Islamic banking

ISLAMIC BANKING AND MODE OF FINANCING
2.1 Islamic Banking
Islamic banking has been defined as banking in consonance with the ethos and value system
of Islam and governed, in addition to the conventional good governance and risk
management rules, by the principles laid down by Islamic Shariah.[1]
The objective of Islamic banking system is to make a positive contribution to the fulfillment
of socioeconomic objectives of the society in all spheres, including trade, industry &
agriculture etc.[2] in general, is to promote, foster and develop the application of Islamic
principles, law and tradition to the transaction of financial, banking and related business
affairs and to promote investment companies. Islamic banks accept deposits which they can
either commit to investment or general deposits. They also have investment accounts with or
without authorization. Banks engage in investment activities based onMusharakah (equity
participation) Mudarabah or Qirad (agencies), Murabaha, Bai' Salam (post delivery sale)
and/or leasing arrangements especially for equipment. On the lending side, Islamic banks
issued a number of new lending instruments such as Al Muqarada profit bonds to finance
large projects and Al-Mudarabah certificates which were not issued for specified projects.
Islamic banks practice conventional short term financing on a profit/loss basis.[3]
2.2 PHILOSOPHY OF ISLAMIC BANKING AND FINANCE
The prohibition of interest by Islam is the base of the development of Islamic Banking
Phelosopghy. The Islamic system order based on a set of principles constituting the concept
and philosophy as enunciated explicitly in the Quran.This philosophy provides what can be
understood as the Islamic system of social justice. [4]In Islamic law some gain has been
prohibited which are generally fixed or if there is no concept of risk shearing. Conventional
Finance believes in return without risk, whilst Islamic Finance prohibits the latter and
enforces the opposite.[5]
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 sharia
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[1], makes the financial activities in an Islamic set-up real
asset-backed with ability to cause ‘value addition’.[6]
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.[7] 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.[8]
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 creatingbetter discipline in conductive
of fiscal and monetary policies.[9]
All such things/assets corpus of which is not consumed with their use can be leased out
against fixed rentals. The ownership in leased assets remains with the lesser that assumes
risks and gets rewards of his ownership. The institution may either rent the equipment or
receive a share of the profits earned through its use; Islamic leasing (Ijara wal Iqtina) are the
same as Ijarah except that the lessee can acquire ownership of the asset by making
installment payment.[10]
2.3 MAJOR MODES OF ISLAMIC BANKING AND FINANCE
Following are the main modes of Islamic banking and finance:
1. Murabaha
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in
which the seller declares his cost and profit. Islamic banks have adopted this as a mode of
financing. As a financing technique, it involves a request by the client to the bank to
purchase certain goods for him. The bank does that for a definite profit over the cost, which
is stipulated in advance.[11]
2. Ijara
Ijara is a contract of a known and proposed usufruct against a specified and lawful return or
considerationfor the service or returnfor the benefit proposedto be taken, or for the effort or
work proposed to be expended. In other words, Ijara or leasing is the transfer of usufruct for
a consideration which is rent in case of hiring of assets or things and wage in case of hiring
of persons.[12]

3. Ijarah-Wal-Iqtina
A contract under which an Islamic bank provides equipment, building or other assets to the
client against an agreed rental together with a unilateral undertaking by the bank or the client
that at the end of the lease period, the ownership in the asset would be transferred to the
lessee. The undertaking or the promise does not become anintegral part of the lease contract
to make it conditional. The rentals as well as the purchase price are fixed in such manner that
the bank gets back its principle sum along with profit over the period of lease.[13]
4. Istisna
It is a contractual agreement for manufacturing goods and commodities, allowing cash
payment in advance and future delivery or a future payment and future delivery. Istisna’a can
be used for providing the facility of financing the manufacture or construction of houses,
plants, projects and building of bridges, roads and highways.[14]
5. Bai Muajjal
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic
banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a
profit margin onhis purchase price and allows the buyer to pay the price of the commodityat
a future date in a lump sum or in installments. It has to expressly mention cost of the
commodityand the margin of profit is mutually agreed. The price fixedfor the commodity in
such a transaction can be the same as the spot price or higher or lower than the spot
price.[15]
6. Mudarabah
A form of partnership where one party provides the funds while the other provides expertise
and management. The latter is referred to as the Mudarib. Any profits accrued are shared
between the two parties on a pre-agreedbasis, while loss is borne only by the provider of the
capital.[16] Murabaha in tandem with Bai Muajjal is a useful means of financing in the
Islamic Mortgages arena. It allows the Bank to purchase the house at spot price and then sell
it to the client over a deferred period thereby generating a profit for the Bank.[17]
7. Musharakah
Musharakah means a relationship established under a contract by the mutual consent of the
parties for sharing of profits and losses in the joint business. It is an agreement under which
the Islamic bank provides funds, which are mixed with the funds of the business enterprise
and others. All providers of capital are entitled to participate in management, but not
necessarily required to do so. The profit is distributed among the partners in pre-agreed

ratios, while the loss is borne by each partner strictly in proportion to respective capital
contributions.[18]
8. Bai Salam
Salam means a contract in which advance payment is made for goods to be delivered later
on. The seller undertakes to supply some specific goods to the buyer at a future date in
exchange of an advance price fullypaid at the time of contract. It is necessarythat the quality
of the commodityintendedto be purchased is fully specified leaving no ambiguity leading to
dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Barring
this, Bai Salam covers almost everything, which is capable of being definitelydescribedas to
quantity, quality and workmanship.[19]
9. Qard Hassan (Good Loan)
This is a loan extended on a goodwill basis, and the debtor is only required to repay the
amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount
beyond the principle amount of the loan (without promising it) as a token of appreciation to
the creditor. In the case that the debtor does not pay an extra amount to the creditor, this
transaction is a true interest-free loan. Some Muslims consider this to be the only type of
loan that does not violate the prohibition on riba, since it is the one type of loan that truly
does not compensate the creditor for the time value of money.[20]
2.4 RATIO OF PROFIT
There is a difference of opinion among the Muslim jurists about the Ratio of Profit.
In the view of Imam Malik and Imam Shafii, it is necessary for the validity of Musharaka
that each partner gets the profit exactly in the proportion of his investment. Therefore, if A
has invested 40% of the capital, he must get 40% of the profit. Any agreement to the contrary
which makes his entitled to get more or less than 40% will render the musharkah invalid in
Shariah.
On the contrary, the view of Imam Ahmad is that the ratio of profit may differ from the ratio
of investment if it is agreed between the partners with their free consent. Therefore, it is
permissible that a partner with 40% of investment gets 60% or 70% of the profit, while the
other partner with 60% of the investment gets only 40% or 30%.
The third view is presented by Imam Abu Hanifah which can be taken as a via media
between the two opinions mentioned above. He says that the ratio of profit may differ from
the ratio of investment in normal conditions. However, if a partner has put an express
condition in the agreement that he will never work for the musharkah and will remain a

sleeping partner throughout the term of musharkah, then his share of profit cannot be more
than the ratio of his investment. [21]
2.5 ISLAMIC FINANCING AND ITS GLOBAL EVOLUTION
As with all things Islamic, the origination of Islamic finance goes back to the time of
Prophet Muhammad (Peace be upon Him). The Qur’an and the example of Prophet
Muhammad (Peace be upon Him) provide direct behavioral guide and represent bedrock of
Islamic faith to over one billion Muslims globally. The Prophet Muhammad (Peace be upon
Him) happened to be a businessman serving as a trader for Khadija (May Allah be pleased
with Her). The Prophetic example was the very epitome of fair-trade. Refraining from usury,
ensuring transparency in transactions, and total honesty entitled him Al- Amin (The
trustworthy) in pre-Islamic Arabia[22]
During the Islamic Golden Age, early forms of proto-capitalism and free markets were
present inthe Caliphate; the first modern experiment with Islamic banking was undertaken in
Egypt under cover, without projecting an Islamic image, for fear of being seen as a
manifestation of Islamic fundamentalism which was anathema to the political regime. The
pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-
sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967[23],
by which time there were nine such banks in the country. These banks, which neither charge
nor paid interest, investedmostlyby engaging in trade and industry, directlyor inpartnership
with others, and shared the profits with their depositors.[24]
But some views whows that the first modernIslamic modernbanking institutionstablishedin
Pakistan in 1950. As a former credit Union. This was first Islamic financing movement.
Using this idea Mit Ghamr saving Bank emerged as a rural institution in Egypt in
1963. [25] At meeting of Foreign minister of Islamic countries in Karachi Pakistan in 1970,
Pakistan and Egypt jountly proposed for the establishment of international Islamic Bank for
trade and development this again discussed in 1973 with Banghzi (Libya) in a meeting which
further suggested for constituting a committee of experts for designing this international
Islamic Bank. This was finally established in 1972 as Islamic Development Bank in Jeddah
Saudia Arabia.[26] The IDB was established in 1974 by the Organization of Islamic
Countries (OIC), but it was primarily an intergovernmental bank aimed at providing funds
for development projects inmember countries. The IDB provides fee basedfinancial services
and profit-sharing financial assistance to member countries. The IDB operations are free of
interest and are explicitly based on Shariah principles. [27]

In the seventies, changes tookplace in the political climate of manyMuslim countries so that
there was no longer any strongneed to establish Islamic financial institutions under cover. A
number of Islamic banks, both in letter and spirit, came into existence in the Middle
East,[28]. After that, numbers of Islamic Bank established in different Islamic countries.
Dubai Islamic Bank in 1975 in Dubai, Faisal Islamic Bank in Egypt and Sudan in 1972,
Kuwait Finance House in 1977. Jordan Islamic Bank in 1978 and Bahrain Islamic Bank in
1979[29]
Islamic banking made its debut in Malaysia in 1983, but not without antecedents. The first
Islamic financial institutioninMalaysia was the Muslim Pilgrims Savings Corporationset up
in 1963 to helppeople save for performing hajj (pilgrimage to Mecca and Medina). In 1969,
this body evolved into the Pilgrims Management and Fund Board or the Tabung Haji as it is
now popularly known. The Tabung Haji has been acting as a finance company that invests
the savings of would-be pilgrims in accordance with Shariah, but its role is rather limited, as
it is a non-bank financial institution. The success of the Tabung Haji, however, provided the
main impetus for establishing Bank Islam Malaysia Berhad (BIMB) which represents a full
fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per
cent of BIMB's initial capital of M$80 million. BIMB has a complement of fourteen
branches in several parts of the country. Plans are afoot to open six new branches a year so
that by 1990 the branch network of BIMB will total thirty-three [30]
Reference shouldalso be made to some Islamic financial institutions established in countries
where Muslims are a minority. There was a proliferation of interest-free savings and loan
societies in India during the seventies. [31] The Islamic Banking System (now called Islamic
Finance House), established in Luxembourg in 1978, represents the first attempt at Islamic
banking in the Western world. There is also an Islamic Bank International of Denmark, in
Copenhagen, and the Islamic Investment Company has been set up in Melbourne,
Australia.[32]
2.6 HISTORY OF ISLAMIC BANKING IN PAKISTAN
Pakistan now recognized one of the Islamic finance industries in the World. Muhammad Ali
Jinnah as early1948, emphasizedon Islamic principles inhis address at inauguration of State
Bank of Pakistan he said.
“I shall watch with keenness the work of your Organization in evolving banking practices compatible
with Islamic ideasof social and economic life. We must work our destiny in our own way and present

to the world an economic system based on true Islamic concept of equality of manhood and social
justice.”[33]
Pakistan has a protracted history of Islamic banking with the initial attempt to Islamize
banking system in 1980s2, leading to sweeping changes in the Banking Companies
Ordinance, 1962 (BCO’62) andassociatedlaws and regulations to accommodate non-interest
based banking transactions[34]. The Islamization measures included the elimination of
interest from the operations of specialized financial institutions including HBFC, ICP and
NIT in July 1979 and that of the commercial banks during January 1981- June 1985.[35]
Separate Interest-free counters started operating in all the nationalized commercial banks,
and one foreign bank (Bank of Oman) on January 1, 1981 to mobilize deposits on profit and
loss sharing basis. Regarding investment of these funds, bankers were instructed to provide
financial accommodation for Government commodity operations on the basis of sale on
deferred payment with a mark-up on purchase price. Export bills were to be accommodated
on exchange rate differential basis. [36]
In March, 1981 financing of import and inland bills and that of the then Rice Export
Corporationof Pakistan, CottonExport Corporation and the Trading Corporation of Pakistan
were shifted to mark-up basis. Simultaneously, necessary amendments were made in the
related laws permitting the State Bank to provide finance against Participation Term
Certificates and also extend advances against promissory notes supported by PTCs and
Mudarabah Certificates. From July 1, 1982 banks were allowed to provide finance for
meeting the working capital needs of trade and industry on a selective basis under the
technique of Mishawaka.[37]
As from April 1, 1985 all finances to all entities including individuals began to be made in
one of the specified interest-free modes. From July 1, 1985, all commercial banking in Pak
Rupees was made interest free.[38]
From that date, no bank in Pakistan was allowed to accept any interest-bearing deposits and
all existing deposits in a bank were treated to be on the basis of profit and loss sharing.
Deposits incurrent accounts continuedto be acceptedbut no interest or share inprofit or loss
was allowed to these accounts.
However, foreigncurrencydeposits inPakistan and on-lending of foreign loans continued as
before. The State Bank of Pakistan had specified 12 modes of non-interest financing
classified in three broad categories.

However, in any particular case, the mode of financing to be adopted was left to the mutual
option of the banks and their clients. The procedure adopted by banks in Pakistan since July
1 1985, based largely on ‘mark-up’ technique with or without ‘buy-back arrangement’, was,
however, declared un-Islamic by the Federal Shariat Court (FSC) in November 1991.
However, appeals were made in the Shariat Appellate Bench (SAB) of the Supreme Court of
Pakistan.[39]
The Commissionfor Transformation of Financial System (CTFS) was constituted in January
2000 in the State Bank of Pakistan under the Chairmanship of Mr. I.A. Hanfi, a former
Governor State Bank of Pakistan.[40]
A Task Force was set up in the Ministry of Finance to suggest the ways to eliminate interest
from Government financial transactions. Another Task Force was set up in the Ministry of
Law to suggest amendments in legal framework to implement the Court’s Judgment. The
CTFS constituted a Committee for Development of Financial Instruments and Standardized
Documents inthe State Bank to prepare model agreements and financial instruments for new
system.
The House Building Finance Corporation had shifted its rent sharing operations to interest
based system in 1989.[41] The Task Force of the M/O Law proposed amendments in the
HBFC Act to make it Shariah Compliant. Having vetted by the CTFS, the amended law has
been promulgated by the Government. Accordingly, the HBFC launched in 2001 Asaan Ghar
Scheme in the light of amended Ordinance based on the Diminishing Musharaka concept. A
Committee was constituted in the Institute of Chartered Accountants, Pakistan (ICAP),
wherein the SBP was also represented, for development of accounting and auditing standards
for Islamic modes of financing. The Committee is reviewing the standards prepared by the
Bahrain based Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) with a view to adapt them to our circumstances and if considered necessary, to
propose new accounting standards.
It was decidedin September 2001 that the shift to interest free economy would be made in a
gradual and phased manner and without causing any disruptions. It was also agreed that State
Bank of Pakistan would consider for:
1. Settingup subsidiaries by the commercial banks for the purpose of conducting
Shariah compliant transactions;
2. Specifying branches by the commercial banks exclusively dealing in Islamic
products, and

3. Settingup new full-fledgedcommercial banks to carry out exclusively banking
business based on proposed Islamic products.[42]
Accordingly, the State Bank issued detailed criteria in December 2001 for establishment of
full-fledged Islamic commercial banks in the private sector. The Meezan Bank was granted a
‘Scheduled Islamic Commercial Bank’ license on January 31, 2002, and formally
commencedoperations as a Scheduled Islamic Commercial Bank with effect from March20,
2002, on receiving notification in this regard from the State Bank of Pakistan (SBP) under
section 37 of the State Bank of Pakistan Act, 1956. Currently, the Bank is engaged in
corporate, commercial, Consumer, investment and retail banking activities. Further, all
formalities relating to the acquisition of Societies General, Pakistan by the MBL were
completed, and by June, 2002 it had a network of 5 branches all over the country, three in
Karachi, one in Islamabad and one in Lahore.[43]
The Government as also the State Bank is mainly concerned with stability and efficiency of
the banking system and safeguarding the interests, particularly, of small depositors. Withthis
concern in mind it has been decided to operate Islamic banking side by side with traditional
banking. The approach is to institute best practice legal, regulatory and accounting
frameworks to support Islamic banks and investors alike. The year 2002-2003 witnessed
strengthening measures taken in the areas of banking, non-bank financial companies and the
capital markets.
2.7 ROLE OF ISLAMIC BANKING IN THE DEVELOPMENT OF THE COUNTRY
Islamic banks and financing performing according to the sharia law, those are helpful for
mobilization of resources, and their use in right manner. PLS (Musharaka and Mudarabah)
and non-PLS (trading & leasing) based categories of modes and strengthening the payments
systems to contribute significantly to economic growth and development.[44] Islamic mode
of financing system offeringfinance inshort tem, long term, and different type of instrument
for liquidity management, asset management etc, for enterprises and projects. This creates
employment opportunities in the economy. It would be necessary to create an environment
that could induce financiers to earmark more funds for Musharaka/Mudarabah based
financing of productive units, particularly of small enterprises.[45]
The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS
modes, but also provide flexibility of choice to meet the needs of different sectors and
economic agents in the society. Trade-based techniques like Murabaha with lesser risk and
better liquidity options have several advantages vis-à-vis other techniques but may not be as
fruitful in reducing income inequalities and generation of capital goods as participatory

techniques. Ijarah related financing that would require Islamic banks to purchase and
maintain the assets and afterwards dispose of them according to Shariah rules, require the
banks to engage in activities beyond financial intermediation and can be very much
conducive to the formation of fixed assets and medium and long-term investments.
On the basis of the above it can be said that supply and demand of capital would continue in
an interest free scenario with additional benefit of greater supply of risk-based capital along
with more efficient allocationof resources and active role of banks and financial institutions
as required in asset based Islamic theory of finance. Islamic banks can not only survive
without interest but also could be helpful in achieving the objective of development with
distributive justice by increasingthe supply of riskcapital in the economy, facilitatingcapital
formation, and growth of fixed assets and real sector business activities.
Salam has a vast potential infinancing the productive activities incrucial sectors, particularly
agriculture, agro-based industries and the rural economy as a whole. It also provides
incentive to enhance production as the seller would spare no effort in producing, at least the
quantity neededfor settlement of the loan taken by him as advance price of the goods. Salam
can also lead to creating a stable commodities market especially the seasonal commodities
and therefore to stability of their prices. It would enable savers to direct their savings to
investment outlets without waiting, for instance, until the harvesting time of agricultural
products or the time when they actually need industrial goods and without being forced to
spend their savings on consumption.
Small and medium enterprises (SME) sector has a great potential for expanding production
capacity and self-employment opportunities in the country. Enhancing the role of financial
sector in development of SME sub-sector could mitigate the serious problems of
unemployment and low level of exports. The banks may introduce ‘SME Financing Funds’
with various geographical locations. The corporate sector and the commercial banks may set
up a network of such Funds under the aegis of SECP by establishing institutions under
syndicate arrangements or otherwise. [46]

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