A critical comparison of Instruments of Islamic banking with the commercial
banks in the United Kingdom.
Department of Finance
Dissertation prepared for the partial fulfillment of the requirements for the
Masters of Business Administration
This Dissertation is a product of my own work and is not the result of anything
done in collaboration.
Student Signature…………………………………….. Date………………….
I agree that this Dissertation may be available for reference and photocopying,
at the discretion of the university of Wales institute, Cardiff.
Student signature…………………………………….. Date…………………
The present dissertation topic ‘A critical analysis of Islamic banking instruments with Commercial
banking in the United Kingdom’ has been attempted so as to analyze the basic differences in the
principles of these two systems of banking.
The data reveals that basically the Islamic banking operates on the principles of interest free
banking with a participatory system of sharing of profits and losses with its clients. Conventional
banking in Britain works on interest charging as its basis of finance.
Although Islam has prohibited Riba (interest), the question still remains whether it is the same as
the bank interest.
There are a number of Islamic banks and Islamic ‘Windows’ in commercial banks in the United
Profit and Loss Sharing principle applies to some major instruments of the Islamic banking system
such as Musharaka and Mudarabah and cost plus profit is applied to Mudarabah.It is argued that
Murabaha is not entirely based on Shariah and Mudarabah though permitted has great
disadvantage attached to the financier. On the Savings account there is no bank guarantee on the
return of principle as per Shariah law.
Critical differences between Islamic and Conventional banks on the whole reveal that profit and
loss sharing system may have greater beneficiary effect upon society than interest based finance.
The future of Islamic banking in the United Kingdom seem bright on account of the fact that there
is a large Muslim population in Britain who want to do financial transaction preferably through
Islamic banking in order to satisfy their religious principles. Further the data also reveals that
Islamic banking has fared better during economic crisis in the recent past.
This research recommends that in view of the benefits associated with the interest free system of
banking, it may be encouraged in its true Shariah form or through a system of Binary Economy
where the products are managed with out involving interest as in conventional banking.
Table of Content
1.1 Purpose and main objective 12
1.2. Background and preliminary scene setting 13
1.2.1. Emergence of conventional banks in United Kingdom 13
1.2.2. Islamic banks in UK 14
1.3. Instruments of Islamic banking 15
1.4. Outlines of the subsequent chapters 17
Literature Review 18-48
2.1. Britain’s First Islamic Bank 18
2.2. Principles of Islamic Banking System 19
2.2.1. Practice of Interest (Riba) In Early Arabia 19
126.96.36.199. Riba Al Nasiah 20
188.8.131.52. Riba Al Fadal 20
184.108.40.206. Injunctions against Riba in the Quran 21
220.127.116.11. Ill Effects of Riba 22
18.104.22.168. Comparison between Riba and Trade 23
2.3. How Does Interest Affect Us 24
2.4. Profit And Loss Sharing 27
2.4.1. Instruments of Islamic Banking 28
22.214.171.124. Deposit Accounting 28
126.96.36.199. Investment Financing 28
2.5. Critical Evaluation of Islamic Banking Instruments 35
2.5.1 Murabaha V Conventional Loans 35
2.5.2 Profit And Loss Sharing 36
2.6. Differences between Islamic and Conventional Banking 37
2.6.1. Differences in Concepts and Operations 39
2.7. Risk Management 41
2.7.1. Risks Involved In Islamic Banking 41
2.7.2. Risk Management by Conventional Banks 43
2.8 Future of Islamic Banking in UK 44
3.1. Sourcing data 49
3.2. Data collection 49
3.3. Qualitative data collection 51
3.4. Quantitative methods 51
3.4.1. To observe ethical procedure and obtain relevant data 51
3.5. Sources of secondary data collection 52
3.5.1. Advantages of quality data 53
3.5.2 .Reasons for preference 53
Data Analysis 54-67
4.1 .Equating riba with bank interest 55
4.1.1 .Critical analysis of profit and loss sharing 56
4.1.2 .Difficulty in implementation 56
4.2 .Critical review of instruments of Islamic banks 57
4.2.1. Murabaha 57
4.2.2 Diminishing Musharaka 57
4.2.3. Modarba 59
4.2.4 .Savings account 59
4.4. Critical differences between conventional and Islamic banks 63
4.5. Risk management by Islamic and conventional banks 64
4.6. Future of Islamic banking in Britain 65
5.1. Interpretation of Shariah Law 71
5.2 Conventional Banking 72
5.3 Constrains and Challenges of Islamic Banks in the UK 72
List of Figures
Figure 1-Basic Types of Growth Pattern 25
Figure 2-Constant Growth Curves 26
Figure 3-Examples of the Amount of Interest within the Normal Prices and Fees 27
Figure 4-Musharakah Contract 29
Figure 5-Profit Sharing Contract 31
Figure 6-Diminishing Musharaka 32
Figure 7- Murabaha 33
Figure 8- Global Assets of Islamic Finance 45
Figure 9-Islamic Finance by Country 46
Figure 10-Islamic Banks in UK 47
Figure11- Global Assets of Islamic Finance and Islamic Finance by Country 47
Figure12-Assets of Islamic Banks in UK 48
Figure 13-Before the Crisis 65
Figure 14-Initial Crisis Effect 66
Figure 15-Deepening Impact 67
Figure 16-Country Wise market Share of Islamic Banking 68
Figure16.1- Global Islamic Funds Industry 68
First of all I am grateful to the Almighty God for making me accomplish my dream of studying in
London at the University of Wales.
I am indeed grateful to my professor and guide Professor Jim Matthews who has very
systematically guided me during the preparation of my dissertation work. His soft approach and
timely guidance enabled me to go through the assignment in a methodical manner.
I am very much grateful to my parents for their continued moral support and their constant prayers
for my success. May the Almighty God give them health with a long life and happiness.
I am thankful to my friends especially Mr. Sanjay, for helping me to adjust to the London
Human behaviour over the ages has been guided by great religions of the world. Norms and
standards have been set for man to follow a systematic way of life in tolerance, patience,
perseverance and in all dealings with fellow human beings as well as with his surroundings .These
standards and laws also extend to the economic areas which are the most vital aspect of human
All great religious leaders and philosophers from the ancient Greece to the modern day have made
a concerted effort to curb the evil of exploitation of the poor by the rich. However much, one
might try to curb this monetary exploitation; this evil continues to persist in the modern society.
Unfortunately feudal system of exploitation of exorbitant interest has now been extended into a
global arena as a result of which many nations are facing the same plight as did individuals.
Modern economists have predicted that the interest free banking would alleviate many of the
existing financial problems facing mankind. The recent recession through out the world, especially
in advanced countries is linked to the bad effects of interest on society. Thus according to Margrit
Kennedy (1995), the reasons for the accumulations of huge debts and rise in unemployment and
unrest are on account of interest and compound interest. Money should always be going into
circulation rather than remaining in the possession of a few. This can be achieved by an interest
free economy. Therefore it becomes necessary to examine this system now known as Islamic
Banking more critically and compare it with Conventional banking.
The principle area of research topic pertains to Islamic Banking .The most important aspect of
Islamic banking system is that it is interest free and this is strictly in accordance with the Shariah
which is the Islamic law. My interest in this topic is for finding the main principles of its operation
as it seems to be gaining popularity among Muslims in London and would like to probe whether it
could stand against competition from Conventional banking which has been in existence since a
1.1. PURPOSE AND MAIN OBJECTIVE:
The main purpose of making this study is not only to know the critical differences but also to know
the basis of its formation and popularity. The United Kingdom has been the major hub of banking
system and it is but natural that Islamic banking which is comparatively a new idea has found its
The main foundations are:
• Prohibition of Riba (Interest)
• Prohibition of Miser (Game of Chance)
• Prohibition of Haram (Illegal and unsociable activities)
• Payment of Zakat (Part of bank profits for charity), Solé (2007).
Interest is designated as Riba in Islamic terminology and it would be necessary to explain Riba
because it is based on this objection that the Islamic banks design all their products and activities.
Also to detail the points based on which the scholars have come to a conclusion that Riba, the type
of interest that was practiced in early Arab world, is similar to the interest as charged by the
Conventional banks. Secondly, Islamic banks function on the basis of profit and loss sharing. Here
the purpose would be to find its salient features, how does it applies to various instruments of
Islamic banking and what is its short falls. Finally to get an over all assessment in comparing the
Conventional and Islamic banking systems.
Therefore the area of research would be to assess whether there is any operational difference
between these two systems or not. The following are the points with which an analysis would be
• To study the background of Islamic Banking in the UK.
• To review the definitions by various scholars regarding Riba.
• To study the principles of Islamic Banking.
• To study Islamic Banking Instruments and critically evaluate them.
• To find the critical differences between Conventional and Islamic Banks.
• Comparative risk management
• Future of Islamic Banking in Britain
1.2 BACKGROUND AND PRILIMINARY SCENE SETTING:
To have a comprehensive study it would be essential to go through the background in order to
form a scene setting of the topic which relates to Conventional and Islamic Banking system in the
1.2.1 Emergence of Conventional Banks in United Kingdom:
History of banking in England starts with the legalization of interest by British King Henry the III
in the year 1545, although the Church had opposed it.
The Bank of England was founded in the year 1694 and its monopoly was strengthened with an
Act of Parliament in the year 1709.Later in 1770, Bankers Clearing House was founded as cheques
were being gradually introduced. The Industrial Revolution added strength to the banking industry
and smaller banks came into being. In 1920 the Barclays, Lloyds, National Provision, Westminster
and Midland which was then the largest banks in the world, opened their branches in other towns.
In 1946 the Bank of England was nationalized (Lip comb and Pond 2002, Baron 1958).
Islamic Banking on the other hand is a rather recent phenomenon which is basically based on the
concept of interest free banking.
According to a report in FSA Briefing note (2006) Muslims constitute about 3% of the population
that is about 1.8 million in the United Kingdom. In London itself there are about 50% residents
who call themselves as Muslims. As in other parts of the world, Muslims are trying to live by the
Laws of Islam with its basic principle of prohibition of interest in any form what so ever. This,
they are trying to do by following Shariah Law which describes a framework with in which they
are told to conduct themselves especially in matters relating to finance.
Based on these factors, the United Kingdom has opened its doors to permitting banks to
investments, savings and mortgaged tailored to the needs of the Muslim community as per the
Shariah law. There are wholly Shariah compliant banks operating in Britain. One of the most
prominent banks in Briton is the Islamic Bank of Britain (IBB). Today London has become a very
important center of finance dealings where international firms as well as the Gulf traditional banks
are offering Islamic based banking instruments. The Financial Services and Market Act 2000 have
welcomed the innovative method of banking with its diversities in the various instruments of
Islamic Banking systems. This encourages as well as strengthens the financial scenario of the
United Kingdom. By permitting Shariah based banking, the UK has enabled its citizens whose
faith prevents them to deal with the products that are normally offered by the UK conventional
Banks and other financial institutions, to deal in financial matters according to their religious
1.2.2 ISLAMIC BANKS IN UK:
Matthews (2007) reports that there are about five thousand rich Muslims in UK with liquid assets
of around 3.6 million pounds and the expected growth is approximately by 40% by the year
2025.The formation of the Shariah based banks has been encouraged by the UK government to
facilitate the process as it wanted to give its large Muslim community financial services which are
in conformation with their religious belief. The Financial Services Authority as well as the Bank of
Britain have played a major role in these developments. (Ainley.M. (2007).
Briefly speaking one would say that Islamic Bank is an intermediary and a trustee where it shares
the loss as well as the profits with its customers although in practice its overall setup has many
similarities with the conventional banking such as acceptance of deposits, offering loans for
business or housing, letters of credit, over drafts and other banking facilities with the main
difference as said above that it works on the principle of no interest.
In general the salient features of Islamic Banking are:
• No interest on deposits.
• Loans carry a service charge
• Investments are on profit and loss basis.
• Value erosion on capital due to inflation is compensated, (Gafoor, 2008-2009)
It is a common belief that in the Islamic Banking instruments there is no likelihood of the public
becoming a victim of loans and advances and become insolvent. On the other hand there is every
likelihood of Islamic Banks becoming bankrupt because there is too much of risk of insolvency in
each of its instrument as most of it is based on trust, if followed according to Sharia law.
The basic idea in the Islamic Bank is against fixed interest but on equity participation contracts,
that is profit and loss sharing. And therefore may be a good route to long-term wealth. In view of
the U.S. savings and loan crisis and the present problems confronting the USA, it has been
suggested even by prominent western economists like Simon as early as 1948, Kindelberger in
1985, Khan in 1986, and more recently by Akaoem in 1991(Ibrahim 1993,). That the banking
system based on Islamic profit –loss sharing arrangement could be a better alternative to the fixed
interest rates. This would be possible if the Islamic Banks follow Shariah law in its totality.
The following are the various instruments of Islamic Banking which would be critically compared
with the Conventional Banking.
1.3 INSTRUMENTS OF ISLAMIC BANKING:
A brief introductory note on the instruments of Islamic banking would be helpful in obtaining
preliminary view of their mode of function.
This term is derived from the Arabic word Ribh which means profit. It is a cost plus profit. In this
case if the customer intends to purchase equipment, He approaches the bank which purchases the
commodity and then sells it to the customer on a pre agreed profit. It is similar to letter of credit.
The word Mudarabah is derived from Arabic darb fil-ard (Darb meaning travel, ard meaning land)
that is traveling through land. (Usmani, 2010).All the investments are done by the capital provider,
but he or she has no rights to interfere in the business matters. Both parties agree to divide the
profits but losses if any are to be faced by the investor except those which are caused by
negligence by the entrepreneur (Chapra, 2010).
A partnership based instrument which is different from Mudarabah, here the partnership is of
limited time, in basic commercial terminology it would rather be called as a joint venture. It is
sharing partnership where each partner provides a capital and takes part in the day to day activities
or appoints an agent. Thus it is basically different from Mudarabah.
It focuses on shares. A method to structure a bond where the bondholders have a cash flow from
the project planned intended to be financed.
A leasing instrument of Islam where the bank buys the property and leases it out under the
This is an instrument which is based on sales. The sale is of a particular commodity which should
be present physically during its sale.
It plays a vital role in house financing. It is also an instrument based on sales like salaam but it is
of different nature. Here the commodity is transacted before it exists physically.
Bay Bithamin Ajil:
In other words it is differed payment sale. Buying a product or goods and paying the price in
installements .This method is inclusive of profits agreed by both the parties.
1.4 OUTLINES OF THE SUBSEQUENT CHAPTERS:
Structure of this dissertation constitutes different chapters as per the guide lines of the University.
These are divided into the following chapters each dealing with various aspects of Islamic and
Commercial banking systems .These chapters are as follows:
• The first chapter consists of Introduction. This gives the purpose of the project namely.’ A
critical comparison of Instruments of Islamic banking with the commercial banks in the
United Kingdom, a background to the study, preliminary scene setting about the concept
of financial dealings with out interest, an outline of, aims and objectives, the various
instruments of Islamic Banking.
• The second chapter is review of the relevant academic literature upon which this
dissertation is built in a critical way. Briefly it consists of a brief history of conventional
and fundamentals of Islamic Banking, philosophy of interest free banking, description of
Riba, injunctions in the Quran against interest, comparison between Riba , trade and profit,
modern concept of interest and its impact on economy , current practices in Islamic
Banking and its critical evaluation.
• The third chapter consists of Methodology, the description of quantities and qualitative
analysis, collection of primary and secondary data preferences in methodology of
collecting data with justification.
• The fourth chapter consists of research findings of what has been discovered with critical
analysis of the main topic of dissertation. More emphasis would be made on some of the
main Instruments of Islamic banking.
• The fifth chapter consists of conclusions linking the literature review with research findings
based on arguments with assessments of the main question .It also includes contributions
to general literature and the specific field of research.
• The sixth chapter is the recommendations as a result of the research findings. Here any new
concept that would have emerged would also be mentioned.
• Bibliography as per Harvard method.
Literature review is confined to the examination of the various instruments of Islamic banking,
reasons of growth in UK, description of Riba, its prohibition and the critical differences between
Conventional and Islamic banking practices with its future prospects.
Before going into this, a brief background of the emergence of Islamic banking would help in
reviewing its system.
2.1 Britain’s first Islamic bank:
In the year 2004 The Islamic Bank of Britain (IBB) was established at Birmingham with a start up
capital of 14 million pounds, from investors in the UK as well as the Gulf. To establish this,
permission was granted by the banking regulators of Britain. Branches in Leicester were also
opened . In 2007 the Bank of London and the Middle East (BLME) was formed. According to
Grose (2008 web 4), London had nearly twenty five companies which offered Shariah based
finance. With in six months, BLME recorded profits up to $ 2.7 million and its assets more than
doubled to $ 931 million.
According to Ainley (2007) the various causes for the growth in the Islamic banking sector in the
Markets and skill base:
The UK is an important financial service centre with a proven record with the preference for the
English law as the legal base for many Islamic finance transactions.
Opening of Shariah base ‘windows’:
The Citi bank,HSBC,Deutsche bank which have great experience in the middle east and are very
much knowledgeable about Islamic markets and products, have opened ‘Shariah based windows’
in their banks in UK.
Excess liquidity in the Middle East:
Due to rise in oil prices there has been a huge liquidity and the market in the Middle East was not
been able to meet this growing demand and UK provided the suitable alternative.
Public policy and taxation:
Since the year 2000, the government in UK has introduced specific legislative and tax change in
order to remove obstacle in the development of Shariah based Islamic finance in the United
Global expansion of Islamic finance:
This has been due to growth of industry in the Middle East and South East Asia which has
influenced the UK markets.
A single financial regulator, the FSA which was established in 1997 has done much to do all it can
to support this development with in its authority.
2.2 PRINCIPLES OF ISLAMIC BANKING SYSTEM:
Islamic banking is structured on the basis of two major principles
1. Prohibition of Riba which generally regarded as interest.
2. Profit and loss sharing.
2.2.1 PRACTICE OF INTEREST (RIBA) IN EARLY ARABIA:
According to Rahman (1964), in the early Arabia, that is pre Islamic history, interest was of two
1. Riba Al Nasiah
2. Riba Al Fadal
188.8.131.52. Riba Al Nasiah:
The word Nasiah is derived from Nasih which means to defer or to delay the repayment with an
additional amount. This is a way of getting profit for the period of wait. This is the usual kind of
interest that was followed by the Arabs. The loan was for development as well as consumption, but
mostly it was for development of trade as the central source of income for Arabs over centuries has
always been trade (Udovitch 1981).Through its verse in the Quran, 2:275, God has allowed trade
but has forbidden Riba.
Thus scholars of Islamic jurisprudence have said that Riba al Nasiah is totally prohibited in Islam.
Since it has similarities with the Interest levied by conventional banks and therefore on this basis it
184.108.40.206 Riba al Fadal:
This relates to the indirect type of usury that was practiced by the Arabs when they were not
dealing with cash. Here the trader would get in exchange a commodity in excess of or in better
quality than what he has given in a trade transaction. Ibn al Arabi in his Ahkam al Quran (Chapra
2010) explains that any thing in excess of what is justified by its counter value is not permitted.
The injunction against Riba al Fadal was executed so as to prevent exploitation by unfair exchange
so that not even an indirect Interest would be practiced. This type of Riba has been referred to by
the second Caliph Umar as Riba, to clear the doubt that arises in the minds of people whether Riba
al Fadal has the resemblance with Riba that is pure interest.
There are three types of Riba al Fadal:
The first being receipt of commodities in excess of what is justified. The second being the
acceptance of reward for making a recommendation .This is actually a charitable act and therefore
should not be used as a means of exploitation. Such acts of apparent charity but having the
motivations towards money making are prohibited. The third type of Riba al Fadal is done during
barter transaction because there is difficulty in measuring the counter value of the commodity.
Therefore the Prophet of Islam (PBUH) discouraged barter dealings but advised that the
commodity be first sold against cash and this amount used to purchase the required commodity.
Thus it can be seen that Riba al Nasiah is defined quite precisely, Riba al Fadal which involves a
large array of business transactions has to be dealt with great care.
It can be seen from the examples given that in all kinds of Riba,the is a definite advantage for the
lender of cash and the exchanger of commodities ,where there is neither an element of risk or hard
work involved as there is an assurance of positive return to the financier.
220.127.116.11 INJUCTIONS AGAINST RIBA IN THE QURAN:
There are at least twelve verses in the Quran (Pickthal 1994) where there is severe warning and
admonitions against Riba.
1. Chapter II.verses, 275-280.
These verses try to establish that, firstly Riba is totally banned for all, secondly the meaning of
Riba is explained as that which is collected over and above the principle, thirdly it is an unjust
practice, fourthly it is destined to destruction and finally Riba lowers the values of individuals who
deal with it. Further there is a total rejection of the thought or concept that Riba is like trade.
Obviously trade is of mutual benefit while Riba ensure profit to only the lender.
2. Chapter III verse 130.
Muslims are warned not to devour through usury by doubling and quadrupling and that they should
observe their duty to Allah so as to be successful.
3. Chapter IV verse 160,161.Similarly in the fourth chapter it has been informed that Riba is being
prohibited for Muslims so also were to the Jews before them and there is a warning for those who
disbelieve(the injunctions against Riba of a painful doom).
4. Finally in chapter 30, verse 39, it is declared that any increase in wealth through the practice of
Riba cannot and will not be blessed by Allah. (Pickthal1994, Ali 1934)
18.104.22.168 ILL EFFECTS OF RIBA:
Based on these injunctions, it is possible to deduce why Riba was prohibited. According to
Siddiqui (2005) some of these could be:
1. Riba corrupts individuals and through them society. According to Pickthal (1994) the Quran has
likened the charging of interest with corruption, which is ‘fasad’ in Arabic. In other words wrong
doings lead to wrong behavior and this in turn leads to severing the ties of kinship ,dividing people
into classes and discriminating between them, shedding of blood, arrogance and sexual
perversion’.(The Quran 47:22;28:4;2:30;28:77;’29:28-30 respectively)
2. Riba undervalues the properties of the borrower and places an advantage with the lender.Khan
and Mirakhor (1987) have pointed out that interest levied on money is an unjustifiable and an
immediate right that is handed over to the lender who acquires a right over property as soon as the
contract is signed.
3. Riba, through its devouring tendencies ultimately brings down overall growth.
4. Riba reduces the respect of individuals and diminishes human personality.
According to Ahsan (2006) Shariah as per Quran encourages people to indulge in such transactions
in business which helps them to earn profit through risk taking with out blocking down all risks
with fixed returns.
According to him the wisdom behind this method of wealth creation is the concern for the moral,
economic, social and cultural welfare of mankind.
Interest based practice discourages people doing good to people from doing good to one another,
that is when the really needy people take a loan on interest they are required to pay back the loan at
any cost, here there is no mercy shown to the poor and the needy by the money lender, whether it
is a bank or an individual who has offered the loan on interest. This results in huge burden to the
poor individual who has to part with a portion of his belongings in the form of jewels or property.
The general tendency of the people who depend on interest as a source of income discourages
them from working or indulging in trade or business where an effort has to be made and a lot of
risk is involved.
If interest is allowed, the rich (who are most likely to be lender) will exploit the poor (borrower).
As a result, the rich becomes richer and the poor becomes poorer. This generates envy and hatred
among the poor towards the rich, resulting in social disorders, conflicts and at times breeds and
movements with revolutions. (Uzair 2000)
22.214.171.124 COMPARISON BETWEEN RIBA AND TRADE:
The Arabs who used to indulge in the practice of Riba initially did not understand the basis for the
prohibition of Riba because they regarded Riba as a form of trade. Some argue that when a person
gave money as a loan and charged an interest on it was for the help that he had extended. But the
Quran has bluntly treated Riba as impermissible whereas trade was indeed the mode through
which one should earn a living. As explained above Riba has many bad effects on society and
cannot be likened to trade.
Some of the differences between trade which yields a legitimate profit and Riba which is unlawful
in Islam are as follows.
Comparison between Riba and Profit:
Riba is defined as the premium received by the
lender from the borrower with the principal
and is the main condition of the loan.
Profit is defined as the difference between sale
and the purchase price which may be positive
The recovery of the capital is assured. The recovery of the capital is not assured.
There is always an assured positive return. There is uncertainty of the nature of returns.
The profits are predetermined. Profits are not predetermined.
There is no particular and definite advantage to
There is some perceived advantage for both
The rate of profit goes on increasing with the
passage of time on the initial capital
Once the sale is performed the profit is
obtained and it does not increase with passage
Money is used as a commodity Money is used as a facilitator of transaction
It can be deduced that there is no possibility of
occurrence of losses
It can be said that there is always the
possibility of occurrence of losses
2.3 HOW DOES INTEREST AFFECT US:
Margrit Kennedy (1995) in her book, Interest and Inflation Free Money explains the damage
caused by interest .She refers to money as the unit of economic concept which never stays steady
as another unit like the unit of weight, the Kg The major factor according to her which brings
about huge debt, unemployment, environment degradation with building up of arms and nuclear
proliferation is principally due to interest and compound interest. Money that is used as a
commodity when used for interest purposes grows exponentially rather than through a natural and
physical growth like a cancer tissue as shown in the graph below.
Courtesy: Margrit Kennedy Interest and Inflation Free Money
The curve A describes normal physical growth, B describes the linear growth exemplified by the
production of more goods by more factories which stop once factories close down and curve C
describes the growth of money, growing exponentially like cancer cells which ultimately kills the
A graph depicting rate of growth of interest is shown below:
Courtesy: Margrit Kennedy Interest and Inflation Free Money
The above figure shows that at 12% interest money gets doubled in a mere six years and even at
1% interest rates the initial money gets doubled at 72nd
One of the misconceptions about interest, according to the author is that we pay interest only when
we borrow money. The following diagram gives a close look at the way individuals are made to
pay interest, if not directly as interest gets automatically included in the things we use or buy.
Courtesy: Margrit Kennedy Interest and Inflation Free Money
From the arguments and the points given, it would be beneficial to mankind to create a monetary
system that could follow a natural trend in growth and this can only be done by replacing the
present interest based economy by another suitable mechanism. Based on this, Kennedy
recommends that there should be a mechanism which would create an interest free and through this
inflation free monetary system.
2.4. PROFIT AND LOSS SHARING:
The other principle of Islamic banking is profit and loss sharing. As explained above; Islam
prohibits finance management based on interest. The idea is that for a successful entrepreneurship
wealth creation should be based on profits alone. According to this concept the profit and loss
sharing leads to progress in society.
Thus profit and loss sharing forms the main structure upon which Islamic banking operates. And
according to Schaik(2001) noted that Profit and Loss sharing (PLS) includes Joint Ventures
(Musharaka) and Trust Financing(Mudarabah).The Non PSL Financing include Markup Finance or
2.4.1 INSTRUMENTS OF ISLAMIC BANKING:
Gafoor (1995) in his book, Interest Free Commercial Banking has given a review of the current
concept and practices of Islamic banking which are described below.
126.96.36.199 DEPOSIT ACCOUNTING:
Islamic Banks also have three types of deposit account namely, current accounts, saving accounts,
In this there is a guarantee for the money deposited and it is a demand deposit and the depositor is
entitled to with draw at any time and in any amount.
In this type, depending upon the bank, there are different operations. In some banks, the bank uses
the money of the depositors, with their permission, giving full guarantee to the depositors that their
amount would be available to them, that is they would get back the money they have deposited.
Some banks use savings as investments, the amount being invested in less risky short term
projects. There are less restrictions on withdrawals and minimum balance. Here only lower rates
of profits could be expected.
188.8.131.52 INVESTMENT FINANCING:
Investment financing is done in three main ways.
Here a joint venture is set up by the banks joining another entity with both the parties taking active
part, at various levels, in the activities of the project. Profits and loss are shared in an amicably pre-
agreed principle. This mode of operation is very much similar to the joint venture that is in
operations with respect to the commercial banks.
Courtesy: Islamic Finance made simple
According to Usmani(2010) the word Musharaka is derived from the word Shirkah which means
in Arabic sharing and the type of Shirkah involved in Musharaka is known as Shirkatul-amwal
which is a relationship established by parties through a mutual contract. This contract should be
entered through free consent with out duress or fraud. The specific ingredients in Musharaka are as
1. Distribution of Profit:
Before the contract is made, there should be an agreement on the proportion of the profit to be
distributed between partners.
When deciding upon the ratio of profit distribution, it should be done according to the actual
profits and not on the capital invested. (Agarwal and Yousf 2000)
2. Sharing of loss:
If a loss has occurred then all the partners will suffer in accordance with the ratio of investment.
This means that if the partner has invested forty percentage of the actual capital, then He must
suffer the same portion that is 40% of loss.
3. Nature of Capital:
Capital that is invested should be in liquid form that is in terms of money and not on commodities
or objects. The reason is that commodities, for example cars as a contribution will remain as
property of the donor and if the car is sold then the money will go to the owner. On the other hand
if money is used as the investing means then it would not be possible to distinguish the share
capital of each partner unlike the commodity. However it has also been said that the market value
of the commodity at the time of contribution could be taken as share of the partner.
It is necessary that each and every partner has a right to take part in the management of business
unless there is a previous agreement, but in such a case when one of the partners is unable to take
active part then the sleeping partner would only get profit only to the extent of the ratio of
This is different from the previous type of investment. The bank (Shohbul mal) offers finance to an
individual and the client (Mudorib) in turn provides the expertise with the responsibility to manage
the labour. When profits are obtained, these are shared by the two parties in a pre-agreed upon
proportion. On the other hand when a loss occurs, then the total loss is bourn by the bank itself and
there is no liability upon the other partner.
Courtesy: Islamic Finance made simple
I) Difference between Musharaka and Mudarabah;
According to (Usmani 2010) the main differences between these two are:
1. In Musharaka each partner invests his capital where as in Mudarabah the investment comes only
through only one partner (Shohbul mal).
2. In Musharaka each individual partner has a right to participate in the day to day business where
as the investing partner in Mudarabah cannot indulge in day to day business.
3. Loss sharing in Musharaka applies on all the investing partners where as in Mudarabah only the
first partner namely the investor suffers the loss.
C .Diminishing Musharaka:
Diminishing Musharaka as practiced by the Islamic bank of Britain (2009) involves the offering of
property and home purchase finance plans through the Diminishing Musharaka (reducing
partnership).Here the bank enters into an agreement for joint purchase of property. The rental
income is received by the bank as per its share. The other party pays separately the rent and also
for the purchase of the proportions of the property from the company so that the ownership share
of the bank is reduced but that of the client is increased till the borrowed amount is fully repaid
Mark up finance (Murabaha) is by far the most popular instrument of Islamic finance. According
to Schaik (2001) the main factors that determine this are, 1.Mark up finance is a short term
finance, which reduces bank risk, where as PLS is a medium or long term proposition. 2. The bank
is also guaranteed a certain profit.3.Risk for the bank is much limited.
Shariah allows the final buyer in a Murabaha contract to refuse the ordered object thus putting the
bank under constrains. In order to avoid this, modern banks have issued two separate contracts. 1.
The promise by the main buyer that he would not go back on the contract signed, 2.A separate sale
contract. This is comparable to a letter of credit.
. The bank which does this transaction gets its time value of money by in the form of profit margin
but the bank cannot charge additional money for the late payment although the commodity remains
under the possession of the bank until full payment is done.
According to the Islamic Bank of Britain (2010, Annual Report for 2009), Murabaha is a
transaction whereby a commodity is purchased by the company to be sold to the counter party
under the agreement of promise from the counter party to buy the item under certain terms and
conditions. The pre agreed profit margin is fixed to the commodity actual price before the sale is
Compared to this Wakala is an instrument the bank gives money to the agent for investment
according to certain condition so as to achieve a certain specified returns. If there is any
negligence, violations, the agent is obliged to return the amount invested.
E) Other forms of Islamic banking instruments are:
This is an instrument which is based on sales. The sale is of a particular commodity which should
be present physically during its sale that is, it cannot take place in its absence.
Qard-e-Hasna (Benevolent Loan):
This type of loan is regarded as the true transaction as per the Shariah because it is a loan which
does not compensate the creditor for the time value of money. Here the loan is a goodwill loan
given to the needy where in the borrower has to return the loan with out interest .As a token of
appreciation, the debtor may also add some amount and repay the loan but this is not considered
interest as it is as per the discretion of the borrower but this is not a condition.
This is a deferred payment for a sale which could be in instalment as per the agreement between
parties. There is no charge for this delayed payment.
This leasing product which involves leasing of machinery, buildings or equipment on an agreed
Ijarah wa iqtina:
This is also a leasing product but is coupled with the lessee having the right to purchase the
commodity at the end of the lease period.
Here the purchaser pays the full amount for a commodity which will be delivered at a later date.
Shohet (2007) describes Sukuk as Islamic bonds which is relatively a new instrument in the
traditional world of finance management.
Credit ratings are assigned to Sukuk circulation so as to assess their credit worthiness and these are
managed in accordance with the universal standards. Some of the different types of Sukuks are,
lease Sukuk, partnership Sukuk and investment Sukuk.
Sukuk vary according with the nature of company and nature of assets. London is the main centre
of short and medium term financial transaction, estimated around three billion US dollars per day,
which operates according to Shariah.
However there are certain aspects of Shariah law which require that Sukuk must represent the
ownership of real economic assets which can generate revenue and returns should be linked to
actual profit and not percentage of capital. (Shafiq 2008,)
Many Muslim countries have adopted Islamic Banking System especially those who have a sizable
Muslim population such as Pakistan,Indonesia,Malaysia,Iran,Sudan,Indonesia ,Bangladesh .These
have either full fledged Islamic Banks or have opened services through conventional banking. In
the UK, the Islamic Bank of Britain has a full fledged Sharia based banking operation.
2.5 CRITICAL EVALUATION OF ISLAMIC BANKING INSTRUMENTS:
One of the Islamic banking instruments which has been in frequent demand is the Murabaha
Iqbal (2008)contends that in Murabaha which is ‘cost plus profit’ works out to be the same just as
the Conventional bank interest schemes .According to him, the adoption of Murabaha is a
legitimate instrument based on the opinion of just a few Muslim scholars.
2.5.1. Murabaha v Conventional loans:
Contending further, he states that in the execution of Murabaha there is a change in terminology
from interest to profit and in reality these two are the same because the ultimate result is the same.
He places this criticism due to the fact that the profit in Murabaha is usually determined on the
basis of interest benchmark such as London Interbank Offered Rate (LIBOR) which fuels the
criticism of formalism within the contemporary Murabaha.
Shariah, not being a uniform code and therefore Islamic scholars can have their own personal
opinion. They give their opinion based upon an analysis and deductions known as Ijtihad which
they utilize to approve or disapprove any financial matter.
Hussain (2007) also feels that Islamic financial institutions are engaging in lending money through
a ‘back door entry’ which they call as Murabaha, and He considers it as Riba.His claim is based on
the argument that when the credit price is greater than the cash price, then it implies that time has
value which is the basis of Riba whose essence is that money grows over time..
Application of Time Value of Money:
Sheik (2007) observed that the basic principle of interest is time value of money. Islam prohibits
this because no fixed amount can be charged on money over a certain period. With out money
going through the entire procedure of business activity, any gain on it is considered not permissible
as per the Shariah. Some banks assign weightages to the tenor of investment which is another way
of giving interest based on the time value of money.
2.5.2 PROFIT AND LOSS SHARING:
Dar and Presley (2000) of the Department of economics Loughborough University in their paper
Lack of Profit and Loss Sharing in Islamic Banking, have observed that most of the major financial
transaction that takes place on profit and loss sharing involve two of the instruments of Islamic
banking, namely Mudarabah and Musharaka but unfortunately in actual practice these are far from
models. These two models are mutual arrangements between parties who pool their resources in a
business undertaking and sign a contract for sharing on the basis of profit and loss. According to
the above authors, the poor implementation of Profit and Loss Sharing (PLS) process is the
hesitation by the capitalist as they are less compensated in their contributions in the process of
production activities and since they are also less inclined to share losses that would have taken
place. Further, there is always a stiff competition from the Conventional banks who are well
established and therefore Islamic banks have to offer less risky instruments as compared to
Musharaka or Mudarabah. Participants in business like Mudarabah are only sleeping partners and
non participatory in the business activities or decision making and this accounts for their
dissatisfaction. There is also unfair treatment in case of taxation, that is profits are taxed but
interest is not taxed by the governments.
2.6 DIFFERENCES BETWEEN ISLAMIC AND CONVENTIONAL BANKING:
Hussein(2007),Head of Islamic Banking,Maybank Singapore stated that on a general basis most
Muslims have no clear cut concept of the basic differences between Conventional and Islamic
banking systems ,because basically both these banks operate with the main objectives of collection
of funds and generation of profitable revenue and through this they help the countries economy.
But the manner of their revenue generation has many basic differences. These, according to the
author are as follows.
1. Types of Contracts:
Majority of income in Conventional Banks is through lending contracts on interest, where as
Islamic banks generate their revenue from trade contracts with out levy of interest such as:
• Sale based contracts
• Leasing contracts
• Partnership contracts
• Profit and Loss sharing contracts.
2. Sources of Revenue:
In Conventional banks it is the generation of interest, where as in Islamic banks it is,
• Rental income
• Profit from sales
• Profits and dividends from investments
3. Risk sharing and Debts:
Conventional banks do not get involved in any risk sharing activity with their customers. They are
more concerned with the income that is generated from loans and advances which are given on the
basis of interest. They are also not concerned with the fate of the loan or that of the customer.
Islamic banks take risks in most of its instrument thereby they get involved with the fate of their
The director of The Islamic Bank of Britain in his report lists out the following risks
1. Credit risk:
This could arise from the failure of the customer who fails in his obligation to make necessary
payments. Risk may also arise in the investments of Bank funds in Shariah compliant institutions.
2. Liquidity risk:
Sometimes the bank is unable to meet its financial commitments for want of funds this is due to a
mismatch between available funds and existing liabilities.
3. Market Risk:
This may arise due to unfavorable market situations including foreign rates.
4. Operational Risks:
This may come about due to failure of its internal process, fraud or technology failure.
5. Concentration Risk:
This may occur when investments are made in only one sector with out diversification in
6. Shariah compliance Risk:
Compliance with Shariah law is vital for the banks to succeed. Some products may have Shariah
compliance in them and therefore does not attract customers.
As explained above, Islamic banks take as much risk as the customer by operating on profit and
loss sharing basis, and thus the mismatch between assets and liabilities is avoided. This method
provides a minimal chance of facing bankruptcy with the bank or entrepreneur because they share
responsibilities unlike Conventional Banks. This responsibility makes the Islamic banks vigilant
about the utilization of loan funds by entrepreneurs which ultimately helps mutual progress
Conventional banks charge penalties where as Islamic systems normally do not allow this.
5. Ethical and Moral issues:
Conventional banks do not make any difference between unsociable business activities like
gambling, liquor trade, prostitution, and fund these ventures where as Islamic Banks screen and
prevent funding of such activities.
2.6.1 DIFFERENCES IN CONCEPTS AND OPERATIONS:
Awan (2009) gives further details of the differences between Conventional and Islamic Banking
systems, in their objectives, approaches, concepts and operations and these are:
OBJECTIVES AND GOALS:
The core difference between the objectives of the Islamic and Conventional banks is that the
former operates for the welfare of the poor so that there is a horizontal distribution of wealth where
as the latter’s aim is to favour the rich bringing about the concentration of wealth in the hands of a
few. According to Kennedy, (1995), Conventional banks favours the rich, helping those who are in
regular business where as Islamic banks share the fate of their clients with their own future through
a system of profit and loss sharing. By this way they help the entrepreneurs with poor capital but
with promising ones so that they are able to obtain finance and growth.
MODE OF BORROWING:
Conventional banks maintain their margin of profits safe by charging a higher rate of interest from
the borrowers while offering lower rates to the depositors and by this they satisfy their main
objective namely to maximize their profits all the time. In the Islamic banks the basis being Profit
and Loss sharing, there is no undue gain at the cost of the customers.
CONCEPT OF MONEY:
Money is utilized by Conventional Banks as a commodity. It is used merely as a source of huge
profits only. Kennedy and Kennedy (1995 ) that money when allowed to be kept in the hands of a
few who have excess of it creates a toll gate where those who do not have enough but who are in
need are made to pay to those who have more. Due to interest and compound interest, this debt
increases exponentially leading to creating problems. Many people who are unable to pay the
enormous debts commit suicides. Thus according to her, interest grows like cancer and ultimately
finishes the patients.
On the other hand, Kennedy (1995) contrasts this with the concept of money with the Islamic
banks which use money not as a commodity but as medium of exchange so as to enable transaction
while doing business. As its concept of money is the opposite of the one with Conventional Banks,
Islamic banks share the profits and losses and do not allow the public to face insurmountable debts.
DIFFERENT APPROACHES OF INCOME DISTRIBUTION:
Conventional Banks approach towards the rich is a positive one and towards the needy, a negative
one. It can be seen from the fact that in the United Kindom, during the year 1960-1998, among the
super rich which form just 0.002 % of the UK population, there was an increase in income by 30%
which was 15 times as fast as inflation in the year 2003.Considering this fact as well as the similar
scenario in other parts of the world, the World bank had warned against this inefficiency of this
type of wealth concentration in the hands of a few.
In their book, Comparative Economic System, Gregory and Stuart (1992) philosopher John Rawls
noted that the reason for the unequal distribution of wealth persists because the rich do not have
the tendency to enter into schemes which also favour the poor. This brings to a halt to any attempt
for social changes which could bring about any redistribution of wealth to the poor. On the other
hand, Islamic concept of finance attaches great importance to distribution of wealth between the
rich and the poor, a concept upon which the Islamic banks opertate.For example, the tradition of
Zakat of 2.5% on the year’s savings in the bank, which is a compulsory tax upon the rich. This
amount is collected with an aim to be distributed to the poor. This act also discourages the habit of
hoarding and enables flow of currency in public.
2.7 RISK MANAGEMENT:
2.7.1 RISKS INVOLVED IN ISLAMIC BANKING:
Risks and challenges are common to both Islamic and Conventional.
But as per FSA, there are several risks very specific to Islamic banking. , (Aienly 2007)
Islamic banks face the problem of various interpretation of Islamic law. These may be listed as
1. Some scholars approve a product as Shariah compliant but some others do not approve it. The
FSA is very much concerned about the products that the Islamic banks introduce and would like to
make sure whether it complies with the Shariah.
2. For the products of the Islamic banks, it is necessary that remain compliant with the Shariah that
means that they are continuously being monitored to see whether they are Shariah compliant
through out their productive life.
3. Professional and experienced Islamic financial experts are always in demand, and the banks
have to make sure they get the right people.
4. Shariah contracts face problems while deciding disputes .In the UK the court decides this as per
the British law only. In order to avoid this, documents should be very carefully written.
5. In the United Kingdom, Murabaha which is the popular product is being developed to have the
same liquidity as conventional banks. This involves Shariah compliance.
7. Conventional banks with Islamic windows normally pool the Islamic business risks with their
own products. This may not be acceptable as per Shariah law.
8. The risk arises when a customer fails in his obligations from either secured or unsecured
The Islamic Bank of Britain manages its risks in the following manner:
The following methodology of risk management that the bank faces is explained with respect to
the Islamic Bank of Britain. A few salient features are mentioned below.
Risk management is done through regular reviews of market trends, products and services offered.
These help in setting the limits to risk exposure. This is the responsibility of the Board of Directors
of the bank and the controls are reviewed by an internal audit.
A separate credit committee is set up to manage risks by assessing credits, formulate policies with
other business units it also establishes an authorization for credit exposure limits. They renew the
credit risks before an agreement is signed, and provide guidance expertise to enable the best
methods to be adopted in the management of risks.
When it is decided by the credit department that an amount due cannot be collected or when the
collateral is insufficient to meet the balance, the bank, after getting all the necessary relevant
information writes off the remaining balance.
Against secured advances, the bank obtains the collaterals in the form of assets, guarantees or
Liquidity management is done by the bank by ensuring that it is able to obtain sufficient financial
resources to meet its commitments in case of liabilities.
Rentals for home purchasing and other property financing are bench marked as per the Shariah
Supervisory Committee subject to a minimum level of rent.
Monitoring of market risk is done by AOCL, which is its principle responsibility. Other risks such
as Operational risk is done by implementing an internal control system so as to reduce the financial
loss and by this way it helps support process efficiency and customer interests. The Board of
Directors is the one which sets the guide lines. Monitoring of operational risk is done by the Risk
When the services in an Islamic bank do not comply with the Shariah law, then there is the Shariah
compliance risk. The Islamic Bank of Britain manages its Shariah compliance risk by referring
each of its product and services offered by it to the Shariah Compliance Board. The concerned
officers oversee day to day business in the bank so that no breach is committed.
Concentration risk occurs when there is an inadequacy in diversifying credit risk across sectors. It
is the Board’s duty to set the limits with respects to the assets and to monitor its implementation.
2.7.2 RISK MANAGEMENT BY CONVENTIONAL BANKS:
The overall risk management in Conventional bank is comparatively simpler when compared to
Islamic banks. In Conventional Banks risk arises as a result of lending and borrowing. But
Conventional banks do not bear these risks directly but by shifting the risks to other parties.
Conventional banks are not encouraged to engage in business which would impose unnecessary
risk on itself. However by judicious planning, pricing and product design these banks minimize
Santomero (1996) describes four essential steps in risk management for Conventional banks. These
• Standards and reports.
• Position limits or rules.
• Investment guidelines or strategies.
• Incentive contracts and compensation.
The first step comprises of standard setting and financial reporting. These two operate together.
This involves the standards set for review, categorization of risks, and underwriting standards.
There is a constant evaluation and reporting after giving ratings so as to understand the various
risks. It helps to plan as to how these can be absorbed.
The next step that is taken is the allocation of minimum standards of participation in assets .Limit
is placed to cover the exposure to counter parties.
In investment categories, strategies are formulated in respect of concentration in market areas in
order to avoid mismatch between asset and liability.
Incentive schemes for ensuring incentive compatibility between principals and agents in a
From a managerial point of view, managers are able to avoid risks by simple business practice
depending upon their experience, or as said earlier by transferring it to other participants.
2.8 FUTURE OF ISLAMIC BANKING IN UK:
The future of Islamic banking depends upon risk management. As per the report by the Financial
Market 2011,Islamic banks face many challenges and risk in management of liquidity, cost of
ensuing compliance with Shariah , management of Sukuk, and multiple interpretations by Shariah
scholars .The points as described above describe risk factors and its management by Islamic and
In the United Kingdom, the promotion of Islamic banking is actively guided and assisted by the
UK Islamic Finance Secretariat which coordinates between government, UK Trade and
Investment, HM Treasury and industries to make UK as the global gateway of Islamic finance. It
runs five working groups in the form of domestic Retail Banking, Islamic Financial Institution,
Legal, Accountancy and Education in training and qualification process.
One of the early indications of bright future for Islamic Banking is the resilience of its assets even
during financial crisis. According to Financial Market Series, The, IMF Survey online October 4,
2010,Islamic financial market reached $1,041 bn at the end of 2009,even when there were global
financial crisis(Chart I).
It is estimated to grow by 10-15 % during 2010.The report suggests that there would be further
improvement because it seems to have the potential and also because it was less affected by the
global financial crisis. The key centers comprise of Malaysia, UAE, Saudi Arabia and others as
shown in chart 2.
Country wise financial position of some countries is depicted in the chapter 2.
The United Kingdom occupies the ninth place in this lineup but is the leading country amongst the
countries of Europe. It has a greater capacity to further improve.
Another factor which points to a better future in the UK is growing number of banks offering
Shariah complaint products. There are twenty two banks and five with fully Shariah compliance.
In the UK,Islamic banks are fully supported by the Government as well as nearly twenty Law
firms and four big professional service firms., Global assets of Islamic banking is shown in chart-I.
Table I shows the UK is placed in the ninth position with 19 bn largely based in HSBCAmanah
The assets of Islamic banks in the United Kingdom are shown in the table
Although Islamic banks have been less affected by the global crisis, still these face several
challenges as described below.
1. Islamic banks lack products to enable them to manage liquidity effectively
2. Compliance with Shariah with respect to all its products is a constant challenge.
3. Diversification of assets is essential so as to spread risk such as in real estate which have
contributed to fall in asset values.
With the steady growth of Islamic banking in the UK, the future prospects are very bright because
there are a lot of opportunities to improve in the UK mainly on account of the government’s
support and its help in broadening the market for Islamic products.
Acquisition of data as per the topic on the critical analysis comparing Islamic Banks with the
Commercial Banks in the United Kingdom, the primary concern has been to study the system of
operations in these two banking systems. This comparison has gained great relevance in the
modern era due to the steady rise in the public acceptance of the Islamic Banking system. Data
collection is the major task one has to undertake in analyzing any topic of research. Any research
work requires clarity of research design and this in turn requires the standard methods of data
collection that would be employed to strengthen the conclusions made. (Cameron, 2005),
Therefore the purpose and aim of this study is to analyze how far the banks which claim to have
their instruments based on Shariah law and are they serving their clients with satisfaction in
comparison to conventional banks. An attempt will be made to critically analyze these factors.
3.1. SOURCING DATA:
Data collection technique is a very useful tool in obtaining relevant data and gives one the
opportunity to systematically evaluate the merits or demerits of any information which has been
collected. It should be collected very systematically otherwise it would lead us to wrong
conclusion which would spell disaster to all the efforts that would have gone into the collection
There are two different aspects of data collection. The first is the Technique and the other the Tool.
The techniques involve observations, interviewing’s and written question and the tools are data
compilation formats, senses and other items such as pens, notes, cameras or audio recorders.
Data collection for Islamic Bank performances which is my topic for Dissertation is a challenging
task .I had to visit many places and discuss this issue with a large group of people who are either
customers in Islamic Banks or those who are knowledgeable in this field.
3.2. DATA COLLECTION:
Types of Data:
Quantitative Data and Qualitative Data:
These could be of the following categories:-
1. Primary Data
2. Secondary Data
A.) By Experimental design, this includes Laboratory or Field Experiment.
B.) By Individual survey, this is done by direct contact, telephonic communication, postal
messages, on line data collection.
Secondary data on the other hand is done by collecting relevant details from the work done by
other researchers in the pertaining field. This may be selected from Annual Reports, Case studies,
statistical data published by private and governmental organizations including international
organizations such as International Monetary Fund, the World Bank, United Nations and the
Organization of Islamic Countries which publish economic statistics from time to time.
Analysis of secondary data is of greater advantage because of the already existing background
work such as literature reviews, statistical work, some conclusions and recommendations for
further study. This type of data collection gives an individual confidence because of the
authenticity as the work would have been critically read and approved. It gives an insight into the
recent and the immediate past scenario of this particular subject of banking .It also helps in
designing the research method such as the present topic where an attempt is being made to
critically evaluate two different concepts in banking systems.
Secondary data would be obtained through publications such as:
• Central, State and local Government body publications.
• Publications by foreign government and international agencies
• Trade journals
• Technical journals
• Books and periodicals.
• Magazines and News papers
• Case studies and reports
• Reports by agencies, associations connected with banking
• Reports prepared by various scholars, university professors and professionals.
• Reports by economists, bankers and those dealing in financial undertakings
• Historical documents and public records
Other sources through personal notes from knowledgeable sources, research scholar works and
It should be emphasized that care should be taken so as to ensure that the information which has
been obtained is authentic and through very knowledgeable sources. Therefore the following
points must be kept in mind about the collection of Secondary data.
3.3. QUALITATIVE DATA COLLECTION:
According to Neil (2007), qualitative method of data collection is very suitable for preliminary
servey.The researcher would not have a complete idea of the information that he or she would get,
and that he or she would have a rough idea only and the full picture emerges as the research
progresses. The data has to be done personally by the researcher and the information is in the form
of pictures, words or objects. It is possible to do an in dept interview although only generalized
information is obtained (web 3).
3.4. QUANTITATIVE METHODS:
This is a method which I will utilize while depicting the dynamics of Islamic banking in the world
scenario. The depiction would come in the form of bar and pie diagrams, graphs and other pictorial
display. This will help in understanding the future prospects, the share by countries, world wide
and also the annual turnover in terms of revenue in the Islamic Banks.
The data comprises of:
• The number of Islamic Banks in UK
• The number offering Islamic instrument through a window
• Probable increase in Islamic Bank investment corresponding to increase in population
• How many commercial banks offer Islamic Shariah based investments.
3.4.1. TO OBSERVE ETHICAL PROCEDURE AND OBTAIN RELEVANT DATA:
• To interview people face to face and get answers.
• To hand over questioners to individuals with a request for supply of authentic information.
• Always to obtain prior permission before engaging in interviewing.
• Will avoid loose structured vague questions which might not give concrete replies.
• To prevent bias during collection of data by not putting leading and illogical questions.
• To select people for questioning those who are having knowledge about the topic of my
• To keep in mind the ethical aspects of the data collection like asking sensitive questions,
violating the privacy of the informant and making public what is to be kept as a secret.
• To keep in mind the cultural, traditional and religious values of individuals.(Web-4)
The area of research involves more a collection of data as secondary data where there is a fair
amount of analysis is of major concern, and therefore I would collect more secondary data which
also comprise of the following:
3.5. SOURCES OF SECONDARY DATA COLLECTION:
• News papers
• Visit to Banks, both Islamic as well as commercial Banks in London.
• Visit to centers of Islamic studies from where I would get information about the prospects
of Islamic Banking System.
• Discuss with peers about this topic.
Qualitative method of analysis would be the most ideal in this research as it would provide
easy access to data which would be conceptual with the researcher fully getting involved in
the process of data collection. There would be no need to obtain data from very large
number of customers and also there would be flexibility in selection of area, customers and
timing of the interviews. It would also provide the degree of acceptability or rejection by
judging from the reaction of the customers. This is a topic which involves bank authorities,
customers and local residents and therefore would be very interesting. Further, it could be
more suitable for a student who may not have to spend too much in order to obtain
information unlike quantitative method where some sort of computer analysis would be
required while computing statistical data. Although qualitative data collection might not be
able to give out figures which can be depicted as graphs and diagrams, but it would
certainly give a better analysis of the results which would help in getting an overall view
which would in many ways be better than more specific conclusion which by themselves
would not provide any clear view of the entire scenario.
3.5.1. ADVATAGES OF QUALITATIVE DATA:
• It is possible to gain knowledge fully and personally.
• Time and place is as per the interviewers choice.
• Preferences and choices can be assessed more easily between observations.
• Since it will be done only by me, there will be minimum errors while repeating the
• All questions would be put in a standard manner as it is only by my self.
• Questions would be restructured depending upon the sensitivity of the customer.
• First hand information could be obtained and there will not be any changes while
I would prefer to mostly collect information through journals and magazines with visit to banks for
information so as to make my comparative study meaningful. Thus my reliance would be more on
Secondary data rather than first .It is also more suitable to my topic of research which is, by and
large, the Critical analysis of Islamic Banking
3.5.2. REASONS FOR PREFERENCE -SECONDARY DATA COLLECTION:
• Secondary data helps in evaluations on the basis of adequacy of the material available as
many of the information have been specifically dealt with by other qualified researchers.
• It is more economical and time saving. On the other hand Primary data involves huge
expenditure and is also time consuming.
• Secondary data enables the researcher to analyze data by enabling access to information
repeatedly, as in the case of journal or book references.
• Obtaining secondary data from government sources as well as other organizations gives a
sense of trust as the same would have been collected after wide survey.
• Secondary data helps in the final phases of the research when it is required to define the
problems and also when arriving at hypotheses and conclusions.
• Secondary data also helps to find the general scenario in the past and to arrive at the
possible future trends.
• Secondary data may sometimes be just sufficient to come to a conclusion with the primary
• Secondary data helps in providing enough time to re evaluate the topic and helps in
directing the course of the research work.
Data analysis of the Islamic banking in Britain reveals that this system is of recent phenomenon.
Islamic banks in United Kingdom made their start due to the growth of Muslim populations in
some parts of Britain with a liquid asset of nearly 3.6 million pounds.(Mathews et al 2010).The
first Islamic bank in the United Kingdom was established in the year 2004 with the inception of
Islamic Bank of Britain(IBB). The causes for this has been a growing demand by the large Muslim
community of Britain who were apprehensive of the involvement of Conventional bank interest
which is prohibited as per Islamic Shariah.Fortunately for them, Commercial Bankers found this as
an opportunity to serve their customers in a satisfying manner and they commenced banking
through ‘windows’ based on Shariah with an aim to cater to the needs of the Muslim population.
Thus, international banks such as HSBC, Lloyds TSB, Deutsche banks, and Citi bank having
opened Islamic banking ‘windows’ also helped in their expansion. The Government of the United
Kingdom also helped in removing certain obstacles by introducing certain specific legislatures and
tax changes, for such establishments.
Coupled with this, the British government through its Financial Services Authority act of 2005,
and 2006, put the tax structure on similar basis of Conventional banking.
4.1. EQUATING RIBA WITH BANK INTEREST:
Equating Riba with bank interest is a very important issue. Since the raison d’être of Islamic
banking is prohibition of interest(Riba)and Profit and Loss Sharing it would be worth while to
analyze as to what extent Riba,the prohibited Islamic interest and modern bank interest are
equivalent in the views of scholars and whether there is an unanimous consensus on this issue.
According to Nyazee (2000) there is no standard definition of Riba despite the fact that there is
general agreement about the prohibition of Riba .There are still a number of scholars who do not
agree with equating of Riba with interest(Ali and Kazmi 2011)
However. the issue of whether Riba and interest are the same was finally settled by the Islamic Fiq
Academy of the Organization of Islamic Conference (OIC) which issued a verdict in its resolution
No:10(10/2)upholding the consensus that interest was prohibited in Islam (Farook,2006).
The other principle of Islamic banking which is Profit and Loss Sharing is discussed critically as
4.1.1. CRITICAL ANALYSIS OF PROFIT AND LOSS SHARING:
4.1.2. DIFFICULTY IN IMPLEMENTATION:
The guiding principles of profit and loss sharing in Islamic banking systems have faced several
challenges. Profit and loss sharing is a noble concept which if implemented and if the public gives
its full support, then the system would be one great success. Unfortunately there are some hurdles.
As reported (Schaik2001) banks do not very much encourage this principle but on the other hand
do encourage such schemes which are of short duration and which fetch them a profit with out
great risk like the Murabaha schemes. Gafoor (1995) observed that in the area of financing, bank
lending is practiced as no cost loan such as consumer loans, or loans where only service charges
are collected. Since these two types of loans do not bring any income to the bank, Islamic Banks
do not show any interest in operating them. Thus the investment and trade financing are the main
sources of income it also helps the bank customers who are investing get their profit which forms
their incentive for investments.
Regarding the public which attains loans for business purposes, Dar and Presley (2009) have
analyzed the Profit and Loss (PLS system and observed that most entrepreneurs may not be
interested to show the complete business gains and would therefore report less profit. Further the
capitalist would also hesitate to invest in PLS because of low incentives and are not prepared to
face losses. In the PLS (Mudarabah) there is restriction of the involvement of shareholders which
makes their role as non participatory in nature. Another factor is that profits from Islamic banks are
taxed where as interest in Conventional banks are tax free as it is considered cost item.
These are some of the difficulties in the field of implementation of Profit and Loss schemes,
although with respect to deposits they have got some degree of success.Therefor the main
challenge would be to popularize profit and Loss sharing based medium and long term finance. It
would be essential therefore to develop Islamic Money Markets and Capital markets.
4.2. CRITICAL REVIEW OF INSTRUMENTS OF ISLAMIC BANKS:
This is Markup finance which according to critics of this instrument regards this as a manipulation
by which interest in the form of profit is collected by the bank.
According to Ashker (1987) when a contract for the promise to purchase is signed then it becomes
compulsory for the client to buy the product which is an illegal act .Further neither the buyer has
seen the object nor the bank actually possesses it. These two acts according to Shariah are illegal’
If credit price is higher than spot price, then the increase becomes Riba. Although the Shariah
requires that there should be a time given to the debtor, in the Mark up finance, a penalty is added
for late remittance.
According to Saeed, (1996,) Mark up finance seems as legal maneuver .It is an interest based loan
in disguise. There is a charge namely the cost of financing (mark up) which is actually the interest
and also the time for repayment is fixed.
Ahmed (2009) also claims that Markup (Murabaha) which is adopted as a substitute of interest
does not actually abolish it. Here a factious deal is entered between the borrower and the bank. The
bank purchases certain goods for the borrower by lending money to him. The bank through an
agreement claims back its loan along with mark up by stipulating in the same agreement that the
person who has borrowed will finally purchase the product after the expiry of a certain period
during which the price of the goods is marked up.
He points out some objections to this type of transaction.
1. The first objection is the fixing of the markup value at specific level which works out at a
certain percentage of interest .He claims that what has been done in this case is that there is
merely a change in the name of interest to markup. He bases his objection as per the sayings of
the Prophet (PBUH), (Khan 2000), that one cannot sell a thing which one does not possess. In
this case the bank does not possess the commodity which it resells to the borrower at the time
of full payment of the loan with the “mark up value”.
2. There is actually neither sale nor any resale. The banks as well as the borrower enter into an
agreement with out any commodity passing hands.
The above points reveal that Murabaha is an instrument which requires further investigations and
research so that it could become Shariah compliant fully.
Iqbal (2008) observed that in its pure form Murabaha is similar to conventional loan. According to
him decisions on the authenticity of Islamic Shariah law seem variable because there is no uniform
code in Shariah law. In most cases, He observes that only a minority view has been adopted so as
to suit the interest of the banking system. He believes that there is mere change in terminology
from interest to profit although these two are not the same. This view is in concurrence with view
of Hussain who feels that interest in the operation of Murabaha comes through a back door in the
form of legitimate profit.
4.2.2. DIMINISHING MUSHARAKA:
Diminishing Musharaka has invited some criticism from scholars because its mode of operations
resemble hire purchase in Conventional banks.
Sheik (2007), compares the mode of operation of Conventional Mortgage and Diminishing
Musharaka.In Diminishing Musharaka, two agreements are written, the tenancy and sale which
gets together mixed. The arrangements is such that as the ownership of the customer increases
,the rent that he has to pay decreases until full payment is made for the transfer of the property to
him. In the conventional mortgage, the amount collected is the interest plus principle amount and
these two behave in the same way as rent and ownership. Except procedural differences these,
according to him are the same.
From the above it is quite evident that these types of transactions are the usual way banks offer
loans on credit, calculate the interest rates and advice the borrowers to pay the loan plus interest in
installment and finally the commodity becomes his own. It is similar to hire purchase which works
on interest basis.
The objection to this instrument, according to Sheik (2007) is based on the following analysis.
1. Modarba is a pre Islamic instrument. The common example that is given is that of the Prophet
(PBUH) who acted as the Modarib, that is fund manager, through a contract with Hazrath Khatija
(RA), a rich widow who funded the business for the Prophet to perform trade .Obviously the flow
of money was from the rich individual for a business undertaking .Since this practice does not go
against the values of Islam, it has been adopted in the modern Islamic banking (Nimrod 2009)
2. The above flow of funds is from the rich entity to the individual who needed money to carry out
the business. In the case of Modarba contract with the Islamic banks, flow of money is from small
pool of investors to the larger financial entity namely the Islamic bank. The bank in turn acting as
Mudarib invests the amount in financial instruments .Here there is no effect with regards to self
employment or productions as in the case of true Modarba.
3. In the case of profits, the fund manager suffers no loss in case of business failures and the
investor alone is made to bear the loss, but when there is gain he shares the profits on the sole
assumption that he is the cause of the profits.
4.2.4. SAVINGS ACCOUNT:
Allowing weightage to saving accounts and awarding benefits is the objection as it is not Shariah
based. In the Islamic Bank of Britain, deposits from customers are utilized under the principle of
Modarba where in the customer is assured of a certain percentage of profits which the bank
obtains after making Shariah based investements.But if allowances are made as per
weightages,then it calls for objection.
Writing on the Critical Analysis of the current Islamic banking systems Sheikh, (2007) states that
there is not much difference between Term deposit as practiced by Conventional bank and saving
accounts in Islamic banks as these are based on weightages.
4.2.5. TIME DEPOSIT:
The bank acts as Mudarib that is the Fund Manager, and the customer the investor (Rabul mal).The
banks invests the money in Shariah compliant organizations. The money that is deposited is given
weightages in the beginning itself. The profit is calculated through weightage which are assigned
on the basis of period of investment to calculate profits resembles Time Deposit as practiced in
conventional banks. Time value of money is banned in Islam and therefore according to Sheik
(2007), savings account as per the above schemes do not fall under Shariah regulations as these
inherently involve interest which enables the bank to give profits on the basis of the period of
amount kept in the Savings Account.
4.3. CONTROVERSIES AND CHALLENGES FOR ISLAMIC BANKING IN UNITED
There is no denying the fact that Islamic banking has made great progress in the UK, especially its
continued growth during the recent universal financial meltdown. This has attracted even many
non Muslim countries to introduce this system so as to benefit of the general trends amongst most
of its Muslim population like the UK.Along with this success, there are controversies and
challenges with which this system has to face. Some of these as per Malik et al (2011) are:
• Shariah lacks a single universal authority which can govern its interpretations. Shariah laws
are formulated by the respective Shariah boards formed by the Islamic banks. The problem
is that there is a paucity of scholars who are both well informed of finance management as
well as Islamic laws.
• 2. Various sects of Islam have their own interpretation of its various laws through their own
authorities. This opens a possibility of complications and even conflict of the rules.
• 3. With out a consensus of religious experts, the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIF) is facing difficulty in Islamic Standardisation
• 4.Islamic finance industry faces the challenge of Shariah Auditing which is still not fully
developed(SunGard 2009,).There is also a lack of experts who are well versed with
conventional and Islamic banking system so that rules unique to Islam could be better
understood so as to successfully develop and market the products.
• 5. Confidence building in the Islamic system of banking is another challenge (Aioanei,
2007 13).Attempts should be made to keep the customers and depositors educated about
the compliance of Shariah law in its various instruments.
• 6. There is a lack of short term investment products except Murabaha financing. More such
products must be innovated.
• 7. There should be an attempt to have more sophisticated products so as to meet growing
demands. These should not be a replicate of the existing conventional banking instruments
• 8. Attia (2008) observed that the pure result reached in Murabaha which is cost plus profit,
is the same as interest. He feels that a considerable minority view have been adopted for
Malik et al (2011) stated that the success of Islamic banks depends upon a combination of both
faith and economics unlike conventional banking system which concentrates chiefly upon
In his book, Interest free Commercial Banking Chapter 4, Gafoor (1995) notes that in nearly all
countries of the world, modern commercial banking system have modelled themselves mostly on
the practices as followed in the United Kingdom on two main principles of certainty on the rate of
return on deposits coupled with capital certainty .This comes under the previews of Central Banks
Under these circumstances Islamic banks in the United Kingdom have found difficulties in
implementation of these rules. The salient features are as follows:
CERTAINTY OF CAPITAL AND RETURN:
Unlike conventional banks, Islamic banks cannot guarantee neither any fixed rate of profits on the
deposits nor the capital, as they work on profit and loss sharing. This happens to be the root of the
problem and therefore it is difficult to get the necessary permission to operate under the profit and
loss sharing system under the system of banking in UK.
The Governor of the Bank of England, Sir Leigh Pemberton while addressing the Arab bankers in
London,(Abikan and Jafar 2006)said that although the Islamic banking system was acceptable as a
mode of finance, it may not fall with in the definition of what constitutes banking in UK.He also
said that it was important not to mislead the public by allowing two entirely different systems to
work side by side which is likely to create confusion, this was because of the main feature of the
banking system in UK which assures capital certainty which forms part of the legal system. Since
the bank of England would not legally authorize under the Banking Act He advocated that Islamic
facilities could be provided under other financial areas of finance.
SUPERVISION AND CONTROL:
Regarding liquidity requirements and adequacy of capital which in turn depends upon the
assessment of the bank values, Steele (1984) opened that as per the 1979 Act, the Bank of England
would find it difficult to value the assets of Islamic banks because of the usual tradition of
assessments for the British Government Instruments which are based on fixed interest instruments.
He observed that if the Islamic banks worked as per British Government instrument, then it would
be possible to value the traditional banking assets based on the quoted market value when they
become non productive. On the other hand, assessing Islamic banks would require a team of
experts to each and every bank operating in the UK, under 1979 Act, in order to put a value on
Suratgar (1984) stated that it was indeed difficult to make an assessment mainly because a
substantial part of Islamic bank operation is based on venture capital with out any guarantee.
It is therefore clear that in order to enable the Islamic system to work under the existing banking
law, some kind of relaxation would be required ,in case of an Islamic bank failing, which in turn
would weaken the confidence of the entire financial system.
Profits are earned income where as interest is a passive income and therefore treated differently. In
Islamic banking system, such as trade financing, there are title transfer two times, once when the
bank acquires the assets from a seller, and another when the asset is transferred to the customer
.This means double taxation which reduces the margin of profit.
4.4. CRITICAL DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC BANKS:
Practically speaking, Islamic and Conventional Banking systems work with the same motive, that
is to collect funds, utilize them in various lending and investments by involving the Government,
public, institutions and business establishments. The main difference lies in the manner of their
operations and the motives involved.
Conventional banks maximize their business by increasing the wealth of the shareholders and
through the process of interest collections and accumulate wealth for themselves. On the other
hand, Islamic banking system operating on profit and loss basis with out involving levy of interest.
Comparatively the ultimate gains for the Islamic banks would be less but the principle of avoiding
interest on moral grounds is upheld.
1. Islamic banks help to stimulate business activities and bring about distribution of gains by
profit and loss sharing where as Conventional banks help in concentration of wealth
amongst a few with the wealth increases exponentially amongst them.
2. The net distribution of profit benefits among depositors in the Islamic banks who are
thousands in number where as wealth among shareholders in Commercial banking is
accumulated in a few.
3. Interest collected from borrowers in the Conventional banks who are in large number but
the amount is distributed among a few shareholders.
4. Conventional banks favour the rich entrepreneurs and are unconcerned with the success of
their business ventures where as Islamic banks through profit and loss sharing activity
attach their own fate with the entrepreneurs and thus remain concerned with their activities.
5. With respect to borrowing, in Conventional banks, the amount received by the depositors is
used to maximize their profits by giving lesser rate of interest to the customers but receive
higher rates from borrowers.
6. In financing process, Conventional banks provide loans to the firms, government, public
sector as well as individuals and charge higher rates of interest which might act as a burden
to the entrepreneur and might result in business failures, where as no such one sided effect
is seen in Islamic banks.
7. The very concept of money itself is different. Money is a commodity in Conventional
banks, which can be bought and sold and they also charge interest on it during transactions.
8. Conventional banks do not entertain any risks. They keep themselves safe from the losses
that the borrower might suffer.
9. Finally Conventional banks mainly work for the specific rich class and they facilitate
accumulation of wealth with the result the rich get richer.
Based on the above it may be said that these two systems have differences in their total outlook
and objectives although they work under similar circumstances.
4.5. RISK MANAGEMENT BY ISLAMIC AND CONVENTIONAL BANKS:
Risk management by both Conventional and Islamic banks involves judicious planning and
execution. Comparatively, Islamic banks face a far more risk in management than Conventional
banks. First of all there is the question of Riba, which seems to be no uniformity in interpretation
of bank interest although the OIC has clarified by declaring Interest and Riba to be equivalent,
many Muslims still continue to debate this issue. There is also a constant watch by the government
agencies which monitor Shariah compliance in Islamic banks. Islamic banking issues have to be
decided according to Shariah law. Further all banking issues are decided by the British law in case
of disputes and the final result may not be in agreement with the Shariah. There is also a mix up
between conventional and Islamic products in such banks which have Islamic bank ‘windows’
especially while managing risks.
On the other hand, Conventional banks are not exposed to risk factors mainly because these have
the principle of interest which keeps them safe. All the risks are transferred to customers. They
also do not indulge in unnecessary risky business propositions.
Thus it is clear that Islamic banks have to be careful in dealing with their instruments so that they
remain Shariah compliant.
4.6. FUTURE OF ISLAMIC BANKING IN BRITAIN:
There is ample evidence to suggest that Islamic banks in the United Kingdom as elsewhere will
continue to perform effectively. As per the IMF survey magazine2010, Islamic banks performed
differently than Conventional banks by showing better resilience during global crisis. They were
better placed in the run up to the global crisis as shown in the following chart.
During the crisis, Islamic banking model helped to protect the business against the adverse effects
of the down trend.Specifically the smaller investments,lower leverages and Shariah principle
helped them to contain the global impact during this period.The following chart reveals the overall
impact during the early stages of crisis.
The above chart shows that during the later stages, there was greater impact .But when compared
to Conventional banks their asset growth was at least twice as good despite the fact that their
declined. This is shown in the following chart.
Thus the above discussions reveal that there is enough of evidence to believe that Islamic banking
has great future in the United Kingdom.
Sole (2007) of the IMF and Capital Market Department reports that the growth of Islamic banks
has been impressive with an increase of 15% globally. There is still a great scope of improvement
in uncharted territories. It has expanded even in countries with a minority Muslim population such
as the UK.
Professor Torre 201, writing in Islamic Column in the International banking, in his article ‘Four
lessons that western banks can learn from Islamic counterparts’ suggests that Islamic banks have
at least four lessons to teach the western counterparts. Pictorial representation of the Islamic and
Conventional present banking scenario is given below.
According to him, Islamic banks stabilize economy and credit growth. Conventional banks lend
too much in good times and too little in bad times. This results in an imbalance by an increase in
the non performing loans by there is an exponential credit growth. Islamic banks encourage
finance only if it is linked to value creating real transaction .Islamic banks are also allowed to
invest only in physical assets which would generate further flow of cash. There will be a lessening
of risk if the financial transactions are linked with wealth creating schemes which the Islamic
Therefore it can be concluded that the system of interest free banking as per Shariah has a lot of
relevance to modern banking system. It is hoped that there would be an overall assessment of the
basic structure and concept of banking only with the main objective to help people achieve their
goals with out overburdening with undue entanglement in credit.