Since the late twentieth century, the rise of Islamic finance as a commercial practice has emerged as a ‘new’ and alternative financial system. This mode of finance has aimed to rival and eventually replace the conventional mode of interest-based finance that currently dominates the financial markets (Nagaoka, 2011). Instead, it is evident that Islamic finance has become a part of the global financial system rather than a replacement. This is proven by the fact that despite some success and a rapid growing trend, we find that on a global scale, Islamic finance only accounts for approximately two percent of banking assets worldwide. Still, Islamic banks hold around $1.6 trillion of global assets as of 2012, a figure expected to rise threefold ($4.8 trillion) by 2015 (EY, 2015). Consequently indicating the steadfast increase in popularity of Islamic financial systems around the world.
Whilst the growth of Islamic finance in the modern world has been impressive in its short history and has reached new levels of sophistication, there are still a number of challenges relating to Islamic instruments that are yet to be addressed and resolved. Within the Islamic Banking sector, there are a number of theoretical instruments available, which offer a range of different payment solutions to a consumer. Despite this, it is evident that Islamic banks are yet to offer a full range of financial solutions, particularly the profit/loss (PLS) sharing instruments such as Mudaraba and Musharaka that are available. Whilst there is evidence of some use of PLS instruments, research shows that the proportion of funds invested into Mudaraba and Musharaka contracts is negligible. Furthermore, PLS thus far accounts for less than 20 percent of investments made by Islamic banks worldwide. (Dar, Presley, 2000).
There are a number of reasons, both internal and external, as to why Islamic banks have been so reluctant to explore PLS sharing instruments available to them in the Islamic financial arena. This includes but is not limited to financial competitiveness, feasibility, and vulnerability to agency costs. All of which will be discussed in more detail later on.
The lack of PLS is a multi-dimensional issue and is identified as one of the key causes for doubt over whether Islamic banking in the modern world is ‘Sharia compliant’, as it is suggested to go against the basic concepts of Islamic finance. Islamic finance conceptualises the idea that the collection and payment of interest (riba) is prohibited, whilst simultaneously permitting and encouraging trade on a PLS arrangement. Although on the surface it may appear that riba is avoided, some commentators have argued that Murabaha and other non PLS modes of finance such as Ijarah and Istisna contracts are misused as a ‘back door’ for interest based financing (Liu, Chong, 2009).
Thus, many experts have maintained that theoretically, from an ethical and efficient viewpoint, Islamic banking is superior to the...