This document provides an overview of Islamic banking, including: - Defining Islamic banking and comparing it to conventional banking. - Describing common Islamic financing techniques like Murabaha, Musharakah, and Mudarabah. - Explaining how Islamic banks currently operate and the sectors they typically finance, with many relying heavily on Murabaha contracts.

1. WHAT IS Islamic BANKING? Concept, Instruments Issues, Theory and Practice AUSAF AHMAD Azerbaijan State Economics University Baku April 7-11, 2008

2. In the name of Allah, the most Beneficent, the Most Merciful.

3. This presentation includes: What is Islamic banking? Basic function: Financial Intermediation An Introduction to Islamic financing techniques. Practices of Islamic Banking and Finance Observations on some common misconceptions.

4. Clarification on Nomenclature Islamic Banking is known by several names: Interest free banking (Iran) PLS Banking (Pakistan) Islamic Banking (Gulf) Special Finance Houses (Turkey) All expressions are used interchangeably. Is it a contradiction in terms?

5. Clarification on Nomenclature contd. Some people prefer Islamic Finance House instead of Islamic bank. (Beit ul tamweel) It is argued that banking is purely Western Phenomenon Islamic banking and Islamic finance are also used interchangeably.

6. Common interface between Islamic and contemporary banks Same purpose: Financial intermediation Same Objective: Profit Successful Operation of Islamic banks has shown that financial intermediation is possible even without interest.

7. FINANCIAL INTERMEDIATION DEFICIT HOUSEHOLDS [Firms} SURPLUS HOUSEHOLDS FINANCIAL INTERMEDIATION FINANCIAL INTERMEDIARIES Financial Flow Financial Flow Goods Real Flow

8. THE FIRM FINANCIAL MARKET FINANCIAL INTERMEDIARIES INDIVIDUALS Indirect financing Indirect financing

9. DIRECT FINANCING Households Businesses Flow of Real goods Financial Flow

10. Indirect Financing Business Financial Institutions Households Financial Resources Financial Resources Return on Investment Return on Investment Goods Goods goods

11. STRUCTURE OF FINANCIAL MARKETS Supervisory Bodies Direct Finance Indirect Finance Bonds Equities Primary Markets Secondary Markets Investment Banks Dealers and Brokers Stock Exchanges Over-the-Counter Exchange Depository Institutions Contractual Savings Institutions Investment I ntermediaries Commercial Banks Saving & Loan Associations Cooperatives Insurance Companies Mutual Funds Pension Funds Finance Companies

12. Islamic Banks and Other businesses ALL BUSINESSES Financial Institutions All Banks Islami Banks

13. Theoretical considerations

14. Social and Moral Norms Should not indulge in Riba Should not involve Gharar Should not indulge in fraudulent behavior Should not coerce Should assure fairness to all parties. No financing of socially undesirable goods such as alcohol, drugs, pornography. Should not resort to morally reprehensible practices such as cheating, bribing, fraudulent practices.

15. The Views on Bank Interest No distinction is made between usury and interest. No distinction is made between consumption loans and productive loans. No distinction between constant and variable interest rates. No distinction is made between individual and institutional rate of interest.

16. AVOIDANCE OF GHARAR Definition of Gharar Uncertainty / Ambiguity Ambiguity of Quantity [Gharar fil Miqdar] Ambiguity of Attributes [ Gharar fis sifah ] such as Ambiguity in time or place of delivery Ambiguity in price etc.

17. DEBT FINANCE Vs. Islamic FINANCE Islamic finance, in comparison, to debt finance is: More just [Treats creditor and borrowers equally] More equitable [ Interest rate is exploitative ] More efficient [ allocates resources on the basis of profitability ] More growth oriented. [ Increases productive Capacity of the society ]

18. Practices of Islamic banking

19. PRESENT SCENE Islamic Banks in the Government Sector Pakistan, Sudan, Iran Islamic Banks in the Mixed Sector - Malaysia Islamic Banks in the Private Sector Gulf Non Banking Financial Institutions Al Ameen [ Bangalore, India] Islamic Financing by standard Commercial Banks in the Domestic Sector Saudi British, NCB, Saudi American, Misr Bank Islamic financing by Commercial banks in the foreign sector. Islamic Banks established by multinational Banks Citibank, HSBC Amanah Bank,

20. TYPES OF ISLAMIC BANKS Predominantly social banks such as Nasser Social Bank Predominantly international development banks such as Islamic Development Bank Predominantly financial investment bank such as Kuwait Finance House Completely government owned banks such as Nasser Social Bank Banks owned by several Islamic governments such as Islamic Development Bank Multipurpose non government banks such as Dubai Islamic Bank [1] [1] Al Hawary, Ma Ma’na Bunk Islami ( Arabic) Cairo: International Association of Islamic Banks, 1982 p. 49

21. Other Classifications Islamic Banks in the Government Sector Pakistan, Sudan, Iran Islamic Banks in the Mixed Sector Malaysia Islamic Banks in the Private Sector Gulf Non Banking Financial Institutions Islamic Financing by standard Commercial Banks

22. Elementary Observations EMERGENCE O F ISLAMIC BANKS WHAT IS AN ISLAMIC BANK? THE DIFFERENCE BETWEEN AN ISLAMIC BANK AND AN ISLAMIC FINANCIAL INSTITUTION. EVOLUTION OF ISLAMIC BANKING. PRESENT SCENE.

23. A TYPICAL BALANCE SHEET Sources of Funds Current Account Saving Accounts Investment Acc Special Invest. Acc Uses of Funds Murabaha Musharakah Mudarabah Ijarah Qard Hasan

24. Business Practices : Sources of Funds Current Accounts Saving Accounts Saving a/c without authorization Saving a/c with authorization to invest Investment Accounts General Investment accounts Limited Period Investment accounts Specified Investment accounts

25. Current Deposits [sources of funds] Very Similar to standard commercial banks No return paid back to depositors Checking facilities Are Current deposits a loan to the bank from depositors ? Are Current deposits a trust by depositors to banks ? Use of Current deposits by the banks on their own risk .

26. Saving Deposits [Sources of Funds] Saving deposits without authorization to invest Saving deposits with authorization to invest Return to depositors who provide authorization to invest. Saving deposits as a part of trust accounts. Saving deposit as Notice account

27. Investment Deposits [Sources of Funds] Islamic Banking counterpart of Fixed Deposits. Withdrawal allowed only in special cases Investment deposits as Mudarabah Accounts. Depositor: Rabbal Mal; Bank: Aamil Share profit on agreed basis, bear full loss. Investment pool Distribution of profits on pro rata basis.

28. Special Investment Deposits [Sources of Funds] Concept of Wakalah The bank acts as a wakeel. Implement\s the instruction of the Mawakkil. Special purpose investment, Specify, purpose, sector, industry, or even project. The bank gets a fee for the services rendered. Full profit or loss goes to the depositor. The bank will share in loss only in case of proven neglect.

29. USES OF FUNDS MUDARABAH MUSHARAKAH MURABAHAH IJARAH (Leasing) IJARAH WA IQTINA (Lease Purchase) MUSHARAKAH MUTANAQISAH LOAN ON SERVICE CHARGE INTEREST FREE LOANS.

30. TYPES OF CONTRCTS Contracts Muawadat Contracts against Payment Musharakat Contracts of Partnerships Tabarruat Contracts of Charity

31. TYPES OF CONTRCTS Contracts of Sale / Lease are Muawadat. Gharar is not allowed in such contracts. Mudarabah and Musharakah are contracts of Partnerships. Some amount of gharar may be tolerated in such contracts. Sadaqat and Hadaya are Tabarruat. No objection to Gharar in these type of contracts.

32. Financing Techniques These techniques were devised in the classical period for the commodity trade Their application to financial sector is an innovation of the modern era. The application of these techniques requires new documentation which was not required in the early period.

33. MURABAHAH [USES OF FUNDS] - I The word MURABAHA is derived from the word Ribh, meaning profit in Arabic. Sale with a profit. Cost-plus financing. Examples of Murabahah. Two contracts: A contact of intent to conduct a Murabaha Sale and another contact to buy the good ordered in previous contract. Promise is not a legal binding. It introduces an element of risk in the transaction. The element of risk justifies the profit in Murabaha sale : Fiqhi principle : Al Kharaj bi Daman.

34. MURABAHAH [USES OF FUNDS] - II Applications of Muraqbaha: In domestic trade In foreign trade In financing consumer durables In financing real estaes ABUSES OF MURABAHA MURABAH AND BAY EINA.

35. MURABAHAH [USES OF FUNDS] - II Applications of Muraqbaha: In domestic trade In foreign trade In financing consumer durables In financing real estaes ABUSES OF MURABAHA MURABAH AND BAY EINA.

36. MUSHARAKAH [USES OF FUNDS] Musharakah is from the word Sharikah. More than one partners: Partnership in capital proportion and project supervision. A partner may waive his right of supervision or delegate it to another partner. Arrangements: Sharing of Profit and loss in accordance with capital proportion agreed proportion. Variant: Share of profit in agreed proportion, share of loss in capital proportion. Applications of Musharakah: i. in Import trade Ii. In Agriculture

37. MUDARABAH [USES OF FUNDS] Mudarabah existing from pre-Islamic times. Permitted on the Cannon of Necessicity. Profit and loss sharing is a wrong translation. Arrangement: Profit is shared on an agreed basis, loss is borne by the Rabbal Mal. Bank: Rabbal Mal, Entrepreneur : Aamil Double tier Mudarabah. Requirements for a successful Mudarabah

38. Other Financing Techniques Loans on Service Charge Qard Hasan [interest free loans] Service Charge is to be equal to actual administrative expenditure Qard Hasan is limited to social purposes only.

39. IJARAH [USES OF FUNDS] Ijarah is emerging as a popular technique of financing amongst the Islamic banks Elements of a lease contact: Lessor, Lessee, instrument and period of lease, The asset remains in the ownership of the lessor. Maintenance is the responsibility of the owner. Ijarah muntahi bit tamlik

40. Other Financing Techniques Diminishing Musharakah Loan of Service Charges. Only administrative expenses can be charged. Interest free loans are provided as a social service

41. A TYPICAL BALANCE SHEET Sources of Funds Current Account Saving Accounts Investment Acc Special Invest. Acc Uses of Funds Murabaha Musharakah Mudarabah Ijarah Qard Hasan

42. MAIN QUESTIONS How Islamic Banks use these techniques? What is the incidence of their use? Are some techniques more amenable to certain sectors? Which techniques are easier to use? Which techniques have lesser documentation requirements? These are all empirical issues !

43. Salient features of the Survey Results based on a Sample survey Period: April –October 1985 IV and V Meetings of the Directors of Islamic Banks 30 Banks approached, 8 Banks responded 55 questions asked. Information to be supplemented by other sources.

44. Responding Islamic Banks Jordan Islamic Bank (1979) Faisal Islamic Bank, Egypt (1977) Islamic Bank for Western Sudan (1981) Tadamon Islamic Bank, Sudan (1981) Qatar Islamic Bank (1983) Islamic Bank International Denmark (1983) Islamic Bank, Bangladesh (1983) Sudanese Islamic Bank, Sudan (1983)

45. Financial Operations of Islamic Banks [Financing Techniques] Mudarabah Musharakah Bay al ajal Murabaha Ijarah Lease purchase financing Qard Hasan

46. FINANCING TECHNIQUES [CONTD. ] These techniques were devised in the classical period for the commodity trade Their application to financial sector is an innovation of the modern era. The application of these techniques requires new documentation which was not required in the early period.

47. Relative Significance of Islamic Financing Techniques Dominance of Murabaha in 1984 Jordan Islamic Bank 72% Bangladesh Islamic Bank 65% Sudanese Islamic Bank 53% Tadamon Islamic Bank 61% Qatar Islamic Bank 97% Significance of Musharakah Hybrid Techniques

48. Financing By Modes for 10 Islamic Banks 1994-96 12.61 11.2 Other 3.73 4.84 Ijarah 8.17 7.29 Mudarabah 9.83 6.49 Musharakah 65.66 70.19 Murabaha Weighted Average Simple Average Modes

49. Mode wise Finance of Islamic Bank, Bangladesh 4.32 3.56 Qard Hasan 3.18 3.87 Musharaka 7.22 7.18 Purchase and Negotiation 16.66 14.57 Hire purchase 18.34 17.28 Deffered sale 50.28 53.54 Murabah 1996 1995 Mode

50. Sector Wise Distribution of Finance 1984 73.01 - - 26.10 0.83 Islamic Bank Bangladesh 90.34 9.35 - - - Qatar Islamic Bank 32.79 25.67 1.00 39.79 0.53 Jordan Islamic Bank Trade Real estate SSI Mfg. Agriculture Name Of the Bank

51. Sectoral Financing by Nine Islamic Banks, 1994-96 19.4 19.1 Other 14.8 12.9 Real Estate 19.7 11.2 Services 9.2 11.0 Industry 2.7 2.4 Agriculture 34.1 42.4 Trade Weighted Average Simple average Sector

52. Relative Significance of Islamic Financing Techniques Dominance of Murabaha in 1984 Jordan Islamic Bank 72% Bangladesh Islamic Bank 65% Sudanese Islamic Bank 53% Tadamon Islamic Bank 61% Qatar Islamic Bank 97% Significance of Musharakah Hybrid Techniques

53. Financing By Modes for 10 Islamic Banks 1994-96 12.61 11.2 Other 3.73 4.84 Ijarah 8.17 7.29 Mudarabah 9.83 6.49 Musharakah 65.66 70.19 Murabaha Weighted Average Simple Average Modes

54. Mode wise Finance of Islamic Bank, Bangladesh 4.32 3.56 Qard Hasan 3.18 3.87 Musharaka 7.22 7.18 Purchase and Negotiation 16.66 14.57 Hire purchase 18.34 17.28 Deffered sale 50.28 53.54 Murabah 1996 1995 Mode

55. Sector Wise Distribution of Finance 1984 73.01 - - 26.10 0.83 Islamic Bank Bangladesh 90.34 9.35 - - - Qatar Islamic Bank 32.79 25.67 1.00 39.79 0.53 Jordan Islamic Bank Trade Real estate SSI Mfg. Agriculture Name Of the Bank

56. Sectoral Financing by Nine Islamic Banks, 1994-96 19.4 19.1 Other 14.8 12.9 Real Estate 19.7 11.2 Services 9.2 11.0 Industry 2.7 2.4 Agriculture 34.1 42.4 Trade Weighted Average Simple average Sector

57. TERM STRUCTURE OF FINANCE Term structure means temporal distribution of finance Significance of term structure Heavy dominance of short term finance Reasons for this dominance: asymmetry between term structure of deposits and term structure of finance.

58. Latest Trends in Islamic Financial Markets Derivatives and secondary market Evolution of Financial Instruments and Financial Papers Securitization Musharakah bonds Ijarah bonds

59. SOME MISCONCEPTIONS ISLAMIC BANKING IS RELIGION BASED. ISLAMIC BANKING IS FOR A SPECIFIC COMMUNITY ISLAMIC BANKING REPLACES INTEREST RATE WITH PROFIT AND THAT IS ALL.