ISLAMIC BANKING AND FINANCE

Introduction

1. The goals of socio-economic justice and equitable distribution of income and

wealth are integral parts of the moral philosophy of Islam. However, one of the

socio-economic reforms made by Islam was the prohibition of riba (interestThe

modern banking system is organized on the basis of a fixed payment called interest.

That is why the practices of the modern banking system are in conflict with the

principles of Islam which strictly prohibit riba.

2. To abide by the rules of Islam, Islamic banking was developed. Islamic

banking refers to a system of banking or banking activity that is consistent with

Islamic law (Sharia) principles and guided by Islamic economics.

Aim

3. To highlight different aspects of Islamic banking and the progress in financial

sector.

Sequence

4. Following sequences will be followed

a. Part I

(1) Inception of Islamic banking

(2) Riba

b. Part II. Services offered in Islamic banking

c. Part III

(1) Principles of Islamic banking

(2) Islamic banking in Pakistan

(3) Islamic Banking in Global Finance Sector

(4) Recommendations

(5) Conclusion

PART l

Inception of Islamic banking

5. The first private interest-free bank, the Dubai Islamic Bank, was set up in

1973 by a group of Muslim businessmen from several countries. Two more private

banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the

Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House.

However, small scale limited scope interest-free banks have been tried before. The

governments of Pakistan took steps in 1981 to introduce interest-free banking. In

Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to

accept deposits on the basis of profit-and-loss sharing (PLS). New steps were

introduced on 1 January 1985 to formally transform the banking system over the next

six months to one based on no interest.

Riba

6. The word riba has been used in the Holy Qur’an on several occasions. So it

is necessary to know what it means or what it really stands for. Riba has been

extracted from Raba. It means addition, increase. So, riba literally means to

increase, to grow to rise, to add, to swell. It is, however, not every increase or

growth which has been prohibited by Islam. In the Sharia, “riba” technically

refers to the premium that must be paid by the borrower to the lender along

with the principal amount as a condition for the loan or for an extension in its

maturity

7. Prohibition of Riba (Interest) in Islam. Riba is prohibited in Islam as it

appears explicitly in the Holy Qur’an. There is complete unanimity among all Islamic

schools of thought regarding the prohibition of riba. Since the Qur’an is the

undisputed source of guidance in Islam for all Muslims, there is unanimous

agreement on the fact that Islam has forbidden the practice of riba.

8. Prohibition of Riba in the Holy Quran. In several verses of the Holy Qur’an,

Allah(swt) has mentioned the consequences of riba. The Qur’an did not declare the

prohibition of riba in the early stage of revelation, rather we find that the complete

prohibition of interest came sequentially. In the Qur’an Allah(swt) says:

a. “That which ye lay out for increase through the property of (other) people, will

have no increase withAllah: But that which ye lay out for charity, seeking the

countenance of Allah (will increase) it is these who will get a recompense

multiplied”. (30:39)

9. The wisdom behind the prohibition of interest. The strict prohibition of

interest in Islam is a result of its deep concern for the moral, social, and economic

welfare of mankind. Muslim scholars have sound arguments explaining the wisdom

of this prohibition, and recent studies have confirmed their opinions, with some

additions and extensions of their arguments.We confine ourselves to what Imam al-

Razi says in his tafsir of the Qur'an:

a. First. The taking of interest implies appropriating another person's property

without giving him anything in exchange, because one who lends one dirham for two

dirhams gets the extra dirham for nothing. Now, a man's property is for (the

purpose of) fulfilling his needs and it has great sanctity, according to the hadith, “A

man's property is as sacred as his blood.” (Reported by Abu Na'eem) This means

that taking it from him without giving him something in exchange is haram.

b. Second. Dependence on interest prevents people from working to earn

money, since the person with dirhams can earn an extra dirham through interest,

either in advance or at a later date, without working for it. The value of work will

consequently be reduced in his estimation, and he will not bother to take the trouble

of running a business or risking his money in trade or industry.

This will lead to depriving people of benefits, and the business of the world

cannot go on without industries, trade and commerce, building and construction,

all of which need capital at risk.

c. Third. Permitting the taking of interest discourages people from doing good to

one another, as is required by Islam.

d. Fourth. The lender is very likely to be wealthy and the borrower poor. If

interest is allowed, the rich will exploit the poor, and this is against the spirit ofmercy

and charity. (This is the social aspect of the prohibition of interest.)

PART ll

What an Islamic bank offers

10. Generally speaking, all interest-free banks agree on the basic principles.

However, individual banks differ in their application. These differences are due to

several reasons including the laws of the country, objectives of the different banks,

individual bank’s circumstances and experiences, the need to interact with other

interest-based banks, etc. In the following paragraphs, we will describe the salient

features common to all banks.

a. Deposit accounts. All the Islamic banks have three kinds of deposit

accounts current, savings and investment.

b. Current accounts. Current or demand deposit accounts are virtually the

same as in all conventional banks. Deposit is guaranteed.

c. Savings accounts. Savings accounts operate in different ways. In some

banks, the depositors allow the banks to use their money but they

obtain a guarantee of getting the full amount back from the bank.

d. Investment account. Investment deposits are accepted for a fixed or

unlimited period of time and the investors agree in advance to share the

profit (or loss) in a given proportion with the bank. Capital is not

guaranteed.

Principles of Islamic Banking

11. Islamic banking has the same purpose as conventional banking except that it

operates in accordance with the rules of Sharia, known as Fiqh al-Muamalat (Islamic

rules on transactions). The basic principle of Islamic banking is the sharing of profit

and loss and the prohibition of riba´ (interest). Amongst the common Islamic

concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping

(Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing .

12. In an Islamic mortgage transaction, instead of loaning the buyer money to

purchase the item, a bank might buy the item itself from the seller, and re-sell it to

the buyer at a profit, while allowing the buyer to pay the bank in installments.

However, the fact that it is profit cannot be made explicit and therefore there are no

additional penalties for late payment. In order to protect itself against default, the

bank asks for strict collateral. The goods or land is registered to the name of the

buyer from the start of the transaction. This arrangement is called Murabahah.

13. There are several other approaches used in business deals. Islamic banks

lend their money to companies by issuing floating rate interest loans. The floating

rate of interest is pegged to the company's individual rate of return.

14. Debt financing

a. Musharakah

(1) Hadees-e-Qudsi. Allah Subhan-o-Tallah has declared that He will become a

partner in a business between two Mushariks until they indulge in cheating or breach

of trust.

(2) Definition and classification of Musharakah. The literal meaning of

Musharakah is sharing. The root of the word "Musharakah" in Arabic is Shirkah,

which means being a partner. It is used in the same context as the term "shirk"

meaning partner to Allah. Under Islamic jurisprudence, Musharakah means a joint

enterprise formed for conducting some business in which all partners share the profit

according to a specific ratio while the loss is shared according to the ratio of the

contribution. It is an ideal alternative for the interest based financing with far reaching

effects on both production and distribution

(a) E.g. if it is agreed between them that 'A' will get 1% of his investment, the

contract is not valid.

(b) It is not allowed to fix a lump sum amount for anyone of the partners or

any rate of profit tied up with his investmet. If A be given Rs.10,000/- per

month as his share in the profit and the rest will go to 'B', the partnership is

invalid

(c) If both partners agree that each will get percentage of profit based on his

capital percentage, whether both work or not, it is allowed.

(d) It is also allowed that if an investor is working, his profit share (%) could be

more than his capital base (%) irrespective whether the other partner is

working or not.

(e) If a partner has put an express condition in the agreement that he will not

work for the Musharakah and will remain a sleeping partner throughout the

term of Musharakah, then his share of profit cannot be more than the ratio of

his investment. However, Hanbali school of thought considers fixing the

sleeping partners share more than his investment to be permissible.

(4) Basic rules of distribution of Loss. All scholars are unanimous on the

principle of loss sharing in Shariah based on the saying of Syedna Ali ibn

Talib that is as follows:

"Loss is distributed exactly according to the ratio of investment and the profit

is divided according to the agreement of the partners."Therefore the loss is

always subject to the ratio of investment eg. if 'A' has invested 40% of the

capital and 'B' 60%, they must suffer the loss in the same ratio, not more, not

less. Any condition contrary to this principle shall render the contract invalid.

b. Murabaha

(1) Definition. Murabahah is a particular kind of sale where the seller

expressly mentions the cost of the sold commodity he has incurred,

and sells it to another person by adding some profit thereon. Thus,

Murabahah is not a loan given on interest; it is a sale of a commodity

for cash/deferred price.

(2) The Bai' Murabahah involves purchase of a commodity by a bank on behalf

of a client and its resale to the latter on cost-plus-profit basis. Under this

arrangement the bank discloses its cost and profit margin to the client. In

other words rather than advancing money to a borrower, which is how the

system would work in a conventional banking agreement, the

bank will buy the goods from a third party and sell those goods on to the

customer for a pre- agreed price.

(3) Murabahah is a mode of financing as old as Musharakah. Today in Islamic

banks world- over 66% of all investment transactions

are through Murabahah.

(4) Difference between Murabahah and Sale. A simple sale in Arabic is called

Musawamah - a bargaining sale without disclosing or referring to what the

cost price is.However when the cost price is disclosed to the client it is called

Murabahah.

c. Mudarabah

(1) Definition. This is a kind of partnership where one partner gives money to

another for investing in a commercial enterprise. The investment comes

from the first partner who is called "Rab-ul-Maal" while the management

and work is an exclusive responsibility of the other, who is called "Mudarib"

and the profits generated are shared in a redetermined ratio.

(2) Types of Mudarabah. There are 2 types of

Mudarabah namely:

(a) Al Mudarabah Al Muqayyadah. Rab-

ul-Maal may specify a particular business or a particular place for the

mudarib, in which case he shall invest the money in that particular business

or place. This is called Al Mudarabah Al Muqayyadah (restricted Mudarabah).

(b) Al Mudarabah Al Mutlaqah. However if Rab-ul-maal gives full freedom

to Mudarib to undertake whatever business he deems fit, this is

called Al Mudarabah Al Mutlaqah.

d. Qardul Hassan – Benevolent loan

(1) In Islam, any loan given and the lender ask the borrower to pay more than

what has been loaned out is riba. However, qardal-hassan (benevolent loan)

is encouraged in Islam. It is the concept where the borrower himself who is

willingly to pay more than the original amount. The reward for sadaqah

is 10 times and for qardhul hassan is 18 times. If you give Allah qard al

hasan. He will double it to your credit and he will

grant you forgiveness (at-Taghabun : 17)

e. Ijara. 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 an integral 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 principal sum along with profit over the

period of lease.

f. Wadiah - Safe-keeping. Agreement between two parties where on agrees

to look after the property of another.Concept is used to take deposits of

money, where bank acts as custodian of money deposited by customer.Bank

agrees they will refund sums deposited “on call”, i.e. on demand.

g. Hibah - Gift.Hibah literally means a ‘gift’. This is used by banks to

compensate depositors for lost earnings on their deposits. It can also be used

by borrowers who have been granted Qardul Hassan loan mention above. No

agreement to provide Hibah can be made – it’s an arbitrary payment made at

the discretion of the person making it.

h. Bonds. Fixed-term, fixed-income, interest-bearing securities cannot be

issued under Shari law.

PART lll

Islamic banking in Pakistan

15. Pakistan initiated a process of the Islamisation of its financial system in 1979.

Though the financial system of the country had undergone significant changes since

then, the process of Islamisation is yet to take its full course. The measures adopted

for this purpose have been characterized by a number of shortcomings and

deficiencies. The Federal Shariah Court in November 1991 declared that a number

of existing financial laws and practices were repugnant to the injunctions of Islam

and called upon the government and other concerned agencies to take appropriate

measures to bring them in conformity with the Islamic tenets by the end of 1992.

16. Over a decade passed away by now that the first step towards Islamisation of

the financial system of Pakistan was put forward. The period 1979 to 1985 saw a

fairly active policy on the part of the government to Islamize the financial system.

The original intention of the government was to eliminate interest from all domestic

banking and financial transactions within a period of three years beginning from

February 10, 1979. It appears that the time frame was not practicable yet the

government was earnest to move speedily towards attaining the goal of an interest-

free economy.

17. It has been mentioned that a parallel system was introduced in which savers

had the option to keep their savings with interest-bearing mechanism or in profit-loss

sharing savings scheme. In June 1984, it was announced by the government that the

parallel system would end in course of 1984-85 in so far as operation of commercial

banks and other financial institutions were concerned. All banking companies were

actually forbidden to accept any interest-bearing deposits as from July 1, 1985,

except foreign currency deposits. Banks were also instructed to invest their PLS

deposits only in interest-free avenues of investment and financing. Serious

consideration was seemingly being given to the issue of eliminating interest from

government transactions in 1984-85 as the then finance minister stated in his budget

speech that the government proposed to consult scholars on the subject. However,

the matter was not pursued vigorously and the movement towards a completely

interest-free economy lost its dynamism and even its sense of direction after 1984-

85

18. The Islamic banking and financial industry is expanding at a fast pace in

Pakistan, but numerous challenges such as liquidity management, lack of bankers

with sound knowledge of Islamic finance and lack of awareness of Islamic banking

among stakeholders are hindering smooth growth of this sector in the country.

19. Like most parts of the world, Islamic banking is witnessing unprecedented

growth in Pakistan. The SBP is playing the leading role in the promotion and

development of Islamic banking in the country. The establishment of a fully- fledged

Islamic Banking Department at the SBP to focus on Islamic banking issues has

provided the industry the necessary impetus for the growth and popularity of this

sector.

20. central bank’s drive to promote Islamic banking as a parallel system, providing

a level playing field with conventional commercial banking is aimed at building a

broad-based financial system in the country to enable all sections of people to

access financial services and play their due role in the overall economic

development.

21. Today Pakistan has six fully-fledged licensed Islamic banks and 12

conventional banks have licences to operate dedicated Islamic banking branches.All

the big five banks in Pakistan are providing Islamic banking services. The total asset

of the Islamic banking industry are more than Rs160 billion, which account for a

market share of around 3.2 per cent. The market share of deposits, financing and

investment, stands at 2.9 per cent and 2.5 per cent, respectively. Islamic banks have

more than 200 branches in 32 cities and towns of the four provinces of the country.

22. Pakistan has several comparative advantages in Islamic banking. Since

Muslims constitute 97 per cent of the country’s 160 million population, this provides a

huge untapped domestic market base.The growing popularity of Islamic products

offered by Islamic banks and other commercial banks indicate the rise of this sector

in future both in Pakistan and other countries.

23. “The SBP is planning to achieve a 15 per cent share, in deposits and assets,

in Islamic baking by 2012, besides expanding and extending the outreach of Islamic

banking products to a maximum number of consumers and the corporate sector. It

also plans to introduce Islamic finance in micro finance, SME, agriculture and other

sectors .Islamic banking is gaining financial depth as 10 to 15 per cent customers

approaching Islamic banking institutions are said to be new to banking who stayed

away from the conventional banking system because of their belief.

24. Meezan Bank, being the largest Islamic Bank, stands today at a noteworthy

point along the evolution of Islamic Banking in Pakistan with the fastest growing

branch network of 74 online branches. Meezan Bank’s main shareholders are

leading local and international financial institutions, including ‘Pak-Kuwait Investment

Company’; the only AAA rated financial entity in the country, the ‘Islamic

Development Bank of Jeddah’, the renowned ‘Shamil Bank of Bahrain’ and the Noor

financials of Kuwait. The bank has a full-fledged Advisory Division headed by

Dr.Muhammad Imran Ashraf Usmani. This function’s areas of expertise include

Product Development & research, training & development, publications and advisory

services in the field of Islamic Finance.

Islamic Banking In Global Finance Sector

25. A significant trend in global finance over the last15 years has been the rapid

growth of Islamic banking and finance (hereafter IBF). There are now over 300

Islamic banks and financial institutions worldwide, with estimated assets of between

US$200 and $300 billion, and there may be a further $1.1 trillion in Islamic global

funds (Henry and Wilson 2004; Sandhu 2005; Ibrahim 006). Countries such as

Bahrain, Brunei, Iran, Malaysia, Pakistan, Saudi Arabia and Sudan have

‘Islamicized’ their banking systems to one degree or another, and ‘interest-based’

banks throughout Muslim-dominated countries order to expand their client base.

26. Once restricted to Muslim-dominated countries, almost 25 per cent of Islamic

financial institutions now operate in countries that do not have Muslim majorities and

interest-based banks have opened up ‘Islamic windows’ to attract the growing

number of Muslims living in Europe and North America are now considering

converting to Islamic banks in.

27. The Islamic banking and finance sector is increasing its valuable market share

day by day in the Global Finance Industry. Today, over 300 Islamic banks and

finance organizations are successfully running their businesses from Dubai, Las

Angles, London and world-wide. Total assets of all these are now reaching a mile-

stone of 400 billions dollars.

28. The Islamic banking system is very popular even in non-Islamic countries,

especially in Singapore where its market share is rapidly growing as compare to

other countries. Leading Islamic banks are expanding their network from their native

countries to their region and world-wide. In this regard, Islamic banks of Middle East

countries are very prominent in Africa, Central Asian region and in Australian

Financial market due to their unique and popular products and services for Muslims

and non-Muslims as well. In today Islamic world, there are more than 1200 Islamic

banks are working in Malaysian finance market alone. They are currently enjoying of

12.2% of total deposits assets of Malaysian banking sector and market expectations

are indicating that it will be increased by 20% in 2010. Indonesia and India are also

sharing in the Islamic banking sector.

29. Pakistan is one of the leading and pioneer country in the filed of Islamic

banking. With the total assets of 135 billions rupees, there are 170 branches of 6

Islamic and 13 traditional banks are providing Islamic banking products and services

to their customers in Pakistan. The numbers of Islamic bank’s borrowers are just 23

thousands as compare to 5 million of traditional banks. The numbers of their

branches are increasing day by day in urban and rural areas of Pakistan. There is a

huge potential is available for the growth of Islamic banking in the vast rural areas of

Pakistan.

Recommendations

30. Islamic banking is a new concept and it will take time to flourish. It has the

great potential to compete the conventional banking. For that following

recommendations are given:

a. Islamic banks must develop the concept of Musharakah (participating in profit

& loss) and Mudaraba, and use it more aggressively

b. Adopt new financing policies to encourage development and support for the

small scale traders

c. Develop the Islamic liquidity management and Islamic money market

d. Must improve its services to be competitive with the best in the market

Conclusions

31. Islamic banking is a very young concept. Yet it has already been implemented

as the only system in two Muslim countries; there are Islamic banks in many Muslim

countries, and a few in non-Muslim countries as well. Despite the successful

acceptance there are problems. These problems are mainly in the area of financing.

With only minor changes in their practices, Islamic banks can get rid of all their

cumbersome, burdensome and sometimes doubtful forms of financing and offer a

clean and efficient interest-free banking. All the necessary ingredients are already

there. The modified system will make use of only two forms of financing -- loans with

a service charge and Mudaraba participatory financing -- both of which are fully

accepted by all Muslim writers on the subject. Such a system will offer an effective

banking system where Islamic banking is obligatory and a powerful alternative to

conventional banking where both co-exist. Additionally, such a system will have no

problem in obtaining authorisation to operate in non-Muslim countries.