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The management of finacial operations in islamic banking

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Nowadays, due to the various types of financial crises and mistrust to modern banking system it is quite popular and well-known such terms as “Islamic economy”, “Islamic banking system”. But, what is it? What it has been built on? What does it underlie? Certainly, it would be impossible to explicate in a brief description, since Islamic economy is the whole science based on Islamic jurisprudence. Therefore, I try to reveal this curtain of fundamentally different system, touching with expository theory such aspects as: principles of Islamic economic theory, its ethical principles, prohibited trade deals and reasons for these forbiddances and et al. Islamic banking services.
Islamic finance and banking system have been growing rapidly in recent years. Motivated by a heightened interest in financial instruments that emphasize risk sharing, it has been attracting greater attention in the wake of the recent financial crisis. Today, as a consequence of broad changes in the political-economic environment, a new generation of Islamic financial institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new –aggiornamento-update. Perhaps the most important development has been the growing integration of Islamic finance into global economy.

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The management of finacial operations in islamic banking

  1. 1. RIGA TECHNICAL UNIVERSITY THE MANAGEMENT OF FINACIAL OPERATIONS IN ISLAMIC BANKING Sardorbek Mirzaev Riga 5/27/2014 Abstract The globalization of finance has allowed Islamic finance to thrive and there has been in recent years a fusion of sorts between Islamic and conventional banking. My task includes to provide the apprehensible and intelligible description for Islamic financial terms, specifications and peculiarities of financial transactions; to explain the non-interest system in Islamic banks and the substitutions and alternatives of them. At last but not least, to analyze the interactions of Islamic and conventional banks in modern society, pertaining to corporate finance; to distinguish the advantages and cons in financial operations; elicit the competitive prevailing advantages of techniques and methods of allocation of assets and liquids both in Islamic and conventional banking system. Primarily, to proper analysis of the issue in details I have divided my paper into two main parts: Analytical (Theoretical) Part and Practical Part. In analytical part I have covered main theories and definitions related to Islamic banking and Islamic financial operations, transactions. Also it covers existing methods and techniques of Islamic financial operating system and gives information about results and success of the management of financial operations in Islamic banking system in early stages, before and after the world crisis, interaction between Islamic banks and conventional ones, their current status quo in contemporary economic and financial world, respectively. The second main part is about Islamic banks and financial institutions operating throughout the world, their annual financial reports and statistical data. To investigate their efficacious performance and amelioration of their reputation in the financial market I’ve researched apposite data from a few Islamic financial institutions. In addition to it, I’ve exampled a typical leasing situation in both Islamic and conventional banks. Prioritizing the benefit from client-costumer side, I have proved the possible outcomes depending on client’s decision on which of the financial institutions are suitably meets his expectations. The examples create pictures of the ordinary banks’ credit-borrowing transparent procedures and distinct conditions in Islamic banking and conventional financial institutions, respectively.This paper includes 7 formulas, 16 figures and 7 tables. The total volume of it is 65 pages.
  2. 2. 1 CONTENT INTRODUCTION……………………..………………………………………………….2 1. ANALITICAL PART…………………………………………….…………………4 1.1. Uzbekistan banking overview……………………………………………….4 1.2. The Principles and Characteristics of an Islamic Economy………..……....10 1.2.1. Principles of Islamic Economy………………………………...………..10 1.2.2. The Elements and Superstructure of Islamic Financial System………...12 1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend…16 1.3. The Role Non-interest Philosophy of Islamic Finance……...……..………19 1.4. Islam, Economics and Finance…………………………..…………………20 1.4.1. Historical and Religious Background…….…………………………….20 1.4.2. Islamic Economics……………………………...………………………22 1.4.3. Reconciling Islam and Finance..………………………………………..23 1.5. The Ethical Framework of Islam …………………………………………..24 1.5.1. Riba and Gharar……………………………………………………….24 1.5.2. The Moral Economy of Islam…………………………………………25 1.6. Financial Products and Instruments in Islamic Banking and Their Conformity with Conventional Banks………………………………………27 1.6.1. Murabaha………………………………………………………………27 1.6.2. Leasing ………………………………………………………………...30 1.6.3. Profit and loss Sharing………………………………..............................31 1.6.4. Sukuk – Islamic Bonds………………………………………………...33 1.6.5. Islamic Mutual Funds…….……………………………………………36 1.6.6. Mircro-lending or Mirco-finance………………………………………37 1.7. The management and Control, the Islamic Moral Hazard………………….37 2. PRACTICAL PART……………………………………………………………….40 2.1. Uzbekistani Leasing Market……………………………………………..…40 2.2. Leasing Procedures in Conventional Banks………………………………44 2.3. The Leasing in Islamic Banks………………………………………………49 2.4. The Comparison of the Systems: Leasing and Ijarah in Conventional and Islamic Banks Respectively…………………………………………………52 CONCLUSION………………………………………………………………………….…55 BIBLIOGRAGHY….…………………………………………………………………...…57
  3. 3. 2 INTRODUCTION Nowadays, due to the various types of financial crises and mistrust to modern banking system it is quite popular and well-known such terms as “Islamic economy”, “Islamic banking system”. But, what is it? What it has been built on? What does it underlie? Certainly, it would be impossible to explicate in a brief description, since Islamic economy is the whole science based on Islamic jurisprudence. Therefore, I try to reveal this curtain of fundamentally different system, touching with expository theory such aspects as: principles of Islamic economic theory, its ethical principles, prohibited trade deals and reasons for these forbiddances and et al. Islamic banking services. Islamic finance and banking system have been growing rapidly in recent years. Motivated by a heightened interest in financial instruments that emphasize risk sharing, it has been attracting greater attention in the wake of the recent financial crisis. Today, as a consequence of broad changes in the political-economic environment, a new generation of Islamic financial institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new – aggiornamento-update. Perhaps the most important development has been the growing integration of Islamic finance into global economy. The Islamic banking industry is based on the prohibition of interests, and it promotes just distribution of wealth whereby all levels of the society would benefit. The Western World, in particular the Europe has been using and developing the conventional banking system which has brought a lot of economic instability for many people living there. The conventional banking system which basically operates on the basis of interest has created social problems because it is simply not sustainable. Many have written about the conventional banking system which produced capitalistic society and the financial crisis. Therefore, the existing conventional banking system is definitely not suitable and the sound of alternative should be sought. Islamic banking system could be that alternative everywhere in the world because it is an ethical financing which promotes welfare for everyone [21]. In my thesis I’ve tried to reach the objective of presenting the core principles of Islam finance, that place great emphasis on social justice, inclusion, and sharing of resources between the haves and the have-nots. Islamic finance addresses the issue of financial inclusion from two directions: one by promoting risk-sharing contracts that provide a viable alternative to conventional debt-based financing; and the other through specific instruments of redistribution of wealth in society; to improve understanding of the perspective of Islamic finance on economic development, social and economic justice, human welfare, and economic growth. The author has analyzed the structural difference in management of financial instruments between Islamic finance and conventional financial institutions. The purpose of the paper is to
  4. 4. 3 identify and analyze the affinity for financial operations and tools in two banking financial institutions, disparate from one another. There have been a great number of discussions pertaining Islamic finance and its possible future prospective. For this reason I’ve decided to analyze that differences, fluctuations and performances of both financial institutes as my subject in my work. In consideration of these prospects and objectives, this research tends to accomplish the following tasks:  Discuss the banking sector in Uzbekistan, especially it for Islamic finance in the nearest future  Analyze the theoretical background of Islamic banking and finance instruments  Describe the positioning of Islamic banking in global financial market and its role  Study the elements of Islamic financial products and the possible corresponding products in conventional banking sectors  Explain the problematic issues concerning expansion of Islamic banking in Europe  Overview the implications of regulatory standards on bank capital adequacy, stress testing and market liquidity risk, and related Islamic baking indices  Define pros and cons of leasing in Islamic and conventional banking sectors. The paper itself is divided into two major parts. Analytical part reviews the Uzbekistan’s banking sector in brief, including an analysis of them. Moreover, in the first part the reader can discover the origin and foundation of Islamic financial system, its technics, products, and regulations. The second part is about the calculations and practical analysis; opportunities for leasing operation are analyzed in conventional banks of Uzbekistan, also, in Islamic banks in example of Turkish participation bank “BankAsya”. The author used in his work the methods of grouping, processing statistical data related to the theme of the thesis. The author confined by analyzing leasing operation procedures in Uzbekistan as well its alternative transaction in participation bank “BankAsya” based on Islamic non-interest principle. The author does not consider the features and problems of value added tax (VAT) describing formulas and solutions in his calculations. In design of this work, the writer uses internship experience gained in “BankAsya”, Istanbul, Turkey in 2013. The paper ends with brief concluding remarks and appendix after the second part.
  5. 5. 4 1. ANALYTICAL PART 1.1. Uzbekistan banking system overview Uzbekistan has traditional two level banking systems, headed by the Central Bank of the Republic of Uzbekistan (CB). Main functions and objectives of the Central Bank are defined in the Law on Central Bank, issued in December 1995. At present, the CB is fulfilling functions of central monetary-lending institution. Main goal of the Bank is to maintain stability of the national currency. The priority objectives of the Bank are as follows:  development / maintaining monetary-lending, credit and currency policy of the country;  introduction of efficient payment system in Uzbekistan;  licensing and regulation of banking and financial activity;  management of cash flow of the state budget and performance of commercial activities on behalf of the Government (together with the Ministry of Finance);  Management of state reserves of the Republic of Uzbekistan (currencies, precious metals and etc.). Aggregate capital of commercial banks of Uzbekistan in 2010 increased by 44% versus 2009 and reached 4.1 trillion Soums (about US 18 billion) by the 1 January. The domestic financial sector was not directly affected due to the isolated and underdeveloped nature of the financial system. The banking sector and capital market in Uzbekistan is not yet well developed. The government has taken a gradual approach in economic reform. Similarly, reforms in the banking sector and capital market are slowly undertaken. The deposit base and penetration (ratio of loans and assets to GDP) are one of the lowest in CIS countries. Credit to economy/GDP and broad money /GDP are quite low. Credit to economy was about 38% of GDP in 2001, however, it declined to around 14% in 2007, which was low compared to other CIS countries. The state-owned banks are predominant in the banking system . Over half of the assets, capital, and loan portfolio in the Uzbek banking are possessed by state banks. The banking system is concentrated in Uzbekistan since the five largest banks own 70% of assets. Government guaranteed loans are still significant, albeit they are declining every year 22]. Uzbekistan’s state-dominated banking sector has promoted industrial development by channeling public investment to strategic industries and increasing total bank lending, while keeping banks sound. At the end of 2013, the sector’s capital adequacy ratio reached 24.3%. Aggregate capital in the banking sector rose by 25%, helping expand total credit by 31%. In August 2013, Moody’s Investors Service issued a stable outlook for the country’s banking
  6. 6. 5 Source: based on information from[33] 2009 2010 2011 2012 2013 GDP 8.1 8.5 8.3 8.2 7.4 Inflation (%) 7.8 7.2 7.3 7 7.2 Investment FDI(%) 2.5 4.2 3.6 1.7 1.7 Labor remittances (%) of GDP 3.9 4.5 6 6.8 6.5 Debt (%)of GDP 15 14.8 13.4 13 13 0 2 4 6 8 10 12 14 16 18 Uzbekistan Key Economic Indicators sector, citing healthy bank profits, improvements in asset quality, stable liquidity, limited reliance on wholesale funding, and few problem loans, averaging less than 10% of total lending. The government reported a budget surplus of 0.3% of GDP in 2013, though the surplus in the augmented budget, which includes the FRD, is estimated to have narrowed to 1.8% of GDP from the 4.7% recorded in 2012 Budget revenues (including the FRD’s estimated revenues) are estimated to have declined slightly, from 38.6% of GDP in 2012 to 35.8% in 2013, in line with declining international prices for key export commodities (Figure 1.1). Rising government spending, particularly for health and education, helped slightly raise budget expenditures (including the FRD’s estimated expenditures) from 33.9% of GDP in 2012 to 34.0% in 2013. The government adopted a new budget code in 2013, streamlining legislation on public finance management and strengthening the enforcement framework [3]. The government raised public sector wages and pensions by 21% in 2013 and maintained large-scale public investment in industry and housing. State investment spending grew by 11.0% to $11.3 billion, enabling gross fixed capital formation to rise by 19.8%, following 11.1% growth in 2012. An increasing share of investment is financed by the Fund for Reconstruction and Development (FRD), a sovereign wealth fund with assets exceeding $15 billion [33]. Figure 1.1 Key economic indicators of Uzbekistan There are following banking system and insurance market in Uzbekistan: I. Commercial banks - 30:  3 state-owned banks  13 joint stock banks
  7. 7. 6 NBU 31% Asaka Bank 12% AgroBank 7% UzPSB 8% Ipotekaban k 4% Microcredit bank 7% People'sBan k 6% Others 25% Capital NBU 32% Asaka Bank 11%Agrobank 10% UzPSB 11% IpotekBa nk 5% Microcre ditbank 3% People's Bank 6% Others 22% Assets  5 banks with foreign capital  9 private banks Over 4600 branches and retail offices all over the country II. Nonbank financial Institutions:  110 Credit Unions  82 Microfinance Entities III. Fund for Reconstruction and Development Since the Uzbek government saw the banking sector’s role as an important instrument in the implementation of the country’s import substitution policies, the sector was dominated by state- 9 owned and state-controlled banks. The assets of the three banks that are directly owned by the government comprised 65 to 80 per cent of the assets of the banking sector over the period 1996 to 2005. Among these three, the National Bank of Uzbekistan stands out. Since 1996, this giant bank has controlled over 50 per cent of assets of the banking system. Thus, since 2004 the National Bank has shown positive dynamics of development and strengthened its position in the Republican financial market. The consolidated balance of the National Bank in terms of US dollars comprised 2,929 million. However, nowadays the tendency of private banks, for instance, Hamkorbank, Trastbank, et al. have shown escalating progress in financial operations in both medium and large scales of banking economic sector of Uzbekistan. Figure 1.2 Assets and capital of Uzbekistan banking system according to Fund for Reconstruction and Development of Uzbekistan The following Figure 1.2 illustrates the distribution of assets and capital of Uzbekistan banking system among national and commercial banks [5710]. Source: based on information from [10]
  8. 8. 7 1386 4904 1181 934 0 1000 2000 3000 4000 5000 6000 7000 2005 2011 Domistic sources External Debt Stable banking and financial system are in strict compliance with the Basel Core principles of banking supervision sustaining the stability of banking system in Uzbekistan. The one of the fundamental rations as bank capital adequacy ratio is over 23%, which indicates the positive efficiency of banks and being almost 3 times higher than international standards. The banks’ total assets of banks are more than 2 times higher than the total balance of the population and legal entities deposits, insuring complete protection and guarantee of timely payments. For the last 10 years domestic sources channeled to financing the real sector of the economy )increased by 25 times Total current liquidity of the banking system is 10 times higher than external payments due (Figure 1.3). Figure 1.3 Credit portfolio of commercial banks (USD mln) The Islamic Development Bank (IDB) is an international financial institution established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in Dhul Q'adah1 1393H, corresponding to December 1973. The Inaugural Meeting of the Board of Governors took place in Rajab 1395H, corresponding to July 1975, and the Bank was formally opened on 15 Shawwal 1395H corresponding to 20 October of 1975. The purpose of the Bank is to foster the economic development and social progress of member countries and Muslim communities individually as well as jointly in accordance with the principles of Shariah i.e., Islamic Law. 1 Dhu al-Qi'dah is the eleventh month in the Islamic calendar. It is one of the four sacred months in Islam during which warfare is prohibited, hence the name ‘Master of Truce’. Source: The authors idea based on information from[10].
  9. 9. 8 Uzbekistan became an IDB member in 2003; an exemplary step in this direction is the recent IDB’s US$37 million 14-year financing that will be used to purchase medical equipment for the modernization of oncological institutions in the country. The project, whose total amount is US$83 million, is one of the 15 projects currently jointly implemented by the Uzbek government and the IDB in the fields of health, education, agriculture, energy and transport, with a total value exceeding US$400 million. In the past three years, IDB has sponsored several important projects and signed many significant treaties: • US$30 million in loan financing, co-financed with the Asian Development Bank, to improve water supply to major cities around the country, including Bukhara and Samarkand. • US$54 million grant: Of this amount US$15 million will go the National Bank for Foreign Economic Activity to finance small business projects; US$12.5 million will be spent on modernizing an asphalt factory, constructing roads and buying equipment for these purposes; US$25 million will be spent on the construction of an electricity line from two existing power stations; and US$143,000 will be spent on preparing a project on setting up an investment company. • In 2005, the Islamic Corporation for the Development of the Private Sector, a member of the IDB Group, and the National Bank of Uzbekistan signed an agreement of cooperation to further develop the Uzbek private sector. In the three years following Uzbekistan’s induction into the IDB, the IDB has already established a strong presence within the country providing the Uzbek government with considerable financing and sponsorship of numerous projects. This trend will likely continue in the future. In just over a decade, Uzbekistan has proven to be prime candidates for the establishment of Islamic banking and finance. Although primarily landlocked, the countries of this region for the first time are being linked to a greater network of commerce and trade throughout the Muslim world with the help of not only the IDB but also the just-flourishing Islamic banks . Not only has an organization like the IDB effectively demonstrated its support for socio-economic development, but it has also provided the six Muslim republics of this study with a means to remain Islamic-compliant when running various banking and finance projects that promote national development. [11]. On the other side, the private-owned bank – Hamkor Bank – is gearing up to provide Islamic banking services across the country leveraging on the bank’s wide network.Hamkor Bank is open joint-stock commercial bank, was established in 1991. Since its inception, Hamkor
  10. 10. 9 Bank is focused on private and corporate customers. The bank's customers are companies who are attracted to sound banking philosophy, which allows ensuring the stability, efficiency and security of financial transactions. Hamkor Bank, being a universal financial organization provides services to customers regardless of their activity and size of business. Current customers are representatives of large and small businesses, leading manufacturers of consumer goods and construction companies, telecommunication and transportation companies, trading organizations and representative offices. In previous years, Hamkor Bank was looking to collaborate with selected international organizations to become the first entity to provide Islamic banking solutions to the country’s 29 million Muslims to develop its human capital base to ensure that its Islamic banking initiatives and, to a greater extent, Uzbekistan’s Islamic banking and finance aspirations, can be kick- started with "sound foundations". He added that the bank, which focuses mainly on SMEs, is the only bank in Uzbekistan which is looking to collaborate with international financial institutions, such as the World Bank, Islamic Development Bank and Asian Bank for this purpose. In May 2010 the International Finance Corporation (IFC) acquired a 14.5% stake in Hamkor Bank, at US$0.09 cents per share, for US$3 million. The stake was then diluted to 12.59% in 2012 when the bank issued additional equity worth US$3.4 million. In February 2013 the Chief Executive Officer of Al Huda Centre of Islamic Banking and Economics – Muhammad Zubair Mughal – recently has met with Ikram Ibragimov, the chairman of supervisory board of Hamkor Bank in Uzbekistan's capital, Tashkent. There was a detailed discussion on affairs of their mutual interest for the advancement of Islamic banking in Uzbekistan. Unfortunately, Hamkor Bank is the only bank is Uzbekistan which is working in collaboration with international organization e.g. World Bank, Islamic Development Bank, Asian Development Bank, European Bank, KFW, Triple Jump and others Hamkor Bank will cooperate and be supervised by Al Huda CIBE Pakistan, especially advising and consulting in Islamic Banking; Shariah advisory; and Human Capital Development in this field. Consequently, Islamic banking can be initiated in Uzbekistan with sound foundations. Furthermore, Hamkor Bank, though not as big as leading banks in Uzbekistan, has a wide network in the country through which they wish to render the services of Islamic Banking. Shariah compliance and Islamic human capital development will be privileged so that Islamic banking can be initiated in Uzbekistan with sound foundations [15]. Uzbekistan is not the only country in the region to have realized the opportunities offered by Islamic finance and competition is rife between countries to conquer the Islamic finance pole position in central and north Asia [2].
  11. 11. 10 It should be noted that Hamkor Bank is a part of a large financial group of Uzbekistan. The group comprises of a bank, insurance company, 4 leasing companies and other institutions. 1.2. The principles and characteristics of an Islamic economy 1.2.1. Principles of Islamic economy The Islamic economy is an economic, social and political model based on the theological doctrines and values promoted by the Quran and Sunnah1 . In other words, as “Islamic economy is an approach to, and progress of, interpreting and solving the economic problems of human beings based on the values, norms, and institutions found in, and derived from sources of islam”.2 While the Quran is considered prescriptive, the Sunnah and hadith literature is considered descriptive. These two textual sources serve as the foundation of Islamic law. There are no compete economic or financial systems described in Islam. If to locate economics and finance in Islam, one could visualize the connection as seen in Figure 1.4. Figure 1.4 Economics and Finance in Islam Another useful definition is following: Islamic financial institutions are those that are based, in their objectives and operations, on Koranic Principles [Ibrahim Wade, Edinburgh University Press, 2001]. They are thus set apart from ‘conventional’ institutions, which have no much preoccupation. This definition goes beyond simply equating Islamic finance with ‘interest- Islam Faith and Belief Practices and Activities Morality and Ethics Worship to God Social Interaction Political Activities Economic Activities Social Activities Banking and Financial Activities Other Activities Source: Designed based on the ideas of the author
  12. 12. 11 free’ banking. It allows to take into account operations that may or may not be interest-free, but are nonetheless imbued with certain Islamic principles: the avoidance of riba (in the board sense of unjustified increase) and gharar (uncertainty, risk, speculation); the focus on halal (religiously permissible) activities; and more generally the quest for justice, and other ethical and religious goals. Two aspects of Islamic finance must be signed out. Fist is risky-sharing philosophy: the lender must share in the borrower’s risk. Since fixed, predetermined interest rates guarantee a return to the lender and fall disproportionately on the borrower, they are seen as exploitative, socially unproductive and economically wasteful. They preferred mode of financing is profit- and-loss sharing (PLS). Second is the promotion of economic and social development through specific business practices and through zakat (almsgiving). Figure 1.5 Islamic Concepts of a Market Economy between Economics and Law Source: Designed based on information from[25]. . Most but not all Islamic institutions have a Shariah board- a committee of religious advisers whose opinion is sought on the acceptability of new instruments, and which conduct a religious audit of the bank’s activities – as well as other features reflecting their religious status. In sum, the defining difference is that while ‘conventional’ finance usually seeks profit- maximization within a given regulatory framework, Islamic finance is also guided by other, religiously-inspired goals. Secular Economics Koran Sunna Fiqh (jurisprudence)Islamic Economics Shariah (Islamic law) Concept of market Economy Principles Rules Systems Design IslamicSystemSecularLaw
  13. 13. 12 Islamic banking also involves more than banking more than banking. It includes mutual funds, securities firms, insurance companies and other non-banks. Where once - in the mid- seventies – Islamic banks were few numbers and easily identifiable, the phenomenon has become quite amorphous with the proliferation of Islamic institutions and the blurring of the lines between traditional banking and other forms of finance (Figure 1.5). Another complicating factor is that growing number of conventional institutions, inside and outside the Islamic world, have in recent years created Islamic subsidiaries or have been offering Islamic ‘windows’ or products in addition to conventional ones. For the outside observe, the inevitable question is: how can a financial system operate without interest rate? The answer is that it can through the development of profit-and-loss sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as young agents for clients. 1.2.2. Elements and Superstructure of Islamic system Over the past decade, public duties (both of society and the state) have broadened to include safeguarding sustainable economic activity and protecting the environment. Finally, the state should create favorable framework conditions for a private economy consistent with the requirements of Islam, something which can have particular implications [25]. Essentially, this list contains all the elements that constitute a social market economy, which have been summarized in the Konrad-Adenauer-Stiftung’s publication entitled “Guidelines for Prosperity, Social Justice and Sustainable Economic Activity”. The prevalent doctrine of Islamic economics today can be summarized as follows:  Islam conveys a positive outlook on this life in general and provides a supportive value system for economic activities in particular  Islamic economic ethics exhibits considerable overlap with Western-Christian perceptions in the field of individual ethics. Great importance is ascribed to personal achievement.  Individuals are expected to earn their living through their own work. A person’s own achievement (physical and intellectual work) is the most important basis for legitimately obtaining material goods and wealth. Neither individual human skills nor natural resources should lie idle unnecessarily, and it is forbidden to waste or wantonly abuse resources.  Legitimately acquired wealth should not be used to maximize the pursuit of a person’s own wants (in this life): luxury is frowned upon; Islam preaches moderation; and the use of surpluses for social aims is meritorious.
  14. 14. 13  The needy have their own claim to solidarity from the community, which is institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a two and a half percent levy on assets or a five or ten percent levy on agricultural produce, which is used for specific (social) purposes. This is an obligation for the individual, and the claims of the needy should be satisfied by the community or the society (and only then by the state); this is very similar to the principle of subsidiarity.  The needy have their own claim to solidarity from the community, which is institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a two and a half percent levy on assets or a five or ten percent levy on agricultural produce, which is used for specific (social) purposes. This is an obligation for the individual, and the claims of the needy should be satisfied by the community or the society (and only then by the state); this is very similar to the principle of subsidiarity.  Since Allah has made the goods of this world available to all human beings, inequalities in the distribution of income and wealth must not be allowed to become too great. If needs be, the state must intervene with corrective measures to fight poverty.  Humans, as God’s custodians of the earth, only have the right to use creation. They must not inflict lasting damage on it and must consider the legitimate claims of future generations in what they do. This principle gives rise, among other things, to a collective ownership of non- renewable resources (natural resources, but also water) and, more recently, a duty to protect the environment.  Islamic law recognizes private ownership of the means of production. Nationalization and state control of the economy are only permissible in exceptional circumstances. Land and capital become productive only as factors of production when combined with labor. Therefore, income may not be derived from merely owning land or capital. Financing, lease, and other contracts, which allocate returns and risks to the owners of factors of production, must meet particular criteria of justice. [4]. For the outside observe, the inevitable question is: how can a financial system operate without interest rate? The answer is that it can through the development of profit-and-loss sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as young agents for clients. By this means of information, a following chart can be structured to properly understand the Islamic economic system (Figure 1.6.). Legal framework Law and the rule of law are important: linking government action to a superior law – Shariah (which only contains some directly applicable economic content) and Shariah compliant secular law (the formulation of which gives great creative leeway). Concepts of an Islamic
  15. 15. 14 Source: Designed based on information from [25] economic system are compatible with different forms of government (democracy, monarchy, etc.). Figure 1.6. Elements and Superstructure of an Islamic Economic System Competition as a basis Justice is important: price fairness; state protection of competition against monopolization; occasional state intervention in the case of “sensitive” prices. Solidarity and social security Poverty reduction is as a primary economic objective. Zakat at the core of a social security system that is independent of the family (claim of the needy in respect of society – state is subsidiary). Sustainability Allah is the ultimate owner, human beings are merely custodians, and duty extends to future generations (idea of sustainability). Open markets Science Ideology Religion Prescriptiveness Mobilization Open and Competitive Markets, Competition Policy Financial and Monetary Economy  Prohibition of riba  Stable money ( gold, 100%,…) Individual social Security  Zakat (social security contributions)  Takaful (mutual insurance) State and the Public Sector Economy  Legal Framework  Infrastructure, environment Legitimacy Functionality
  16. 16. 15 In principle, for all open goods, services, and labor markets, but reservations with capital markets (issue of interest, speculative transactions). Therefore, the special regulations in Islamic economy lead to sustain development of the social market and life of the nations. For that reason there were the formal restrictions, which stem from the requirements for Shariah-conformity, do not prevent the construction of a sophisticated and efficient financial system and capital market – without which the social market economy could not function. In view of the current global financial crisis, such a strong link between the financial sector and the real economy, and a limit to the development and application of synthetic financial products for speculative and high-risk purposes is, perhaps, more beneficial than detrimental for a social market economy. Against the backdrop of replications of problematic, conventional techniques and products that conform to Shariah law, the calls by Islamic economists – which perhaps go a little too far – for every financial transaction to be based on a real economy transaction, can also be understood in some respects as self-criticism, or at least a warning to Islamic financial engineers. The Islamic economic systems are indeed compatible with the concept of the social market economy, and that Islamic economics can act as an advocate of such a concept transfer. Nevertheless, this alone would not bring much benefit as the political effectiveness and the practical relevance of Islamic economics as an academic discipline is relatively weak at a systems level, and this influence has tended to wane rather than wax over the past twenty years. It is an obvious fact that the social market economy is a concept that was created for highly developed and structurally differentiated economies only in the twentieth century in the Western world, where it has proved itself. In Islamic countries, most of which only gained their independence in the middle of the twentieth century, this concept was rather unknown. In the light of the lasting development problems of many countries of the Muslim world – stretching from North Africa, across the Middle East to Southeast Asia – these states have by no means ruled out the search for economic concepts that promote development. Not least as a result of disappointment with the results of the capitalist and socialist economic systems, since the mid-1970s people have been progressively formulating ideas about an Islamic economic system, propagating them as an alternative to the unsatisfactory status quo. Against this backdrop, therefore, it is worth investigating the general principles of the social market economy and their compatibility with such economic systems in order to share the experiences of our own economic system as part of the dialog surrounding development policy.
  17. 17. 16 1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend Over the last three decades, the concepts of Islamic Finance and Islamic economics have captured the attention of researches. The growing market for transactions compatible with Islamic law (Shari’ah) is further evidence of growing interest in this mode of finance. Although Islamic finance is one of the fastest growing segments of emerging global financial markets, it is often stated that the market is far below its true potential. At the same time, the concept of Islamic finance are not fully explained and exploited – especially in the areas of economic development, inclusion, access to finance, and public policy. Over the last two decades, by some estimates, the total volume of Islamic financial assets has grown by 15-20 percent a year and now exceeds $1.3 trillion [7].  There are more 267 Islamic financial institutions (IFI) worldwide with capitalization in excess of $13 billion. This includes banks, mutual funds, mortgage companies & Takaful  Shariah-compliant financial products estimated to exceed $250 billion with annual growth rate of 23.5%over the past 5 years  There is approx. $1.5 trillion of GCC funds held in investment assets worldwide (Treasuries/corporate bonds/equities/funds etc). Of this $1.5 trillion, $250 billion constitutes of High Net Worth Individuals  The potential is huge. By 2020, there will be 2.5 billion of Muslim population worldwide from the current 1.5 billion level  Islamic banks are expected to manage 40%-50% of total savings of Muslim  Population in 8 to 10 years. Therefore, potential for Islamic financial services is estimated at $4 trillion by 2020 It is crucial these huge amounts of funds are channeled towards productive use –into GCC infrastructure/economic sectors and other emerging economies. Following on from the significant developments that have occurred in what we view as the core area for this market – the predominantly Muslim countries – we are now witnessing the globalization if Islamic finance. In recent years, significant interest in Islamic finance has merged in the world’s leading financial centers, including London, New York, and Hong Kong, and Western investors are increasingly considering investment in Islamic financial products. The growth of this market has been driven by the high demand for Shari’ah-compliant products, as well as increasing liquidity of Gulf States. The table 1.1 shows the growth trend in Islamic finance for banking sectors by different regions, with estimates of total Islamic banking assets reaching $1.8 trillion by the end of 2013 [7].
  18. 18. 17 19 9 34 20 25 42 22.5 8 5 18 13 15 31 14 0 10 20 30 40 Malaysia Indonesia Turkey Saudi Arabia United Arab Emirates Qatar Median Islamic banking Conventional Banking Table 1.1. Total Islamic Banking Assets (in $ billion) Global Islamic banking assets 1.334 Growth estimates by the region through 2013 Southeast Asia 89 Gulf Cooperation council (GCC) countries 131 Rest of the world 257 Global Islamic Banking assets (2013, est.) 1.811 In the following figure 1.7 we can see trends promoting the growth of the Islamic financial sector in the 2006-2010 periods surpassed the growth of the conventional financial sector in all segments of the market, ranging from commercial banking, investment banking, and fund management to insurance in several Muslim-majority countries [6]. Islamic banking continues to be an exciting growth story characterized by robust macro outlook of core Islamic finance markets and increasing share of system assets. It is increasingly gaining acceptance, especially in high-growth emerging markets, as an effective means to build an inclusive financial system and replace the shadow economy. Figure 1.8 illustrates the global distribution of Islamic assets in world’s financial market. One of the recent developments in Islamic finance is the introduction of Islamic bonds, or sukuk, which are structured as a securitized product. The key feature of sukuk is that they are structured following principle of linking the financial return to the real sector activity. We will Figure 1.7 Growth of Islamic Banking and Conventional Banking Assets in Selected Countries (in percent) Source: based on information from [3,33]
  19. 19. 18 Saudia Arabia 16% Malaysia 8% UAE 5% Kuwait 4%Qatar 3% Turkey 2% Indonesia 1% Bahrain 1% Rest of the world(inc. Iran) 60% 50 50 100 180 300 370 420 685 831 794 825 0 100 200 300 400 500 600 700 800 900 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Volume ($ billion) Number of issues describe more explanatory about this special financial product later on, however there is a room to mention about important value of the introduction of sukuk escalated the financial stability of Islamic liquidityin world market. Figure 1.9 shows the total number of sukuk and their volume over the last ten years, which is testimony to the rapid growth of this market, and its quick recovery during global downturn. The sukuk market has been used by both the public sector and corporate sector to mobilize finance [21]. Figure 1.8 The Global Distribution of Islamic Assets Source: based on information from[3,33] Figure 1.9 Total Sukuk Issuance 2002-2012 Source: based on information from[29]
  20. 20. 19 1.3. The Role non-interest philosophy of is Islamic Finance Most definitions reduce Islamic banking to ‘interest-free’ banking. Islam prohibits interest but it does not means, that it prohibits all gains on capital. The only increase stipulated or sought over the principle loan or debt is prohibited in Islamic shariah law. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, as enshrined in the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value addition’. Islam deems profit, rather than interest, to be closer to its sense of morality and equity because earning profits inherently involves sharing risks and rewards. Islam encourages shearing of risk among lender and borrower, Islamic financing system is based on this principle, it has also another character of owing and handing of real assets, its involvement in trading, construction and leasing using Islamic mode of financing. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income. Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conductive of fiscal and monetary policies [30]. The most important prohibition is riba (usury/ interest). The subject of riba is a difficult for many scholars. There is huge number of literature discussing the topic of riba in accordance to Islamic teachings. Islam, however, strongly and precisely prohibits interest, but permits trade. Doing interest business is viewed equal to rebel against God and His prophets. In Koran2 it states: “Those who take riba (increased amount, i.e. usury / interest) will not stand but as stands the one whom the devil has driven to madness. That is because they say: ‘Trade is like usury’, but Allah has permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist (from indulging riba), shall be pardoned for the past; their case for Allah to judge; but those who repeat (the offence) are companions of the Fire: They will abide therein (forever)” [17]. “Allah 2 Koran (Quran) is the scripture, the holly book of Muslims and was verbally revealed from God to his prophet Muhammad.
  21. 21. 20 will deprive usury of all blessing, but will give increase for deeds of charity: for He loves not creatures impious and sinning”.[17]. “O you, who believe, do not eat up the amounts acquired through Riba, doubled and multiplied. Observe your duty to Allah, that you may be successful”.[17]. At the same time, there is a notable number of hadith explicitly pointing of the prohibition of interest, e.g. the Prophet Muhammad (BPH) cursed “the one who accepted interest, the one who paid it and the one who recorded it and the one who witnessed it, and said that they are all alike (i.e. they are equal partners to the sins)”.[5]. Trade on the other hand is permitted, furthermore, encouraged. It says as follows in relevant verses: “There is no sin on you that you seek the grace of your Lord (by trading)” [17]. Despite numerous proofs and easily accessible information presented, the question of whether interest is prohibited in Islam seems to be the most frequently asked question in regard to Islamic finance. The main reason Islam has delivered such a harsh rulings against interest that it is set to establish economic system in which all forms of exploitation are eliminated, and particularly the injustice in the form of financier being assured of a positive return without doing any work or sharing risk, while entrepreneur, in spite of his management and hard work, is not assured such a positive return. In this regard, Islam wishes to establish justice between the financier and the entrepreneur. The difficulty to understand the prohibition comes from lack appreciation of the whole complex of Islamic values, and particularly its emphasis on socio- economic justice and equal distribution of income and wealth. [20]. 1.4. Islam, Economics and Finance 1.4.1. Historical and Religious Background Any successful belief system, whether religious or secular, has seemingly contradictory characteristics: it is malleable enough to adopt to a variety of geographical settings and survive the test of the time, yet it must be able to maintain its specificity, or else it would disappear or become fused with competing belief systems; it is idealistic, sometimes even utopian, yet capable of adjusting to human imperfection and making the kinds of compromises that are endemic to political and economic life. With this in mind we can better understand hoe a system rooted in the Middle Ages could survive, and thrive, in the global economy [14]. Following, a board of overview of the parallel evolution of religion and history we can now deepen into the mechanisms by which Islam adapted to changing circumstances, and explains how Islam could accommodate itself with modern economic and finance. The tenets of the Islamic religion can be conceived as a pyramid. At the top stands Koran, considered by Muslims to be God’s word as conveyed to the Prophet Mohammed. Below it are
  22. 22. 21 the Hadith and the Sunna. Often interchangeably, the first actually refers to the words and deeds. In other words, the Hadith, in the form of a large and ill-defined number of short texts, relates stories about and sayings (specific pronouncements, deeds, or approvals of other people’s actions) of the Prophet, whereas the Sunna consists of the practices and rulings deduced from such narratives. In order to examine the impact of Islamic banking it is important to understand the historical origins of the banking system in predominantly Muslim countries and the evolving divergences from conventional banks. The modern conventional banking system in Islamic countries is a product of colonizers using the support of financial institutions for mining, agriculture, and manufacturing. The initial banks were predominantly used for the funds of foreigners and as a means to increase foreign-owned industries that spread through imperial rule. These institutions were used to finance the expansion of the public sector in the Middle East and North Africa, huge portions of the population made up of devout Muslims [23]. Throughout its golden age (roughly the seventh to tenth centuries in the Middle East, and the eleventh to fourteenth centuries in North Africa and Spain), the Islamic world did not fit the imagine of a narrow-minded theocracy. Great libraries and translation centers were established where great works of philosophy, literature, medicine and science from East and West were collected and translated. Such knowledge was improved upon and formed a necessary link to later advances in the West. So where does the persistent image of an Islam incapable of separating mosque and state – indeed incapable of dealing with the modernity and change – come from? The answer lies in the parallel evolutions of Islam and the West, starting with the end of the golden age. However, due to the industrial revolution in the West countries in the late nineteenth centuries, most countries followed a path of Westernization and secularization that led to adopt, under foreign tutelage, Western models in politics, economics, law, and education. Muslims were divided. While some did not see a necessary contradiction between Islam and Westernization, a number of political and religious movements emerged throughout the Islamic world, calling for a return to Islamic values and traditions. There was no clear consensus, insofar as some wanted a return to the past while others called for an update of Islamic doctrine. Islamic modernists shared with traditional Islamist groups the belief that the ills of the society were caused by the betrayal of Islamic ideals. While they shared with secularists the embrace of the reason, science and progress, what set Islamic modernists apart their belief that political liberalization and intellectual reawakening could be, indeed had to be, rooted in a return to Islam [14].
  23. 23. 22 In sum, modernity – undertaking a radical reinterpretation of Islam to suit modern conditions – is not easy to dissociate from a quest for authenticity. And traditional fundamentalism – if defined as the effort to return to the fundamentals of the religion – is not necessarily the same as literalism. 1.4.2. Islamic Economics The commerce is central to the Islamic tradition. The Prophet Mohammed was himself a merchant. In his day, the economic system was quite simple. Mecca, at the time wealthiest Arabian city, depended heavily on trade. The continuous spread of Islam soon brought the region’s lucrative trade routes, previously controlled by Byzantium and Sassanid Persia, under Islamic control. As the expansion of trade in Islamic world, the economy became increasingly complex institutional innovation occurred, for example with the creation of hisbah, an office in charge of supervising markets, providing municipal services, and settling petty disputes. By the time passed, Muslims in the liberal era who had studied Western-style economics tried to transpose that knowledge to the Islamic world. With decolonization and the nascent tend toward a return to Islam, religious scholars attempted to rethink economics and the social sciences in the light of their religious training, with the goal of creating an ‘authentic’ or at least indigenous brand of economics. It is usually agreed that the most original work in Islamic economy is that of Mohammed Baqer as-Sadr, whose book Iktisaduna (‘our economy’) is an attempt to develop an Islamic approach to economics. With the newfound wealth of oil-producing countries and the rise of Islamic militancy, the need to promote further thinking on economic matters gained new urgency. A number of fiqh3 academies sprouted throughout the Islamic World, have settled a majority based decision making processes. Gathering in convocations, scholars deliberate collectively and decide questions by the majority vote. First time the Islamic economics conference was held in 1976, in Mecca, where the conference dealt exclusively with economic matters. King Abdul Aziz University established the International Center for Research in Islamic Economics in 1979. Starting with Pakistan in 1977, a growing number of countries sought to Islamicize their economic systems. Islam would typically be presented as offering a ‘third way’ between capitalism and socialism that would be not only different, but also superior to, and no less efficient than, the two others. In Islam, strict definitions have typically prevailed. But as its economy grew more complex, the Islamic world was able to find proper substitutes, justifications, or subterfuges. 3 Fiqh is Islamic jurisprudence, based on the expansion and interpretation of Shariahh; deals with the observance of rituals, morals and social legislation in Islam
  24. 24. 23 1.4.3. Reconciling Islam and Finance Muslims’ Holy book – Koran states that despite superficial resemblance, profits from commerce are fundamentally different from profits from money-lending [Surah Al-Baqarah, 275]. Muslims, unlike other nations, have traditionally looked favorably at commerce, while being suspicious towards finance. While the reconciling between other religious representatives and finance was long-drawn and fraught with theological and philosophical disputes, in Islam however, riba would occasionally be interpreted not as interest [14], but the usury or excessive interest, severe and accurate descriptions have, in common, as a rule dominated. The early years of Islam, jurists devised an impressive array of contracts designed to circumvent interest-riba, the most important ones being profit-and loss contracts (mudarraba or qirad). Modern finance entered the Islamic world alongside wit Western colonial expansion. Foreign banks financed trade and development, and in due course Islamic governments, strapped for cash, had become debtors, therefore paying interest to foreign creditors. For example, the Ottoman Empire in the middles of 19 century had been issuing interest-bearing treasury bonds [28]. In Egypt foreign banks played a crucial role: in 1920 Banque Misr was established, the first ever to be formed exclusively with local capital. Egypt’s thriving stock-market made it a favorite among early twentieth-century ‘emerging markets’, which promoted to be a third largest stock market in the world after World War 2. Perhaps most importantly, it is in Egypt that interest was legitimated by religious authorities in 1904. The riba controversy was temporarily ignored but not to rest. Many legal codes adopted by Islamic countries observed an ‘eloquent silence’ – on the issue of interest-bearing loans. The world finance took a new tern with the end of colonialism: newly independent states established national monetary authorities and central banks, issuing local currencies. Thus, until resent attempts at ‘Islamicizing’ economic systems, all countries regardless of ideological learnings, learned to live with interest and with modern finance. With the advent of Islamic finance, prevailing consensus among Islamic scholars was that dealing with conventional banks was acceptable if Islamic institutions were not accessible to them. The transformation of modern finance that has taken place since 1980s has also reopened the debate about the acceptability of new financial instruments. But rather than a wholesale rejection, the trend has been towards a now ijtihad designed to separate those products that are acceptable from those that are not, and to create financial instruments adapted to the need of Islamic societies [9].
  25. 25. 24 1.5. The Ethical Framework of Islam 1.5.1. Riba and Gharar Most definitions reduce Islamic banking to ‘interest-free’ banking. While the injunctions against riba are indeed the cornerstone of Islamic finance, debates persist as to the exact significance of the word. Since the early days of Islam, the majority of scholars have adopted a restrictive definition: any form of interest constitutes riba. The debate is nonetheless still keeps actual topicality in modern world. The most common way of financing throughout recorded history is where the owner of money loans it to someone in need and receives the principal plus an agreed upon amount of interest after an agreed upon time. The riba debate has been approached from many angles. One set of discussions contrasts ‘interest’, a moderate economically justified remuneration of capital, with ‘usury’, an excessive, sometimes extraordinary rate. A few scholars have argued that only latter constitutes rib, however the majority of Islamic scholars still consider that any increase in the amount of money returned by a borrower constitutes riba and is therefore prohibited. Another angle is the requirements of modern economy. As one of the Islamic modernist – Fazlur Rahman says: “As long as our society has not been reconstructed on the Islamic pattern, it would be suicidal for the economic welfare of the society and the financial system of the country and would also be contrary to the spirit and intentions of the Koran and Sunna to abolish bank- interest [16]. Despite argues and long debates; in 1986 the Fiqh (jurisprudence) Academy of Islamic Conference supported the restrictive interpretation of early jurists, condemning all interest-bearing transactions as void. But in 1989, while an economic and rhetorical debate between Islamic financial institutions and conventional banks was raging, the mufti (religious scholar) of Egypt A. Tan2tawi, issued what he considers fatwa (code), one legitimizing ‘capitalization certificates’, which are interest-bearing government bonds underwritten by Egyptian banks. There is little difference between Western-style bans which offer fixed interest rates, and Islamic banks in which depositors share the risk of investing projects, for Islam simply requires financial transactions to be market by clarity and justice.[29]. On the other hand, the Egyptian fatwas had paradoxical impact on Islamic finance, insofar as they added the legitimacy to more pragmatic approaches, but the intellectual debate on riba is still raging. It is all the more inconclusive that unassailable, factual elements about the origin of riba are scarce. Islamic scholars have insisted that the prohibition of the riba is not an isolated religious injunction but ‘an integral part of Islamic economic order with its overall ethos, goals and values. Based on the definitions it comes out the riba is not necessarily about interest rates as such and it certainly is not exclusively about interest rates. It really refers to any unlawful gain
  26. 26. 25 derived from the quantitative inequity of the counter values. Interest or usury would then be only one from riba. The meaning of the word ‘Gharar’, however is not mentioned as riba in Koran, etymologically relates to the words deception or delusion. The principals are the same as prohibition of riba: unequivocal though the concept itself is somewhat vague. The Gharar in addition to deception and delusion also connotes peril, risk and hazard. In more financial terms it can be interpreted as ‘uncertainty, risk or speculation’. Any gain that may result from chance, from undetermined causes, is here prohibited. There are some examples to clear up with this definition. It would be wrong to get a worker to ski an animal by promising to give him half the skin as the reward, or to get him to grind some grain by promising him the bran separated out by the grinding process. It is impossible to know for certain whether the skin may not be damaged and lose its value in the course of the work, or to know how much bran will be produced. More accurately, Gharar refers to aleatory transactions, that is, transactions conditioned on uncertain event. Gharar should not be used interchangeably with the broad concept of risk. Gharar is prohibited yet it would be nonsensical to prohibit risk. There are Hadith goes much further, extending the concept of commercial transactions involving uncertainty. The meanings of most significant of them are following:  Do not buy fish in the sea, for it is Gharar.  To sell grapes until they become black, and sale grain until it is strong.  Do not sale what in wombs, contents of the udders, pebble. 1.5.2. The Moral Economy of Islam The three pre-requisites for an economic system as being a set of rules, an ideology to justify them, and a conscience in the individual which makes him strive to carry them out [ 27]. The Ethical dimension is not all too often forgotten, though it exists, as well in any society. Hard work and participation in economically creative activity is obligatory for every Muslims [17]. Economic activity is not to be confined to earning or producing enough to meet one’s personal needs only. Muslims are expected to produce more because they cannot participate in the process of purification through providing security to others (zakat or alms tax) unless they produce more than what themselves consume. The most recommended use of fairly earned wealth is to apply it to procuring of all means to fulfill a Muslim’s covenant with Allah [18]. The broad ethical/economic system emphasizes fairness and productivity, honesty in trade and fair competition, the prohibition of hoarding wealth and worshipping it, and protection
  27. 27. 26 of human beings from their own folly and extravagance. Such a system, although rooted in ancient tradition, is not, at least in its broad outlines, far moved from many contemporary approaches to ethical business practices. As for the ethical/economic justification for the prohibition of riba, it is three-pronged: riba is unfair, it is exploitative, and it is unproductive. Due to this relation the lender and borrower are in equalized balance of economic chain. Islam prefers the risks of loss be shared equitably between the two both lender and borrower. In other words, rather than collecting a ‘fixed, predetermined’ compensation in the form if interest, leaders should be entitled to a share from any profits from a venture they have helped to finance. The broader argument is that any point should be morally and economically justified. As in other religions riba was also seen as exploitative, since it tended to favour the rich, who are were guaranteed a return, at the expense of the vulnerable who assumed the risk. A number of economists and philosophers disagreed with the idea of marking capital gain without any effort and living off other people’s work unethical. The prominent ancient-Greek philosopher Plato (424-347 BC) pointed out immortality of interest and argued that in an ideal society interest should be forbidden as it leads to inequity, egoism and egotistical conflicts among people. Another Greek philosopher Aristotle (384-322 BC) like his teacher did not agree the idea of exploiting money interest. According to him there was a ‘natural’ and ‘unnatural’ way of income. Shepherding, fishing, farming, hunting and alike were natural ways. Unnatural ways on the other hand were those done with the sole purpose of making profit. The worst way of gaining wealth through unnatural ways was interest. In this regard he recorded: “Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways of getting wealth, the most contrary is to nature.” [32].In the early times of Roman Empire there were laws forbidding interest. Even later under the ‘Law of the Twelve Tables’ interest rates was fixed, and loan sharking was illegal. Significantly, the issue of fairness is related to the issue of productivity and efficiency. Earning a profit is legitimate when one is engaged in an economic venture and thereby contributes to the economy. By certain accounts, Meccan merchants in the days of the Prophet routinely engaged (usually in-between arrivals and departures of caravans) in interest-based lending, speculation and aleatory transactions [13]. This would account for the sharp distinction drawn in the Koran between profit from trade and profit from riba. While the former benefited the community and enhanced welfare, the latter diverted resources towards non-productive uses and contributed to illiquidity and scarcity. The modern-day economy equivalent of that debate
  28. 28. 27 contrasts the real, productive economy with the financial, speculative one. Some Islamic economists have also argued that an interest-based economy was inherently inflationary and caused unemployment and poverty because of money was not linked to productive investment. 1.6. Financial Products in Islamic Banking and Their Conformity with Conventional Banks Most Islamic financial institutions engage in a variety of financial operations. Besides their range of equity, trade financing and lending operations, Islamic banks worldwide also offer a wide array of wholesale and retail products including loans, partnership investments, foreign exchange transactions, fund transfers, letters of credit, securities safe-keeping, investment management and advice, and other conventional banking services. Many are also in active derivatives, fund management and insurance. There are favourable investment climate on liability side in Islamic banks for depositors as well. Current accounts are operated on the principles of al-wadia (safekeeping) and are not remunerated. In this term, depositors are provided with the cheque-books and can withdraw their funds at any time without any restrictions or conditions, unlike in conventional banks. Investment in profit-and-loss (PLS) deposits linked to bank mudaraba investments are in the theory though not in practice the principal instruments offered to depositors. Banks usually offer a variety of accounts – PLS deposit accounts, PLS special notice deposit accounts, etc. (Figure 1.10). Yet in classical Islamic tradition, the only acceptable loan was the ‘qadr hasan’ (meaning- good loan) or interest-free loan in the only common form of deposit was ‘al-wadia’ (safekeeping). By creating new products that pose no religion objections, or by invoking custom, or overriding the general interest to justify the creation of somewhat controversial instruments, Islamic bankers have been able to devise new products and instruments by updating or combining contracts that go back to classical Islam. In Appendix, the reader can find more information about differences of products and techniques in Islamic and conventional banks. 1.6.1. Murabaha The best-known Islamic banking instrument is murabaha a cost-plus contract in which a client wishing to purchase the equipment or goods requests the financial provider to purchase the items and sell them to him at cost plus a declared profit. It is thus a financing-cum-sale the items and sells them to him at cost plus a declared profit. It is thus a financing-cum-sale: the bank purchases the required goods directly and sells them on the basis of fixed mark-up profit, agreeing to defer the receipt of the value of the goods. While the interest-based bank would lend the money on interest to client, and he would go and purchase the required commodity from the
  29. 29. 28 Shariah Sources Koran Sunna Ijtima jurists’consensus) Qiyas (Analogy) Ijtihad (Reasoning) Shariahh Filter islamic products transations Islamic Trade/ Financial Contracts Musharaka ( partnership) Murabaha (purchase-sale) Ijarahh (lease) Takaful (insurance) Salam( forward sale) market, in Islamic bank, as it does not operates on interest basis, the bank therefore, purchases the commodity in cash and sells it to the client on an agreed mark up. Thus, the client gets the commodity on credit for which financing required and the Islamic bank makes profit on the amount it has spent in acquiring the commodity and selling it to the client on installments. There are a number of requirements for a murabaha transaction to be a legit transaction and meet Islamic standards of a legal sale. The whole murabaha transaction is completed in two stages. In the first stage, the client requests the bank to undertake a murabaha transaction and promises to buy the specified commodity from the bank. A promise under Shariah, however, is not legally binding. Which means, if the client goes back on the promise to purchase, the bank risks the loss of the full or part of amount it has spent to acquire the goods. To eliminate such situations, Islamic banks sign legally binding agreements with their clients beforehand, which also can Figure 1.10 Islamic Finance in Ethical and Religious Framework Banking and financial needs Asset-backed transactions with investments in real durable assets Islamic Banking and finance Prohibition of certain investments: - Sectors: (e.g.: alcohol, armaments, tobacco pork pornography ) - Instruments(e.g. no forward transactions, no derivatives, short selling Credit debt products are not encouraged
  30. 30. 29 Supplier Financial Institution Costumer Sell asset at purchase price Make upfront payment Deferred payment Sell asset at purchase price + markup be understood as a promise between the two parties. In the second stage, the client purchases the good acquired by the bank on a deferred payments basis and agrees to a payment schedule. Another important requirement of a murabaha sale is that it consists of two sales contracts, and through which the bank acquires the commodity for the client, and the other through which it sells the acquired commodity to the client. The two contracts should be separate and real transactions (Figure 1.11). Murabaha form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors such as consumer finance – for the purchase of consumer durables, for example, cars and household appliances, the real estate – to provide housing finance, the production sector – to finance the purchase of machinery, equipment and raw materials. Murabaha contracts are also used to issue letters of credit and to provide financing to import trade at Islamic banks. A Murabaha transaction has the following characteristics:  The cost price of the asset is known to both the buyer and seller  The buyer pays the seller at a fixed agreed time after receipt of the asset for an agreed mark-up  The mark-up may be a lump sum or a certain percentage of the purchase price  The mark-up can, and often does, relate to the prevailing LIBOR (or equivalent) rate  Payment default will require the buyer to cover the seller's stated cost of capital for this period A Murabaha transaction is a debt based transaction and is therefore not tradable (as Figure 1.11 Murabaha transaction structure
  31. 31. 30 Shariah forbids trading in debt) but can be transferred at par value. Generalizing the incidental closeness between profit shares and interest rates, which appear in some periods, and thereby reaching some conclusions will not give correct results. A conventional bank determines the interest rate it will pay clients at the time of depositing money. A Islamic banks on the other hand utilizes the money through applicable profit margins, and shares the money it earns. Event in case that the distributed profit shares are close to the interest rates of conventional banks, this does not mean that the work done is the same. Important here is not the rate of interest and profit sharing, but the source of each. While interest steams from a source forbidden by all theistic religions and condemned by many prominent philosophers and economics, profit sharing at participation banks is a result from permissible economic activity. In order for earning yield to be interest, it is necessary that income is known beforehand, and that money earned in return for lending out money. For instance, a conventional banks collect money from the depositors in return for a certain interest, and yet again present it in terms of cash loans to those in need for financing, subject to current interest rates. But on the other hand, there is neither a promise made for income nor a guarantee for principal capital of the people under profit sharing. 1.6.2. Leasing Ijarah4 or leasing is probably the fastest growing activity in Islamic financial institutions. The principle is well knows and virtually identical to conventional leasing: the bank leases as asset to a third party in exchange for specified rent[1]. The amounts of payments are knows in advance and the asset remains the property of the lessor. Only in a few respects do Islamic contracts differ. A variation of basic principle is ijarah wa iktina, a lease- purchase agreement whereby at the expiration of the lease, the lessee becomes the owner of the asset (Figure 1.12). From the standpoint if classical Islamic fiqh, ijarah is understood as the sale of usufruct (manfaa) and, as such, its rules closely follow those of ordinary sales. In order to avoid the elements of riba and gharar, there are minor differences between ijarah and commercial leasing. The law views some benefits and burdens of the property as belonging naturally and unchangeably to the lessee, others to the lessor. For example, law provides that the duty to repair the goods always fall on the lessor since the repair benefits him as the owner. Also, the usufruct is not something existent and tangible, but a stream of the use extending into the future, which is risky and unstable. Islamic law thus gives broad scope to the lessee to cancel the lease if the 4 “Ijarah” or in various literature “ijara”, which are identical in definition.
  32. 32. 31 usufruct proves less valuable than expected. Finally, the price at which the asset may be sold to the lessee at the expiration date of the contract cannot be predetermined. Main characteristics of Ijarah:  It is necessary that the lessor own the asset and holds valid title to it.  Operating lease – the asset is returned to the lessor  Financial lease – the asset is sold to lessee be lessor upon completion of lease term  Lease rent is fixed by parties updating to market competitiveness  Lease will terminate upon total loss of asset or damage A number of reasons account for the repaid growth of leasing : it is an acceptable instrument in the eyes of the most scholars; it is an efficient means of financial intermediation; by financing assets, it is useful tool in the promotion of economic development; because it is a well-established instrument that lends itself to standardized mechanisms and procedures, and because the similarity to conventional leasing, it is a flexible mode pf financing that lends itself to securitization and secondary trading and to collaboration with conventional institutions. 1.6.3. Profit-and-Loss Sharing The basic principle of profit-and-loss is that instead of lending money at a fixes rate of return, the banker forms a partnership with the borrower, sharing in a venture’s profits and losses. The partnership can be one or two types: mudarraba (commenda partnership or finance trusteeship) and musharaka (long term equity-like arrangements). In both cases, the bank receives a contractual share of the profits generated by business ventures. The principle is at the core of the Islamic banking philosophy. It is at once the most ‘authentic’ form of Islamic finance since it replicates transactions that were common in the early days of Islam, the one that is most consistent with the value system and moral economy of Islam, and the most ‘modern’ one. Indeed, venture capital and merchant banking – both among the Bank (Lessor) Client (Lessee) Asset Purchases Bank leases Asset to Client Client pays rent to Bank Figure 1.12 Ijarah (Leasing) transaction structure
  33. 33. 32 fastest growing segments of contemporary finance – would be conventional equivalents of profit- and-loss sharing arrangements. The bank, being an investor, as opposed to a lender, has a stake in the long-term success of the venture. The entrepreneur, rather than being concerned with debt- servicing, can concentrate on a long-term endeavor that in turn would provide economic and social benefits to the community. Mudaraba partnership (entrepreneur based partnership) is a type of partnership where one party supplies the capital and the other the labor. One party who owns capital – rabb al-mal (beneficial owner or the sleeping partner) – entrusts money to the other party, called the mudarib (managing trustee), who is to utilize it in an agreed manner. After the operation is concluded, the rabb al-mal receives the principal and the pre-agreed share of the profit. The mudarib keeps for himself the remaining profits. The rab al-mall also shares in the losses, and may be in position of losing all his principal. Among the other rules od mudaraba are the following: the division of the profits between the two parties must necessarily be on proportional basis and cannot be lump sum or guaranteed return; rab al-mal is not liable for losses except for the losses beyond the capital he has contributed; the mudarib does not share in the losses except the loss of his time and efforts. Musharaka is similar in its principle to mudaraba, except for the fact that the financier takes an equity stake in the venture. It is in effect a joint-venture agreement whereby the bank enters into a partnership with a client in which both share the equity capital, and sometimes the management, of the project or the deal. Participation in a musharaka can be either in a new project or in an existing one. Profits are divided on a pre-determined basis, and any losses shared in proportion to the capital contribution. Under certain circumstances, for example if the mudarib has engaged in religiously illicit activities (speculation, production of forbidden goods), or of the bank has imposed a collateral for its investments, the mudaraba or musharaka contracts can be considered null and void. Recent variations of mudaraba (mudaraba mutanaqisa) and musharaka (musharaka mutanaqisa), where the bank’s capital or the bank’s share increase his share in he projects. Although many scholars consider profit-and-loss sharing as the most authentic and most promising form of Islamic contracts, there are a few dissenting voices. In addition, profit- and- loss sharing arrangements create managerial and regulatory problems that have yet to be fully mastered. To finance such arrangements, most Islamic banks offer accounts that act like investment funds. Depositors can reap profits from a venture’s success, but risk losing money if investments perform poorly. The return paid on investment accounts is determined by the yield obtained from all financial activities of the bank. After deducting such administration costs as wages, provision,
  34. 34. 33 and capital depreciation, the bank pools the yields obtained from all ventures, and the depositors, as a group, share the net profits with the bank, according to a predetermined ratio that cannot be modified for the duration of the contract. Perhaps the greatest strategic challenge of Islamic financial institutions is to increase their involvement in PLS activities and overcome the institutional and cultural obstacles that have so far stood in the way [14]. 1.6.4. Sukuk – Islamic Bonds Sukuk market is one of the fastest growing segments of the Islamic capital market (“direct funding market”) usually translated as Islamic bond is the most active Islamic debt market instruments (in addition to Islamic equity market). The development of the sukuk market has accompanied the transformation of the economy that has now become more diversified and private sector driven. The market, initially dominated by the Government debt securities, now reflects the growing demand for the long term financing requirements of the private sector. In this highly competitive environment, the presence of a deep and liquid of sukuk market thus contributes towards the stability of the financial system. Nowadays, sukuk or Islamic fixed-income securities that have emerged over the past 15 years become as an increasingly important asset class. Sukuk may be defined as certificates of equal value that represent an undivided interest (proportional to the investor’s interest) in the ownership of an underlying asset (both tangible and intangible), usufruct, services or investments in particular projects or special investment activities. Through this concept, sukuk enjoy the benefit of being backed by assets, thereby affording the sukuk holder or investor a level of protection which may not be available from conventional debt securities. Furthermore, unlike conventional debt securities that mirror debts or loans on which interest is paid, sukuk can be structured based on innovative applications of Islamic principles and concepts. Sukuk share some similarities with conventional debt securities, in that they are similarly structured based on assets that generate revenue. The underlying revenue from these assets represents the source of income for the payment of profit on the sukuk [19]. Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want to balance their equity portfolios with bond-like products. Because sukuk are asset-based securities — not debt instruments — they fit the bill. Each sukuk has a face value (based on the value of the underlying asset), and the investor may pay that amount or (as with a conventional bond) buy it at a premium or discount. With sukuk, the future cash flow from the underlying asset is transferred into present cash flow. Sukuk may be issued for existing assets or for assets that will exist in the future.
  35. 35. 34 Source: based on information from[8] Investors who purchase sukuk are rewarded with a share of the profits derived from the asset. They don’t earn interest payments because doing so would violate Shariah. As with conventional bonds, sukuk are issued with specific maturity dates. When the maturity date arrives, the sukuk issuer buys them back. However, with sukuk, the initial investment isn’t guaranteed; the sukuk holder may or may not get back the entire principal (face value) amount. That’s because, unlike conventional bond holders, sukuk holders share the risk of the underlying asset. If the project or business on which sukuk are issued doesn’t perform as well as expected, the sukuk investor must bear a share of the loss. Table 1.2. Most shariah scholars believe that having sukuk managers, partners, or agents promise to repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based on the net value of the underlying assets (each share receiving its portion of that value) or at a price agreed upon at the time of the sukuk purchase [8]. Distinguishing Sukuk from Conventional Bonds Conventional Bonds Sukuk Asset ownership Bonds don’t give the investor a share of ownership in the asset, project, business, or joint venture they support. They’re a debt obligation from the issuer to the bond holder. Sukuk give the investor partial ownership in the asset on which the sukuk are based. Investment criteria Generally, bonds can be used to finance any asset, project, business, or joint venture that complies with local legislation. The asset on which sukuk are based must be shariah-compliant. Issue unit Each bond represents a share of debt. Each sukuk represents a share of the underlying asset. Issue price The face value of a bond price is based on the issuer’s credit worthiness (including its rating). The face value of sukuk is based on the market value of the underlying asset. Investment rewards and risks Bond holders receive regularly scheduled (and often fixed rate) interest payments for the life of the bond, and their principal is guaranteed to be returned at the bond’s maturity date. Sukuk holders receive a share of profits from the underlying asset (and accept a share of any loss incurred). Effects of costs Bond holders generally aren’t affected by costs related to the asset, project, business, or joint venture they support. The performance of the underlying asset doesn’t affect investor rewards. Sukuk holders are affected by costs related to the underlying asset. Higher costs may translate to lower investor profits and vice versa.
  36. 36. 35 In practice, some sukuk are issued with repurchase guarantees just as conventional bonds are. Although not all shariah scholars agree that this arrangement complies with Islamic law, a product called sukuk ijarah may come with a repurchase guarantee. The key characteristic of sukuk — the fact that they grant partial ownership in the underlying asset — is considered shariah-compliant. This ruling means that Islamic investors have the right to receive a share of profits from the sukuk’s underlying asset. When you have the basics about how conventional bonds and sukuk work, it’s time to put them next to each other. Table 1.2 offers a quick look at the key ways in which these investment products compare. The sukuk bonds can be applied to all other Islamic transactions and agreements, and therefore, potentially gain the profit of invested capital. In a mudaraba sukuk, the sukuk holders are the silent partners, who don’t participate in the management of the underlying asset, business, or project. The working partner is the sukuk obligator. The sukuk obligator, as the working partner, is generally entitled to a fee and/or share of the profit, which is spelled out in the initial contract with investors. With sukuk that are based on the murabaha contract, the SPV (Special Purpose Vehicle) can use the investors’ capital to purchase an asset and sell it to the obligator on a cost-plus-profit- margin basis. The obligator (the buyer) makes deferred payments to the investors (the sellers). This setup is a fixed-income type of sukuk, and the SPV facilitates the transaction between the sukuk holders and the obligator. The murabaha contract process begins with the obligator (who needs an asset but can’t pay for it right now) signing an agreement with the SPV to purchase the asset on a deferred-payment schedule. This agreement describes the cost-plus margin and deferred payments (Figure 1.13). The basic idea of ijarah sukuk is that the sukuk holders (investors) are the owners of the asset and are entitled to receive a return when that asset is leased. The ijarah contract process begins when a company that needs an asset but can’t afford to purchase it outright contracts with an SPV, which agrees to purchase the asset and rent it to the company for a fixed period of time. In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each investor gets a portion of ownership in the asset to be leased. The SPV buys the title of the asset from the same company that is going to lease the asset. In turn, the company pays a rental fee to the SPV. Istisna is a contract between a buyer and a manufacturer in which the manufacturer agrees to complete a construction project by a future date. The contract requires a fixed price and product specifications that both parties agree to. If the end product doesn’t meet contract specifications, the buyer can withdraw from the contract. Istisna sukuk are based on this type of contract. The sukuk holders are the buyers of the project, and the obligator is the manufacturer.
  37. 37. 36 The obligator agrees to manufacture the project in the future and deliver it to the buyer, who (based on a separate ijarah contract) will lease the asset to another party for regular payments. The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and the SPV sign an istisna contract. Another innovative type of sukuk is hybrid sukuk which has new complicated structures. Based on various demands of investors, a more diversified kind of hybrid sukuk or mixed sukuk emerged in the market. The assets can comprise of istisna, murabaha as well as ijarah. Islamic Development Bank issued the first Hybrid Sukuk for US$400 million. The assets comprised 66% ijarah sukuk, 31% murabaha and 3% istisna sukuk. The hybrid sukuk structure represents the potential of new structures and benefits to the investors. Sukuk has now become the strongest segment in Islamic finance, are involved in the international market and generate significant cross-border flow of funds as may be achieved beyond domestic markets. Along with hard work, growth and balanced development agenda, all countries have the potential to expand the role of Islamic finance is increasing in contributing to global growth and financial stability. Investment sukuk are the ideal investment for investors requiring a fixed investment return with low risk and the Shariah Compliant. 1.6.5. Islamic Mutual Funds Islamic investment funds are similar to socially responsible mutual funds n that they select their placements bot in bases of profitability alone, but on non-economic criteria – in this Investor (seller) SPVAsset or commodity supplier Obligator (Buyer) 1. Cash proceeding 2. Sukuk certificate issuance 4.Delivery of asset 3.Purchase of asset for spot payment and delivery 5. Differed payments on installment or lump sum (cost+profit) 6. Periodic distribution of deferred payments Figure 1.13 Murabaha sukuk structure Source: Designed based on the ideas of the author
  38. 38. 37 case, compatibility with Islamic values. Driven by abundant liquidity and the boom in financial markets, thousands of investments funds were started in recent years. In addition to Islamic financial institution, virtually every major Western financial institution – such as Merrill Lynch, Goldman Sachs, Flemings, etc. – now offers Islamic investment funds. In 1990, Dow Jones and Company has created the Dow Jones Islamic Market Index or DJIM, which track 600 companies whose products and services do not violate Islamic law. An Islamic mutual fund is similar to conventional mutual fund in many ways. However, unlike its conventional counterpart, an Islamic mutual fund must confirm to shariah investment precepts. The Shariah encourages the use of profit and loss sharing and partnership schemes, and forbids riba (interest), gambling and gharar (selling something that is not owned or cannot be described in accurate detail in terms of size, type and amount). Shariah guides and supervises the several aspects of Islamic mutual funds, including its asset allocation (portfolio screening), investment and trading practices, and income distribution. Any Mutual Fund falls roughly into the following two sub-groups:  Income Funds. The investor receives a regular income (monthly/quarterly) by investing in securities that provide income (e.g. dividend paying stocks, etc.).  Growth Funds. The main aim of this type of fund is to grow the capital invested by appreciation of the underlying securities, and not to provide any annual/quarterly income. The following Mutual Funds presented below are ones of best prospective funds advertise that they operate according to Islamic Shariah principle. Most have a Shariah Advisory board that oversees its compliance with Islamic teachings:  Azzad Asset Management is a financial services firm specialized in providing ethical (halal only) financial solutions. The company offers the Azzad Funds as well as an ethical (halal) separately managed program using asset allocation. Clients can choose from a variety of retirement, college savings, and managed investment accounts. In addition, the company assists affluent investors with their estate planning needs. Businesses and individuals depend on Azzad to help them turn their wealth into their goals by using only halal investing.  Amana Mutual Funds. They offer two Mutual Funds (Growth and Income) operating according to Islamic Principles, with an Islamic Advisory Board.  Allied Asset Advisors. These are an Islamic Mutual Fund that tracks the Dow Jones Islamic Markets USA (DJIM-US).  Wright Islamic Equity Investment. Their objective is to "provide competitive Shariah compliant investment returns utilizing a globally diversified portfolio of high quality equity investments rigorously screened for Shariah compliance.
  39. 39. 38 1.6.6. Micro-lending or Micro-financing Most micro-lending or micro-finance institutions (MFI) are not, technically, Islamic banks. Yet they may be closer to the moral of economy of Islam than many self-styled Islamic banks, and will no doubt be a source of ideas and concepts for Islamic finance in the future. The micro-financing idea has gained a number of adherents, in particular among governments and international organizations in recent years. Micro-finance purports to provide a market-based solution to one of capitalism’s thorniest problems: integrating the poor into the economy. This finance scheme focuses on moving people off the dole and into productive enterprise. Self-helped and self-reliance are at the center of the system. The scheme turns the conventional banking logic on its head: rather than looking for creditworthy customers and basing lending decisions on credit history and collateral, MFIs lend small amounts of money to people – principally women – with no resources, as means of integrating them in the productive economy. The best known experience in micro-financing is Muhammed Yunus’s Grameen Bank, which was initially started in Bangladesh and has since been replicated in more than 50 countries. Although interest-based and devoid of explicit references to Islam, Grameen Bank concept – not to mention the fact that it was created in an overwhelmingly Islamic country by a Muslim – is based on a central tenet of the moral economy of Islam. The MFIs are in the process of destroying several very old myths: the poor are not creditworthy; they are not reliable borrowers; they are not successful enough to make saving; they are bad investors and even worse entrepreneurs. Grameen Bank boasts that 98 per cent if its loans are repaid on time [14]. The main objection of Islamic scholars to micro-lending banks is that they lend at interest. 1.7. The Management and Control, and ‘Islamic Moral Hazard’ The notion of moral hazard is commonly use in the connection with financial regulation. It refers to policies that many encourage reckless behavior. For many, it is axiomatic that bank and their customers are people of virtue, who act at all times in a righteous manner. While it is undeniable that religious fervor was for many people a reason to work for an Islamic bank, or to conduct business with it, it was soon discovered that religion could be a double-edged sword. In the Koran there are numerous references to hypocrisy [17]. Since time immemorial, con artists have used the cover of religion as a means of rapid enrichment. Even when the overwhelming majority of people are honest, all it takes is a few bad ‘apples’ – a few dishonest customers or employees – for banks to incur serious difficulties.
  40. 40. 39 There are four factors of special importance in this regard. One is the assumption of righteous behavior on the part of employees and customers, which sometimes turns certain institutions into magnet for dubious characters [14]. The second is the use of religion as a shield against scrutiny. The third is the religious and legal ambiguity that often allows borrowers to escape their obligations with impunity. The fourth involves conflicts of interest involving the bank and its clients. In the early years, Islamic bankers failed to act prudently and exercise the kind of due diligence expected of bankers, because implicit assumptions about the virtue of their employees, and customers Internal control has also been a problem for the same reasons. A number of failure in management of banking was seen in Dubai, the world’s centre of Islamic commercial banks and regulations in last decade of twentieth century. A Second type of Islamic moral hazard occurs when financial activities of certain Islamic institutions or group become immune to scrutiny or criticism, whether for political or religious reasons. A more subtle but equally pervasive form of Islamic moral hazard is the advantage that can be taken from ambiguity. Unlike specular systems, the legal system of Islam incorporates both an economic and religious logic. In the religious law of Islam, equitable considerations of the individual conscience in matters of profit and loss override the technicalities of commercial dealings. It is harmonization of these two very different approaches which poses the real challenge for developing Islamic law today [24]. Islamic banks face serious problems with late payments, not to mention outright defaults, since some people take advantage of every dilatory legal and religious device. However, it should be notes that same problems often hurt conventional banks in Islamic countries. In Saudi Arabia, problems of late payment are endemic, and banks receive little help from juridical system. In Pakistan, many borrowers took advantage of the ambiguity of a multilayered legal system to avoid repaying much of their debt. The last type of Islamic moral hazard is related to the bank’s relation with its depositors. Islamic banks share their profits with those of their customers who hold investment deposits. For example, 80 per cent of the net profits may be distributed to the depositors, and 20 per cent to the shareholders. Empirical surveys have shown that banks often arbitrarily change distribution ratios. Perhaps the most vexing managerial issue is the lack of qualified personnel. Bank officers at once management skills appropriate to conventional institution and religious training.

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