient in containing costs, they are relatively efficient in generating profit. The average allocative efficiency is 73.3%, whereas the average technical efficiency is approximately 84.3%. This means that the dominant source of inefficiency is due to allocative inefficiency rather than technical inefficiency. These results are consistent with the fact that Islamic banks operate in overall regulatory environments that are not very supportive of their operations.

Hassan (2003b) found that when Islamic banks operate in countries such as Iran and Sudan, where the entire banking system operates under Islamic Shariah, the banks become more allocatively efficient. Average scale efficiency is approximately 89.1%, and average pure technical efficiency is approximately 95%, suggesting that the major source of the total technical inefficiency for Islamic banks is not pure technical inefficiency (input related) but scale inefficiency (output related).

Our results indicate that there have been moderate increases in productivity growth over the years. Productivity increases in the Islamic banking industry is mainly driven by technological change (opening up and penetrating other markets) not technical efficiency change (efforts of inefficient banks to catch up with those that are efficient). The results indicate that larger bank size is associated with higher scale efficiency. These results indirectly support the economies of scale arguments in the Islamic banking industry.

Most of the Islamic banks are of smaller size compared to their conventional counterparts. It is imperative that Islamic banks be allowed to merge to obtain an optimal size in order to become more technically efficient and compete with their conventional counterparts. Multinational conventional banks which engage in Islamic banking have a size advantage over smaller Islamic banks. The only way for Islamic banks to be competitive with multinationals is to bring products and services in conformity with the true spirit of Islamic prohibition of interest, utilize modern technology and expand the score and scale of their operations.

The information obtained from efficiency studies can be used to help bank managers, government regulators and investors. Managerial performance can be improved by identifying “best practice” and “worst practice” associated with high and low efficiency firms, respectively. In addition, success in competitive markets demands achieving the highest levels of performance through continuous improvement and learning. Finally, frontier efficiency analyses can identify best practice banks and provide numerical efficiency scores and rankings which can be quite useful to policy makers, market analysts, and managers of competing banks.

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Efficiency of the Islamic Banking Industry in the World

Islamic banking is a worldwide phenomenon involving a variety of institutions and instruments. Islamic institutions and instruments have developed in many countries during the past few decades. In countries such as Iran, Sudan, and Pakistan, all or most financial inter-mediation conforms to Islamic Shari[ah as defined by local authorities. These countries also have banking authorities that govern the general level of charges and returns in the system. In most other countries, Islamic transactions and institutions make up a small part of the total and must compete with conventional financial institutions. Islamic instruments are simply a narrow group of familiar financing instruments.

During the last two decades, Islamic banks have significantly expanded their network, and have been able to amass large amounts of deposits as well as promote many economic ventures. In addition, they play a major role in rendering banking services to poverty stricken households, who historically have been treated apathetically. Given the differential behavior of Islamic banks compared to traditional commercial banks, and their involvement in both social and economic activities, there has always been the question of long run sustainability of these banks. The diverse involvement of Islamic banks in social and economic activities indeed increases their operational costs, which many critics consider to be the major constraint for the long run sustainability of this newly introduced profit sharing banking system.

This paper employs both parametric (cost and profit efficiency) and nonparametric methods (DEA analysis and Malmquist productivity index) to study cost, profit and X-efficiency of 43 Islamic banks in 21 Muslim countries over the 1995-2001 period. First, it employs a stochastic cost frontier approach to compute the cost efficiency. Second, it employs alternative profit efficiency which considers both cost and revenue simultaneously to examine profit efficiency. Third, it employs a nonparametric data envelopment analysis (DEA), to calculate the overall, technical, pure technical, allocation and scale efficiencies. While technical inefficiency is caused and correctable by management, allocation inefficiency is caused by regulation and may not be controlled by management. Finally, by applying a Malmquist DEA method to the panel data over time, Malmquist total factor productivity (TFP) indices are calculated. These indices will help us to examine the productivity improvement of Islamic banks over time in these countries. The results of this study will allow us to examine what factors are important in improving the cost-efficiency of Islamic banks, and under what conditions such institutions are sustainable.

Regardless of a bank’s underlying philosophy, its long run sustainability depends on economic efficiency. A bank is economically efficient if it operates with both technical efficiency and price efficiency. A firm is said to be more technically efficient than another if it produces relatively larger output from the same set of inputs. A firm is price efficient if it maximizes profits. That is, if it equates the marginal value of product of each factor to its price. Such a study is important both from an operational as well as an academic point of view. First, such a study will exhibit the expansion potentials of Islamic bands in a mixed banking system. Second, it will have policy implications for Islamic banks and the banking system as to how to improve cost efficiency. Third, it will suggest policy measures to improve price efficiency within the banking system. Finally, much less research has been done in the area of Islamic banking compared to the traditional commercial banking industry. Since Islamic banks differ from conventional banks in their cost, profit and revenue structures, it is important for these banks to be studied independently.

The frontiers are constructed using cost, output, and input data for each bank. Linear programming techniques allow for the construction of best practice cost and production frontiers from these data. The performance of a particular branch is then judged relative to this frontier. The specific efficiency measures calculated can be given fairly simple interpretations. The technical efficiency measure gives the proportional reduction in input usage, which could have been achieved if the firm operated on the production frontier. The technical efficiency can be decomposed into the proportional reduction in input usage if inputs were not wasted (pure technical efficiency) and that reduction if there existed constant returns to scale (scale efficiency). As such, pure technical inefficiency reflects excess input levels for a given level of output. This inefficiency may be sustainable if competitive forces are weak. This inefficiency is unique in that it is caused by and correctable by management. From a societal standpoint, firms that operate at constant returns to scale represent the socially efficient level of operation. Therefore, choosing a non-constant scale of operation also constitutes inefficiency.

The allocative efficiency measure gives the proportional reduction in costs if the optimal combination of inputs had been utilized. As such, allocative inefficiency reflects suboptimal proportions of factor inputs. Management cannot correct this inefficiency to the extent that it is due to regulation, such as the need to substitute service for interest payments on demand deposits. Overall efficiency measures the proportional reduction in costs which could have been achieved if firms had been both allocatively and technically efficient. The Malmquist-DEA technique allows us to decompose total factor productivity into changes in technical efficiency over time and shifts in technology over time. Improvements in technical efficiency change are considered to be evidence of moving close to the efficient frontier over time, whereas improvements in technological change are considered to be evidence of innovation.

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