Islamic finance tasks and handouts

Islamic Finance Tasks
The Islamic economic system is the collection of rules, values and standards of conduct that
organize economic life and establish relations of production in an Islamic society. These rules and
standards are based on the Islamic order as recognized in the Quran and Sunna and which was
developed over the last 1400 years by thousands of jurist, responding to the changing
circumstances and evolving life of Muslims all over the globe.
Students are required:
 To approach at least one Sharia Scholar / (banker) to discuss the significance of Islamic
economic system and prepared a report at least one thousand words.
 To explore the banking crisis in America in 2008 and write,why the banks survived
which were following Asset Backed financing and prepared a report at least one
thousand words.
To identify the reasons that why views and opinions against Capitalism are strengthening in the
world.
Consider that you are an entrepreneur and have a project but he does not have
adequate resources (financial and non-financial) to execute it. In this case if there
is no system to provide him with sufficient funds to carry out his project, a
potential opportunity for the development of a society will be wasted. Financial
intermediaries like banks play a significant role to solve this problem. They
attract the surplus money from those who do not need it immediately and
provide it to those who need it immediately. Many systems and mechanisms
have been developed through Islamic banks.
Task-1 Islamic Economic System
Task-2 assets back financing
Task-3 capitalism economy and Islamic economicsystem
Task-4 Musharka

To make a Musharka project by considering 5o Lac rupees.
A Sudanese Islamic bank invested into a grocery store for a one month period, applying a
Musharaka contract. The investment contributions of the bank and the grocery store partner
with the net profit are given in Table 2.2.
Table 2.2 Sudanese bankinvestment contributions (£ Sudanese)
Bank Partner Total
Investment 735 690 1425
Percentage 52 48 100
Net profit 179 271 450
It was agreed that the profit distribution for the management of the project should be 37% for
the bank and 63% for the grocery store manager. The 37% was to be distributed as being 30%
of the partner’s percentage in the management with the bank contributing 7% of the
management.
It was also agreed that the 63% should be divided as being 30% of the partner’s percentage of
the profit and 33% as being the bank’s percentage of the profit.
Students are required
1. The total amountreceived by each party (bank and grocery store) as themanagement share.
2. The total amount received by each party as the shared profit.
3. The grocery store’s monthly rate of return
4. The grocery store’s annual rateof return
5. The bank’s monthly rate of return.
6. The bank’s annual rateof return.
 To assume he does not has funds but he wants to start a business. How finance of
Rs.30 lacs can be arranged for the business by using Mudarabah.
Task-4 .1 Musharaka
Task-5 Mudarbah

The Mudarib contributes 100 of his own capital into the project. The bank contributes capital
of 100 on a Mudaraba basis. No other capital sources are used. PLS is agreed at a ratio of
50/50. Profits are paid to the Mudarib as a reward forthe successfuloperation ofthe business.
The balance of any profit is paid to the other partner(s) in the scheme.
Provide the solutions to two potential outcomes:
1. Profits of 20are made
2. Losses of 20 aremade
The Mudarib borrows 100 capital from the bank which he invests into the project. This loan
must be repaid at the maturity of the project whether profits or losses are made. The bank
contributes capital of 100. No other capital sources are used. PLS is agreed at a ratio of 50/50.
Profits are paid to the Mudarib as a reward for the successful operation of the business. The
balance of any profit is paid to the other partner(s) in the scheme.
4. Losses of 20are made
The Mudarib acquires 100capital through a third party Mudaraba.The Mudarib invests 100of
his own capital into the project. The bank contributes capital of 100. No other capital sources
are used. PLS is agreed at a ratio of 33/33/33. Profits are paid to the Mudarib as a reward for
the successfuloperation ofthe business.The balance ofany profit is paid to the otherpartner(s)
in the scheme.
5. Profits of 30 aremade
6. Losses of 30 aremade
Task-5.1 Mudarbah case-1

The Mudarib acquires 100 capital froma business partner. The Mudarib invests none of his
own capital into the project. The bank agrees to the partnership agreement and contributes
capital of 100. No other capital sources are used. The Mudarib and the partner agree a PLS
ratio of 50/50. The bank and the Mudarib agree that the bank will receive half of the profit
earned by the Mudarib.Profits are paid to the Mudarib as a reward forthe successfuloperation
of the business. The balance of any profit is paid to the other partner(s) in the scheme.
8. Losses of 20are made
 To Visitany Islamic bank and find outhow practically car financingis done.
House Purchase
Diminishing Musharaka has beenmostly usedin house financing.The client wants to purchase
a house for which he does not have adequate funds. He approaches the financier who agrees
to participate with him in purchasing the required house. To take an example, assume 20% of
the price is paid by the client and 80% of the price by the financier. Thus the financier owns
80% of the house while the client owns 20%. After purchasing the property jointly, the client
uses the house forhis residentialrequirements and pays rent to the financierforusing his share
in the property. At the same time the share of the financier is further divided into eight equal
units, each unit representing 10% ownership of the house.
The client promises the financier that he will purchase say one unit every three months.
Accordingly, after the first term of three months he purchases one unit of the share of the
financier by paying one-tenth of the house price. This reduces the share of the financier from
80% to 70%. Hence, the rent payable to the financier is also reduced to that extent. At the
end of the second term, the client purchases another unit thereby increasing his share in the
property to 40% and reducing the share of the financier to 60% and consequentially reducing
the rent to that proportion. This process goes on in the same fashion until,afterthe end oftwo
years, the client purchases the whole share of the financier thereby reducing the share of the
financier to zero and increasing his own share to 100%.
This arrangement allows the financier to claimrent according to his proportion ofownership
in the property and, at the same time, allows him periodical return of a part of his principal
through purchases of the units of his share of the property.
Task-6 Diminshing Musharka and Murabaha
Task-6.1 Diminshing Musharka

 To Visitany Islamic bank and find outhow practically Murabaha and Ijarah can be used
for buying a product on installments?
HANDOUTS
Islamic ﬁnancial institutions are those that are based, in their objectives and operations, on
Qur’anic principles. They are thus set apart from ‘conventional’ institutions,which have no
such religious preoccupations. Islamic banks provide commercial services that comply
with the religious injunctions of Islam. Crucially, these banks provide services to their
customers free from interest, (the Arabic term for which is riba), and the giving and taking
of interest is prohibited in all transactions. This prohibition makes an Islamic banking
systemdiffer fundamentally from a conventional banking system.
Technically, riba refers to the addition in the amount of the principal of a loan according to
the time for which it is loaned and the amount of the loan. In earlier, historical times there
was a ﬁerce debate as to whether the term riba relates to interest or usury, although there
now appears to be consensus of opinion among Islamic scholars that the termextends to all
forms of interest.
In Islamic law (the Sharia’a), riba means an addition, however slight, over and above the
Handout-1 Islamic banking principles
Task-7 Murabaha and Ijara
Task-6.1 Murabaha and Ijara case study

principal. According to the Federal Sharia’a Court of Pakistan the concept covers both
usury and interest; is not restricted to doubled and redoubled interest; applies to allforms of
interest, whether large or small, simple or compound, doubled or redoubled; and the Islamic
injunction is not only against exorbitant or excessive interest, but also against even a
minimal rate of interest. Financial systems based on Islamic tenets are therefore dedicated
to the elimination of the payment and receipt of interest in all forms, and this taboo makes
Islamic banks and other financial institutions different in principle from their conventional
counterparts.
There is a range of modern interpretations of why riba is considered haram (forbidden) but
these are strictly secondary to the religious underpinnings.
The fundamental sources of Islamare the Holy Qur’an and the Sunnah,a termthat in Ancient
Arabia meant ‘ancestral precedent’ or the ‘custom of the tribe’, but which is now
synonymous with the teachings and traditions of the Prophet Mohammed as transmitted by
the relaters of authentic tradition. Both of these sources treat interest as an act of
exploitation and injustice and as such it is inconsistent with Islamic notions of fairness and
property rights. Although it is often claimed that there is more than this to Islamic banking,
such as its contribution towards economic development and a more equitable distribution
of income and wealth, its increased equity participation in the economy and so on, Islamic
banking nevertheless derives
This rejection of interest poses the central question of what replaces the interest rate
mechanism in an Islamic framework. Financial intermediation is at the heart of modern
financial systems. If the paying and receiving of interest is prohibited, how do Islamic
banks operate? Here profit and loss sharing (PLS) comes in as a substitute for interest as a
method of resource allocation and financial intermediation.
In fact, the basic idea of Islamic banking can be stated simply. The operations of Islamic
financial institutions primarily are based on a PLS principle. An Islamic bank does not
charge interest but rather participates in the yield resulting from the use of funds. The
depositors also share in the profits of the bank according to a predetermined ratio. There is
thus a partnership between the Islamic bank and its depositors, on one side, and
between the bank and its investment clients, on the other side,as a managerofdepositors’
resources in productive uses. This is in contrast with a conventional bank, which mainly
borrows funds,paying interest on one side of the balance sheet, and lends funds.
Predetermined Payments are Prohibited
Any predetermined payment overand above the actualamount ofprincipalis prohibited. Islam
allows only one kind of loan and that is qard al hassan (literally ‘good loan’), whereby the
lender does not charge any interest or additional amount overthe money lent.
Traditional Muslim Jurists have construed this principle so strictly that,according to one
Islamic scholar, ‘the prohibition applies to any advantage or benefits that the lender might
secure out of the qard (loan) such as riding the borrower’s mule, eating at his table or
even taking advantage of the shade of his wall’. The principle derived from the quotation
emphasises that any associated or indirect benefits that could potentially accrue to the lender
are also prohibited.
Profit and Loss Sharing
The principle here is that the lender must share in the profits or losses arising out of the
enterprise for which the money was lent. Islamencourages Muslims to invest their money

and to become partners in order to share profits and risks in the business instead of
becoming creditors. Islamic finance is based on the belief that the provider of capital
and the user of
capital should equally share the risk of business ventures, whether those are
manufacturing industries, service sector companies or simple trade deals. Translated into
banking terms, the depositor, the bank and the borrower should all share the risks and the
rewards of financing business ventures.
This is unlike the interest-based conventional banking system, where all the pressure is on
the borrower: he must pay back his loan, with the agreed interest, regardless of the success
or failure of his venture.
The principle, which thereby emerges, is that in order to try and ensure investments are
made into productive enterprises Islam encourages these types of investments in orderthat
the community may ultimately benefit. However, Islam is not willing to allow a loophole to
exist for those who do not wish to invest and take risks, but are instead intent on hoarding
money or depositing money in a bank in return for receiving interest (riba) on these funds
for no risk (other than the bank becoming insolvent).
Accordingly, under Islam, either people invest with risk or suffer loss by keeping their
money idle. Islam encourages the notion of higher risks and higher returns and promotes it
by leaving no other avenue available to investors. The objective here is that high-risk
investments provide a stimulus to the economy and encourage entrepreneurs to maximise
their efforts to make them succeed.
RiskSharing
As mentioned one of the most important feature of Islamic banking is that it promotes risk
sharing between the providers of funds (investors) and the user of funds (entrepreneur).
By contrast,under conventionalbanking, the investor is assured of a predetermined rate of
interest. Since the nature of this world is uncertain, the results of any project are not
known with certainty ex ante, and so there is always some risk involved.
In conventional banking, all this risk is borne by the entrepreneur. Whether the project
succeeds and produces a profit or fails and produces a loss, the owner of capital is still
rewarded with a predetermined return. In Islam, this kind of unjust distribution is not
allowed. In Islamic banking both the investor and the entrepreneur share the results of the
project in an equitable way. In the case of profit, both share this in pre-agreed proportions.
In the case of loss, all financial loss is borne by the capital supplier with the entrepreneur
being penalised by receiving no return (wages or salary) for his endeavours.
Emphasis on Productivity as Compared to Credit-worthiness
Under conventional banking, almost all that matters to a bank is that its loan and the
interest thereon are paid on time. Therefore, in granting loans, the dominant consideration
is the credit-worthiness of the borrower. Under PLS banking, the bank will receive a
return only if the project succeeds and produces a profit. Therefore, it is reasoned, an
Islamic bank will be more concerned with the soundness of the project and the business
acumen and managerial competence of the entrepreneur.

Making Money out of Money is not Acceptable
Making money from money is not Islamically acceptable. Money, in Islam, is only a
medium of exchange, a way of defining the value of a thing. It has no value in itself,
and therefore
should not be allowed to generate more money, via fixed interest payments, simply by
being put in a bank or lent to someone else.
The human effort, initiative and risk involved in a productive venture are more
important than the money used to finance it. MuslimJurists consider money as potential
capitalratherthan capital, meaning that money becomes capitalonly when it is invested in
business. Accordingly, money advanced to a business as a loan is regarded as a debt of
the business and not capital; as such, it is not entitled to any return (i.e., interest).
Muslims are encouraged to spend and/or invest in productive investments and are
discour- aged fromkeeping money idle. Hoarding money is regarded as being Islamically
unacceptable. In Islam, money represents purchasing power, which is considered to be
the only proper use of money. This purchasing power (money) cannot be used to make
more purchasing power (money) without undergoing the intermediate step of it being
used for the purchase of goods and services.
Uncertainty is Prohibited
Gharar (uncertainty, risk or speculation) is also prohibited, and so any financial
transaction entered into should be free from these aspects.
Contracting parties should have perfect knowledge of the counter values (goods received
and/or prices paid) intended to be exchanged as a result of their transactions. Also,
parties cannot predetermine a guaranteed profit. This is based on the principle of
‘uncertain gains’, which on a strict interpretation does not even allow an undertaking
from the customer to repay the borrowed principal plus an amount to take into account
inflation. The rationale behind the prohibition is the wish to protect the weak from
exploitation. Therefore, options and futures are considered as un-Islamic and so are
forward foreign exchange transactions, given that forward rates are determined by
interest rate differentials.
Only Sharia’a-approved Contracts are Acceptable
Conventional banking is secular in its orientation. In contrast, in the Islamic system, all
economic agents have to work within the moral value system of Islam. Islamic banks
are no exception. As such, they cannot finance any project that conflicts with the moral
value system of Islam. For example, Islamic banks are not allowed to finance a
distillery, a casino, a night club or any other activity prohibited by Islam or known to
be harmful tosociety.
Q1. What is Islamic Banking?
Ans. Islamic banking has been defined as banking in consonance with the ethos
Handout- 2 Islamicbanking systemin Pakistan

and value systemof Islam and governed, in addition to the conventionalgood
governance and risk management rules, by the principles laid down by Islamic
Shariah. Interest free banking is a narrow concept denoting a number of banking
instruments or operations,which avoid interest. Islamic banking, the more
general term is expected not only to avoid interest-based transactions,prohibited
in the Islamic Shariah, but also to avoid unethical practices and participate
actively in achieving the goals and objectives of an Islamic economy.
Q2. What is the philosophy of Islamic banking and finance?
Ans. Islamic Shariah prohibits ‘interest’ but it does not prohibit all gains on
capital. It is only the increase stipulated or sought overthe principal of a loan or
debt that is prohibited. 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 Verse 2:275 of the
Holy Quran, makes the financial activities in an Islamic set-up real asset-backed
with ability to cause ‘value addition’.
Islamic banking systemis based on risk-sharing, owning and handling of physical
goods,involvement in the process of trading, leasing and construction contracts
using various Islamic modes of finance. 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 streamof Halal
income, depositors will also receive stable and Halal income.
The forms of businesses allowed by Islam at the time the Holy Quran was
revealed included joint ventures based on sharing of risks & profits and provision
of services through trading, both cash and credit, and leasing activities. In the
Verse II:275, Allah the Almighty did not deny the apparent similarity between
trade profit in credit sale and Riba in loaning, but resolutely informed that Allah
has permitted trade and prohibited Riba.
Profit has been recognized as ‘reward’ for (use of) capital and Islam permits
gainful deployment of surplus resources for enhancement of their value.
However, alongwith the entitlement of profit, the liability of risk of loss on
capital rests with the capital itself; no otherfactor 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 conduct of fiscal and
monetary policies.
Besides trading, Islam allows leasing of assets and getting rentals against the
usufruct taken by the lessee.All such things/assets corpus ofwhich is not
consumed with their use can be leased out against fixed rentals. The ownership in
leased assets remains with the lessor who assumes risks and gets rewards of his
ownership.
Q3. What is the history of Islamic Banking in Pakistan?
Ans. Steps for Islamization of banking and financial systemof Pakistan were
started in 1977-78. Pakistan was among the three countries in the world that had
been trying to implement interest free banking at comprehensive/national level.

But as it was a mammoth task, the switchover plan was implemented in phases.
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 to June 1985.
The legal framework of Pakistan's financial and corporate systemwas amended
on June 26, 1980 to permit issuance of a new interest-free instrument of corporate
financing named Participation Term Certificate (PTC). An Ordinance was
promulgated to allow the establishment of Mudaraba companies and floatation of
Mudaraba certificates for raising risk based capital. Amendments were also made
in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to
include provision of bank finance through PLS, mark-up in prices, leasing and
hire purchase.
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.In March, 1981 financing of import and inland bills and
that of the then Rice Export Corporation of Pakistan, Cotton Export 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 Mudaraba
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 Musharaka.
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. 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 in current accounts continued to be accepted but no interest or
share in profit or loss was allowed to these accounts.However, foreign currency
deposits in Pakistan 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. The SAB delivered its judgment on December 23,
1999 rejecting the appeals and directing that laws involving interest would cease
to have effect finally by June 30, 2001. In the judgment, the Court concluded that
the present financial systemhad to be subjected to radical changes to bring it into
conformity with the Shariah. It also directed the Government to set up, within
specified time frame, a Commission for Transformation of the financial system
and two Task Forces to plan and implement the process of the transformation.

The Commission for 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. A Task Force was set up in the
Ministry of Finance to suggest the ways to eliminate interest from Government
financial transactions.AnotherTask 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 in the State Bank to prepare model agreements and
financial instruments for new system.
The CTFS in its Report identified a number of prior actions, which were needed
to be taken to prepare the ground for transformation of the financial system. It
also identified major Shariah compliant modes of financing, their essentials,draft
seminal law captioned ‘Islamization of Financial Transactions Ordinance, 2001’,
model agreements for major modes of financing, and guidelines for conversion of
products and services of banks and financial institutions.The Commission also
dealt with major products ofbanks and financial institutions,both for assets and
liabilities side, like letters of credit or guarantee, bills of exchange, term finance
certificates (TFCs), State Bank's Refinance Schemes, Credit Cards, Interbank
transactions,underwriting, foreign currency forward cover and various kinds of
bank accounts.The Commission observed that all deposits,except current
accounts,would be accepted on Mudaraba principle. Current accounts would not
carry any return and the banks would be at liberty to levy service charge as fee
for their handling. The Commission also approved the concept of Daily Product
and Weightage Systemfor distribution of profit among various kinds of
liabilities/deposits. The Report also contained recommendation for forestalling
willful default and safeguarding interest of the banks, depositors and the clients.
According to the Commission, prior/preparatory works for introduction of
Shariah compliant financial systembriefly included creating legal infrastructure
conducive for working of Islamic financial system, launching a massive
education and training program for bankers and their clients and an effective
campaign through media for the general public to create awareness about the
Islamic financial system.
The Finance Minister of Pakistan in his budget speech for the FY02 declared the
following:
“ Government is committed to eliminate Riba and promote Islamic banking in the
country.For this purpose a number of steps are under way which are:
1. A legal framework is designed to encourage practice of Islamic banking by
banks and financial institutions as subsidiary operations of their main operations;
2. Consultations and exchanges are undertaken with brother Islamic countries and
renowned institutions of Islamic learning such as middle eastern countries and
Al-Azhar University of Egypt, to learn more about their experiences and
practices;
3. Amendments in HBFC Act are being made in line with the directive of the
Supreme Court. With these changes,HBFC would be fully Shariah compliant
institution, which will play an effective role both in promotion of Islamic
financing method but also in the development of the important housing sector;

4. Shariah compliant modes of financing like Musharaka and Mudaraba will be
encouraged so that familiarity and use of such products is enhanced and their
adoption at a wider scale made possible.
It is government’s intention to promote Islamic banking in the country while
keeping in view its linkages with the global economy and existing commitments
to local and foreign investors”.
The House Building Finance Corporation had shifted its rent sharing operations
to interest based systemin 1989. 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 Musharakah 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 forIslamic modes of financing. The Committee is
reviewing the standards prepared by the Bahrain based Accounting and Auditing
Organisation 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 decided in 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. Setting up 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. Setting up new full-fledged commercial banks to carry out exclusively banking
business based on proposed Islamic products.
Accordingly, the State Bank issued detailed criteria in December 2001 for
establishment of full-fledged Islamic commercial banks in the private sector.Al
Meezan Investment Bank received the first Islamic commercial banking license
from SBP in January 2002 and the Meezan Bank Limited (MBL) commenced
full-fledged commercial banking operation from March 20, 2002. Further, all
formalities relating to the acquisition of Societe Generale, 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. The MBL now
maintains a long term rating of A+ and short term rating of A1+, assessed by JCR
VIS Credit Rating Co Ltd, signifying a consistent satisfactory performance.
The Government as also the State Bank are mainly concerned with stability and
efficiency of the banking systemand safeguarding the interests,particularly, of
small depositors.With this 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.
Islamic Banking Subsidiaries

A new clause (aa) was inserted in sub-section (1) of Section 23 of the Banking
Companies Ordinance 1962 by an amendment notified in the Gazette of Pakistan
on November 4 2002, which provided that banks could form subsidiaries for
“carrying on of banking business strictly in conformity with the Injunctions of
Islam as laid down in the Holy Quran and Sunnah.” In January, 2003 the State
Bank issued BPD Circular No. 01 outlining detailed instructions on the remaining
two parts of the strategy,viz. setting up of subsidiaries and Stand-alone branches
for Islamic Banking by existing commercial banks.The criteria for subsidiaries
are almost similar to the criteria for setting up scheduled Islamic commercial
bank with emphasis on complete segregation of accounts of Islamic banking
subsidiaries and the parent banks doing conventional banking. The subsidiaries
shall have minimum paid up capital of Rs 1,000 million that is equal to the capital
requirement for full-fledged commercial banks.
Islamic Banking through Stand-alone Branches
For Part-III of the strategy,guidelines for opening of stand-alone branches for
Islamic banking by existing commercial banks, enlisting eligibility criteria,
licensing requirements and other operational details on the subject were issued on
January 1 2003. The criteria pertain to financial strength of the applicant bank as
evident from its capital base (net capital free of actual and potential losses),
adequacy of its capital structure,record of earning capabilities, future earning
prospects ofthe bank, managerial capabilities, bank’s liquidity position, track
record of the bank’s adherence to prudential regulations, credit discipline, quality
of customer services and the convenience and the needs of the population of the
area to be served by the proposed branches.Further, banks seeking permission
should have CAMELS rating of 1, 2 and 3 in the last ON-SITE inspection and
there should not be major adverse inspection findings against the bank. The
applying bank is required to submit proposalto the State Bank, outlining the
following details:
• Number of branches along with name of city where the Islamic Banking Branch
(IBB) is to be offered within the next financial year.
• Products and services to be offered by the IBB including deposits,financing,
investment, etc.
• Method of segregating the funds of IBB from the funds of commercial banking
of the applying bank.
• Infrastructure and logistic requirements, including manpower and training
programs.
• The name, qualification and experience of Shariah Adviser(s), and
• Accounting aspects,such as accounting policies to be followed, profit and loss
sharing mechanism, manuals, etc.
The bank will also be required to set up Islamic Banking Division (IBD) at the
Head Office/Country Office in Pakistan. The responsibilities of this Division
have been depicted in detail. The bank would also appoint a Shariah
adviser/Shariah Supervisory Committee consisting of Shariah scholar(s) of repute
to advise the IBD on matters pertaining to Shariah. Moreover, the bank shall
ensure that proper systems and controls are in place in order to ensure segregation
of funds and to protect the interest of depositors.The banks shall ensure proper
maintenance of records for all transactions for disclosure of assets,liabilities,
expenses and income of IBD/IBB(s). The IBD will also comply with statutory
liquidity and cash reserve requirements determined by SBP.

As regards the status of Islamic banking industry in the country (End June 2004),
Meezan Bank is operating with 10 branches in 5 cities as a full fledged Islamic
bank. In addition to it, 5 banks (MCB, Bank of Khyber, Bank Alfalah, Habib
Bank AG Zurich and Standard Chartered Bank) have been issued licenses for 12
dedicated Islamic Banking Branches (IBB) of which 10 branches are operating in
Karachi, Islamabad, Peshawar, Lahore, Faisalabad and Multan. These banks are
planning to offer Islamic banking products in Quetta, Hyderabad, Gujranwala and
other major cities during the year 2004. SBP has also given in principle approval
for opening 10 more Islamic banking branches during 2004 by MCB and Bank
Alfalah.
Habib Bank Limited and Bank Al Habib Limited have been granted in principle
approval to open two Islamic banking branches.They are expected to start these
branches during the year 2004. At least five more banks are expected to open
Islamic banking branches during the year ending December, 2004. Applications
for two new full-fledged Islamic banks are also underscrutiny while the license
of a foreign Islamic bank is being converted to Islamic banking. Some of the
banks who are operating Islamic banking branches are also offering Islamic
banking products through their existing conventionalbranches by using hub &
spoke arrangement. It will increase the outreach of Islamic banking products in
other cities as well.
Q4. What is the Islamic Banking Global Scenario?
Ans. Over the last three decades Islamic banking and finance has developed into
a full-fledged systemand discipline reportedly growing at the rate of 15percent
per annum. Today, Islamic financial institutions,in one form or the other, are
working in about 75 countries of the world. Besides individual financial
institutions operating in many countries, efforts have been underway to
implement Islamic banking on a country wide and comprehensive basis in a
number of countries.The instruments used by them, both on assets and liabilities
sides,have developed significantly and therefore, they are also participating in
the money and capital market transactions.In Malaysia, Bahrain and a few other
countries of the Gulf, Islamic banks and financial institutions are working parallel
with the conventionalsystem.
Bahrain with the largest concentration of Islamic financial institutions in the
Middle East region, is hosting 26 Islamic financial institutions dealing in
diversified activities including commercial banking, investment banking, offshore
banking and funds management. It pursues a dual banking system, where Islamic
banks operate in the environment in which Bahrain Monetary Agency (BMA)
affords equal opportunities and treatment for Islamic banks as for conventional
banks. Bahrain also hosts the newly created Liquidity Management Centre
(LMC) and the International Islamic Financial Market (IIFM) to coordinate the
operations of Islamic banks in the world. To provide appropriate regulatory set
up, the BMA has introduced a comprehensive prudential and reporting
framework that is industry-specific to the concept of Islamic banking and finance.
Further, the BMA has pioneered a range of innovations designed to broaden the
depth of Islamic financial markets and to provide Islamic institutions with wider
opportunities to manage their liquidity.
Anothercountry that has a visible existence of Islamic banking at comprehensive
level is Malaysia where both conventionaland Islamic banking systems are

working in a competitive environment. The share of Islamic banking operations
in Malaysia has grown from a nil in 1983 to above 8 percent of total financial
systemin 2003. They have a plan to enhance this share to 20 percent by the year
2010. However, there are some conceptualdifferences in interpretation and
Shariah position of various contracts like sale and purchase of debt instruments
and grant of gifts on savings and financial papers.
In Sudan, a systemof Islamic banking and finance is in operation at national
level. Like other Islamic banks around the world the banks in Sudan have been
relying in the past on Murabaha financing. However, the share of Musharaka and
Mudaraba operations is on increase and presently constitutes about 40 percent of
total bank financing. Although the Islamic financial systemhas taken a good start
in Sudan, significant problems still remain to be addressed.
Like Sudan, Iran also switched over to Usury Free Banking at national level in
March 1984. However, there are some conceptualdifferences between Islamic
banking in Iran and the mainstream movement of Islamic banking and finance.
Owing to the growing amount of capital availability with Islamic banks, the
refining of Islamic financing techniques and the huge requirement of
infrastructure development in Muslim countries there has been a large number of
project finance deals particularly in the Middle East region. Islamic banks now
participate in a wide financing domain stretching from simple Shariah-compliant
retail products to highly complex structured finance and large-scale project
lending. These projects, inter alia, include power stations,water plants , roads,
bridges and other infrastructure projects. Bahrain is the leading centre for Islamic
finance in the Middle East region. The establishment of the Prudential
Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in
conjunction with AAOIFI has gone a long way towards establishing a legal and
regulatory framework to meet the specific risks inherent in Islamic financing
structures.
The BMA has quite recently signed MoU with the London Metal Exchange
(LME) to pool assets to develop and promote Shariah compliant tradable
instruments for Islamic banking industry. The arrangement is seen as a major
boost for industry’s integration in the global financial systemand should set the
pace for commodity-trading environment in Bahrain. BMA has also finalized
draft guidelines for issuance of Islamic bonds and securities from Bahrain. In
May 03, the Liquidity Management Centre (LMC) launched its debut US$ 250
million Sukuk on behalf of the Government of Bahrain.
National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance
Card that has all the benefits of a regular credit card. The card does not have a
credit line and instead has a prepaid line. As such,it does not incur any interest.
Added benefits are purchase protection, travel accident insurance, etc and no
interest, no extra fees with no conditions,the card is fully Shariah compliant. It is
more secure than cash, easy to load up and has worldwide acceptance.This
prepaid card facility is especially attractive to women, youth,self employed and
small establishment employees who sometimes do not meet the strict
requirements of a regular credit card facility. Saudi Government has also
endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector
and opened it for foreign investors.

.
.
Islamic banks have also built a strong presence in Malaysia, where Standard &
Poor's assigned a BBB+ rating to the $600 million Sharia-compliant trust
certificates (called sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara
Malaysia (BNM) has announced to issue new Islamic Bank licences to foreign
players. The Financial Sector Masterplan maps out the liberalisation of
Malaysia's banking and insurance industry in three phases during the next decade.
It lists incentives to develop the Islamic financial sectorand enlarge its market
share to 20 percent, from under 10 percent now. A dedicated high court has been
set up to handle Islamic banking and finance cases.
In United Kingdom, the Financial Services Authority is in final stages of issuing
its first ever Islamic banking license to the proposed Islamic Bank of Britain,
which has been sponsored by Gulf and UK investors.The United States of
America has appointed Dr. Mahmoud El Gamal, an eminent economist/expert on
Islamic banking to advise the US Treasury and Government departments on
Islamic finance in June 2004.
The literal meaning of the word Musharaka is sharing. Under Sharia’a law,
Musharaka refers to a joint partnership whereby two or more persons combine
either their capital or labour, forming a business in which all partners share the
profit according to a specific ratio, whereas the loss is shared according to the ratio
of the contribution made. Musharaka is based on a mutual contract and,
therefore, it needs to have the following features to enable it to be valid under the
Sharia’a:
Parties should be capable of entering into a contract (that is, they should be of
legal age). The contract must take place with the free consent ofthe parties (that is,
without any duress).
In Musharaka, every partner has a right to take part in the management, and to
work for it. The partners may agree, however, on a condition in which the
management is carried out by one of them, and no other partner works for the
Musharaka. In such a case the ‘sleeping’ (silent) partner is entitled to the profit
only to the extent of his investment, and the ratio of profit allocated to himshould
not exceed the relative size of his investment in the business.
If all the partners agree to work for the joint venture, however, each one of them
should be treated as the agent of the other in all matters of business. Work done
by any of them, in the normal course of business, shall be deemed as being
authorised by all partners.
Musharaka can take the formof an unlimited, unrestricted and equalpartnership in
which the partners enjoy complete equality in the areas ofcapital,management and
right of disposition. Each partner is both the agent and guarantor of the other.
Anothermore limited investment partnership is also available. This type of
partnership occurs when two or more parties contribute to a capital fund, with
money,contributions in kind or labour.In this case, each partner is only the agent
and not the guarantorof his partner.
For both forms, the partners share profits in an agreed upon manner and bear
losses in proportion to the size of their capital contributions.
In conventional banking, ‘interest’ predetermines a fixed rate of return on a loan
Handout- 3 MUSHARAKA

.
.
advanced by the financier irrespective of the profit earned or loss suffered by the
debtor, whereas Musharaka does not envisage a fixed rate of return. Instead, the
return in Musharaka is based on the actual profit earned by the joint venture. The
presence of risk in Musharaka makes it acceptable as an Islamic financing
instrument.
The finance provider of an interest-bearing loan has many techniques open to
prevent him suffering a loss in the event of failure of the project, whereas the
financier in Musharaka, not having these techniques available, can suffer loss if
the joint venture fails to produce fruit.
1.1 SHARIA’A RULES FOR PROFIT AND LOSS WITH
MUSHARAKA
2.4.1 Distribution of Profits
The distribution of profits in a Musharaka arrangement must abide by two rules:
The proportion of profit to be distributed between the partners must be agreed
upon at the time of effecting the contract. If no such proportion has been
determined, the contract is not valid under the Sharia’a.
The ratio of profit for each partner must be determined in proportion to the actual
profit accrued to the business, and not in proportion to the capital invested by
them. It is not permissible to fix a lump sum amount for any one of the partners,
or any rate of profit tied up with their investment.
The effect of these rules is that if ‘A’and ‘B’enterinto a partnership and it is agreed
between them that ‘A’ will be given 10,000 per month as his share in the profit,
and the rest will go to ‘B’, the partnership is deemed to be invalid. Similarly, if it
is agreed between them that ‘A’ will get 15% of his investment, the contract is
also invalid. The correct basis for distribution would be an agreed percentage of
the actual profit accruing to thebusiness.
If a lump sum amount or a certain percentage of the investment has been agreed
for any one of the partners, it must be expressly mentioned, in the agreement, that
it will be subject to the final settlement at the end of the term. This means that any
amount so drawn by any partner will be treated as ‘on account payment’ and will
be adjusted to the actual profit he may deserve at the end of the term. But if no
profit is actually earned, or is less than anticipated, the amount drawn by the
partner must be returned.
Under a Musharaka contract the profit ratio agreed is not necessarily symmetric
to the capital contribution made to the project.
2.4.2 Sharing of Losses
The potential asymmetry of profit distribution, however, does not occur in the
event of a loss. Each partner willsufferany loss exactly according to the ratio ofhis
investment. So if a partner has invested 40% of the capital, he must suffer 40% of
the loss – no more, no less – and any condition to the contrary renders the
contract invalid under the Sharia’a.
There is a famous Islamic Hadith stating this policy:
“Profit is basedonthe agreement ofthe parties but lossis always subject to the ratioof
investment.”

.
inappropriate to establish a company with borrowed money,for the purpose ofprofit.
.
Therefore, losses in Musharaka are symmetric to the ratio of the capital
contribution made.
2.5 MANAGEMENT OF MUSHARAKA
The normal principle of Musharaka is that every partner has a right to take part in
its management and to work for it. The partners can agree, however, upon a
condition in which the management will be carried out by one of them, and no
other partner will work for the Musharaka. In this latter case the sleeping partner
is entitled to the profit only to the extent of his investment, and the ratio of profit
allocated to him should not exceed the ratio of his investment, as discussed
earlier.
However, if all the partners agree to work for the joint venture, each one of them
must, under the Sharia’a, be treated as the agent of the other in all the matters of
the business; any work done by one of them in the normal course of business
shall be deemed to be authorised by all the partners.
2.6 SHARIA’A RULES FOR MUSHARAKA
To be Sharia’a compliant,a Musharaka must meet the followingconditions:
The capital provided by each partner must be specific, existent and easily
accessible. It is
It is permissible for partners to have unequal ownership in the project. The
percentage of ownership is set forth in the agreement.

Case Study1: Ijara Contract 2
.
. The capital of the company must be money (liquid cash). Some Jurists permit
contributing merchandise as invested capital, but any merchandise must be valued
and the value agreed upon by all parties. Once the value has been established it is
counted as capitaland stipulated in the contract as such.
It is impermissible to impose conditions forbidding one of the partners from
working on the project. The company is built on honour and each partner
implicitly permits and gives power of attorney to the other partner(s) to dispose of
and work with capital as is deemed necessary to conduct business. However, it is
permissible for one partner to have full respon- sibility for the operations of the
company, provided he is granted this authority by the other partners.
A partner is a trustee of company funds in his possession and is held responsible
for their proper use. It is permissible to take a mortgage or a guarantee against
company assets, but it is impermissible to take security for profit or capital.
Each customer/partners’ share of the profits must be known in order to avoid
uncertainty (gharar). Also, it is required that the ownership proportion be in
percentage terms and not as a fixed sum, because this would violate the
requirements of a partnership.
In principle, profit must be divided among partners in ratios proportionate to their
shares in capital. Some Jurists permit variation in profit shares as long as it is
agreed to by all the partners. This may be the case when one of the partners has
more business skills and does not agree to parity, so some variation in the
sharing of profits becomes necessary.
In principle, a partnership isa permissible and nonbinding contract.Thus,ifa partner
wishes, he could rescind the agreement provided that this occurs with the
knowledge of the other partner or partners. Rescinding the agreement without the
knowledge of the other partners prejudices the rescinding partner’s interest.On the
other hand some Jurists take the view that the partnership contract is binding up to
the liquidation of capital or to the accomplishment of the job specification agreed
to on acceptance of the contract.
What is The Ijara Contract?
Ijara is an Islamic mode of finance adopted by Islamic banks. Ijara (leasing) is a mediumto
long-termmethod offinancing capitalequipment orproperty.Underthis contract,the customer
selects the capital equipment or property (assets)to be financed by the bankand the bankthen
purchases these assets from the manufacturerorsupplierand then leases themto the customer
for an agreed period.
In conformity with the Sharia’a, the owner of the assets (in this case the bank) must be
paid rent (fixed or variable, as agreed by the lessor and lessee) and must exercise all the rights
and obligations that are incidental to ownership such as maintaining, insuring and repairing
the assets.
The lessee, on the other hand, obtains the use ofthe asset forthe period ofthe lease subject
to paying the rent. The lessee may assume the obligations, such as maintaining, insuring and
repairing the asset, in return for a reduced rent.
1.1.1 What is Car Ijara?
As mentioned above Ijara is basically the transfer of usufruct (defined below) of a fixed
asset to another person for an agreed period, for an agreed consideration. Under a Car Ijara
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Handout- 4 Ijara

Case Study1: Ijara Contract 3
agreement the car will be rented to the customer for the period agreed at the time of contract.
Upon completion of the lease period the customer in the Meezan case discussed below, gets
ownership of the car against his initial security deposit.
Car Ijara is a Sharia’a-compliant car-leasing scheme. It is based on the principles of Ijara
and is completely free from the element of interest. This product is designed for interest-
averse individuals, looking for a car-financing scheme that helps in avoiding interest-based
transactions. So Car Ijara is simply a rental agreement under which the car will be given to
the customer in exchange for rent for a period, agreed at the time of the contract.
Meezan Bank, based in Pakistan and a pioneerin this area,purchases the carand rents it out
to the customer for a period of three, four or five years. Upon completion of the lease period
the customer gets ownership of the car against his initial security deposit.
Somewhat confusingly, the Meezan Car Ijara scheme has elements ofIjara wa Iqtina within
it. In this case study Ipropose to followthe Meezan assumption in using Ijara in the sense that
it involves car ownership at the end of the maturity of the deal. This is in line with Sharia’a
methodology and terminology.
1.3.2.1 Whatis Usufruct?
Usufruct is the right of enjoying a thing,the property ofwhich is vested in another,and to draw
from the same all the profit, utility and advantage that it may produce, provided it be without
altering the substance of the thing. Items without usufruct cannot be leased.It is necessary for
a valid lease contract that the corpus of the leased asset remains in the ownership ofthe seller,
and only its usufruct is transferred to the lessee.
1.3.3 In what Sense is Car Ijara Interest Free?
In Car Ijara, the asset remains underthe ownership and at the riskofthe bankand the customer
only pays the rental for the use of the asset, just like the rent of a house.

Under leasing or lease purchase, the Islamic financial institution buys the financed asset and retains the title
through the life of the contract. The customer makes a series of lease payments over a specified period of time,
and may have the option at the end to buy the item from the lessor (and owner) at a pre specified residual
value.
Leasing was not originally a mode of financing. It was simply a transaction meant to transfer the usufruct ofa
property from one person to another for an agreed period and an agreed upon consideration. Leasing can be
used as a mode of financing, in Islamic banks, as an alternative to conventional car financing. However, the
consideration of leasing as a mode of financing should be based on certain conditions. It should be
understood, by all using it as a mode of financing, that it is not sufficient to substitute the term‘interest’ with
the term ‘rent’, and use the term ‘mortgage’ instead of the term ‘leased asset’. There must be a significant
difference between leasing and an interest-bearing loan.
It is no secret that an Islamic bank or financial institution will take into consideration the same factors as a
conventional bank when determining the rental payments and residual value. These would include the rate of
inflation, the creditworthiness of the lessee, the opportunity cost value of the money (as reflected by market
interest rates) and so on. An implicit ‘interest rate’ can trivially be calculated from the price, residual value,
term of the lease and the lease payment. This fact is not hidden. Indeed Muslimcustomers are encouraged to
‘shop around’ and ensure that the Islamic financial institution is not implicitly charging an interest rate,which is
in line with the conventionalmarket.
In the final analysis, however, the difference is in the form of the contract. If the lease is structured in
accordance with the various conditions within Islamic jurisprudence, it will contract no riba and ensure that it
cannot contain such forbidden riba in the future (e. g., in terms of late payment fees, etc.).
1.3.4 What is the Difference between a Conventional Lease and an Islamic
Lease?
The most important financial difference between Islamic leasing and conventional leasing is that, with Islamic
leasing, the leasing agency must own the leased object for the duration of the lease. Therefore, although
leasing a car from a car manufacturer or car dealership may in principle be permitted for Muslims (if the
contract satisfies the other conditions), Muslims should investigate further. In many cases, the car dealership
may in fact use a bank or other financial intermediary to provide a loan for the present value of lease pay-
ments, and charge the customer interest on this loan. This would constitute the forbidden riba.
Scrupulous Islamic financial institutions ensure that the contract abides by all the restrictions set out in the
Sharia’a (e. g., subleasing requires the permission of the lessor; late payment penalties must be handled very
carefully to avoid riba,etc.).
The differences between conventional and Islamic financing schemes are described in the sections below.

Situation-1
Consider a person who works in a factory situated 50 km from his residence. He commutes
daily from his home to the factory by public transport that costs him time, money and he also
bears exhaustion because of the hassle of travel in public transport. He earns only 500 US dollar
per month. He does not afford to buy a car immediately. However, he can buy a car by saving
money over a span of 5 years. Modern and Islamic banking systems both provide a way out
from this situation.
Situation-2

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