Islamic banking

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Islamic banking

  1. 1. ISLAMIC BANKING TY.BMSPREFACE The Islamic banking experiment is still new and is still in the earlystage of application. So it is not surprising that members of the public havemany questions to ask as they are keen on understanding Islamic bankingprinciples and interested in dealing with Islamic institutions. The Islamicbanking experiment is not an innovation but is indeed a continuation ofeconomic thought that has prevailed and survived for many years during whichit proved its success in the filed of practical application for many centuriesduring the early Islamic era. Islamic economic thought has been characterizedby the continuation and variety of its interpretation and development of its tools.During the last fourteen years Islamic banks underwent a number of tests, someof which were fairly difficult that could not be overcome by well-establishedbanks which rely on usury in their transactions. However, with the grace ofGod, foresight of Islamic bankers and hard work of the bank employees suchtests were successfully overcome which proves the sound principles andfoundations of the Islamic banking experiment. Since the problems faced bycertain Islamic banks influence other similar banks either in a negative orpositive manner. Such problems also influence the Islamic economic pursuits ingeneral, and the activities of Islamic banks wherever, and the activities ofIslamic banks where they based in particular. Therefore, there is a need forIslamic banks to adopt a position, reflecting the unity and solidarity of Muslimsand demonstrating their profound belief. Their attitude is one which reflectstheir common destiny and their pursuit of an economic and financial strategy 1
  2. 2. ISLAMIC BANKING TY.BMSthat is based upon their Islamic religion which regulates, in a comprehensiveway, their financial life. but it is a concept that has been put in practice.Nowadays Islamic banking.. There are Islamic banks effectively operating in three continents of the world.As they entered the second decade, the Islamic banking experience has provedits existence in the financial activities involving both the private and publicsectors. Through the adoption of Islamic finance methods, they have been able tointroduce financial tools that are acceptable in todays world and these facilitiesare less burdensome to the owners of development projects. Throughencouraging participation in projects, Islamic banks have highlighted the key toThird World developing efforts. Short term finance aiming at making securequick profit that is remote from accepting any risks is not in any wayappropriate for development. Without participation in risks, Western Europe forexample would not have accomplished this level of development nor would thedreams of the earlier generation of the Japanese people have become a reality.Islamic economists look forward to establishing a dynamic global economy inwhich capital interacts with human efforts and thought without depending onrates of interest fixed well in advance. With this aspiration, the soundness ofwhich is confirmed by many western and eastern thinkers, the whole world willenjoy greater economic prosperity. This project throws some light on theactivities of Islamic banks while outlining the philosophy of these activities. 2
  3. 3. ISLAMIC BANKING TY.BMS• OBJECTIVES TO STUDY:1. To know about ISLAMIC BANKING.2. To know whether Islamic Banking will be beneficial for the country in future.3. To know about Islamic finance sector.4. To know about development and growth in Islamic banking.5. To know whether Islamic Banking will be beneficial for the customer in future.• METHODOLOGY 1. Reviewed secondary sources of data available through relevant books, periodicals, internet, relevasnt articles in the newspapers etc. 2. Primary research was also conducted through a field visit to Islamic Research Foundation (IRF) at Sandhurst Road, Mumbai. 3
  4. 4. ISLAMIC BANKING TY.BMS 4
  5. 5. ISLAMIC BANKING TY.BMS CH. 1 . Islamic banking Islamic banking refers to a system of banking or banking activity that isconsistent with the principles of Islamic law (Sharia) and its practicalapplication through the development of Islamic economics. Sharia prohibits thepayment of fees for the renting of money (Riba, usury) for specific terms, aswell as investing in businesses that provide goods or services consideredcontrary to its principles (Haraam, forbidden). While these principles were usedas the basis for a flourishing economy in earlier times, it is only in the late 20thcentury that a number of Islamic banks were formed to apply these principles toprivate or semi-private commercial institutions within the Muslim community.•• History of Islamic banking Classical Islamic banking During the Islamic Golden Age, early forms of proto-capitalism and freemarkets were present in the Caliphate, where an early market economy and anearly form of mercantilism were developed between the 8th-12th centuries,which some refer to as "Islamic capitalism". A vigorous monetary economy wascreated on the basis of the expanding levels of circulation of a stable high-valuecurrency (the dinar) and the integration of monetary areas that were previouslyindependent. A number of innovative concepts and techniques were introduced in earlyIslamic banking, including bills of exchange, the first forms of partnership(mufawada) such as limited partnerships (mudaraba), and the earliest forms ofcapital (al-mal), capital accumulation (nama al-mal), cheques, promissorynotes, trusts (see Waqf), startup companies, transactional accounts, loaning,ledgers and assignments Organizational enterprises similar to corporationsindependent from the state also existed in the medieval Islamic world, while theagency institution was also introduced. Many of these early capitalist 5
  6. 6. ISLAMIC BANKING TY.BMSconcepts were adopted and further advanced in medieval Europe from the 13thcentury onwards.• Riba The definition of riba in classical Islamic jurisprudence was "surplusvalue without counterpart." or "to ensure equivalency in real value" and that"numerical value was immaterial." During this period, gold and silver currencieswere the benchmark metals that defined the value of all other materials beingtraded. Applying interest to the benchmark itself (ex natura sua) made nological sense as its value remained constant relative to all other materials: thesemetals could be added to but not created (from nothing).Applying interest wasacceptable under some circumstances. Currencies that were based on guaranteesby a government to honor the stated value (i.e. fiat currency) or based on othermaterials such as paper or base metals were allowed to have interest applied tothem. When base metal currencies were first introduced in the Islamic world, nojurist ever thought that "paying a debt in a higher number of units of this fiatmoney was riba" as they were concerned with the real value of money(determined by weight only) rather than the numerical value. For example, itwas acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars ofequal aggregate weight (i.e., the value in terms of weight had to be samebecause all makes of coins did not carry exactly similar weight). 6
  7. 7. ISLAMIC BANKING TY.BMS• Modern Islamic banking The first modern experiment with Islamic banking was undertaken inEgypt under cover without projecting an Islamic image for fear of being seen asa manifestation of Islamic fundamentalism that was anathema to the politicalregime. The pioneering effort, led by Ahmad Elnaggar, took the form of asavings bankbased onprofit-sharingin the Egyptiantown of MitGhamr in1963. Thisexperimentlasted until1967 (Ready1981), bywhich timethere were nine such banks in the country. In 1972, the Mit Ghamr Savings project became part of Nasr Social Bankwhich, till date, is still in business in Egypt. In 1975, the Islamic DevelopmentBank was set-up with the mission to provide funding to projects in the membercountries. The first modern commercial Islamic bank, Dubai Islamic Bank,opened its doors in 1975. In the early years, the products offered were basic andstrongly founded on conventional banking products, but in the last few years the 7
  8. 8. ISLAMIC BANKING TY.BMSindustry is starting to see strong development in new products andservices.Islamic Banking is growing at a rate of 10-15% per year and with signsof consistent future growth. Islamic banks have more than 300 institutionsspread over 51 countries, plus an additional 250 mutual funds that comply withthe Islamic principles. The relative stability of Islamic banking institutions incurrent recession has gained it attention. Even The Vatican said banks shouldlook at the rules of Islamic finance to restore confidence amongst their clients ata time of global economic crisis. The World Islamic Banking Conference, heldannually in Bahrain since 1994, is internationally recognized as the largest andmost significant gathering of Islamic banking and finance leaders in the world.• Principles Islamic banking has the same purpose as conventional banking exceptthat it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamicbanking is the sharing of profit and loss and the prohibition of riba (usury).Amongst the common Islamic concepts used in Islamic banking are profitsharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah),cost plus (Murabahah), and leasing (Ijarah).In an Islamic mortgagetransaction, instead of loaning the buyer money to purchase the item, a bankmight buy the item itself from the seller, and re-sell it to the buyer at a profit,while allowing the buyer to pay the bank in installments. However, the fact thatit is profit cannot be made explicit and therefore there are no additional penaltiesfor late payment. In order to protect itself against default, the bank asks for strictcollateral. The goods or land is registered to the name of the buyer from the startof the transaction. This arrangement is called Murabaha. Another approach isEIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handleloans for vehicles in a similar way (selling the vehicle at a higher-than-marketprice to the debtor and then retaining ownership of the vehicle until the loan is 8
  9. 9. ISLAMIC BANKING TY.BMSpaid).An innovative approach applied by some banks for home loans, calledMusharaka al-Mutanaqisa, allows for a floating rate in the form of rental. Thebank and borrower forms a partnership entity, both providing capital at anagreed percentage to purchase the property. The partnership entity then rent outthe property to the borrower and charges rent. The bank and the borrower willthen share the proceed from this rent based on the current equity share of thepartnership. At the same time, the borrower in the partnership entity also buysthe banks share on the property at agreed installments until the full equity istransferred to the borrower and the partnership is ended. If default occurs, boththe bank and the borrower receives the proceeds from an auction based on thecurrent equity. This method allows for floating rates according to current marketrate such as the BLR (base lending rate), especially in a dual-banking systemlike in Malaysia. There are several other approaches used in business deals. Islamic banks lendtheir money to companies by issuing floating rate interest loans. The floatingrate of interest is pegged to the companys individual rate of return. Thus thebanks profit on the loan is equal to a certain percentage of the companysprofits. Once the principal amount of the loan is repaid, the profit-sharingarrangement is concluded. This practice is called Musharaka. Further,Mudaraba is venture capital funding of an entrepreneur who provides laborwhile financing is provided by the bank so that both profit and risk are shared.Such participatory arrangements between capital and labor reflect the Islamicview that the borrower must not bear all the risk/cost of a failure, resulting in abalanced distribution of income and not allowing lender to monopolize theeconomy and finally, Islamic banking is restricted to Islamically acceptabledeals, which exclude those involving alcohol, pork, gambling, etc. Thus ethicalinvesting is the only acceptable form of investment, and moral purchasing isencouraged. In theory, Islamic banking is an example of full-reserve banking, 9
  10. 10. ISLAMIC BANKING TY.BMSwith banks achieving a 100% reserve ratio. However, in practice, this is not thecase, and no examples of 100 per cent reserve banking are observed. Islamic banks have grown recently in the Muslim world but are a verysmall share of the global banking system. Micro-lending institutions founded byMuslims, notably Grameen Bank, use conventional lending practices and arepopular in some Muslim nations, especially Bangladesh, but some do notconsider them true Islamic banking. However, Muhammad Yunus, the founderof Grameen Bank and microfinance banking, and other supporters ofmicrofinance, argue that the lack of collateral and lack of excessive interest inmicro-lending is consistent with the Islamic prohibition of usury (riba)• PRINCIPLES OF INVESTMENT IN ISLAM Let us after all this try to see the basis on which Islamic investment ispreferable. When we asked for Islamic banks to be established, some interesttaking bankers suggested opening a branch for Islamic transactions and said thatthere was not need for Islamic banks to be established. They say this so easily,inferring thatIslamic transactions are shallow and easy to shrug off and as if the mere openingof an Islamic branch would be acceptable. By doing this they are trying toexploit us and do not fully understand Islam. Islamic investments are basemainly on good faith not dealing with the taking and giving of usury, not tradingnor participating in the sale of any prohibited goods and no excessive mark-upby exploitation of the market, as these things are harmful to society. Just by notdealing with usury does not automatically make any bank an Islamic bank isthere is not certainty that its other dealings are in accordance with the Islamicconcepts. Islam must be taking as a whole, all Islamic orders must be observed,and any Muslim cannot live a dual personality. 10
  11. 11. ISLAMIC BANKING TY.BMSIt might be easy to wear more than one hat in the normal business day, but whencomes to principles and particularly religious principles only one hat could beworn.• Shariah advisory concil / consultany Islamic banks and banking institutions that offer Islamic banking productsand services (IBS banks) are required to establish Shariah advisorycommittees/consultants to advise them and to ensure that the operations andactivities of the bank comply with Shariah principles. On the other hand, thereare also those who believe that no form of banking can ever comply with theshariah.[16]In Malaysia, the National Shariah Advisory Council, whichadditionally set up at Bank Negara Malaysia (BNM), advises BNM on theShariah aspects of the operations of these institutions and on their products andservices. (See: Islamic banking in Malaysia)A number of Sharia advisory firms(like BMB Islamic) have now emerged to offer Sharia advisory services to theinstitutions offering Islamic financial services.• Bai al-Inah (Sale and Buy Back Agreement) The financier sells an asset to the customer on a deferred-payment basis,and then the asset is immediately repurchased by the financier for cash at adiscount. The buying back agreement allows the bank to assume ownership overthe asset in order to protect against default without explicitly charging interest inthe event of late payments or insolvency. Some scholars believe that this is notcompliant with Shariah principles. 11
  12. 12. ISLAMIC BANKING TY.BMS• Bai Bithaman Ajil (Deferred Payment Sale) This concept refers to the sale of goods on a deferred payment basis at aprice, which includes a profit margin agreed to by both parties. This is similar toMurabahah, except that the debtor makes only a single installment on thematurity date of the loan. By the application of a discount rate, an Islamic bankcan collect the market rate of interest.• Bai muajjal (Credit Sale) Literally bai muajjal means a credit sale. Technically, it is a financingtechnique adopted by Islamic banks that takes the form of murabaha muajjal.It is a contract in which the bank earns a profit margin on the purchase price andallows the buyer to pay the price of the commodity at a future date in a lumpsum or in installments. It has to expressly mention cost of the commodity andthe margin of profit is mutually agreed. The price fixed for the commodity insuch a transaction can be the same as the spot price or higher or lower than thespot price.• Mudarabah (Profit Sharing) Mudarabah is an arrangement or agreement between the bank, or a capitalprovider, and an entrepreneur, whereby the entrepreneur can mobilize the fundsof the former for its business activity. The entrepreneur provides expertise, laborand management. Profits made are shared between the bank and theentrepreneur according to predetermined ratio. In case of loss, the bank loses thecapital, while the entrepreneur loses his provision of labor. It is this financialrisk, according to the Shariah, that justifies the banks claim to part of the profit.The profit-sharing continues until the loan is repaid. The bank is compensatedfor the time value of its money in the form of a floating rate that is pegged to thedebtors profits. 12
  13. 13. ISLAMIC BANKING TY.BMS• Murabahah (Cost Plus) This concept refers to the sale of goods at a price, which includes a profitmargin agreed to by both parties. The purchase and selling price, other costs,and the profit margin must be clearly stated at the time of the sale agreement.The bank is compensated for the time value of its money in the form of theprofit margin. This is a fixed-income loan for the purchase of a real asset (suchas real estate or a vehicle), with a fixed rate of profit determined by the profitmargin. The bank is not compensated for the time value of money outside of thecontracted term (i.e., the bank cannot charge additional profit on late payments);however, the asset remains as a mortgage with the bank until the Murabaha ispaid in full.This type of transaction is similar to rent-to-own arrangements forfurniture or appliances that are very common in North American stores.• Musawamah Musawamah is the negotiation of a selling price between two parties withoutreference by the seller to either costs or asking price. While the seller may ormay not have full knowledge of the cost of the item being negotiated, they areunder no obligation to reveal these costs as part of the negotiation process. Thisdifference in obligation by the seller is the key distinction between Murabahaand Musawamah with all other rules as described in Murabaha remaining thesame. Musawamah is the most common type of trading negotiation seen inIslamic commerce.• Bai salam Bai salam means a contract in which advance payment is made for goodsto be delivered later on. The seller undertakes to supply some specific goods tothe buyer at a future date in exchange of an advance price fully paid at the timeof contract. It is necessary that the quality of the commodity intended to bepurchased is fully specified leaving no ambiguity leading to dispute. 13
  14. 14. ISLAMIC BANKING TY.BMS• Basic features and conditions of salam 1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. 2. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. If the price were not paid in full, the basic purpose of the transaction would have been defeated. Muslim jurists are unanimous in their opinion that full payment of the purchase price is key for Salam to exist. Imam Malik is also of the opinion that the seller may defer accepting the funds from the buyer fr two or three days, but this delay should not form part of the agreement. 3. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. For example, precious stones cannot be sold on the basis of salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible. 4. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. 5. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which 14
  15. 15. ISLAMIC BANKING TY.BMS may lead to a dispute. All the possible details in this respect must be expressly mentioned. 6. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa. 7. The exact date and place of delivery must be specified in the contract. 8. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.• Hibah (Gift) This is a token given voluntarily by a debtor to a creditor in return for aloan. Hibah usually arises in practice when Islamic banks voluntarily pay theircustomers a gift on savings account balances, representing a portion of theprofit made by using those savings account balances in other activities.It isimportant to note that while it appears similar to interest, and may, in effect,have the same outcome, Hibah is a voluntary payment made (or not made) at thebanks discretion, and cannot be guaranteed. However, the opportunity ofreceiving high Hibah will draw in customers savings, providing the bank withcapital necessary to create its profits; if the ventures are profitable, then some ofthose profits may be gifted back to its customers as Hibah. 15
  16. 16. ISLAMIC BANKING TY.BMS• Ijarah Ijarah means lease, rent or wage. Generally, Ijarah concept means sellingbenefit or use or service for a fixed price or wage. Under this concept, the Bankmakes available to the customer the use of service of assets / equipments such asplant, office automation, motor vehicle for a fixed period and price.• Advantages of Ijarah Ijarah provides the following advantages to the Lessee:Ijarah conservesthe Lessee capital since it allows up to 100% financing.Ijarah gives the Lesseethe right to access the equipment on payment of the first installment.This is important as it is the access and use (and not ownership) of equipmentthat generates income.Ijarah arrangements aid corporate planning and budgetingby allowing the negotiation of flexible termsIjarah is not considered DebtFinancing so it does not appear on the Lessee Balance Sheet as a Liability. Thismethod of "off-balance-sheet" financing means that it is not included in the DebtRatios used by bankers to determine financing limits. This allows the Lessee toenter into other lease financing arrangements without impacting his overall debtrating.All payments towards Ijarah contracts are treated as operating expensesand are therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations.Many types of equipment (i.e computers) become obsoletebefore the end of their actual economic life. Ijarah contracts allow the transfer ofrisk from the Lesse to the Lessor in exchange for a higher lease rate. This higherrate can be viewed as insurance against obsolescence.If the equipment is usedfor a relatively short period of time, it may be more profitable to lease than tobuy.If the equipment is used for a short period but has a very poor resale value,leasing avoids having to account for and depreciate the equipment under normalaccounting principles. 16
  17. 17. ISLAMIC BANKING TY.BMS• Ijarah Thumma Al Bai (Hire Purchase) Parties enter into contracts that come into effect serially, to form acomplete lease/ buyback transaction. The first contract is an Ijarah that outlinesthe terms for leasing or renting over a fixed period, and the second contract is aBai that triggers a sale or purchase once the term of the Ijarah is complete. Forexample, in a car financing facility, a customer enters into the first contract andleases the car from the owner (bank) at an agreed amount over a specific period.When the lease period expires, the second contract comes into effect, whichenables the customer to purchase the car at an agreed to price.The bankgenerates 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 moneybeing invested in purchasing the product to be leased for the intended term. Thecombining of these three figures becomes the basis for the contract between theBank and the client for the initial lease contract.This type of transaction is similar to the contractum trinius, a legal maneuverused by Europeanbankers and merchants during the Middle Ages to sidestep the Churchsprohibition on interest bearing loans. In a contractum, two parties would enterinto three concurrent and interrelated legal contracts, the net effect being thepaying of a fee for the use of money for the term of the loan. The use ofconcurrent interrelated contracts is also prohibited under Shariah Law.• Ijarah-Wal-Iqtina A contract under which an Islamic banks provides equipment, building, orother assets to the client against an agreed rental together with a unilateralundertaking by the bank or the client that at the end of the lease period, theownership in the asset would be transferred to the lessee. The undertaking or thepromise does not become an integral part of the lease contract to make it 17
  18. 18. ISLAMIC BANKING TY.BMSconditional. The rentals as well as the purchase price are fixed in such mannerthat the bank gets back its principal sum along with profit over the period oflease.• Musharakah (Joint Venture) Musharakah is a relationship between two parties or more, of whomcontribute capital to a business, and divide the net profit and loss pro rata. Thisis often used in investment projects, letters of credit, and the purchase or realestate or property. In the case of real estate or property, the bank assess animputed rent and will share it as agreed in advance. All providers of capital areentitled to participate in management, but not necessarily required to do so. Theprofit is distributed among the partners in pre-agreed ratios, while the loss isborne by each partner strictly in proportion to respective capital contributions.This concept is distinct from fixed-income investing (i.e. issuance of loans).• Qard Hassan (Good Loan) This is a loan extended on a goodwill basis, and the debtor is only requiredto repay the amount borrowed. However, the debtor may, at his or herdiscretion, pay an extra amount beyond the principal amount of the loan(without promising it) as a token of appreciation to the creditor. In the case thatthe debtor does not pay an extra amount to the creditor, this transaction is a trueinterest-free loan. Some Muslims consider this to be the only type of loan thatdoes not violate the prohibition on riba, since it is the one type of loan that trulydoes not compensate the creditor for the time value of money.• Sukuk (Islamic Bonds) Sukuk is the Arabic name for a financial certificate but can be seen as anIslamic equivalent of bond. However, fixed-income, interest-bearing bonds arenot permissible in Islam. Hence, Sukuk are securities that comply with the 18
  19. 19. ISLAMIC BANKING TY.BMSIslamic law (Shariah) and its investment principles, which prohibit the chargingor paying of interest. Financial assets that comply with the Islamic law can beclassified in accordance with their tradability and non-tradability in thesecondary markets.Conservative estimates suggest that over US$500 billion ofassets are managed according to Islamic investment principles.• Takaful (Islamic Insurance) Takaful is an alternative form of cover that a Muslim can avail himselfagainst the risk of loss due to misfortunes. Takaful is based on the idea that whatis uncertain with respect to an individual may cease to be uncertain with respectto a very large number of similar individuals. Insurance by combining the risksof many people enables each individual to enjoy the advantage provided by thelaw of large numbers• Wadiah (Safekeeping) In Wadiah, a bank is deemed as a keeper and trustee of funds. A persondeposits funds in the bank and the bank guarantees refund of the entire amountof the deposit, or any part of the outstanding amount, when the depositordemands it. The depositor, at the banks discretion, may be rewarded with Hibah(see above) as a form of appreciation for the use of funds by the bank.• Islamic equity funds. Islamic investment equity funds market is one of the fastest-growingsectors within the Islamic financial system. Currently, there are approximately100 Islamic equity funds worldwide. The total assets managed through thesefunds currently exceed US$5 billion and is growing by 12–15% per annum.With the continuous interest in the Islamic financial system, there are positive 19
  20. 20. ISLAMIC BANKING TY.BMSsigns that more funds will be launched. Some Western majors have just joinedthe fray or are thinking of launching similar Islamic equity products.Despitethese successes, this market has seen a record of poor marketing as emphasis ison products and not on addressing the needs of investors. Over the last fewyears, quite a number of funds have closed down. Most of the funds tend totarget high net worth individuals and corporate institutions, with minimuminvestments ranging from US$50,000 to as high as US$1 million. Targetmarkets for Islamic funds vary, some cater for their local markets, e.g., Malaysiaand Gulf-based investment funds. Others clearly target the Middle East and Gulfregions, neglecting local markets and have been accused of failing to serveMuslim communities.Since the launch of Islamic equity funds in the early1990s, there has been the establishment of credible equity benchmarks by DowJones Islamic market index (Dow Jones Indexes pioneered Islamic investmentindexing in 1999) and the FTSE Global Islamic Index Series. The Web sitefailaka.com monitors the performance of Islamic equity funds and provide acomprehensive list of the Islamic funds worldwide.• Islamic laws on trading The Quran prohibits gambling (games of chance involving money) andinsuring ones health or property (also a game of chance). The hadith, in additionto prohibiting gambling (games of chance), also prohibits bayu al-gharar(trading in risk, where the Arabic word gharar is taken to mean "risk" orexcessive uncertainty).The Hanafi madhab (legal school) in Islam defines gharar as "that whoseconsequences are hidden." The Shafi legal school defined gharar as "that whosenature and consequences are hidden" or "that which admits two possibilities,with the less desirable one being more likely." The Hanbali school defined it as"that whose consequences are unknown" or "that which is undeliverable, 20
  21. 21. ISLAMIC BANKING TY.BMSwhether it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is wherethe buyer does not know what he bought, or the seller does not know what hesold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that"Gharar is the sale of probable items whose existence or characteristics are notcertain, due to the risky nature that makes the trade similar to gambling." Thereare a number of hadith that forbid trading in gharar, often giving specificexamples of gharhar transactions (e.g., selling the birds in the sky or the fish inthe water, the catch of the diver, an unborn calf in its mothers womb etc.).Jurists have sought many complete definitions of the term. They also came upwith the concept of yasir (minor risk); a financial transaction with a minor riskis deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to be haram. What gharar is, exactly, was never fullydecided upon by the Muslim jurists.• Microfinance Microfinance is a key concern for Muslims states and recently Islamicbanks also. Islamic microfinance tools can enhance security of tenure andcontribute to transformation of lives of the poor.• Controversy In Islamabad, Pakistan, on June 16, 2004: Members of leading Islamistpolitical party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged aprotest walkout from the National Assembly of Pakistan against what theytermed derogatory remarks by a minority member on interest banking:Takingpart in the budget debate, M.P. Bhindara, a minority MNA [Member of theNational Assembly]...referred to a decree by an Al-Azhar Universitys scholarthat bank interest was not un-Islamic. He said without interest the country could 21
  22. 22. ISLAMIC BANKING TY.BMSnot get foreign loans and could not achieve the desired progress. Apandemonium broke out in the house over his remarks as a number of MMAmembers...rose from their seats in protest and tried to respond to Mr Bhindarasobservations. However, they were not allowed to speak on a point of order thatled to their walkout.... Later, the opposition members were persuaded by a teamof ministers...to return to the house...the government team accepted the right ofthe MMA to respond to the minority members remarks.... Sahibzada FazalKarim said the Council of Islamic ideology had decreed that interest in all itsforms was haram in an Islamic society. Hence, he said, no member had the rightto negate this settled issue.[ Some Islamic banks generate profits by charging forthe time value of money, the common economic definition of Interest (Riba).These institutions are criticized in some quarters of the Muslim community fortheir lack of strict adherence to Sharia.The concept of Ijarah is used by someIslamic Banks (the Islami Bank in Bangladesh, for example) to apply to the useof money instead of the more accepted application of supplying goods orservices using money as a vehicle. A fixed fee is added to the amount of theloan that must be paid to the bank regardless if the loan generates a return oninvestment or not. The reasoning is that if the amount owed does not changeover time, it is profit and not interest and therefore acceptable under Sharia. Islamic banks are also criticized by some for not applying the principle ofMudarabah in an acceptable manner. Where Mudarabah stresses the sharing ofrisk, critics point out that these banks are eager to take part in profit-sharing butthey have little tolerance for risk. Ch 2.ISLAMIC BANKING FROM THEORY TO PRACTICE. Certain universities sponsored this concept on the theoretical level. Thefirst Islamic Economy Department was set up in the Umm Durman IslamicUniversity, in Sudan in 1967. This move was followed by efforts made by 22
  23. 23. ISLAMIC BANKING TY.BMSleading Muslim intellectuals who embraced this particular concept, and theiracademic works provide concrete evidence in this area. Specialized studies byacademics seeking to obtain M.A. and Ph. D. degrees dealt with the theoreticaland applied aspects of this emerging concept.• ROLE OF MONEY IN ISLAMIC BANKING Indeed, Islam views money as a means of serving the humanity ratherthan being served by mankind. So wealth is held by the wealthy as a trust ratherthan enjoying absolute ownership that could be disposed off in any manner.Obviously, this gives a new dimension to the philosophy of funds and to thenature and role of Islamic banks in the international community.• INSTRUMENTS OF ISLAMIC INVESTMENT Thanks to Islamic banks, the world markets became acquainted within afew years only with new Islamic investment instruments and different forms offinancing were introduced. The most important of these are the following :-1. Islamic Modaraba : This form of finance relies upon combining knowledge, know-how and human efforts as well as available funds to produce the expects fruits for human happiness.2. Forms of Islamic Sales : The most important forms are :- (a) Morabaha which allows a bank customer the opportunity to plan for the future through a regulated financial programme providing for honoring obligations when they become due without allowing 23
  24. 24. ISLAMIC BANKING TY.BMS for any complacency or laxness to the practice created by the conventional banking methods of overdraft financing; (b) Al Sulam sale gives the opportunity to a farmer to look after his crops with the use of finance provided by Islamic banks prior to the harvest season so that the latter would recover their capital finance after the harvest and a settlement becomes possible; (c) Factoring sale (Bai Al Estisna) is a form which encourages Islamic industries to boost their productivity. This particular from of financing is combined with Morabaha sale provided by Islamic banks to allow industries to operate more efficiently and effectively as production financed by (Bai Al Estinsna) and buyer of the factory production is financed by Morabaha. In addition to the above forms, there are other instruments which are notdealt with here. The most interesting of the applicable instrument is that ofoptions. In Islam, options are governed by fair and just rules and regulationsseeking to establish an international economic order. I do not have any doubtthat this approach will enable a more appropriate application of the optionaltransactions in the near future.As regards attracting cash liquidity their banking methods have greatlydeveloped especially in the Arabian Gulf region, and area which is characterizedby the availability of cash funds as well as the presence of several Islamic banksand innovative Islamic banking instruments. Now a depositor has numerousalternatives offering him the normal saving account which permits participationin profit and loss, and there are the investment deposits the period of whichcould extend from one month to a year. There are also the short and medium -term investment certificates of deposits (Bonds). 24
  25. 25. ISLAMIC BANKING TY.BMSAlso there are what is called specific deposits which allow the depositor toparticipate in more specialized portfolios involving a higher degree of risk inconsideration of participating in receiving higher returns on his investment.Furthermore, Islamic companies with floating capital were introduce for the firsttime in Bahrain giving individuals and Islamic financial institutions a greateropportunity to investment will provide the basis for the future Islamic stockmarket. If successful we will completely overcome the liquidity problem inIslamic banks. All these Islamic financial instruments, in addition to other existingforms that we have not dealt with, are being used in practice not only in theIslamic capital market but also in the worlds major capital markets. With thegrowth and advancement of telecommunications, todays world has becomesmaller than it used to be. However, it remains for the efforts of Islamic banksofficials to promote and market such financing forms and investmentinstruments, so that they would reflect the attractive aspects and effectiveness ofsuch instrument. I do not have any doubt that these methods and instrumentswill appeal to rational people who think with a balanced and scientific mind. 25
  26. 26. ISLAMIC BANKING TY.BMS Ch.3 PROHIBITION OF USURY IN ISLAM. Muslims of today have several ways of investing their money butour duty as Muslims is to think carefully before choosing, in order to avoidthings forbidden under Islam, such as usury. In fact is the most important thingto avoid as it is expressly prohibited under Islam as well as being unethical. Byits nature usury is a negative force and has bad moral effects and createseconomic disadvantages. Usury is an oldeconomic phenomenon which originatedfrom unscrupulous individuals and Islamshould seek to end this phenomena. Islamarrived at a time when evil practices werealready firmly rooted in society and it is notalways easy to eradicate these practices. Insome cause Islam has to totally rebuild thevery fabric of society. The Quran has dealtwith this problem in a marvelous way because it takes into consideration thehuman situation. Islam is not so much concerned about actions as it is aboutintentions. Since Almighty God knows the nature of human beings and since weneed a radical change it is not merely a matter of obeying a dictate but rather atrue acceptance of these things in ones heart. When God set out these rules inthe Quran he took into consideration human limitations by gradually introducingprohibitions. When Islam arrived, usury was already very prominent and so wellentrenched in society that it was impossible to eradicate immediately but had tobe phased out gradually in order to avoid serious damage to the fabric of 26
  27. 27. ISLAMIC BANKING TY.BMSsociety. We see from the Quran that the prohibition of usury came in fourstages. The first verse which relates to usury in the Quran was merely theintroduction to its prohibition and was dictated to Mohammad (peace be uponHim) in Mecca. All the verses which were dictated in Mecca are characterizedby the consideration for human nature and seek to purify the human soul of thesins remaining from the pre-Islamic era.• In sura Rom (ch.no.. 30) we read : "Whatever usury you take for increase through property of other peoplewill have no increase with God." This verse is drawing peoples attention, in a gentle manner, to the factthat if people take interest from others now, that interest in their reward resultedin increasing their wealth but they will not be entitled to any reward in theafterlife. So we can see that the verse contains no threat of punishment ofwarning but is simply a statement that one should not expect further reward.Sometime later in the Quran another verse shows Gods anger towards theIsraelis who were taking usury against his wishes and thereby deservingpunishment.• From Sura Nissa (chp no...4) Verse 160 - 161 God says : "For the iniquity of the Jews we made unlawful for them certain foodsgood and whole-some which had been lawful for them; In that they hinderedmany from Gods way that they took usury, though they were forbidden, andthat they devoured mens substance wrongfully, we have prepared for thoseamong them who reject faith a grievous punishment." 27
  28. 28. ISLAMIC BANKING TY.BMS There are certain orders from God and other prophets who believe inGod, which do not contradict in spite of great time lapses; therefore whatever isprohibited is prohibited no matter how much time has elapsed. Thus the Muslim people were made ready to accept the radical changeno the subject of usury and they were eager to know Gods final decision on thismatter. Even the third verse showed people the disadvantages of usury and toldthem how exploitative this system was.• In sura Al-I-Umran : "Ye who believer! Devour not usury doubled and multiplied; but fearGod that ye may really prosper" What we should not in this verse is the clear reference to the worstimages of usury in the pre-Islamic period as the worst type of financialagreement between two parties; thus it becomes clear to the Muslim how heused to sin against his own brother. But the picture does not finish here whenone thinks of the effect is has on society as a whole. Therefore, the Quran inthese three previous verses states the case as an outstanding problem and theMuslim knows, the Islamic way of solving this problem is radical and that itsrules cannot be constructed in any other way when it comes to the things whichare prohibited. The first thing which comes to mind when one thinks of usuryand its disadvantages is that it leads to economic and social pressure and leadsto paralysis of the efforts of those that lend because they just sit and wait fortheir money and reap the profits which is undeniably unlawfully earned money.Obviously the disadvantages of usury are vast and we can see from theeconomic situation of today that usury is one of the main causes of inflation, ifnot the main cause. It has direct negative impact on national economy. We seethat the rates of interest cause continuous increase in debit figure of allborrowing countries. Therefore, if we have to put an end to inflation then we 28
  29. 29. ISLAMIC BANKING TY.BMShave to deal with the problem of interest rates. This is one of the negativeaspects of usury and its effect on the economy but there are many other aspectswhich we are going to discuss. Usury creates a paralyzed group who sits andwait and therefore they refrain from the usual activities which might be of use tosociety. Usury also puts and end to informal borrowing and if usury becomescommon amongst people, human nature becomes avaricious and it becomesvery difficult for anyone to loan anything even to his own parents withoutexpecting something in return. Now that it is clear to us all how bad usury is so we are prepared toaccept some orders from God which prohibit the dealings in usury. We read in Sura Buqara(chp no.. 2) verse 275 " "Those who devour usury will not stand except as stands one whome theevil one by his touch hath driven to madness. That is because they say "trade islike usury, but God hath permitted trade and forbidden usury". Those who afterreceiving direction from their Load, desist, shall be pardoned for the past, theircase is for God to judge. But those who repeat the offence are companions of that fire; they willabide therein forever”. A marvelous description of the lender by usury and thekind of society made by so many people like this is to be found in this verse ofthe Quran. The verse 278 from same Sura puts an end to such transactions inorder to purify the human soul. 29
  30. 30. ISLAMIC BANKING TY.BMS "Ye who believe; Fear God and give up what remains of your demandFor usury, if ye are Indeed believers". Therefore, we are not allowed to take interest on capital no matter howlong the period of lending is. It is addressed to the believers and starts with the words those whobelieve and ends with the same words and anyone who deals with usury is thena non-believer as this verse is addressed to only those who believe. Those whoignore this are at war with God as clearly stated in verse 279 of Sura Buqara."If ye do it not,Take notice of warFrom God and His apostle;But if ye turn back,Ye shall haveYour capital sums;Deal not unjustly,And we shall notBe dealt with unjustly". The punishment for anyone disobeying this command is very serve.Other wrong-doings are punished during this life, but for usury the punishmentcomes during and after the life. The punishment is grave because the effects ofusury extend to the whole society and to the economy of the country and even tothe economy of the whole world so the punishment should be equal to theCrime. The verse covers the whole subject of usury and leaves no place fordoubt, confusion or discussion. By this He gives final solution to eradicate suchdealings in society. This verse of the Quran was reaffirmed by one of thesayings of the Prophet Mohammad (peace be upon Him) when he said that thosewho are involved in usury including those who take, give, write or witnesstransactions, would be demand. 30
  31. 31. ISLAMIC BANKING TY.BMS Thus we see that in prohibiting this evil transaction society is saved fromeconomic, social and moral disaster. In Islam other evils such as deceit,hoarding goods and exploitation are not given such prominence, as is the subjectof usury, as these are more obvious evils. But the subject of usury is given suchprominence as man can try to justify it and to make its presence in various ways. Ch4. Islamic banking: A variation of conventional banking? The Encyclopaedia Britannica defines a bank as “… an institution thatdeals in money and itssubstitutes and provides other financial services. Banksaccept deposits and make loans andderive a profit from the difference in theinterest rates paid.”.Islamic bank will fit thisdescription only just even if onereplaces ‘interest rates paid’ with ‘profit-shares and fees’.1Then what is thedifference between a conventional bank and this new form of bankingunderwidespread public discussion today? A bank is an institution because,similar to any others ocietally-sanctioned institutions such as an insurancecompany, a bank is heavily regulatedby a set of laws (seewww.hifip.harvard.edu) passed by a society in which the bank operates.Thesame is also true of the Islamic banks: see Mulijan, Dar and Hall (2004) oncapitaladequacy as an example of rules. In addition to the normal banking laws 31
  32. 32. ISLAMIC BANKING TY.BMSand prudential laws,an Islamic bank is supervised by a Shari’ah Board toenforce the application of fair-dealingand avoidance of a number of prohibitedfinancial transactions. Having thus given a simplebut yet satisfactory definition,the motivation for this paper is to introduce the quintessence ofIslamic bankingin the broader context of conventional banking to lay bare the essentialprinciplesand practices involved.First and foremost banking is a modern human inventionwithin the financial sector of aneconomy - as opposed to the real sector of aneconomy - with specific aims to fulfilthreesocially beneficial functions: (i)efficient payment system that expedites payments to be madeto parties toeconomic activities; (ii) intermediation function (see any standard bankingbookor for Islamic banking, see Chapra, 2002) that is to channel savings ofhouseholds in aneconomy to the producer units (businesses and government) forreinvestment as capital, ascarce resource of mankind; and (c) other financialtransactions, which are a whole range ofspecialised activities such as mortgagecreation, cross-border trade guarantee (letter or credit), securities trading such asin common stocks and others. The Islamic bank fulfils thesethree broadfunctions as well as does a conventional bank: Islamic bank alsoengagesinMonash Business Review Volume 3 Issue 1 – April 2007 2investmentfinancing, which a conventional bank generally avoids. An Islamic bank hasafourth function . 28 which is absent, to a large extent,in conventional banking.The above discussion of what a bank is but brief. In thelast 100 years, banks have becomemore specialised thus complex: it is also thecase with the Islamic banks over the last 40years, which has led to newerspecialised entities of Islamic banking-finance-insurance.Broadly definedfinancial transactions are performed by several specialised bank-likeinstitutions:commercial banks; investment banks; savings institutions; credit unions;bankholdingas well as financial-holding companies; development banks; and allof them areregulated heavily.2 In the case of Islamic bank-like activities too,newer form of financialactivities undertaken by banks are licensed separately;Islamic Mutual funds; Islamic IndexFunds; Islamic Development Bank; Islamic 32
  33. 33. ISLAMIC BANKING TY.BMSor Takaful Insurance; etc. In this article, not muchwill be discussed about thesespecialised forms of banking-financial entities.• Binding principles of financial transactions Ethical principle 1 is that the profits earned by a bank from its activitiesand returns made by abank to the depositors shall be (a) from sharing of risk inthe project and (b) profit-shareagreements and not pre-agreed fixed interestpayments, which is considered as prohibitedearnings because pre-agreed interestagreement has no sharing of risk of investment ofmoney.3 Principle 2 is theavoidance of financing any economic activity considered not in thelong-terminterest of society (examples are prostitution; gambling; production and saleofliquor for intoxication; etc).4 Principle 3 is avoidance of earnings fromextremely uncertainrisky financial activities bordering closely to a level of riskof loss of money as in gambling:this principle arises from the mandate inKoranic law that requires parties to contracts to avoidextreme risk.The firstprinciple is identified as avoidance of interest receipts and payments in financialtransactions as agreed among contemporary jurists’ interpretation since the1960s.6 InearlierIslamic era, this principle was enunciated as avoidance of usuryor excessive interest (riba)and there is a continuing debate about this questionamong the Muslim jurists as well as layscholars (a long line of commentatorsfrom Aristotle to modern day Benjamin Franklin and achairman of Bank ofEngland) on how to deal with what is interest and what is excessiveinterest.29Although for practical purposes today, avoidance of any form of interestreceived orpaid is considered as a must in Islamic banking, a position that hasled to the devising Islamic banking as a solution. In place `of a pre-agreedinterest payment/receipt, a pre-agreedprofit-share formula conditional on theoutcome of the end-result of financial lending activities– by sharing inriskisconsidered as permissible in Islamic banking.The second principle is akinto the enunciation of a pro-society social movement in recenthistory. In the 33
  34. 34. ISLAMIC BANKING TY.BMS1970s in the U.S., there was a movement that started ethical investmentfunds,and created what were then termed ethical mutual funds. That movementalso considerefinancing anti-societal activities (as well as investment by fundsin firms producing weapons ofmass destruction) as not-pro-society. An Islamicbank will not engage in financingactivitiesthat are considered unequivocally as illegal (haram) for an adherent to Islam.Hence, nofinancing activities considered anti-society arepermittedinfinancialtransactions.The thirdprinciple is that a contract of financialservice must have upfront all dangers pre-announced ordeclared: that is, as inmodern finance, there ought to be transparency in financial contractsthat reducesasymmetric information advantage of parties to the contract. Hence, itisconsidered that a contract that is likely to result in loss of capital, and the levelof risk (garar)borders that of gambling (gain always for the gas operator, and asure loss for almost allothers), an Islamic bank is not permitted to offer such afinancial product.Monash . 30• Operations First, by practice over many centuries, certain forms of financialtransactions have been vested as consistent with this form of banking. The over-riding criteria are: is money begetting money without risk-sharing?; is the socio- 34
  35. 35. ISLAMIC BANKING TY.BMSethical value of a financial transaction prosociety?By answering these twocritical criteria, new products are being financially engineered in addition to theones that had existed in historical time. What a bank is as a business can beconceived by referenced a balance sheet of a banklikebusiness: see Chart 1. Onthe left side of the balance sheet (which describes the financial position of abank at the end of, say, a year) are the assets that earn income. These are theloans marked A (that offer interest income to a conventional bank and profit-share income ton Islamic bank). Fixed assets are marked B (some of which, forexample, the office space, issued to produce the financial products and serviceswhile some assets may provide capital gains if owned by a bank while such abuilding also saves the rent that needs to be paid).While a conventional bankwould call loan as shown in the Performa as an earning assets from makingloans, an Islamic bank would not call it a loan asset, and may prefer to call itfinancing or profit-share agreements as loan has the connotation of interestbeing attached tout. A and B together add up as the total assets of a bank bait aconventional or an Islamic bank: how these items are classified are controlledby the accounting standards: for Islamic banking standards, see Rifaat (2001).The Sample Balance Sheet of a Banking BusinessA : loan C : DepositsB : fixed assets D : CapitalTotal assets. = Liability’s + equity Item C on the right-hand side is the deposit from the members of thepublic either as time/savingsdeposits or checking deposits In the case ofchecking deposits for safekeeping and convenience(wadiah), no return isguaranteed: however, an Islamic bank may make ex gracia payments, whichispermitted. 31 35
  36. 36. ISLAMIC BANKING TY.BMSIn that case, in a conventional bank, a time deposit will earn a small interest pre-agreed withthe depositor while, in an Islamic bank, the depositor receives aprofit share declared at the end of eachmonth on the basis of profits made on the deposits by the bank if the loan isprofit-share basis(mudaraba) or joint venture return if on joint venture basis(murabaha).A point to remember here is that, by engaging in profit-sharingfunding/financing agreements, the fundprovided Islamic banks thereby takes onthe character of “investment” which a conventional bank doesnot do. Pleaserefer to Footnote No. 1 for elucidation. If the deposit is a checking account, thenanIslamic bank ensures its safekeeping and return, but does not guarantee areturn although the bank isfree to make a donation; most conventional banksused to pay nothing, but since the 1980sItem C on the right-hand side is the deposit from the members of the publiceither as time/savingsdeposits or checking deposits In the case of checking deposits for safekeepingand convenience(wadiah), no return is guaranteed: however, an Islamic bankmay make ex gracia payments, which ispermitted. In that case, in a conventionalbank, a time deposit will earn a small interest pre-agreed withthe depositorwhile, in an Islamic bank, the depositor receives a profit share declared at theend of eachmonth on the basis of profits made on the deposits by the bank if theloan is profit-share basis(mudaraba) or joint venture return if on joint venture basis (murabaha).A pointto remember here is that, by engaging in profit-sharing funding/financingagreements, the fundprovided Islamic banks thereby takes on the character of“investment” which a conventional bank doesnot do. Please refer to FootnoteNo. 1 for elucidation. If the deposit is a checking account, then anIslamic bankensures its safekeeping and return, but does not guarantee a return although thebank isfree to make a donation; most conventional banks used to pay nothing,but since the 1980s. 36
  37. 37. ISLAMIC BANKING TY.BMSTable 1: A Simple Classification of Islamic BankingUsing Financial StatementsFinancial Statement items CONVENTIONAL BANK ISLAMICBANKPanel A: Performance of a bankProfit & LossNet interest incomeFinancial services incomeCapital gainsLess-Operating expenses-Amortisation of goodwill-Charge for doubtful loans= Gross Profits- Income taxes= Net ProfitsNet income (profit shares)Financial services incomesCapital gainsLess-Operating expenses-Amortisation of goodwill-Charge for doubtful loans= Gross Profitsa- Income taxes 37
  38. 38. ISLAMIC BANKING TY.BMS= Net ProfitsaPanel B: Financial Position of a BankBalance SheetAssets:≡ Liabilities andShareholder capitalLoans and Advances(after provisions for NPL)Fixed assetsTotal AssetsTotal Risk-weighted AssetscDeposits & other borrowingBonds, notes & subor debtFloating Rate NotesOrdinary SharesEquity instrumentsTotal EquityLoans & Advancesb(after provisions for NPL)Fixed assetsTotal AssetsTotal Risk-weighted AssetscDeposits & other borrowingBonds, notes & subor debtbFloating Rate NotesbOrdinary Shares (musharaka)Equity instrumentsTotal Equity (musharaka) A Income earned by an Islamic bank is from profit-shares, services feeand the excessover all expenses.b Can be any or all of: profit shares 38
  39. 39. ISLAMIC BANKING TY.BMS(mudarabah); cost plus services (murabaha); joint-venture(musaraka);safekeeping and leasing of assets (ijarah).c This refers to therequirement of both conventional and Islamic banks to risk-weight the assets asper Basel I or IIaccord. These accords (wadiah); at the Bank for InternationalSettlements (BIS) in Basel Switzerland requires that the value ofassets are adjusted downwards by a system of risk evaluation of the assets sothat the adjusted figures could thenbe compared as assets adjusted to account forrisk.Please note that the spelling of the concepts used in this paper vary as in theliterature. I have chosen the mostsimple spelling to keep this readable, thusincurring the mistake of incorrect pronunciation.The Table includes twofinancial statements: Panel A refers to the performance of a bankover areporting period (Profit and Loss); and Panel B is a financial position.The of areporting period in a balance sheet.A conventional bank reports netincome on loans net of interest paid to the depositors andloan capital providers.An Islamic bank does not accept or pay interest but reports net incomefromprofit-shares agreements (see footnotes “a” and “b” to the Table for the Islamicbankterms used) and fee incomes from sale-like or lease-like or bankingservices fees. Profit shareincome may be from different forms of lending (morecorrectly financing) activities such asprofit shares (mudarabah) or joint-venture(musaraka) or some specialised form of financingnot described here. Or it maybe from services fees for safekeeping (wadiah), cost plusservices (murabaha,and leasing of assets (ijarah). One final item (not shown in the pro-formaabove)is a portion compulsorily deducted from profits for charitable purposes. Inpractice itamounts to a tiny fraction of the pre-tax profits.Continuing the otheritems in the Panel A, all items are similar, but for the exception we havenotedthat the entire report is conditional on income reporting that (i) avoids interest,(ii)financing activities that are not in the long-term interest of society (no fundsfor liquorproduction for consumption, no gambling, etc.) and (iii) prohibitionsof financial products withextreme information asymmetry bordering near 39
  40. 40. ISLAMIC BANKING TY.BMSgambling, hence dangerously risky as aninvestment. Looking at the balancesheet in Panel B, the Islamic bank would have the sametype of entries (theactual items will have some technical terms equivalent to them).Depositsand other borrowings would mean that these borrowings are consistentwith the threeprinciples discussed earlier: for example a bank may hold a bond,and but it is called a sukukbond as it is issued with no pre-agreed interestcoupons as is the case in conventional bondsthat offers a pre-agreed interestpayment. There are finer points to consider here. The issuerof sukuk (say acentral bank) has some real assets, which provides periodic rentalincomes,which income is then used to provide returns to the investor in a sukukbond. Similarly, theequity may be referred to as the musaraka fund but it meansexactly the same as equity.The identical nature9 of the column entries to explainthe terms in Table 1 for the conventionaland the Islamic banks may convinceonce again that the latter is a newer form of banking. As such it is yet anotherspecialised bank offering newer products in the same way as investmentbankingstarted to offer opportunities for securitisation of assets some decades ago.Newerforms of banking fulfil the demand by clients who would not otherwiseparticipate in thebanking activities of a typical conventional bankIslamic banks provide for their clients secularsatisfaction that their financialactivities is carried out in a manner that is socio-ethicallyconsistent with theirbeliefs of avoidance of interest (riba), pro-societal financing(non-haram)andavoidance of extreme risk (garar). The nature of profits therefore takes adifferent formfrom than the pre-agreed, pre-fixed, non-risk-shared rewards thathas been promoted by thefinancial institutions for four centuries. Over the historical time, banks have tended to seek profits bydistancing their monitoringfunction by going from fixed to variable interest, andswitching from engaging in monitoringaggressively to securitising their riskyproducts and taking such products off the balancesheet. This results in firmswith bank loans relaxing their management oversight or in somefamous casesengaging in outright fraud unknown to the bank that lends! These 40
  41. 41. ISLAMIC BANKING TY.BMSmoderninnovations have tended on the other hand to reduce the burden imposedby modern andcomplex societies on banks to perform the function of delegatedmonitors. It must also besaid that the same forces have diminished the socialresponsibility of modern banks, andhelped them to be more focused on profitswithout due consideration of the end-use to whichthe humanity’s accumulated scarce capital is being deployed. From the outsethistorically,banks have not been conditioned to promote broader social goals.10Is ethical banking thewedge that would make banking more sociallyresponsible?Term Structure of Investment by 20 Islamic Banks, 1988Type of Investment Amount* % of TotalShort-term 4,909.8 68.4Social lending 64.2 0.9Real-estate investment 1,498.2 20.9Medium- and long-term investment 707.7 9.• Contemporary scene In this context, Islamic banking with its orthodoxy may appear to be arevisionist banking. Yes, it is and if the customer requires that, the banks arewilling to provide that service wholeheartedly. Islamic banking is growing at arate of about 15% per annum, about four times faster than conventional banking:see Islamic Development Bank website and Internet sources. From just ahandful of institutions mostly in the Arab countries in the 1960s, it hasinnovated itself to be accepted by the bastions of banking in England andSwitzerland. Both these countries appear to be doing the big-ticket Islamicbanking and their major banks have begun to join in the chase for a slice of the 41
  42. 42. ISLAMIC BANKING TY.BMSbusiness: Citigroup; HSBC; UBS; DresdnerBank;ABN-Amro are the big ticketbanks doing large-ticket banking and, importantly, having the expertise tofinancially engineer new products that are exciting for the customers withdeeper pockets but demanding Islamic financial products. There are about 400-over banks licensed as Islamic banks or many have operating divisions with aShari’ah Board in about 44countries or more. The total assets of these banks areestimated at around US$ 7 trillion witan equity capital base of some US$ 400billion.11.A number of institutions have been organised to supervise thesebanks. Apart from theircompliance with the laws (licensing-operation laws;prudential supervision laws; international supervision rules), these supra-national bodies provide a degree of standardization in accounting treatments ofnumbers (Accounting and Auditing Standards Organization for IslamicFinancial Institutions, AASOIFI); in financial service provision (IslamicFinancial Services Board, which also works with the BIS on Basel II, and oncapital adequacy). The Islamic Development Bank (IDB) is anotherorganization that promotes this new form of banking. An international bodynamed General Council for Islamic Banks and Financial Institutions (GCIBFI)is a self-regulating information gathering body that promotes some degree ofhomogenization of this new form of banking-finance-insurance. On the trainingof human resources, not much has been done till recently as the provisionIslamic finance expertise has been left to the private sector with very fewcountries or institutions (exception are Indonesia, Malaysia and IslamicDevelopment Bank) allocating resources for.the very specific purpose of training in this new form of banking. The scholarstrained in religious studies has adequate training contracts based upon theinterpretations of legal schools in Islam. There are plenty of resources in thisregard since Arabic studies and religious studies have been adequately cateredfor in major universities. However, training in banking, finance and insuranceremains inadequate. In 2006, a body has been formed (INCEIF for InternationalCentre for Education) 42
  43. 43. ISLAMIC BANKING TY.BMS• Risk Management Issues in Islamic Banking In the following pages, we’ll look at examples ofsome different risks faced by Islamic banks• Impacts of shari’a compliance on credit, market, andoperational risk• Not exhaustive list of all unique Islamic risks• Based mainly on observations in Saudi Arabia andGCC• Islamic law – shari’a – has several clearProscriptions on financial activity• The requirement to pay zakat• Prohibitions on financing prohibited activity, suchas alcohol or prostitution• Prohibition of:– Qimar (gambling)– Myisur (deceptive gaming)– Gharar, or speculative outcomes– Riba, usually translated as interest• Riba implies unfairly getting a return on funds• without sharing in the risk• Riba comes from the root for ‘increase’ or ‘grow’ –meaning increase in money value in and of itself• Early Muslim scholars considered money a symbol ofvalue but not a store of value in itself 43
  44. 44. ISLAMIC BANKING TY.BMS• An increase in money without an underlying increasein the value of the symbolic good was unfair • To most observers, riba sounds like interest on debt• A few scholars believe that riba means usury, i.e.inequitable interest rates• The great majority of scholars define riba more closelyto interest – rent on money• Concept of risk sharing – i.e. if enterprise loses money,unfair to expect the same back• Seems to rule out classic deposit-taking and lendinginstitution• At first glance, seems classic division between debt andequity, but in fact more complicated. • Commercial and investment banks are separated by • the difference between debt and equityCommercial and investment banks are separated bythe difference between debt and equity• I give you a loan of 100• I expect 100 back, no matterwhat• I am willing to accept alower (but sure) return inexchange for myexpectation 44
  45. 45. ISLAMIC BANKING TY.BMS• I give you equity of 100• I share in your ownership• I expect to participate in the upsand downs of your enterprise• But I have a much greater(unsure) upside potential tocompensate me for my risktakingCommercial Banking Intermediary Investment Banking Intermediary • Most governments distinguish between deposittaking • banks and investment companies• Until recently, the Glass-Steagall Act segregated UScommercial banks from investment banks• In most countries, including Saudi Arabia, separateagencies regulate each – conventional or Islamic. • We all know there is not a hard line between debt • risk and equity risk• The two are increasingly blended and interdependent• Low risk equity may be safer than high risk debt• But contractually they differ – and deposits above allare seen as different. 45
  46. 46. ISLAMIC BANKING TY.BMS • Governments are universally keen to protect • depositors• When deposit-taking banks fail, especially systemically,governments typically protect depositors• The Basel accords (I and II) evolved to agree on a globalapproach to assigning bank capital to risk. • In the following pages, we’ll look at a few bank • credit products, as well as some broader risk issues • Islamic banking Products. • The classic murabaha is closest to the risk profile of • a standard bank credit. Client specifies goods to be purchased, e.g. raw material or capital goods. Contracts with Bank to acquire on client account. • Bank buys goods and acquires title of ownership from seller. • Client takes delivery. Client contracts to pay on deferred basi.• May be over 90% of assets in some banks• Very high in consumer lending, with most creditsguaranteed by garnished salaries• Believed to be over 80% of total system Islamic credits• Remainder mainly ijara (e.g. cars) in consumer andmusharaka in corporate• Not often widely touted, since many feel this is not the most ideal Islamic investment. 46
  47. 47. ISLAMIC BANKING TY.BMS • Most important, the bank must own the asset, even • if momentarily• If ownership does not pass through the bank, becomes a cash loan – and so haram• The degree of proof of ownership differs by Shari’s Board, and so with it the risk. • Payments may not include interest, however finance • charges may be included in the installments• Not charged separately (as is interest) but as part ofTotal fees.• May reflect prevailing interest rates, as a marketReference. • If a murabaha defaults, the Bank cannot • compensate itself by running penalty charges• Otherwise it would be riba• Shari’a Boards feel differently about levying a onetime late fee. 47
  48. 48. ISLAMIC BANKING TY.BMS • In Saudi Arabia and the GCC, a large share of • transactions are commodity murabaha• Back-to-back commodity trade which effectively permitsa cash deposit or a cash credit• For foreign currency, typically on London CommodityExchange (copper, palladium, etc.)• For domestic currency, may be with local broker (e.g.rice, coffee)• Interbank placements are usually commodity murabaha• Most consumer credits and many corporate credits arestructured in this way. • The direct credit risk of a tawarruq is similar to a • conventional cash credit, but with some added risks• The extra group of contracts adds operational risk,which may lead to other risks– Market risk (e.g. settlement risk)– Credit risk (e.g. counterparty risk)• Again, the degree and timing of ownership requiredchanges the risk• Similar to simple murabaha, penalty charges may notbe added. 48
  49. 49. ISLAMIC BANKING TY.BMS • Ijara are leases and their risks are comparable to • conventional leases• Bank owns asset, with all that implies• Often must be in separate leasing company• If leased to purchase, economically very similar to aconventional credit• Financial charges may be built into rental fees• Mainly used for cars, but some attempt to set upijara to buy homes• May be set up to be variable rate – re-priced againsta reference rate• Less popular among corporates, due to zakatDisadvantages. • Treasury risksTreasury and, more broadly, market riskmanagement is complicated by shari’a compliance• Most derivative contracts typically not permitted– Swaps (e.g. foreign exchange)– Options• Some synthetic products have been created and arebeing tested in more liberal regimes• Strong need for shari’a compliant instruments tomanage liquidity: 49
  50. 50. ISLAMIC BANKING TY.BMS– Short-term placements and borrowings– Government and investment grade sukuk Ch .5 RESPONSIBILITIES OF ISLAMIC BANKS In fact, Islamic banks have a major responsibility to shoulder for the fateof the community and for rescuing it from the threats posed by economicproblems confronting it. In view of this responsibility, emphasis must be laid inthe forthcoming stage on a number of points, the most important of which are asfollows:-1. Enforcing the teachings of Islam in all transactions concluded provided that all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching and Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God, the Almighty, for the purposes allowed in this worldly life.2. Stressing that spiritual and religious values and good conduct and behavior are the essential prerequisites for the happiness of the community, and that any amassing of funds and any capital growth at the expense of our Islamic ideals are contrary expense of our Islamic ideals are contrary to divine laws and in the process are destructive to the human community. 50
  51. 51. ISLAMIC BANKING TY.BMS3. Advising Muslims to develop savings and savings habit regardless of how small such savings are, since through the promotion of saving awareness Muslims will be able to plan their development projects.4. Seeking to improve the economic and social standards of Muslim peoples and realization of solidarity and social cohesion among them.5. Striving to set up Islamic financial institutions and promoting them throughout the world in order to achieve their missionary role and in order to complement the services needed by Islamic financial institutions.6. Establishment of Islamic financial markets such as Islamic stock market and commercial centers and introducing such other financial instruments required for the recycling of capital.7. Seeking to establish an Islamic common market which is believed to be one of the most important means leading to the cohesion of Islamic peoples, eliminating barriers between them and eventually benefiting from their capabilities. 51
  52. 52. ISLAMIC BANKING TY.BMSCh6. GROWTH OF ISLAMIC BANKING 52
  53. 53. ISLAMIC BANKING TY.BMS In 1975 the first Islamic commercial bank opened for business in Dubai,United Arab Emirates under the name of Dubai Islamic Bank and within twelveyears the number of Islamic banks grew to almost sixty. And interested observerwill note that the balance sheets of these banks showed a rapid and steadygrowth when we compare the figures for the two Hijri year 1405 and 1406. Inspite of the prevailing economic recession in the world, Islamic banks recordeda remarkable growth in the items of their balance sheets. Information obtained from the International Association of Islamic Banks(IAIB) indicates that the consolidated total balance sheets of Islamic banks rosefrom US$ 7,548.3 million at the end of 1405 to US$ 8,787.4 million at the endof 1406, and increase of US$ 1,239.1 million or 16.4%Total customer depositsat the end of 1406, were US$ 6,683.8 million, compared with US$ 5,752.3million at the end of 1405, showing an increase of US$ 931.5 million or16.2%Shareholders equity recorded and increase of US$ 90.7 million. It rosefrom US$ 784.6 million at the end of 1405 to reach US$ 87.3 million at the endof 1406, showing an increase of 11.6%. • SPREAD OF ISLAMIC BANKING 53
  54. 54. ISLAMIC BANKING TY.BMS This advanced and remarkable trend is accompanied by anothernoteworthy development, which is reflected in the diversity of the geographicalareas where Islamic3 banks are based. Within a few years they managed tomake their presence felt in three of the worlds major continents, namely Asia,Africa and Europe. This geographical diversification serves as proof of the viability of theIslamic economic system for every geographical region. In addition, it will serveto enhance economic co-operation based upon Islamic law (Shariaa) amongstthe peoples of these continents. This will undoubtedly give Islamic economy afurther boost and significant dimensions in actual practice and application. • SURVIVAL OF ISLAMIC BANKING Islamic banks have succeeded within a brief span of time in influencingexisting methods of business dealings in the world capital market and to createnew investment channels that are acceptable to and recognized by Muslims andnon-Muslims. This phenomenon has been of special interest to internationalbanks which respond to this Islamic revival by introducing specialistdepartments for studying this emerging trend and for creating channels for co-operating with Islamic banks. Furthermore, they have gone as far as to alter theiraccounting policies in order to cancel their interest calculations from theiraccounting systems. Instruction were given to their accounting departments todo without the element of usury in term of "giving and taking". Parties doing business with Islamic banks have shown mounting interestin their proposed financial transactions, which reflect the tolerance of Islam andits response to the needs of the community. Moreover, such transactions arebelieved to be the most regulated manner for the management of funds by wellconsidered and planned practices. 54
  55. 55. ISLAMIC BANKING TY.BMS While conventional banking institutions basically rely on thecreditworthiness of the borrower and the size of the available securities providedby borrowers, Islamic banks pursue another policy that does not ignore theborrowers credit-worthiness and his financial reputation but at the same timethey do not overestimate these factors. They pay more attention of the feasibility of the proposed project, howbeneficial it is to the community and the management and scientificqualifications enjoyed by the persons proposing a particular project.Even wherethe borrower lacks the necessary financial capabilities and securities but has thenecessary management and scientific qualifications guaranteeing the success ofa well planned project, an Islamic bank will participate as a financial institutionproviding the necessary funds that will be combined with the efforts andavailable know-how of the parties proposing the project. In this Islamicmodaraba (participation financing), so that the Muslim community or even theglobal community will not be deprived of a project that is beneficial to thewhole world. 55
  56. 56. ISLAMIC BANKING TY.BMS Ch.7 Islamic banking is not for Muslims alone Filed under: Islamic Banking News, Qatar The Qatar International Islamic Bank (QIIB) is keen to tap the vastexpatriate population in the country, non-Muslims in particular. QIIB strategistshope to reach out to the expatriate communities by spreading general awarenessabout Islamic banking. Islamic banking is not for Muslims alone. This is thefirst and foremost thing that needs to be made clear, says Abdul Basit Al Sheibi,general manager of QIIB. The basic difference between conventional andIslamic banking is that the latter’s focus is on making a society savings-orientedrather than encouraging people to spend. “In that sense, you can say that Islamicbanks basically follow the concept of investment banking as they do not preachand encourage spending,” stresses Abdul Basit. And, that is precisely the reasonwhy Islamic banks do not lend. That they do not deal in interest-based banking,is common knowledge. QIIB, says the general manager, is the only bank in thecountry that shares profits with customers four times in a year, on a quarterlybasis. Other banks disburse returns twice a year. Return by way of profits is 4.25per cent annual on term deposits of a year. The percentage is four for six-monthdeposits and 3.5 and 3.25 per cent, respectively, for three and one monthdeposits. 56
  57. 57. ISLAMIC BANKING TY.BMS Savings bank deposits carry a return (profits) of three per cent a year.Anyone can open term and savings deposit accounts with QIIB, says the GM.As conventional banks have been permitted to set up Islamic banking windowsand some have been allowed to open full-fledged Islamic banking branches inthe country, the competition has become fierce.“It is a good sign, though, for the opening of so many Islamic banking windowsand branches point to the fact that there is growing demand for its products andservices,” says Abdul Basit. Additionally, the competition has prompted us tolearn and enhance our own products and services, he adds. Qatar was the onlycountry in 1991 to have two Islamic banks, he said. Islamic banking is growingat a rate of 15 per cent worldwide annually. The figure is much lower fortraditional banks. There are an estimated 235 Islamic banks in some 40countries, including outside the Muslim world. Their total assets were worth$250bn until recently. However, with the opening of Islamic banking windowsand full fledged branches by some conventional banks around the world, theassets have risen to $350bn presently, said Abdul Basit. Bahrain continues to bethe country with the maximum number of Islamic banks. 57
  58. 58. ISLAMIC BANKING TY.BMSCh.8 India is the Best Contender for Islamic Banking-- Dr. Hussein Hamid Hassan, Chairman Dubai Islamic Bank Looking at its past, the present economic growth, and the future withManmohan Singh, the world renowned economist as its Prime Minister, Indiabecomes the best contender for the Islamic Banking and Finance, opined Dr.Hussein Hamid Hassan, father of Islamic Banking and financial products,opined in Mumbai on December 3. Speaking at a Consultation Meeting withprofessional bankers, conventional as well as Islamic, organised by the IslamicBanking Committee Jamaat-e-Islami Hind, Dr. Hassan explained that IslamicBanking is the most equitable form of financing since it enables the creation ofwealth without fuelling inflation or stoking financial crisis. He also believed thatintroduction of Islamic Banking in India would attract billions of dollars intoIndia. Detailing about the Islamic banking and financial products likeMurabahah and Mudarabah which can convert a failed conventional bank into a 58

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