Naeem (desertation)

8/6/2019 Naeem (desertation)

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DISSERTATION REPORT

ON

Role of Islamic Banking in India

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR

THE MASTERS DEGREE IN BUSINESS ADMINISTRATION

BATCH (2009-2011)

UTTARAKHAND TECHNICAL UNIVERSITY, DEHRADUN

SUBMITTED TO: SUBMITTED BY:

Mr. Ankit Nanda Mohammad Naeem

(Lecturer, BCMT) MBA (4th Semester)

BEEHIVE COLLEGE OF MANAGEMENT & TECHNOLOGY

(DEHRADUN)


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PREFACE

A dissertation report is an integralpart of any M.B.A. programme. Itprovides the studentwith opportunity to experience of research in which the company works in a war zone ofrapidly changing competitions. Managed tradepolicies and diminishing customerlocality.

This dissertation reportis submitted forthepartialfulfillment ofMBA (Master ofBusi essAdmi istration) degree from Uttarakhand Technical University,Dehradun.

A unique feature ofIslamicbanking, in theory, is itsprofit-and-loss sharing (PLS)paradigm.

Inpractice, however, we find thatIslamicbankingis notvery differentfrom conventional

banking. Our study on Malaysia shows that only a negligibleportion ofIslamicbank

financingis strictly PLSbased and thatIslamic deposits are notinterest-free,but are closely

pegged to conventional deposits. Ourfindings suggestthatthe rapid growth in Islamic

bankingis largely drivenbythe Islamic resurgence worldwide ratherthanbythe advantagesofthe PLSparadigm and thatIslamicbanks shouldbe subjectto regulations similarto those

oftheirwestern counterparts.


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DECLERATION

I, Mohammad Naeem, student of Beehive College of Managemenet & Technology,Dehradun, MBA 4th semester, hereby declare that dissertation report entitled Role ofIslamic Banking in Indian Economy is the outcome of my own strong effort. This

dissertation so far has neitherbeen published nor submitted to any university/ college/institute for award of any degree/diploma course. The information presented in this

dissertation reportis correctto thebest ofmy knowledge.

MOHAMMAD NAEEM


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INTRODUCTION

Religions, more often than not, and to varying degrees, interfere with the economicbehaviorof men and women. The word Religion itself, and its Arabic counterpart Dn and theessence of the message of all religions imply and indicate setting norms and standards forhuman behavior which, by definition, extend to the economic arena. Hence, it is not asurprise that religion relates to economics. Separation and divorce between them would berather unusual.

The objective ofthis chapteris to give an overview ofthe developmental nature and

characteristics ofIslamicbanking as a concept and howitis implementedbythis relatively

newgeneration offinancialinstitutions called Islamicbanks. This is essentially attributed to

the nature ofIslamic financingitselfwhich is intrinsicallyinter-linked with transactions in

thephysicalgoods market and socially and morally committed.

Therefore, to understand the developmental role ofIslamicbankingwe shallfirstlook atthe

foundations ofIslamic financing. We will discuss whatis meantbythis term ofIslamic

finance? What are its guidingprinciples and howfinancialintermediation is approached

through Islamicbanks? Then we willtake a quicklook atthe operations ofIslamicbanks in

both fund mobilization and fund utilization. This will clearthe wayto the next section that

will argue thatIslamicbanking has three majorintrinsic characteristics that are

developmentalin their nature.

These three characteristics are: a direct and un-detachable linkto the real economy or

physicaltransactions, integration ofethical and moralvalues in financing so thatfinancingisdirected to usefulproducts only and the reconstruction ofrelationshipwith depositors on the

basis ofsharinginstead oflending. The last section will discuss howwould the Islamic model

ofbanking serve as an alternativebanking system?

In the Old Testament (King James Version), Exodus, Chapter 22, verse 25:

Ifyou lend moneyto any of my people that is poor bythee, thou shalt not be to him as

an usurer, neither shaltthoulayupon him usury.

Leciticus, Chapter 25, verses 34-36:

And if thybrotherbe waxen poor, and fallen in decayby thee; then thou shalt relieve him:yea though hebe a stranger, or a sojourner, that he maylive with thee.

Take thou no usury ofhim, orincrease:butfearthy God; thatthybrother maylive with thee.


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Why Islamic Banking

The New Testament also contains edicts on the same line. Thus the very mention ofusury

and the suggestion to avoid indulging in this act in Judaism and Christianity implies its

existence in ancienttimes and the ills thatit carried alongforthe society.

Despite the warning against this practice, the system prospered. Modern financial system

learnt a lesson from these religious warnings and tried to adopt a system that limited the

extent ofusurious exploitation to a great extent. By creating a market for debt, based upon

perfect competition, itpropounded an end to exploitative nature ofusury and thus evolved

the system ofinterest rates which was supposed tobe determinedbythe marketforces freely

competingwith each other. Whatwe see today is an expansion ofthe ancientfeudal system

into a global arena with nations facingthe sameplight as did individuals earlier.

From the traditional Jewish lending system ofthe Shylocks to the Indian feudal system, there

is no need to strain our memories much. Whatis definitely cause for stress is the false claim

ofthe contemporaryworld order to have relieved the masses ofthis burden ofdebt. Figures

2a and 2b show how countries, instead ofindividuals, are gettingtrapped into slavery. There

is no doubtthat Debtto GDP ratio is a robustindicator ofthe Debtburden ofcountries. Ifwe

compare the ratios thattriggered the 1980s Debt crisis with the levelsbeing experienced,

Now, we can see that the situation is nobetter, and couldbe enough cause forthe unipolar

world of the day. Despite the claim that modern interest-based system is not exploitative or

usurious, because the interest rates or debt-service payments are within limits,provide a

differentpicture altogether.


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The transition ofthe world from a multipolarworld orderto a unipolar one has notbeen

withoutpain and suffering. Itis not easyto emphaticallypronounce thatthe cause forthis has

been the interest-based system,but nobody should doubtthatthe cause hasbeen the financial

system as a whole. Interest-based system is one component ofthe economic system where the

concept ofmoneyitself, as a worthlesspiece ofpaper carryingimmensepower, maybe ill-

conceived.

Interest rates and exportprices in Latin America (1972-1986)

Source: Andres Bianchi et al., Adjustment in Latin America, 1981-86, in V. Corbo, M.

Goldstein, and M. Khan, ed., Growth Oriented Adjustment Programs, Washington, D.C.:

International Monetary Fund and The World Bank, 1987.

Similarly, the argumentthatlowinterest rates cannot cause countries to lose their sovereigntyalso does not hold much ground. The diagnosis ofthe DebtCrisis ofearly 80s suggests that

even low interest rates (Figure-3a), acting as a trap (particularlywhen they are floating rate,

as majority of debt was) could cause countries to come down to their knees. Flushed with

funds, due to the sharp oilprice increase in 1973-74 leadingtobooming depositsbyOil-rich

countries, international commercialbanks were eagerto lend at lower interest rates enticing

the third world to borrow more and more. The debtburden measuredby Debt-to-GDP ratio

(Fig-2b) is an indication ofthe inevitable crisis thatwas waitingto happen.

The urge to have a system that claims to provide a solution to such financial crises grows

after everyfinancial (monetary, exchange rate, stock market or Debt) crisis. Itis not hard to

understand thatifthe value ofmoney carried its realworth, currency crises couldbe avoided.

Ifthepaperbeingtraded in stock exchanges were actuallytrading attheirgenuine value, with

no speculation, bubbles that occasionallyburst would not exist. If the interest-free banking

system could see the light ofthe day, no debt-crises would occur, as allthe financingwould

be PLS (Profit-and-Loss Sharing arrangement of Islamic financial system). Islamic banking

and financebased on the Islamic economic system mustbe taken seriously, therefore.


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This paper looks into the realities associated with this system which is growing at a much

fasterpace than its counterpart, and is makingits conventional competitors stand up and have

a look. The success ofthe Islamic system canbe gaugedbythe rush amongthe conventional

banks to open their own Islamic windows notjust in countries dominatedbyMuslimsbut

also in rest of the world. Some of the Western banks already having dedicated Islamic

subsidiaries are: Citibank, HSBC, American Express, AB N Amro, B NP Paribas, Bank ofAmerica, Stantad Chartered, Commerzbank, Barclays, Deutche Bank, ANZ Grindlays,

Golman Schs, Royal Bank of Canada, Pictet & Cie, UBS, Flemings, Merrill Lynch and

Kleinwort Benson. And the list is growing. With countries like Pakistan, Sudan and Iran

adopting 100% Islamic Banking, the prospects of more countries to follow suit rising, the

conventional counterparts cannot sitback and see their market sharebeing eaten away.


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Islamic Banking

Itis difficultto obtain exactfigures on the size ofthe Islamic financial sector. Without doubt,

it is small in comparison to the conventional financial sectorbut it is experiencing strong

growth. Iqbal and Mirakhor (1999) report thatIslamic banks grewfrom an assetbase of$5

billion in 1985 to a level of over $100 billion in the late nineties. The chairman of Dubai

Islamic Bank and EmiratiMinisterfor Financial Affairs, Mohammad Khalfanbin Kharbash,

recently noted that the number of Islamic banks has grown from 34 institutions in 1983 to

250 today, operating and managing assets of$200billion (Phillips, 2001). The annualgrowth

rate for Islamic financial institutions varies from 15 to 40 percent annually (Hamwi and

Aylward, 1999). Yet, a comparison ofthe assets ofallIslamicbanks to HSBC,just one ofthe

world's largestbanks with assets of$569 billion in 1999 (Azzam, 2000), demonstrates how

smallthe Islamic sector remains on the worldbanking stage.

Nevertheless, Islamic banking is spreading and gaining acceptance inboth Muslim and non-Muslim countries. In 1999, the Middle East alone had 12 top-tiered Islamicbanks with total

capital of about $1.8 billion and assets of approximately $18 billion. Bosnia Bank

Internationalbecame operationalin March 2001,positioned as a regionalIslamicbankforthe

Balkan area, with wholesale and retail services in Bosnia (Carvalho, 2001). Many of the

Islamicbanks are gaining strength and achievingprofits. For example, Al RajhiBanking and

InvestmentCorporationposted a netprofit in 1997 of$347 million and return on capital of

25% (Hamwi and Aylward, 1999). Bank Al-Jazira, by far the smallestbank in the Saudi

Islamicbanking sector, grewprofitsbyforty-onepercentin 2000 (MEED, 2001).


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Whyis Islamic Banking creating ripples?

Looking atthe growth rates ofIBF in comparison to the conventionalbanking, the reason

maybe obvious

.

Proportion ofIslamic Bonds in Malysia v/s Non-Islamic Bonds

Malaysiabeing apioneerin expansion ofIFBproducts, our calculations forthe CAGRforits

leadingbank BIMB (Bank Islamic Malaysia Berhard) between 1998 and 2002 yield the

following results: Deposits grew at32.4%, Investments at39.3% and Total assets at 28.3%. It

willbe an impossible taskfor any conventionalbankto match these figures duringtheperiod.

Forthe sake ofdiversityin outlook, we compared the figures fortwobanks in UAE underthe

same ownership- NationalBank ofAbu Dhabi, a ConventionalBank and Abu DhabiIslamic

Bank, an Islamicbank. The results are even more astounding, as depicted in Figure-5.

None of the Islamic banks yielded any negative growth rates during theperiod under study

while thirteen conventionalbanks in terms ofLoans, seven in terms ofAssets and eight in

terms of Deposits reported negative CAGR. The data for all these banks are provided inAppendices.

-40% -20% 0% 20% 40% 60% 80% 100% 120% 140%

1996

1997

1998

1999

2000

2001

2002

Islamic

on-Islamic


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Comparison ofCAGRfor 53 conventional and 8 Islamicbanks in GCC

Average CAGR (1999-2001)Financing (Loans) Deposits Assets

LocalConventionalBanks 7.3% 7.6% 9.5%

LocalIslamic Banks 19.2% 21.4% 18.6%

Western banks and financial institutions, like Chase Manhattan, J.P. Morgan, Goldman

Sachs, Commerzbank AG, Deutsche Bank AG, HSBC, Citicorp and Bankers Trust, have

joined the race forproviding Islamic products, but they currently exist in trade and other

forms ofshort-term finance, mostly. Independentfinancial institutionsbased on Shari'ah are

also becoming common forthe Western banks and financial institutions. Citicorps Islamic

banking unit in Bahrain established in 1996 is an example. Standard Chartered Bank

Malaysia Bhd. is planning to extend its Islamic banking services to become a total money

management and financial provider within two to three years (The Star, May 17, 2001).

From less than 10 Islamic mutualfunds a decade ago to over 90, now, accordingto a report

by Wall (2001), is no mean achievement. High-tech fever has not caused Islamic financial

Web sites to crop up and grow alongwith Islamic Finance.

0

1,000

2,000

3,000

4,000

5,000

6,000

200120001999

B

oans

0

500

1,000

1,500

2,000

IB

oans

ationa l Bank of

bu

habi

bu

habiIslamic Bank

6,500

,000

,500

,000

,500

9,000

200120001999

B

eposits

0

500

1,000

1,500

IB

eposits

ation al Bank of

bu

habi

bu

habiIs lamic Bank

,500

,000

,500

9,000

9,500

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B

ssets

0

500

1,000

1,500

2,000

IB

ssets

ational Bank of

bu

habi

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habiIs lamic Bank

Fig-5: Comparison between Conventional and Islamic Banks in UAE (National Bank of Abu Dhabi v/s AbuDhabi Islamic Bank); Source: Annual Reports of respective banks

CAGR(1999-01)

Financing

(Loans)

Deposits Assets

NBAD 10.21% 0.2% 1.2%

ADIB 50.12% 69.1% 51.45%

NBD 2.3% 17.1% 14.5%


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Literature Review:

The information on Islamic Banking & Finance is available in many forms, e.g., PhD

dissertations (El-Bdour, 1984; Khan, 1983), books written by leading academics and

practitioners (e.g. Homoud, 1985; Shirazi, 1990), published research in the form of reports

(Ahmad, 1987; Iqbal and Mirakor, 1987) andjournal articles (e.g. Erol and El-Bdour, 1989;

Erol et al., 1990; Shook and Hassan, 1988; and Sudin et al., 1994). Because ofRiba, Islamic

banks have had to developfinancialproducts which are notin conflictwith the Sharia'h. The

task hasbeen achievedby creating a number ofspecialfinancialproducts (Ali and Ali, 1994).

The main thrust of Islamic financial contracts is on profit and loss sharing, which can be

deemed as equity (Musharakah) and hybrid (modified Mudharabah and Ijara) facilities

(Ahmad, 1994). However, the risks ofthese vehicles are inherently higherthan conventional

ones as espousedby Ebrahim (1999). One definition ofan Islamic Bankis a bankthat,byits

own choice, opts to complywith two sets oflaw: the law ofthe Land (Jurisdiction); and the

Islamic Law (Shari'ah). This is why Islamic bankers have two types of legal counsel:

traditional "lawyers" and "Shari'ahCouncils" (Al-Bahar, 1996).

Similar results can be seen when comparing Dubai

Islamic Bank (Islamic) with National Bank of Dubai

(conventional) two banks under Dubai Government

(Figure-6). Exceptionally larger growth for the AbuDhabi Islamic Bank may be due to its short history

the bank might be growing at this unprecedented

rate because it has recently come to fulfill the

unsatiated need of the people of Abu Dhabi (or UAE).

But, the growth rate of Dubai Islamic Bank, the oldest

Islamic bank of the modern world, provides enough

empirical evidence in favour of much larger growth

rates for the IFBs.

Another study of fifty-three conventional banks and

eight pure Islamic IBFs in GCC, covering almost theentire population of local banks in the region yielded

results on similar lines, as listed in Table-1.

Fig-6: Comparison between Conventional (National Bank of

Dubai) and Islamic (Dubai Islamic Bank) Banks in UAE

1,800

1,850

1,900

1,950

2,000

200120001999NBA

D

Loans

0

1,000

2,000

3,000

4,000

ADIBLoans

0

2,000

4,000

6,000

8,000

200120001999

NBADDeposits

0

1,000

2,000

3,000

4,000

ADIBDeposits

0

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200120001999

NBADAssets

0

1,000

2,000

3,0004,000

5,000

ADIBAssets

Nationa lBank of Dubai DubaiIslamic Bank


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"Islam is deeply concerned with theproblem ofeconomic development,buttreats this as an

importantpart ofa widerproblem, that oftotal human development. Theprimaryfunction of

Islam is to guide human development on correctlines and in the right direction. It deals with

all aspects of economic development but always in the framework of total human

development and never in a form divorced from this perspective" (Al-Harran, 1993). The

Shari'ah specifies, inter alia, rules that relate to the allocation ofresources, property rights,production and consumption, and the distribution ofincome and wealth (Iqbal and Mirakhor,

1987).

Islamicbanking advances the following set ofbeliefs: interest as a reward for saving does not

have anybasis as a moralfoundation; abstinence from spending ofpresent income does not

deserve a financial reward; and to benefit from money is to transform the money into

investments, conditioned to accept risks and bringing the knowledge of other factors of

production together (Presley, 1988).

Rayner (1991) lays down four elements ofa contract on aproperty (mal): they are lawfulness,

existence, deliverability and precise determination. Ebrahim (1999) explains thatprofits onMurabahah facilities are generally higher than conventional loans because Islamicinstruments are structured to share the risk of the asset orventure. Hence, the "profits" and"interest-charge" implied are similarin outcome, although notby design (Iqbal and Mirakhor,1999; Rosly, 1999). Thomas (1995) is ofthe viewthatRiba, GhararandMaysirmanifested

in the conventional system can wreak havoc in an economy as advanced as the USA, asdepicted by the massive failures of US savings and loans institutions of the 1980s. Islamic

banking aims to promote economic growth through risk-sharing instruments whose payoffsfluctuate with economic output and do not structurally impairthe economy in the manner of

excessive fixed-interest debt does in a poor economic environment such as a recession(Asquith et al., 1994; Andrade and Kaplan, 1998).

The potential of Islamic fixed income securities backed by anIjara facility is discussed by

Kahf(1997).


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Islamic Derivatives:

These comprise both Islamic Futures and Embedded Options in a contract. However, the

development ofitis largely unrealized (Khan, 1995). Ebrahim (2001) recommends to design,develop and implementIslamic hedging and risk minimizingfacilities such as Islamic futures( Bai Al-Salam/Istisna), Islamic swaps, etc. (Iqbal, 1999). (Ebrahim, 2000) furtherrecommends to design, develop and implementIslamic facilities that enhance the competitiveability ofIslamicbanks and reduce their risk exposure.

The excessive use ofcreditfacilitiesbyIslamicbanks globally has drawn the ire ofscholars

such as Ahmad (1989) and El-Naggar (1994). Conventional futures are very controversialwith the Ulema - religious scholars (Kamali, 1999). It should be noted that certain Ulema

such as Justice Taqi Usamani have given their verdict allowing contracts with embeddedoptions (Kahn, 1999).

Part ofthe study ofErol and El-Bdour (1989), conducted in Jordan, aimed at establishingthe

attitude oflocalpeople towards Islamicbanking. The results suggestthat religious motivationdid not appeartoplay aprimary role inbank selection; the opening ofnewbranches was not

an important factor in increasing the utilization of financial services provided by Islamic

banks; while 39.4per cent ofrespondents would withdraw their deposits ifan Islamic bank

did notgenerate sufficientprofitto make a distribution in any one year, 30.4per centwould

retain their depositsbecause the Islamicbank could distribute a higher dividend the following

year.

Gerrard & Cunninghams (1997) studyestablishes that, in Singapore, which has a minority of

Muslims in its population, both Muslims and non-Muslims are generally unaware of the

culture ofIslamicbanking. Also the two separate groups have different attitudes towards the

Islamic banking movement, with the degree of difference depending on the nature of the

respective matterput to them. For example, when asked what they would do ifan Islamic

bank did not make sufficientprofits to make a distribution in any one year, 62.1per cent of

Muslims said they would keep their deposits within the Islamic banking movement, while

66.5per cent ofnon-Muslims said theywould withdrawtheir deposits.

Much hasbeen written since the early 1960s on the theme ofthebank selectionprocess (see,for example, the published articles ofAnderson et al. (1976); Holstius and Kaynak (1995);Kaynak (1986); Kaynak et al. (1991); Laroche et al. (1986), and the workingpaper ofChan(1989)). Erol & El-Bdour (1989) and Erol et al. (1990) compared thebank selectionprocessin relation to "conventional" and Islamicbanks. Sudin et al. (1994) compared responses about

thebank selection criteria ofboth Muslims and non-Muslims.

In addition to establishing attitudes towards Islamic banking, Erol and his co-researchers

(1989 and 1990) soughtto establish, then compare, thebank selection criteria ofcustomers of

conventional and Islamicbanks in Jordan. Sudin et al. (1994), among otherthings, soughtto

establish the relative importance ofcertainbank selection criteria using a sample ofMuslims

and non-Muslims, none of whom had to be patronizing an Islamic bank at the time of the

study. The three mostimportant criteria in thebank selectionprocess forMuslims were: first,


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"the provision ofa fast and efficient service"; second, "the speed of transaction"; and third,

"friendliness ofbankpersonnel". As regards the non-Muslims, the three mostimportantbank

selection criteria were: first, "friendliness ofbankpersonnel"; second, "theprovision ofa fast

and efficient service"; and third, "the reputation and image ofthebank".


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ISLAMIC BANKS:

An Islamicbankis an intermediary and trustee ofotherpeoples moneylike any conventional

bankwith thepossible difference that thepayoff to all its depositors is a share inprofit and

loss in one form or the other. This difference introduces an element ofmutuality in Islamic

banking, making its depositors as customers with some ownership rights inherent within it.

However, inpractice, Islamicbanks hardlylook differentfrom its conventional counterpartin

terms oforganisational set-up (Dar and Presley, 2000).

Islamic banking has been defined in a number of ways. General Secretariat of the OICs

definition goes like this: An Islamic bank is a financial institution whose status, rules and

procedures expressly state its commitment to the principle of Islamic Shariah and to the

banning ofthe receipt andpayment ofinterest on any ofits operations (Ali & Sarkar-1995)

Unlike conventionalbanks, however, Islamicbanks offer PLS accounts, among others, which

do notguarantee a fixed certain return on investment deposits. This leads to a reluctance of

deposit holders, who have no representation in the organisation, to use PLS accounts. The

bankfaces a similarproblem on the assets side when it comes to investing on PLS.

The essentialfeature ofIslamicbankingis thatitis interest-free. Although itis often claimed

that there is more to Islamic banking, such as contributions towards a more equitable

distribution ofincome and wealth, and increased equityparticipation in the economy (Chapra

l982), it nevertheless derives its specific rationale from the factthatthere is noplace forthe

institution ofinterestin the Islamic order.

Itis simply an accepted factthatthere are sufficientMuslim investors andborrowers inboth

Islamic and non-Islamic countries to warrant the attention of traditionalbanks who seek to

serve such clients and capture a potentiallyprofitable slice of a still relatively untapped

market. Just as interesting and usefulfor non-Islamicbankers are the lessons learned from the

innovation and creativity applied in meetingIslamic criteria.

Someproducts are more Islamic and than others. Thebasicprinciple is thatinterest- usury or

Riba used interchangeably- is prohibited on theprinciple ofnopain no gain. What a "pure"

Islamicbanking seems tobe structurallyvery similarto venture capitalfinance, non-recourse

projectfinance or ordinary equityinvestment. The investortakes a share in theprofits, ifany,of the venture and is liable to lose his capital. It involves investingbut not lending and

therefore on a systemicbasis is similarto the German, Japanese and Spanishbanking systems

ratherthan the British or American systems.

Just as in theprocess ofconvertinginterestinto capitalgains fortax purposes, earlyIslamicinvestors were content to enter into zero-coupon bonds or discounted Treasurybills andreceive the interestforegone in the form ofcapitalgains.


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Beyond the question of interest or Riba lies an ethical issue. Islamic investments exclude

tobacco, alcohol, gaming and other "undesirable" sectors. Islamic investors,by and large, are

motivated in their choice of investments by much the same criteria as their Western ethical

counterparts. The search for acceptable investments is balanced by natural risk-aversion.

Islamic borrowers, on the other hand, also demonstrate a reluctance to give away a share in

theprofits oftheir enterprise. Itis nottherefore surprisingthat most ofIslamicbankingtakesthe form ofone type ofmark-up or other ratherthanprofit-sharing.

An analysis oftheproducts suggests thatIslamicbanking has six keyfeatures:

y free ofinterest,y trade-related and there is aperceived "genuine" need forthe funds,y In itspurestform, itis equity related,y meantto avoid exploitation no usury,y invests ethically,y there are retail and wholesale applications.

Under the current interpretation of the rules governingIslamic banking, Usury and Riba areregarded as synonymous. The prohibition is on interest and notjust on usurious interest. In

practice, there appears to be more emphasis on the prohibition and restructuring of interestthan on thepotentially exploitative aspect offinancing.


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Brief History:

Itis worth notingthatthere is nothing new orparticularlyIslamic orChristian about Usury

or interest controls. In 24th century B. C. Manu established a rate ceiling of24% in India.Later, Hammurabi, King ofBabylon, authored laws around 19th B. C. established a cap onlending rates. On loans ofgrain, which were repayable in kind, the maximum rate ofinterestwas limited to 33 1/3% per annum. On loans of silver, the maximum legal rate was 20%although it appears thatin some cases rates of25per centper annum were charged. The lawremained for most of the next 12 centuries but as with any law "regulatory arbitrage" took

place and was subsequently eliminated. Unfairpractices also existed. For example, creditorswere forbidden from calling a loan made to a farmerpriorto harvest. Ifthe cropfailed due toweather conditions, all interest on the loan would be cancelled forthat year. In the case ofhouses, due to the scarcity ofwood, a door couldbe used as collateral and was considered to

be separate from a house. The 6th century Greeks, through the laws of Solon, lifted allmaximum limitations on the legal rate ofinterest a moneylender might charge. The temple at

Delphi was the "City" or "Wall Street" of the Greek Empire lending money for interestregularly. Credit regulation was once again part of the legal code at the start of the RomanEmpire. The legallimitation on interestwas established at 8 1/3%perin the 5th centuryB.C.Julius Caesars attempts to control interest rates could well havebeen the real reason for hisassassination since many the Roman senators were the main moneylenders. (This section isdrawn from Edwardes-2000. The reader is also referred to Armstrong-1987, for more

details).

Back to the present day, quite a few Western countries have Usury laws thatprohibitexcessive interest rates. The UKs usury laws which prevented "excessive" interest wereabolished in 1854. South Africa and the US still have usurylaws. Usury results when a lendercharges more than the legal amount of interestpermitted in that geographical area. Usury

percentage limits varyby state, in USA, and at least one state, Virginia, has no usury limit.Today most ofthe states have had their abilityto limit interest rates curtailedby over-ridingUS Federal law. Higher than permissible rates have been regarded by US Federalbankingauthorities as penalty fees and insurance premiums. And the federal rate limits are high.(RefertoEdwardes-2000).

In some states there is no restriction on the rates used forlendingto incorporated entities. The

controls are often on lending to persons. The usury rate usually is variable depending on

market rates. In September 1998 in North Dakota it was 10.556%. California has recently

imposed strict consumer lending limits. But these only apply to state banks and not to

nationalbanks. The California Constitution allows parties to contract for interest on a loan

primarilyforpersonal, family or householdpurposes at a rate not exceeding 10%per annum

(compound annualpercentage rate). The allowable rate in California is 5% overthe amount

chargedbythe Federal Reserve Bank ofSan Francisco on advances to memberbanks on the

25th day ofthe monthbefore the loan. The usurylaws do not applyto any real estatebroker

ifthe loan is securedby real estate. This applies whether or not he or she is acting as a real

estate broker. The limitations also do not apply to most lending institutions such as banks,

credit unions, finance companies,pawnbrokers, etc. State laws place limitations on some of


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these loans, but at a higherpercentage rate than the usury laws listed above. (Refer to

Edwardes-2000).

In the Old Testament (King James Version), Exodus, Chapter 22, verse 25:

Ifyou lend money to any of my people that is poor by thee, thou shalt not be to him as an

usurer, neither shalt thou lay upon him usury.

Leciticus, Chapter 25, verses 34-36:

And ifthy brother be waxen poor, andfallen in decay by thee; then thou shalt relieve him:

yea though he be a stranger, or a sojourner, that he may live with thee.

Take thou no usury of him, or increase: butfear thy God; that thy brother may live with

thee.

THE New Testament also contains edicts on the same line. Thus we can see that Judaism and

Christianity are no differentin terms ofprohibition ofusury.

Chronology ofrecent historical events in the industry:

1963: Egyptinterestfree savingsbanks, not overtlyIslamic -invested in trade and industryon thebasis ofshare inprofits.

1971: Egypt Nasr Socialbank, still no overt reference to Islam.

1973: Conference ofIslamic finance ministers.

1975: Islamic DevelopmentBank, Jeddah, feebased and PLS, revolving capital.

1975: DubaiIslamic Bank, UAE, firstIslamic CommercialBankin the world.

1970s: FaisalIslamic Bank ofSudan / Egypt; Bahrain Islamic Bank; Malaysia, Philippines,

Nigeria, Indonesia; Islamic Finance House, Luxembourg; DMI Geneva; Al Rajhi London,

Denmark, Australia, South Africa; HSBC Amanah Fund; ANZ First ANZ International

Murabah Ltd., IBU ofUnited Bank ofKuwait.

Timepayment contracts such as retailinstallment contracts are notgenerallytreated as loans

and the usurylaws normally do not applyto them. There are no limits on finance charges for

thepurchase ofpersonal, family and household goods or services atthis time. The maximum

interest rate for car loans is almost 22%. Banks also treat interest charges for third party

credit cards such as Visa, MasterCard and American Express as notbeing subject to Usury

lawlimitations. (RefertoEdwardes-2000).

In transactions for the purchase ofgoods or services which are not forpersonal, family or

household purposes, there are normally no limits to finance charges except those setby the

parties. Limited liability companies and limited liabilitypartnerships can no longer assert

usury as a defence in civil recovery actions. The usury interest limit that applies to limited

liability companies and limitedpartnerships hasbeen raised from 30%per annum to 50%per

annum to equate to the levelthat applies to corporations. (RefertoEdwardes-2000).


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But there is a problem with usury laws as can be seen in South Africa. If there is a

particularly risky investment and an interest rate limit, thenbanks will simply not lend. The

poorestwill find themselves deprived of financing, and under a free market there willbe a

shift to quality or to those that do not really need financing. Unless there is government

imposed mandatory ortax driven lendingto certain sectors orpublic opinionpressure, certain

sectors or individuals deemed riskyby the banks will simply not get the funding required.(RefertoEdwardes-2000).


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The Concepts behind Islamic Banking:

Distinguishing Features:

The economic doctrine of Islam is based on encouraging free markets, discouragingpricecontrols and forbiddingfinancial contractsbased on riba, gharar and maysir.

Riba (Charging ofInterest):

Taking orpaying ofinterest (riba) isprohibitedby Shariah (Islamic law). The concept ofriba

extendsbeyond interest and usury, and volumes havebeen writtenby scholars to explain the

concept. In simple terms, riba can be considered as exploitation of one party who owns a

product (that includes money and capital) and which anotherparty wishes to acquire.

Although interest comes very close to this concept, itis stillbetterto consider riba as unfair

exploitation.

Ebrahim (1998) explains that Riba is expounded by Ibn Qayyim & Al-Jawziyya (n.d.),

anotherprominentIslamic scholar, to imply (i) anyform ofunfairtrade, market manipulation

or engaging a marketparticipant to trade under duress (riba-al-fadl) and (ii) risk-free debt

contracts (riba-al-nasi'ah). From a financial economist's perspective, riba-al-nasi'ah can be

defined as a risk-free return from an investmentvehicle or strategy. (see also Chapra-1986,

Rahman-1969, Saeed-1995, Thomas-1995).

Gharar(Uncertainty):

The existence ofuncertainty in a contractisprohibitedbecause it requires the occurrence of

an event which may not ultimately occur. Full disclosurebyboth parties is the norm incontractual relationships. Any type of transaction where the (i) subject matter, (ii) theprice,

orboth are not determined and fixed in advance amounts to uncertainty. Thus hedging and

dealingin derivatives is not allowed.

Maisir or Speculation:

Speculation is equivalent to gambling, and therefore is prohibited. Derivative transactions

like Options, Futures, Swaps and forward contracts (that insure profit) are considered un-

Islamic. They are also considered un-Islamic because for most ofthem, rates are determined

byinterest differentials.

Zakah:

A taxation system inherentin the Islamic systembased on theprinciples ofsocialjustice and

equity.


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Implying social justice and general welfare:

Thebasicprinciple is that everybody shouldbe able to fulfill atleastthebasic needs.

Conforming to Shariah:

The Quran and Hadith clearly specify the guidelines for individual, social, organizational,

governmentalbehaviour, and thus become the basic pillar for any Islamic system, with the

banking and financial systembeing no exception.

Qard-e-hasna (benevolentloan), or Qard Hassan:

Qard-e-Hasna means an interest free loan and is the only type of loan permitted by the

Shariah. The loans are made from the pooled donations of the members and are generally

granted to those who are facing emergencypersonal crisis. This form of finance is very

importantpart ofIslamic financial system and all members are encouraged tobecome regular

donors so that the fund maybe strengthened for the benefit of all Muslim The guiding

principle again is the socialjustice and general welfare. Some Islamic banks provide the

privilege of interest free loans only to the holders of investment account with them. Some

extend to allbank clients. Some restrict it to needy students and other economicallyweaker

sections of the society. Yet some other Islamic banks provide interest free loans to small

producers, farmers and entrepreneurs who are not qualified to getfinance from other sources.

The purpose of these loans is to help start them their independent economic life and thus to

raise their incomes and standard of living. Banks usually charge a small fee (say, 1.5%)

annuallyto covertheir administrative costs, etc.

Profit and loss sharing (PLS):

Itis an alternative to interest-based transactions.

Risk sharing:

No risk, no gain is thebasis.

ProhibitedInvestments and Permissibility ofActivities:

Investments should only support Halal (permitted) activities. So, investments involvingproducts like pork, alcohol, pornography, arms & ammunitions, Cinema, Tobacco,

Conventional Financial Services and activities like gambling areprohibited.

Hoarding:


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Hoarding moneyis considered improperin Islam; moneyis merely a means ofexchange and

should notbe treated as a commodity. Islam encourages Trade and Enterprise, which can

generate wealth forthebenefits ofthe community as a whole with PLS as its core.

Role of Islamic Banks:

The role of Islamic banks becomes difficult compared to their conventional counterparts

because of thebasic principle that money is not supposed to earn interest. This eliminates a

major role of the financial institution. So, what do they do? Theyinvest in viable projects,

with reliableborrowers. Iftheproject succeeds, thebanker shares in theprofit, if itfails, he

suffers the losses.


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Prohibition of Interest:

Prohibiting the receipt and payment of interest is the nucleus of the system, supported by

otherprinciples of Islamic doctrine advocating risk sharing, individuals' rights and duties,

property rights, and the sanctity of contracts. Similarly, the Islamic financial system is not

limited to banking, but covers capital formation, capital markets, and all types of financialintermediation. Since prohibition on transactions based on interestpayments is the most

important factor and is at the heart of the Islamic financial system, it willbe unjust not to

provide some light on it.

The basic philosophy underlying transaction of money is that the one who is offering his

moneyto anotherperson has to decide whether:

(a)He is lending moneyto him as a sympathetic act or,

(b)He is lending moneyto theborrower, so that hisprincipal maybe saved or,

(c)He is advancing his moneyto share theprofits oftheborrower.


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Comparison between Riba and Profit

Riba Profit

1. When money is charged, its imposed

positive and definite resultisRiba

1. When moneyis used inproductive activity

(e.g., in trading), its uncertain resultisprofit.

2. By definition, Ribais thepremiumpaidby

the borrower to the lender along with

principal amount as a condition forthe loan.

2. By definition, profit is the difference

between the revenue fromproduction and the

cost ofproduction.

3. Riba is prefixed, and hence there is no

uncertainty on thepart ofeitherthe givers or

the takers ofloans.

3. Even if a sharing ratio is agreed in

advance,profitis still uncertain, as its amount

is not known untilthe activityis completed.

4.Riba con notbe negative, it can atbestbe

verylow orzero.

4. Profit can be positive, zero or even

negative.

5. From Islamic Shariah point of view, it is

Haram (prohibited).

5. From Islamic Shariah point of view, it is

Halal(allowed).

Making Money from Money is notpermissible - the basic points of difference between

money and commodity are highlighted tojustify this. Money (of the same denomination) is

not held to be the subject matter of trade, like other commodities. Its use is restricted to its

basicpurpose i.e. to act as a medium ofexchange and a measure ofvalue.

Ifmoneyis tobe exchanged for money oritisborrowed, thepayment onboth sides mustbe

equal, so thatitis not used fortrade in moneyitself. In short, moneyis treated as "potential"

capital. Itbecomes actual capital onlywhen itjoins hands with other resources to undertake a

productive activity. Islam recognizes the time value of money, but only when it acts as

capital, notwhen itis "potential" capital.

Muslim scholars term interest asRiba. UnderShariah,Ribatechnically refers to thepremium

that mustbepaidbytheborrowerto the lender alongwith theprincipal amount as a condition

forthe loan or for an extension in its maturity (Chapra 1985, p.64). In otherwords,Riba is

the predetermined return on the use of money. In the past there has been dispute about

whetherRiba refers to interest or usury, butthere is now consensus amongMuslim scholars

thatthe term covers allforms ofinterest and not only excessiveinterest (Khan 1985,p.52).

The mostimportant characteristic ofRibais thatitis thepositive and definite result ofmoney

when changed. In other words, when moneybegets money, withoutbeing exchanged for

goods or services, orwithoutindulgingin anyproductive activity, itis calledRiba. Thebasic


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characteristics ofRiba are:

y It mustbe related to loan;y Aprefixed amount ofmoneytobepaid when due;y A time is fixed forthe repayment; andy Allthese elements for repayment are taken as conditions forloan.

Since Interest or Riba has emerged as thebasic alternative for Profit, a comparison isjustifiedbetween the two things.


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Differences between Islamic & ConventionalBanking:

Characteristics Islamic Banking System ConventionalBanking System

Guiding

principle

Guidedby Quranic edicts,Hadeeth, Islamic ethics and

Islamic laws.

Guidedbyprofit motive alone,

with no religious or ethical

considerations.

Ethics of

financing

Financingbeing asset-backed,

and meantforproductive use

helps reduce the overall debt

burden.

Debtburden arising out ofexcessive use ofcreditleads to

bankruptcies, and waste offinancial resources.

Liquidation

Assets

An Investment Account Holder

will have similar rights as

shareholders.

Depositors arepaidbefore the

shareholders.

Involvement ofrisk & Equity

financing

Equityfinancingis available to aproject orventure thatinvolves

profit-and-loss sharing. Risk-

sharing andprofit sharinggo

together.

Commercialbanks do notusuallyindulge in equity

financing, onlyventure capital

companies and investment

banks do. Conventionalbanks

carry much less risk, majorpart

ofthe risksbeingtransferred to

theborrowers.

Return on

Capital

Depends onproductivity, idle

money cannot earn any return.

Moneyis not capitalper se, onlypotential capital1.

Even idle moneyinbank

deposits earns returns.

Prohibition of

Gharar

(uncertainty)

The existence ofuncertaintyin a

contractisprohibitedbecause it

requires the occurrence ofan

eventwhich may not ultimately

occur. Full disclosurebyboth

parties is the norm in contracts.

Derivatives trading e.g. options

are considered as havingelements ofGharar.

Trading and dealingin

derivatives are widely

considered as the main source of

liquidityin the conventional

financial, commodity and

capital markets.

Profit and Loss

Sharing

Mosttransactions arebased on

this variable returns, dependent

on lendersperformance. Greater

share ofrisks forces them to

There is no relationshipbetween

bankperformance and returns tothe depositors orinvestors, who

mostly enjoy a risk-free return.


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manage risks more

professionally, to ensurebetter

returns than conventional

accounts. Depositors & investors

have opportunityto earn higher

returns than in conventionalsystems.

Conventionalinstitutions mostlyact as intermediariesbetweenlenders &borrowers enjoyingalmost a risk-free spread.

Zakat It hasbecome one ofthe

functions ofthe Islamicbanks to

collect and distributeZakat.

Government Taxesperhaps

serve the samepurpose - mode

and rate ofcharging are

different, though.

Compounding

or Interest on

interest

The Islamicbanks have no

provision to charge any extra

moneyfrom the defaulters.

It can charge additional money

(compound rate ofinterest) in

case ofdefaulters.

Money-Market

Borrowing

Forthe Islamicbanks, itis

comparatively difficulttoborrow

moneyfrom the money market.

For commercialbanks,

borrowingfrom the money

marketis the main source of

liquidity.

Developing

expertise

Since it sharesprofit and loss, the

Islamicbankspaygreater

attention to developingproject

appraisal and evaluation systems.

Since income from the advances

is fixed, itgives little

importance to developing

expertise inproject appraisal

and evaluations.

Viability v/s

credit-

worthiness

The Islamicbanks, on the other

hand, give greater emphasis on

the viability oftheprojects.

The conventionalbanks give

greater emphasis on credit-

worthiness ofthe clients.

Relationship

with Clients

The status ofIslamicbankin

relation to its clients is that of

partners, investors and trader.

The status ofa conventional

bank, in relation to its clients, is

that ofcreditor and debtors.

Capital

Guarantee

No guarantee. Builtinto the system.

Deposit

insurance

None Anintegral component


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Key Islamic Financialtechniques:

Islamic banking and financial institutions have developed a wide rage of techniques which

allowthem to uphold the religious and legalprinciples while enablingthem, atthe same time,

to offer viable financialproducts. The search is actually still going on to find newer

techniques, and forvariationsbased upon the existing ones to offer more attractive and usefulinstruments for the investors. The following list covers many of them, but must notbe

considered as exhaustive:

Mudaraba (Participation ortrustfinancing):

It involves two parties, the managing trustee (Mudarib) and the beneficial owner (Rub-ul-Maal). Usually the investment account holders are the provider of funds, and the IslamicBanks are the managingpartner (mudarib). The Islamic Financial Institution may eitherputup allthe funds itselfand undertake responsibilityforinvestingin them, or alternatelyit can

provide funds to a customer who then acts as Mudarib. The borrower retains a fixedpercentage ofprofits, the Islamic Financial Institutions reward is a fixed percentage in thebalance ofthe revenue generatedbythe investments and the remaindergoes to the investors.Underlyingprinciple is no-pain-no-gain, i.e., no one is entitled to any addition to the

principal sum ifhe does not share in the risks involved. Althoughprofits are shared on apre-agreedbasis, losses are wholly sufferedbythe Rub-ul-Maal.

Musharaka (Equity Financing):

It is quite similar to the Mudarabah contract. It involves financing through equity. Here thepartners or shareholders for a Project use their capital through a Joint Venture, LimitedPartnership to generate a profit. Profits or losses willbe splitbetween the shareholdersaccordingto some agreedpre-formula depending on the investment ratio.


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Difference between Mudaraba and Musharaka Contracts :

In a Mudaraba contract, the managing agent (beneficiary ortheborrower, called the Mudarib)does not have any financialparticipation. In a Musharaka contract, the agent is a financial

partner along with the provider of fund (Rubb-ul-Maal of Mudaraba contract) sharing the

gain orloss at thepre-designated ratio which is likely tobe higherthan what he is likely to

getin a Mudaraba contract. Thus, in Mudaraba, the agent acts as a workingpartnerwho does

notbear any losses and simply manages the fund (theprojectin which the fund is invested),

whereas in Musharaka, alltheparties are shareholders in the venture.

Murabaha (Cost-plus financing):

This technique is extensively used to facilitate trade financing activities ofIslamic Financial

Institutions. The Mudaraba and Musharaka transactions are often seen on the retail liabilityside of Islamic banks. The asset side whether retail or wholesale is quite risky. The mostcommon such financialinstrumentis the 'mark-up' structure called Murabaha. It sounds quitesimilarto a "repo" agreement commonly used in the West.

In a Murabaha transaction, thebankfinances thepurchase ofan assetbybuying it onbehalfofits client. Thebankthen adds a "mark-up" in its saleprice to its clientwhopays forit on adeferred basis. The 'cost-plus' nature of Murabaha sounds very much like the interest intocapital gains manipulations of tax-avoiders. Islamic banks are supposed to take a genuinecommercial riskbetween thepurchase ofthe assetfrom the seller and the sale ofthe assettotheperson requiringthe goods. Thebank stands inbetween thebuyer and the supplier and isliable if anything goes wrong. There is thus some form of guarantee with respect to thequality ofthe goodsprovidedbythebankto the end userin the strictform ofMurabaha. Title

to the goods financed maypass to the bank's client at the outset or on deferred payment.From theperspective ofmodern finance, a Murabaha facilityis equivalentto an asset-backedriskyloan. Ifthe capital markets areperfect and all agents in the economy have equal accessto information, then competitionbetween Islamicbanks and conventionalbanks would resultin Murabahah havingthe same expected return as that ofconventionalloans.

Baimuajjal(Deferred Payment Sales):

The payments for this sale could be eitherin installments or a one-offdeferred payment as

per agreementbetween theparties atthe time ofthe sale, and cannotinclude any charges for

deferment. This is like as a Murabaha mode of investment with an exception that the sale

underthis cost-plus sale mode of investment is made on a creditbasis ratherthan cash. It is

deemed acceptable to charge higherprices for deferred payments. Such transactions are

regarded as trades and notloans.

Ijara (Operating Lease):

Itinvolves leasing ofmachinery, equipment,buildings and other capital assets. The financier

purchases the asset and leases itto the end-user for an agreed rentalwhich maybe fixed in


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advance or subject to occasional reviewby a mutually acceptable third party, e.g. an

internationalfirm ofaccountants. Insuring ofthe asset remains a contentious issue.

Ijara wa iqtina (Financial Lease):

This is a leasing structure coupled with a right available to the lessee topurchase the asset at

the end of the lease period (Bay al Wafa). The lessee agrees to make payments into an

Islamic investment account (with right to allprofits) tobe used in ortowards financing the

ultimatepurchase ofthe asset. The instrument hasbeen used increasingly in a range ofasset

classes including ships, aircrafts, telecom equipment andpower station turbines, etc.

Baisalam orBai Salaf(Purchase with deferred delivery):

It is a short-term commodity finance contract in which thebuyer (usually ofagricultural ormanufacturedproducts)pays the sellerfull negotiatedprice ofaproductthatispromised fordelivery at a later date. It has similarities with the forward contracts ofconventionalfinancialsystems exceptthatin Islamic instruments the rate ofreturn is tied to each transaction ratherthan to a time dimension. Another difference lies in the factthatin Salam, thebuyerpays theentire amount in cash, at the time of contract. Both the quality and quantity of the sold

products are definitely specified in the contract. The counter-party risk in Al Salam is one-sided as itlies with thebuyer alone (the IBF) unlike the forward contracts in which it affects

both parties. Hence, it is expected that this riskwillbe priced one way unless a security isprovidedby the seller. This involves thebankpaying for theproducer's goods at a discountbefore they have been delivered or even made. Difference ofopinion exists on whetherthesubject ofBai Salam transaction shouldbe available in the market atthe time ofthe contractor whether it is enough that the asset willbe available at the date set in the contract fordelivery. Difference of opinion also can be seen on the minimum time period between thedate ofcontract and delivery ofassets.

Theparty on thepurchase side ofthe contract may sellthe assetbackto theparty on the sale

side ofthe contract orto a thirdpartyfor aprofit. Thepurchaser/financier may also selltheassetsbyway ofaparallelBai Salam contract (a salam contractwith a thirdparty) to hedge

the asset-risk orforprofit.


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The stipulation offull cash prepayment in Al Salam contracts is meant to facilitate working

capital finance wherein the party on the buyer side is the IBF institution. Since full

prepayment is involved, the price paid is lower than the future spotprice of the goods in

question unlike the futures or forward price which is always higher than the spotprice. Animportantfeature ofAl salam contractis the underlying assetwhich mustbe standardizable,

ofdeterminate quality and easytobe quantified.

Istisna and Parallel Istisna:

Itinvolves a deferred delivery sale contract similarto salam. Itis also similarto conventionalwork-in-progress financing of capitalprojects like construction. It is also used for tradefinance such as pre-shipment export finance. In this contract, the seller ( Al Sani), based

Box-1: Islamic Financial Instruments

Islamic Bank as an intermediary for Mudaraba or Musharaka: Islamic bank depositors act as

Rabbulmals and place funds with the bank. The bank is the Mudarib on its liability side with

respect to the depositors. The bank uses the funds on the Mudaraba or Musharaka basis or any

other Islamically approved basis with clients in search of funding. Here the bank is the Rabbulmal

with respect to the end users of the funds. Under such a scenario the bank acts as a principal. The

bank may also act in an off-balance sheet capacity as a fee-earning agent on behalf of the fund

providers and/or fund seekers or as a traditional fund manager investing in a diversified portfolio

of Musharaka contracts.

RetailIslamic Banking Products: At a retaillevel, Islamicbanksprovide current, savings,and investment accounts.

Alwadiah: It is equivalent of the current account of the conventionalbanks, and used fordayto day cash management. No return ispaid to depositors. Mostbanks have no chargesfor such accounts, and provide facilities similar to any conventionalbank. Alwadiah

structures are also used for higher return savings account. Banks may sometimes pay thesavers a return, depending on their own profitability. Savings accounts also are quitesimilar except for the absence of interestpayments. There may or may notbe a servicecharge incurred. Losses are not, in practice, passed on to depositors and are absorbedthrough thebanks' reserves.Term Deposits: They are considered as investment accounts, and use the Mudaraba format.Deposits are fixed term and cannotbe cashed in before maturity. The profit-sharing ratiovariesbetween institutions and couldbe a function ofthebank'sprofitability orthat ofthe

portfolio ofend borrowers. Inpractice there is onlyprofit sharing and no loss sharing forretailinvestors. The lower risk means a lowerprofit share.There are considerable variations on the Mudaraba principle. The Islamic Bank ofBangladesh has been offering Profit and Loss sharing (PLS) Deposit Accounts, PLSSpecial Notice Deposit Accounts, and PLS Term Deposit accounts. Bank Islam Malaysia

provides wholesale and retail investment accounts both on the PLS principle. Thefrequency ofpayment is anothervariable. Profits are declared and distributed monthly inMalaysia, whilst in Egypt there is a quarterly distribution. In Bangladesh and Pakistandistributions tend tobe half-yearly.A common thread is the short-term liquid nature of the deposits. Long-term mortgage-type


33/72

upon an order from purchaser (Al Mustasni), undertakes to manufacture or havemanufactured/ acquired the subjectitem (AlMasnoo) asperpurchasers specifications. The

price,payment structure and the date ofdelivery are fixed in advance. InparallelIstisna, theAl-Sani may enter into a second Istisna contract (subcontract) with a third party to

manufacture the subject item unless Al Mustasni (ultimate purchaser) has stipulated in thecontarct specificallyfor Al Sani to manufacture himself.

Similarity with Bai Salam contract: Sale ofa product not available at the time of thedeal.

Difference with Bai Salam contract:In Bai Salam, fullprice forthe asset mustbepaidat the outset, whereas in Istisna, payment in full orin installments maybe made at anyagreed upon time (evenbeyond delivery date).

Similarity with Ijarah: In Istisna, al-sani may eitherprovide the raw material orlabour.The labourpartis the similaritywith Ijarah.

Arbun or Urboun (Pre-purchase ofrightto acquire asset):

Thepurchaser makes a deposit (a down-payment, which maybe a fraction oftheprice) for

thepurchase ofan asset at a later date on the understandingthat, should the sale ofthe assets

notproceed (say, if the purchaser chooses not to proceed), the seller willbe permitted to

retain the deposit. Because of its similarity to an option, it has met with varying levels of

approvalfrom the schools ofIslamicjurisprudence. A lot ofworkwillbe required to mould

the instrument so as to remove anypossibility ofspeculation ensuringtotal acceptability.

Khiyar al-shart:

This is a sale contract concluded at the time ofsigning the agreement, butwhere one of thetwoparties to the contract has a rightto cancelthe sale within a stipulated time. Cancellation

is not contingent upon any uncertain future event. For example,party A enters into a contract

withpartyBto sell a given quantity ofequity stock on an agreedprice, today. Party A has the

rightto either confirm or rescind the contractby a certain time in the future (lets term it as

maturity). IfPmaturity > Pcontract, A may choose to rescind the contract and instead sell the

stock in the market. The similarity of the exercise features of this contract with the

conventional PutOption invites some controversy.

AlBayBithaman Ajil:

BBA, popular in Malaysia, is a mark-up sale in which payments are delayed and made inequalinstallments. Theoretically, in the contract ofBBA thebank sells theproduct (a house,

equipment or machinery, etc.) to the customer at a mark-upprice, whose content consists of

the costprice plus a profit margin. The client may be allowed to settle payment by

installments within a pre-agreed period, or as a lump sum. It is similar to a Murabaha

contract, but with payment on a deferred basis. The BBA facility can also be utilised for

refinancing of assets owned by the Customer, and the proceeds to be utilised for the

Customers working capital.


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Syndication: Islamic FinancialInstitutions are increasinglyprepared toparticipate in large

projectfinancing, and are getting readyto compete with their conventional counterparts. The

syndication works on the techniques discussed above, mostpopularbeing the Mudarabah

contract modified to suitthe technicalities.

Joalah:Aparty undertakes topay anotherparty a specified amount ofmoney as a fee forrendering a specified service in accordance with the terms ofthe contract stipulatedbetweenthe two parties. This mode usually applies to transactions such as consultations and

professional services, fundplacements, and trust services.

Certificates of sale:It hasbeen suggested that consumersbuying consumables on creditwould issue 'certificates ofsale' similar to letters ofcredit. These could be encashed by theseller atthebank at a discount. This seems very similarin structure to Baisalam.

Prizes and bonuses: Iran and Pakistan have both attempted to fully Islamise the entirebanking. Iran converted to Islamicbankingin Augustl983with a three-yeartransitionperiod.In Iran banks accept current and savings deposits withoutpaying any return. The banks are

permitted to offerbonuses and prizes on these deposits very similar to the UKs premiumbonds. This is apparently not regarded as gamblingbythe Iranian Islamicbanking units.

No fee accounts:There is a substantialMuslimpopulation in South Africa and they areserviced bytwo smallIslamic banks. The mainproductbeing offered is the "no fee" currentaccount which is also provided by the conventionalbanks by arrangement. Transactioncharges are waived and interestis notpaid on current accounts.

Gifts: Gifts to depositors are given entirely at the discretion of the Islamic banks on thebasis of the minimum balance. These gifts maybe monetary or non-monetary are based on

thebanks returns.Non PLS Modes: Non-Profit-and-Loss SharingModes. They are used in cases where PLS

modes cannotbe implemented, e.g., in cases of small-scale borrowers or for consumption

loans.

Qard Al Hasnah (Beneficence Loans): Zero return loans that Islam edicts for

Muslims to make to the needy. Banks can only charge theborrowers a one-offservice fee to

coverthe administrative expenses, but this fee cannotbe related, by any means, to the loan

amount orits maturity.

Islamic Derivative Products: Salam (Bai Al Salam), Urboun (Arbun) and Khiyar al-

shart are the existing derivativeproducts approvedby some schools ofIslamicjurisprudence.

Dr. Kenneth Baldwin has suggested some Profit Rate Swaps that replicate the risk

management capability ofconventionalinterest rate swaps, using Sharia-compatiblebuilding

blocks (existing and extensively used instruments).

It is generally assumed that the term "Islamic Derivatives" is a contradiction. The

requirements ofderivatives and rules ofShariah atfirst sight are diametrically opposed and

all derivatives are thereforeHaram. Butitis importantto recallthe generalised definition we


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use ofa financial derivative. It is simply a financial instrument that is derived from another

financial instrument or a combination of such instruments. It is argued that as derivatives

"unquestionably" involve interest or interest-based products they are contaminated and

should be prohibited. Well, derivatives only involve interest ifone orboth parties using the

derivative seek to hedge the derivative. It could be argued thatMurabaha could involve

interest if the parties seek to match the interest free but guaranteed return product with aninterest-bearing equivalent. Islamic banking derivatives should be perfectly acceptable so

long as they do notinvolve interest.

The literature contains hardly any serious criticism of the interest-free character of the

operation, since this is taken forgranted, although concerns have been expressed about the

lack ofadequate interest-free instruments. There is a near-consensus that Islamic banks

can function well without interest. An InternationalMonetary Fund (IMF) studybyIqbal

and Mirakhor (l987) found Islamic banking to be a viable proposition that can result in

efficient resource allocation.


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Advantages of Islamic Finance:

Efficient allocation of funds: Since allocation offundsbybanks willbe dependent uponthe soundness ofprojects underthe PLS arrangements, the allocation is more efficient.

Productive use of capital:Banks are likely to know their fund users better in order toensure that the funds are used forproductive purposes. In this way, both the fund

providers and the financial intermediary contribute to promotingproductive economicactivities and greater financial responsibility. Thus, IBFs would promote economicgrowth [Chapra (1998), Siddiqui (1983)]

Similarly, since banks have no pressure of fixed regularpayments on deposits, theefficiency ofallocating resources toprofitable and moreproductive use is furtherboosted.

Equitable distribution of wealth: The efficiency in allocation leads to this, and createsadditional wealth as well. Interest distribution is considered unjust and inequitable

because itis notbased on anyproductive use ofcapital, and it exploits the misfortune oftheborrower (who has run out ofmoney).

Generation of employment: Productive use ofcapital implies investments and creationofjobs. The investmentis not dependent upon the cost ofcapital (andpositive NPVs) or

time value of money, hence number of investible projects is likely to be much higherresultingin larger capitalformation.

Saving in information costs:Being apartner ofthe entrepreneur (or a firm), the financialinstitution has easier and cheaper access to information on matters relating to the firm.This may make credit rating agencies redundant, and lending more efficient.

Saving in deposit insurance costs: Risk-sharing conceptbuiltinto the IBF system, there

willbe no need for deposits tobe insured. Reduction of debt burden: The IBF system of equity financing encourages debt to be

swapped with equity which can help many developing countries get rid of the immensedebt-burden. Instead of rescheduling of existing loans or selling Bradybonds at heavydiscounts, which does not help relieve the pressure much, converting debt to equity

promises a much more fruitful alternative.

Promoting Ethical behaviour: Because of its strong emphasis on the ethical and moraldimensions ofdoingthebusiness and selectingthe activities/ commodities tobe financed,the Islamic financing institutions could play an important role in promoting sociallydesirable investment and corporate behavior. In this context, it is worth mentioning thatIslamic financinginstitutions are subjectto Shariah (Islamic Law) regulations in addition

to conformingto the conventional regulatory standards. This is further expected to ensuregreaterprudence and responsibility.

Higher profits: Account holders under Islamic finance could expect higherprofit fromtheir investment as Islamic banks are required to share the entire netprofit according tothe agreed formula ratherthanjust aportion oftheprofit, as is the conventionalpractice.

Reduction in run-on-deposits: Banks usingprofit and loss sharing (PLS) to mobilizeresources are less likelyto face a sudden run on their deposits.


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More stable economic environment: The perspective of investments is long-term incomparison to short-term expectations ofreturns in conventional financial system this

may resultin a more stable economic environmentless dependent onbusiness cycles.

Less likelihood of flight of capital: UnderIslamic finance, debtinstruments that maybecreated through sellinggoods and services on credit are not readilytradable. This greatlyeliminates thepossibility ofsudden mass movement offunds from one countryto another.


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Reduction in speculative transactions: Examination of daily records of trading infinancial markets vividly shows that institutionalparticipants carry out huge speculativetransactions. More often than not, such transactions are sources of instabilities. Incontrast, Islamic banks and financial institutions are inherentlyprevented from carryingout such activities. As a result destabilizing speculations wouldbe significantly curtailedin financial markets, although liquidity will remain with secondary market tradingallowed in stocks orinvestment certificates.

Reduction of inflationary pressures: Under Islamic economics the inflationarypressures would be reduced to a great extent, as over or under-supply of money withrespect ofsupply ofgoods is not allowed (money directlylinked to supply ofgoods in theeconomy).

Reduction in unproductive use of borrowings: By eliminating unnecessary andexcessiveborrowing (borrowingbeyondproductive use), riskto lenders is reduced underPLS, as lendingis directly related toproject appraisals and feasibility.

Automatic Shock-absorption: Forbanks involved in the equity-based system, Khan

(1986) argues that the shocks to assetpositions are immediately absorbed by changes inthe values ofshares heldby depositors in thebank. This makes the realvalues ofassetsand liabilities ofbanks equal at all times, preventingbanking crises. Nienhaus (1986)agrees with the argument.

Guaranteed market ofpracticingMuslims. Islambeingthe fastestgrowing religion in theworld further enhances thepotential marketability ofIBF instruments.


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Perceived Disadvantages of Islamic Finance:

With PLS, the role ofthebank undergoes a change frombeing an intermediarytrader ofmoney, earningprofits from the margin between lending and borrowing, to being aninvestingpartner. The role ofan investmentbankbrings in added costs:

o Search cost resultingfrom the need to decide on the mostprofitable ventures. With anIslamicbank required to finance so many different kinds ofbusinesses, acquiring skillsin all ofthem maybe immensely costly.

o Monitoring costs resulting from the need to prevent mishandling of the venture andfraudulent means (including creative accounting) adoptedbyborrowers/partners are inaddition to those involved in conventionalfinancial system.

o Managing costs incurredbecause ofits obligation as apartnerin the PLS deals.

Determination of mechanism forprofit sharing in the short-term is difficult in a PLS

system based on returns only from productive deployment of funds. In the absence ofastandard mechanism forprofit/loss sharing (both for short-term as well as long-term), the

possibility ofexploitative contracts cannotbe eliminated.

Eliminatinginterest may reduce thepropensityto save (withbanks) orinvest (consideringthe risk associated with returns), thus curtailing economic growth affecting employment(Pryor-1985), generation ofwealth and its distribution. Ofcourse, IBFproponents do notagree, as an opportunityfor equitable sharing ofwealth earned fromproductive activitiescouldbe enough stimulantforinvestors.

Dispute settlement mechanism adds to the costfurther, as the accountputforward bytheborrower (entrepreneur) may notbe convincing enough for the banks or other investorpartners. Fixed return ofthe conventional system has no such costs.

A risk sharingproposition of IFBs and resulting absence of deposit insurance systemleaves small investors in the risky avenues, particularly when the Islamic financialinstitution carries fraudulentintentions.

Curtailing speculative activities in the secondary market would be extremely difficultresultingin the same risks and costs thatthe conventionalfinancial systems carry.

The mark-up system ofmost ofthe non-PLS schemes resembles the interest-based systemto the extent of becoming indistinguishable, sometimes, and provides unscrupulousfinanciers opportunityto replicate the conventional system.

Additional cost of supervision by the Sharia Board: Product development, its offering,agreements between counterparties, functioning of the IBF system, accounting, etc needto be Sharia compliant which needs certification by the Sharia Boards resulting inadditional costburden overthe IBF Operators.

Account holders underIslamic finance could expect higherprofitfrom theirinvestment asIslamic banks are required to share the entire netprofit according to the agreed formularatherthanjust aportion oftheprofit, as is the conventionalpractice.


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Impediments to the growth of Islamic Banking:

The impediments are being discussed in this paper after grouping them in seven broad

categories: (1) Social Impediments, (2) Economic Impediments, (3) Financial Impediments,

(4) Structural Impediments, (5) Institutional Impediments, (6) Political Impediments,

TechnologicalImpediments, and (7) Religious Impediments.

1. Social Impediments: Humans are undoubtedly the most important resourceendowment for any country. Their development is the key to the competitiveness of anynation in any sphere. Even in the field of IBF, it is the level ofhuman development in the

promoter nations that will ultimately steer the IBF into a competitive arena. The HumanDeveloped Index (HDI) available with the Human Development Reportbrought outbyUnited Nations Development Programme (UNDP) is a composite index that measuresachievements of a country in three basic parameters ofhuman development (HDR 2003).These are: (i) longevity measuredbylife expectancy atbirth, (ii) knowledge, measuredby a

combination of the adult literacy rate and the combined primary, secondary, and tertiarygross enrolment ratio, and (iii) standard ofliving, measuredby GDPper capita.

It is worthwhile, then, having a look (Figure-7) at the HDI of member nations of

Organization ofIslamic Countries (OIC), having some kind ofIBF (as they are thepromoters

of IBF), in comparison with some of the world leaders (promoters ofConventionalbanking

& financial system).

Accumulation of human capital is an indicator of endogenous growth and is often used in

empirical growth models. In most regressions, this variable turns out with a positive

coefficient (Barro, 1991). The highest ranked country among the Islamic countries, in terms

ofHDI, is Brunei with a rank of 31, the second highestbeing Bahrain at 37, both of them

with so small apopulation thattheir impact on the development ofas important a system as

IBF is not expected to be large. However, in terms of developing a financial market (and

related systems, also in terms of IBF) the maximum effort has been made byBahrain after

Malaysia (Countries with 100% Islamic Financial system in place, i.e., Iran was placed at

106, Sudan at 138 and Pakistan had a rank of144 in HDR of2003). The developmentin the

area is not likely to bear much fruit unless the promoter countries of IBF take giant steps

towards developing their most important infrastructure element, i.e. the Human Resources.

The initial successes may remain at superficial levels, and sustainability of growth and the

challenges posed to the conventional financial system may remain feeble otherwise. At the

moment, itposes a significantimpedimentto the growth ofIBF.

(a)SocietalImpediments: Thebasic societalfabricbuilds thepsyche ofthe masses.

Coming out ofthisbox, then, is not easy. Afterinitialleadership over a longperiod, when

the Islamic society ultimately lost its primacy to the Western world because of their

consistent multi-dimensional development activities, it seems the members ofthe Islamic

society also lostthe motivation to winback. This has had a lasting impact on the society

in all spheres that are cited next. Islamic FinancialInstitutions aspart ofthis society have


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a strongbarrier to scale, and along with its parent society has a backlog of many

generations to clear.

Social alienation, particularly in the wake of 11th September, may detract non-Muslims

even further awayfrom anythingIslamic, and act as a major source ofimpediment.

(b) EducationalImpediments: Education is thebackbone ofany development, andis one of the most important reasons behind the lost glory of the Islamic society. The

absence of Islamic Banking and Finance from the horizon, for centuries, is pointer

enough towards lack ofeducation and research. However, figure-8provides the status of

education in the Islamic World represented here by countries of the Organization of

Islamic Countries (OIC) Countries that have IBFs in comparison with some ofthe world

leaders.

In terms of Adult literacy and Education Index (a measure thatprovides a composite

indicator of the level of education), all the countries in the OIC sample lagbehind the

world leaders. In terms of Public Expenditure on education reported as percentage ofrespective GDPs, Saudi Arabias figure is encouraging as it leads the sample in this

respect (except Yemen, whose ratio couldbe misleading as the GDP figure is too small)

but also increased from 6.5% in 1990 to 9.5% during 1998-2000 (data refers to the year

duringthisperiod forwhich itwas available) which shows its recent commitmenttowards

educating its citizen. But the scenario in all other countries even in this respect is no

differentfrom whatisprojectedbythe Adultliteracy orthe Education Index.

The enrolment into educational institutions provides indication towards the future of

education in a country. From the data available in the Human Development Report 2003

(HDR 2003) for 175 countries, we find that, amongthe OIC countries, only Guyana with

91% enrolment (although its overall HDI rankis apoor 92) waspart ofthe top quartile ofCombinedprimary, secondary and tertiarygross enrolment ratio, duringthe year 2000-01

compared with thirty (30) non-OIC members. The second quartile of ranks had twenty

(20) OIC members while the third quartile had seventeen (17) and the last one had sixteen

(16) of them. More than sixty-one percent (61%) OIC members fell in the lower half,

compared with thirty-three percent (33%) of non-OIC members. The full list of 174

countries had 31% OIC members (54 numbers), whereas the lower half of the ranks,

based on combined enrollment, had 45% ofthem. Thispresents a gloomypicture not only

forthepresentbut has repercussions forthe foreseeable future. Only exponentialgrowth

in enrollments, now, canprovide some hope ofcatching upwith rest ofthe world.

(c) PsychologicalImpediments : Psychological mindset needs to change for those

who have been using the conventionalbanks and FIs as well as those for those who

havebeen abstainingfrom them due to their anti-usuriousbeliefs. This tantamounts to

a paradigm shift that is not easy to happen in a shortperiod and it requires a lot of

concerted effort on allfronts. On the other hand,psychologicalpressure on the Islamic

institutions, in general, from fundamentalist organizations is keeping a check on

declaringinnovations thatthey could launch otherwise.


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2.Economic Impediments:

Size of the economy is an important indicator of the kind of flowpassing through thebanking and financial channels thatthe IBF have to chase. Consideringthat homebankingand financialinstitutions have a clear advantage overforeign institutions, GDP shouldbe agood indicator for development of these institutions. Looking at the GDP of the IBF

promoter countries (our sample of OIC having some type of IBF) vis--vis rest of theworld provides some clue as to why it maybe difficult to promote the IBF in the era ofopening economywhere they have to compete with the worldplayers too. The GDP ofallthe sample Islamic countriesputtogetherwas less than 17% ofthe GDP ofUSA. When weadd Japanese GDP to the GDP of USA, the sample Islamic countries do not reach even12%. What influence an economy like USA or Japan can have on the prosperity of afinancial system canbe seen from this fact. The chart (Figure-9) therefore excludes USA,Japan, Germany, UK, France, China and Italy the top seven nations (constituting of68.75% ofWorld GDP, the worldbeing represented, here, by 170 nations included in the

HDR 2003) so thatthe remainingfigures couldbe comparable.


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3. Financial Impediments:

a. Lack of active capital market: Equity is an excellent source of capital andorganizations are likely to exhaust this source before exploring other means when

planningto acquire, upgrade orproduce technologyto sell as a product. An absence

ofactive capital market hinders technology intensive, high capital endeavors as wellas any expansion of such projects. Since acquisition of technology is capital-intensive, the paybackperiod for which is usually long, whereas bankborrowings

seldom indulge in 100% financing orlong-term financing, itis almost an impossiblesource for the start-ups, capital markets have proven to be the most successful and

feasible means offinancing.

b. Lack of active debt market: The absence ofsecondary debt marketin UAE is also aserious handicapforthe investing community. As a result, debtissuesbecome illiquidand costly. There is no scope of long term debt financing and with bank financingcatering to short term or medium term finance, it acts as a deterrence to technologyintensive ventures. At the same time, bank finance is mostly suitable for Working

Capital financing rather than Capital Expenditure funding that is required forTechnology-intensive ventures.

c. Lack of Money Market:Itis another majorimpedimentleavingthe market notjustilliquid and costlier,but also leaves the government devoid offinancing its expensesthrough a cheaper and liquid medium.

d. Supportive Institutions for Venture Capital Financing: The strongest form ofIslamic financingbeing the PLS forms of Mudarabah and Musharakah, VentureCapitalfinancing (VCF) should havebeen the strongestin the countries thatpromotethe IBFs, but the reality is surprisingly different. VCF needs institutional support interms of an active network of financiers, entrepreneurs, technology promotinginstitutions like Private and Government R&D laboratories, Universities, Stock

Exchanges and regulatoryframework, etc. A Silicon Valleytype network ofalliancesis required which is largely absent in the OIC. Some efforts in the direction of

establishingtechnologyparks andbusiness incubators have started in some countries,but they have a longway to go. For individual small economies it may take a lot oftime to achieve the critical mass, a strong need therefore is for the association ofcountries like the GCC or ASEAN topooltheir resources.

e. Lack of an active secondary market: Secondary markets are in the process ofevolving and itwill take time before they could reallyprovide this marketwith therequired liquidity. Secondary markets do notjustbecome meetingpointsbetween theinvestors and the corporates, theybecome a benchmark for the health of the wholefinancial system.

f. Lack of Business incubators: Incubators connect talent, technology, capital andknow-how to leverage entrepreneurial talent, accelerate the development of newknowledge-based businesses and thus speed up the commercialization of newknowledge and technology. Although the system has started in some countries likeUAE, itwilltake time in shaping upto a stage where it couldbe ofreal use. There isa strong relationshipbetween the financial institutions and the business incubators.Business incubators cannotgrowwithout financial support and growth in the sectormeans a growth in demand forthe financial sector. Hence a lack ofthis system, in theIslamic countries, is an impedimentto the growth ofIBF system.


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4. Structural Impediments:

y Financial Engineering: The structuring of any new system that can pose realcompetition to an existingwell-established system requires notjust a robust structure

to start with but a structure that supports innovation and continual improvement.

Financial Engineering is an integralpart of the financial service provider so thatinnovativeproducts canbe offered regularlyto

Documents

Naeem (desertation)