Understanding Islamic Finance - Doha Academy of Tertiary Studies

180 Understanding Islamic FinanceIn its modern form, a bank is an establishment for the custody of money received from,or on behalf of, its customers, whose drafts it has to honour and pay. The pooled moneyis used by it for the purpose of making advances to others to get a return in the form ofinterest, dividends or others.Traditionally, modern banking is divided into two main categories: commercial and investmentbanking. Commercial banking involves intermediation between depositors and fundusers, and making payments on behalf of their clients. On the other hand, investment bankingprimarily comprises capital market activities for facilitating fundraising by the corporatesector, directly or indirectly from the investors. In the USA, the 1933 Glass–Steagall Actenforced tight regulations on the banking industry, separating the practices of commercialand investment banking. This separation was achieved in Japan by law after World War II. Inthe UK, this separation prevailed because of institutional history rather than any regulation.While the financial world in past decades was clearly divided between commercial andinvestment banking, banks have, over time, adopted the German-style banking model, performingdifferent functions simultaneously. Further, investment banking has become animportant function of the commercial banks as well. The amendment of the London StockExchange regulations in 1986 eroded the distinction between commercial and investmentbanking in the UK. In the US, the Glass–Steagall Act was repealed in 1999, as a resultof which a large number of banks started operations in the capital market and securitiestrading, many of them providing investment services to Muslim investors. A different andnew development is emerging in the shape of Islamic banking within the banking industryin a large number of countries.8.3 THE STRATEGIC POSITION OF BANKS AND FINANCIALINSTITUTIONSFinance is the most strategic part of modern economics that functions like blood arteriesin the human body. In every society there are surplus as well as deficit households andinstitutions. While a large number of people have relatively smaller savings, a number ofothers, particularly businesses, are short of funds for their business expenses or productionneeds. Financial institutions provide a link between the deficit and the surplus units. In aconventional set-up, individuals and households provide funds to business and industriesthrough financial institutions, which charge a fixed or floating but risk-free rate of returnfrom the fund users and give a part of the return to the fund owners (savers/investors),keeping the remainder for themselves as spread.Like all other goods and services, the availability of the funds is governed by the forcesof demand and supply and the risk profiles of various stakeholders. While the supply offunds comes from individuals or households and corporate bodies, demand is generated intrade, business, industry, agriculture, corporations and government sectors. The institutionsinvolved in this process of resources transfer are commercial banks, investment banks, savingsand loan institutions, specialized institutions like micro credit, SME credit, industry,agriculture, trade, export/import, housing, leasing, venture capital, discount houses, insurancecompanies, fund management companies, asset management companies, etc. Theseinstitutions can be divided from one angle into two broad categories of banks and nonbankfinancial companies or institutions (NBFIs). Further, there are some development