Islamic bankig sir aman ullah

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  • 1. Name Roll NoMarium Burki 461Saima Burki 460Zoya Ali 463Rida FarooqSehrish Jabeen 452Asima Sadia Gul 451Islamic BankingThe project is about Islamic economy and financial systemSir Aman ullah Khattak5/4/2011 1
  • 2. 2 Department of Business Administration, Gomal University Dera Ismail Khan
  • 3. 3 Department of Business Administration, Gomal University Dera Ismail Khan
  • 4. Islamic Economics System Islamic economics refers to the body of Islamicstudies literature that "identifies and promotes an economic order that conforms toIslamic scripture and traditions," and in the economic world an interest-free Islamicbanking system, grounded in Sharias condemnation of interest (Riba). The literatureoriginated in "the late 1940s, and especially" after "the mid-1960s. The banking systemdeveloped during the 1970s. Islamic economic literatures central features have beencalled "behavioral norms" derived from the Quran and Sunna, zakat tax as the basis ofIslamic fiscal policy and prohibition of interest. Islamist movements and authors generally describe an Islamiceconomic system as neither Socialist nor Capitalist, but a "third way" with none of thedrawbacks of the other two systems.Introduction During the Islamic Golden Age, early forms of proto-capitalism and free markets were present in the Caliphate,where an early marketeconomy and an early form of mercantilism were developed between the 8th-12thcenturies, which some refer to as "Islamic capitalism".The monetary economy of the 4 Department of Business Administration, Gomal University Dera Ismail Khan
  • 5. period was based on the widely circulated currency the dinar, and it tied togetherregions that were previously economically independent. A number of economic concepts and techniques were applied in earlyIslamic banking, including bills of exchange, partnership (mufawada) such as limitedpartnerships (mudaraba), and forms of capital (al-mal), capital accumulation(nama al-mal), cheques, promissory notes, trusts (Waqf), transactional accounts,loaning, ledgers and assignments.]Organizational enterprises independent fromthe state also existed in the medieval Islamic world, while the agency institution wasalso introduced during that time.Many of these early capitalist concepts were adoptedand further advanced in medieval Europe from the 13th century onwards.History Traditional Islamic concepts having to do with economics included zakat - the "taxing of certain goods, such as harvest, with an eye to allocating these taxes to expenditures that are also explicitly defined, such as aid to the needy." Gharar - "the interdiction of chance ... that is, of the presence of any element of uncertainty, in a contract (which excludes not only insurance but also the lending of money without participation in the risks)" Riba - "referred to as usury (modern Islamic economist have consensus that it does not refer to usury only rather Riba is any kind of interest)"These concepts, like others in Islamic law, came from the "prescriptions, anecdotes,examples, and words of Muhammad, all gathered together and systematized bycommentators according to an inductive, casuistic method. Sometimes other sources 5 Department of Business Administration, Gomal University Dera Ismail Khan
  • 6. such as al-urf, (the custom), al-aql (reason) or al-ijma (consensus of the jurists) wereemployed.In addition, Islamic law has developed areas of law that correspond to secular lawsof contracts and torts.Early reforms under Islam Some argue early Islamic theory and practice formed a "coherent"economic system with "a blueprint for a new order in society, in which all participants would betreated more fairly". Michael Bonner, for example, has written that an "economy of poverty"prevailed in Islam until 13th and 14th century. Under this system Gods guidance made sure theflow of money and goods was "purified" by being channeled from those who had much of it tothose who had little by encouraging zakat (tax) and discouraging riba (usury/interest) on loans.Bonner maintains Muhammad also helped poor traders by allowing only tents, not permanentbuildings in the market of Medina, and not charging fees and rents there.Riba The word "Riba" means excess, increase or addition, whichaccording to Shariah terminology, implies any excess compensation without dueconsideration (consideration does not include time value of money). The definitionof riba in classical Islamic jurisprudence was "surplus value without counterpart", or "toensure equivalency in real value", and that "numerical value was immaterial." Applying interest was acceptable under some circumstances.Currencies that were based on guarantees by a government to honor the stated value(i.e. fiat currency) or based on other materials such as paper or base metals wereallowed to have interest applied to them. When base metal currencies were firstintroduced in the Islamic world, the question of "paying a debt in a higher number of 6 Department of Business Administration, Gomal University Dera Ismail Khan
  • 7. units of this fiat money being riba" was not relevant as the jurists only needed to beconcerned with the real value of money (determined by weight only) rather than thenumerical value. For example, it was acceptable for a loan of 1000 gold dinars to bepaid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weighthad to be same because all makes of coins did not carry exactly similar weight).Modern Islamic banking The early 1970s saw institutional involvement. TheConference of the Finance Ministers of the Islamic Countries held in Karachi in 1970,the Egyptian study in 1972, the First International Conference on Islamic Economics inMecca in 1976, and the International Economic Conference in London in 1977 were theresult of such involvement. The involvement of institutions and governments led to theapplication of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in1975, was born of this process. The first modern experiment with Islamic banking wasundertaken in Egypt under cover without projecting an Islamic image—for fear of beingseen as a manifestation of Islamic fundamentalism that was anathema to the politicalregime.The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bankbased on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experimentlasted until 1967 (Ready 1981), by which time there were nine such banks in country. In 1972, the Mit Ghamr Savings project became part of Nasr SocialBank which, currently, is still in business in Egypt. In 1975, the Islamic DevelopmentBank was set-up with the mission to provide funding to projects in the membercountries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened itsdoors in 1975. In the early years, the products offered were basic and strongly founded 7 Department of Business Administration, Gomal University Dera Ismail Khan
  • 8. on conventional banking products, but in the last few years the industry is starting to seestrong development in new products and services. Islamic Banking is growing at a rate of 10-15% per year and withsigns of consistent future growth. Islamic banks have more than 300 institutions spreadover 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply withIslamic principles. It is estimated that overUS$822 billion worldwide sharia-compliantassets are managed according to Economist. This represents approximately 0.5% of totalworld estimated assets as of 2005. According to CIMB Group Holdings, Islamic financeis the fastest-growing segment of the global financial system and sales of Islamic bondsmay rise by 24 percent to $25 billion in 2010.Largest Islamic banks In 2009 Iranian banks accounted for about 40 percent of total assets of the worlds top 100 Islamic banks. Bank Melli Iran, with assets of $45.5 billion came first, followed by SaudiArabias Al Rajhi Bank, Bank Mellat with $39.7 billion and Bank Saderat Iran with $39.3billion. Iran holds the worlds largest level of Islamic finance assets valued at $235.3bnwhich is more than double the next country in the ranking with $92bn. Six out of ten topIslamic banks in the world are Iranian. In November 2010, The Banker published its 8 Department of Business Administration, Gomal University Dera Ismail Khan
  • 9. latest authoritative list of the Top 500 Islamic Finance Institutions with Iran topping thelist. Seven out of ten top Islamic banks in the world are Iranian according to the list.Fundamentals of Islamic finance The term “Islamic banking” refers to a system of banking orbanking activity that is consistent with Islamic law (Shariah) principles and guided byIslamic economics. In particular, Islamic law prohibits usury, the collection and paymentof interest, also commonly called riba in Islamic discourse. In addition, Islamic lawprohibits investing in businesses that are considered unlawful, or haraam (such asbusinesses that sell alcohol or pork, or businesses that produce media such as gossipcolumns or pornography, which are contrary to Islamic values). In the late 20th century,a number of Islamic banks were created to cater to this particular banking market.Usury in Islam The criticism of usury in Islam was well established during theProphet Muhammad life and reinforced by several of verses in the Qur’an dating back toaround 600 AD. The original word used for usury was Riba, which literally means“excess or addition”. This was accepted to refer directly to interest on loans , accordingto Islamic economists by the time of Caliph Umar, the prohibition of interest was a well-established working principle integrated into the Islamic economic system. Thisinterpretation of usury has not been universally accepted or applied in the Islamic world. Principles of Islamic Banks Islamic banking has the same purpose as conventional banking exceptthat it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). 9 Department of Business Administration, Gomal University Dera Ismail Khan
  • 10. • Prohibition of riba The basic principle of Islamic banking is the sharing of profit and loss and theprohibition of riba (usury). Common terms used in Islamic banking include profitsharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus(Murabahah), and leasing (Ijara). • Murabaha & EIjara wa EIqtina In an Islamic mortgage transaction, instead of loaning the buyermoney to purchase the item, a bank might buy the item itself from the seller, and re-sellit to the buyer at a profit, while allowing the buyer to pay the bank in installments.However, the banks profit cannot be made explicit and therefore there are no additionalpenalties for late payment. In order to protect itself against default, the bank asks forstrict collateral. The goods or land is registered to the name of the buyer from the startof the transaction. This arrangement is called Murabaha. Another approach is EIjara waEIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles ina similar way (selling the vehicle at a higher-than-market price to the debtor and thenretaining ownership of the vehicle until the loan is paid). • Musharaka al-Mutanaqisa An innovative approach applied by some banks for home loans,called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. Thebank and borrower form a partnership entity, both providing capital at an agreedpercentage to purchase the property. The partnership entity then rents out the property 10 Department of Business Administration, Gomal University Dera Ismail Khan
  • 11. to the borrower and charges rent. The bank and the borrower will then share theproceeds from this rent based on the current equity share of the partnership. At thesame time, the borrower in the partnership entity also buys the banks share of theproperty at agreed installments until the full equity is transferred to the borrower and thepartnership is ended. If default occurs, both the bank and the borrower receive aproportion of the proceeds from the sale of the property based on each partys currentequity. This method allows for floating rates according to the current market rate suchas the BLR (base lending rate), especially in a dual-banking system like in Malaysia. • Mudaraba Mudaraba is venture capital funding of an entrepreneur whoprovides labor while financing is provided by the bank so that both profit and risk areshared. Such participatory arrangements between capital and labor reflect the Islamicview that the borrower must not bear all the risk/cost of a failure, resulting in a balanceddistribution of income and not allowing lender to monopolize the economy. Islamic banking is restricted to Islamically acceptabletransactions, which exclude those involving alcohol, pork, gambling, etc. The aim of thisis to engage in only ethical investing, and moral purchasing Islamic Banking andFinance Database provides more information on the subject. Islamic banks have grown recently in the Muslim world but are a verysmall share of the global banking system. Micro-lending institutions founded byMuslims, notably Grameen Bank, use conventional lending practices and are popular insome Muslim nations, especially Bangladesh, but some do not consider them trueIslamic banking. However, Muhammad Yunus, the founder of Grameen Bank andmicrofinance banking, and other supporters of microfinance, argue that the lack 11 Department of Business Administration, Gomal University Dera Ismail Khan
  • 12. of collateral and lack of excessive interest in micro-lending is consistent with the Islamicprohibition of usury(riba). • Bai al inah (sale and buy-back agreement) Bai al inah is a financing facility with the underlying buy andsell transactions between the financier and the customer. The financier buys an assetfrom the customer on spot basis. The price paid by the financier constitutes thedisbursement under the facility. Subsequently the asset is sold to the customer on adeferred-payment basis and the price is payable in installments. The second saleserves to create the obligation on the part of the customer under the facility. There aredifferences of opinion amongst the scholars on the permissibility of Bai al inah,however this is practised in Malaysia. • Bai bithaman ajil (deferred payment sale)This concept refers to the sale of goods on a deferred payment basis at a price, whichincludes a profit margin agreed to by both parties. Like Bai al inah, this concept is alsoused under an Islamic financing facility. Interest payment can be avoided as thecustomer is paying the sale price which is not the same as interest charged on a loan.The problem here is that this includes linking two transactions in one which is forbiddenin Islam. The common perception is that this is simply straightforward charging ofinterest disguised as a sale. 12 Department of Business Administration, Gomal University Dera Ismail Khan
  • 13. • Bai muajjal (credit sale) Literally bai muajjal means a credit sale. Technically, it is afinancing technique adopted by Islamic banks that takes the form of murabahah muajjal.It is a contract in which the bank earns a profit margin on the purchase price and allowsthe buyer to pay the price of the commodity at a future date in a lump sum or ininstallments. It has to expressly mention cost of the commodity and the margin of profitis mutually agreed. The price fixed for the commodity in such a transaction can be thesame as the spot price or higher or lower than the spot price. Bai muajjal is also calleda deferred-payment sale. However, one of the essential descriptions of riba is anunjustified delay in payment or either increasing or decreasing the price if the paymentis immediate or delayed. • Musharakah Musharakah (joint venture) is an agreement between twoor more partners, whereby each partner provides funds to be used in a venture. Profitsmade are shared between the partners according to the invested capital. In case ofloss, each partner loses capital in the same ratio. If the Bank provides capital, the sameconditions apply. It is this financial risk, according to the Shariah, that justifies the banks 13 Department of Business Administration, Gomal University Dera Ismail Khan
  • 14. claim to part of the profit. Each partner may or may not participate in carrying out thebusiness. A working partner gets a greater profit share compared to a sleeping (non-working) partner. The difference between Musharaka and Madharaba is that, inMusharaka, each partner contributes some capital, whereas in Madharaba, one partner,e.g. A financial institution, provides all the capital and the other partner, theentrepreneur, provides no capital. Note that Musharaka and Madharaba commonlyoverlap.[34] • Musawamah Musawamah is the negotiation of a selling price between twoparties without reference by the seller to either costs or asking price. While the sellermay or may not have full knowledge of the cost of the item being negotiated, they areunder no obligation to reveal these costs as part of the negotiation process. Thisdifference in obligation by the seller is the key distinction between Murabaha andMusawamah with all other rules as described in Murabaha remaining the same.Musawamah is the most common type of trading negotiation seen in Islamic commerce. • Bai salamBai salam means a contract in which advance payment is made for goods to bedelivered later on. The seller undertakes to supply some specific goods to the buyer at afuture date in exchange of an advance price fully paid at the time of contract. It isnecessary that the quality of the commodity intended to be purchased is fully specifiedleaving no ambiguity leading to dispute. The objects of this sale are goods and cannotbe gold, silver, or currencies based on these metals. Barring this, Bai Salam coversalmost everything that is capable of being definitely described as to quantity, quality,and workmanship.Hibah (gift) 14 Department of Business Administration, Gomal University Dera Ismail Khan
  • 15. This is a token given voluntarily by a debtor to a debitor in return fora loan. Hibah usually arises in practice when Islamic banks voluntarily pay theircustomers a gift on savings account balances, representing a portion of the profit madeby using those savings account balances in other activities.It is important to note that while it appears similar to interest, and may, in effect, havethe same outcome, Hibah is a voluntary payment made (or not made) at the banksdiscretion, and cannot be guaranteed. However, the opportunity of receiving highHibah will draw in customers savings, providing the bank with capital necessary tocreate its profits; if the ventures are profitable, then some of those profits may be giftedback to its customers as Hibah. • Ijarah Ijarah means lease, rent or wage. Generally, Ijarah concept meansselling the benefit of use or service for a fixed price or wage. Under this concept, theBank makes available to the customer the use of service of assets / equipments suchas plant, office automation, motor vehicle for a fixed period and price. • Advantages of Ijarah • Ijarah provides the following advantages to the Lessee: • Ijarah conserves the Lessee capital since it allows up to 100% financing. • Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This is important as it is the access and use (and not ownership) of equipment that generates income. 15 Department of Business Administration, Gomal University Dera Ismail Khan
  • 16. • Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible terms • Ijarah is not considered Debt Financing so it does not appear on the Lessee Balance Sheet as a Liability. This method of "off-balance-sheet" financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating. • All payments towards Ijarah contracts are treated as operating expenses and are therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations. • Many types of equipment (i.e computers) become obsolete before the end of their actual economic life. Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange for a higher lease rate. This higher rate can be viewed as insurance against obsolescence. • If the equipment is used for a relatively short period of time, it may be more profitable to lease than to buy. • Qard hassan/ Qardul hassan (good loan/benevolent loan) This is a loan extended on a goodwill basis, and the debtor is onlyrequired to repay the amount borrowed. However, the debtor may, at his or herdiscretion, pay an extra amount beyond the principal amount of the loan (withoutpromising it) as a token of appreciation to the creditor. In the case that the debtor doesnot pay an extra amount to the creditor, this transaction is a true interest-free loan.Some Muslims consider this to be the only type of loan that does not violate theprohibition on riba, since it is the one type of loan that truly does not compensate thecreditor for the time value of money.[36] 16 Department of Business Administration, Gomal University Dera Ismail Khan
  • 17. • Sukuk (Islamic bonds) Sukuk is the Arabic name for financial certificates that are the Islamicequivalent of bonds. However, fixed-income, interest-bearing bonds are not permissiblein Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and itsinvestment principles, which prohibit the charging or paying of interest. Financial assetsthat comply with the Islamic law can be classified in accordance with their tradability andnon-tradability in the secondary markets. • Takaful (Islamic insurance) Takaful is an alternative form of cover that a Muslim can avail himselfagainst the risk of loss due to misfortunes. Takaful is based on the idea that what isuncertain with respect to an individual may cease to be uncertain with respect to a verylarge number of similar individuals. Insurance by combining the risks of many peopleenables each individual to enjoy the advantage provided by the law of large numbers.See Takaful for details. • Wadiah (safekeeping)In Wadiah, a bank is deemed as a keeper and trustee of funds. A person depositsfunds in the bank and the bank guarantees refund of the entire amount of the deposit, orany part of the outstanding amount, when the depositor demands it. The depositor, atthe banks discretion, may be rewarded with Hibah (see above) as a form ofappreciation for the use of funds by the bank. and is growing by 12–15% per annum.With the continuous interest in the Islamic financial system, there are positive signs thatmore funds will be launched. Some Western majors have just joined the fray or arethinking of launching similar Islamic equity products.With help of Bahrain-based International Islamic Financial Market and New York-based International Swaps and Derivatives Association, global standards for 17 Department of Business Administration, Gomal University Dera Ismail Khan
  • 18. Islamic derivatives were set in 2010. The “Hedging Master Agreement” provides astructure under which institutions can trade derivatives such as profit-rate and currencyswaps.Some Islamic banks charge for the time value of money, the common economicdefinition of Interest (Riba). These institutions are criticized in some quarters of theMuslim community for their lack of strict adherence to Sharia. The majority of Islamic banking clients are found in theGulf states and in developed countries. With 60% of Muslims living in poverty, Islamicbanking is of little benefit to the general population. The majority of financial institutionsthat offer Islamic banking services are majority owned by Non-Muslims. With Muslimsworking within these organizations being employed in the marketing of these servicesand having little input into the actual day to day management, the veracity of theseinstitutions and their services are viewed with suspicion. One Malaysian Bank offeringIslamic based investment funds was found to have the majority of these funds investedin the gaming industry; the managers administering these funds were non Muslim.[40] These types of stories contribute to the general impression within the Muslimpopulace that Islamic banking is simply another means for banks to increase profitsthrough growth of deposits and that only the rich derive benefits from implementation ofIslamic Banking principles.Hence, the controversy that surrounds Islamic Banking continues. Is Islamic Bankingreally Islamic? This is a question that still is a matter of debate among the Muslimacademia.In Korea a proposal to open the country to Islamic Banking has been controversial.According to some estimates more than 100 financial institutions in over 45 countriespractice some form of Islamic finance, and the industry has been growing at a rate of 18 Department of Business Administration, Gomal University Dera Ismail Khan
  • 19. more than 15 percent annually for the past five years. The market’s current annualturnover is estimated to be $70 billion, compared with a mere $5 billion in 1985, and isprojected to hit the $100 billion mark by the turn of the century.The growth in Islamicfinance initially coincided with the current account surpluses of oil-exporting Islamiccountries.But its continued growth in the face of eroding oil revenues reflects theinfluence of other factors, such as the desire for sociopolitical and economic systemsbased on Islamic principles and a stronger Islamic identity. In addition, the introductionof broad macroeconomic and structural reforms—in financial systems, the liberalizationof capital movements, privatization, and the global integration of financial markets havepaved the way for the expansion of Islamic finance.What is Islamic finance? Islamic finance was practiced predominantly in the Muslimworld throughout the Middle Ages, fostering trade and business activities with thedevelopment of credit. In Spain and the Mediterranean and Balticstates, Islamicmerchants became indispensable middlemen for trading activities.In fact, manyconcepts, techniques, and instruments of Islamic finance were lateradopted byEuropean financiers and businessmen. In contrast, the term “Islamic financial system” is relatively new,appearing only in the mid-1980s. In fact, all the earlier references to commercial ormercantile activities conforming to Islamic principles were made under the umbrella ofeither “interest- free” or “Islamic” banking. However, describing the Islamic financialsystem simply as “interest-free” does not provide a true picture of the system as awhole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the 19 Department of Business Administration, Gomal University Dera Ismail Khan
  • 20. system, but it is supported by other principles of Islamic doctrine advocating risksharing, individuals’ rights and duties, property rights, and the sanctity of contracts.Similarly, the Islamic financial system is not limited to banking but covers capitalformation, capital markets, and all types of financial intermediation. Interpreting the system as “interest free” tends to createconfusion. The philosophical foundation of an Islamic financial system goes beyond theinteraction of factors of production and economic behavior. Whereas the conventionalfinancial system focuses primarily on the economic and financial aspects oftransactions, the Islamic system places equal emphasis on the ethical, moral, social,and religious dimensions, to enhance equality and fairness for the good of society as awhole. The system can be fully appreciated only in the context of Islam’s teachings onthe work ethic, wealth distribution, social and economic justice, and the role of the state.The Islamic financial system is founded on the absolute prohibition of the payment orreceipt of any predetermined, guaranteed rate of return. This closes the door to theconcept of interest and precludes the use of debt-based instruments. The system 20 Department of Business Administration, Gomal University Dera Ismail Khan
  • 21. encourages risk-sharing, promotes entrepreneurship, discourages speculative behavior,and emphasizes the sanctity of contracts. An Islamic financial system can be expected to be stable owing to theelimination of debt-financing and enhanced allocation efficiency. A “two-window” modelfor Islamic financial intermediaries has been suggested in which demand deposits arebacked 100 percent by reserves, and investment deposits are accepted purely on anequity-sharing basis. Analytical models demonstrate that such a system will be stablesince the term and structure of the liabilities and the assets are symmetrically matchedthrough profit-sharing arrangements, no fixed interest cost accrues, and refinancingthrough debt is not possible. Allocation efficiency occurs because investmentalternatives are strictly selected based on their productivity and the expected rate ofreturn. Finally, entrepreneurship is encouraged as entrepreneurs compete to becomethe agents for the suppliers of financial capital who, inturn, will closely scrutinizeprojects and management teams.Principles of Islamic finance systemThe basic framework for an Islamic financial system is a set of rulesand laws,collectively referred to as shariah, governing economic,social, political, and culturalaspects of Islamic societies. Shariah originates from the rules dictated by the Quran andits practices, and explanations rendered (more commonly known as Sunnah) by theProphet Muhammad. Further elaboration of the rules is provided by scholars in Islamicjurisprudence within the framework of the Quran and Sunnah.The basic principles of an Islamic financial system can be summarized as follows • Prohibition of interest 21 Department of Business Administration, Gomal University Dera Ismail Khan
  • 22. Prohibition of riba, a term literally meaning “an excess” andinterpreted as “any unjustifiable increase of capital whether in loans or sales” is thecentral tenet of the system. More precisely, any positive, fixed, predetermined rate tiedto the maturity and the amount of principal (i.e., guaranteed regardless of theperformance of the investment) is considered riba and is prohibited. The generalconsensus among Islamic scholars is that riba covers not only usury but also thecharging of “interest” as widely practiced. This prohibition is based on arguments ofsocial justice, equality,and property rights. Islam encourages the earning of profits butforbids the charging of interest because profits, determined ex post, symbolizesuccessful entrepreneurship and creation of additional wealth whereas interest,determined ex ante, is a cost that is accrued irrespective of the outcome of businessoperations and may not create wealth if there are business losses. Social justicedemands that borrowers and lenders share rewards as well as losses in an equitablefashion and that the process of wealth accumulation and distribution in the economy befair and representative of true productivity. • Risk sharing Because interest is prohibited, suppliers of funds become investors insteadof creditors. The provider of financial capital and the entrepreneur share business risksin return for shares of the profits. • Money as “potential” capitalMoney is treated as “potential “capital—that is, it becomes actual capital only when itjoins hands with other resources to undertake a productive activity. Islam recognizes thetime value of money, but only when it acts as capital, not when it is “potential” capital. 22 Department of Business Administration, Gomal University Dera Ismail Khan
  • 23. • Prohibition of speculative behaviorAn Islamic financial system discourages hoarding and prohibits transactions featuringextreme uncertainties, gambling, and risks. • Sanctity of contractsIslam upholds contractual obligations and the disclosure of information as a sacredduty. This feature is intended to reduce the risk of asymmetric information and moralhazard. • Shariah-approved activitiesOnly those business activities that do not violate the rules of shariah qualify forinvestment. For example,any investment in businesses dealing with alcohol, gambling,and casinos would be prohibited.Market trends Banking is the most developed part of the Islamic financial system.The state constitutions of Iran and Pakistan, for example, require their banking systemsto be fully compatible with Islamic law. In Egypt, Indonesia, Malaysia, Sudan, and theGulf Cooperation Council (GCC) countries, Islamic banking exists alongsideconventional banking. Islamic banking is currently practiced through two channels:“specialized” Islamic banks and “Islamic windows.” Specialized Islamic banks arecommercial and investment banks, structured wholly on Islamic principles, and theydeal only with Islamic instruments. 23 Department of Business Administration, Gomal University Dera Ismail Khan
  • 24. Islamic windows are special facilities offered by conventional banks toprovide services to Muslims who wish to engage in Islamic banking. Both Westernbanks and banks headquartered in Islamic countries provide Islamic windows.Traditionally, specialized Islamic banks have been well positioned to attract depositsfrom Muslims, but these institutions have generally lacked the technical ability to investefficiently. This gap has been bridged by the services of Western banks that swiftly andefficiently deploy funds into Islamic ally acceptable channels. But this has often meantlower returns for Islamic investors owing to the second layer of intermediation. Thistrend is changing. Islamic banks are becoming resourceful and are going global, in partowing to their increased integration with international markets. At the same time, awareof the potential of Islamic markets, Western banks are reaching out to investors directlyand eliminating the middleman—the Islamic banks or Islamic windows of banks inMuslim countries. For example, Citibank opened its first Islamic bank subsidiary inBahrain in 1996. Historically, Islamic financial markets have lacked liquidity-enhancinginstruments, thus eliminating a large segment of potential investors. However, moreliquid instruments are emerging through securitization; Islamic funds, with a currentmarket size of $1 billion, represent the initial application of securitization (see table).There are three types of Islamic funds: equity, commodity, and leasing. Equity funds,the largest share of the Islamic funds market are the same as conventional mutualfunds but with an Islamic touch that requires a unique “filtration” process to selectappropriate shares. The filtration process ensures that the mode, operation, and capitalstructure of each business the fund invests in are compatible with Islamic law,eliminating companies engaged in prohibited activities and those whose capitalstructure relies heavily on debt financing (to avoid dealing with interest). For this reason,companies with a negligible level of debt financing (10 percent or less) may be selected,provided that the debt does not remain a permanent feature of the capital structure. The 24 Department of Business Administration, Gomal University Dera Ismail Khan
  • 25. future of Islamic equity funds is bright in part because of a new wave of privatizationunder way in Muslim countries such as Egypt and Jordan, and in high-growth Islamiccountries such as Indonesia and Malaysia, where the demand for Islamic financialproducts is growing rapidly. Commodity and leasing funds are other forms of Islamicfunds. Commodity funds invest in base metals. Leasing funds pool auto, equipment,and aircraft leases and issue tradable certificates backed by the leases.Internationaland regional institutions are working with Islamic finance and are contemplating theintroduction of derivative products and syndication to enhance project finance. TheInternational Finance Corporation (IFC) has successfully executed several transactionsin the Middle East and Pakistan that conform to Islamic principles. 25 Department of Business Administration, Gomal University Dera Ismail Khan