3

1.3 Traditional Finance Compared to Islamic FinanceThe principles of Islamic banking and fi nance are derived from two primary sources - the Quran (the holy book of Islam) and the Sunnah or Hadith (the examples and sayings of the Prophet Muhammad). As we discuss elsewhere in the CIFA program, Muslims interpret ‘interest’ to be equivalent to riba. As a result, the emerging Islamic banking and fi nance market must operate with fi nancial tools that do not generate interest.

Although fi nance and investment may operate easily without interest, interest is a common and prevalent tool even though most faith traditions once banned interest-based lending. Over time, in all faiths but Islam, the prohibition weakened, with excess interest or usury becoming the ‘challenge’. Islam, however, continues to object to any form of interest-based lending.

Shariah, in modern times, has the characteristics of a legal system. Nonetheless the most common modern application of Shariah is as a moral or value system. This is important as most Muslim countries have adopted variations of the French-inspired civil code or a system based on English common law.

Therefore, Shariah is often not the applicable law for a deal. In some countries like Pakistan, Shariah serves as a form of appeal. In other countries Shariah is a source or a main source of law. The successful application of Shariah principles, as a result, often requires changes in law and revisions to fi nancial service regulations.

An important element of the CIFA program is to demonstrate the clear concepts of Islamic fi nance and then to build examples of applicability in as many legal contexts as possible. In general we will discover that Islamic tools are widely applicable, practical and may fi t under most modern legal and regulatory regimes. The CIFA approach to Shariah is to see it as being practical - the Shariah allows many business activities that are already present in most modern regulatory and legal systems.

In contrast to some traditional secular fi nancial approaches, a Shariah-based fi nancial system must take into account specifi c moral guidance. Some other important differences are:

1.The most prominent moral directive is the prohibition of interest. This is based upon four direct Quranic injunctions,3 and several very clear statements by Prophet Muhammad. From the Prophet’s sayings, we understand that traditional interest-bearing deposits and loans are forbidden; and we also understand clear restrictions on the exchange of currencies, such as direct forward exchange contracts.

2. In addition to riba or interest, a concept called gharar is to be managed or avoided whenever possible. Gharar equates to a form of contractual or business uncertainty or ambiguity which impairs the rights of one contracting party. Consequently, the ambiguity makes it diffi cult for that party to make a proper business decision. The desire to reduce gharar to a tolerable level is akin to consumer protection laws and the types of disclosure required in many countries when dealing with consumer fi nance deals or securities sales.

3. Additionally, investment in goods or services which are forbidden by Shariah is prohibited. In general, a product or a service would be considered haram (morally forbidden) if it violates a clear Quranic ruling. For instance, one is not allowed to deal with matters such as alcohol, intoxicants, pork, interest, conventional insurance, pornographic material, and forms of entertainment and hospitality. As a result the portfolio activities of Islamic institutions are distinct from those of traditional banks in many countries.

In summary, Islamic fi nance is governed by special rules stipulated by Islamic commercial and ethical rules called fi qh al muamalat. The prohibitions stipulated by Islamic commercial rules have an impact both the process of fi nancial and treasury operations and business performance. The key sub-set of rules is called ahkam al sarf, or the rules of monetary exchange. Once we know our parameters, it is surprisingly simple abide by them.

For instance, if one wishes to lend money, the Shariah principle is that a loan is to help. When one helps another person, then the concept of profi t does not make sense as the goal is not to gain when helping. Therefore a loan of money is not permitted to earn interest. The same may apply to a guarantee to pay money, which should not necessarily generate a fee.

On the one hand, a guarantee is a promise to pay money at a later date. Therefore, a number of leading scholars believe that the fee is a form of interest. This follows from their view that a guarantee is a means to help another person and should not normally be compensated. On the other hand, other leading scholars believe that guarantees may be compensated to refl ect the work and risk undertaken by the guarantor. Through the course of CIFA we will learn the different approaches taken in the market towards the use of fi nancial guarantees.

3 - Chapter30 verse 39; Chapter 4 verses 160-161; Chapter 3 verse 130; and Chapter 2 verses 275 – 279.

4

Since Shariah rules mean that we cannot pursue traditional lending, we must apply commercial contracts to create credit and investment returns. Such contracts include sales and leasing contracts, agency and partnership rules to provide credit and investment to our customers.

The fi rst group of contracts, sales and leasing is naturally certain in their outcomes, and allows us to earn a fi xed yield based on our fi xed price to our customer. Agency and partnership concepts are naturally uncertain, and allow for participation in the profi t of a business at the risk of losing our capital.

Not only do these rules restrict how we offer credit and make investments, but they also impact our foreign currency exchange practices. For instance, the Prophet stated:

“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt — like for like, equal for equal and hand to hand. If the commodities differ, then you may sell as you wish, provided that the exchange is hand to hand.” (Muslim, Kitab al-Musaqat)

This maxim leads to two important rules:

1. Currency exchange of the same type of currency (like for like) must be spot (hand to hand) and without any form of profi t (equal for equal). In other words, we are asked to exchange one gram of 18-carat gold for one gram of 22-carat gold, just because the two types of gold fall under the rules of currency. We may sell our gold for another currency. After that, we may buy the different quality gold with currency, but not gold. In other words, we may not exchange the same type of currency for the same type with different values, based on the argument that a difference in the quality of the currency is the basis for a premium or discount in price.

2. Two different currencies may be exchanged at any mutually agreed rate. But the exchange must take place on a spot basis, the modern equivalent of hand to hand. Therefore, the rate for euros to US dollars may be negotiated between the parties so long as the transaction is executed on a spot basis.

Later, we will discuss the widely applied solutions to this challenging restriction. As a result of these conceptual differences between Islamic and traditional fi nance, an Islamic bank is more likely to be a profi t-sharing institution, or a merchant banking institution relying heavily on sales oriented contracts.

1.4 Sources of Funds: DepositsIn a conventional bank a deposit is a loan from a customer or another bank. Commonly, deposits are collected in the form of the following types of account: checking, savings, money market, fi xed deposits and certifi cates of deposit. A bank will normally pay interest linked to how long the deposit sits with the bank. The longer the deposit term, the higher is the interest to be paid.

Checking or current accounts are usually not interest-bearing. However, some fi nancial institutions do offer interest-bearing checking accounts with a minimum balance requirement. Savings accounts and time deposits (fi xed deposits and certifi cates of deposit) bear an interest rate yield that is based on the duration of the deposit.

Figure 2: Illustration of Depositor/Bank Relationship in a Conventional Bank

Deposit insurance

Deposits guaranteed

Interest

Payments(P&I)

Collateral

BorrowersDepositors(lenders)

Step 1 Step 2

1.Customers deposit in (lend to) the bank; the principal of the deposit is guaranteed and the interest is contractual; and in many countries these loans are guaranteed by a state-sponsored insurance program.

2. The bank then lends the money to business and retail borrowers. There is no relationship or dependency between the loans received by the bank and made by the bank.

5

In contrast, the funding of an Islamic bank involves deposits, quasi deposits and profi t sharing investment accounts (PSIA). Remember, a deposit is a loan, therefore it may not from a Shariah perspective generate a contractual return. Typically, Islamic banks offer Wadiah accounts which include checking or current accounts. A Wadiah account will not contract to pay any return or interest at all.

Some Islamic banks characterize their savings and time deposits as Wadiah. In these cases the bank may not contract to pay a return to the depositor. But many Islamic banks seek the permission of depositors to use their money. If the account is an amanah or safekeeping account, some scholars believe that the permission to use the money changes the account into a qard or loan account. This will be found in the deposit contract. Then, should the bank make a profi t it may elect to pay a return to the depositor as a hibah or gift.

The important point here is that the gift is non-contractual. The depositor has no claim on a profi t, even if the bank is very profi table. In contrast, should the bank lose money in its operations the Wadiah contract is essentially a contract of safekeeping, and the bank must return the customer’s money in the same amount as deposited.

Typically, Islamic banks have used a form of deposit called Mudarabah. This is a form of PSIA. In this method, the customer co-invests with the bank and the bank manages the customer’s money. The bank normally posts a profi t sharing ratio (PSR). The returns, if any, are based on how the invested funds perform. For example, a PSIA deposit investing in the leasing business may return an attractive yield at a moderate risk.

In contrast, a PSIA investing in the purchase and sale of commodities in a secured environment may yield a very low return with virtually no chance of loss. One may view these accounts as being similar to equity. Keep in mind that some banks and their regulators treat PSIA accounts as deposits, whereas others cause them to bear the risk of loss.

Figure 3: Illustration of Mudarabah PSIA relationship in an Islamic bank

LEASE

Step 1 Step 2

Co-investment

PSIAaccount holders

PSR Returns

1.Depositor co-invests money with an Islamic bank; the bank invests in sales, leasing or business operations with its customers.

2. If the bank is profi table, it shares with the depositor according to the PSR. With the PSIA, there is a correlation between the bank’s business and the return of the depositor’s capital as well as the return on the depositor’s capital.

Wakalah or agency accounts are a new PSIA trend among Islamic banks. These are like deposits in the sense that the customer will not invest in the bank, but will appoint the bank as its agent to apply the customer’s money to profi table transactions. These could be leasing or sales or other businesses of the bank. The bank may be paid a fee for its services.

In the agency deposit the money belongs to the customer and should be returned. But the money is at risk of loss if the bank loses money in the business to which the bank applied the money. Hence, we may consider this as a quasi deposit. Several key central banks including those of Malaysia, Kuwait and Bahrain have approved Wakalah deposits for inter-bank, consumer and business deposits.

Due to the inherent risks involved, PSIA accounts are often supported by special reserves at Islamic banks. These reserves are designed to protect depositors from ‘displaced commercial risk’. These reserves are often called the profi t equalization reserve (PER) and the investment risk reserve (IRR).