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  1. 1. ISLAMIC BANKING AND FINANCE IN THE CONTEMPORARY WORLD DISSERTATION Shakeel Ahmad ( Facilitator: Dr. H. K. Pradhan ( Executive Post Graduate Program (Ex-PGP) in Management XLRI (, Dubai ( Approved for submission: February 2004 Acknowledgements I am grateful to Dr. H.K. Pradhan, my guide, for his continuous encouragement that enabled this study of a subject that had remained within my heart, since early ages. His teachings of International Financial Management provided insights beyond theoretical concepts, and his friendly style inspired the quest for excellence. I am thankful to XLRI, an institution that provided me with the opportunity to pursue this post graduate study in management, for which this dissertation project was undertaken. I take this opportunity to express my sincerest gratitude to all the members of Islamic Banking and Finance Community (IBFnet) in the Yahoogroups mailing list. Islamic finance community has worked hard in providing a wealth of resources on the internet. They deserve appreciation and rewards from no less an entity than Allah SWT Himself. Special thanks go to Dr. Obaidullah, the IBFnet’s founder. This dissertation work would not have been possible without the special help and encouragement from Dr. Shahid Ebrahim – it is difficult to express my special thanks for him, in a few words.
  2. 2. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Finally, the time that I devoted on the Ex-PGP, and this project, was taken away from my family whose support acted not only as facilitator but also was a source of continuous inspiration. Exploratory Channel: Sequence Title Pag e 1 Introduction 3 2 Why Islamic Banking? 4 3 Islamic Banking and Finance (IFB) Sector, now 6 4 Why is Islamic Banking and Finance (IBF) creating ripples? 6 6 Literature Review 7 7 Islamic Banks 10 8 Brief History 11 9 Concepts behind Islamic Banking and Finance 13 10 Distinguishing Features 13 11 Role of Islamic Banks 14 12 Prohibition of Interest 14 13 Table-2: Comparison between Riba and Profit 15 14 Table-3: Differences between Islamic & Conventional Banking 16 15 Key Islamic Financial techniques/ Products 17 16 Box-1: Islamic Financial Instruments 19 17 Islamic Derivative Products 21 18 Advantages of Islamic Finance 21 19 Box-2: Landmark Islamic finance deal inked 23 20 Perceived Disadvantages of IBFs 24 21 Impediments to the growth of IBFs 24 22 Recommendations to counter Impediments to growth of IBFs 36 23 Latest Developments 38 24 Box-3: How Islamic is Bank Negara’s IIMM? 40 25 Islamic Bonds (Sukuk) Funds 41 26 Box-4: Conventional Investors find Islamic Bonds attractive 41 27 Box-5: US$250 Government Islamic Leasing Securities 42 28 Box- 6: Islamic Development Bank launches bond issue worth $400m 43 29 Box-7: Latest Trends & Challenges 45 30 Box-8: Bahrain: LMC to issue $1.2b bonds 46 31 Rating Agencies 48 32 Basel II Implications 49 33 Important Institutions 49 34 Conclusion 51 35 References 54 36 Appendix-A0: Estimation of TAI for UAE 59 APPENDIX-A: Competitiveness of Banking Sector In Case of Opening Local 37 59 Markets to GCC Banks 38 APPENDIX-B: Islamic Financial Institutions in the World 61 Submitted by: Shakeel Ahmad Page 2 of 77
  3. 3. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus APPENDIX-C: Islamic Equity Funds in the World 39 68 40 APPENDIX-D: The Dow Jones Islamic Market Indexes 72 41 APENDIX-E1: Assets, Deposits and Loans of 53 Conventional local Banks in GCC 73 42 APENDIX-E2: Assets, Deposits and Loans of 8 Islamic local Banks in GCC 74 Introduction: To start with graphics may not be a novel idea, but if you are associated in any way with promoting deposits or instruments of a conventional bank anywhere in the world, these graphics must already have left some alarm bells ringing in your mind. 32.83% CAGR in Deposits and 24.69% CAGR in total assets over a four-year period in a country which was written off the books of financial wizards and stock-market punters after the Asian Currency Crisis. In figure–1, the rapid rise can be seen not in one aspect but in all major aspects of banking and finance reinforcing the belief that the growth rate witnessed was an all encompassing one. The question that arises at this moment is whether this growth rate is 450,000 18,000,000 400,000 16,000,000 350,000 14,000,000 300,000 12,000,000 250,000 10,000,000 200,000 8,000,000 150,000 6,000,000 100,000 4,000,000 50,000 2,000,000 0 0 1998 1999 2000 2001 2002 Deposits from Customers Financing of Customers Investments Revenue Total Assets Fig-1: Revenue (RM '000) (Left Scale) and Assets/ Investments/ Financing/ Deposits (RM '000) (Right Scale) for Bank Islam Malaysia Berhad (BIMB), Malaysia’s oldest Islamic bank (established on July 1st 1983) Source: BIMB Annual Report 2002 sustainable. An answer to that would be premature without looking at the reasons behind this phenomenon, and whether the same success story is repeated anywhere else in the world. We will try to answer some of the above questions, and also try to see if the growth in Islamic banking and finance sector could have been better. If yes, we will try to peep into the reasons behind less than expected growth. Much has been written by historians about the feudal lords who by virtue of charging high interest rates controlled those in desperate need to finance their survival. Financial clout led to political clout and ended up in enslaving the masses. Before the historians touched upon this exploitation of the masses, religious scriptures had already warned of usurious acts existing in the society. In the Old Testament (King James Version), Exodus, Chapter 22, verse 25: If you lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury. Submitted by: Shakeel Ahmad Page 3 of 77
  4. 4. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Leciticus, Chapter 25, verses 34-36: And if thy brother be waxen poor, and fallen in decay by thee; then thou shalt relieve him: yea though he be a stranger, or a sojourner, that he may live with thee. Take thou no usury of him, or increase: but fear thy God; that thy brother may live with thee. Why Islamic Banking? The New Testament also contains edicts on the same line. Thus the very mention of usury and the suggestion to avoid indulging in this act in Judaism and Christianity implies its existence in ancient times and the ills that it carried along for the society. Despite the warning against this practice, the system prospered. Modern financial system learnt a lesson from these religious warnings and tried to adopt a system that limited the extent of usurious exploitation to a great extent. By creating a market for debt, based upon ‘perfect competition’, it propounded an end to exploitative nature of usury and thus evolved the system of interest rates which was supposed to be determined by the market forces freely competing with each other. What we see today is an expansion of the ancient feudal system into a global arena with nations facing the same plight as did individuals earlier. From the traditional Jewish lending system of the Shylocks to the Indian feudal system, there is no need to strain our memories much. What is definitely cause for stress is the false claim of the contemporary world order to have relieved the masses of this burden of debt. Figures 2a and 2b show how countries, instead of individuals, are getting trapped into slavery. There is no doubt that Debt to GDP ratio is a robust indicator of the Debt burden of countries. If we compare the ratios that triggered the 1980s Debt crisis with the levels being experienced, now, we can see that the situation is no better, and could be enough cause for the unipolar world of the day. Despite the claim that modern interest-based system is not exploitative or usurious, because the interest rates or debt-service payments are within limits, Figures 2c and 2d provide a different picture altogether. Submitted by: Shakeel Ahmad Page 4 of 77
  5. 5. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus F Fig-2a: Debt to GDP Ratios for Developing countries & HIPC Fig-2b: Debt to GDP Ratios of crisis-ridden c countries during the Debt Crisis of 1980s F Fig-2c: Amortization payments Fig-2d: Interest Payments Source: For Fig-1a: IMF World Economic Outlook 1999 & 2003- Statistical Appendix; For Fig-1b: Sachs and Larrain (1993) The transition of the world from a multipolar world order to a unipolar one has not been without pain and suffering. It is not easy to emphatically pronounce that the cause for this has been the interest-based system, but nobody should doubt that the cause has been the financial system as a whole. Interest-based system is one component of the economic system where the concept of money itself, as a worthless piece of paper carrying immense power, may be ill- conceived. Submitted by: Shakeel Ahmad 7 Page 5 of 77
  6. 6. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Fig-3a and 3b: Interest rates and export prices in Latin America (1972-1986) Source: Andres Bianchi et al., “Adjustment in Latin America, 1981-86,” in V. Corbo, M. Goldstein, and M. Khan, ed., Growth Oriented Adjustment Programs, Washington, D.C.: International Monetary Fund and The World Bank, 1987. Similarly, the argument that low interest rates cannot cause countries to lose their sovereignty also does not hold much ground. The diagnosis of the Debt Crisis of early 80s suggests that even low interest rates (Figure-3a), acting as a trap (particularly when they are floating rate, as majority of debt was) could cause countries to come down to their knees. Flushed with funds, due to the sharp oil price increase in 1973-74 leading to booming deposits by Oil-rich countries, international commercial banks were eager to lend at lower interest rates enticing the third world to borrow more and more. The debt burden measured by Debt-to-GDP ratio (Fig-2b) is an indication of the inevitable crisis that was waiting to happen. The urge to have a system that claims to provide a solution to such financial crises grows after every financial (monetary, exchange rate, stock market or Debt) crisis. It is not hard to understand that if the value of money carried its real worth, currency crises could be avoided. If the paper being traded in stock exchanges were actually trading at their genuine value, with no speculation, bubbles that occasionally burst would not exist. If the interest-free banking system could see the light of the day, no debt-crises would occur, as all the financing would be PLS (Profit-and-Loss Sharing arrangement of Islamic financial system). Islamic banking and finance based on the Islamic economic system must be taken seriously, therefore. This paper looks into the realities associated with this system which is growing at a much faster pace than its counterpart, and is making its conventional competitors stand up and have a look. The success of the Islamic system can be gauged by the rush among the conventional banks to open their own ‘Islamic windows’ not just in countries dominated by Muslims but also in rest of the world. Some of the Western banks already having dedicated Islamic subsidiaries are: Citibank, HSBC, American Express, ABN Amro, BNP Paribas, Bank of America, Stantad Chartered, Commerzbank, Barclays, Deutche Bank, ANZ Grindlays, Golman Schs, Royal Bank of Canada, Pictet & Cie, UBS, Flemings, Merrill Lynch and Kleinwort Benson. And the list is growing. With countries like Pakistan, Sudan and Iran adopting 100% Islamic Banking, the prospects of more countries to follow suit rising, the conventional counterparts cannot sit back and see their market share being eaten away. Islamic Banking and Finance (IFB) Sector, now: It is difficult to obtain exact figures on the size of the Islamic financial sector. Without doubt, it is small in comparison to the conventional financial sector but it is experiencing strong growth. Iqbal and Mirakhor (1999) report that Islamic banks grew from an asset base of $5 billion in 1985 to a level of Submitted by: Shakeel Ahmad Page 6 of 77
  7. 7. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus over $100 billion in the late nineties. The chairman of Dubai Islamic Bank and Emirati Minister for Financial Affairs, Mohammad Khalfan bin Kharbash, recently noted that the number of Islamic banks has grown from 34 institutions in 1983 to 250 today, operating and managing assets of $200 billion (Phillips, 2001). The annual growth rate for Islamic financial institutions varies from 15 to 40 percent annually (Hamwi and Aylward, 1999). Yet, a comparison of the assets of all Islamic banks to HSBC, just one of the world's largest banks with assets of $569 billion in 1999 (Azzam, 2000), demonstrates how small the Islamic sector remains on the world banking stage. Nevertheless, Islamic banking is spreading and gaining acceptance in both Muslim and non- Muslim countries. In 1999, the Middle East alone had 12 top-tiered Islamic banks with total capital of about $1.8 billion and assets of approximately $18 billion. Bosnia Bank International became operational in March 2001, positioned as a regional Islamic bank for the Balkan area, with wholesale and retail services in Bosnia (Carvalho, 2001). Many of the Islamic banks are gaining strength and achieving profits. For example, Al Rajhi Banking and Investment Corporation posted a net profit in 1997 of $347 million and return on capital of 25% (Hamwi and Aylward, 1999). Bank Al-Jazira, by far the smallest bank in the Saudi Islamic banking sector, grew profits by forty-one percent in 2000 (MEED, 2001). Why is Islamic Banking and Finance (IBF) creating ripples? Looking at the growth rates of IBF in comparison to the conventional banking, the reason may be obvious (Figure-4). 2002 2001 2000 1999 1998 1997 1996 -40% -20% 0% 20% 40% 60% 80% 100% 120% 140% Islamic Non-Islamic Fig-4: Proportion of Islamic Bonds in Malysia v/s Non-Islamic Bonds Source: Annual Reports of Bank Negara (Central Bank of Malaysia) and Authors’ calculations Malaysia being a pioneer in expansion of IFB products, our calculations for the CAGR for its leading bank BIMB (Bank Islamic Malaysia Berhard) between 1998 and 2002 yield the following results: Deposits grew at 32.4%, Investments at 39.3% and Total assets at 28.3%. It will be an impossible task for any conventional bank to match these figures during the period. For the sake of diversity in outlook, we compared the figures for two banks in UAE under the same ownership - National Bank of Abu Dhabi, a Conventional Bank and Abu Dhabi Islamic Bank, an Islamic bank. The results are even more astounding, as depicted in Figure-5. None of the Islamic banks yielded any negative growth rates during the period under study while thirteen conventional banks in terms of Loans, seven in terms of Assets and eight in Submitted by: Shakeel Ahmad Page 7 of 77
  8. 8. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus terms of Deposits reported negative CAGR. The data for all these banks are provided in Appendices-E1 and E2. Table-1: Comparison of CAGR for 53 conventional and 8 Islamic banks in GCC Financing (Loans) Deposits Assets Average CAGR (1999-2001) Local Conventional Banks 7.3% 7.6% 9.5% Local Islamic Banks 19.2% 21.4% 18.6% Western banks and financial institutions, like Chase Manhattan, J.P. Morgan, Goldman Sachs, Commerzbank AG, Deutsche Bank AG, HSBC, Citicorp and Bankers Trust, have joined the race for providing Islamic products, but they currently exist in trade and other forms of short- term finance, mostly. Independent financial institutions based on Shari'ah are also becoming common for the Western banks and financial institutions. Citicorp’s Islamic banking unit in Bahrain established in 1996 is an example. Standard Chartered Bank Malaysia Bhd. is planning to extend its Islamic banking services to become a total money management and financial provider within two to three years (The Star, May 17, 2001). From less than 10 Islamic mutual funds a decade ago to over 90, now, according to a report by Wall (2001), is no mean achievement. High-tech fever has not caused Islamic financial Web sites to crop up and grow along with Islamic Finance. 2,000 6,000 5,000 1,500 4,000 1,000 3,000 NBAD Loans ADIB Loans 2,000 Million $ Million $ 500 1,000 0 0 ( ) ( ) 1999 2000 2001 A National Bank of Abu Dhabi Abu Dhabi Islamic Bank C CAGR (1999-01)Financing (Loans)DepositsAssetsNBAD10.21%0.2%1 ( .2%A . ADIB50.12%69.1%51.45%NBD2.3%1 7.1%14.5%D 7 DIB27.3%31.1%28.1%Table-1: Comparison between Conventional and Islamic Banks of UAE Fig-5: Comparison between Conventional and Islamic Banks in UAE (National Bank of Abu Dhabi v/s Abu Dhabi Islamic Bank); Source: Annual Reports of respective banks Submitted by: Shakeel Ahmad Page 8 of 77
  9. 9. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Literature Review: The information on Islamic Banking & Finance is available in many forms, e.g., PhD dissertations (El-Bdour, 1984; Khan, 1983), books written by leading academics and practitioners (e.g. Homoud, 1985; Shirazi, 1990), published research in the form of reports (Ahmad, 1987; Iqbal and Mirakor, 1987) and journal articles (e.g. Erol and El-Bdour, 1989; Erol et al., 1990; Shook and Hassan, 1988; and Sudin et al., 1994). Because of Riba, Islamic banks have had to develop financial products which are not in conflict with the Sharia'h. The task has been achieved by creating a number of special financial products (Ali and Ali, 1994). Similar results can be seen when comparing Dubai Islamic Bank (Islamic) with National Bank of Dubai (conventional) – two banks under Dubai Government (Figure-6). Exceptionally larger growth for the Abu Dhabi Islamic Bank may be due to its short history – the bank might be growing at this unprecedented rate because it has recently come to fulfill the unsatiated need of the people of Abu Dhabi (or UAE). But, the growth rate of Dubai Islamic Bank, the oldest Islamic bank of the modern world, provides enough empirical evidence in favour of much larger growth rates for the IFBs. Another study of fifty-three conventional banks and eight pure Islamic IBFs in GCC, covering almost the entire population of local banks in the region yielded results on similar lines, as listed in Table-1. Fig-6: Comparison between Conventional (National Bank of Dubai) and Islamic (Dubai Islamic Bank) Banks in UAE S Source: Respective Annual Reports The main thrust of Islamic financial contracts is on profit and loss sharing, which can be deemed as equity (Musharakah) and hybrid (modified Mudharabah and Ijara) facilities (Ahmad, 1994). However, the risks of these vehicles are inherently higher than conventional ones as espoused by Ebrahim (1999). One definition of an Islamic Bank is a bank that, by its own choice, opts to comply with two sets of law: the law of the Land (Jurisdiction); and the Islamic Law (Shari'ah). This is why Islamic bankers have two types of legal counsel: traditional "lawyers" and "Shari'ah Councils" (Al-Bahar, 1996). "Islam is deeply concerned with the problem of economic development, but treats this as an important part of a wider problem, that of total human development. The primary function of Islam is to guide human development on correct lines and in the right direction. It deals with all aspects of economic development but always in the framework of total human development and never in a form divorced from this perspective" (Al-Harran, 1993). The Shari'ah specifies, inter alia, rules that relate to the allocation of resources, property rights, production and consumption, and the distribution of income and wealth (Iqbal and Mirakhor, 1987). Islamic banking advances the following set of beliefs: interest as a reward for saving does not have any basis as a moral foundation; abstinence from spending of present income does not deserve a financial reward; and to benefit from money is to transform the money into Submitted by: Shakeel Ahmad Page 9 of 77
  10. 10. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus investments, conditioned to accept risks and bringing the knowledge of other factors of production together (Presley, 1988). Rayner (1991) lays down four elements of a contract on a property (mal): they are lawfulness, existence, deliverability and precise determination. Ebrahim (1999) explains that profits on Murabahah facilities are generally higher than conventional loans because Islamic instruments are structured to share the risk of the asset or venture. Hence, the "profits" and "interest-charge" implied are similar in outcome, although not by design (Iqbal and Mirakhor, 1999; Rosly, 1999). Thomas (1995) is of the view that Riba, Gharar and Maysir manifested in the conventional system can wreak havoc in an economy as advanced as the USA, as depicted by the massive failures of US savings and loans institutions of the 1980s. Islamic banking aims to promote economic growth through risk-sharing instruments whose payoffs fluctuate with economic output and do not structurally impair the economy in the manner of excessive fixed-interest debt does in a poor economic environment such as a recession (Asquith et al., 1994; Andrade and Kaplan, 1998). The potential of Islamic fixed income securities backed by an Ijara facility is discussed by Kahf (1997). Islamic Derivatives: These comprise both Islamic Futures and Embedded Options in a contract. However, the development of it is largely unrealized (Khan, 1995). Ebrahim (2001) recommends to design, develop and implement Islamic hedging and risk minimizing facilities such as Islamic futures (Bai Al-Salam/Istisna), Islamic swaps, etc. (Iqbal, 1999). (Ebrahim, 2000) further recommends to design, develop and implement Islamic facilities that enhance the competitive ability of Islamic banks and reduce their risk exposure. The excessive use of credit facilities by Islamic banks globally has drawn the ire of scholars such as Ahmad (1989) and El-Naggar (1994). Conventional futures are very controversial with the Ulema - religious scholars (Kamali, 1999). It should be noted that certain Ulema such as Justice Taqi Usamani have given their verdict allowing contracts with embedded options (Kahn, 1999). Part of the study of Erol and El-Bdour (1989), conducted in Jordan, aimed at establishing the attitude of local people towards Islamic banking. The results suggest that religious motivation did not appear to play a primary role in bank selection; the opening of new branches was not an important factor in increasing the utilization of financial services provided by Islamic banks; while 39.4 per cent of respondents would withdraw their deposits if an Islamic bank did not generate sufficient profit to make a distribution in any one year, 30.4 per cent would retain their deposits because the Islamic bank could distribute a higher dividend the following year. Gerrard & Cunningham’s (1997) study establishes that, in Singapore, which has a minority of Muslims in its population, both Muslims and non-Muslims are generally unaware of the culture of Islamic banking. Also the two separate groups have different attitudes towards the Islamic banking movement, with the degree of difference depending on the nature of the respective matter put to them. For example, when asked what they would do if an Islamic bank did not make sufficient profits to make a distribution in any one year, 62.1 per cent of Muslims said they would keep their deposits within the Islamic banking movement, while 66.5 per cent of non-Muslims said they would withdraw their deposits. Much has been written since the early 1960s on the theme of the bank selection process (see, for example, the published articles of Anderson et al. (1976); Holstius and Kaynak (1995); Kaynak (1986); Kaynak et al. (1991); Laroche et al. (1986), and the working paper of Chan (1989)). Erol & El-Bdour (1989) and Erol et al. (1990) compared the bank selection process Submitted by: Shakeel Ahmad Page 10 of 77
  11. 11. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus in relation to "conventional" and Islamic banks. Sudin et al. (1994) compared responses about the bank selection criteria of both Muslims and non-Muslims. In addition to establishing attitudes towards Islamic banking, Erol and his co-researchers (1989 and 1990) sought to establish, then compare, the bank selection criteria of customers of conventional and Islamic banks in Jordan. Sudin et al. (1994), among other things, sought to establish the relative importance of certain bank selection criteria using a sample of Muslims and non-Muslims, none of whom had to be patronizing an Islamic bank at the time of the study. The three most important criteria in the bank selection process for Muslims were: first, "the provision of a fast and efficient service"; second, "the speed of transaction"; and third, "friendliness of bank personnel". As regards the non-Muslims, the three most important bank selection criteria were: first, "friendliness of bank personnel"; second, "the provision of a fast and efficient service"; and third, "the reputation and image of the bank". ISLAMIC BANKS: An Islamic bank is an intermediary and trustee of other people’s money like any conventional bank with the possible difference that the payoff to all its depositors is a share in profit and loss in one form or the other. This difference introduces an element of mutuality in Islamic banking, making its depositors as customers with some ownership rights inherent within it. However, in practice, Islamic banks hardly look different from its conventional counterpart in terms of organisational set-up (Dar and Presley, 2000). Islamic banking has been defined in a number of ways. General Secretariat of the OIC’s definition goes like this: “An Islamic bank is a financial institution whose status, rules and procedures expressly state its commitment to the principle of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations” (Ali & Sarkar-1995) Unlike conventional banks, however, Islamic banks offer PLS accounts, among others, which do not guarantee a fixed certain return on investment deposits. This leads to a reluctance of deposit holders, who have no representation in the organisation, to use PLS accounts. The bank faces a similar problem on the assets side when it comes to investing on PLS. The essential feature of Islamic banking is that it is interest-free. Although it is often claimed that there is more to Islamic banking, such as contributions towards a more equitable distribution of income and wealth, and increased equity participation in the economy (Chapra l982), it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order. "Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997 Neither a borrower nor a lender be; for loan oft loses both itself and friend and borrowing dulls the edge of husbandry. - Shakespeare’s Hamlet - a Danish father advising his son. UK usury laws on excessive interest abolished in 1854. South Africa and US (except Virginia and Delaware) have usury laws. US Federal law allows penalty rates / insurance premiums Happy the man who far from schemes of business, like the early generations of mankind, ploughs and ploughs again his ancestral land with oxen of his own breeding, with no yoke of usury on his neck. (Roman philosopher, Horace) Julius Caesar limited interest to 8 1/3 % Those who devour usury will not stand except as stands one whom the Evil one by his touch hath driven to madness. That is because they say: "Trade is like usury but Allah hath permittedby: Shakeel Ahmad Submitted trade and forbidden usury.” Page 11 of 77
  12. 12. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus It is simply an accepted fact that there are sufficient Muslim investors and borrowers in both Islamic and non-Islamic countries to warrant the attention of traditional banks who seek to serve such clients and capture a potentially profitable slice of a still relatively untapped market. Just as interesting and useful for non-Islamic bankers are the lessons learned from the innovation and creativity applied in meeting Islamic criteria. Some products are more Islamic and than others. The basic principle is that interest - usury or Riba used interchangeably - is prohibited on the principle of no pain no gain. What a "pure" Islamic banking seems to be structurally very similar to venture capital finance, non-recourse project finance or ordinary equity investment. The investor takes a share in the profits, if any, of the venture and is liable to lose his capital. It involves investing but not lending and therefore on a systemic basis is similar to the German, Japanese and Spanish banking systems rather than the British or American systems. Just as in the process of converting interest into capital gains for tax purposes, early Islamic investors were content to enter into zero-coupon bonds or discounted Treasury bills and receive the interest foregone in the form of capital gains. Beyond the question of interest or Riba lies an ethical issue. Islamic investments exclude tobacco, alcohol, gaming and other "undesirable" sectors. Islamic investors, by and large, are motivated in their choice of investments by much the same criteria as their Western ethical counterparts. The search for acceptable investments is balanced by natural risk-aversion. Islamic borrowers, on the other hand, also demonstrate a reluctance to give away a share in the profits of their enterprise. It is not therefore surprising that most of Islamic banking takes the form of one type of mark-up or other rather than profit-sharing. An analysis of the products suggests that Islamic banking has six key features: • free of interest, • trade-related and there is a perceived "genuine" need for the funds, • In its purest form, it is equity related, • meant to avoid exploitation – no usury, • invests ethically, • there are retail and wholesale applications. Under the current interpretation of the rules governing Islamic banking, Usury and Riba are regarded as synonymous. The prohibition is on interest and not just on usurious interest. In practice, there appears to be more emphasis on the prohibition and restructuring of interest than on the potentially exploitative aspect of financing. Brief History: It is worth noting that there is nothing new or particularly Islamic or Christian about Usury or interest controls. In 24th century B. C. Manu established a rate ceiling of 24% in India. Later, Hammurabi, King of Babylon, authored laws around 19th B. C. established a cap on lending rates. On loans of grain, which were repayable in kind, the maximum rate of interest was limited to 33 1/3% per annum. On loans of silver, the maximum legal rate was 20% although it appears that in some cases rates of 25 per cent per annum were charged. The law remained for most of the next 12 centuries but as with any law "regulatory arbitrage" took place and was subsequently eliminated. Unfair practices also existed. For example, creditors were forbidden from calling a loan made to a farmer prior to harvest. If the crop failed due to weather conditions, all interest on the loan would be cancelled for that year. In the case of houses, due to the scarcity of wood, a door could be used as collateral and was considered to be separate from a house. The 6th century Greeks, through the laws of Solon, lifted all maximum limitations on the legal rate of interest a moneylender might charge. The temple at Delphi was the "City" or "Wall Street" of the Greek Empire lending money for Submitted by: Shakeel Ahmad Page 12 of 77
  13. 13. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus interest regularly. Credit regulation was once again part of the legal code at the start of the Roman Empire. The legal limitation on interest was established at 8 1/3% per in the 5th century B.C. Julius Caesar’s attempts to control interest rates could well have been the real reason for his assassination since many the Roman senators were the main moneylenders. (This section is drawn from Edwardes-2000. The reader is also referred to Armstrong-1987, for more details). Back to the present day, quite a few Western countries have Usury laws that prohibit excessive interest rates. The UK’s usury laws which prevented "excessive" interest were abolished in 1854. South Africa and the US still have usury laws. Usury results when a lender charges more than the legal amount of interest permitted in that geographical area. Usury percentage limits vary by state, in USA, and at least one state, Virginia, has no usury limit. Today most of the states have had their ability to limit interest rates curtailed by over-riding US Federal law. Higher than permissible rates have been regarded by US Federal banking authorities as penalty fees and insurance premiums. And the federal rate limits are high. (Refer to Edwardes-2000). In some states there is no restriction on the rates used for lending to incorporated entities. The controls are often on lending to persons. The usury rate usually is variable depending on market rates. In September 1998 in North Dakota it was 10.556%. California has recently imposed strict consumer lending limits. But these only apply to state banks and not to national banks. The California Constitution allows parties to contract for interest on a loan primarily for personal, family or household purposes at a rate not exceeding 10% per annum (compound annual percentage rate). The allowable rate in California is 5% over the amount charged by the Federal Reserve Bank of San Francisco on advances to member banks on the 25th day of the month before the loan. The usury laws do not apply to any real estate broker if the loan is secured by real estate. This applies whether or not he or she is acting as a real estate broker. The limitations also do not apply to most lending institutions such as banks, credit unions, finance companies, pawn brokers, etc. State laws place limitations on some of these loans, but at a higher percentage rate than the usury laws listed above. (Refer to Edwardes-2000). In the Old Testament (King James Version), Exodus, Chapter 22, verse 25: If you lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury. Leciticus, Chapter 25, verses 34-36: And if thy brother be waxen poor, and fallen in decay by thee; then thou shalt relieve him: yea though he be a stranger, or a sojourner, that he may live with thee. Take thou no usury of him, or increase: but fear thy God; that thy brother may live with thee. THE New Testament also contains edicts on the same line. Thus we can see that Judaism and Christianity are no different in terms of prohibition of usury. The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. Chronology of recent historical events in the industry: 1963: Egypt interest free savings banks, not overtly Islamic - invested in trade and industry on the basis of share in profits. Submitted by: Shakeel Ahmad Page 13 of 77
  14. 14. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus 1971: Egypt Nasr Social bank, still no overt reference to Islam. 1973: Conference of Islamic finance ministers. 1975: Islamic Development Bank, Jeddah, fee based and PLS, revolving capital. 1975: Dubai Islamic Bank, UAE, first Islamic Commercial Bank in the world. 1970’s: Faisal Islamic Bank of Sudan / Egypt; Bahrain Islamic Bank; Malaysia, Philippines, Nigeria, Indonesia; Islamic Finance House, Luxembourg; DMI Geneva; Al Rajhi London, Denmark, Australia, South Africa; HSBC Amanah Fund; ANZ First ANZ International Murabah Ltd., IBU of United Bank of Kuwait. Time payment contracts such as retail installment contracts are not generally treated as loans and the usury laws normally do not apply to them. There are no limits on finance charges for the purchase of personal, family and household goods or services at this time. The maximum interest rate for car loans is almost 22%. Banks also treat interest charges for third party credit cards such as Visa, MasterCard and American Express as not being subject to Usury law limitations. (Refer to Edwardes-2000). It is not surprising to know that the first documented interest-free bank (Agibi Bank) was established circa 700 BC, in Babylonia, and functioned exclusively on an equity basis. ………..….… Baron-1952 In transactions for the purchase of goods or services which are not for personal, family or household purposes, there are normally no limits to finance charges except those set by the parties. Limited liability companies and limited liability partnerships can no longer assert usury as a defence in civil recovery actions. The usury interest limit that applies to limited liability companies and limited partnerships has been raised from 30% per annum to 50% per annum to equate to the level that applies to corporations. (Refer to Edwardes-2000). But there is a problem with usury laws as can be seen in South Africa. If there is a particularly risky investment and an interest rate limit, then banks will simply not lend. The poorest will find themselves deprived of financing, and under a free market there will be a shift to quality or to those that do not really need financing. Unless there is government imposed mandatory or tax driven lending to certain sectors or public opinion pressure, certain sectors or individuals deemed risky by the banks will simply not get the funding required. (Refer to Edwardes-2000). The Concepts behind Islamic Banking and Finance: Distinguishing Features: The economic doctrine of Islam is based on encouraging free markets, discouraging price controls and forbidding financial contracts based on riba, gharar and maysir. Riba (Charging of Interest): Taking or paying of interest (riba) is prohibited by Shariah (Islamic law). The concept of riba extends beyond interest and usury, and volumes have been written by scholars to explain the concept. In simple terms, riba can be considered as exploitation of one party who owns a product (that includes money and capital) and which another party wishes to acquire. Although interest comes very close to this concept, it is still better to consider riba as “unfair exploitation”. Ebrahim (1998) explains that “Riba is expounded by Ibn Qayyim & Al-Jawziyya (n.d.), another prominent Islamic scholar, to imply (i) any form of unfair trade, market manipulation or engaging a market participant to trade under duress (riba-al-fadl) and (ii) risk-free debt Submitted by: Shakeel Ahmad Page 14 of 77
  15. 15. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus contracts (riba-al-nasi'ah). From a financial economist's perspective, riba-al-nasi'ah can be defined as a risk-free return from an investment vehicle or strategy.” (see also Chapra-1986, Rahman-1969, Saeed-1995, Thomas-1995). Gharar (Uncertainty): The existence of uncertainty in a contract is prohibited because it requires the occurrence of an event which may not ultimately occur. “Full disclosure” by both parties is the norm in contractual relationships. Any type of transaction where the (i) subject matter, (ii) the price, or both are not determined and fixed in advance amounts to “uncertainty”. Thus hedging and dealing in derivatives is not allowed. Maisir or Speculation: Speculation is equivalent to gambling, and therefore is prohibited. Derivative transactions like Options, Futures, Swaps and forward contracts (that insure profit) are considered un-Islamic. They are also considered un-Islamic because for most of them, rates are determined by interest differentials. Zaka’h: A taxation system inherent in the Islamic system based on the principles of social justice and equity. Implying social justice and general welfare: The basic principle is that everybody should be able to fulfill at least the basic needs. Conforming to Shariah: The Quran and Hadith clearly specify the guidelines for individual, social, organizational, governmental behaviour, and thus become the basic pillar for any Islamic system, with the banking and financial system being no exception. Qard-e-hasna (benevolent loan), or Qard Hassan: Qard-e-Hasna means an interest free loan and is the only type of loan permitted by the Shariah. The loans are made from the pooled donations of the members and are generally granted to those who are facing emergency personal crisis. This form of finance is very important part of Islamic financial system and all members are encouraged to become regular donors so that the fund may be strengthened for the benefit of all Muslim The guiding principle again is the social justice and general welfare. Some Islamic banks provide the privilege of interest free loans only to the holders of investment account with them. Some extend to all bank clients. Some restrict it to needy students and other economically weaker sections of the society. Yet some other Islamic banks provide interest free loans to small producers, farmers and entrepreneurs who are not qualified to get finance from other sources. The purpose of these loans is to help start them their independent economic life and thus to raise their incomes and standard of living. Banks usually charge a small fee (say, 1.5%) annually to cover their administrative costs, etc. Profit and loss sharing (PLS): It is an alternative to interest-based transactions. Risk sharing: No risk, no gain is the basis. Prohibited Investments and Permissibility of Activities: Investments should only support Halal (permitted) activities. So, investments involving products like pork, alcohol, pornography, arms & ammunitions, Cinema, Tobacco, Conventional Financial Services and activities like gambling are prohibited. Hoarding: Hoarding money is considered improper in Islam; money is merely a means of exchange and should not be treated as a commodity. Islam encourages Trade and Enterprise, which can generate wealth for the benefits of the community as a whole with PLS as its core. Role of Islamic Banks: The role of Islamic banks becomes difficult compared to their conventional counterparts because of the basic principle that m Submitted by: Shakeel Ahmad Page 15 of 77
  16. 16. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus oney is not supposed to earn interest. This eliminates a major role of the financial institution. So, what do they do? They invest in viable projects, with reliable borrowers. If the project succeeds, the banker shares in the profit, if it fails, he suffers the losses. Prohibition of Interest: Prohibiting the receipt and payment of interest is the nucleus of the system, supported by other principles of Islamic doctrine advocating risk sharing, individuals' rights and duties, property rights, and the sanctity of contracts. Similarly, the Islamic financial system is not limited to banking, but covers capital formation, capital markets, and all types of financial intermediation. Since prohibition on transactions based on interest payments is the most important factor and is at the heart of the Islamic financial system, it will be unjust not to provide some light on it. The basic philosophy underlying transaction of money is that the one who is offering his money to another person has to decide whether: (a) He is lending money to him as a sympathetic act or, (b) He is lending money to the borrower, so that his principal may be saved or, (c) He is advancing his money to share the profits of the borrower. Table-2: Comparison between Riba and Profit Riba Profit 1. When money is “charged”, its imposed 1. When money is used in productive activity positive and definite result is Riba (e.g., in trading), its uncertain result is profit. 2. By definition, Riba is the premium paid by 2. By definition, profit is the difference the borrower to the lender along with between the revenue from production and the principal amount as a condition for the loan. cost of production. 3. Riba is prefixed, and hence there is no 3. Even if a sharing ratio is agreed in advance, uncertainty on the part of either the givers or profit is still uncertain, as its amount is not the takers of loans. known until the activity is completed. 4. Riba con not be negative, it can at best be 4. Profit can be positive, zero or even negative. very low or zero. 5. From Islamic Shariah point of view, it is 5. From Islamic Shariah point of view, it is Haram (prohibited). Halal (allowed). Making Money from Money is not permissible - the basic points of difference between money and commodity are highlighted to justify this. Money (of the same denomination) is not held to be the subject matter of trade, like other commodities. Its use is restricted to its basic purpose i.e. to act as a medium of exchange and a measure of value. If money is to be exchanged for money or it is borrowed, the payment on both sides must be equal, so that it is not used for trade in money itself. In short, money is treated as "potential" capital. It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital. Muslim scholars term interest as Riba. Under Shariah, Riba technically refers to the premium that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity (Chapra 1985, p.64). In other words, Riba is the Submitted by: Shakeel Ahmad Page 16 of 77
  17. 17. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus predetermined return on the use of money. In the past there has been dispute about whether Riba refers to interest or usury, but there is now consensus among Muslim scholars that the term covers all forms of interest and not only “excessive” interest (Khan 1985, p.52). The most important characteristic of Riba is that it is the positive and definite result of money when changed. In other words, when money begets money, without being exchanged for goods or services, or without indulging in any productive activity, it is called Riba. The basic characteristics of Riba are: • It must be related to loan; • A prefixed amount of money to be paid when due; • A time is fixed for the repayment; and • All these elements for repayment are taken as conditions for loan. Since Interest or Riba has emerged as the basic alternative for Profit, a comparison is justified between the two (Table-2). Table-3: Differences between Islamic & Conventional Banking: Characteristics Islamic Banking System Conventional Banking System Guiding Guided by Quranic edicts, Hadeeth, Guided by profit motive alone, with principle Islamic ethics and Islamic laws. no religious or ethical considerations. Ethics of Financing being asset-backed, and Debt burden arising out of financing meant for productive use helps excessive use of credit leads to reduce the overall debt burden. bankruptcies, and waste of financial resources. Liquidation An Investment Account Holder will Depositors are paid before the Assets have similar rights as shareholders. shareholders. Involvement of Equity financing is available to a Commercial banks do not usually risk & Equity project or venture that involves indulge in equity financing, only financing profit-and-loss sharing. Risk-sharing venture capital companies and and profit sharing go together. investment banks do. Conventional banks carry much less risk, major part of the risks being transferred to the borrowers. Return on Depends on productivity, idle money Even idle money in bank deposits Capital cannot earn any return. Money is not earns returns. capital per se, only potential capital1. Prohibition of The existence of uncertainty in a Trading and dealing in derivatives Gharar contract is prohibited because it are widely considered as the main (uncertainty) requires the occurrence of an event source of liquidity in the which may not ultimately occur. conventional financial, commodity “Full disclosure” by both parties is and capital markets. the norm in contracts. Derivatives trading e.g. options are considered as having elements of Gharar. 1 It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital. Submitted by: Shakeel Ahmad Page 17 of 77
  18. 18. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Profit and Loss Most transactions are based on this There is no relationship between Sharing variable returns, dependent on bank performance and returns to lenders’ performance. Greater share the depositors or investors, who of risks forces them to manage risks mostly enjoy a risk-free return. more professionally, to ensure better Conventional institutions mostly returns than conventional accounts. act as intermediaries between Depositors & investors have lenders & borrowers enjoying opportunity to earn higher returns almost a risk-free spread. than in conventional systems. Zakat It has become one of the functions of Government Taxes perhaps serve the Islamic banks to collect and the same purpose - mode and rate distribute Zakat. of charging are different, though. Compounding The Islamic banks have no provision It can charge additional money or Interest on to charge any extra money from the (compound rate of interest) in case interest defaulters. of defaulters. Money-Market For the Islamic banks, it is For commercial banks, borrowing Borrowing comparatively difficult to borrow from the money market is the main money from the money market. source of liquidity. Developing Since it shares profit and loss, the Since income from the advances is expertise Islamic banks pay greater attention fixed, it gives little importance to to developing project appraisal and developing expertise in project evaluation systems. appraisal and evaluations. Viability v/s The Islamic banks, on the other The conventional banks give credit- hand, give greater emphasis on the greater emphasis on credit- worthiness viability of the projects. worthiness of the clients. Relationship The status of Islamic bank in relation The status of a conventional bank, with Clients to its clients is that of partners, in relation to its clients, is that of investors and trader. creditor and debtors. Capital No guarantee. Built into the system. Guarantee Deposit None An integral component insurance Key Islamic Financial techniques: Islamic banking and financial institutions have developed a wide rage of techniques which allow them to uphold the religious and legal principles while enabling them, at the same time, to offer viable financial products. The search is actually still going on to find newer techniques, and for variations based upon the existing ones to offer more attractive and useful instruments for the investors. The following list covers many of them, but must not be considered as exhaustive: Mudaraba (Participation or trust financing): It involves two parties, the managing trustee (Mudarib) and the beneficial owner (Rub-ul-Maal). Usually the investment account holders are the provider of funds, and the Islamic Banks are the managing partner (mudarib). The Islamic Financial Institution may either put up all the funds itself and undertake responsibility for investing in them, or alternately it can provide funds to a customer who then acts as Mudarib. The borrower retains a fixed percentage of profits, the Islamic Financial Institution’s reward is a fixed percentage in the balance of the revenue generated by the investments and the remainder goes to the investors. Underlying principle is ‘no-pain-no- gain’, i.e., no one is entitled to any addition to the principal sum if he does not share in the Submitted by: Shakeel Ahmad Page 18 of 77
  19. 19. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus risks involved. Although profits are shared on a pre-agreed basis, losses are wholly suffered by the Rub-ul-Maal. Musharaka (Equity Financing): It is quite similar to the Mudarabah contract. It involves financing through equity. Here the partners or shareholders for a Project use their capital through a Joint Venture, Limited Partnership to generate a profit. Profits or losses will be split between the shareholders according to some agreed pre-formula depending on the investment ratio. Difference between Mudaraba and Musharaka Contracts: In a Mudaraba contract, the managing agent (beneficiary or the borrower, called the Mudarib) does not have any financial participation. In a Musharaka contract, the agent is a financial partner along with the provider of fund (Rubb-ul-Maal of Mudaraba contract) sharing the gain or loss at the pre-designated ratio which is likely to be higher than what he is likely to get in a Mudaraba contract. Thus, in Mudaraba, the agent acts as a working partner who does not bear any losses and simply manages the fund (the project in which the fund is invested), whereas in Musharaka, all the parties are shareholders in the venture. Murabaha (Cost-plus financing): This technique is extensively used to facilitate trade financing activities of Islamic Financial Institutions. The Mudaraba and Musharaka transactions are often seen on the retail liability side of Islamic banks. The asset side whether retail or wholesale is quite risky. The most common such financial instrument is the 'mark-up' structure called Murabaha. It sounds quite similar to a "repo" agreement commonly used in the West. In a Murabaha transaction, the bank finances the purchase of an asset by buying it on behalf of its client. The bank then adds a "mark-up" in its sale price to its client who pays for it on a deferred basis. The 'cost-plus' nature of Murabaha sounds very much like the interest into capital gains manipulations of tax-avoiders. Islamic banks are supposed to take a genuine commercial risk between the purchase of the asset from the seller and the sale of the asset to the person requiring the goods. The bank stands in between the buyer and the supplier and is liable if anything goes wrong. There is thus some form of guarantee with respect to the quality of the goods provided by the bank to the end user in the strict form of Murabaha. Title to the goods financed may pass to the bank's client at the outset or on deferred payment. From the perspective of modern finance, a Murabaha facility is equivalent to an asset-backed risky loan. If the capital markets are perfect and all agents in the economy have equal access to information, then competition between Islamic banks and conventional banks would result in Murabahah having the same expected return as that of conventional loans. Baimuajjal (Deferred Payment Sales): The payments for this sale could be either in installments or a one-off deferred payment as per agreement between the parties at the time of the sale, and cannot include any charges for deferment. This is like as a Murabaha mode of investment with an exception that the sale under this cost-plus sale mode of investment is made on a credit basis rather than cash. It is deemed acceptable to charge higher prices for deferred payments. Such transactions are regarded as trades and not loans. Ijara (Operating Lease): It involves leasing of machinery, equipment, buildings and other capital assets. The financier purchases the asset and leases it to the end-user for an agreed rental which may be fixed in advance or subject to occasional review by a mutually acceptable third party, e.g. an international firm of accountants. Insuring of the asset remains a contentious issue. Ijara wa iqtina (Financial Lease): This is a leasing structure coupled with a right available to the lessee to purchase the asset at the end of the lease period (Bay’ al Wafa). The lessee Submitted by: Shakeel Ahmad Page 19 of 77
  20. 20. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus agrees to make payments into an Islamic investment account (with right to all profits) to be used in or towards financing the ultimate purchase of the asset. The instrument has been used increasingly in a range of asset classes including ships, aircrafts, telecom equipment and power station turbines, etc. Baisalam or Bai’ Salaf (Purchase with deferred delivery): It is a short-term commodity finance contract in which the buyer (usually of agricultural or manufactured products) pays the seller full negotiated price of a product that is promised for delivery at a later date. It has similarities with the forward contracts of conventional financial systems except that in Islamic instruments the rate of return is tied to each transaction rather than to a time dimension. Another difference lies in the fact that in Salam, the buyer pays the entire amount in cash, at the time of contract. Both the quality and quantity of the sold products are definitely specified in the contract. The counter-party risk in Al Salam is one-sided as it lies with the buyer alone (the IBF) unlike the forward contracts in which it affects both parties. Hence, it is expected that this risk will be priced one way unless a security is provided by the seller. This involves the bank paying for the producer's goods at a discount before they have been delivered or even made. Difference of opinion exists on whether the subject of Bai Salam transaction should be available in the market at the time of the contract or whether it is enough that the asset will be available at the date set in the contract for delivery. Difference of opinion also can be seen on the minimum time period between the date of contract and delivery of assets. Submitted by: Shakeel Ahmad Page 20 of 77
  21. 21. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Box-1: Islamic Financial Instruments Islamic Bank as an intermediary for Mudaraba or Musharaka: Islamic bank depositors act as Rabbulmals and place funds with the bank. The bank is the Mudarib on its liability side with respect to the depositors. The bank uses the funds on the Mudaraba or Musharaka basis or any other Islamically approved basis with clients in search of funding. Here the bank is the Rabbulmal with respect to the end users of the funds. Under such a scenario the bank acts as a principal. The bank may also act in an off-balance sheet capacity as a fee- earning agent on behalf of the fund providers and/or fund seekers or as a traditional fund manager investing in a diversified portfolio of Musharaka contracts. Retail Islamic Banking Products: At a retail level, Islamic banks provide current, savings, and investment accounts. Alwadiah: It is equivalent of the current account of the conventional banks, and used for day to day cash management. No return is paid to depositors. Most banks have no charges for such accounts, and provide facilities similar to any conventional bank. Alwadiah structures are also used for higher return savings account. Banks may sometimes pay the savers a return, depending on their own profitability. Savings accounts also are quite similar except for the absence of interest payments. There may or may not be a service charge incurred. Losses are not, in practice, passed on to depositors and are absorbed through the banks' reserves. Term Deposits: They are considered as investment accounts, and use the Mudaraba format. Deposits are fixed term and cannot be cashed in before maturity. The profit-sharing ratio varies between institutions and could be a function of the bank's profitability or that of the portfolio of end borrowers. In practice there is only profit sharing and no loss sharing for retail investors. The lower risk means a lower profit share. There are considerable variations on the Mudaraba principle. The Islamic Bank of Bangladesh has been offering Profit and Loss sharing (PLS) Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit accounts. Bank Islam Malaysia provides wholesale and retail investment accounts both on the PLS principle. The frequency of payment is another variable. Profits are declared and distributed monthly in Malaysia, whilst in Egypt there is a quarterly distribution. In Bangladesh and Pakistan distributions tend to be half-yearly. A common thread is the short-term liquid nature of the deposits. Long-term mortgage-type finance hardly exists. The longest-term deposits are being raised in Malaysia. Even there almost all the deposits are under two years in maturity. The party on the purchase side of the contract may sell the asset back to the party on the sale side of the contract or to a third party for a profit. The purchaser/ financier may also sell the assets by way of a parallel Bai Salam contract (a salam contract with a third party) to hedge the asset-risk or for profit. The stipulation of full cash prepayment in Al Salam contracts is meant to facilitate working capital finance wherein the party on the buyer side is the IBF institution. Since full prepayment is involved, the price paid is lower than the future spot price of the goods in question unlike the futures or forward price which is always higher than the spot price. An important feature of Al salam contract is the underlying asset which must be standardizable, of determinate quality and easy to be quantified. Istisna and Parallel Istisna: It involves a deferred delivery sale contract similar to salam. It is also similar to conventional work-in-progress financing of capital projects like construction. It is also used for trade finance such as pre-shipment export finance. In this contract, the seller ( Al Sani’), based upon an order from purchaser (Al Mustasni’), undertakes to manufacture or Submitted by: Shakeel Ahmad Page 21 of 77
  22. 22. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus have manufactured/ acquired the subject item (Al Masnoo’) as per purchaser’s specifications. The price, payment structure and the date of delivery are fixed in advance. In parallel Istisna, the Al-Sani’ may enter into a second Istisna’ contract (subcontract) with a third party to manufacture the subject item unless Al Mustasni’ (ultimate purchaser) has stipulated in the contarct specifically for Al Sani’ to manufacture himself. Similarity with Bai Salam contract: Sale of a product not available at the time of the deal. Difference with Bai Salam contract: In Bai Salam, full price for the asset must be paid at the outset, whereas in Istisna, payment in full or in installments may be made at any agreed upon time (even beyond delivery date). Similarity with Ijarah: In Istisna, al-sani’ may either provide the raw material or labour. The labour part is the similarity with Ijarah. Arbun or Urboun (Pre-purchase of right to acquire asset): The purchaser makes a deposit (a down-payment, which may be a fraction of the price) for the purchase of an asset at a later date on the understanding that, should the sale of the assets not proceed (say, if the purchaser chooses not to proceed), the seller will be permitted to retain the deposit. Because of its similarity to an option, it has met with varying levels of approval from the schools of Islamic jurisprudence. A lot of work will be required to mould the instrument so as to remove any possibility of speculation ensuring total acceptability. Khiyar al-shart: This is a sale contract concluded at the time of signing the agreement, but where one of the two parties to the contract has a right to cancel the sale within a stipulated time. Cancellation is not contingent upon any uncertain future event. For example, party A enters into a contract with party B to sell a given quantity of equity stock on an agreed price, today. Party A has the right to either confirm or rescind the contract by a certain time in the future (let’s term it as “maturity”). If Pmaturity > Pcontract, A may choose to rescind the contract and instead sell the stock in the market. The similarity of the exercise features of this contract with the conventional Put Option invites some controversy. Al Bay Bithaman Ajil: BBA, popular in Malaysia, is a mark-up sale in which payments are delayed and made in equal installments. Theoretically, in the contract of BBA the bank sells the product (a house, equipment or machinery, etc.) to the customer at a mark-up price, whose content consists of the cost price plus a profit margin. The client may be allowed to settle payment by installments within a pre-agreed period, or as a lump sum. It is similar to a Murabaha contract, but with payment on a deferred basis. The BBA facility can also be utilised for refinancing of assets owned by the Customer, and the proceeds to be utilised for the Customer’s working capital. Syndication: Islamic Financial Institutions are increasingly prepared to participate in large project financing, and are getting ready to compete with their conventional counterparts. The syndication works on the techniques discussed above, most popular being the Mudarabah contract modified to suit the technicalities. Jo’alah: A party undertakes to pay another party a specified amount of money as a fee for rendering a specified service in accordance with the terms of the contract stipulated between the two parties. This mode usually applies to transactions such as consultations and professional services, fund placements, and trust services. Certificates of sale: It has been suggested that consumers buying consumables on credit would issue 'certificates of sale' similar to letters of credit. These could be encashed by the seller at the bank at a discount. This seems very similar in structure to Baisalam. Submitted by: Shakeel Ahmad Page 22 of 77
  23. 23. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Prizes and bonuses: Iran and Pakistan have both attempted to fully Islamise the entire banking. Iran converted to Islamic banking in August l983 with a three-year transition period. In Iran banks accept current and savings deposits without paying any return. The banks are permitted to offer bonuses and prizes on these deposits very similar to the UK’s premium bonds. This is apparently not regarded as gambling by the Iranian Islamic banking units. No fee accounts: There is a substantial Muslim population in South Africa and they are serviced by two small Islamic banks. The main product being offered is the "no fee" current account which is also provided by the conventional banks by arrangement. Transaction charges are waived and interest is not paid on current accounts. Gifts: Gifts to depositors are given entirely at the discretion of the Islamic banks on the basis of the minimum balance. These gifts may be monetary or non-monetary are based on the banks’ returns. Non PLS Modes: Non-Profit-and-Loss Sharing Modes. They are used in cases where PLS modes cannot be implemented, e.g., in cases of small-scale borrowers or for consumption loans. Qard Al Hasnah (Beneficence Loans): Zero return loans that Islam edicts for Muslims to make to the needy. Banks can only charge the borrowers a one-off service fee to cover the administrative expenses, but this fee cannot be related, by any means, to the loan amount or its maturity. Islamic Derivative Products: Salam (Bai Al Salam), Urboun (Arbun) and Khiyar al- shart are the existing derivative products approved by some schools of Islamic jurisprudence. Dr. Kenneth Baldwin has suggested some Profit Rate Swaps that replicate the risk management capability of conventional interest rate swaps, using Sharia-compatible building blocks (existing and extensively used instruments). It is generally assumed that the term "Islamic Derivatives" is a contradiction. The requirements of derivatives and rules of Shariah at first sight are diametrically opposed and all derivatives are therefore Haram. But it is important to recall the generalised definition we use of a financial derivative. It is simply a financial instrument that is derived from another financial instrument or a combination of such instruments. It is argued that as derivatives "unquestionably" involve interest or interest-based products they are contaminated and should be prohibited. Well, derivatives only involve interest if one or both parties using the derivative seek to hedge the derivative. It could be argued that Murabaha could involve interest if the parties seek to match the interest free but guaranteed return product with an interest-bearing equivalent. Islamic banking derivatives should be perfectly acceptable so long as they do not involve interest. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. An International Monetary Fund (IMF) study by Iqbal and Mirakhor (l987) found Islamic banking to be a viable proposition that can result in efficient resource allocation. Advantages of Islamic Finance:  Efficient allocation of funds: Since allocation of funds by banks will be dependent upon the soundness of projects under the PLS arrangements, the allocation is more efficient.  Productive use of capital: Banks are likely to know their fund users better in order to ensure that the funds are used for productive purposes. In this way, both the fund Submitted by: Shakeel Ahmad Page 23 of 77
  24. 24. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus providers and the financial intermediary contribute to promoting productive economic activities and greater financial responsibility. Thus, IBFs would promote economic growth [Chapra (1998), Siddiqui (1983)]  Similarly, since banks have no pressure of fixed regular payments on deposits, the efficiency of allocating resources to profitable and more productive use is further boosted.  Equitable distribution of wealth: The efficiency in allocation leads to this, and creates additional wealth as well. Interest distribution is considered unjust and inequitable because it is not based on any productive use of capital, and it exploits the misfortune of the borrower (who has run out of money).  Generation of employment: Productive use of capital implies investments and creation of jobs. The investment is not dependent upon the cost of capital (and positive NPVs) or time value of money, hence number of investible projects is likely to be much higher resulting in larger capital formation.  Saving in information costs: Being a partner of the entrepreneur (or a firm), the financial institution has easier and cheaper access to information on matters relating to the firm. This may make credit rating agencies redundant, and lending more efficient.  Saving in deposit insurance costs: Risk-sharing concept built into the IBF system, there will be no need for deposits to be insured.  Reduction of debt burden: The IBF system of equity financing encourages debt to be swapped with equity which can help many developing countries get rid of the immense debt-burden. Instead of rescheduling of existing loans or selling Brady bonds at heavy discounts, which does not help relieve the pressure much, converting debt to equity promises a much more fruitful alternative.  Promoting Ethical behaviour: Because of its strong emphasis on the ethical and moral dimensions of doing the business and selecting the activities/ commodities to be financed, the Islamic financing institutions could play an important role in promoting socially desirable investment and corporate behavior. In this context, it is worth mentioning that Islamic financing institutions are subject to Shariah (Islamic Law) regulations in addition to conforming to the conventional regulatory standards. This is further expected to ensure greater prudence and responsibility.  Higher profits: Account holders under Islamic finance could expect higher profit from their investment as Islamic banks are required to share the entire net profit according to the agreed formula rather than just a portion of the profit, as is the conventional practice.  Reduction in run-on-deposits: Banks using profit and loss sharing (PLS) to mobilize resources are less likely to face a sudden run on their deposits.  More stable economic environment: The perspective of investments is long-term in comparison to short-term expectations of returns in conventional financial system – this may result in a more stable economic environment less dependent on business cycles.  Less likelihood of flight of capital: Under Islamic finance, debt instruments that may be created through selling goods and services on credit are not readily tradable. This greatly eliminates the possibility of sudden mass movement of funds from one country to another.  Reduction in speculative transactions: Examination of daily records of trading in financial markets vividly shows that institutional participants carry out huge speculative transactions. More often than not, such transactions are sources of instabilities. In contrast, Islamic banks and financial institutions are inherently prevented from carrying out such Submitted by: Shakeel Ahmad Page 24 of 77
  25. 25. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus activities. As a result destabilizing speculations would be significantly curtailed in financial markets, although liquidity will remain with secondary market trading allowed in stocks or investment certificates.  Reduction of inflationary pressures: Under Islamic economics the inflationary pressures would be reduced to a great extent, as over or under-supply of money with respect of supply of goods is not allowed (money directly linked to supply of goods in the economy).  Reduction in unproductive use of borrowings: By eliminating unnecessary and excessive borrowing (borrowing beyond productive use), risk to lenders is reduced under PLS, as lending is directly related to project appraisals and feasibility.  Automatic Shock-absorption: For banks involved in the equity-based system, Khan (1986) argues that the shocks to asset positions are immediately absorbed by changes in the values of shares held by depositors in the bank. This makes the real values of assets and liabilities of banks equal at all times, preventing banking crises. Nienhaus (1986) agrees with the argument.  Guaranteed market of practicing Muslims. Islam being the fastest growing religion in the world further enhances the potential marketability of IBF instruments. Box-2: Landmark Islamic finance deal inked Khaleej Times: 03 July 2003 DUBAI - In a landmark deal for Islamic finance, Dubai Islamic Bank (DIB), in partnership with ABC Islamic Asset Management of London, has signed a leasing transaction agreement with the AAA-rated General Electric of the USA. The transaction involves the purchase of machines and engineering equipment by DIB and ABC and leased under Sharia principles to General Electric. "We intend to source more deals with investment grade companies from around the world," Mr Aref Kooheji, DIB's Executive Vice-President for Investment Banking said. "We pay special attention to the elimination of risk by means of watertight structures that provide protection against residual risk during the term of the lease." Mr Kooheji concluded the signing with Mr Duncan Smith, ABC Islamic Asset Management's CEO, in Dubai recently. "This is a landmark deal. If General Electric is prepared to go the Islamic financing route, then it's hard to see how similar multinationals will not avail themselves of this excellent financing facility in the future. This will give the Islamic industry a tremendous boost," Mr Smith said. Mr Smith added that the partnership transaction was made possible through cooperation between investment professionals at DIB and ABC Islamic Asset Management, whose understanding of complex structures, legal and other matters, particularly Sharia compliance, facilitated smooth cross-border dealings of significance in the development of investments in the Islamic financial industry. Abu Dhabi power project signs $1.8b loan deal Khaleej Times: 3 July 2003 ABU DHABI - A $1.8-billion loan facility was signed here yesterday for the expansion of Abu Dhabi's fourth independent power and water project in what was described as "the largest project financing ever" in the capital of the United Arab Emirates. Project developers International Power of Britain and Japan's Mitsui and Co. and Tokyo Electric Power Company (Tepco), signed the facility with a consortium of local and international banks to finance the Umm Al Nar project. Lead arrangers of the conventional loan include Gulf International Bank, HSBC, Sumitomo, Mitsui Banking Corporation and National Bank of Abu Dhabi, while Abu Dhabi Islamic Bank lead arranged a $250-million Islamic tranche. Perceived Disadvantages of IBFs: Submitted by: Shakeel Ahmad Page 25 of 77
  26. 26. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus  With PLS, the role of the bank undergoes a change from being an intermediary trader of money, earning profits from the margin between lending and borrowing, to being an investing partner. The role of an investment bank brings in added costs: o Search cost resulting from the need to decide on the most profitable ventures. With an Islamic bank required to finance so many different kinds of businesses, acquiring skills in all of them may be immensely costly. o Monitoring costs resulting from the need to prevent mishandling of the venture and fraudulent means (including creative accounting) adopted by borrowers/ partners are in addition to those involved in conventional financial system. o Managing costs incurred because of its obligation as a partner in the PLS deals.  Determination of mechanism for profit sharing in the short-term is difficult in a PLS system based on returns only from productive deployment of funds. In the absence of a standard mechanism for profit/ loss sharing (both for short-term as well as long-term), the possibility of exploitative contracts cannot be eliminated.  Eliminating interest may reduce the propensity to save (with banks) or invest (considering the risk associated with returns), thus curtailing economic growth affecting employment (Pryor-1985), generation of wealth and its distribution. Of course, IBF proponents do not agree, as an opportunity for equitable sharing of wealth earned from productive activities could be enough stimulant for investors.  Dispute settlement mechanism adds to the cost further, as the account put forward by the borrower (entrepreneur) may not be convincing enough for the banks or other investor partners. Fixed return of the conventional system has no such costs.  A risk sharing proposition of IFBs and resulting absence of deposit insurance system leaves small investors in the risky avenues, particularly when the Islamic financial institution carries fraudulent intentions.  Curtailing speculative activities in the secondary market would be extremely difficult resulting in the same risks and costs that the conventional financial systems carry.  The mark-up system of most of the non-PLS schemes resembles the interest-based system to the extent of becoming indistinguishable, sometimes, and provides unscrupulous financiers opportunity to replicate the conventional system.  Additional cost of supervision by the Sharia Board: Product development, its offering, agreements between counterparties, functioning of the IBF system, accounting, etc need to be Sharia compliant which needs certification by the Sharia Boards resulting in additional cost burden over the IBF Operators.  Account holders under Islamic finance could expect higher profit from their investment as Islamic banks are required to share the entire net profit according to the agreed formula rather than just a portion of the profit, as is the conventional practice. Impediments to the growth of IBF: The impediments are being discussed in this paper after grouping them in seven broad categories: (1) Social Impediments, (2) Economic Impediments, (3) Financial Impediments, (4) Structural Impediments, (5) Institutional Impediments, (6) Political Impediments, Technological Impediments, and (7) Religious Impediments. 1. Social Impediments: Humans are undoubtedly the most important resource endowment for any country. Their development is the key to the competitiveness of any nation in any Submitted by: Shakeel Ahmad Page 26 of 77
  27. 27. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus sphere. Even in the field of IBF, it is the level of human development in the promoter nations that will ultimately steer the IBF into a competitive arena. The Human Developed Index (HDI) available with the Human Development Report brought out by United Nations Development Programme (UNDP) is a composite index that measures achievements of a country in three basic parameters of human development (HDR 2003). These are: (i) longevity measured by life expectancy at birth, (ii) knowledge, measured by a combination of the adult literacy rate and the combined primary, secondary, and tertiary gross enrolment ratio, and (iii) standard of living, measured by GDP per capita. It is worthwhile, then, having a look (Figure-7) at the HDI of member nations of Organization of Islamic Countries (OIC), having some kind of IBF (as they are the promoters of IBF), in comparison with some of the world leaders (promoters of Conventional banking & financial system). HDI Score HDI Rank 0.94 0.94 0.94 0.94 0.94 0.94 0.93 1.00 200 0.89 0.88 0.87 0.84 0.83 0.90 180 0.82 0.82 0.79 0.77 0.76 0.75 0.74 0.74 0.74 0.73 0.73 0.80 160 0.72 0.70 0.68 0.65 0.70 140 0.61 0.60 120 0.50 0.50 0.50 0.47 0.46 0.46 0.46 0.45 0.43 0.43 0.50 100 0.40 80 0.29 0.30 60 0.20 40 0.10 20 0.00 0 Belgium Gambia Djibouti Banglade Nigeria Guinea Brunei Mauritani Bahrain Yemen Niger Canada Singapore Malaysia Tunisia Albania Palestine Egypt Lebanon Algeria Kuwait Saudi Senegal Oman Turkey Pakistan Qatar UK UAE Australia Indonesia Norway Sweden Hong Jordan Iran Morocco Sudan USA Fig-7: Human Development Index Scores (left scale) and ranks (right scales) Source: Human Development Report2003 brought out by United Nations Development Programme (UNDP) Accumulation of human capital is an indicator of endogenous growth and is often used in empirical growth models. In most regressions, this variable turns out with a positive coefficient (Barro, 1991). The highest ranked country among the Islamic countries, in terms of HDI, is Brunei with a rank of 31, the second highest being Bahrain at 37, both of them with so small a population that their impact on the development of as important a system as IBF is not expected to be large. However, in terms of developing a financial market (and related systems, also in terms of IBF) the maximum effort has been made by Bahrain after Malaysia (Countries with 100% Islamic Financial system in place, i.e., Iran was placed at 106, Sudan at 138 and Pakistan had a rank of 144 in HDR of 2003). The development in the area is not likely to bear much fruit unless the promoter countries of IBF take giant steps towards developing their most important infrastructure element, i.e. the Human Resources. The initial successes may remain at superficial levels, and sustainability of growth and the challenges posed to the conventional financial system may remain feeble otherwise. At the moment, it poses a significant impediment to the growth of IBF. Submitted by: Shakeel Ahmad Page 27 of 77