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Islamic Banking


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Islamic Banking

  1. 1. DECLARATIONThis is to certify that present project report entitled “ISLAMIC BANKING-MAKINGA BETTER SOCIAL AND FINANCIAL WORLD “is based on my original researchwork and indebtedness to other work duly acknowledged at relevant places.The project report has not been submitted either in part or full for any other degree ordiploma for any other University------------------------------- -------------------------------- (Supervisor) (Student) 1
  2. 2. ISLAMIC BANKING-MAKING A BETTER SOCIAL AND FINANCIAL WORLDProject report submitted to Department of Commerce, Zakir Husain College, andUniversity of Delhi in partial fulfillment of the requirement of B.Com (H) Part – IIIExamination. Submitted by SOOBIAN AHMED B.Com (H) III yr. Roll No 07/546 2009-10 Under supervision Of DR.ABDUL WAHID FAROOQI Department of Commerce Zakir Husain College University of Delhi New Delhi-110002 2
  3. 3. First of all I would like to express my gratitude to my Mentor, who guided me withhis knowledge and skill and helped me in successful completion of the work.I gratefully acknowledge my project guide and my Mentor DR. ABDUL WAHIDFAROOQI. The support and guide that was provided to me lead to thesuccessful completion of this project.I am grateful to him for his great support and help all throughout the project. I amthankful to him for taking out time and pointing out the multitudinous aspects ofIslamic banking and helping me increase my learning out of the project.I would heartily thank all my friends without whose support & valuable inputs thisproject would not have been completed. B.Com (H) III yr. Roll No 07/546 3
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  7. 7. "People think the Islamic Banking system is basedon faith, but its based on justice. The system isbased on justice for the two parties and how youget to the justice is extracted from Islamic faith" BRIEF HISTORY OF BANK:The first state deposit bank, Banco di San Giorgio (Bank of St. George), was founded in 1407 atGenoa, Italy.The name bank derives from the Italian word banco "desk/bench", used during theRenaissance by Florentine bankers, who used to make their transactions above a desk coveredby a green tablecloth. However, there are traces of banking activity even in ancient times.In fact, the word traces its origins back to the Ancient Roman Empire, where moneylenders wouldset up their stalls in the middle of enclosed courtyards called macella on a long bench called abancu, from which the words banco and bank are derived. As a moneychanger, the merchant atthe bancu did not so much invest money as merely convert the foreign currency into the onlylegal tender in Rome—that of the Imperial Mint.The earliest evidence of money-changing activity is depicted on a silver drachm coin from ancientHellenic colony Trapezus on the Black Sea, modern Trabzon, c. 350–325 BC, presented in theBritish Museum in London. The coin shows a bankers table (trapeza) laden with coins, a pun onthe name of the city. 7
  8. 8. In fact, even today in Modern Greek the word Trapeza means both a table and a bank.Traditional banking activitiesBanks act as payment agents by conducting checking or current accounts for customers,paying cheques drawn by customers on the bank, and collecting cheques deposited tocustomers current accounts. Banks also enable customer payments via other paymentmethods such as telegraphic transfer, EFTPOS, and ATM.Banks borrow money by accepting funds deposited on current accounts, by accepting termdeposits, and by issuing debt securities such as banknotes and bonds. Banks lend money bymaking advances to customers on current accounts, by making installment loans, and byinvesting in marketable debt securities and other forms of money lending.Banks provide almost all payment services, and a bank account is considered indispensable bymost businesses, individuals and governments. Non-banks that provide payment services suchas remittance companies are not normally considered an adequate substitute for having a bankaccount.Banks borrow most funds from households and non-financial businesses, and lend most funds tohouseholds and non-financial businesses, but non-bank lenders provide a significant and in manycases adequate substitute for bank loans, and money market funds, cash management trusts andother non-bank financial institutions in many cases provide an adequate substitute to banks forlending savings to.Interest is one of the main source of bank earning.Apart from using your money to make more money by investing it... they can also lendto individuals about 10 times what they receive.i.e: If you deposit Rs10000 in the bank, the bank will be able to lend Rs10, 000 to Mr.Sharma who just came after you... and they will charge Mr. Sharma interest on the Rs.10,000... the bank does not need to have the money in cash to lend it out. In this case thebank is happy to pay you 5% interest on the Rs.1,000 (Rs. 50 in one year) because if theycharge Mr. Sharma 8% on the Rs 10,000 theyll make in 1 year Rs.800... Total profit forthe bank Rs.800-Rs 50 = Rs.750. 8
  9. 9. A bank generates a profit from the differential between the level of interest it pays fordeposits and other sources of funds, and the level of interest it charges in its lendingactivities. This difference is referred to as the spread between the cost of funds and theloan interest rate. INTEREST A SOCIAL AND ECONOMICAL EVILIn modern secular economic systems interest plays a very important role. In fact, in theWestern world people cannot think of any economic system without interest. From atheoretical standpoint, interest has been a debatable subject among economic and politicaltheorists. Abu Saud defines interest as “the excess of money paid by the borrower tothe lender over and above the principal for the use of the lender’s liquid money overa certain period of time”. Economists have presented different interpretations ofinterest. Samuelson states that “Interest is the price of rental for the use of money”.Don Patinkin gives the following definition: “Interest is one of the forms of incomefrom property, the other forms being dividends, rent and profit”. However, J.M.Keynes did not define interest but mentioned the rate of interest as “The percentage ofexcess of a sum of units of money contracted for forward units of time over the spotor cash price of the sum thus contracted for forward delivery” 9
  10. 10. However, socialist and a number of capitalist economists have questioned theseexplanations on both theoretical and technical grounds. They often stress the point thatmoney capital cannot be treated as capital goods on the same basis as productivefactors. It is pertinent to remark here that lending of money for interest was abhorredand, in most cases, prohibited by all the monotheistic religions.An eminent Western economist, Roy Harrod, regards the abolition of interest is the onlyway to avert a collapse of capitalism. Not only this, but he speaks with great admirationfor an interest-less society in his work on Economic Dynamics. Harrod clearlyrecognizes that, “It is not the profit itself, earned by services, by assiduity, byimagination, or by courage, but the continued interest accruing from the accumulationthat makes that profit taker eventually appear parasitical…” and he further states that aninterest-less society which will be a totally new kind of society” would be the correct andfinal answer to all that is justly advanced by the critics of capitalism.1,500 farmers commit mass suicide in IndiaOver 1,500 farmers in an Indian state committed suicide after being driven to debt bycrop failure.The agricultural state of Chattisgarh was hit by falling water levels."The water level has gone down below 250 feet here. It used to be at 40 feet a few yearsago," Shatrughan Sahu, a villager in one of the districts, told Down To Earth magazine"Most of the farmers here are indebted and only God can save the ones who do nothave a bore well." 10
  11. 11. Mr Sahu lives in a district that recorded 206 farmer suicides last year. Policerecords for the district add that many deaths occur due to debt and economicdistress.In another village nearby, Beturam Sahu, who owned two acres of land was among thosewho committed suicide. His crop is yet to be harvested, but his son Lakhnu left to take upa job as a manual labourer.His family must repay a debt of 3000 and the crop this year is poor."The crop is so bad this year that we will not even be able to save any seeds," saidLakhnus friend Santosh. "There were no rains at all.""Thats why Lakhnu left even before harvesting the crop. There is nothing left to harvestin his land this time. He is worried how he will repay these loans."Bharatendu Prakash, from the Organic Farming Association of India, told the PressAssociation: "Farmers suicides are increasing due to a vicious circle created bymoney lenders. They lure farmers to take money but when the crops fail, they areleft with no option other than death."Mr Prakash added that the government ought to take up the cause of the poor farmers justas they fight for a strong economy."Development should be for all. The government blames us for being againstdevelopment. Forest area is depleting and dams are constructed without proper planning.All this contributes to dipping water levels. Farmers should be taken into considerationwhen planning policies," he said. ---INTEREST PROHIBITED IN ALL MAJOR RELIGION----- INTEREST PROHIBITED IN ISLAMThe word ―Riba‖ is used in the Holy Quran 8 times. In 30:39,4:161,3:130, 2:276,2:278 and 3times in 2:275. The Quran says:―Those who devour usury will not stand except as stand one whom the Evil one by his touch Hathdriven to madness. That is because they say: "Trade is like usury," but Allah hath permitted tradeand forbidden usury. Those who after receiving direction from their Lord, desist, shall bepardoned for the past; their case is for Allah (to judge); but those who repeat (The offence) are 11
  12. 12. companions of the Fire: They will abide therein (for ever).‖ (Quran 2:275)―O ye who believe! Devour not usury, doubled and multiplied; but fear Allah. that ye may (really)prosper.‖ (Quran 3:130)―O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye areindeed believers. If ye do it not, take notice of war from Allah and His Messenger. But if ye turnback, ye shall have your capital sums: Deal not unjustly, and ye shall not be dealt with unjustly.‖(Quran 2:278-279)If you are dealing in interest. Please do not expect angels to come down with swords to wage awar against you. It is talking about the severity of the sin. For other sins like alcohol, gambling etc.the Quran says:―O ye who believe! Intoxicants and gambling, (dedication of) stones, and (divination by) arrows,are an abomination,- of Satans handwork: eschew such (abomination), that ye may prosper.‖(Quran 5:90)Here the Quran says that intoxicants and gambling are Satan‘s handiwork and abstain from it. Inthe case of Riba (Interest) the Quran does not only say that it‘s a sin but it says that Allah (SWT)and his messenger Muhammad (pbuh) will wage a war against. Showing how grave this sin reallyis. Prophet Muhammad (pbuh) said:Prophet Muhammad (pbuh) classified it among the seven major sins” Volume 8, Book 82,Number 840: Narrated Abu Huraira:The Prophet said, "Avoid the seven great destructive sins." They (the people!) asked, "OAllahs Apostle! What are they?" He said, "To join partners in worship with Allah; to practicesorcery; to kill the life which Allah has forbidden except for a just cause; to eat up usury (Riba),to eat up the property of an orphan; to give ones back to the enemy and freeing from the battle-field at the time of fighting and to accuse chaste women who never even think of anythingtouching chastity and are good believers."Some may argue that only the taking of interest is prohibited. But one Sahih Hadith says―· Hazrat Jabir r.a. has reported that the Messenger of Allah cursed the devourer of usury, itspayer, its scribe and its two witnesses. He also said that they were equal (in sin).‖ (Mishkat-ul-Masabih) INTEREST PROHIBITED IN BIBLE“Do not charge your brother interest, whether on money or food or anything else thatmay earn interest.” (Deuteronomy 23:19)“Do not take interest of any kind from him, but fear your God, so that yourcountryman may continue to live among you.” (Leviticus 25:36)“If you lend money to one of my people among you who is needy, do not be like amoneylender; charge him no interest” (Exodus 22:25)Righteous servant of God doesn’t take interest 12
  13. 13. "Suppose there is a righteous man who does what is just and right. He does not eat at themountain shrines or look to the idols of the house of Israel. He does not defile hisneighbors wife or lie with a woman during her period. He does not oppress anyone, butreturns what he took in pledge for a loan. He does not commit robbery but gives his foodto the hungry and provides clothing for the naked. He does not lend at usury or takeexcessive interest. He withholds his hand from doing wrong and judges fairly betweenman and man. He follows my decrees and faithfully keeps my laws. That man isrighteous; he will surely live, declares the Sovereign LORD. (Ezekiel 18:5-9)But the violent one will take it "Suppose he has a violent son, who sheds blood or does any of these other things(though the father has done none of them): "He eats at the mountain shrines. He defileshis neighbors wife. He oppresses the poor and needy. He commits robbery. He does not return what he tookin pledge. He looks to the idols. He does detestable things. He lends at usury and takesexcessive interest. Will such a man live? He will not! Because he has done all thesedetestable things, he will surely be put to death and his blood will be on his own head”(Ezekiel 18:10-13)Jesus Christ came to fulfill the Law. He said:“Think not that I am come to destroy the law, or the prophets: I am not come to destroy,but to fulfill. For verily I say unto you, till heaven and earth pass, one jot or one tittleshall in no wise pass from the law, till all be fulfilled. Whosoever therefore shall breakone of these least commandments, and shall teach men so, he shall be called the least inthe kingdom of heaven: but whosoever shall do and teach them, the same shall be calledgreat in the kingdom of heaven. For I say unto you, that except your righteousness shallexceed the righteousness of the scribes and Pharisees, ye shall in no case enter into thekingdom of heaven.” (Mathew 5:17-20)The prohibition of usury was adopted as a major campaign by the earliest ChristianChurch, following on from Jesus expulsion of the money-lenders from the temple.The decrees of the Hebrew Bible were revived and a new reference to usury in the NewTestament was added. Based on the authority of those texts, the Catholic Church of the4th century AD banned the clergy from charging interest, a rule that was later extended inthe 5th century to the laity.In the 8th century, under Charlemagne, usury was declared a criminal offense. Theanti-usury movement gathered force in the late Middle Ages and reached its peak in 1311when Pope Clement V totally banned the practice and declared null and void allsecular law defending it.In spite of subsequent papal and legislative bans, loopholes in the law and contradictionsin the Churchs arguments began to appear. Soon, on the rising tide of commerce, the pro-usury movement began to grow. The rise of Protestantism and its pro-capitalist slantstrongly influenced change. However while both Luther and Calvin expressed 13
  14. 14. reservations about the practice of usury, neither condemned it outright.Calvin, for example, cited seven situations in which interest was sinful. These werelargely ignored however and his position interpreted as a general sanctioning of charginginterest. As a result of these influences, around 1620, according to the theologian Ruston,usury passed from being an offense against public morality, which a Christiangovernment was expected to suppress, to being a matter of private conscience, and a newgeneration of Christian moralists redefined usury as excessive interest.Nevertheless, the ancient criticisms continue to pervade the Churchs modern thinking, assuggested by the viewpoint of the Church of Scotland (1988) when it released a report onthe ethics of investment and banking.We accept that the practice of charging interest for business and personal loans is not initself incompatible with Christian ethics. What is more difficult to determine is whetherthe interest imposed is just or excessive said the report.In the same vein, it is interesting to contrast the clear moral mandate expressed throughPope Leo XIIIs Rerum Novarum (634-644 AD) about ravenous usury as a demoncondemned by the Church but practized in a deceitful way by avaricious men, with PopeJohn Paul IIs encyclical Solicitude Rei Socialis (1987) which omits any explicit mentionof usury, except for a vague reference to recognizing the Third World debt crisis.This demon governs current global relations, condemning most of the worldpopulation to living under the sign of debt: i.e., each person born in Latin Americaowes already $1,600 in foreign debt; each individual being conceived in Sub-SaharanAfrica carries the burden of a $336 debt, for something that its ancestors have longago paid-off. In 1980 the Southern countries debt amounted to $567 billion; sincethen, they have paid $3,450 billion in interests and write-offs, six times the originalamount. In spite of this that debt had quadrupled by the year 2000 reaching $2,070billion. INTEREST PROHIBITED IN JUDAISMJudaisms criticisms of usury are rooted in several passages of the Old Testament in whichcharging interest is scorned, discouraged and prohibited. The Hebrew word for interest isneshekh, which means bite (though in Leviticus tarbit and marbit are also used), and it isbelieved to refer to the charging of often exorbitant interest (from the debtors perspective). 14
  15. 15. In the Hebrew books of Exodus and Leviticus the ban is thought to be applied exclusivelyto loans to the poor and the sick, while in Deuteronomy, it extends to all loans, excludingtrade with foreigners. The word foreigner is interpreted in general as enemy and, armedwith this text, Jews employed usury as a weapon, as other peoples needs could betransformed into submission.Beyond these biblical roots, there are several Talmudic extensions of the bans on interest, knownas avak ribbit -literally the dust of interest, which is applied for example to certain types of sales,rent or work contracts. It is distinguished from the rubbit kezuzah, interest adjusted over aquantity or a rate agreed between the lender and borrower. The legal difference is that the latter,if the debtor pays the lender, is recoverable from the lender, while the former, once paid, is notrecoverable, though it is recognized that a contract sullied by the dust of interest may not befulfilled.In spite of the ban, this rule does not appear to have been observed in biblical times. In additionto the various references in the Old Testament to lenders who are rigidly exacting high interestrates, it can be seen in the Elephantine Papyrus (dating to the reign of Tuthmosis III) that amongthe Jews of Egypt in the 5th century BC it was the norm for interest to be charged for loans. Thissuggests that the violation of the ban was not seen as a criminal offense with a penal sanction,but as a moral transgression.This can also be partially explained by the change in economic conditions, beginning in theAmoraim period in Babylonia (200-500 AD), when the prohibition against interest was agreedwhen usury became incompatible with the communitys economic needs.At the same time, a standard way of legalizing interest was established, known as hetter iska.This referred to the permission to create partnerships, which has become so common that todayall transactions with interest are made openly according to Jewish law, simply adding to thecorresponding note or contract the words al-pi hetter iskah. INTEREST PROHIBITED IN HINDUISM & BHUDDAISMThe oldest references to usury are found in religious manuscripts of India, dating back to2000-1400 BC where the usurer is associated with any interest lender. In the Hindu Sutra(700-100 BC) as well as in the Buddhist Jatakas (600-400 BC) there are many references tothe payment of interest, along with expressions of disdain for the practice. 15
  16. 16. Vasishtha, a prominent lawmaker of the era, drafted a law that banned the high casteBrahmans and Kshatryas from being usurers or money-lenders. In the second century AD,the term usury becomes relative, meaning that interest above the legal rate could not be charged;that would be a usurious loan. But usury in some form or other has continued to the present day,and although in principle it is condemned, the term usury refers only to exorbitant interest, ie wellabove socially accepted rates. The practice operates in most parts of the world. INTEREST PROHIBITED IN WESTERN PHILOSOPHYMany of the early Western philosophers including Plato, Aristotle, Cato, Cicero, Seneca andPlutarch were critics of usury. In the legal reforms of the Roman Republic (340 BC), usury andinterest were banned. However, in the final period of the Republic, the practice was common.Under Julius Caesar, a limit of 12 per cent was imposed due to the great number ofdebtors, and under Justinian it was set at a mean between 4 per cent and 8 per cent.In the Book, the FUTURE OF MONEY, Bernard lietar, he expertly highlights the intrinsic dangerof Interest and then mentions how Islam has admirably represented the last bastion of resistance.He illustrates how interest is direct cause of inflation, wealth imbalance contributing rich gettingricher and poor getting poorer. WHY INTEREST IS PROHIBITED IN DIVINE LAW?It is worth to present an example to start with the subject, a factual example from existing interestbased banking methodology that is valid and current, which can be well understood by a commonperson. One should consider the following facts before going through the example. The factsare: Only Banks create money. The created money is then supplied in to the economy only in the form of loan at some specified interest. There are no other institutions that create money other than banks. 16
  17. 17. As all the banks are creating money and supplying in to the economy on interest and without anydoubt all of them are practicing the same technique, so let us consider there is only one bank inour example that creates some money and supply in to the peoples economy.Suppose Bank XYZ creates Rs.1, 00,000 and supplies it at an interest rate of 10% per annum toseveral entrepreneurs and governmental units active in the economy remember there is nomoney available in the economy from any other source. The bank has taken substantial collateralor guarantee as security of its money from each borrower. See in the following diagram - theborrower‘s intake loan and repayment liabilities at the end of the first year:It is very simple and clear that at the end of the first year, a combined sum of Rs.1,10,000 is dueon all borrowers to repay to the loaning bank.But the money available in the economy is only Rs.1, 00,000 as the bank is only supplier ofmoney, so from where the rest 10,000 would come that is the difference in the borrowers intakeand total repayment amount...... from NOWHERE. Yes, that is right from nowhere because thatmoney does not exist in the economy.Look at the scene, the bank is the only supplier of money, it creates and supplies 1,00,000 in theeconomy and that is the total money available in the economy, but as per loan agreements -these borrowers collectively have to pay back 110,000. How is that possible? There is no way.Dont you believe, it is 100% like this - no less. This is cheating and criminal foul play. So whatwill happen, at least one or more of these borrowers would default on their loan(s) and wouldloose their personal assets or belonging that they had put as security to the bank for therepayment. The money creator has designed a mechanism that would force few of the borrowerseach year to default so that bank could forfeit the security assets and gain wealth by foul play.This is an eye opening example for those who previously had no idea about the mechanism ofbanks as how they operate and cause artificial shortage (scarcity) of the money in the societies.This is happening every where in this world from USA to the smallest country on this beautifulplanet. This artificial scarcity of money is the root cause of peoples problems from hard strugglefor surviving to the loss of happiness from their lives.In a Riba (interest) based system, people are not aware of this foul play - borrowers think thatthey will manage to repay the principal plus Riba (interest) as they think it would be coming from 17
  18. 18. some where else, but the fact is - every borrower would be in battle with others where someborrowers have to lose in order for others to win, some would fail to pay their loans in order forothers to get the sum they need to pay off the Riba (Interest). When seen in totality, the supplyside is always in deficit and the liability is always in excess due to Riba (interest), the totalcombined supply cannot discharge the liability.After going through the above real example, I believe, now we are close to find out why Riba wasdeclared Haram in all religion.Let us begin with the economic reasoning of WHY: 1. The availability of each produce is limited, the liability cannot exceed the availability limit. 2. In any transaction, if a liability of produce "in excess" of "the produce available" is created, that extra liability would be artificial because excess quantity of produce does not exist.This universal economic code applies to each and every type of produce; to further get in to theexplanation of the rule, let us now identify what represents "the produce", "the transaction", and"extra liability":The ProduceIn its general expression "the produce" is any thing available to human beings for their use orconsumption, but here specifically those produce that can be involved in a transaction, it is best totake historical standards of transactions which are based on produce like gold, silver, grains,currency etc. because throughout history all transactions are carried out in publicly acceptableproduce only. These produce have served the societies as "medium of exchange", so it is moreappropriate logically and historically to consider the produce as "the medium of exchange" whichis again a general expression and can accommodate any other commodity/produce that may beused in a transaction.The TransactionIn this universal economic principle, the transaction is based on a single produce and naturally itcan only be a transaction of loan or exchange and nothing else. Although donations/grants alsoinvolve only one produce but that is not a transaction because a transaction means exchange ofgood(s) and/or service(s) either on spot or in any specified time frame involving one or moretypes of produce.Extra LiabilityRiba (interest, usury) is that extra liability created in excess of the produce available and thatdoes not exist. Every liability is a demand in practice, the basic rule of economics known to everyone is that to maintain economic equilibrium (stability) in the society, the supply side should beequal to the demand, if the demand is more than the supply - a shortage will occur. Creating anextra liability means creating an extra demand without increasing equal supply, this will start anever ending mechanism of perpetually increasing the shortage of that produce in the society.Conclusion: 18
  19. 19. Riba was prohibited just to prevent the creation of "extra liability/demand" because that isfake and "does not exist" physically, this artificial "extra liability/demand" creates scarcityof the produce in the society and unjustly accumulation of the produce in few hands. Riba(interest, usury) is a mechanism and dangerous weapon that has a power to get hold ofassets/properties of individuals, enterprises, and nations deceitfully. This is unfair and against thenature, so ALLAH (SWT) banned Riba (interest, usury) very strictly to stop this criminal action.A Just SystemThere is no doubt that a just system could only be designed by keeping the Islamic economiccode at the heart of the system. This would only be possible when there will be a political will inthe leadership. Muslim scholars and bankers have spent much time in designing many bankingprocedures and instruments according to Shariah that can expedite the transformation easily, butthe question remains for the central governing system controlling the economy, the system mayincorporate and accommodate the following: The money creation should be the responsibility of the state. The banks must invest only in equity investment. The discounting should be explored such that it should serve as the driving force for the banks and the capital. Riba (Interest) must be declared as crime in the society.Few examples of RibaTo demonstrate the devastating power in the mechanism of Riba and the ignorance on thesubject, following are few examples. 1. Suppose, if just One Gram of Gold (i.e., one millionth of a metric ton) was loaned at an interest rate of 2% p.a. at the time of first Hijri year (Islamic calender), then today (after 1422 Islamic years) the quantity of gold required to repay that loan would be 1,696,071.847 metric tons of gold, while the total gold reserve of the world known today (explored or unexplored) are less than 160,000 tons. 2. If a nation takes a loan of say US dollars one billion at an interest rate of 3% p.a., it would have to repay US dollars 4.3839 billion after fifty years. One can imagine the multiplying rate of Riba mechanism that had badly affected the economies of already weak nations. INTEREST CAUSES INFLATIONThe argument of inflation is often advocated to compensate for the loss of value‖ or the―depreciation in money‖, and therefore any consideration to offset this damage may well bejustified. This approach may find its way fast in conventional organism, and to incorporate suchcomputations may not be a problem in a mere profit driven interest based system rather it can belooked upon as another risk calculating element. However, it can‘t and shall not go uncheckedwithout proper evaluation for its Islamic permissibility; a viewpoint is required to be established off 19
  20. 20. topic. Although, the same sense has traveled to many of Islamic minds as well except with aquestion mark, it equates to similar asking that an extra ―equivalent to inflation‖ if charged by thelender will be considered as ―Riba‖ or not? Here the problem is double, there is a well-knownconfusion on the subject of inflation in Western economies and when coupled with the prevailingconfusion on the subject of ―Riba‖ in Islamic World – it becomes horrendous!At least there is a common settled perception that inflation is some sort of phenomenon related tothe upward trend in prices, but there is no unanimous agreement on the definition or what causesinflation. A wide variety of somewhat segmented classifications is provided from different schoolsof thoughts and work groups, like:1. Demand Pull Inflation (Demand Supply Phenomenon)2. Cost Push Inflation (Due to increase in the cost of production/supply)3. Built-in Inflation (Result of past events experienced now)4. Hyperinflation (Inflation getting out of control), etc.You may find different variants of definition in English dictionaries, and few are generous enoughto accommodate even sentimental statement within definition like "in inflation everything getsmore valuable except money" but the acuity is matching all across. In dynamic societies /economies, when some happening or any phenomenon is observed influencing the economy orsociety then to keep the system ongoing, the management drive also institutes and enforcescontrolling mechanisms. Since the exact and agreed upon cause(s) of inflation are not identified,therefore the subject is also handled segment-wise to a certain extent. A proof for this partialhandling is the formation of different indexes like:1. Consumer Price Index (CPI)2. Producer Price Index (PPI)3. Employer Cost Index (ECI)4. Purchasing Power (PP), etc. etc.There are many drawbacks connected naturally to indicators thus established from these indexesmainly because of the reason that these indexes do not cover every aspect but a weightedaverage of select group and therefore can not be reputed ―as convincing as it demands‖ to dealwith the problem. In addition to the statistics and analysis based on selected groups, there is aninteresting circle that further deteriorates the credibility of these pointers, that is:1. Use previous Price, Cost, and Purchasing Power etc. as reference.2. Calculate Inflation from present Price, Cost and PP.3. Prepare Reflection for the next.4. Remember we are talking about inflation – the upward trend,It is common and easy to understand that demand of certain things go high during some specificperiod or time or event, say for example ―dates‖ are high-in-demand in the month of Ramadan,therefore prices are inflated. Shortage of products and commodities is certain in the times of warsthus prices are blown-up. What is difficult to understand is the situation where say, I am on myplace for long; my city is calm, negligible change in habitants, increase in demand if any is metwith the increase in supply, wages are not increased since last year, and lifestyle of the citypeople cannot change overnight. No reflective change in anything, no specific period or event isaround, but prices are increasing in a regular pattern, a BIG WHY? This big why is regularizedand justified with the contraption of ―Inflation‖.What inflation is? - Answer “7.2%”How calculated? - “from CPI which is …..”What causes inflation? - “may be blab bla bla!” 20
  21. 21. Figures work simple is that, it works because mostly people are interested in figures, so even ifnobody knows ―what causes inflation‖ - it will not make a difference or just very little difference –at least the inflation figure is known, isn‘t it interesting?What causes Inflation?An adequate amount of literature on different explanations is there available on book-shelves andInternet; inflation is explained as a result of ―excess money supply‖, a result of ―paper money‖,an outcome of ―increase in demand‖, a burden derived from ―over expenditure of government inthe form of taxes‖ etc.Central banks seem more convinced with the cause of ―excess money supply‖ (or may bebecause it is their jurisdiction and they can control it easily), anyway what ever is the reason oftheir persuasive cause, the adjustment they normally do is to squeeze money supply byincreasing ―interest rates‖ to fight ―so-called inflation‖. The monetary contraction and expansionpolicies are well known styles of central banks to address inflation and deflation respectively.What are the results of all these efforts taken in the context of ―inflation‖? I don‘t know any butconfusion. The every time successful strategy worked again, i.e., if you can‘t answer or can‘t doanything about a problem – try to confuse. But the monkey (if you know the story) was notsucceeded in confusing the complainant by jumping from one tree to another (exerting efforts) inorder to solve the problem of plaintiff. There are people in the society not satisfied with efforts ormeans undertaken to tackle inflation issue and the projections of its causes.What causes inflation is still not answered to their satisfaction. Although, the mentioning of―interest‖ as a relative of ―inflation‖ is seen, but ―Riba or Interest‖ is not labeled as the main causeof producing inflation which in my view is the ―true story‖. How and why?“Riba or Interest” AS THE “Cause of Inflation”In order to explain how ―Riba or Interest‖ becomes the main cause of Inflation, it is mandatory tofurther elaborate my point of view about ―Riba‖ that revolves around the ―non-existence‖ of theextraliability created in a transaction.At a given time of transaction when a lender and a borrower are going to agree on interest basedloan contract, there is an owner of each penny of capital available in the economy. Is there acontract executed at that moment with similar time span in the economy to bring about the―change of ownership of capital‖ equivalent to the ―Riba or Interest‖ in favour of borrower?Because of the deficit he is in now due to the just concluded agreement. No need of such asimultaneous contract, might be argued in a case where the borrower already owns equivalent tothat extra he has committed in terms of ―Riba or Interest‖ and is able to discharge his total liability.Any problem now, YES! Still there is. Whatsoever is the case, the borrower owns that much ornot, his commitment or promise is reflected in accounting books of lender in ―receivable‖ columnand ―balance sheet projection with increase of profit‖. Is there any manifestation of the contract onthe part of borrower? Yes, of course there will be. The books of borrower will be adjusted for anincreased liability, the assets side will be re-evaluated to balance or to gain profit (profit is themotive every where, means and rules are subjective), a check on options available to theborrower to match the increased liability will sound only to adjust the saleable assets pricesupward. If ―Riba or Interest‖ was not there in the contract; absolutely there was no requirement toadjust accounting books, and therefore no forced increase in the prices of saleable assets(inventory). From this single case in point, one can expand the canvas to every type of financialcontract incorporating ―Riba or Interest‖, the ―receivable‖ of lender is always reflected asincreased liability on accounting books of the borrower (an industrialist, trader, service provider,individual etc.), accounting adjustment of that ―increased liability‖ is only possible by upward priceadjustment of products and services. It can happen at the start of the business, in midway or 21
  22. 22. whenever ―Riba or Interest‖ is recorded in books. Here, the whole economy is run like this,lending is taking place on regular basis incorporating ―Riba or Interest‖, prices are increased witheach cycle of lending, there is a continuous trend of increase in prices, study CPI and otherbunch of indexes, regard it as empirical evidence but please don‘t call it a phenomenon of ―Ribaor Interest‖ but ―Inflation‖. It looks simple; true as well ―the root cause of inflation is thepractice of incorporating Riba or Interest in lending”. This is totally opposite to the belief (ormistaken belief) posed by central banks. When central banks adopt the policy of ―increasinginterest rates‖, it gives an impression that by increasing interest rates, the inflation is reduced orat least capped from further increase in it, you heard this and kept in mind, but you can‘t beconvinced because there is no logic told. How interest-free banking works The case of JAK By- Ana Carrie 22
  23. 23. Can a bank operate successfully if it does not charge interest on its loans? The Swedish JAKMedlemsbank (Members‘ Bank) certainly does – it has been called the safest bank in Sweden.This account of how it does so is based on two visits to its headquarters in Skövde and numerousconversations with JAK‘s enthusiastic staff and members, both in Sweden and in Ireland. I amindebted to the staff of JAK for their hospitality and assistance, and to Feasta for its financialsupport.Savings PointsJAK‘s primary objective is to provide its members with interest-free loans. In order to accomplishthis, it must attract interest-free savings. JAK uses a system of ―Savings Points‖ in order tobalance saving and borrowing. Given the choice of borrowing without interest or savingwithout interest, most of us would gladly choose borrowing. While people are generally willing tosave temporary surpluses of money in current accounts that don‘t pay interest, few are willing orable to save more significant amounts over a long period of time with no compensation.JAK cannot, of course, lend money without having savings on deposit and so, using anImaginative system of Savings Points, each member who wishes to take out a loan must saveMoney first and, over a lifetime with JAK, every member will have saved roughly as much moneyand for the same period of time as they will have borrowed. You could almost imagine JAK asAllowing its members to borrow (interest-free) from their future selves.For a new JAK member, the first step towards an interest-free loan is to save and therebyearn Savings Points. These are calculated as the amount saved, multiplied by the numberof months for which it is saved, multiplied by a Savings Factor. This factor variesaccording to the type of savings account the member has selected and is lower (about 0.7)for a demand account from which savings can be withdrawn at any time. For example,assuming a Savings Factor of 0.9,we have1:€100 1 Month 0.9 = 90 Savings Points The Savings Factor varies with the type of depositaccount and is lowest for demand accounts where savings can be withdrawn at any time(about 0.7).Example 1: Either of these scenarios would earn identical Savings Points.After saving for a minimum of six months, a member may apply for a loan. In order to borrow €1for one month, one Savings Point must be redeemed. The amount borrowed and the time takento repay are entirely up to the member, provided that the appropriate Savings Points areavailable. For example, borrowing €90 (or €9,000) over 1 year uses as many savings points asborrowing €45 (or €4,500) with repayments spread over 2 years. 23
  24. 24. Example 3: An alternative basic loan, borrowing half as much but repaying it over a longerperiod.In addition to a Basic Loan that uses Savings Points already earned, members may apply for anAdditional Loan using Savings Points that will be earned in the future. An ―Allocation Factor‖(currently 14) is multiplied by the member‘s current Savings Points to determine the number 24
  25. 25. of points available for an Additional Loan. Each loan repayment includes a savings installment,and the payments are structured so that when the loan is fully repaid, all necessarySavings Points have been earned. A consequence of this is that upon full repayment of anAdditional Loan, the member has built up significant savings. Savings made during the course ofrepaying a loan are known as Post-Savings, while those that precede the loan are Pre-Savings.Once the loan has been repaid, the balance of the post-savings is available to the member to bewithdrawn or, as frequently happens, to be used as the start of saving for a new loan.Example 4: A Basic Loan with an Additional LoanThere is no interest charged on a loan, of course, but members must place 6% of the value of theloan on deposit for the duration of the loan, and additionally pay a loan fee to coveradministration costs. Members also pay 200 SEK (about €22) when they first join JAK and 200SEK per year as a membership fee. JAK is a virtual bank in the sense that it has nobranches and business cannot be transacted in person. A necessary and prudent decision sincethe membership of JAK is quite spread out over a large country, and also resulting in no biasagainst rural members who would have to travel much farther to their nearest branch. A result ofthis ―virtual‖ status is that JAK members must have an account with another bank with which toconduct their day-to-day financial affairs. Members transfer money into or out of their JAKbasic account via post giro, bank giro or Internet into their other accounts. With improvements intechnology and the changing financial infrastructure, JAK hopes in the near future tooffer direct deposit of pay cheques and credit/debit card facilities to its members. Forsome members, this might negate the need to bank elsewhere.Credit controlLike any bank, JAK must ensure that loans can and will be repaid. Unlike most banks, however,JAK‘s system of saving and borrowing has several unique features that combine to give it an 25
  26. 26. enviably low default rate. A member applying for a loan is given a range ofoptions for the loan size and duration based upon their desired loan amount, desiredrepayments and available savings points. When they have made their selection, the loandepartment within JAK must assess the member‘s ability to repay the desired loan. Themember‘s income and expenses are evaluated with the assistance of computer software thatcalculates average living expenses for individuals and families based upon age and gender.Between 20 and 25 applications are processed per week, and 95% are approved. Most loans aresecured, either against property or with a personal guarantor. Loans for up to 37,000 SEK(about €4,000) with 2-5 years‘ duration can be unsecured, but these are limited to 5% of JAK‘sturnover and so surplus applications must be held in a queue until funds are available. Themost common reason for borrowing is to refinance a conventional bank loan obtained tobuy a house followed by purchasing a car and making home improvements.In general, people who can save regularly are good performers when it comes to loanrepayments. The JAK system where saving must precede borrowing is therefore ideally suited toattracting these regular savers. In addition, around half-way through repayment of a loanthere is a break-even point where the Post- Savings on deposit are equal to the balanceoutstanding on the loan and from this point forward the loan is fully secured by the member‘ssavings.Very few JAK loans end in default. Borrowers are decidedly involved ―members‖ as opposed todisinterested ―customers‖. Many feel quite strongly about the idea of interest-free bankingand this common bond goes a long way towards encouraging good behavior. Personalguarantors rarely need to be asked to make good on their guarantee.LiquidityAt the simplest level, a bank takes one person‘s savings and lends them to someone else.Ideological arguments aside, this presents some practical difficulties. Firstly, what if a saver wantstheir money back before the borrower has finished with it? Secondly, what if there are notenough or too many borrowers relative to savers? The first point is generally dealt with in thebanking system by having a reasonably large number of savers and making sure that enoughmoney is set aside to cope with those who, on any given day, want some of their money back.While individuals might withdraw their savings in a random manner, a large group of savers willtend to be stable and predictable. It is JAK‘s policy to keep a minimum of 20% ofpre-savings available in either a bank account or in government bonds, either of which can be 26
  27. 27. made available almost immediately. Too much liquidity means that money is lying idle ratherthan being lent out to members, so it is not seen as desirable to have much more than 20% onreserve. Post-savings do not need to have a component on reserve since these can only bewithdrawn at specified times. JAK also encourages stability from its savers by offering a higherSavings Factor in long-term deposit accounts. JAK members can choose from 6, 12 and 24-month deposit accounts which represent the advance notice required to make a withdrawal. Withregard to the second point, JAK has a more difficult balancing act between saving and borrowingthan other banks, due to the fact that the two are intimately linked by Savings Points.Most people save with the intention of borrowing in the future. An excess of saving today couldindicate too much demand for borrowing next year.The Allocation Factor has a central role in the relationship between supply of savings anddemand for loans. In general, the JAK board sets the Allocation Factor to reflect the current levelof liquidity within the bank. The greater the pool of excess savings, the higher the AllocationFactor to encourage members to take out loans and reduce the excess. Unfortunately for JAK,the relationship between the Allocation Factor and the demand for loans is not as simple as this.In the short term, increasing the Allocation Factor can actually make things worse, as membersdecide to increase their Savings Points with a view to taking out a larger loan in the future.Excess demand for loans would be particularly problematic for JAK. Reducing the AllocationFactor would likely lead to an outcry from members who had made financial plans based on ahigher factor. The alternatives, however, would be to refuse more loans or to introduce a waitinglist. The dynamics of this saving/borrowing relationship are likely to be a constant challenge toJAK‘s management as the membership grows and the range of banking services offered by JAKexpands.JAK cultureA significant amount of JAK‘s energy is devoted to communicating with its 21,000-strongmembership. JAK is a co-operative, fully owned by its members. In addition to a quarterlynewsletter, 24 regional offices staffed by trainedvolunteers keep in touch with members through study groups and exhibitions. While JAK‘sprimary function is to provide interest-free banking, it is also viewed by the membership as avehicle for economic reform.A recent innovation in support of economic reform is the Local Enterprise Bank. Communitymembers save in a special JAK account and, rather than earning points themselves, their savingsare used to provide an interest-free loan for a local enterprise. Savings are fully guaranteed, somembers are not exposed to any financial risk. The first two projects to be funded in this way arean ecological slaughterhouse and a replica Viking village. It is an interesting experiment in localfinance for local projects, and so far has been very warmly received by localmedia and participants. While savers don‘t, of course, receive any interest on their savings, theybenefit both economically and otherwise from the improvements in their local economy andinfrastructure as a result of the projects.ConclusionsThe JAK Members‘ Bank is unique in the commitment it inspires from its volunteers and staff. Itprovides affordable and responsible finance, and enables its members to have a say in wheretheir money is invested. I have no doubt it will continue to be true to its purpose and values whileexploring new frontiers in ethical finance. 27
  28. 28. Why interest-free banking mattersDoes it matter whether a bank charges interest or not? After all, every bank has to charge for itsservices or it won‘t stay in business. Interest is simply the way that banks calculate the chargethey make for the service they render when they approve a loan and for the risk they take on bydoing so. Why shouldn‘t the charge be based on the amount of money involved, the time forwhich it‘s being lent and the demand for money at the time? Doesn‘t that method of calculationseem fair? As Ana Carrie shows in her article, even the JAK Bank charges an arrangement feefor approving a loan and then an annual fee every year for as long as that loan is on its books. Ifthese charges were expressed as an interest rate, they would work out at about 3%. That seemscheap until you realize that JAK requires its borrowers to lend it the sum that they borrow for anequivalent length of time. This means that, while they are lending to the bank, customers loseroughly the same amount of interest that they would have paid, net of the 3% service charge, ifthe JAK had been an ordinary bank and had charged them interest when they were borrowing.So if the JAK system merely involves people losing on the swings what they gain on theroundabouts, why are the bank‘s members so enthusiastic about it? One reason is that somebelieve that the charging of interest sets up a growth compulsion in the economy and that, asperpetual economic growth is unsustainable; the development of a no-interest banking system isa key step towards building a sustainable economy. The roots of this type of thinking run back tothe time when gold was used as currency. Since gold did not increase itself, and very little wasbeing mined, where, people asked, was the extra bullion to come from to pay the interest whenboth principal and interest had to be handed over at the end of the year? Obviously, the borrowercould only obtain more gold if someone else had less, so lending money at interest meant thateither the borrower impoverished himself when he paid over the extra or he impoverishedsomeone else. And, as neither outcome was socially desirable, usury, as all forms of moneylending were called no matter how low the interest rate, stood morally condemned by both theRoman Catholic Church and by Islam.Even though we now use paper currencies, this source-of-interest problem has not gone away.Since almost all money in circulation is issued on loan, the money to cover interest payments canonly be obtained by borrowers if other borrowers have borrowed sufficiently more. Moreover, thenecessity to pay interest on these additional borrowings means that the economy needs toexpand if the proportion of world income which is paid over in interest to the lenders is not toincrease. But let‘s look at this argument a little more closely. How much is ‗sufficiently more‘? Notall the interest paid over to the banks gets withdrawn from the stock of money in circulation.Some of it is returned to the stock right away by being paid as interest to the people from whomthe banks themselves are borrowing money. Some returns by being paid to cover the banks‘operating costs, such as their wages bill. And the amount paid in dividends to the banks‘shareholders goes back into the stock too. So only the fraction of the interest paid that ends up asthe banks‘ retained earnings has to be borrowed back into the system. This is not a seriousproblem. If inflation was allowed to run at about 2.5% a year, that would be enough to allow theratio between the level of outstanding loans and national income to be held constant. So, if onehas a fairly relaxed attitude to inflation, the charging of interest is not a serious component of thegrowth compulsion. If the JAK bank made a surplus one year and increased its reserves, it wouldbe just as much a part of the problem as its commercial, interest charging, competitors.Other members of JAK have more sophisticated reasons for giving the bank their support. OscarKjellberg, the development director, is opposed to charging interest because it transfers wealthfrom the poor to the rich and from declining areas - often rural ones - to more prosperous parts.―That sort of transfer doesn‘t happen with JAK,‖ he says. ―People save with us because theyeither want to borrow interest-free themselves or because they want to assign the right to aninterest-free loan to a relative, a son or daughter, perhaps or to an organization they support. Thismeans that most money is lent out in the same area that it was collected, and, if it‘s not, it‘s onlyloaned in a place and for a purpose which the original saver has approved.‖ 28
  29. 29. In other words, perhaps the most important reason for backing JAK-style interest-free banking isthat it limits a dangerous, destabilizing positive feedback built into the present economic system.The feedback occurs because prosperous parts of the world get more investment because betterreturns can be had from projects there, which makes them still more prosperous, while poorerareas have what capital they possess taken away because no good projects can be found. As aresult, the poorer areas fall further behind and people living in them are forced to leave to seekwork wherever investment is going on. They take up residence in the expanding areas and addtheir spending to its rising income flow, generating further investment possibilities. And so thecycle goes on. A major cause of the emigration of young people from rural Ireland used to be thattheir parents had allowed their savings to be invested away from home. A JAK bank would helpprevent a recurrence of that situation.The JAK bank is a good example of a flourishing cooperative - the lenders and the borrowers andthe owners of the bank are all the same people – engaged together in an independent enterprisewhich serves them all and accords with their beliefs. Although the services provided and thepurposes for which loans are made are still fairly limited, these are expanding as Ana Carriementions at the end of her article. JAK is one of thousands of small cooperative banks around theworld that confound the myth that financial services are best provided by the large capitalistinstitutions which dominate the mainstream financial services industry. 29
  30. 30. Basic Differences between Islamic and Conventional BankingBefore we understanding the detailed differences between Islamic and conventionalbanking products and transactions, it is important to know these broad differences:-# Islamic banking only deals in “halal” products and services. Thus, all transactions mustbe SHARIAH COMPLIANT i.e. must be in accordance with the Islamic Jurisprudence.# Most Islamic Financing transaction is based on trading and deferred exchange contract,whereas conventional banking loan product is granted on the basis of debtor and creditorrelationship. In short, Islamic bank relationship is regarded as “Financier &Customer/Client” rather than “Lender & Borrower”. The only lender and borrowertransaction under Islamic banking is when the borrower (i.e. the Bank) grant interest freeloan under the principle of "Al-Qhad". Under this transaction, we expect the borrower torepay the loan at no extra charges. But if it is granted based on "Al-Qhadhul Hassan", it islent based on benevolent basis i.e. if the borrower cannot pay, we should not be expectedto demand for repayment.# The consideration of collateral to be looked upon separately. However, if thetransaction is based on "joint-venture" basis, there should not be any collateral;# In a default or termination situation, the Bank (or financier) normally demand theoutstanding sale price. Generally, the sale price is fixed and comprise "principal andprofits" predetermined upfront before a contract is signed.# compounding calculation i.e. to conventional practice of "interest upon interest"element is strictly prohibited under Islamic banking system.PRINCIPAL OF ISLAMIC BANKING 30
  31. 31. Islamic banking has the same purpose as conventional banking except that it operates inaccordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions).The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba(usury). Common terms used in Islamic banking include profit sharing (Mudharabah),safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing(Ijarah).In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, abank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowingthe buyer to pay the bank in installments. However, the fact that it is profit cannot be madeexplicit and therefore there are no additional penalties for late payment. In order to protect itselfagainst default, the bank asks for strict collateral. The goods or land is registered to the name ofthe buyer from the start of the transaction. This arrangement is called Murabaha. Anotherapproach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loansfor vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor andthen retaining ownership of the vehicle until the loan is paid).An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa,allows for a floating rate in the form of rental. The bank and borrower form a partnership entity,both providing capital at an agreed percentage to purchase the property. The partnership entitythen rents out the property to the borrower and charges rent. The bank and the borrower will thenshare the proceeds from this rent based on the current equity share of the partnership. At thesame time, the borrower in the partnership entity also buys the banks share of the property atagreed installments until the full equity is transferred to the borrower and the partnership isended. If default occurs, both the bank and the borrower receive a proportion of the proceedsfrom the sale of the property based on each partys current equity. This method allows for floatingrates according to the current market rate such as the BLR (base lending rate), especially in adual-banking system like in Malaysia.There are several other approaches used in business transactions. Islamic banks lend theirmoney to companies by issuing floating rate interest loans. The floating rate of interest is peggedto the companys individual rate of return. Thus the banks profit on the loan is equal to a certainpercentage of the companys profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba isventure capital funding of an entrepreneur who provides labor while financing is provided by thebank so that both profit and risk are shared. Such participatory arrangements between capital andlabor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resultingin a balanced distribution of income and not allowing lender to monopolize the economy.And finally, Islamic banking is restricted to Islamically acceptable transactions, whichexclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the onlyacceptable form of investment, and moral purchasing is encouraged.Islamic banks and banking institutions that offer Islamic banking products and services (IBSbanks) are required to establish a Shariah Supervisory Board (SSB) to advise them and to ensurethat the operations and activities of the bank comply with Shariah principles. On the other hand,there are also those who believe that no form of banking can ever comply with the Shariah.Malaysia, the National Shariah Advisory Council, which additionally set up at Bank NegaraMalaysia (BNM), advises BNM on the Shariah aspects of the operations of theseinstitutions and on their products and services. In Indonesia the Ulama Council serves asimilar purpose. 31
  32. 32. A number of Shariah advisory firms (either standalone or subsidiaries of larger financialgroups) have now emerged to offer Shariah advisory services to the institutions offeringIslamic financial services. Issue of independence, impartiality and conflicts of interesthave also been recently voiced. ISLAMIC BANKING TERMINOLOGY1) Bai al-inah (sale and buy-back agreement)The financier sells an asset to the customer on a deferred-payment basis, and then theasset is immediately repurchased by the financier for cash at a discount. The buying backagreement allows the bank to assume ownership over the asset in order to protect againstdefault without explicitly charging interest in the event of late payments or insolvency.Some scholars believe that this is not compliant with Shariah principles.2) Bai bithaman ajil (deferred payment sale)This concept refers to the sale of goods on a deferred payment basis at a price, whichincludes a profit margin agreed to by both parties. This is similar to Murabahah, exceptthat the debtor makes only a single installment on the maturity date of the loan. By theapplication of a discount rate, an Islamic bank can collect the market rate of interest3) Bai muajjal (credit sale)Literally bai muajjal means a credit sale. Technically, it is a financing technique adoptedby Islamic banks that takes the form of murabaha muajjal. It is a contract in which thebank earns a profit margin on the purchase price and allows the buyer to pay the price ofthe commodity at a future date in a lump sum or in installments. It has to expresslymention cost of the commodity and the margin of profit is mutually agreed. The pricefixed for the commodity in such a transaction can be the same as the spot price or higheror lower than the spot price. (Deferred-payment sale)4) Mudarabah (profit sharing)Mudarabah is an arrangement or agreement between the bank, or a capital provider, andan entrepreneur, whereby the entrepreneur can mobilize the funds of the former for itsbusiness activity. The entrepreneur provides expertise, labor and management. Profitsmade are shared between the bank and the entrepreneur according to predetermined ratio.In case of loss, the bank loses the capital, while the entrepreneur loses his provision oflabor. It is this financial risk, according to the Shariah, that justifies the banks claim topart of the profit. The profit-sharing continues until the loan is repaid. The bank iscompensated for the time value of its money in the form of a floating rate that is peggedto the debtors profits. 32
  33. 33. 5) Murabahah (cost plus)"Mudarabah" is a special kind of partnership where one partner gives money to anotherfor investing it in a commercial enterprise. The investment comes from the first partnerwho is called "rabb-ul-mal", while the management and work is an exclusiveresponsibility of the other, who is called "mudarib". This concept refers to the sale ofgoods at a price, which includes a profit margin agreed to by both parties. The purchaseand selling price, other costs, and the profit margin must be clearly stated at the time ofthe sale agreement. The bank is compensated for the time value of its money in the formof the profit margin. This is a fixed-income loan for the purchase of a real asset (such asreal estate or a vehicle), with a fixed rate of profit determined by the profit margin. Thebank is not compensated for the time value of money outside of the contracted term (i.e.,the bank cannot charge additional profit on late payments); however, the asset remains asa mortgage with the bank until the Murabaha is paid in full.This type of transaction is similar to rent-to-own arrangements for furniture or appliancesthat are very common in North American stores.6) MusawamahMusawamah is the negotiation of a selling price between two parties without reference bythe seller to either costs or asking price. While the seller may or may not have fullknowledge of the cost of the item being negotiated, they are under no obligation to revealthese costs as part of the negotiation process. This difference in obligation by the seller isthe key distinction between Murabaha and Musawamah with all other rules as describedin Murabaha remaining the same. Musawamah is the most common type of tradingnegotiation seen in Islamic commerce.7) Bai salamBai Salam means a contract in which advance payment is made for goods to be deliveredlater on. The seller undertakes to supply some specific goods to the buyer at a future datein exchange of an advance price fully paid at the time of contract. It is necessary that thequality of the commodity intended to be purchased is fully specified leaving noambiguity leading to dispute. The objects of this sale are goods and cannot be gold,silver, or currencies based on these metals. Barring this, Bai Salam covers almosteverything that is capable of being definitely described as to quantity, quality, andworkmanship.8) Ijarah thumma al bai (hire purchase)Parties enter into contracts that come into effect serially, to form a complete lease/buyback transaction. The first contract is an Ijarah that outlines the terms for leasing orrenting over a fixed period, and the second contract is a Bai that triggers a sale orpurchase once the term of the Ijarah is complete. For example, in a car financing facility, 33
  34. 34. a customer enters into the first contract and leases the car from the owner (bank) at anagreed amount over a specific period. When the lease period expires, the second contractcomes into effect, which enables the customer to purchase the car at an agreed to price.The bank generates a profit by determining in advance the cost of the item, its residualvalue at the end of the term and the time value or profit margin for the money beinginvested in purchasing the product to be leased for the intended term. The combining ofthese three figures becomes the basis for the contract between the Bank and the client forthe initial lease contract.This type of transaction is similar to the contractum trinius, a legal maneuver used byEuropean bankers and merchants during the Middle Ages to sidestep the Churchsprohibition on interest bearing loans. In a contractum, two parties would enter into threeconcurrent and interrelated legal contracts, the net effect being the paying of a fee for theuse of money for the term of the loan. The use of concurrent interrelated contracts is alsoprohibited under Shariah Law.9) Ijarah-wal-iqtinaA contract under which an Islamic bank provides equipment, building, or other assets tothe client against an agreed rental together with a unilateral undertaking by the bank orthe client that at the end of the lease period, the ownership in the asset would betransferred to the lessee. The undertaking or the promise does not become an integral partof the lease contract to make it conditional. The rentals as well as the purchase price arefixed in such manner that the bank gets back its principal sum along with profit over theperiod of lease.10) Musharakah (joint venture)Musharakah is a relationship between two parties or more, of whom contribute capital toa business, and divide the net profit and loss pro rata. This is often used in investmentprojects, letters of credit, and the purchase or real estate or property. In the case of realestate or property, the bank assess an imputed rent and will share it as agreed in advance.All providers of capital are entitled to participate in management, but not necessarilyrequired to do so. The profit is distributed among the partners in pre-agreed ratios, whilethe loss is borne by each partner strictly in proportion to respective capital contributions.This concept is distinct from fixed-income investing (i.e. issuance of loans).11) Qard hassan/ Qardul hassan (good loan/benevolent loan)This is a loan extended on a goodwill basis, and the debtor is only required to repay theamount borrowed. However, the debtor may, at his or her discretion, pay an extra amountbeyond the principal amount of the loan (without promising it) as a token of appreciationto the creditor. In the case that the debtor does not pay an extra amount to the creditor,this transaction is a true interest-free loan. Some Muslims consider this to be the onlytype of loan that does not violate the prohibition on riba, since it is the one type of loanthat truly does not compensate the creditor for the time value of money. 34
  35. 35. 12) Sukuk (Islamic bonds)Sukuk isthe Arabic name for a financial certificate but can be seen as an Islamicequivalent of bond. However, fixed-income, interest-bearing bonds are not permissible inIslam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and itsinvestment principles, which prohibit the charging or paying of interest. Financial assetsthat comply with the Islamic law can be classified in accordance with their tradability andnon-tradability in the secondary markets.13) Takaful (Islamic insurance)Takaful is an alternative form of cover that a Muslim can avail himself against the risk ofloss due to misfortunes. Takaful is based on the idea that what is uncertain with respect toan individual may cease to be uncertain with respect to a very large number of similarindividuals. Insurance by combining the risks of many people enables each individual toenjoy the advantage provided by the law of large numbers.14) Wadiah (safekeeping)In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds inthe bank and the bank guarantees refund of the entire amount of the deposit, or any partof the outstanding amount, when the depositor demands it. The depositor, at the banksdiscretion, may be rewarded with Hibah as a form of appreciation for the use of funds bythe bank.Shariah SupervisorsThe Board of Directors to appoint a Shariah Supervisor, responsible for monitoring allthe Bank‟s transactional procedures and assuring Shariah compliance.Also the General Secretary of the Fatwa & Shariah Supervision Board, the ShariahSupervisor handles queries about the Bank‟s administration from staff members,shareholders, depositors and customers, liaises with the Shariah auditors and providesthem with guidance. He submits reports and suggestions to the Fatwa & ShariahSupervision Board and to the Chairman of the Board of Directors. The position also callsfor participation in the Bank‟s training programmes.Shariah Auditing 35
  36. 36. The supervisory function forms a part of the Shariah Supervision procedures, its maintask being to check Shariah compliance under the guidance of the Shariah Supervisor.The auditors continuously review the Bank‟s transactional procedures to ensureadherence to the framework created by the Fatwa & Shariah Supervision Board. TheShariah auditors submit periodic reports to the Shariah Supervisor so as to monitor andmaintain Shariah compliance. Islamic equity fundsIslamic investment equity funds market is one of the fastest-growing sectors within the Islamicfinancial system. Currently, there are approximately 100 Islamic equity funds worldwide. Thetotal assets managed through these funds currently exceed US$5 billion and is growing by 12–15% per annum. With the continuous interest in the Islamic financial system, there are positivesigns that more funds will be launched. Some Western majors have just joined the fray or arethinking of launching similar Islamic equity products.Despite these successes, this market has seen a record of poor marketing as emphasis is onproducts and not on addressing the needs of investors. Over the last few years, quite a number offunds have closed down. Most of the funds tend to target high net worth individuals and corporateinstitutions, with minimum investments ranging from US$50,000 to as high as US$1 million.Target markets for Islamic funds vary; some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting localmarkets and have been accused of failing to serve Muslim communities.Since the launch of Islamic equity funds in the early 1990s, there has been the establishment ofcredible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes pioneeredIslamic investment indexing in 1999) and the FTSE Global Islamic Index Series. The Website monitors the performance of Islamic equity funds and provide a comprehensivelist of the Islamic funds worldwide. 36
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  41. 41. Why Islamic Banking Is Successful?- By Prof. Rodney WilsonThe collapse of leading Wall Street institutions, notably Lehman Brothers, and the subsequentglobal financial crisis and economic recession, are encouraging economists world-wide toconsider alternative financial solutions.Attention has been focused on Islamic banking and finance as an alternative model. Whatlessons can be learnt, and how resilient have Islamic banks been during the current crisis?Islamic Banking Principles And Sub-prime LendingThe religious teaching underpinning Islamic finance is concerned with justice in financial contractsto ensure that none of the parties is being exploited.Riba( interest or usury) is one source of exploitation, especially, as in the case of sub-primelending, the highest rates were charged to lower earners. Such discriminatory charging byconventional banks was justified as being a reflection of the risks involved.Those on lower incomes, with poorer prospects of finding new employment in the event ofredundancy, were less likely to be able to service their interest payments.Islamic housing finance involves risk sharing between the bank and the client, rather thantransferring all the risk to the latter. Under the most commonly used diminishing musharaka(partnership) contract, the bank and the client form a partnership, with the bank providing up to 90percent of the purchase price, and the client at least 10 percent.Over a period of usually 10 to 25 years, the client buys out the ownership share of thebank which makes its profit from the rent paid by the client for the share the bank owns.In the event of a rental or repayments default, the bank may advance the clients an interest-freeloan (qard hassan in Arabic) to enable them to continue their payments during the recession inanticipation that they will pay in full when the economy rebounds. The client retains their homerather than being faced with eviction— like the victims of the sub-prime crisis.Of course Islamic banks have to appraise credit risk, and indeed are more cautious about whothey should finance than conventional banks. The banks in the United States charged higharrangement fees for sub-prime borrowers which were used to pay bonuses for those signing upnew clients.As the mortgages were sold on to Freddie Mac and Fanny Mae, the arrangers were unconcernedthat the sub-prime borrowers might be unable to meet their financial obligations. Indeed, giftswere provided to entice the feckless to sign up, and the mortgages often exceeded the value ofthe property. The banks in other words became mere booking agents, with no long termcommitment to their clients. 41
  42. 42. The Islamic Banking RecordIn contrast to conventional banks, no Islamic bank has failed and has needed governmentrecapitalization which ultimately becomes a burden on hard pressed taxpayers.All Islamic banks comply with the Basel II capital adequacy requirements and the IslamicFinancial Services Board (IFSB)- the body which advises regulators with respect to Islamicfinance- has produced detailed guidelines on compliance. The IFSB has an on-going relationshipwith the Bank for International Settlements-the institution which developed the Basel standards-and is certain to be consulted as Basel III guidelines are drafted for capital adequacy which arelikely to be implemented globally in the coming decade.The soundness of Islamic banks is accounted for by the fact that they use a classical bankingmodel, with financing derived from deposits, rather than being funded by borrowings fromwholesale markets. Consequently when the credit crunch came and borrowing from wholesalemarkets was halted, Islamic banks were not exposed. However, Islamic banks are not immunefrom the effects of the global recession, and the fall in oil prices will inevitably have a negativeimpact on 2008 results of Gulf-based Islamic banks. The situation will become clearer fromFebruary once the audited financial statements start to appear.Two Islamic housing financial institutions, Amlak and Tamweel are being merged, as both havefaced problems given their exposure to the Dubai property market.In Iran where all financial operations have been shariah-based since the Law on Usury FreeBanking was introduced in 1983, banks have been relatively insulated from the financial crisis,ironically because United States sanctions meant they could not deal with institutions such asLehman Brothers which were trying to place large amounts of toxic debt with Middle Easternbanks. The sanctions therefore proved to be a blessing in disguise for Iran— although the Islamicbanks there have been adversely affected recently by the fall in gas prices.Nevertheless being state owned, institutions such as Bank Melli, the largest Islamic bank in theworld, are well placed to ride out the global financial storm. With assets of over $50 billion, and2007 profits exceeding $540 million, it has more than adequate resources to cope.Islamic Financial StabilityIslamic banks enjoy a built-in stabilizer to help them cope with economic downturns, as instead ofpaying interest to depositors, those with investment mudaraba accounts share in the banksprofits. Thus, if profitability declines in an economic downturn, depositors receive lower returns,but if profits rise they enjoy higher returns.This profit sharing reduces risk for the banks and means they are less likely to become insolvent.However as the banks build up a profit equalization reserve, which can be used to finance pay-outs during difficult years, depositors benefit from some protection of their returns duringeconomic downturns.The last year has been difficult, if not disastrous, for equity investors, given the fall in stockmarket prices globally.Investors in equities screened for shariah compliance have also suffered, but less than theirconventional counterparts, because they have not invested in the shares of riba-based bankswhich have fared especially badly during the global financial turmoil. 42
  43. 43. Investors seeking Shariah compliance have portfolios which are more heavily weighted in sectorssuch as healthcare or utilities where revenue streams are maintained even during cyclical down-turns.Prospects for Islamic FinanceIslamic banking provides a viable alternative to conventional banking and is less cycle prone. Thespread of Islamic finance into western markets demonstrates that it now being treated seriouslyby regulators and finance ministries.There are already five wholly Islamic banks in London, and the first Islamic bank will openin France in 2009. According to the conservative estimates of the Banker in October 2008,Islamic financial assets globally exceed $500 billion, a figure that could easily double overthe coming decade. The experience of Islamic banking in the United Kingdom has beenextremely positive. Islamic Bank of Britain has been operating as a retail bank for over fouryears, and has attracted over 40,000 customers. HSBC Amanah, the Islamic financesubsidiary of HSBC, has been operating for ten years in London, focusing mainly oninstitutional clients and business finance.Alburaq, the Islamic finance subsidiary of Arab Banking Corporation, has become themarket leader for shariah compliant home finance in the United Kingdom. None of theseinstitutions has been affected by the global financial crisis, and their resilience bodes wellfor the future.Sukuk Are Real AssetsIn addition to banking, Islamic sukuk security issuance has enormous potential. Unlikeconventional bonds and notes, sukuk are backed by real assets, which provides assurance toinvestors .Although global sukuk markets were adversely affected by the global recession in2008, longer term prospects look promising, with the United Kingdom authorities promotingLondon as an international centre for sukuk issuance to rival Bahrain, Dubai and Kuala Lumpur.The Malaysian ringgit sukuk market has been largely unaffected by the global turmoil in securitiesmarkets, and issuers such as the Saudi Arabia Basic Industries Corporation, one of the world‘slargest petrochemical producers, view sukuk as a desirable instruments to raise funding for plantexpansion. There can be no doubt that Islamic finance has an exciting future, and the quest for afinancial system based on moral values rather than greed and fear, is bound to enhance itsposition in the global system.Professor Rodney Wilson is the Director of Postgraduate Studies, School of Government andInternational Affairs of Durham University. Prof. Wislons research areas are Islamic economicsand finance, Middle Eastern political economy, and The political economy of oil and gas. Hewrote various books on Islamic economics. 43
  44. 44. Islamic equity funds see rapid growth-----Daniel Stanton on Monday, 18 February 2008The Islamic equity funds industry has grown to around US$20 billion in assets undermanagement, according to research released on Monday.Failaka Advisors, a fund monitoring company, said that Islamic equity funds had grown rapidly inrecent years, driven by GCC investors.Tariq Al-Rifai, chairman of Failaka, said: "The size of this market has tripled over the past fiveyears."Funds investing in the GCC market represent more than half of the entire Islamic equity fundindustry. Saudi Arabian funds and fund managers dominate the industry, accounting for nearly 75funds out of around 300 Islamic equity funds worldwide. Bahrain has become the favoredcentre for fund registrations in the Gulf, with institutions such as Kuwaits Global InvestmentHouse and Saudi Arabias National Commercial Bank having established fund managementoperations there recently.Failaka reported that in 2007 the best performing Islamic equityfund managed in the GCC was Saudi British Banks Amanah GCC Equity fund, whichdelivered a return of 83.2%. 44
  45. 45. Islamic banks going forward: challengesThe continuing rapid growth of demand for Islamic financial services is clearly goodnews for Islamic banks. At the same time, it also presents some challenges, as the banksneed to invest in upgrading their credit risk management capabilities in line with the morecomplex and larger projects into which they are entering.Despite the rapid growth, business models and products of Islamic banks are still ratherhomogeneous, while Shari‟ah compliance amplifies risks stemming from productconfiguration and process implementation. The success of Islamic banking in recent yearshas produced too many Islamic banks with the same business models. There is a lack of„bread and butter‟ lending, and the current excess liquidity has led to too muchcomplacency among Islamic banks.In addition, there is a large and diverse set of accounting standard differences acrossdifferent jurisdictions. The development and setting of simple standard legal contracts isnecessary in order to overcome the complexity and heterogeneity of current contracts.Furthermore, the deployment of IT systems that help monitor the fulfillments andvisibility of processes on an end-to-end basis are crucial to facilitate the continuousmonitoring of activities by Shari‟ah scholars while eliminating the possibilities of non-compliance, which in some cases might render transactions invalid.Liquidity risk management of Islamic banks is an important challenge and is constraineddue to limited availability of tradable Islamic money market instruments and weaksystemic liquidity infrastructure. At the moment, there is no Shari‟ah-compliant short-term Islamic money market (less than one week maturity) in local currency or in USdollars, and Islamic repo markets have not yet developed. Islamic money markets withlonger maturities, which are based on commodity murabaha transactions (mark-upfinancing), sometimes suffer from unreliable brokers with low creditworthiness. Islamicbanks also have a competitive disadvantage with conventional banks, as they deposittheir overnight money with their domestic central bank interest free. The lack of liquidityand viable alternatives, combined with the competitive disadvantage, hamper the localIslamic banks and can even create a liquidity crisis.Islamic banks going forward: solutions and opportunitiesBoth risk managers and regulators are working to address the above challenges. Toovercome the shortcomings of the Islamic money market, many investment banks arecurrently designing new complex products, compliant with Shari‟ah law. It remains to beseen whether these new solutions will obtain widespread Shari‟ah-compliant status in theIslamic finance community, and generate enough demand for a functional Islamic moneymarket to develop.The rapid developments are likely to continue. Financial institutions in countries such asBahrain, the UAE and Malaysia have been gearing up for more Shari‟ah-compliant 45
  46. 46. financial instruments and structured finance – on both the asset and liability sides. At thesame time, the leading financial centers, such as London, New York and Singapore, aremaking significant progress in establishing the legal and prudential foundations toaccommodate Islamic finance side-by-side with the conventional financial system. Manyof the largest western banks, through their Islamic windows, have become active andsometimes leading players in financial innovation, through new Shari‟ah-compliantfinancial instruments that attempt to alleviate many of the current constraints such as aweak systemic liquidity infra-structure. More conventional banks are expected to offerIslamic products, enticed by enormous profit opportunities and also ample liquidity,especially across the Middle East.New product innovation is also driven by domestic banks‟ interest in risk diversification.With a large number of new Islamic banks across the Middle East and Asia especially,diversification of products enables banks to offer the right product mix to moresophisticated clients. A few banks are already active across different jurisdictions, andthis trend is certainly going to continue in the near future, possibly with someconsolidation.On the regulatory front, the Islamic Financial Services Board (IFSB), an internationalstandard-setting organization based in Malaysia, has moved ahead with its efforts aimedat fostering of the soundness and stability of the Islamic financial services industrythrough more standardized regulation. Globally accepted prudential standards have beenadopted by the IFSB that smoothly integrate Islamic finance with the conventionalfinancial system. For instance, the adoption of the IFSB standards (somewhat akin toBasel II), which take into account the specificities of Islamic finance, ensures a levelplaying field between Islamic and conventional banks.Many challenges still lie ahead, as is clear from the discussion above. However, theongoing improvements in banks‟ risk management techniques and prudential frameworksfor Shari‟ah-compliant banking give reasonable hope that the Islamic financial industry‟sgrowth will contribute positively to broader financial and economic stability. 46