attitude of conventional and islamic bank customers towards islamic banking practices in sri lanka

ATTITUDE OF CONVENTIONAL AND ISLAMIC BANK

CUSTOMERS TOWARDS ISLAMIC BANKING

PRACTICES IN SRI LANKA

MI. MOHAMED RIYATH

DEPARTMENT OF ACCOUNTANCY AND FINANCE

FACULTY OF MANAGEMENT & COMMERCE

SOUTH EASTERN UNIVERSITY OF SRI LANKA

OLUVIL

2009

i

ATTITUDE OF CONVENTIONAL AND ISLAMIC

BANK CUSTOMERS TOWARDS ISLAMIC

BANKING PRACTICES IN SRI LANKA

MI. MOHAMED RIYATH

REGISTRATION NO: SEU/IS/04/MG/021

INDEX NO: MG0385

A Dissertation Submitted to the Faculty of Management & Commerce,

South Eastern University of Sri Lanka, in partial fulfillment of the requirements

of the Bachelor of Business Administration Degree.

(Specialization in Finance)

Department of Accountancy and Finance

Faculty of Management & Commerce

South Eastern University of Sri Lanka

Oluvil

2009

ii

CERTIFICATION

This is to certify that the dissertation on “Attitude of Conventional and Islamic

Bank Customers Towards Islamic Banking Practices in Sri Lanka” submitted by

Mohamed Ismail Mohamed Riyath (SEU/IS/04/MG/021) to the Faculty of

Management & Commerce of South Eastern University of Sri Lanka in partial

fulfillment of the requirements for the award of the Degree of Bachelor of Business

Administration (BBA) is his original work based on the study carried out

independently by him during the period of study under my guidance and supervision

is approved for submission.

……………………………

Signature of the Supervisor,

Mr. A.Jamaldeen

Lecturer- in- Commerce,

Department of Accountancy and Finance,

Faculty of Management & Commerce,

South Eastern University of Sri Lanka,

Oluvil.

Sri Lanka.

Saturday, January 30, 2010

iii

DECLARATION

I do hereby declare that this work has been originally carried out by me under the

guidance and supervision of Mr. A. Jamaldeen, Lecturer in Commerce, Department

of Accountancy and Finance and this work has not been submitted elsewhere for any

other degree.

I certify that this dissertation, to the best of my knowledge, does not contain any

materials previously published or written by another author except where due

acknowledgement and reference is made in the text.

………………………….

Signature of the Candidate

MI Mohamed Riyath

The Researcher,

Faculty of Management and Commerce,

South Eastern University of Sri Lanka.

Oluvil

Saturday, January 30, 2010

iv

ACKNOWLEDGEMENT

I have great pleasure to take this opportunity to thanks ALLAH who gave me the

knowledge and ability to prepare this dissertation.

I am obliged to express my gratitude to the supervisor of this study Mr. A

Jamaldeen, Lecturer, Faculty of Management & Commerce, South Eastern

University of Sri Lanka for giving me valuable academic guidance, direction, and

dedicated encouragement extended through the research, in addition to that, his

prompt assistance and good honor should be immensely appreciated.

I am very grateful to thank our Dr.A.Jahfer, Head of the Department of Accountancy

and Finance for give confidence me to do this research effectively and also express

my sincere thanks to Dean of the faculty of Management and Commerce and the

academic staff for their corporation and guidance.

My sincere thanks go to Mr. Sarjoon Mov, Lecturer, Department Of Islamic And

Culture, Faculty of Islamic and Culture, South Eastern University of Sri Lanka. My

special thanks go to my friends those who provide support in my research work.

I would also like to thank my Brother Mr.MIM. Illyas for supporting me during my

research work and provide printing facilities.

Eventually my heartfelt gratitude goes to my parents Mr. & Mrs. MM Ismail for

their dedication to my studies and further my thanks go to my beloved brothers and

my sister for their commitment of divers with the view of my future prosperity and

life.

MI. Mohamed Riyath,

The Researcher,

Faculty of Management and Commerce,

South Eastern University of Sri Lanka,

Oluvil

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vii

ABSTRACT

Islamic banking is an investment and financing concept which expands globally.

People are becoming more aware of the Islamic banks. Islamic banking is different

from conventional banking in most aspects, since its close tie to religion is very

important. The connections to politics and history have influenced the implementation

of the Islamic banking system in the countries where the system operates.

The paper seeks to identify and clarify the controversial issues between Islamic and

conventional banks in order to help remove the misconceptions about Islamic

banking. It is due to incomplete and often distorted knowledge about Islamic banking

that the civil society remains doubtful about the viability of such a system. As the

civil society is an active and potential agent of dissemination of ideas and information

in the society, its lack of knowledge and conviction has limited the scope of Islamic

banking practices. Once the public is convinced about the utility and uniqueness of

the system, Islamic-banking practices will grow further in many Muslim countries.

The transformation of the present interest-based financial system into an interest free

Islamic system is one of the objectives espoused by many Muslims.

The paper is divided into five sections. Following this introduction, Literature review

of Islamic banking and finance has been given in section Two. The survey

methodology used in this study is presented in section Three. In section Four

Analyzes the opinions of the customers of both Islamic and conventional bank. And

finally Section Five presents the findings, conclusions and recommendations of the

study.

viii

Table of Contents Page NoTitle iCertification iiDeclaration iiiAcknowledgement ivDedication vBismillah viTable of Contents viiIndex of Table viiiTable of Figures xiAbstract xii

Chapter One INTRODUCTION 1.1. Background of the Study 11.2. Literature Review 21.2.1. Brief History Islamic Banking 21.3. Players In Islamic Finance 31.4. Problem Identification 41.5. Significant of The Study 51.6. Objective of The Study 51.6.1. Primary Objective 51.6.2. General Objective 61.7. Research Questions 61.8. Research Methodology 61.8.1. The Sample 61.9. Limitations 71.9.1. Limitation Of The Study 71.10. Organization of Chapters 8

Chapter Two LITERATURE REVIEW 2.1. Background 92.1.1. Environmental Background of Islam 92.1.2. Ownership and wealth 92.1.3. Almsgiving - Zakath 102.2. Islamic Law – Shariah 122.3. Interest Versus Profit 13

ix

2.3.1. Introduction 132.3.2. The Concept of Riba : 142.3.3. Definition of Riba or Interest 152.3.4. The Nature of Modern Banking : 162.3.5. The Feasibility of the Interest Rate Mechanism: 172.3.6. The Efficacy of the Profit Mechanism 192.4. Islamic Finance 202.4.1. Environmental Background 212.4.2. The Emergence and Spread of Islamic Finance 222.4.3. Contracts And Business Relations 222.5. The Islamic Banking System 232.5.1. Introduction 232.5.2. Environmental Background 232.5.3. The Concept of Islamic Banking 242.5.4. Aims of Islamic Banks in general 252.5.5. Activities of Islamic banks 262.6. Permissible Financing Methods 272.6.1. Cost-plus sales (Murabaha) 282.6.2. Credit sales (Bay Bithaman Ajil) 292.6.3. Leasing (Ijarah or Ijar) 312.6.4. Partnerships (Musharakah and Mudarabah) 332.6.5. Islamic forwards (Salam and Istisna) 342.7. Advantages of Islamic Finance 352.7.1. Efficiency 352.7.2. Stability 362.7.3. Moral Hazard and Adverse Selection 382.7.4. Finance And Development 392.7.5. Integrity 402.7.6. Equity 412.7.7. Sustainability 432.8. Challenges Facing Islamic Banking 442.8.1. Financial Engineering 442.8.2. Some Other Shariah Issues 452.8.3. Teaching, Training, Research and Development 472.8.4. Lack of Profit Sharing Finance 482.8.5. Defaulters and the Issue of Compensation and Penalties 502.8.6. Illiquidity of Assets 512.8.7. Short-Term Asset Structure 512.8.8. Mobilization of Deposits and Indigenizing Placement of Funds 532.8.9. Competition 542.8.10. Globalization 56

x

Chapter Three RESEARCH METHODOLOGY

3.1. Introduction 583.2. The Sample To Be Used By The Researcher 583.3. Types of Data 583.4. Methods of data collection 593.4.1. Primary Data Collection 593.4.1.1. Primary Data Collection Methods 593.4.2. Secondary data collection 63

Chapter Four DATA PRESENTATION AND ANALYSIS

4.1. Introduction 664.2. Analysis of Questionnaire 664.3. Question and Answers in the course of Interview 814.3.1. Question One 814.3.2. Question Two 834.3.3. Question Three 844.3.4. Question Four 854.3.5. Question Five 864.3.6. Question Six 87

Chapter Five FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

5.1. Introduction 895.2. Finding 895.3. Conclusions 915.4. Recommendations 93

APPENDIX Glossary of Arabic Terms 95References 101Questionnaire 104

xi

Index of Table Table Page No Table: 4. 1 Question One: Type of Customer by Profession 66Table: 4. 2 Question Two; Age 67Table: 4. 3 Question Three; Sex 67Table: 4. 4 Question Four; Education Level 68Table: 4. 5 Question Five what type Account you are keeping 68Table: 4. 6 Question Six; what you are expecting from your money 69Table: 4. 7 Question Seven; Profit and Loss Sharing System is the

Essence of Islamic Finance. 69

Table: 4. 8 Question Eight; Benefits Accrued to the Society from Islamic Banking.

70

Table: 4. 9 Question nine; which is the major Basis of Development of Islamic Banking

71

Table: 4. 10 Question Ten; which is the major Causes of Continuation of Interest-based Transaction through Back Door by Islamic Banking system

72

Table: 4. 11 Question eleven; which is the major Causes of Interest Creeping into the Islamic Banking System

73

Table: 4. 12 Question twelve; Present Success of Islamic Banks is not in Conformity with Shariah

74

Table: 4. 13 Question thirteen; which is the major Cause of Not Patronizing the Islamic Banks by Rich and Prominent Muslim Businessmen and Industrialists

75

Table: 4. 14 Question fourteen; Most of Investment Financing Techniques by Islamic Banks do Not Share Risk Proportionally.

76

Table: 4. 15 Question fifteen; Many Customers are not interested in Dealing with Islamic Banks as they feel that only the Name has been changed and Interest in Real Sense has not been eliminated.

77

Table: 4. 16 Question sixteen; Possibility of Loss of Deposit is not Detrimental to Deposit Mobilization.

78

Table: 4. 17 Question Seventeen; Present Modes of investment of Islamic Banks are Compromised Modes of Financing with Interest

79

Table: 4. 18 Question Eighteen; Moral Uplifting of the Society Will Pave the Way for Islamic

80

xii

Table of Figures Figure Page NoFigure: 4.1 Question One: Type of Customer by Profession 66Figure: 4.2 Question Two; Age 67Figure: 4.3 Question Three; Sex 67Figure: 4.4 Question Four; Education Level 68Figure: 4.5 Question Five what type Account you are keeping 68Figure: 4.6 Question Six; what you are expecting from your money 69Figure: 4.7 Question Seven; Profit and Loss Sharing System is the

Essence of Islamic Finance. 70

Figure: 4.8 Question Eight; Benefits Accrued to the Society from Islamic Banking.

70

Figure: 4.9 Question nine; which is the major Basis of Development of Islamic Banking

71

Figure: 4.10 Question Ten; which is the major Causes of Continuation of Interest-based Transaction through Back Door by Islamic Banking system

72

Figure: 4.11 Question eleven; which is the major Causes of Interest Creeping into the Islamic Banking System

73

Figure: 4.12 Question twelve; Present Success of Islamic Banks is not in Conformity with Shariah

74

Figure: 4.13 Question thirteen; which is the major Cause of Not Patronizing the Islamic Banks by Rich and Prominent Muslim Businessmen and Industrialists

75

Figure: 4.14 Question fourteen; Most of Investment Financing Techniques by Islamic Banks do Not Share Risk Proportionally.

76

Figure: 4.15 Question fifteen; Many Customers are not interested in Dealing with Islamic Banks as they feel that only the Name has been changed and Interest in Real Sense has not been eliminated.

77

Figure: 4.16 Question sixteen; Possibility of Loss of Deposit is not Detrimental to Deposit Mobilization.

78

Figure: 4.17 Question Seventeen; Present Modes of investment of Islamic Banks are Compromised Modes of Financing with Interest.

79

Figure: 4.18 Question Eighteen; Moral Uplifting of the Society Will Pave the Way for Islamic

80

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Attitude of Conventional and Islamic Bank Customers Towards Islamic Banking Practices in Sri Lanka

MIM Riyath. SEU/IS/04/MG/021 Specialization in Finance Page | 1

Chapter One INTRODUCTION

1.1. Background of the Study Sri Lanka is one of the few non-Islamic countries to have legislated for Islamic

banking. The revised Banking Act No 30 of 1988, as amended in 2005, allows both

commercial banks and specialized banks to operate on a Shariah compliant basis,

including: “the acceptance of a sum of money in any manner or form from any person

for a fixed period of time for investment in a business venture of the bank on the basis

that profits or losses of the venture will be shared with the person from whom such

money is accepted in a manner determined at the time the money is accepted.”

Islamic Finance refers to a system of Finance that is consistent with Islamic law

(Sharia) known as Fiqh Al-Muamalat, and is guided by Islamic economics. Islamic

law prohibits usury, which is the collection and payment of interest, commonly called

‘Riba’. Islamic law also prohibits investing in businesses that are considered unlawful

or ‘Haram’ (such as alcohol, gossip columns or pornography).

Islamic Finance has a large market potential in Sri Lanka. Muslim is second largest

populated religion in Sri Lanka. It can address the long drawn issue of ‘Financial

inclusion’ and will create a feel good factor among Muslims. Sri Lankan government

can gain diplomatic advantages to make financial dealings with Muslim dominated

nations and can attract equity finance from gulf countries for infrastructure

development, thereby financing the fiscal deficit.

There exist significant challenges to materialize the objective of expansion of Islamic

Finance in Sri Lanka. Lacks of experts in this field, lead to differences in

interpretation and compliance with Shariah laws. Moreover in case of Sri Lanka,

Finance regulation & Acts are needs to be suitably modified to introduce Islamic

Finance. New Standard Accounting practices have to be developed. Islamic Finance

per say goes against the secular framework of our nation and can create financial

separation. It can also be exploited politically, so it has to be seen in the right light.



There is a need to customize and advertise Islamic Finance to make it equally

attractive to Non- Muslims. The product trends are positive in Sri Lanka and given the

double digit growth of Islamic Finance in other Asian countries like Asia and

Singapore, it is definitely a possible option for Sri Lanka.

1.2. Literature Review 1.2.1. Brief History Islamic Banking During the Islamic Golden Age, early forms of proto-capitalism and free markets

were present in the Caliphate, where an early market economy and an early form of

mercantilism were developed between the 8th-12th centuries, which some refer to as

"Islamic capitalism". A vigorous monetary economy was created on the basis of the

expanding levels of circulation of a stable high-value currency (the dinar) and the

integration of monetary areas that were previously independent.

A number of innovative concepts and techniques were introduced in early Islamic

banking, including bills of exchange, the first forms of partnership (Mufawada) such

as limited partnerships (Mudaraba), and the earliest forms of capital (al-mal), capital

accumulation (Nama al-mal), cheques, promissory notes, trusts (Waqf), startup

companies, transactional accounts, loaning, ledgers and assignments. Organizational

enterprises similar to corporations independent from the state also existed in the

medieval Islamic world, while the agency institution was also introduced. Many of

these early capitalist concepts were adopted and further advanced in medieval Europe

from the 13th century onwards.

Although Islamic Finance can be traced backed to 8th Century in Muslim countries,

modern Islamic Finance started in Egypt in 1963 by Ahmad EL Najjar. In 1975, the

Islamic Development Bank was set-up with the objective to provide funding of

projects in the member countries. The first modern commercial Islamic Bank, Dubai

Islamic Bank, opened its doors in 1975.With presence in over 60 countries and a

15% CAGR, it has estimated designated assets worth $1.3 trillion in more than 400

financial institutions offering Shariah compliant products. Saudi Arabia’s Al Rajhi

is the world’s biggest Islamic Bank by assets, which stand at $28 billion.



1.3. Players In Islamic Finance The market value of the Islamic banking sector in Sri Lanka is estimated at Rs 70

billion to Rs 100 billion. Islamic financial services providers currently active include

Amana Investments Ltd, Ceylinco Islamic Investment Corporation (CIIC), Muslim

Commercial Bank (MCB), National Asset Management Limited (NAMAL), First

Global Investments Group and ABC Investments.

Amana Investments, established in 1997, leads the country’s Islamic financial

services market. Its subsidiary Amana Takaful Ltd (ATL) began operations in June

1999 and is acknowledged as the market leader for Takaful services (commonly

perceived as the Islamic alternative to conventional insurance). ATL was listed on the

Colombo Stock Exchange in late 2006. CIIC made its entry in 2003 and is fully

backed by Ceylinco Insurance, one of the leading conventional insurance providers in

Sri Lanka. CIIC offers both selected Shariah compliant and Takaful products. The

new kid on the block MCB — owned by MCB Pakistan — commenced operations

early this year. It offers both Islamic and conventional financial products.

NAMAL is the first fund management company in Sri Lanka licensed to manage unit

trusts. Together with Amana Capital (a subsidiary of Amana Investments), it launched

the NAMAL Amana Equity Fund early this month. The objective of the equity fund is

to achieve significant growth over the medium to long term by primarily investing in

equity securities that are Shariah compliant.

First Global Group is a public limited finance investment company that deals with

Shariah compliant investments and financing products and services. Domestically, it

is the first institution to promote training and career development programmes related

to Islamic banking and finance.

Finally, there’s ABC Investments, a relatively new Islamic investment group that

claims to have strong funding backing from different countries. It has a memorandum

of understanding with the Central Bank of Sudan in which the latter’s experts will

provide assistance on training and development to ABC — especially in its Takaful

segment — and will be working closely with leading Islamic financial countries for

the funding in Takaful as they plan to start off with general insurance.



1.4. Problem Identification How are the Attitudes of Conventional and Islamic Bank Customers towards Islamic

Banking practices in Sri Lanka? Despite the phenomenal growth of Islamic banking

practices worldwide, there is a debate among scholars about whether Islamic banking

practices are any different from the conventional banking system. This debate is not

confined to the academic circles only, but has also made its way to the banking

community and the banks’ customers. We argue that there is a lack of knowledge

about the various Islamic-banking practices among the banking community as well as

the banks’ customers. A question that generally arises is why is the Islamic banking

system growing so fast if it is not different from the conventional banking system.

Analysis of the deposit and investment mechanisms and the opinions of the

professionals and customers of both Islamic and conventional banks would be useful

to understand and identify Islamic banking with its separate unique features and its

impact on economy and society. The primary objective of this study is to examine the

reality of apparent similarities between Islamic and conventional banks, which

frequently tend to equate both systems of banking. This is done at the theoretical

plane as well as by opinion survey of the users (i.e., professionals and customers) of

the two systems.

The paper seeks to identify and clarify the controversial issues between Islamic and

conventional banks in order to help remove the misconceptions about Islamic

banking. It is due to incomplete and often distorted knowledge about Islamic banking

that the civil society remains doubtful about the viability of such a system. As the

civil society is an active and potential agent of dissemination of ideas and information

in the society, its lack of knowledge and conviction has limited the scope of Islamic

banking practices. Once the public is convinced about the utility and uniqueness of

the system, Islamic-banking practices will grow further in many Muslim countries.

The transformation of the present interest-based financial system into an interest free

Islamic system is one of the objectives espoused by many Muslims.



1.5. Significant of The Study The current Muslim population of the world is 1.8Bn and Muslims are about 8% of

total population of Sri Lanka approximately 2 million Muslims, Given the above

mentioned statistics, it becomes essential to introduce this form of Finance in Sri

Lanka as there exist wide difference in terms of regions, religions, languages etc. This

difference provides us with a Blue Ocean which can be exploited to make a positive

mark on the Finance landscape of our country. It would help to increase the size of the

Finance industry various and prove to be a foundation for many more innovations to

be introduced in future.

The approximately 30% Muslims are financially qualified. The long held issue of

financial inclusion can be taken care of by introducing Islamic Finance. Majority of

Sri Lankan Muslims are so poor that they are not targeted by the Commercial Banks

and whose savings lie idle at home. Muslims in Sri Lanka generally creditworthiness

primarily because they form part of business areas. It is here where the actual market

potential of Islamic Baking lies. One may argue that Sri Lankan Muslims are

satisfactorily using the existing Conventional Finance system. A one to one interview

with Bank executives of Personal Finance division of many Banks revealed that a

significant Muslim population is:

Not investing in mutual funds with a debt component.

Donating the interest on their salary savings account to charity.

Using a zero-interest current account instead of a savings account.

The above steps are diligent efforts made by many Sri Lankan Muslims to make the

current conventional Finance ‘Shariah’ compliant in their own way. This is the huge

market which can be tapped by Islamic Finance.

1.6. Objective of The Study 1.6.1. Primary Objective The purpose of this dissertation is to describe the Islamic Banking system and how it

is implemented based on whether profit or interest in Sri Lanka.



1.6.2. General Objective To understand Islamic Finance

To understand system of Islamic Finance and its components

To understand implementation of Islamic Finance in Sri Lanka

To understand opportunities and challenges.

To understand how is differ from conventional bank

1.7. Research Questions How are the Attitudes of Conventional and Islamic Bank Customers towards

Islamic Banking practices in Sri Lanka? It is the main research problem. It is

analyzed that the following research questions.

The dissertation is based on following research questions:

What is Islamic Finance?

How does the system work and what are its components?

How do interest and profit and its mechanism regarding Islamic banking system?

How is it different from a conventional bank?

Is Islamic Finance practicable?

1.8. Research Methodology A purposive random sampling was used to collect data on a series of questions

regarding Islamic banking practices. Data of the study was collected from both

primary and secondary sources. The sets of approved questionnaire were used in the

survey, through interview method, among the customers as well as professionals of

selected Islamic and conventional banks in Sri Lanka.

The study includes Islamic and conventional banks. So we assume that the officers of

these banks and their customers know and understand the similarities and differences

in the banking practices of Islamic banks and conventional banks.

1.8.1. The Sample The sample consists of customers of each bank and professionals. As such,

professionals and customers were interviewed to record their opinions about some

noticeable similarities between Islamic and conventional banks. Findings of the study



were consulted with the available literature and executives of the banks to confirm

their reliability and acceptability.

1.9. Limitations Limited time as well as limited scope has caused us to restraint the dissertation to

Islamic Finance in Sri Lanka.

1.9.1. Limitation of The Study The focus of the study is limited to few factors which means only work load, target

achievement, superior behavior etc. are considered to illustrate and represent the

concept of intention to leave. But when we considering broadly there is another

factors also to affect this situation.

Some time selected sample may not represent the whole population.

Lack of specialists on the area under discussion of Islamic finance in the region.

Peoples who are the passion in the Islamic Bank are hesitating to give data

regarding the bank.

Lack of articles and journals regarding Islamic finance in Sri Lankan point of

view.

There are some constraints to meet, cost, other available resource, literature

reviews.



1.10. Organization of Chapters The dissertation is divided into five chapters as follows.

CHAPTER ONE: Introduction.

This chapter will present the brief introduction, history, objective, research questions,

methods used and limitations as well as the authors, upon whose works, based this

Dissertation.

CHAPTER TWO: Literature Review.

This chapter will present the environmental background of Islam, the Islamic view on

ownership, wealth and almsgiving and the Islamic Law – Shariah emergence and

spread, contracts used and business relations, different categories of Islamic banks, as

well as concept of Islamic Banking will be described.

CHAPTER THREE: Research Methodology.

This chapter will explain about data collection, sample interpretation, and way of

analyzing.

CHAPTER FOUR: Data Presentation and Analysis.

This chapter will analyze the opinions of the professionals and customers of both

Islamic and conventional banks.

CHAPTER FIVE: Findings, Conclusion and Recommendation.

This chapter will present the summary Conclusions and Recommendation of the

study.

A


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Chapter Two LITERATURE REVIEW

2.1. Background The environmental background of Islam, the Islamic view on ownership, wealth and

almsgiving and the Islamic Law – Shariah will be described.

2.1.1. Environmental Background of Islam In order to understand Islamic finance, it is necessary to have certain knowledge about

the history and the tenets of Islam. It is also important to be familiar with Islam’s

position within the society, which is different from the religious power within the

Western countries. It is not always easy for individuals used to the Western traditions

to understand the teachings of Islam. (Samuelsson, 2000)

Islam means ‘submission’ which points out that a believing Muslim should submit to

the will of Allah. It might be worth mentioning that the expression ‘the will of Allah’

has a quite different meaning to the true Muslim than to the secularized Western

citizen. The superiority of Allah in the eyes of the Muslims forms the foundation for

both Islam and Islamic banking. The Koran is the holy book of Islam and to be seen

as the true words of Allah. (Samuelsson, 2000)

There are five pillars or corner stone’s in Islamic faith; the Islamic Confession, the

daily prayers, the fast during Ramadan, the almsgiving (Zakath) and the pilgrimage to

Mecca. (Samuelsson, 2000) Since the main topic of this dissertation concerns the

financial part of Islam, the corner stone about almsgiving naturally receives most

interest. Before studying the almsgiving more closely, one should take a look at what

Islam teaches about property and wealth in general.

2.1.2. Ownership and wealth In Islam brotherhood and justice are strongly pointed out and the well being of society

is more important than the well being of the individual. Efforts made to improve or

expand production in order to raise the output are good and worth struggling for, but

justice and fair play at all levels of human interaction must take place. Wealth or



income is considered as a favor from Allah and not as an evil. Heaven is open equally

to the rich and the poor.

Poverty is not necessarily associated with virtue. It is, however, still considered as

provocative if wealthy people boast with their wealth. If a rich person sees his- or

herself as being superior to other people, it is a blasphemy against Allah.

(Samuelsson, 2000) What matters is not whether a person has wealth but how it is

obtained and how it is used. Wealthy persons should use their wealth in the

community to gain society. (Al-Omar et. al., 1996)

To better understand the behavior of consumer and producer it is useful to study the

concept of property within Islam. The following three points are particularly relevant.

(Al-Omar et. al., 1996)

1. Property is unconditionally owned only by Allah

2. Property among human beings is a form of stewardship or care taking – in other

words: it is conditional. A person is answerable to Allah for the use of every property

he or she uses.

3. Conditional ownership is either collective or individual:

Collective ownership: fundamental natural resources as water air and fire

Individual ownership: things as goods, buildings, livestock and rights to lease, rent

or re-sale

According to Islam, “Allah owns all resources and man is only a trustee in their use”

(Al-Omar et. al., 1996, p 5). Therefore, the economic aspect of how to handle those

resources in real life is also not completely free. There are moral and legal constraints.

2.1.3. Almsgiving - Zakath As mentioned above, one of the five pillars or duties in Islamic faith is the

almsgiving, the Zakath, which literally means ‘purification’. Persons with resources

above an exemption limit are to pay an amount levied on their wealth in order to

purify the wealth and the person’s soul. (Al-Omar et. al., 1996) The main purpose of

the Zakath is redistribution of wealth and income. It has been regarded throughout

Islamic history as the principal welfare system – a way of taking care of the poor and

the needy in society. It can be seen as a form of religious tax, even though the



almsgiving in theory is considered to be voluntary. The true Muslim is also strongly

encouraged to practice charity besides the Zakath. (Warde, 2000)

In the Koran it is clearly written who should pay Zakath, how much to pay and who

the receivers are. Islam requires every Muslim, having resources in excess of a certain

basic amount, to pay the Zakath as a given proportion of her or his net worth or

agricultural output. The Zakath receivers are the poor and needy people or people in

different kinds of trouble – independent of their religion. The Zakath is paid once a

year and calculated at 2.5 per cent of the total value of capital and profits minus

unrecovered debts and depreciation. In agriculture it varies from 5 per cent to 10 per

cent, according to the type of irrigation. (Al-Omar et. al., 1996; Samuelsson, 2000;

Warde, 2000)

The socio-economic function of the Zakath aims not only at satisfying the hunger of a

poor man or to help him with a few pounds. The purpose is also to enable him to

support himself by his own efforts so that he may have a fixed source of income. This

rescues the individual from the indignity of dependence on others or on the state, for a

livelihood. This way of acting runs well with the special rules for collection and

distribution of the Zakath. The rules say that the Zakath should be collected and

distributed locally. It should also be made collectively and not by each individual. The

reason for this is to avoid almsgivers from boasting with their actions and to prevent

the Zakath receivers from feeling ashamed. Many Islamic banks are involved in

Zakath – either through setting aside a percentage of their profits for charitable

activities or through administration of Zakath funds, collection or distribution of

money. In countries where the ruler takes charge of collecting alms a Zakath fund

must be established in each Islamic bank. The Islamic bank can then play a technical

assistance role in the government’s fight against poverty. (Al-Omar et. al., 1996;

Warde, 2000)

In the early days of Islam, detailed rules as to amounts, collection practices,

exemptions and the like were established for the practice of the Zakath. This system,

however, has changed through the years to fit the Islamic community’s revenue and

welfare needs of today.



The Zakath payment has been replaced by modern tax systems in Muslim countries,

but is, nevertheless, still considered as a religious duty among true Muslims.

(Samuelsson, 2000)

There is a debate between the proponents of social solidarity, compassion and mutual

obligation and the proponents of the sanctity of private property. The first part

believes that the rich should pay to the needy, even beyond their obligation to pay

Zakath. The latter part, however, is of the idea that the only obligatory claim on the

wealth of Muslims is Zakath. This debate has apparently been going on since the

death of the Prophet Mohammed. It is obviously related to the modern debate over the

capitalist or socialist nature of the Islamic economic system. Since the Islamic

economic system is based on the Islamic Law – the Shariah – the main question is

whether the practical economic purposes should be emphasized on the strict letter of

the law or on the spirit of the law. (Nomani & Rahnema, 1994)

2.2. Islamic Law – Shariah As the Islamic ‘nation’ grew, a need for a more detailed legal system arose. The

Islamic Law is called the Shariah and is defined as the Divine Law – the Law of

Allah. It is mainly based on the Koran, the Sunnah and the Hadith. Among those

sources the Koran has a superior place. The Koran is considered to be divine and

eternal since it is the true words of Allah. (Al-Omar et. al., 1996) The Sunnah

contains the words and acts of the Prophet Muhammad and relates to the practice or

ruling deduced from them. The Sunnah transmits and explains the Koran. The Hadith

refer to a tradition or story of the Prophet. In short, the Sunnah is what was practiced

and the Hadith are the record of what was practiced. Both the Sunnah and the Hadith

refer back to the Koran. (Nomani et. al., 1994)

The Hadith are – as Warde puts it – a collection of stories about and sayings of the

Prophet Mohammad set down in writing two or three centuries later. It has become a

source of controversy between Islamic groups since there are a number of

interpretations of it. (Warde, 2000)



Since the Shariah is the Law given from Allah, it is divine and not to be questioned by

human beings. According to Al-Omar, human reason has considerable sovereignty

within the law, but it has no sovereignty over the law. What Allah has prohibited

cannot be made unconditionally permissible. The Divine Legislator is not bound by

the limits of theoretical reason. What the law declares must be accepted and never

doubted, even when it passes or appears to contradict human reasoning. (Al-Omar et.

al., 1996)

The statement of the Shariah as a divine law is, however, denied by Amereller. He

claims that the Shariah should not be considered as a divine law like for instance the

Ten Commandments, but instead be declared as a “body of Islamic law created and

developed by jurists” (Amereller, 1995, p 25). According to Amereller, the Koran

does not serve as a code of laws. The Koran and the Sunnah do mostly not contain

clear laws and regulations, but decisions and hints that laws and regulations can be

founded on. Therefore, law advisors are recommended only to use the Koran and the

Sunnah if necessary. Much more are the interpretations of the Koran and the

analogical conclusions of known jurists to be used. Those works were completed in

the 10th century and considered as valid for coming generations. (Amereller, 1995)

The Shariah does not allow certain condition as interest (riba) and gambling or

speculation (maysir). From a Shariah point of view, business and investments made

by Muslims must be conducted in a responsible and committed way. (Archer & Abdel

Karim, 2002)

The Shariah might give the impression of being very restraining since it contains a

number of prohibitions. On the other hand, the law includes the general principle that

if nothing is specifically prohibited, it is permitted. (Al-Omar et. al., 1996)

2.3. Interest Versus Profit 2.3.1. Introduction For the past few years, particularly after the emergence of "Islamic" monetary,

financial, and economic institutions, there has been a argument as to whether bank



interest is a legitimate, permissible (Halal) return or a forbidden Riba and as to its

feasibility as a mechanism for the management of contemporary economic activity.

2.3.2. The Concept of Riba : Rib as a term is the increment obtained over the principal in return for nothing in

commutative contracts. Riba mentioned in the Holy Qur'an is. The pre-Islamic Riba,

the clear Riba which is the Riba of a debtor loan. It is the increment given in return

for time, whether the increment is specified as a condition at the conclusion of

contract or designated at the time of repayment for extending the due date. In this

context, Riba is forbidden in all Divine Revelations as it represents the most

abominable form of illegally expropriating personal and public capital. As such, it is

considered a grave sin in Islam. Any excess over the original debt, no matter how

little it may be is considered an evil gain. On that, Allah, the Exalted says: "If you

repent, you may retain your principal, wronging none (with an increase) without being

wronged (by suffering a loss).

Riba in this sense is forbidden, irrespective of the nature of the loan whether for

consumption or production or of the nature of the parties to the loan contract

individuals, individuals-companies, governmental, or international organizations or

the circumstances of one party, or all parties, to the contract rich or poor; and, finally,

of the change of the value of the currency decrease or increase.

Riba, in this sense, is really the "AIDS" of contemporary economic activity, as it

deprives economic life of its immunity and robs it of its ability to fight economic

diseases. Consequently, a feeling of exploitation prevails, productivity decreases, the

efficient use of resources deteriorates, economic potential is wasted, and, ultimately,

economic disorders are aggravated.

Please see in Al Quran

(Surah al-Baqarah, verses 275, 276, 278,) (Surah Al 'Imran, Verses 130), (Surah Al-

Nisa', Verse 161), (Surah Al-Rum, Verse 39),



2.3.3. Definition of Riba or Interest The word "Riba" means excess, increase or addition, which correctly interpreted

according to Shariah terminology, implies any excess compensation without due

consideration (consideration does not include time value of money). This definition of

Riba is derived from the Quran and is unanimously accepted by all Islamic scholars.

There are two types of Riba, identified to date by these scholars namely 'Riba An

Nasiyah' and 'Riba Al Fadl'. 'Riba An Nasiyah' is defined as excess, which results

from predetermined interest which a lender receives over and above the principle (Ras

ul Maal)

'Riba Al Fadl' is defined as excess compensation without any consideration resulting

from a sale of goods. During the dark ages, only the first form (Riba An Nasiyah) was

considered to be Riba. However the Holy Prophet also classified the second form

(Riba Al Fadl) as Riba.

The meaning of Riba has been clarified in the following verses of Quran:

"O those who believe, fear Allah and give up what still remains of the Riba if you are

believers. But if you do not do so, then be warned of war from Allah and His

Messenger. If you repent even now, you have the right of the return of your capital;

neither will you do wrong nor will you be wronged." Al Baqarah 2:278-9

These verses clearly indicate that the term Riba means any excess compensation over

and above the principal which is without due consideration. However, the Quran has

not altogether forbidden all types of excess; as it is present in trade as well, which is

permissible. The excess that has been rendered Haram in Quran is a special type

termed as Riba. In the dark ages, the Arabs used to accept Riba as a type of sale,

which unfortunately is also being understood at the present times. Islam has

categorically made a clear distinction between the excess in capital resulting from sale

and excess resulting from interest. The first type of excess is permissible but the

second type is forbidden and rendered Haram.

“Seized in this state they say: ‘Buying and selling is but a kind of interest’, even

though Allah has made buying and selling lawful, and interest unlawful.” Al Baqarah

2:275



2.3.4. The Nature of Modern Banking : The work of modern banks, commercial or specialized, is to handle credits, debts, or

loans. Credits and debts are the two aspects of a loan. Credit pertains to the loan-giver

in relation, to the loan, and debt pertains to the loan-receiver in relation to the loan.

The relationship between the bank-and those dealing with it are control-led by the

loan contract. The way that the bank deals with its clients is revealed in the details of

its financial position as presented in its balance sheet. The balance sheet is divided

into two parts: resources of funds, or liabilities, and uses of funds, or assets.

Resources are basically controlled by the loan contract. The major part of these

resources comes mainly from depositors. As such, depositors are loan-givers and the

bank is a loan-receiver in return for interest which the bank pays a debit interest from

its part, except for current deposits for which the owners are not usually given any

interest. In relation to all deposits, the bank is, a guarantor, i.e., the bank guarantees

the original deposit and -offers interest" on deposits that are not current.

As to the uses, the bank loans the money it has accumulated to merchants, investors

and others. Their status as loan-receivers is that of a guarantor, i.e., guaranteeing the

original loan and paying interest a credit interest from the bank's part. The "difference

between the-total interest that the bank pays to its depositors and the total interest

which the bank receives from those making use of its financial resources represents

the bank's net return.

Therefore, in the bank's balance sheet there are fixed debts on both sides which must

be paid after a definite period of time, along with a conditional increment defined at

the start, for payment on due date, or on a new due date after maturity for extending

the period of time. Thus, the return for the use of the debt is justifiable for the debtor

as he is the guarantor, but is not justifiable to the creditor, according to the Islamic

principle which stipulates that "Al Kharaj bi Addamaan, i.e., the return is not justified

unless there is some risk involved, and, in this case, the loan-giver, in contrast to the

loan-receiver, bears no risk.



In this basis, Islam, emphasizing real social solidarity, recognizes only Qard Hasan.

Any loan repaid with any benefit is Riba. If people wish to develop and invest their

money, then they must do so through true Islamic investment, by placing their money

in risk-taking projects and bearing the consequence, be it profit or loss. Money does

not by itself generate money; it increases or accumulates, justifiably, through actual

investment in economic activity, in accordance with different Islamic modes of

investment based on partnership and sales contracts. Thus, money grows through a

partnership system, not through a debt system in return for interest. This, in essence,

is how Islamic banks function

2.3.5. The Feasibility of the Interest Rate Mechanism: Some economists consider the interest rate as the strategic price in the contemporary

economic system. For them, it is the nervous system of modern banking; the main tool

for the management of the monetary system; the effective savings factor; and the

criterion that helps to ensure investment allocation in the most efficient projects. They

believe that the use of this mechanism will save developing countries from further

foreign indebtedness and, consequently, from dependence. Eventually, they believe, it

will guarantee the most efficient use of resources through better distribution; and as a

result, economic development will be achieved; pillars of economic power will be

perfected; and society will progress. Some economists even consider the use of the

interest rate mechanism in contemporary economic system to be a manifest destiny

and an irreversible fate.

They further believe that if any existing system attempts to free itself from the interest

rate mechanism, a great misfortune will befall the owners of wealth, most especially

creditors. They believe that this would result in the collapse of the banking system,

the paralysis of the monetary system and decreasing savings by- increasing hoardings,

and the flight of capital to the rest of the world, exposing a nonconforming economy

to escalating foreign debt in order to finance investment with interest loans. This, they

believe, is inevitable and unavoidable.

For Western economists, the contemporary economic system with its methodology

and modern institutions is inextricably bound to the interest rate mechanism. The



elimination of this mechanism will lead to collapse and destruction. Money and banks

are among the variables of modern global economics, and the Islamic economic

system should not be 'prevented from adapting to the innovations of the present age

simply because there are no precedents (i.e. Banks) from earlier Islamic period. At the

same time, the adaptation of these innovations to the needs of Islamic society does not

presume the abandonment of one of the immutable principles of the Islamic economic

system on the pretext that contemporary economics cannot function without the

interest rate mechanism.

The situation in developing countries is, in fact, very different. In spite of the

existence of monetary and banking systems in these countries, we find that many, of

the basic conditions for the already limited efficiency and effectiveness of Monetary

and credit policy are either completely absent, or present only in a primitive form.

As a result, it is clear that this policy is even much less efficient in these countries.

Economists agree that the problem, here, is not a monetary problem; it is, rather, a

structural one. What these countries need to end their chronic stagnation is not more

monetary spending. They need a structural change in the production process through

development. The problem here is not a problem of "Demand" as much as it is a

matter of "supply". It is necessary to raise the level of the utilization of existing

productive resources. In this context, it is possible that rational monetary, financial

and commercial policies, not the interest rate mechanism, will play a beneficial role in

this process In the opinion of many economists the negative influence of the rate of

interest on the process of capital formation and its ineffectiveness in the treatment of

inflationary and deflationary disorders are considered the most important causes of

instability in. contemporary economies. In the early 1980s, M. Friedman asked what

caused the unprecedented irrational performance of the American economy. He

concluded that the main cause was the equally irrational behavior of interest rates.

Finally, R. Turvey has confirmed that the rate of interest does not control the

economy that the interest rate mechanism is, in fact, unfit for investment decisions

and that it should be replaced by the rate of the price of real assets or by the general

level of prices of shares. From this understanding, a general theory may be proposed



in which the price of real assets and not paper assets is central to the economy and in

which profit and not interest is it’s real and effective mechanism. This brings us to a

discussion of the efficacy of the profit mechanism.

2.3.6. The Efficacy of the Profit Mechanism There are four factors of production: land, labor, capital and entrepreneurship. Each

one of these factors generates an income corresponding to the: actual part it plays in

economic activity. Income generated from land is rent; Income generated from labor

is wages. Income generated from capital is interest and income generated from

entrepreneurship is profit. The fourfold division of the factors of production and their

corresponding incomes, particularly capital and interest, are basic to economic theory

and fundamental to the theory of capital.

The analysis of the theory of capital rests upon an unrealistic over-simplification,

which assumes the existence of certainty or perfect foresight. In this strange certainty-

based setting, strange things are put forward,, as for example contending that the

equilibrium rate of interest always equals exactly the marginal productivity of capital,

or as P. Samuel-son and D. Patinkin say, the rate of interest is equivalent to the rate of

profit anticipated to be certainly realized.

According to Western economic literalism, investible capital without interest, i.e.,

"free" capital, would create "unlimited" demand. The result will be an absence of a

supply and demand mechanism (through interest), hence no capital equilibrium can be

achieved. The end result will be wastage of capital as a consequence of this irrational

utilization which leads inevitably to economic spoil.

The real participation of capital in the production process, Islamic or otherwise,

definitely yields a return. From an Islamic perspective, this return is not a pre-

determined rate of interest but a common and proportional share in the actual or

estimated realization of profits. Simply because it exists, no one should be dogmatic

on this concept of the fourfold division of return on the ground that such ideas of

conventional economics cannot be challenged.

According to Islamic economic principle, this share in profits is the cost of capital. In



consequence, profit becomes the criterion which controls the allocation of financial

resources. It is a mechanism which balances the demand for and the supply of these

resources. When the anticipated profit rate from a new investment exceeds the

achieved prevailing rate of the actual profit in the economic activity where investment

is to be under-taken, under uncertainty conditions, and on the basis of developmental

priorities of the society and the goal of achieving sufficiency, the supply of investible

funds for the project increases and the project is actually implemented. The opposite

is also absolutely correct.

Therefore, the actual profit generated is considered in Islamic economics as a decisive

factor in determining the success of a new project, and its ability to attract investible

capital. Capital in an Islamic economy is quite naturally invested where profit is

greater, rather than where interest is higher. So profit and not interest is the true

indicator of the real scarcity in the supply of capital and guarantees the efficient and

productive utilization of available financial resources in all economic activities.

Islamic states cannot, therefore, face the economic and cultural challenges presented

by the modern world without the comprehensive application of Islam. The aim of the

Islamic system is realized through the worship of Allah the Almighty which, in the

broadest sense, involves the constant struggle to improve real human progress through

learning, economic development and the realization of a decent and righteous life for

everyone living under this system.

If this can be achieved, the objectives of Shariah, i.e., the protection of faith; life,

intellect, property and progeny for present and future generations of Muslims, will be

realized. The above discussion has touched briefly upon one aspect of the fourth

objective, which is the protection of property or wealth, manifest in the efficacy of the

mechanism of profit in the utilization of resources.

2.4. Islamic Finance This includes a discussion about Islamic Finance, its environmental background,

emergence and spread as well as contracts used and business relations.



2.4.1. Environmental Background Warde summarizes the situation in the Islamic world in a comparison with the

situation in Europe. “At a time when Europe was still in the Dark Ages”, he claims,

“Culture and knowledge thrived in the Islamic world. Later, as the West went through

its ‘great transformation’, the Islamic world remained stagnant”. (Warde, 2000, p 25)

The so-called Golden Age of the Islamic world took place in the 7th-10th centuries in

the Middle East countries and between the 11th-14th centuries in North Africa. The

available financial instruments in the Islamic world were, Warde claims, at least until

the 13th century far more advanced than in the West. Although banks did not exist,

innovative financial instruments were a part of commercial life. A frequently used

expression is that they were ‘bankers without banks’. After the Golden Age a period –

between the 15th and the 20th centuries – followed, which is on the contrary

remembered as a period of stagnation and decline. The reasons for this might be that

the Islamic world suffered a double break – not only with its own past but also with

the West. “The Renaissance, the Reformation, even the scientific revolution and the

Enlightenment passed unnoticed in the Muslim world.” (Warde, 2000, p 26)The

colonization during the 16th and 17th centuries delayed the development of the

Islamic financial models. Instead European banks were established at the end of the

17th century in Turkey, Egypt and Iran (Samuelsson, 2000; Zineldin, 1990). By the

19th century, most of the Islamic world was brought into a Western imposed

economic order for which it was ill prepared. Between the Golden Age of Islam and

this encounter, the world of ideas and institutions had changed dramatically. Most

institutions with relevance to finance that exist today – capital markets, corporations,

etc – did not exist in the early days of Islam. (Warde, 2000) In some areas the

classical Islam anticipates modern finance:

Private property

Emphasis on written contracts

Favorable view of business endeavors

Some Islamic business forms such as commend a partnership; have found their way in

European legal codes. Along with economic and political transformations came new

perspectives on debt and indebtedness. Debt was no longer seen as something

negative. With the rise of capitalism and the industrial revolution, it became logical



that a nation needed not only skills and knowledge but also capital in order to

succeed. In those countries where there was only little money to lend, the

entrepreneurship was held back, which had a negative impact on the country. (Warde,

2000)

2.4.2. The Emergence and Spread of Islamic Finance Today, Islamic banking is estimated to be managing funds of US$ 200 billion. Its

clientele is not confined to Muslim countries but are also spread over Northern Africa,

the Far East, Europe and the United States. Islamic banking continues to grow.

Islamic bankers, keeping pace with sophisticated techniques and latest developments

have evolved investment instruments that are both profitable and ethically motivated.

Today, more than 250 Islamic financial institutions are operating worldwide.

(www.islamic-banking.com)

2.4.3. Contracts And Business Relations As mentioned before, Islamic finance is strongly based on the principles and rules of

the Islamic Law – the Shariah. The Shariah contains rules about contracts, which are

the main instrument in Islamic finance. A branch of the Shariah points out which

contracts are permissible or valid, which ones to be used and which are not to be. It

also gives instructions on how to form those contracts to avoid any form of confusion

or disputes. The clear rules about contracts have made the contracts an optimal

instrument in the Islamic finance. They have existed ever since the early days of

Islamic finance, when there were no Islamic Financial Institutions. At the beginning

of Islam, businesses through partnerships were quite frequent. Business was based on

‘credit instruments’ and it was the good name that ruled the credit abilities. People

with good reputation – normally through high social status – bought goods on credit

and resold them later on. The business relations were as good as always based on

already existing personal relations, but the social position of the business partners was

also of great importance. The risk sharing is very important within Islamic finance.

The Shariah manages this risk sharing by insisting on the use of well-defined

contracts when financial transactions take place. The contracts are to be clear and well

formulated to avoid all kinds of misunderstanding and confusion. It also fulfils its

purpose to stabilize future happenings by connecting the unknown future to the



known past. In this way the uncertainty is lowered and the desire to minimize the risk

is met. (Al- Omar et. al., 1996) According to Al-Omar, there should in Islam not be a

winner and a loser when doing business, but a partnership that will gain both parts.

2.5. The Islamic Banking System The environmental background and different categories of Islamic banks are

described. The concept of Islamic Banking is presented as well as the aims and

activities of Islamic banks in general.

2.5.1. Introduction It is hard to pinpoint the start of Islamic banking. Although financial transactions had

existed for a long time, there was, until the 14th century, no institution exclusively

devoted to banking. As mentioned above, one explanation for the late development of

Islamic financial institution could have been the powerful role of the existing

contracts. Another interpretation of the reasons why Islamic banks did not develop in

the Islamic world is that it had to do with the structure of economic life. For one

thing, Warde argues, finance was never an autonomous activity; it was always a

subset of commerce. Financial relationships were to a much greater extent embedded

in personal and communal ties in the Islamic world compared to the European

economies of the late middle Ages.

2.5.2. Environmental Background Western banking arose as a combination of two factors: the generation of capital by

means of deposits of the many on the one hand, and money lending and the provision

of credit for the few on the other. In the Islamic world, there was a disconnection

between deposit and credit, and the conversion of deposits into loans was therefore

not necessary. Credit and financing operations were conducted through transactions,

usually involving profit-and-loss sharing and, therefore, unrelated to safekeeping.

(Warde, 2000) Al-Omar claims that theoretical discussions and articles on Islamic

economics and banking led to the pioneering experiment in Egypt in 1963 (Al-Omar

et. al., 1996).



The experiment was based on the Mudarabah principle and lasted until 1967 – by that

time there were nine banks involved. The non-interest banks invested mostly in the

trade and industry sectors. The banks were not called Islamic banks for political

reasons; since the regime in Egypt feared it might be associated with fundamental

currents within the country. The banks were established to win the confidence of

farmers and workers in Egypt. Those people were more religious and traditionally

minded and shared no confidence in the secularized banks, which were run according

to Western laws. In Cairo and Alexandria, though, the Islamic banks had less success

when competing with the secularized banks. However, in 1967 the Islamic banks were

shut down for political reasons. (Samuelsson, 2000; Zineldin, 1990)

2.5.3. The Concept of Islamic Banking The Islamic bank is a mix of commercial bank and investment bank. The banking

operations must be compatible with Islamic norms. Furthermore they must be viable

and profitable overall because the system must protect the depositors and give them

an adequate rate of return. Islamic banks general objective is to develop the economy

within and according to Islamic principles. The banks can therefore under no

circumstances engage in the payment and receipt of interest, in alcoholic beverage

trade, in the gambling industry or in the pork meat trade, or any other activities

explicitly prohibited by the Shariah. (Al-Omar et. al., 1996)

Islamic banks operate on the basis of profit and not on paying and receiving interest.

The banks can earn profit from three areas: trading, leasing and by direct financing in

Profit-and-Loss-Sharing contracts. Different instruments are devised to earn profit in

any of these ways. The structure and conditions of these transactions must conform to the

Shariah and fulfill its desired objectives. This means that Islamic banks can extend

loans only if interest or return is not earned on it. The only way to finance

consumption activities, if at all, is through cost plus the capital, since there is no profit

to be earned or shared. The banks advance money for commercially productive

activities on the basis of profit-sharing principles. (Al-Omar et. al., 1996)

There are four principles of special importance for Islamic banking (Al-Omar et. al.,

1996, p 24)



There must be some risk, whether funds are used in commercial or productive

venture.

All funds should preferably finance socially productive activity:

Financial risk must lie solely with the lender of the capital and not with the manager

or agent who works with the capital;

Interest is prohibited in that it is a predetermined, fixed sum owed to the lender

irrespective of the outcome of the business venture in which the fund is used.” The

Islamic banking system aims at developing new financial instruments to deal with the

problems of the Muslim communities. This can be done by mobilizing internal

resources into a banking system conforming to Islamic teaching and principles. The

main objective is to make the financial system an efficient medium for intermediation

between savings and investments. (Zineldin, 1990)

The relationship between the bank and its clients is not the same for Islamic banks as

for conventional banks. In the former it is one of direct trading or equity participation

while in the latter it is that of lender/borrower. Islamic banks do not trade in debts as

conventional banks do. Suggestions have been made by some Muslim writers that the

financial intermediation sector should be nationalized. However, very few share this

opinion. Nationalization in general is not an authentic Islamic policy. It is considered

to violate the basic Islamic philosophy of free will and respect for private property.

(Al-Omar et. al., 1996)

2.5.4. Aims of Islamic Banks in general Prince Muhammed al-Faisal al-Sa´ud from Saudi-Arabia has said the following about

the aims of the bank Dar al-Mal al-Islami/Faisal Group (DMI). The following list can

be seen as rather representative of what Islamic banks state as their goals.

1. “To undertake all financial operations required by Muslims today in the

framework of the principles and precepts of the Shariah.

2. To implement its (DMI’s) various activities through subsidiaries to be established

in Islamic and other countries.

3. To invest, within an Islamic context, the funds of Muslims to generate licit profits.

4. To promote and consolidate co operations among Muslims.” (Ray, 1995, p16)

Ray suggests two additions to the list. The first is to promote economic and social

development in Muslim countries. The social aspect has been implemented through



the aims giving Zakath and creation of funds which Islamic banks employ (on a

limited scale) in charitable works. On the whole, Islamic banks have achieved

significant success in economic development by using participatory financing

methods such as Mudarabah, Musharakah and (rarely) interest-free loans. The other

aim must be the main motivating principle behind Islamic banking; to mobilize the

capital of the hundreds of millions of Muslim farmers, artisans, shop owners, and

other relatively poor people who have never put their savings in banks. (Ray, 1995)

The norm for an Islamic bank is to assess the profitability of a project and back those

projects which promise the highest rate of profit, are the safest and the most socially

beneficial. The primary basis on which the projects for PLS funding are selected is

their anticipated profitability rather than the credit-worthiness of the borrower. (Al-

Omar et. al., 1996)

The profits made by the bank are shared in two steps. First the profit is shared

between the bank and the business partner and then the bank’s profit is shared

between the bank and the holders of investment deposits. Let us say that the profit in

the business venture is $ 20.000 and the profit-sharing ratio is 50 per cent each. The

bank would then get $10.000 and the business partner $10.000 as a compensation for

his successful work with the bank’s capital. Clients with investment accounts are

entitled to a share in the profits of the activities done by the bank. The profit-sharing

ratio might be 40-60, that is 40 per cent of the profit goes to the bank and 60 per cent

is given to depositors. This means that $ 4000 stays with the bank while $ 6000 is

given to the depositors. (Zineldin, 1990)

2.5.5. Activities of Islamic banks Every bank must offer various accounts to attract different customers. Not all

customers have the same needs and wishes. The range of customers varies from

personal customer, business people, official customers, organizations and clubs to

societies. (Zineldin, 1990)

Some conventional bank activities are not conducted in Islamic banking. Interest, in

all forms, is rejected by the participants in modern Islamic banking. This includes

bonds, bank deposits, and certificates of deposits and the discounting of commercial



paper. Islamic banks can deal with commercial paper at it initial stage, or to

collect/accept it at face value. The majority of Islamic banks forbid the purchase of

stock in companies dealing with interest (including Western companies). Exceptions

do exist; for instance banks as al-Baraka accept trading of stock in Western firms.

(Ray, 1995)

Currency futures cause diversity among the Islamic banks; some forbid them while

others distinguish between two cases. The first case is where one currency is paid on a

spot basis and the other delayed; this is forbidden. The second permitted case involves

the future exchange of both currencies at the previously agreed rate. Future trading in

commodities is forbidden for gold and silver, but not for other commodities.

According to Ray currency options should be forbidden since it is necessary for

currencies to change hands without delay. Ray further argues that commodities or

shares options are acceptable in principle, but there is debate as to whether or not they

can be traded to third party. (Ray, 1995) Charges on issuing travelers cheques and

transferring money are also permitted is some banks. (Saeed, 1996)

2.6. Permissible Financing Methods Most types of trade (buying and selling) are permitted in Islam, where prohibition is

the notable exception. Yusuf ‘Ali (1991) translated the meaning of [2:275] thus:

Those who devour usury (riba) will not stand except as stands one whom the Evil One

by his touch hath driven to madness. That is because they say: ‘trade is like usury’,

but Allah hath permitted trade and forbidden usury. Thus, “Allah has permitted trade”

(bay‘) is the general rule, with Riba sales being a strictly forbidden exception.

A valid trade is concluded in Islam if the seller and buyer exchange an offer and

acceptance which specify the object of sale and the price, and they both agree. Yusuf

‘Ali (1991) translates the meaning of [4:29] thus: But let there be among you traffic

and trade by mutual good will.

Al-Bayhaqi and Ibn Majah narrated on the authority of ’Abu-Saıd Al-Khudriy that the

Messenger of Allah said (translation of the language in Ibn Majah): I shall meet Allah

before I give anyone something owned by an-other without his consent, for a trade



requires mutual consent. Not only is trading permitted, it is encouraged. Al-Suyutı

mentioned in Al-Jami, Al-Sagıra Hadith on the authority of Rafi that:

“The Prophet (Sal) was asked: “which are the best forms of income generation?”

He (Sal) replied: “A man’s labor, and every legitimate sale”.

Therefore, any financing conducted through valid trading by mutual consent is

permissible. However, since most Muslims lack sufficient knowledge regarding the

various conditions for a sale to be valid, contemporary jurists and financial

practitioners have limited Islamic banking and finance to a few “named” contracts.

Those are contracts that have been studied extensively by jurists over the centuries,

and whose validity is well established through the Prophet’s (Sal) own actions

(Sunnah), or consensus of the early Muslim communities and jurists (’ijma‘). To

further add credibility to the industry, the Arabic names for those contracts are often

used instead of their English counterparts (e.g. the term ’ijarah is often used instead

of its English counterpart “lease”). In what follows, I shall review the most commonly

used contracts in Islamic finance, utilizing both their Arabic and English names.

2.6.1. Cost-plus sales (Murabaha) In this sale, the buyer knows the price at which the seller obtained the object to be

financed, and agrees to pay a premium over that initial price. It was narrated that ’Ibn

Masud ruled that there was no harm in declared lump sum or percentage profit

margins. Thus, one may approach an Islamic financial institution and say “purchase

this item on my behalf at this price, and I shall give you a profit (Urbihuka) margin of

$10”, or “purchase this item on my behalf at this price, and I shall give you a profit

(Urbihuka.) margin of 10%”. The fact that the latter statement may be perceived to

make explicit a percentage payment should not be of concern, since it is not Riba if

the sale satisfies the conditions of Murabaha. Notice that in this contract, the Islamic

bank or financial institution must own the item at the time the customer buys it from

them with the specified profit margin.



2.6.2. Credit sales (Bay Bithaman Ajil) Very rarely is Murabaha used by Islamic banks with the price paid immediately by

the customer. In such cases, there would be no financing included, and the Islamic

bank would simply be a middle-man or broker-agent (Simsar). When a customer

approaches an Islamic bank to finance a purchase through Murabaha the payment of

the price is usually deferred, and most commonly paid in installments.

In such cases, it is easy to look at the end result and assume that this is simply a

juristic “trick” to circumvent the prohibition of Riba. However, this is certainly not

the case. Indeed, the Murabaha component determines a profit margin (even as a

percentage of the original price), and the deferment ensures that this profit is collected

over a period of time. The rate of return is thus guaranteed (up to the risk of default on

payments by the buyer) over a fixed period of time. Twenty-some year-old

misconceptions in the literature on Islamic banking would argue that this makes the

banks’ profits a form of Riba. However, it is curious to note that some of the

proponents of this view in the 1970s were themselves the pioneers of the field of

Islamic banking in the Arab Islamic countries and elsewhere. Those banks dealt

almost exclusively in the early years in instruments such as the one considered here

(and leases to which we shall turn shortly). It was only a matter of time for

sophisticated observers to note that those banks’ rhetoric contradicted their actions.

This early confusion about Islamic banking and finance continues to plague the

immigrant Muslim community in North America to this day.

Perhaps the source of the confusion is precipitated by the conjunction of the

deferment of the price payment and the profit rate. A seventh grader can calculate the

implicit annual interest rate in such a contract. However, traditional Islamic jurists

over the centuries have indeed permitted such a conjunction of increase with

deferment. In fact, they have explicitly justified the increase by the deferment. Al-

Misri (1997, pp.39-44) lists a number of quotes by traditional jurists of various

schools, illustrating the permissibility of increasing the price based on deferment.

Some jurists qualified this permissibility with conditions to ensure that other reasons

for prohibition (e.g. two sales in one, a sale and a condition in one contract, etc.) were

not present.



I shall only list a few of the quotations included in the above text to illustrate that

increasing the price due to deferment is without a doubt permissible:

Al-Kasanıin Badai Al-Sanai‘ (Hanafı masterpiece) said: “the price may be

increased based on deferment”

Hin (compendium of Hanafı jurisprudence): “a price. is increased if it is deferred”

Ibn Rush d (Malikı) in Bidayat Al-Mujtahid wa Nih¯ayat Al-Muqtas.id: “He has

given time a share in the price”

In Al-Majmam Al-Nawaw in Al-Subk¯I (Shıu‘by Al-’Imıand Taqiyud Al-Subki

(safi masterpiece): “deferment earns a portion of the price”, also in Hiyatash El-

Gamal ‘al¯aSh arh. Al-Manhaj (Shafiı), and Fatawa’ Ibn Taymiya (Hanbalı),

The contemporary confusion is hardly new. In ’Ibn Al-‘Arab ıs ’Aham Al-Quran, he

reports a specific argument given by the Arabs during the time of Prophet

Muhammad (Sal) to support their statement that “trade is like Riba” [2:275]. They

argued as follows: Consider a credit sale, with a price of 10 payable in a month. After

a month, the buyer and seller agree to postpone for one more month, and increase the

price to 11. The latter is forbidden Riba. They then argued: is this not the same as an

initial sale with the price of 11 deferred for two months? The answer in [2:275] was a

decisive “but Allah has permitted trade and forbidden Riba”.

The legal difference between the two is very clear: one is a sale in which price is

increased for deferment, and the other is an increase in the amount of a debt for

deferment. The first is permitted, and meets almost all the financing needs which can

be met through forbidden Riba-based lending. The second, however, is strictly

forbidden. The permissibility of the first and the prohibition of the second are both

quite clear and unequivocal. Therefore, we may use credit sales as a form of finance,

and we must categorically avoid interest-bearing loans. Why one is permitted while

the other is forbidden can only be fully known by Allah and whomsoever he gave

such knowledge. As a practical matter, we should know what is permitted and use it

to our advantage and what is forbidden and avoid it.



2.6.3. Leasing (Ijarah or Ijar) Legally, the lease contract is not a sale of the object, but rather a sale of the usufruct

(the right to use the object) for a specified period of time. The sale of usufruct is

permissible in Islam, as evidenced by the verses (translation of meaning by Yusuf Ali

(1991)):

And if they suckle your offspring, give them their recompense. [65:6] Said

one of them: ‘O father, hire him on wages, for truly the best to employ is a

strong and trustworthy man’. He said: ‘I intend to wed one of my daughters

to you, on condition that you work for me for eight years, and if you

complete ten full years, that will be a grace from you’. [28:26-27]

It is also established by the following Hadith narrated by ’Ahmad, ’Abu Dawud, and

Al-Nasaı on the authority of Sad (Rali):

The farmers during the time of the Prophet (Sal) used to pay rent for the

land in water and seeds. He (Sal) forbade them from doing that, and

ordered them to use gold and silver (money) to pay the rent.

Also, ’Ah.mad, Al-Bukharı and Muslim narrated on the authority of ’Ibn Abbas (Rali)

that the Prophet (Sal) hired a man to cup [water] for him, and paid him his wages.

There are a number of conditions for lease-financing to be valid (the in-terested reader

may refer to M. Taqi Usmani (1998, pp. 157-174) for a partial list). The most

important financial difference between Islamically permitted leasing and conventional

financial leasing is that the leasing agency must own the leased object for the duration

of the lease. Therefore, while leasing an automobile from a car manufacturer or

dealership may in principle be permitted (if the contract satisfies the other conditions),

Muslims should be careful. In many cases, the dealership will in-fact use a bank or

other financial intermediary to provide a loan for the present value of lease payments,

and charge the customer an interest on this loan. This would constitute the forbidden

Riba. Careful Islamic financial institutions ensure that the contract abides by all the

restrictions set in the Shariah (e.g. sub-leasing requires the permission of the lessor,

late payment penalties must be handled very carefully to avoid the forbidden Riba,

etc.).



Recently, Muslim jurists have also provided an Islamic alternative to conventional

lease-purchase agreements (called in Arabic ijarah waiqtina’). In this contract, a lease

is written as discussed above, with an additional promise by the lessor that he will

agree to sell the leased object at the end of the lease at a predetermined residual value.

This promise is binding on the lessor only, and the lessee has the option of purchasing

the item at the end of the lease, or returning it to the owner-lessor (c.f. ibid. (pp.175).

A common model for equipment, auto and home financing in North America is based

on leasing or lease-purchase. The Islamic financial institution buys the financed

object, and retains the title through the life of the contract. The customer makes a

series of lease payments over a specified period of time, and may have the option at

the end to buy the item from the lessor (and owner) at a pre-specified residual value.

The period of the lease and the rent payments may be made such that the final

payment is only symbolic.

It is no secret (at least it should not be a secret) that the Islamic bank or financial

institution will take into consideration the same factors when determining the rental

payments and residual value that a regular bank would consider: the value of the

financed item, its depreciation value, inflation, the credit-worthiness of the lessee, the

opportunity-cost value of the money (as reflected by market interest rates), etc. Of

course, an implicit “interest rate” can trivially be calculated from the price, residual

value, term of the lease and the lease payment. There is no need to hide this fact, and

indeed, the intelligent Muslim customer (as Muslim customers should always be)

must be encouraged to “shop-around” and ensure that the Islamic financial institution

is not implicitly charging an interest rate which is not in line with the conventional

market. However, in the final analysis, the difference will be in the form of the

contract. If the lease is structured in accordance with the various conditions detailed in

books of jurisprudence, it will contain no Riba and will ensure that it cannot contain

such forbidden Riba in the future (e.g. in terms of late payment fees, etc.).



2.6.4. Partnerships (Musharakah and Mudarabah) Various forms of partnership can be direct financing methods. In the early days of

Islamic banking and finance, those forms were commonly grouped under the banner

“profit and loss sharing”, to be contrasted with the above listed debt-based forms of

financing. It was assumed by some that the profit and loss sharing methods were

somehow more ideal from an Islamic point of view. The fact that most Islamic

banking practice concentrated on credit sales and leases was thus often lamented as

re-labeling of the forbidden inter-est. As we have already seen, if the Islamic banks

and financial institutions are careful to abide by the rules of Shariah, there is no

reason to think that credit sales are any “less Islamic” than a silent partnership

(Mudarabah) or full partnership (Musharakah number of rules in Musharakah

regarding the language of the various partnership contracts, the rights and obligations

of various parties, and the sharing rules for profits and losses.

Most of the users of such partnership contracts will require the services of legal

experts in any case and therefore should also consult Islamic legal experts on the

legitimacy of any specific contract. Therefore, there is no need to spend much time on

those general contracts.

However, one model of financing which has been used in North America is based on

a form of Musharakah, where the financing agency and the customer share the

ownership of real estate. This contract is known by many names; most prominent

among them is the name mushaqisah (diminishing partnership). In contrast to the

leasing model, where ownership of the financed item remains with the lessor for the

entire lease period, ownership in a diminishing partnership is explicitly shared

between the customer and the Islamic financial institution (legally, what is established

is an Islamic sharikat al-milk). The periodic payments of the customer in this model

contain two parts: (i) a rental payment for the part of the property owned by the

Islamic financial institution, and (ii) a buy-out of part of that ownership. Over time,

the portion of the asset which is owned by the customer increases, until he owns the

entire asset and needs to pay no more rent. At that time, the contract is terminated.



Examining the periodic payments, the customer will find that they look very much

like a conventional mortgage schedule. Early-on, a large portion of the payment is

“rent” (corresponding to “interest payment” in conventional mortgage), and a small

part is “buy-out” (corresponding to the “principal payment” in a conventional

mortgage). As time progresses, the first component gets smaller, and the latter

component gets bigger, until the rent becomes zero when the customer owns 100% of

the asset. Given this one-to-one correspondence between the two components of the

payments, it is again trivial to calculate the equivalent interest rate which would make

the conventional mortgage payments identical with the diminishing partnership

payments.

Again, this should not be cause for concern, as long as the partnership contract is

written in full accordance with the rules of Shariah (for a partial list and general

discussion, see M. Taqi Usmani (1998, pp. 31-92)). For in-stance, there is a

fundamental difference between a mortgage company which holds a lien on a

financed house, and the actual joint ownership of the house between the client and the

Islamic financial institution. There are a variety of issues which such institutions need

to resolve to operate in compliance with Shariah as well as government regulations,

and the intelligent Muslim customer is again encouraged to ensure that both sets of

regulations are met. As for the correspondence of the “rental” portion of payments to

what would be an interest payment on the principal balance in a conventional

mortgage, this should afford the intelligent Muslim customer an opportunity to ensure

that he is not being charged excessively relative to the conventional market. As far as

compliance with the Islamic Shariah is concerned, the form of the contract is what

matters. To keep the Islamic financial industry from creeping excessive profits at the

expense of devout Muslims with few alternative sources of financing, this comparison

to conventional market trends is very valuable.

2.6.5. Islamic forwards (Salam and Istisna) Those forms of financing are very rarely used, and hence will be mentioned only in

passing. In general, the sale of non-existent objects is forbidden due to Gharar.

However, to facilitate certain types of business, exceptions were given through those



two contracts. The six major books of Hadith narrate on the authority of ’Ibn ‘Abbas

(Rali):

The Messenger of Allah (Sal) came to Madınah, and found its inhabitants

entering Salam contracts (with the price paid in advance) in fruits for one,

two, and three years. He (Sal) said: “whoever enters into a Salam contract

let him specify a known volume or weight, and a known term of deferment”.

Thus, he (Sal) permitted this trade, where the price is paid in full, and the well-defined

object of the sale is delivered after a specified time. This pre-payment of the price

allowed the farmers to buy seeds, spend for their own sustenance, etc., in order to be

able to produce the fruits.

Most jurists reasoned by analogy (Qiyas) and preference (Istihsan) from the

permissibility of Salam to the permissibility of Istisna, which may be translated as

“commission to manufacture”. In the latter contract, the price is paid in installments

as the work progresses in manufacturing or building an otherwise non-existent object.

The price pre-paid in installments in this case will often be lower than the cost of

purchasing the finished product (if it were to exist), and can therefore be a useful tool

for building schools, Masjids, etc. Those two contracts are permitted as exceptions to

the general rules of sale. As such, there are many conditions which must be met for

Salam or Istisna contracts to be valid. Those considering the use of such contracts are

advised to consult an Islamic Legal expert along with their other lawyers to ensure

that they abide by Shariah as well as government regulations.

2.7. Advantages of Islamic Finance This section examines Islamic finance from several sides, including efficiency,

stability, moral hazard and adverse selection, role in economic development, integrity,

equity and sustainability.

2.7.1. Efficiency At the macroeconomic level, Islamic finance avoids the use of interest-based lending.

The rate of interest is replaced by the rate of profit on equity and profit-sharing

finance, by markups on credit-purchase finance and by rental rates on leasing finance.



While the time-value of money is maintained, there is no need to handle the

complicated questions of how to bring the rate of interest down to zero in order to

reach the optimal allocation of resources.

Conventional finance allocates financial resources with paramount regard for

borrower’s ability to repay loan principal and interest. In modes of Islamic finance

that are based on equity and profit sharing, focus would be on the profitability and

rate of return of the concerned investment. This type of finance has the potential of

directing financial resources to the most productive investments. This would increase

the efficiency of the financing process and reinforce efficiency in the real sectors.

2.7.2. Stability A conventional bank has on the one hand liabilities that include demand, time and

saving deposits, which the bank guarantees. On the other hand, it has assets that are

mostly composed of debt instruments each of which has a quality that depends on the

ability of the corresponding debtor to repay. Default on the asset side, if it happens in

significant proportion, would imply inability to meet the bank’s obligations on the

liability side. Such default can be expected at times of crises, be it of macroeconomic

nature or caused by circumstances specific to the bank. A bank operating according to

Islamic rules of finance has liabilities of different nature. Only demand deposits are

guaranteed. Meanwhile, investment deposits are placed on profit-and-loss sharing

basis. When such bank faces macroeconomic or specific crises, investment depositors

automatically share the risk. The bank is less likely to fall and a bank run is less

probable. It can therefore be said that an Islamic banking system is relatively more

stable when compared to conventional banking (Khan, 1986).

In conventional finance, present money is traded in an integrated debt market against

future money, which takes the shape of commitments to pay specified amounts at

specified future dates, or bonds. Bonds are supposed to be easily traded financial

instruments, many of which are listed in international financial markets. Hundreds of

billions of dollars of debt are traded daily in those markets. Bonds markets provide an

easy and automatic mechanism through which short-term funds flow at will from one

country to another. Much of those flows follow factors that are only nebulously



related to economic fundamentals. They bring an important element of instability into

national economies. They threaten the world economy with the spread of instability

that might start in one single debt market in a fashion that economists have come to

call “contagion.” The integrated debt market has grown immense in size as well as in

scale of integration that now encompasses the whole world economy. Many

experiences, as lately manifested in the Southeast Asian economies, have shown that

integrated debt markets are sources of both domestic financial instability and

contagion. Some economists have come forward with proposals to place restrictions

on capital movements in contrary with what has been considered in economics as

received doctrine.

In contrast, debt is created in Islamic finance through selling goods and services on

credit. Resulting debt instruments are not readily tradable. We can visualize the

existence of a credit market for each commodity and service in which the demand and

supply to buy it on credit determines a mark-up rate. Such credit markets would be

fully segmented, while the debt instruments themselves are traded only for nominal

values at maturity. There is no room for sudden and mass movements of funds.

Possibilities of instability and contagion through the debt market would therefore be

remote and the justifications to choke capital movements with restrictions become

unnecessary.

Examination of daily records of trading in financial markets vividly shows that

institutional participants carry out huge speculative transactions. More often than not,

such transactions are sources of instabilities. In contrast, Islamic financial institutions

are automatically prevented from carrying out such gambling activities; destabilizing

speculations would be significantly curtailed in financial markets.

We have noted above that Islamic finance never provides present money in return for

future money. All Islamic modes of finance involve money on the one end and goods

and services on the other. Monetary flows through Islamic financial modes would

have to be tied directly with commodity flows. In other words, Islamic finance

removes the dichotomy between financial and real activities. Obviously, this leaves

little room for excessive credit expansion, as the finance extended is automatically

earmarked for specific uses.



Speculative activities related to interest rate expectations would become out of place.

Changes in spending would automatically be reflected on changes in demands and

supplies of goods and services, causing quantities of output produced to respond more

quickly to market forces. In other words, markets are more likely to operate

efficiently and smoothly. It is therefore interesting to note that Islamic finance, though

non-conventional, supports market forces and mechanisms more than does

conventional finance.

2.7.3. Moral Hazard and Adverse Selection We have mentioned above that Islamic banks hold equity and trade in goods and

services as they operate as universal rather than commercial banks. Universal banks

are defined as “large-scale banks that operate extensive networks of branches, provide

many different services, hold several claims on firms (including equity and debt), and

participate directly in the corporate governance of the firms that rely on the banks as

sources of funding or as securities underwriters“(Calomiris, 2000).

A bank can be exposed to moral hazard when the firm obtaining finance uses the

funds for purposes other than those for which finance was advanced. This could lead

to business failure and inability to repay on part of the debtor firm. The bank would

be exposed to adverse selection when it fails to choose the finance applicants who are

most likely to perform.

Obviously, adverse selection can be avoided by careful screening of finance

applicants. When a bank provides equity and debt finance simultaneously, it will have

more access to information than when only debt finance is provided. We can therefore

conclude that screening would be more effective and adverse selection less probable

with universal banking.

Reducing possibilities of moral hazard requires monitoring the firm that obtains

finance. All three kinds of ex ante, interim and ex post monitoring must be exercised

to be effective (Aoki, Masahiko, 1994). Equity finance provides the bank with access

to information necessary to practice monitoring at all intervals. It also reduces the

firm incentives to substitute riskier for safer assets. Meanwhile, debt finance would



reduce the firm incentives to hide its profits. Furthermore, when the firm faces

problems, the bank, as an equity holder, will assist in order to protect its investment.

In summary, banking theory indicates that universal banking would be exposed to

lower levels of moral hazard and adverse selection. In addition, by sitting on the

firms’ board of directors, banks could influence corporate governance in the whole

productive sector, leading to improvements in economic performance. Empirically, it

has been found that using a combination of debt and equity finance by banks seems to

carry several advantages to both banks and firms, confirming theoretical findings.

Banking theory would indicate that banks would be relatively more exposed to

adverse selection during economic upturns and to moral hazard during downturns.

Applied research has found that universal banks face lower risk than commercial

banks during both upturns and downturns. In addition, the risk differential between

universal and commercial banks gets wider and more significant during downturns

(Dewenter and Hess, 1998).

2.7.4. Finance And Development Given the characteristics of Islamic finance mentioned above, particularly the fact that

Islamic banks operate according to the rules of universal rather than commercial

banking, we can ask which system gives better support to economic development. In

this regard, we can intuitively conclude that the practice of universal banking by

Islamic banks put their financing activities right in the center of the development

process. Bankers in this case become both partners and financiers of entrepreneurial

efforts to develop the economy. Empirical findings seem to confirm such intuition.

Calomiris (2000), through his study of pre-World-War I Germany, has found that

universal banking served to reduce the cost of financing industrialization in Germany

relative to its corresponding level in other countries where commercial banking is

prevalent. He also found that the financial sector reached a higher level of a locative

efficiency in the former than in the latter country. We can therefore rest assured that

banks operating as universal banks give better support to development efforts.

It is widely accepted that economic development requires mobilization of vast



financial resources both internally and externally. Any financial resources left

hoarded would imply unrealized potential for economic development. As Islamic

teachings emphatically prohibit trading present for future money at a rate of interest,

many Muslims hold their funds outside the banking and financial sector, thereby

missing an opportunity to apply those funds to the development process. Islamic

finance opens the door to the effective use of much needed financial resources within

many Islamic countries that would be otherwise kept idle. In addition, it provides

Muslims with a way through which they can participate in the development process

without exceeding their religious beliefs. Muslim minorities in other countries, whose

banking systems do not provide Islamic financial products, suffer from cultural

exclusion. Some of those Muslims may have to keep their savings outside the

financial system thereby contributing to idle financial resources in their countries.

2.7.5. Integrity Conventional finance can be likened to a spectator’s game where few skilled players

stay in the playground and a big crowd is watching from outside. Islamic finance,

meanwhile, is similar to participatory sports, where everyone is playing and no one is

concerned with mere watching. In addition, there is a moral side to Islamic finance

that seems to be in the back of mind of everyone.

Risk is known to be one of the most important ingredients of making investment.

Those who finance investment share a good part of the risk involved with those who

carry out actual investment activities. Conventional finance leaves risk to be borne by

specialists. Banks and financial institutions provide investors with loans guaranteed

by collateral. In this fashion, they keep themselves apart from certain kinds of risk,

like those attached to production, marketing and distribution, and limit their exposure

to risk related to collateral only.

Islamic finance allows savers who deposit their funds to share with banks the risks

associated with choosing the right investment and how successful it would be. Banks

and financial institutions advancing funds share risk with those receiving finance,

including producers, traders, and the like. Islamic finance with proper corporate

governance allows depositors some influence on banks investment decisions and



allows banks and financial institutions a share in the decision-making process, by

sitting on the boards of directors of firms receiving funds.

We can therefore notice that risk as well as decision-making is spread over a much

larger number and wider variety of concerned people. Risk sharing is balanced by

sharing in decision-making. This allows for wider involvement in economic activities,

so that people will eventually feel they are partners rather than spectators.

The benefit of wider involvement goes beyond the mere feeling of involvement. It

adds to the stability of banks. Holders of investment deposits with banks share in both

the profits and losses. When a bank faced the unlikely event of an overall loss over

the placement of its investment pool, its depositors shoulder their proportional share

of the loss. Individual banks as well as the banking system as a whole would therefore

be less likely to break down.

2.7.6. Equity Islamic financial institutions must be viewed as basically private profit-seeking

business enterprises that operate according to the market mechanism. By themselves,

they cannot reduce, let alone, eradicate poverty. However, if given the right tools,

they can contribute to the efforts taken by the whole society in that regard.

Islam prescribes a tax-subsidy approach to reducing poverty. A levy called Zakath is

paid out by the wealthy (those whose wealth exceeds a certain minimum level) in

proportion to their property.

Zakath proceeds are to be earmarked for several uses including income and wealth

maintenance for the poor. Income maintenance is provided within narrow limits to

those incapable of work and wealth maintenance is provided to the rest of the poor.

The latter policy entails giving the poor productive assets, which they can use to

produce goods and services and sell them for profit. This method of poverty reduction

can be closely intertwined with that of economic development, as redistribution is

mostly directed towards making the poor more productive, which in turn contributes

to economic development.



Income maintenance would involve regular (monthly) payments to the needy. Wealth

maintenance, meanwhile, involves transferring to the poor a combination of

productive resources, which would be capable of generating sufficient income to

maintain at least one household.

Zakath collection would be expected to be carried out mostly by nongovernmental

and sometimes by governmental organizations. Islamic banks can help by acting as

custodians and in the disbursement of the proceeds. In addition, non-banking financial

institutions can also take part in collecting Zakath, using Islamic banks as

depositories, and invest the proceeds allocated to the poor in special accounts with

Islamic financial institutions, to which they would also add a proportion of Zakath due

on their shareholders equity. They can even accept direct payments of Zakath and

other donations on behalf of philanthropic institutions.

As to income maintenance, Islamic banks and financial institutions can credit the

accounts of the prescribed poor with monthly payments. Wealth maintenance can be

implemented through the establishment of micro enterprises that would be owned and

operated by the poor. While, the titles to such enterprises are transferred to the poor,

certain measures must be taken to insure that the new businesses would not be

immaturely liquidated to finance consumption outlays for their owners. The

experience of Islamic banking and financial institutions in project financing should

come in handy in eradicating poverty and increasing equity through proper use of

Zakath proceeds.

Conventional lending gives utmost attention to the ability to repay loans. To ascertain

such ability, it depends overwhelmingly on the provisions of collaterals and

guarantees. Thus those already rich would have most access to finance. In contrast,

Islamic finance providing funds on equity or profit-sharing basis would be more

concerned about profitability and rate of return and less concerned about collateral as

the primary consideration. Those who are not wealthy, but have worthy investment

projects, would have more access to finance.



2.7.7. Sustainability Conventional debt has certain characteristics that could place debtors in difficulties if

circumstances do not allow them to repay in time. Interest is usually calculated on the

outstanding balance of debt, usually compounded annually and sometimes at shorter

intervals. Delinquent debtors are often subjected to penalty rates of interest, which are

higher than regular rates. It is not uncommon to find borrowers who end up paying

debt service that is many folds the original principal they borrowed. This is

particularly symptomatic of developing countries debt, as they continue to face debt

problems that sometimes reach crisis levels. Creditor countries and institutions have

often sought to find ways and mechanisms to provide debt relief to debtor countries.

Despite continuous efforts, the debt problems faced by developing countries seem to

be ever-present.

We can therefore conclude that interest based financing lacks a great deal of

sustainability. Creditors have to stop every few years to give debtors relief in terms of

rescheduling and forgiveness. Sometimes this also includes floating low quality debt

at lower market value and swapping it with equity. The system has demonstrated

unsustainability several times. Unconventional debt created through Islamic finance

has characteristics with which debt crises are less likely to rise. Particularly, the total

value of debt, which includes the spot value of Commodities purchased on credit as

well as an implicit mark-up, is set from the very beginning. The total value of debt

can be repaid in installments, without increase in its total value, as there is no

compounded interest to pay on outstanding balance.

When debtors face unavoidable circumstances that would make them temporarily

insolvent, they are often granted grace periods to help them bring their finances back

to order. No penalty fees can be levied in this case. In other words, debt

rescheduling, when justifiable, would be granted at no extra cost to borrowers.

Therefore, we can conclude that Islamic finance is sustainable and less liable in itself

to cause undue hardship to debtors.

Quite often, conventional debt cannot be repaid because it was not used for its

prescribed purpose. Under the rules of conventional finance, creditors assume that the

use of the loans they extend would strengthen the ability of debtors to meet their



future obligations. However, conventional loans are usually offered without ways or

mechanisms to assure their use for certain purpose. In contrast, Islamic debt is created

through the finance of acquiring goods and services on credit. In other words, the

loan is used from the very beginning for its prescribed purpose. Default resulting

from improper use of borrowed funds would therefore be most unlikely.

As Islamic finance provided to finance investment is asset-based, i.e., it is used to

acquire real assets; it is much less likely to lead to debt crises. Such type of asset-

based finance, directly contributes to the ability of the economy to meet its internal

and external financial obligations. This is certainly a welcome effect.

2.8. Challenges Facing Islamic Banking 2.8.1. Financial Engineering “Financial engineering”, as the word indicates refers to the art of designing financial

products to meet the needs and tastes of the users with regard to risk, maturity and

yield. Financial markets are becoming more and more sophisticated, and competitive.

In order to exploit the fast changing market environment and face increasing

competition, financial engineering and innovation is imperative. Until now, the

Islamic financial tools have essentially been limited to classical modes developed

centuries ago. They were developed to meet the needs of those societies. While they

may serve as useful guidelines for contemporary Islamic contracts, there is no reason

to be restricted only to those.

In the light of the principles of Maslaha and Istihsan, a “needs approach” to financial

engineering is desirable, of course within the known principles of Islamic finance. In

this regard, the example of bai‘Salam is very important to remember. In general, it is

not allowed to sell anything, which is not in one’s possession. But in case of Salam,

the Prophet (Sal) allowed such sale because of “need” of the people, but laid down

clear rules to protect the interests of both parties. Financial needs of both individuals

and businesses have changed. Engineers in modern finance have designed several new

ways such as mortgages, options, derivatives, hedging, insurance pension plans, credit

cards etc., to meet those needs. We must examine what needs are being fulfilled by



these instruments. If the needs are genuine (Islamically speaking), then we must either

adapt them for our purposes or invent Islamic alternatives for them.

The process of adaptation is well recognized in Islamic fiqh and has never stopped.

However, its speed needs to be greatly enhanced. Classical contracts have been

modified in a number of cases to meet current needs. One potent example is the

initiation of Islamic banking on the basis of Al-Mudarib Udarib principle, which

provides that a Mudarib (agent) may himself appoint another agent to actually run the

business. Another is the practice of Murabaha, through which the bank buys

merchandize upon the promise of another party to purchase it from the bank at a

higher price.

The principle of Al-Mudarib Udarib essentially allows for sub-contracting. If the

principle is acceptable, there is no reason to restrict it only to Mudarabah. Contracts

can also be designed on the basis of other principles, like Al-Muajjar Uajjir, Al

Mustasna’ Yastasna’, etc. In other words, the original contractee may arrange to fulfill

the obligations under the contract through third parties. That the principle is

acceptable from an Islamic point of view is not questionable.

While it is possible to modify classical contracts to suit modern conditions, a much

broader scope for financial engineering exists in developing new contracts. These

contracts could be hybrids of old contracts or may be entirely new. The scope for

financial engineering, and for that matter for innovations in other fields, is quite wide.

It is important that the task is given over to those experts who know the needs and

niceties of the trade. The final contract may be, say a, Leasalam contract (a

combination of leasing and Salam), an Ijarka contract (a combination of ijarah and

Musharakah) or even an entirely new product.

2.8.2. Some Other Shariah Issues Because of the religious dimension of Islamic banking and finance, no new product

can be adopted until it is cleared by Shariah scholars. Even after a new product is put

into use, Shariah auditing of the operations of financial institutions is very important

to ensure that the actual practice complies with the requirements of Shariah. This is



important not only for religious reasons but also for purely business considerations

because the clients of Islamic banks will not have confidence in their operations

unless Shariah scholars clear their activities. In this background, the expertise of fiqh

scholars in understanding the pre-requisites of modern financial products and in

evaluating these products becomes very important.

Almost all Islamic banks have their own Shariah boards or Shariah advisers. A survey

of the members of these boards would reveal that hardly any of these scholars have a

formal training in modern finance. They are using a number of ways to acquire the

necessary background information before issuing a fatwa. One way is to discuss an

issue in meetings/ workshops attended by both Shariah scholars and financial experts.

Institutions working in the field of Islamic economics, banking and finance are

playing an active role in organizing such workshops. However, these workshops have

no mandate to issue a fatwa. For that purpose, the meetings of the Fiqh Academies,

the most prominent among which is the OIC Fiqh Academy in Jeddah, play an

important role. Those academies also commission a number of studies by specialized

experts on specific issues before discussing them and taking a decision. In the absence

of the required expertise in the field of finance among Shariah scholars, this approach

of group ijtehad is playing an important role in safeguarding against serious mistakes

in adopting doubtful instruments.

The situation is, however, far from being ideal. As any participant of the workshops

and meetings of the Fiqh Academies can notice that the interaction between Fiqh

scholars and the experts of modern economics and finance does not always proceed

smoothly. They have so different backgrounds and speak such different technical

languages that the communication between them requires special effort. It is,

therefore, quite understandable that the Shariah scholars are cautious in giving their

rulings. The result has been that the fatwa-giving process has become extremely slow

and tends to be over-conservative.

The past record shows that Shariah bodies have done a commendable job in

evaluating the applications of classical contracts. However, when it comes to

evaluating modern financial contracts or Islamic substitutes for them, Shariah bodies

have found it quite difficult to issue verdicts. This is basically due to an acute shortage



of scholars with dual specialization or at least having working knowledge of modern

finance and Shariah at the same time.

Another important issue relating to the Shariah boards is to determine their exact role.

As mentioned before, questions have been raised about the autonomy and powers of

these boards. “Supervision” by definition implies autonomy and independence in

decision-making. This does not seem to be the case. Furthermore, Shariah boards of

different banks could issue different rulings on similar practices which may raise

doubts in the minds of clients. Minimum Shariah standards for each type of contract

issued by an autonomous body will go a long way to assure customers of the “Shariah

compatibility” of those contracts as well as actual operations. This need becomes

more important in the wake of the entry of several Western banks in Islamic banking.

2.8.3. Teaching, Training, Research and Development Teaching, training and research are the wherewithal for the development of any

discipline. This is more so for a discipline like Islamic banking and finance, which is

still nascent. As mentioned above, there is a serious shortage of scholars who possess

even a working knowledge of both Islamic fiqh and modern economics and finance.

Similarly, many managers of Islamic banks are not very well trained in the use of

Islamic modes of finance. Unfortunately, very little effort has been made to meet

these requirements.

In the area of teaching, some universities in some Muslim countries particularly,

Egypt, Saudi Arabia, Pakistan and Malaysia have initiated some teaching programs to

produce graduates with the dual specialization. However, a close examination of their

curricula would reveal that they are not well designed to achieve this objective. This

may also be confirmed by the fact that the Islamic banks have not been able to find a

reasonable number of suitable managers from the graduates of those universities nor

could anyone of them find a place in the Shariah board of any Islamic bank.

In the area of research, the Islamic banks, neither individually nor as a group spend

enough amount on research and development. Some Islamic banks have small units

for research but very little of this research activity is designed for product



development. It is, therefore, not surprising that the Islamic banking industry has not

been able to produce enough new financial products. The Islamic universities and the

few research institutions working here and there have not received any substantial

financial assistance from Islamic banks. Another very important component for useful

and scientific research is the availability of authentic information. This has not

received much attention from Islamic banks. There is no consistent data series on the

activities of Islamic banks for a reasonable number of years available anywhere.

In the area of training, a small effort was made in early 1980s by establishing a

training institute in Cyprus. Due to certain reasons, this institute has been closed. The

managers of Islamic banks may have been attending some short-term courses either

on the job or elsewhere but there are not many formal training programs meant to

prepare the employees of the Islamic banks for the needs of the system. Most of the

employees of the Islamic banks, including the managers and financial experts come

from traditional sources lacking necessary expertise in Islamic banking. An institution

is what its employees make it. Therefore, it is extremely important to have the people

with the right kind of skills and commitment.

The future of Islamic banking and finance crucially depends on teaching, training and

research in the desired specialization. There is also a need to arrange short courses for

Shariah scholars in economics and finance and similar courses for economists in

Shariah. The efforts in this area need to be enhanced to several times of current levels.

2.8.4. Lack of Profit Sharing Finance Islamic financial transactions are two kinds. One is based on fixed charge on capital

and the other is based on profit sharing. Both kinds provide finance through the

purchase and sale of real commodities. Conventional financial transactions are based

on lending and borrowing of money for a fixed charge (interest).

Islamic economics specialists built up their hopes on Islamic banks to provide a significant

amount of profit-sharing finance. This would have economic effects similar to direct

investment and produce a strong economic development impact. Theoreticians have provided

some arguments in favor of profit-sharing finance over fixed return-on-capital finance.



However, in practice, profit-sharing finance has remained negligible in the operations

of Islamic banks. Reasons for this are numerous seen from the perspective of the

Islamic banks and their clients. From the perspective of firms as fund users, it is

important to note that those financial contracts, which do not impose restrictions and

encourage re-investment of earnings in the firm’s growth, are more preferable. The

profit sharing contracts have not been properly adapted to this requirement of firms as

ongoing concerns. From the perspective of the banks, it appears that there are

significantly higher costs of placing funds on profit-sharing basis. The choice of the

right project to finance requires feasibility studies, technical and financial evaluation.

The cost of such effort usually exceeds that of fixed return placements. In addition,

profit-sharing arrangements require follow-up and provision of technical and

sometimes additional financial support to entrepreneurs. In all cases project managers

must have a good accounting system and be subjected to scrupulous auditing.

The Islamic banks can be encouraged to provide more profit-sharing finance, if

arrangements are made to reduce the costs involved by institutional appropriate

arrangements as well as financial engineering consistent with the preferences of fund

users. The benefits of direct investment in terms of economic development may not

always be fully reflected in the rate of return. However, they occur to the society as a

whole. It may, therefore, pay to support the involvement of Islamic banks into profit-

sharing finance through some of the following arrangements.

Take care of the genuine concerns of the clients with regard to their requirements

and preferences for funds,

Undertake entrepreneurial promotion activities by using appropriate incentive

compatible financial arrangements,

Giving tax incentives to companies working on project feasibility studies and their

evaluation,

Giving Islamic banks tax incentives to use the services of investment auditing

companies,

Enforcement of sound accounting practices on small and medium size enterprises,

and

Creating a special department in Central banks through which information of

project feasibility and evaluation can be exchanged in addition to provision of

technical assistance to Islamic banks when needed.



Banks, under the present circumstances, cannot afford to increase their risk exposure

to any large extent. The emphasis should rather move to a greater reliance of

businesses on equity and smaller reliance on credit. For this purpose attempts should

be made to increase the number of equity institutions such as mutual funds, unit trusts,

etc. Nobody denies that Murabaha and leasing are permissible modes of financing.

They also have some desirable features such as simplicity, convenience and safety.

Under present circumstances, financing modes like Murabaha are indispensable. They

are serving a useful purpose, that of providing investors high liquidity with low risk.

Until proper institutional set up is built and needed products, including those for

managing risk are developed, it may not be advisable to drastically increase the use of

risky modes. However, several problems have been noted in the way Murabaha is

being used. Serious attempts should be made to “cleanse” the “quasi” Murabaha being

practiced by many banks at present of the undesirable features, to make it “genuine”

Murabaha. Islamic banks must ensure that the conditions specified by jurists for the

use of these modes are strictly observed.

However, an overwhelming use of these modes by Islamic banks in the absence of

other Islamic financial institutions has led to some undesirable results for Islamic

finance scene. These include:

2.8.5. Defaulters and the Issue of Compensation and Penalties By using fixed rate modes of financing, the Islamic banks are able to side step the

problems of moral hazard and adverse selection. But precisely because of the same

reason, i.e., use of debt as compared to equity, they land themselves into a serious

problem. Murabaha deals create debt obligations against buyers. Now, while it is

permissible to charge a higher price in credit sales as compared to cash sales, the

wherewithal of Murabaha mode of financing, once the deal has been entered, it

creates a fixed liability. If the buyer defaults on his payment, banks cannot charge

anything extra because that would mean taking riba. Thus, there is a built-in incentive

for immoral buyers to default.



Islamic jurists have been discussing this problem. It is generally agreed that penalties,

both physical and financial, can be imposed against defaulters but the bank cannot get

any benefit out of these penalties. Many contemporary scholars have argued that the

banks can be compensated because a damage has been caused by the defaulter and

Islam permits, rather encourages compensation of damages. The issue still remains

unresolved.

2.8.6. Illiquidity of Assets Another problem caused by the predominance of debt-based modes of financing is

that it is difficult to transform these financial modes into negotiable financial

instruments. Once a debt has been created, it cannot be transferred to anyone else

except at par value. This renders the whole structure of Islamic financial market as

highly illiquid. This is one of the major obstacles in the development of secondary

markets in Islamic financial instruments. Unless equity-based modes become more

popular or other negotiable instruments are developed, the Islamic financial markets

will remain undeveloped. Some attempts are being made to develop negotiable

instruments based on Ijarah and Salam. However, these have not been used to any

significant extent so far. The major hope for developing Islamic secondary markets

lies in a wider application of equity-based financial instruments and securitization of

some of the existing modes With the exception of Ijarah.

2.8.7. Short-Term Asset Structure Banks everywhere prefer short-term investments. This is so because they work on the

basis of small reserves. They have to have the ability to liquidate their assets fairly

quickly, if the need arises. In the case of Islamic banks, the short-term structure of

their assets is even more pronounced. This also has to do with the predominance of

Murabaha among the modes of finance. Murabaha, a trading practice, by its very

nature is a short-term contract. Even though it is conceivable to design an installment

sale Murabaha contract spreading over many years, the needs for which the Murabaha

contract can “genuinely” be used are, by and large, short term. Therefore, Murabaha

deals entered into by the Islamic banks have been and are going to be largely short

term. Since Murabaha comprises a very large percentage of Islamic banks’

investments, the structure of their assets has also become short-term.



Is it a problem? There are needs for financial resources on a long-term basis, e.g.,

venture capital. In the conventional framework, these needs are met by the other

financial institutions such as securities markets. For this purpose equities need to be a

major activity in the financial market. The problem assumes a more critical dimension

in view of the fact that in most of the Muslim countries, the major domain of Islamic

banks well developed securities markets do not exist.

It must, however, be emphasized that providing these needs is the responsibility of

the financial system as a whole. It is unfair to expect that Islamic banks should

provide an alternative for all kinds of needs. There is an urgent need to establish other

financial institutions for performing those functions.

The situation is also ripe for establishing equity-based institutions and instruments. As

mentioned in an earlier section, there is now a worldwide trend for establishing equity

institutions such as mutual funds. Savers are now increasingly recognizing the

benefits of profit-based instruments. The appeal of rate-based investment is waning.

Although stock market investments have not become any less risky over the years,

savers are beginning to accept the historical evidence that in any five year period

since World War II, with one exception, stocks have produced higher returns than

bank accounts, bonds or bullion.

There is also an historic opportunity of taking advantage of privatization programs

going on in many Muslim countries. A number of public companies, many with good

track records and bright prospects are being offered to private parties. Islamic banks

and financial institutions can take advantage of this opportunity. It must be noted,

however, that leading Shariah institutions have ruled that it is not permissible to take

equity stake in companies which deal in interest even in small proportions. While this

rightly reflects the serious concern that Muslims must garner against the use of

interest, it puts a serious constraint on placement of funds. It closes an important

market to Islamic banks and also exposes many big corporations in Muslim countries

to foreign ownership. The matter needs serious consideration with a view to find an

acceptable solution on the basis of a common need.



2.8.8. Mobilization of Deposits and Indigenizing Placement of Funds As mentioned above, Islamic banks have shown tremendous success in mobilizing

deposits in the past. However, it will require much more strenuous efforts to maintain

even a relatively modest rate of growth in the future. It must be realized that much of

the deposits now with the Islamic banks came not due to the attraction of higher

returns but because of the religious commitment of the clients. Many of them were

keeping their savings in conventional banks without taking any interest and many

others were keeping them “under their pillows”. For all such persons, a modest return

or even no return from Islamic banks was acceptable. Now, most of this money has

already found its way into the coffers of Islamic banks.

As conventional banking and financial institutions apply their vast experience to

establishing financial instruments that conform to Islamic modes, Muslim savers will

continue to find alternatives to depositing their cash in Islamic banks at lower rates of

return. Competition from other institutions is gradually introducing new realities to

the Islamic banking industry. Therefore, it is reasonable to assume that the rate of

growth of deposits of the Islamic banks will be much lower unless they are able to

attract deposits on competitive basis and from new sources. As a matter of fact, this is

already happening. A recent study shows that the rate of growth of deposits in major

Islamic banks has slowed down in the nineties.

This has serious implications for the profitability of Islamic banks. Deposits constitute

a very important source of investible funds. The data for the Islamic banks in our

sample show that deposits are 15 times the owners’ capital.

While Islamic banks and investment funds have so far mobilized huge financial

resources, a large part of these resources have found its way into Western financial

markets. Likewise, the same thing happened with resources mobilized with

conventional banks. There is no Islamic (or for that matter, conventional indigenous)

financial institution which has been able to channel savings from Western countries

into Muslim countries in spite of the great demand for such resources in the latter

countries. This is another challenge for Islamic banks with very important

implications for Muslim countries.



2.8.9. Competition So far, Islamic banks had a fairly large degree of ‘monopoly’ over the financial

resources of Islamically motivated clients. This situation is changing fast. Islamic

banks are now facing ever increasing competition. An important development in

Islamic banking in the last few years has been the entry of some conventional banks

in that market. Although, it is difficult to know with certainty how many conventional

banks around the globe practice Islamic banking techniques, even a randomly selected

short list may contain some of the giants of international banking business such as

Chase Manhattan, Citibank, ANZ Grind lays, Kleinwort Benson along with others

such as Union Bank of Switzerland, Girozentale of Australia, the ABC International.

In addition to these, in many Muslim countries, several commercial banks are offering

Islamic banking services. Bank Misr in Egypt and National Commercial Bank in

Saudi Arabia have opened Islamic Branches. In Malaysia, commercial banks have

been permitted to open Islamic banking windows.

While this development is recognition of the viability of Islamic banking, does it

augur well for the future of Islamic banking? The answer may not be very simple. In

general, competition is supposed to be good for the growth of any industry. It forces

inefficient firms to either shape up or ship out. It reduces the costs and improves

services to consumers. It promotes innovation and brings improvements in product

quality.

There is one exception to this rule. This is the well-known infant-industry argument

which states that small firms in their infancy may be protected from harsh, ruthless

competition until they can stand on their feet and be able to face competition from

their bigger counterparts. One may argue that Islamic banks may well deserve that

treatment. Conventional banks, particularly western banks have a large advantage

over Islamic banks in terms of their experience and long standing in the market. Their

systems, procedures, techniques of product innovations, marketing strategies,

diversification in portfolio, are much superior to those of Islamic banks. This exposes

Islamic banks to an unequal competition. On the other hand, it may be argued that

such competition may be good for Islamic banking as western banks may bring their

efficiency, market research and innovative capabilities, sophisticated banking and



result oriented approach to Islamic banking which may lead to the development of

new products and provision of better services to consumers.

While it may be difficult to settle the point on theoretical grounds, the stark reality is

that even if one could invoke infant industry entitlements for Islamic banks, there is

no institutional arrangement to put those in operation. Infant industry benefits are

usually offered by governments in terms of tax concessions or provision of subsidies.

No such possibility exists at present. Therefore, the survival of Islamic banks

essentially depends on their own efficiency. As mentioned earlier, at present more

than 85 percent of Islamic banking in the corporate sector is concentrated in the hands

of Islamic banks of GCC origin. This is going to be at stake in the near future due to

competition from West-based multinational banks. Indigenous banks of Muslim

countries will have to increase their efficiency substantially in order to keep a

reasonable share of the market.

There are some other genuine concerns about the entry of large multinational banks

into Islamic banking market. Naturally, their motives are purely commercial. They

view it as a lucrative business opportunity. That is fair enough. However, serious

doubts have been expressed as to whether they are following the rules of the game. It

is apprehended that conventional banks may not follow correctly and faithfully the

percepts of Islamic banking. In all major Islamic banks, there is a Shariah board

which regularly reviews the operations and contracts of the bank to determine their

compliance with the requirements of the Shariah. Similar arrangements do not exist at

the conventional Western banks in most cases. It is also suspected that conventional

banks may not be able to keep fully separate accounts for their Islamic banking

operations. In the event they do mix “Islamic money” with their general pool of

investible resources or they do not keep separate accounts for Islamic banking

activities, there is a strong possibility that permissible (Halal) returns may be

‘contaminated’ by riba.

There may be a silver lining, however. Even under competitive conditions, there is

room for product differentiation. It is well known that the bulk of deposits of Islamic

banks come from individuals with strong commitment to religious principles. Serious

concerns have been expressed with respect to “Shariah compatibility” of certain



practices of Islamic banks. The entry of Western banks in the market has increased

those concerns. Under these circumstances, Islamic banks are in a better position to

allay those fears by paying attention to criticisms of some of current practices in

Islamic banking. Practice of “genuine” risk sharing and increasing the use of more

variable return modes will “differentiate” their products and hence will enable them to

keep a niche of the market.

2.8.10. Globalization The competition from conventional banks is expected to increase further in the near

future due to globalization. Globalization refers to “growing economic

interdependence of countries worldwide through the increasing volume and variety of

cross border transactions in goods and services and of international capital flows and

also through the more rapid and widespread diffusion of technology”. Due to

liberalization, the world markets are rapidly converging into a single market place.

This poses opportunities as well as challenges for Islamic banks. On the one hand, it

will allow more portfolio diversification and hence reduce the risk in profit sharing

modes. This will open up opportunities for Islamic banks to increase the use of such

modes. It is also expected that Islamic banks may be allowed to open more and more

branches in non-Muslim countries. The possibilities of further deposit mobilization by

Islamic banks are the greatest in this area, especially in the Muslim communities of

these countries. On the other hand, they should also be prepared for more intense

competition from foreign banks. To benefit from the opportunities offered by

globalization, the Islamic banks need to improve the quality of their services and

develop suitable products. Once again, customers will be the ultimate benefactors.

Technological innovations have played a more important part in financial integration

and globalization. Electronic banking and widespread use of computers in banking

has transformed the way banking was done. It has prompted the large scale banking

corporation to step in, as the application of modern technology requires more

resources. Mergers are already producing in Western countries mega banking and

financial establishments. Globalization of financial markets has led to more and more

integration of capital markets. Liberalization of foreign exchange markets has further

reinforced this trend. The paper currency is being replaced with plastic cards and



electronic records have replaced accounts books. The communication revolutions

through faxes, telexes, emails, have reduced the cost of international communication.

Now, the saving of one country can be invested in other countries by the click of a

mouse. Customers in many countries can now “navigate” on the internet between

competing banks, unit trusts, mutual funds and even business firms.

What is this entire means for Islamic banking? Shall it help Islamic banks or harm

them? It may be difficult to venture out a definite answer to these questions but it may

not be too adventurous to put on record some initial conjectures:

Islamic banks are too small to benefit from, or even participate effectively in the

process of globalization. They cannot play any significant role because of their

small size. This reinforces our earlier suggestion that they should consider

mergers or at least establish joint ventures.

Under the right conditions, internationalization of financial markets can benefit

Islamic banking. Most importantly, Islamic countries need to improve their

investment climate, develop their financial markets and reform their economies.

This would enable Islamic financial institutions to channel domestic as well as

foreign savings into Muslim countries to meet the great demand for such resources

in those countries.

A

Attitude of Con

C

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Islamic Bank C

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Customers Tow

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Banking Practi

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ka


MIM Riyath. SEU/IS/04/MG/021 Specialization in Finance P a g e | 58

Chapter Three RESEARCH METHODOLOGY

3.1. Introduction

This chapter contains the methodology that is used by the researcher. Data have been

collected from various sources for this particular research. Thos chapter describes

sample of the study, method of data collection, and data analysis methods.

3.2. The Sample To Be Used By The Researcher

The study includes two Islamic and two conventional banks. The two Islamic banks

are: Amana Investment Ltd, Ceylinco Islamic Investment Corporation (CIIC) Ltd.

The two conventional banks are Haton National Bank Limited (HNB) and Peoples

Bank. These Islamic banks were established after introduction of conventional

banking and which are facing major competition in Sri Lankan banking industry as

well insurance. So we assume that the officers of these banks and their customers

know and understand the similarities and differences in the banking practices of

Islamic banks and conventional banks.

Data of this study was collected from both primary and secondary sources. Set of

questionnaire were used in the interview survey, among the customers and

professionals of selected Islamic and conventional banks in Sri Lanka. A purposive

random sampling was used in the survey. One hundred (100) customers were

interviewed to record their opinions about some apparent similarities between Islamic

and conventional banks.

3.3. Types of Data Data in lots of places in The Knowledge Base, but here I just want to make a

fundamental distinction between two types of data: qualitative and quantitative. The

way we typically define them, we call data 'quantitative' if it is in numerical form and

'qualitative' if it is not. Notice that qualitative data could be much more than just

words or text. Photographs, videos, sound recordings and so on, can be considered

qualitative data.



The distinction between qualitative and quantitative data to have some utility, I think

most people draw too hard a distinction, and that can lead to all sorts of confusion. In

some areas of social research, the qualitative-quantitative distinction has led to

protracted arguments with the proponents of each arguing the superiority of their kind

of data over the other. The quantitative types argue that their data is 'hard', 'rigorous',

'credible', and 'scientific'. The qualitative proponents counter that their data is

'sensitive', 'nuanced', 'detailed', and 'contextual'.

For my research purpose I will use both qualitative data and quantitative data. These

data is collected as follows.

3.4. Methods of data collection The relevant and related data for this research have been collected mainly from two

sources as follows.

Primary data

Secondary data

3.4.1. Primary Data Collection Primary data collection is necessary when a researcher cannot find the data needed in

secondary sources. Market researchers are interested in primary data about

demographic/socioeconomic characteristics, attitudes/opinions/interests,

awareness/knowledge, intentions, motivation, and behavior. Three basic means of

obtaining primary data are observation, surveys, and experiments. The choice will be

influenced by the nature of the problem and by the availability of time and money.

3.4.1.1. Primary Data Collection Methods

Under this section, I am going to explain the primary data collection methods of the

study and the way of analyzing method.

In primary data collection, the data using methods such as interviews and

questionnaires. The key point here is that the data I collect is unique to my research

and, until I publish, no one else has access to it. There are many methods of collecting

primary data and the main methods include:



Questionnaires

Interviews

Focus group interviews

Observation

Case-studies

Diaries

Critical incidents

Portfolios

A. Questionnaires

Questionnaires are a popular means of collecting data, but are difficult to design and

often require many rewrites before an acceptable questionnaire is produced.

Types of questions

a. Closed questions

A question is asked and then a number of possible answers are provided for the

respondent. The respondent selects the answer which is appropriate. Closed questions

are particularly useful in obtaining factual information:

b. Attitude questions

Frequently questions are asked to find out the respondents’ opinions or attitudes to a

given situation. A Likert scale provides a battery of attitude statements. The

respondent then says how much they agree or disagree with each one:

c. Open questions

An open question such as ‘What are the essential skills a manager should possess?’

should be used as an adjunct to the main theme of the questionnaire and could allow

the respondent to elaborate upon an earlier more specific question. Open questions

inserted at the end of major sections, or at the end of the questionnaire, can act as

safety valves, and possibly offer additional information. However, they should not be

used to introduce a section since there is a high risk of influencing later responses.

The main problem of open questions is that many different answers have to be

summarized and possibly coded.



The primary data, which is generated by the above methods, may be qualitative in

nature (usually in the form of words) or quantitative (usually in the form of numbers

or where you can make counts of words used). I briefly outline these methods but you

should also read around the various methods.

Data of the study was collected from primary sources. A purposive random sampling

was used to collect data on a series of questions regarding Islamic banking practices

and interview. The sets of approved questionnaire were used in the survey, and

through interview method, among the customers and bankers of selected Islamic and

conventional banks in Sri Lanka.

The final sample consists of customers and professionals in Islamic and conventional

banking field. As such, 100 Muslim customers and professionals were interviewed to

record their opinions about some apparent similarities between Islamic and

conventional banks. Findings of the study were consulted with the available literature

and executives of the banks to confirm their reliability and acceptability.

B. Interviews

Interviewing is a technique that is primarily used to gain an understanding of the

underlying reasons and motivations for people’s attitudes, preferences or behaviour.

Interviews can be undertaken on a personal one-to-one basis or in a group. They can

be conducted at work, at home, in the street or in a shopping centre, or some other

agreed location.

Types of interview

a. Structured:

Based on a carefully worded interview schedule.

Frequently require short answers with the answers being ticked off.

Useful when there are a lot of questions which are not particularly contentious

or thought provoking.

Respondent may become irritated by having to give over-simplified answers.



b. Semi-structured

The interview is focused by asking certain questions but with scope for the respondent

to express him or herself at length.

c. Unstructured

This also called an in-depth interview. The interviewer begins by asking a general

question. The interviewer then encourages the respondent to talk freely. The

interviewer uses an unstructured format, the subsequent direction of the interview

being determined by the respondent’s initial reply. The interviewer then probes for

elaboration – ‘Why do you say that?’ or, ‘That’s interesting, tell me more’ or, ‘would

you like to add anything else?’ being typical probes.

Conducting an interview:

I. Personally – Arrive on time be smart smile employ good manners

find a balance between friendliness and objectivity.

II. At the start – Introduce yourself re-confirm the purpose assure

confidentiality – if relevant specify what will happen to

the data.

III. The questions – Speak slowly in a soft, yet audible tone of voice

control your body language knows the questions and

topic ask all the questions.

IV. Responses – recorded as you go on questionnaire written verbatim,

but slow and time-consuming summarized by you

taped – agree beforehand – have alternative method if

not acceptable consider effect on respondent’s answers

proper equipment in good working order sufficient

tapes and batteries minimum of background noise.

V. At the end – Ask if the respondent would like to give further details

about anything or any questions about the research

thank them.

d. Telephone interview

This is an alternative form of interview to the personal, face-to-face interview.



This dissertation is to the larger part based on primary data. The primary data also has

been collected through a personal interview with professionals regarding Islamic

Banking, such as Prof Dr. Mohamed Asmi Omer, International Islamic University

Malaysia. The interview took place at the Auditorium, South Eastern University of

Sri Lanka, Oluvil, on July 10th, 2009.

3.4.2. Secondary data collection All methods of data collection can supply quantitative data (numbers, statistics or

financial) or qualitative data (usually words or text). Quantitative data may often be

presented in tabular or graphical form. Secondary data is data that has already been

collected by someone else for a different purpose to yours. For example, this could

mean using:

Data collected by a hotel on its customers through its guest history system

Data supplied by a marketing organization

Annual company reports

Government statistics.

Trade associations

Trade and other journals

Private research publishers

Stock broking firms

Large company market reports

Local authorities

Professional bodies

Academic institutions.

Secondary data can be used in different ways:

You can simply report the data in its original format. If so, then it is most likely that

the place for this data will be in your main introduction or literature review as support

or evidence for your argument.

You can do something with the data. If you use it (analyze it or re-interpret it) for a

different purpose to the original then the most likely place would be in the ‘Analysis



of findings’ section of your dissertation. In this way, data that had been collected for

quite a different purpose and used it in his own study – but to do a lot of comparisons

and statistical correlations in order to analyze the data. (See Haralambos, 1995, for

details of Durkheim’s work).

Most research requires the collection of primary data (data that you collect at first

hand), and this is what students concentrate on. Unfortunately, many dissertations do

not include secondary data in their findings section although it is perfectly acceptable

to do so, providing you have analyzed it. It is always a good idea to use data collected

by someone else if it exists – it may be on a much larger scale than you could hope to

collect and could contribute to your findings considerably.

As secondary data has been collected for a different purpose to yours, you should treat

it with care. The basic questions you should ask are:

Where has the data come from?

Does it cover the correct geographical location?

Is it current (not too out of date)?

If you are going to combine with other data are the data the same (for

example, units, time, etc.)?

If you are going to compare with other data are you comparing like with like?

Thus you should make a detailed examination of the following:

Title (for example, the time period that the data refers to and the geographical

coverage).

Units of the data.

Source (some secondary data is already secondary data).

Column and row headings, if presented in tabular form.

Definitions and abbreviations, for example, what does SIC stand for? For

example, how is ‘small’ defined in the phrase ‘small hotel’? Is ‘small’ based

on the number of rooms, value of sales, number of employees, profit, turnover,

square meters of space, etc., and do different sources use the word ‘small’ in

different ways? Even if the same unit of measurement is used, there still could

be problems.



There are many sources of data and most people tend to underestimate the number of

sources and the amount of data within each of these sources.

Sources can be classified as:

Paper-based sources – books, journals, periodicals, abstracts, indexes,

directories, research reports, conference papers, market reports, annual reports,

internal records of organizations, newspapers and magazines

Electronic sources– CD-ROMs, on-line databases, Internet, videos and

broadcasts.

The main sources of qualitative and quantitative secondary data include the

following:

Official or government sources.

Unofficial or general business sources.

The output of all publishers of non-official sources is included in the most

comprehensive directory available:

Mort D. (1997) Sources of Unofficial UK Statistics 3rd Edition Aldershot: Gower

The guide lists 1,059 statistical titles and series published by 635 different

organizations. It excludes one-off surveys or market reports.

The arrangement is alphabetical by organization with details of titles produced and

contacts for further information.

Secondary data has been collected from several sources. Relevant literature has been

gathered from a number of libraries. Extensive data has only been collected through

various different databases, websites and articles. To receive objective information

works by different authors and organizations have been used. Since I have mainly

used secondary data, most of which is written in English, in my dissertation I have

chosen to shortly present those authors most used in my work.

A

Attitude of Con

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Chapter Four DATA PRESENTATION AND ANALYSIS

4.1. Introduction This chapter is dealing with presenting and analyzing the data that are collected from

both interview and questioner.

4.2. Analysis of Questionnaire This research purpose I have used closed ended question. The collected questionnaires

are analyzed using SPSS 10 Software package and presented using tables and chards.

Question One:

Table: 4. 1

It is observed from the survey that an overwhelming group of the customers are

businessmen. They total 45 per cent of the sample. The remaining groups are: service

holders (33 per cent), self-employed (10 per cent), housewives (5 per cent) and others

(7 per cent) (Table: 4.1).

These data shown in the following Pie cart

Others

Housew ife

Self Employed

Businessman

Service holder

Figure: 4.1

Composition of the Customers by Profession

13 13.058 58.015 15.07 7.07 7.0

100 100.0

Service holderBusinessman Self Employed Housewife Others Total

Frequency Percent



Question Two;

Table: 4. 2

The 56 per cent sample consists of customers in the age group 20-29 years, 21 per

cent in the age group 30-39, 20 per cent in the age group 40-49 (Table: 4.2),

These data shown in the following Pie cart

AGE

35-60

20-35

Figure: 4.2

Question Three;

Table: 4. 3

The 89% of them are male and 11% are female (Table: 4.3).

These data shown in the following Pie cart Female

Male

Figure: 4.3

Composition of the Sex of the Customers

89 89.011 11.0

100 100.0

Male FemaleTotal

Frequency Percent

Age of customer

56 56.021 21.020 20.03 3.0

100 100.0

20-2930-3940-4950-69Total

Frequency Percent



Question Four;

Table: 4. 4

The education level is dominated by the under graduate degree (43%) followed by the

graduates (28%) the postgraduate degree (8%), and others (21%) (Table: 4.4). It

seems that the qualities of the respondent customers are unique in the perspective of

generally understood social fabrics of Sri Lanka.

These data shown in the following Pie cart;

Figure: 4.4

Question Five;

Table: 4. 5

The 66 per cent sample consists of customers are keeping their money in saving account and 34per cent in fixed deposit. (Table: 4.5), These data shown in the following Pie cart

Figure: 4.5

Type of Account keeping by the customer

66 66.034 34.0

100 100.0

SavingFixed DepositTotal

Frequency Percent

Composition of Education Level of the Customers

43 43.028 28.08 8.0

21 21.0100 100.0

Under Graduate Graduate Post GraduateOtherTotal

Frequency Percent

Other

Post Graduate

Graduate

Under Graduate

Fixed Deposit

Saving



Question Six;

Table: 4. 6

The 84 per cent sample consists of customers are expecting profit and 16 per cent are interest from their money. (Table: 4.6), These data shown in the following Pie cart;

Figure: 4.6 Question Seven;

Table: 4. 7

Regarding the essence of the profit and loss sharing system of Islamic finance, Table:

4.7 shows that the customers are more aware. 39 per cent of them believe that Islamic

finances aim at both profit and losses. Most customers (45%) believe that Islam

permits profit and forbids riba. The opinions vary due to the fact that the Islamic

bankers get formal training on Islamic Economics and Banking and the conventional

bankers are aware due to their professional consciousness. However, the customers

are conscious about the relation of profit, in lieu of interest, to Islamic finance. It is

the outcome of launching Islamic banking in the country. The basis of such

observation is that 08% of the customers believe that Islamic finance always mean for

investment in real assets, while 8% of them have mentioned that Islamic finance

cannot earn riba in anyway.

Profit and Loss Sharing System is the Essence of Islamic Finance

39 39.045 45.08 8.08 8.0

100 100.0

Islamic finance aims at both profit and losses.Islam permits profit and forbids riba.Islamic finance cannot earn riba in any way.Islamic finance is always meant for investment.Total

Frequency Percent

Customer Expectation

16 16.084 84.0

100 100.0

InterestProfitTotal

Frequency Percent

Profit

Interest




Islamic f inance is a

Islamic f inance cann

Islam permits profit

Islamic f inance aims

Figure: 4.7 Question Eight;

Table: 4. 8

A majority (67%) of the customers (Table: 4.8) view that Zakath has been mobilized

through the Islamic banking system. 15 per cent of the respondents have mentioned

that welfare activities are organized through the Islamic banking system, Again, 10%

of respondents view the concept of Halal and Haram is introduced in the case of

investment, buying and selling, while of them (8%) mention that mobilization of

financial resources to the real sector of the economy is well introduced. This indicates

that the life and society of Sri Lanka have benefited from Islamic banking, which

further justifies a separate role of the Islamic Banking system in the economy of Sri

Lanka.


New products of bank

Mobilization of Fina

The concept of Halal

Welfare activities a

Zakat Fund has been

Figure: 4.8

Benefits Accrued to the Society from Islamic Banking

67 67.015 15.0

10 10.0

8 8.0

100 100.0

Zakat Fund has been mobilized through banking system.Welfare activities are organized through banking systemThe concept of Halal and Haram in case of investment/buying andselling has been introduced.Mobilization of Financial resourcesto the real sector of the economyhas been introduced Total

Frequency Percent



Question nine;

Table: 4. 9

The next question is: what is the basis of the development of Islamic banking system

in Sri Lanka. 54% of customers (Table: 4.9) think that this is due to ‘mere faith in

Islam’ of the overwhelming Muslims (8%) of the country. In contrast, 20% of them

believe that the ‘intention to earn profit’ is the basis of development of Islamic

banking system. However, 12% of the customers have the opinion that the ‘tendency

to avoid interest’ is the basis. Such discrepancy is again observed: when 5% of the

customers said that ‘to do welfare of the economy’ is the basis. 9% of customers agree

that the basis is ‘to ensure justice in the financial transactions.


To contribute to the

To ensure justice in

To avoid interest;

Intention to earn pr

Mere faith in Islam;

Figure: 4.9 It follows that the item 'to avoid interest' as a basis of development of Islamic banking

system has not drawn the attention of the majority of the respondents. Why does it

happen so? Do they believe that Islamic banks have opened the back door for

continuation of transactions like interest-based banks?

Basis of Development of Islamic Banking

54 54.020 20.012 12.09 9.05 5.0

100 100.0

Mere faith in Islam;Intention to earn profit; To avoid interest; To ensure justice in the financial transactions;To contribute to the welfare of the economyTotal

Frequency Percent



Question Ten;

Table: 4. 10

In fact, all respondents believe so (Table: 4.10). They have mentioned several causes

for opening such a back door. The major cause, according to the 73% of the

customers is that the trading and the rental modes of investments of Islamic banks do

not differ much from the transactions of interest-based banks. The agreement of

payment of installment in due time and the extra payment for excess time of

repayment of an investment under the trading and rental mode create the same

financial burden to an investment customer. Besides, other arrangements (mortgage,

security, registration etc.) for getting an investment loan from Islamic banks are the

same as those of conventional banks.

On the other hand, 7% of the respondents view that the degree of risk in the present system of

Islamic banking is not enough to justify this sort of banking. It is followed by 10% of the

respondents, who views that Islamic banks are working along with the interest-based banks.

The 10% of them believes that the products of present Islamic banks serve the purpose of

interest-based banks.


Islamic banks are w o

Risk-sharing in curr

Products of present

Trading and Rental b

Figure: 4.10

Causes of Continuation of Interest-based Transaction through Back Door by Islamic Banking System

73 73.0

10 10.0

7 7.0

10 10.0100 100.0

Trading and Rental based modes of investment do not differmuch from the interest-based transactions.Products of present Islamic Banking are similar to those ofinterest-based banking system.Risk-sharing in current practices of Islamic Banking is notproportional to its profiteering.Islamic banks are working along with the interest-based bankTotal

Frequency Percent



Question eleven;

Table: 4. 11

In response to the question: what are the causes of crept of interest into the Islamic

banking system, 58% of respondents replied that exploitation is going on through

Islamic banking (Table: 4.11). Alternatively, 18% mentioned causes: the products of

Islamic banks have failed to remove the curse of interest-based banking; and 10%

mentioned causes the bankers lead the Islamic-banking system to the garb of interest.

14 per cent believe that Islamic banking is introduced in a society, which is not

reorganized on Islam. It seems that the customers are concerned about the interest

factor, which tends to make both Islamic and conventional banks similar.


Islamic system of Ba

Banking professional

Products of Islamic

Exploitation is goin

Figure: 4.11

Causes of Interest Creeping into the Islamic Banking System

58 58.0

18 18.0

10 10.0

14 14.0

100 100.0

Exploitation is going on through Islamic system of bankingProducts of Islamic Banking have failed to remove to removethe curse of interest from financial transactions.Banking professionals have led Islamic system of Banking tothe garb of interest based bankingIslamic system of Banking was introduced in a society, whichwas not re-organized on Islamic ideology.Total

Frequency Percent



Question twelve;

Table: 4. 12

The question is what are the reasons for which the Islamic banks do not operate in

true spirit of Islamic Shariah? In response, the majority 49% think that the status of

the Shariah Council/Department is advisory, not supervisory in the system of Islamic

banking. While (30%) of the respondents have mentioned that only the level of profit

earning cannot be the success criterion for an Islamic bank, when Islamic banks are

registered as a schedule commercial bank with a view to earning profit., A

respondents (12%) believes that exploitation still remains in the Islamic banking

system. a minority of respondents 10% has the opinion that Islamic banks do not

ensure justice and welfare in financial transactions.


Exploitation still r

Justice and w elfare

Earning of profit ca

The status of Shari[

Figure: 4.12

Present Success of Islamic Banks is not in Conformity with Shariah

49 49.0

30 30.0

10 10.0

11 11.0100 100.0

The status of Shari[ah Council/Department is advisory, notsupervisory in the system Islamic BankingEarning of profit cannot be the success criterionJustice and welfare in financial transactions are not ensureIslamic BanksExploitation still remains in Islamic banking systemTotal

Frequency Percent



Question thirteen;

Table: 4. 13

As a result, many Muslim businessmen and industrialists do not really patronize the

Islamic banks. About 75% believe that the potential patrons do not find any business

difference between Islamic and conventional banks (Table: 4.13). The other two

causes identified (21%) are: (i) lack of consciousness of the patrons, and (ii)

confusion about Islamic banking. Minorities of respondents (4%) believe that people

are not properly motivated to Islamic Banking.


They are not motivat

Confused about Islam

Not conscious about

They do not f ind any

Figure: 4.13

Causes of Not Patronizing the Islamic Banks by Rich and Prominent Muslim Businessmen and Industrialists

75 75.0

10 10.011 11.04 4.0

100 100.0

They do not find any real business differences between Islamand conventional banking Not conscious about Islamic banking.Confused about Islamic BankingThey are not motivated to I-BankingTotal

Frequency Percent



Question fourteen;

Table: 4. 14

The risk factor of business came into consideration. This factor is always considered

for generating profit in any business. However, it is observed (Table: 4.14) that the

respondents opine that most of the Islamic modes of investment practiced by Islamic

banks do not practically share risk for many reasons. While a majority of them (70%)

believe that the insurance company covers risks, 16% said that Islamic banks do not

buy practically for a sale. 9 per cent observe that buying and selling arrangements of

Islamic banks are almost risk-free. Only 5% of the respondents believe that Islamic

banks do business with depositors' money. Therefore, if there is any risk, it is borne

by the depositors. It seems that the respondents are conscious about the relation of

risk factor with Islamic banking. These data shown in the following Pie cart;

Islamic banks do bus

Buying and Selling a

Islamic Banks do not

The Insurance Compan

Figure: 4.14

Proportionally

70 70.016 16.0

9 9.0

5 5.0

100 100.0

The Insurance Company covers risks of Islamic banks' loansIslamic Banks do not always buy for sale.Buying and Selling arrangements by Islamic banks are almostrisk-free. Islamic banks do business with depositors money and sharerisk Total

Frequency Percent

Most of Investment Financing Techniques by Islamic Banks do Not Share Risk



Question fifteen;

Table: 4. 15

Further, the respondents confirm that many customers are not interested in dealing

with Islamic banks because they feel that only the title name of the banks has been

changed and interest in a real sense has not been eliminated. Table 15 shows some

causes behind these feelings. For example, many respondents (72%) feel that mark-up

profit has created a financial burden like the interest burden of conventional banks.

Other reasons are: (i) repayment of the bank’s money by installment (11%), and (ii) a

failure of payment of installment create additional liability (11%). A few of them

(6%) opine that Islamic banks, in most of the cases, do not consider business losses of

the entrepreneur for adjusting repayments. These data shown in the following Pie cart;

The Islamic Banks in

Failure of installme

Customers are requir

Mark-up profit makes

Figure: 4.15

Possibility of reduction in the value of deposits through losses suffered by bank is a

feature of Islamic banking system, but it may be harmful for deposit mobilization.

With this view in mind, the respondents were asked: do they believe that the condition

of deposit loss is not harmful for deposit mobilization? I received the response that

possibility of loss is not detrimental to deposit mobilization.

Many Customers are not interested in Dealing with Islamic Banks as they feel that only theName has been Changed and Interest in Real Sense has not been eliminated

72 72.0

11 11.0

11 11.0

6 6.0

100 100.0

Mark-up profit makes customers liable for additional paymentwhich is same as that of conventional bank’s fixedinterest-based loan. Customers are required to repay banks money on installmentbasis Failure of installment payment creates additional liabilityThe Islamic Banks in most cases do not consider businessloss Total

Frequency Percent



Question sixteen;

Table: 4. 16

The respondents believe that the profit and loss sharing system of banking cannot

ultimately make a loss of deposit. This opinion is expressed (Table: 4.16) by 56% of

respondents. However, 16% of respondents believe that it is an actual element of

investment, which makes the profit on the Islamic bank’s deposit Halal (legitimate)

therefore acceptable. 15 per cent of respondents think that the condition of a deposit

loss is insignificant to a true Muslim, who expects a garden in the heaven in the life

hereafter. This implies that the respondents have expressed their strong feelings in

favor of Islamic banking. While others (13%) view that the condition of deposit loss

does not mean total loss of deposit.


It does not mean tot

A true Muslim is not

It is realized profi

PLS system of bankin

Figure: 4.16

Possibility of Loss of Deposit is not Detrimental to Deposit Mobilization

56 56.0

16 16.0

15 15.0

13 13.0100 100.0

PLS system of banking does not lead to loss of value of depositultimately. It is realized profit of investment which makes return on on bankdeposit Halal.A true Muslim is not concerned about deposit loss, because heexpects Haven in the life hereafter.It does not mean total loss of deposit.Total

Frequency Percent



Question Seventeen;

Table: 4. 17

Regarding the present modes of investment practiced by Islamic banks both bankers

and customers believe that it is compromised with the interest factor of conventional

banks. For example, according to the respondents, bay-Murabaha and bay-muajjal

modes of investment are compromised with the Pledge and Hypothecation techniques

of interest–bearing banking. It is observed that 71% believe that finance under both

systems of banking gave the same effect on business results. The remaining 29% view

that both banks are (i) justice (adl) and welfare (ihsan)-free, (ii) working side by side,

and (iii) working in the same value loaded society (Table: 4.17).


Both are w orking in

Both are w orking sid

Both are justice ([a

Both gives same effe

Figure: 4.17

Present Modes of investment of Islamic Banks are Compromised Modes of Financing withInterest.

71 71.011 11.09 9.09 9.0

100 100.0

Both gives same effect on business resultsBoth are justice ([adl) and Welfare (ihsan) free.Both are working side by side.Both are working in the same value loaded society.Total

Frequency Percent



Question Eighteen;

Table: 4. 18

Finally, a last question was asked about how to get free of that situation. They quest

for governmental reformation measures for moral building and eradication of false

values of life, which would pave the way for Islamic baking. They have also

mentioned several causes to support their opinions (Table: 4.18). A majority of them

(65%) feel that Islamic banks cannot work well in an immoral society. While 14%

have mentioned that governmental power can change social values, 11% believe that

governmental reformation measures are powerful to build a moral society. About 10%

of them have expressed that false values of life give a detrimental environment to

Islamic banking. This indicates that the bankers and customers hold a very strong

opinion in favor of governmental measures for reformation.


Governmental reforma

Governmental pow er c

False values of life

Islamic banks cannot

Figure: 4.18

The above analysis of the misleading similarities between Islamic and conventional

banks, along with the understandings, values and attitudes of the customers about the

Islamic banking system, indicates the degree of commitments to Islamic banks in Sri

Lanka.

Moral Uplifting of the Society Will Pave the Way for Islamic Banking

65 65.0

10 10.0

14 14.0

11 11.0

100 100.0

Islamic banks cannot work well in an immoral society.False values of life give detrimental environment to IslamicBanking.Governmental power can change the social valuesGovernmental reformation measures are powerful to build amoral society. Total

Frequency Percent



4.3. Question and Answers in the course of Interview Before the first Islamic bank was established, the understanding of Islamic banking

relied mainly on theoretical models developed by a variety of scholars. Now,

theoretical contributions as well as real life practices of Islamic banking have clarified

the picture. The following questions bring forward the most important facts associated

with Islamic banks. They provide the reader with a taste of the mainstream thinking

among Islamic economists and bankers.

4.3.1. Question One What is an Islamic bank? How different is it from a conventional bank?

Before we define what an Islamic bank is like, it is better to give a short description of

conventional banking. Conventional banking does not follow one pattern. In Anglo-

Saxon countries, commercial banking dominates, while in Germany, Switzerland, the

Netherlands, and Japan, universal banking is the rule. Naturally, then, a comparison

between banking patterns becomes inevitable.

Commercial banking is based on a pure financial intermediation model, whereby

banks mainly borrow from savers and then lend to enterprises or individuals. They

make their profit from the margin between the borrowing and lending rates of interest.

They also provide banking services, like letters of credit and guarantees. A proportion

of their profit comes from the low-cost funds that they obtain through demand

deposits. Commercial banks are prohibited from trading and their shareholding is

severely restricted to a small proportion of their net worth.

Because of the fractional reserve system, they produce derivative deposits, which

allow them to multiply their low-cost resources. The process of bank lending is,

however, subject to some problems that can make it inefficient. Borrowers usually

know more about their own operations than lenders. Acting as lenders, banks face this

information asymmetry. Because borrowers are in a position to hold back information

from banks, they can use the loans they obtain for purposes other than those specified

in the loan agreement exposing banks to unknown risks. They can also misreport their

cash flows or declare bankruptcy fraudulently. Such problems are known as moral

hazard. The ability of banks to secure repayment depends a great deal on whether the

loan is effectively used for its purpose to produce enough returns for debt servicing.



Even at government level, several countries have borrowed billions of dollars, used

them unproductively for other purposes and ended up with serious debt problems.

Banks can ascertain the proper use of loans through monitoring but it is either

discouraged by clients or is too costly and, hence, not commercially feasible. Hence,

why the purpose for which the loan is given plays a minimal role in commercial

banking. It is the credit rating of the borrower that plays a more important role.

By contrast, universal banks are allowed to hold equity and also carry out operations

like trading and insurance, which usually lie beyond the sphere of commercial

banking. Universal banks are better equipped to deal with information asymmetry

than their commercial counterparts. They finance their business customers through a

combination of shareholding and lending. Shareholding allows universal banks to sit

on the boards of directors of their business customers, which enables them to monitor

the use of their funds at a low cost. The reduction of the monitoring costs reduces

business failures and adds efficiency to the banking system.

Following the above logic, many economists have given their preference to universal

banking, because of its being more efficient. Commercial banks are not allowed to

trade, except within the narrow limits of their own net worth. As we have noticed,

many Islamic finance modes involve trading. The same rule cannot, therefore, be

applied to Islamic banks. It may be possible for Islamic banks to establish trading

companies that finance the credit purchase of commodities as well as assets. Those

companies would buy commodities and assets and sell them back to their customers

on the basis of deferred payment. However, this involves equity participation. We

may, therefore, say that Islamic banks are closer to the universal banking model. They

are allowed to provide finance through a multitude of modes including the taking of

equity. Islamic banks would benefit from this by using a combination of shareholding

and other Islamic modes of finance. Even when they use trade-based, debt creating

modes, the financing is closely linked to real sector activities. Credit worthiness

remains relevant but the crucial role is played by the productivity/profitability of the

project financed.

An Islamic bank is a deposit-taking banking institution whose scope of activities

includes all currently known banking activities, excluding borrowing and lending on



the basis of interest. On the liabilities side, it mobilizes funds on the basis of a

Mudarabah or wakalah (agent) contract. It can also accept demand deposits which are

treated as interest-free loans from the clients to the bank and which are guaranteed.

On the assets side, it advances funds on a profit-and-loss sharing or a debt-creating

basis, in accordance with the principles of the Shari `

ah. It plays the role of an

investment manager for the owners of time deposits, usually called investment

deposits. In addition, equity holding as well as commodity and asset trading constitute

an integral part of Islamic banking operations. An Islamic bank shares its net earnings

with its depositors in a way that depends on the size and date-to-maturity of each

deposit. Depositors must be informed beforehand of the formula used for sharing the

net earnings with the bank.

4.3.2. Question Two The value of paper currency depreciates in inflationary situations. In order to

compensate lenders for the erosion in the value of their principal, a scheme of

"indexation" has been suggested. Is such a scheme acceptable from an Islamic

point of view?

The question of indexation is often raised in the presence of a sustained high rate of

inflation. This happens in some countries under special circumstances, when the

authorities do not follow non-inflationary monetary and fiscal policies. Within the

Islam perspective, it is required of monetary and fiscal authorities to refrain from

following inflationary policies. However, once a country is caught in the mess of

inflation, the question of a possible resort to indexation arises. The Shari `ah aspect of

indexation in such exceptional situations is still under consideration by the fuqaha,

especially the OIC Fiqh Academy. While the Academy has so far allowed indexation

in the case of wages and contracts fulfilled over a period of time, provided that this

does not harm the economy, it has not allowed it in the case of monetary debts.

Meanwhile, it allows the creditor and the debtor to agree on the day of settlement —

but not before — to settle the debt in a currency other than the one specified for the

debt, provided that the rate of exchange applied is the one that prevails on the

settlement date. Similarly, for debts in a specific currency, due in installments, the

parties may agree to settle the installments due in a different currency at the prevailing

rate of exchange on the date of settlement.



The whole practice of Islamic finance is based on modes that do not involve interest.

As a general rule, they involve the carrying out of investment and/or the purchase of

goods, services and assets. The following questions touch upon the nature and uses of

Islamic modes of finance and their implications

4.3.3. Question Three If banking were to be based on interest-free transactions, how would it work in

practice?

An Islamic bank, like other banks, is a company whose main business is to mobilize

funds from savers and supply these funds to businessmen/entrepreneurs. It is

organized as a joint stock company with the shareholders supplying the initial capital.

It is managed by shareholders through their representatives on the Board of Directors.

While a conventional bank uses the rate of interest for both obtaining funds from

savers and supplying these funds to businessmen, an Islamic bank performs these

functions using various financial modes compatible with the Shariah.

On the resource mobilization side, it uses either the contract of Mudarabah or

wakalah with the fund owners. Under the first contract, the net income of the bank is

shared between shareholders and the investment deposit holders according to a

predetermined profit sharing formula. In the case of loss, the same is shared in

proportion to the capital contributions. As far as the nature of investment deposits are

concerned, these could be either general investment deposits that enter into a pool of

investment funds or specific investment accounts in which deposits are made for

investment in particular projects. In addition, there are current accounts that are in the

nature of an interest-free loan to the bank. The bank guarantees the principle but pays

no profit on these accounts. The bank is allowed to use these deposits at its own risk.

In the case of a wakalah contract, clients give funds to the bank that serves as their

investment manager. The bank charges a predetermined fee for its managerial

services. The profit or loss is passed on to the fund providers after deducting such a

fee. On the assets side, the bank uses a number of financial instruments, none of

which involves interest, for providing finance to businesses. A wide variety of such

modes of financing are now available.



4.3.4. Question Four Do we really need Islamic banks?

This question can be divided into two parts. The first part relates to the necessity of

banks in general and the needs of the whole economy that they are expected to satisfy.

The second part relates to the extra value an economy would gain from banks

operating according to the Islamic principles. Both parts are taken up below one by

one.

With regard to whether we need banks, we can divide agents (natural as well as legal

entities) in an economy into two groups, one that has the ability to exploit investment

opportunities requiring more financial resources than they have. We can call this

group the investors or the entrepreneurs. The second group has more financial

resources than required by the investment opportunities that they are themselves able

to exploit. We call them savers. In every economy, there is a need to transfer funds

from savers to entrepreneurs. This function is performed through the process of

financial intermediation in the financial markets, where banks are the most important

operators.

Financial intermediation enhances the efficiency of the saving/investment process by

eliminating the mismatches inherent in the requirements and availability of financial

resources of savers and entrepreneurs in an economy. Savers are often small

households who save relatively small amounts and entrepreneurs are firms who often

need relatively large amounts of cash. Financial intermediaries remove this size

mismatch by collecting the small savings and packaging them to suit the needs of

entrepreneurs. In addition, entrepreneurs may require funds for periods relatively

longer than would suit individual savers. Intermediaries resolve this mismatch of

maturity and liquidity preferences again by pooling small funds.

Moreover, the risk preferences of savers and entrepreneurs are also different. It is

often considered that small savers are risk averse and prefer safer placements whereas

entrepreneurs deploy funds in risky projects. The role of the intermediary again

becomes crucial. They can substantially reduce their own risks through the different

techniques of proper risk management. Furthermore, small savers cannot efficiently



gather information about opportunities to place their funds. Financial intermediaries

are in a much better position to collect such information, which is crucial for making a

successful placement of funds.

The role and functions of banks outlined above are indeed highly useful and socially

desirable. Hence, we do need banks. Unfortunately, their role is marred by dealing on

the basis of interest and limiting their activities to mostly commercial operations as

pointed out above. Islamic banks add value on both counts.

Commercial banks largely finance short-term trade, business,, and personal loans.

This cannot satisfy the financial requirements of venture capital. The impact of

commercial banking on economic development, therefore, would be below potential.

Islamic banking by contrast provides finance with greater involvement in the

production process. Its financing targets both the equity as well as the working capital

needs of enterprises. It is expected that its impact on economic development will be

more pronounced.

The avoidance of interest by Islamic banking is an additional plus. The answers to

previous questions have pointed out that allocating financial resources on a

production basis is more efficient than their allocation on a purely lending basis. It has

also been argued that the whole banking system would be more stable and less liable

to suffer from financial crises Moreover; the existence of an interest-bearing debt

market opens the domestic economy to the unexpected vicissitudes of external

sources. A monetary system based on riba is also unjust. It allows savers and banks to

get away with interest, which is a guaranteed fixed rate of return on their loans,

without bearing a fair part of the risks faced by entrepreneurs.

4.3.5. Question Five How would the role of the central bank and its relationship with the banking system

change?

The elimination of government borrowing would make it inconsistent for the central

bank to continue to issue money against treasury bills and government bonds. Such

interest-bearing instruments are used as a basis for open market operations, as they

represent secure and liquid financial assets. The central bank must therefore find a



procedure for issuing reserve money that is not based on interest. Interestingly, any

procedure that leads to avoiding lending to the government would automatically be

useful in protecting the monetary authority from pressures to increase the money

supply without regard to the state of the economy. Such procedures would therefore

be less inflationary. The following is a suggested procedure that would enable the

monetary authority to exercise effective control, tie the issuance of money to the

needs of real economic growth, and employ the issued funds into real economic

activities.

The central bank monitors the national economy, especially real growth and

inflation rates. It also examines the state of the demand for money arising from the

production and distribution of real goods and services, and makes an estimate of

the elasticity of demand for money.

In consultation with the planning authorities, the central bank sets growth and

inflation targets for the next year.

The desired rate of monetary expansion that would be consistent with growth and

inflation targets would be equal to the target rate of growth X the elasticity of

demand for money plus the target rate of inflation.

A part of the money issued by the central bank to attain the desired rate of

monetary expansion would be placed in banks as investment

4.3.6. Question Six Is Islamic banking viable?

Islamic banking, like any other banking system, must be viewed as an evolving

system. No one disputes that there is a definite desire amongst Muslim savers to

invest their savings in ways that are permitted by the Shariah. Nevertheless, they must

be provided with Halal returns on their investments. Islamic scholars and practical

bankers took up that challenge and have made commendable progress in the last

twenty-five years in providing a number of such instruments. However, the concepts

of Islamic banking and finance are still in their early stages of development and

Islamic banking is an evolving reality for continuously testing and refining those

concepts.

Islamic banking and financial institutions have now spread across several Muslim

countries. Some non-Muslim countries and/or institutions e also keen to experiment



with Islamic financial techniques. Various components of the Islamic financial system

are now available in different parts of the world in varying depth and quality. A

detailed and integrated system of Islamic banking and finance is gradually evolving.

Theoretical arguments and models developed by Islamic economists and the

successful practice of hundreds of institutions in heterogeneous conditions both testify

to the viability of Islamic banking. The average growth rate of deposits in Islamic

banks over the past twenty years has been over ten percent per annum. Many studies

testify to the great success of Islamic banks in mobilizing resources. According to one

of these studies", the relative growth rate of Islamic banks during the period 1980-

1986 surpassed, in most cases, that realized by other banks. Another study noted that,

"These institutions have come of age now and realized a high degree of success in

respect of market penetration. This is considered remarkable in view of the fact that

the markets in which these Islamic banks were established have had highly developed

and well-established commercial banks. Moreover, some of those markets, especially

in the Gulf region, were considered replete with banks"

Another manifestation of the success of Islamic banking is the fact that many

conventional banks have also started using Islamic banking techniques in the conduct

of their business, particularly in dealing either with Muslim clients or in

predominantly Muslim regions.

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Chapter Five FINDINGS, CONCLUSIONS AND

RECOMMENDATIONS

5.1. Introduction This is the last chapter of my research. In this chapter, researcher intended to reveal the findings, the conclusions and the recommendations.

5.2. Findings In this section is going to reveal the findings which were identified from data analysis

in preceding chapter.

The prohibition of riba (interest) makes Islamic banking different from conventional

banking. Of course, the investments of an Islamic bank must be channeled to the

Islamic Shariah approved sectors. The phenomenal growth of Islamic banks has

attracted the attention of bankers, business community and bank customers. It is also

contended that Islamic banks are not very different from conventional banks. This

argues raises a natural question that if Islamic banks are no different from

conventional banks, why they are growing so fast? A survey analysis of the deposit

and investment mechanisms and the opinions of the customers of both Islamic and

conventional banks help our understanding and identification of this debate.

Our theoretical analysis shows that Islamic bank practices are indeed different from

those of conventional banks. The central theme of this study is to examine some

apparent similarities between Islamic and conventional banks, which frequently tend

to equate the similarities, was found through a process of scientific investigation. Data

of this study was collected from both primary and secondary sources. Set of

questionnaire were used in the interview survey, among the customers and

professionals of selected Islamic and conventional banks in Sri Lanka. A purposive

random sampling was used in the survey.

The majority of (sixty six percent) sample consists of customers are keeping their

money in saving account and other (34percent) in fixed deposit. The huge part of (84



percent) sample consists of customers are expecting profit and others (16 percent) are

interest from their money.

The fundamental nature of the profit and loss sharing system of Islamic finance, the

customers are more aware. Mainly of them believe that Islamic finances aim at both

profit and losses. Most customers believe that Islam permits profit and forbids riba.

The majority of the customer view that Zakath has been mobilized through the

Islamic banking system. The minor part of the respondents has mentioned that welfare

activities are organized through the Islamic banking system. More than half of

customers think that this is due to ‘mere faith in Islam’ of the overwhelming Muslims

of the country. In contrast, smaller part of them believes that the ‘intention to earn

profit’ is the basis of development of Islamic banking system.

the majority of the customers preference is that the trading and the rental modes of

investments of Islamic banks do not differ much from the transactions of interest-

based banks, The agreement of payment of installment in due time and the extra

payment for excess time of repayment of an investment under the trading and rental

mode create the same financial burden to an investment customer. More to the point,

other arrangements (mortgage, security, registration etc.) for getting an investment

loan from Islamic banks are the same as those of conventional banks.

The causes of crept of interest into the Islamic banking system, vast of respondents

replied that exploitation is going on through Islamic banking. It seems that the

customers are concerned about the interest factor, which tends to make both Islamic

and conventional banks similar. The majority think that the status of the Shariah

Council/Department is advisory, not supervisory in the system of Islamic banking.

Many Muslim businessmen and industrialists do not really support the Islamic banks.

About 75% believe that the potential customers do not find any business difference

between Islamic and conventional banks.

The respondents discourse that most of the Islamic modes of investment practiced by

Islamic banks do not practically share risk for many reasons. While a majority of

them believe that the insurance company covers risks. The respondents confirm that



many customers are not interested in dealing with Islamic banks because they feel that

only the title name of the banks has been changed and interest in a real sense has not

been eliminated. Many respondents feel that mark-up profit has created a financial

burden like the interest burden of conventional banks.

I received the response that possibility of loss is not detrimental to deposit

mobilization. The respondents believe that the profit and loss sharing system of

banking cannot ultimately make a loss of deposit. It is observed that majority of them

believe that finance under both systems of banking gave the same effect on business

results. They quest for governmental reformation measures for moral building and

eradication of false values of life, which would pave the way for Islamic baking. They

have also mentioned several causes to support their opinions.

5.3. Conclusions In concluding the brief discussion of this important issue, I would like to point out

that I have not dealt with the juristic aspect of the issue of bank interest, as it has been

fully discussed by Islamic jurists, past and present, individually and collectively. I

would like to record here, by way of emphasis not repetition, that bank interest,

whether credit or debit, is Riba and utterly forbidden by the Al Quran, the Sunnah and

the Consensus of jurists. I also wish to stress that the interest rate mechanism is a

wicked and corrupt means of managing modern economic activity, whereas the rate of

profit is the most practical and effective mechanism for the management of an Islamic

economy.

It is pointless to be preoccupied with issues which have already long been resolved.

Such a preoccupation is nothing but a distraction from more immediate and urgent

problems. Instead of using the juridical legacy of Islam to bring our Muslim

economies back to and within Shariah, I keep reverting to matters which have already

been settled. Only when Shariah is applied to finance investment can we take steps to

redress underdevelopment.

It almost seems as if this secondary issue has been artificially revived in an attempt to

validate a prohibited practice by justifying an indulgence in the sin of Riba. The



function of a modern bank is to trade in interest loans. Interest on loans is clearly a

preconditioned increment and constitutes Riba, which is categorically prohibited in

Islam. The interest rate mechanism is, thus, a corrupt method for managing modern

economic activity.

The Islamic system offers an easy, effective, and practical alternative. This alternative

is the profit-loss sharing system instead of credit-debit relationship that is involved in

Riba. With this form of financing investment, conventional banks can be transformed

into Islamic banks, with profit acting as an effective and rational mechanism in the

management of con-temporary economic activity.

An analysis of these deposit mechanisms shows a confusing similarity that both

Islamic and conventional banks pay money for the deposits of the customers, which

is termed as profit in Islamic banking or interest in conventional banking respectively.

While payment of return on deposit in Islamic banking contains element of risk,

payment of interest in conventional banking does not contain the element of risk.

Only payment on deposit apparently generates misunderstanding in the minds of

bank customers whether Islamic banking is definitely different from conventional

banks. In terms of financing techniques, the prevalence of short-term financing in

Islamic banks raises the questions of efficiency, equity and justness of Islamic banks.

In addition, this also raises questions such as, whether Islamic banks pay profit or

interest in the name of profit.

I showed that the Islamic banking financing mechanisms are different from those

of conventional banks. The misleading similarities between Islamic and conventional

banking products are the result of the following observations: First, fixed charges in

percentage, which increases with time as compensation for violation of an agreement

for repayment schedule of investment taken by the entrepreneur from the bank.

Second, dated payment obligations may not synchronize with the firm’s cash

flow. Third, payment obligations are mandatory whether or not the business is

making a profit. Fourth, a security or mortgage is essential for investment.

Finally, returns are practically based on the benchmark of an interest based

bank.



The survey analysis shows that bank customers have confusing thinking about Islamic

banking practices. I argue that this misconception is partly due to incomplete

knowledge in the fundamentals of Islamic finance and due to the over-reliance on

short-term trade financing. The investment portfolio of Islamic banks has generally

favored trade-related activities over production-related activities, short-term

profitability over long-term profitability and private profitability over social

profitability. Almost 80 to 90 per cent of investment has been made to short-term

trade-related activities. Heavy reliance on a short-term asset portfolio makes Islamic

banks vulnerable, increases its risk and threatens its stability. On the other hand, the

borrowers prefer short-term trade loans to profit-loss sharing instruments, which have

weakened the bank’s portfolio. The real rates of return of the Islamic bank’s asset

portfolio are lower than those of conventional banks.

Islamic banks have become, to an extent, successful in the field of deposit

mobilization, but socially beneficial and development oriented utilization of these

deposits did not happen. Employment generation and a flow of resources towards the

lower and middle classes, particularly in the rural areas, have not taken place. Still,

Islamic banks are involved in the heroic role of eliminating riba from financial

dealings in Muslim countries against a backdrop of regulation in the area of taxation,

legal framework, and weak moral fabric of society. In order to remove misconception

from the minds of customers, there is no alternative to publicity, research and training

of Islamic banking practices. Research should focus on the development of financial

products that conform to Islamic Shariah, and training should be given to bankers,

potential researchers and bank customers.

5.4. Recommendations

In order to operate in markets effectively, it is desirable that the size of operations of

Islamic banks be substantially increased. In this regard, serious consideration should

be given to mergers. Islamic banks have to increase their size as well as form strategic

alliances with other banks. It will also be useful to build bridges between existing

Islamic banks and those conventional banks that are interested to do banking on

Islamic principles.



To promote teaching, training and research in Islamic banking and finance and to

produce and disseminate authentic information on their activities with a view to

develop new Islamic financial products.

With a view to broaden the equity base of the economies of Muslim countries, it is

desirable to establish institutions dealing more in equities. These include mutual

funds, unit trusts, pension plans etc. It would also be desirable to encourage

businesses through macro-economic policies to increase the use of equity finance and

decrease their reliance on debt.

Until countries do not choose for a complete Islamic banking system, it is necessary

to perform some laws to facilitate the operation of a mixed system. In this context,

one of the most serious problems being faced by Islamic banks is the lack of proper

legal framework to deal with cases of delayed payments and bad loans expeditiously.

Since Islamic banks cannot charge interest on the delayed debts, they face a bigger

risk of default as well as loss in income. These considerations, among others,

necessitate that special laws for the introduction and practice of Islamic banking be

put in place.

Another important policy issue relates to tax treatment. Under the conventional

system, interest paid by corporations is treated as a tax-deductible expense. Similar

treatment must be given to the dividends paid out by financial institutions.

It is proposed that an autonomous Board for Shariah supervision of Islamic banks

may be constituted. In addition, there is also a need for Central banks in Muslim

countries to consider the special nature of Islamic banking and devise suitable

international standards for major control variables similar to the Basle Committee for

Banking Supervision.

There is an urgent need to increase the supply of scholars with dual specialization in

Shariah and finance. In order to meet this need, it is recommended that courses may

be introduced for Shariah scholars in economics and finance. Similarly, courses in

Shariah especially designed for economists and financial experts may be initiated.

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GLOSSARY OF ARABIC TERMS

Ahadith Plural of Hadith. For meaning, see below.

Al-Maks A pre-Islamic practice whereby the tribesmen imposed

levies on caravan trade passing through their areas.

Ameer Ruler.

Amwal Plural of mal. For meaning see below.

Awqaf (also waqfs) Plural of waqf. For meaning, see below.

Bayt al-mal Public treasury, Also used for a charitable institution meant

to help the poor and needy.

Dawah Acts and deeds for propagation of religion.

Falah Literally, it means to become happy, to have success.

Technically, it means achieving success in the life

Hereafter.

Fard An obligatory duty.

Fard kifayah An obligatory duty the fulfillment of which is a joint

responsibility of all members of the community. If someone

performs it, it is considered to have been fulfilled; otherwise

all members of the community are considered defaulters.

Fay’ Properties/assets that come into the hands of Muslims

without fighting. (Compare with Ghanimah).

Fiqh Refers to the whole corpus of Islamic jurisprudence. In

contrast with conventional law, fiqh covers all aspects of

life, religious, political, social, commercial or economic.

The whole corpus of fiqh is based primarily on

interpretations of the Qur’an and the Sunnah and

secondarily on Ijma (consensus) and Ijtihad (individual

judgment). While the Qur’an and the Sunnah are

immutable, fiqhi verdicts may change due to changing

circumstances.

Fiqhi Relating to fiqh.



Fuqaha’ Plural of faqīh meaning jurist, who gives rulings on various

juristic issues in the light of the Qur’an and the Sunnah.

Ghanimah Enemy Properties/assets that come into the hands of

Muslims after fighting.

Hadith Sayings, deeds and endorsements of the Prophet

Muhammad (peace be upon him) narrated by his

Companions.

Harbi People belonging to countries with which the Muslim state

is at

Hawalah Literally, it means transfer. Technically, it refers to an

arrangement whereby a debtor transfers the responsibility of

payment of a debt to a third party who owes the former a

debt. It is also used for cheque or draft.

Hawalah or

hawalah al-dayn

Islamic rules governing transfer (sale) of debt.

Hisbah Literally, it means reward, calculation. Technically, it refers

to an institution that existed through most of Islamic history

for implementing what is proper and preventing what is

improper. The main role of Al-Hisbah was the regulation

and supervision of markets to ensure proper market conduct

by all concerned.

Ibadah Duties of man due to God.

Idtirar Doctrine of necessity, i.e. condition of extreme necessity

which may temporarily suspend some Shariah ruling.

Ijarah Leasing. Sale of usufruct of an asset. The lessor retains the

ownership of the asset with all the rights and the

responsibilities that go with ownership.

Ijtihad In technical terms, it refers to the endeavor of a jurist to

derive a rule or reach a judgment based on evidence found

in the Islamic sources of law, predominantly, the Qur’an

and the Sunnah.



Istisna Refers to a contract whereby a manufacturer (contractor)

agrees to produce (build) and deliver a well-described well

(or premise) at a given price on a given date in the future.

As against Salam, in Istisna the price need not be paid in

advance. It may be paid in installments in step with the

preferences of the parties or partly at the front end and the

balance later on as agreed

Jizyah A levy imposed on non-Muslims living an Islamic state in

lieu of providing protection to them without obligatory

military duty.

Kharaj A land tax (either lump sump or share in produce) imposed

on non-Muslim’s lands.

Khums Literally means one-fifth. Technically a rate of tax of 20%

imposed on certain types of wealth/assets.

Maadin Mines/natural resources such as coal, copper, gold,

petroleum.

Mal Anything in the possession of someone having value.

Maqasid al-Shariah Basic objectives of the Shariah. These are protection of

faith, life, progeny, property and reason.

Maslahah(plural

Masalih)

Literally, it means benefit. Technically, it refers to any

action taken to protect any one of the five basic objectives

of the Shariah i.e. Protection of faith, life, progeny, property

and reason.

Mudarabah A contract between two parties, capital owner(s) or

financiers (called rabb al-mal) and an investment manager

(called mudarib). Profit is distributed between the two

parties in accordance with the ratio upon which they agree

at the time of the contract. Financial loss is borne only by

the financier(s). The entrepreneur’s loss lies in not getting

any reward for his services.

Mudarib An investment manager in a mudarabah contract.

Muqaradah Same as Mudarabah.



Murabahah Sale at a specified profit margin. The term, however, is now

used to refer to a sale agreement whereby the seller

purchases the goods desired by the buyer and sells them at

an agreed marked-up price, the payment being settled

within an agreed time frame, either in installments or in a

lump sum. The seller bears the risk for the goods until they

have been delivered to the buyer. Murabahah is also

referred to as bay mu’ajjal.

Musaqah A contract in which the owner of a garden agrees to share

its produce with someone in an agreed proportion in return

for the latter’s services in irrigating and looking after the

garden.

Musharakah Partnership. A musharakah contract is similar to a

mudarabah contract, the difference being that in the former

both the partners participate in the management and the

provision of capital, and share in the profit and loss. Profits

are distributed between the partners in accordance with the

ratios initially set, whereas loss is distributed in proportion

to each one’s share in the capital.

Muzaraah Crop-sharing contract. Two or more parties contribute land,

seed, fertilizer, water, etc., and share the crop in agreed

proportions.

Nisab In reference to Zakath, the limit of wealth that marks the

beginning of the imposition of Zakath liability. Wealth

below this limit is exempt.

Nusus Texts from Qur’an or Sunnah.

Qur’an The Holy Book of Muslims, consisting of the revelations

made by God to the Prophet Muhammad (peace be upon

him). The Qur’an lays down the fundamentals of the Islamic

faith, including beliefs and all aspects of the Islamic way of

life.

Qur’anic Reference from Qur’an.



Riba Literally, it means increase or addition or growth.

Technically it 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 an extension in its maturity.

Interest as commonly known today is regarded by a

predominant majority of fuqaha’ to be equivalent to riba.

Sadaqah An act of charity.

Salam The short form of Bay Al Salam.

Sarf Islamic rules governing currency exchange.

Shariah Refers to the corpus of Islamic law based on Divine

guidance as given by the Qur’an and the Sunnah and

embodies all aspects of the Islamic faith, including beliefs

and practices.

Shura The Islamic principle of mutual consultation before arriving

at decision.

Sukuk Plural of ‘sakk’ which refers to a financial paper showing

entitlement of the holder to the amount of money shown on

it. The English word ‘cheque’ has been derived from it.

Technically, sukuk are financial instruments entitling their

holders to some financial claims.

Sunnah The Sunnah is the second most important source of the

Islamic faith after the Qur’an and refers to the Prophet’s

(peace be upon him) example as indicated by his practice of

the faith. The only way to know the Sunnah is through the

collection of Ahadith, which consist of reports about the

sayings, deeds and endorsements of the Prophet (peace be

upon him).

Surah A chapter of Al-Qur’an.

Takaful An alternative for the contemporary insurance contract. A

group of persons agree to share certain risk (for example,

damage by fire) by collecting a specified sum from each. In

case of loss to anyone of the group, the loss is met from the

collected funds.



Ushr Referring to the law of Zakath, it means a rate of ten percent

leviable on certain types of wealth/output/income.

Ushur Taxes imposed on foreign trade during the period of Caliph

Omar.

Wakalah Contract of agency. In this contract, one person appoints

someone else to perform a certain task on his behalf, usually

against a fixed fee.

Wakil Agent.

Waqf Appropriation or tying up a property in perpetuity for

specific purposes. No property rights can be exercised over

the corpus. Only the usufruct is applied towards the

objectives (usually charitable) of the waqf.

Zakath The amount payable by a Muslim on his net worth as a part

of his religious obligations, mainly for the benefit of the

poor and the needy.

Zakatul ard Zakath imposed on the produce of land.

Zakatul mal Zakath imposed on assets/properties.

Zulm Unfair, unjust, unduly encroaching upon the rights of

others.



References

Books and Articles 1. Ahmad, Ausaf (1993), “Contemporary Practices of Islamic Financing Techniques”, Research

Paper Number 20, First Edition: Islamic Research and Training Institute, Jeddah 2. Ahmad, Mahmood (1995), “Principles of Islamic Banking” in the 10th Issue of Nidaul Islam

Magazine, November-December, 1995. 3. Akkas, S. M. (1996), “Relative Efficiency of Conventional and Islamic Banking System in

Financing Investment”, Unpublished Ph.D. Dissertation, Dhaka University. 4. Al-Omar, Fuad & Abdel-Haq, Mohammed. (1996) Islamic banking: Theory, practice and

challenges. London: Zed Books Ltd. 5. Amereller, Florian. (1995) Hintergründe des ‘Islamic Banking’. Berlin: Duncker & Humblot

GmbH 6. Archer, Simon & Abdel Karim, Rifaat Ahmed (eds). (2002) Islamic finance: Innovation and

growth. London: Euromoney Books. 7. Ashour, Yousif (1999), “The Importance of Murabahah in Long-Term Finance Programs in the

Banking Industry,” The American Journal of Islamic Social Sciences, 16 (4), 87-102. 8. M. Ariff (ed), Jeddah: International Centre for Research in Islamic Economics, King Abdul Aziz

University: 9. Doak, E (1988), “Islamic Interest-Free Banking and 100 Percent Money”, International Monetary

Fund Staff Papers, 35, 534-36. 10. Dr. Mabid Ali Al-Jarhi, Islamic Finance: An Efficient & Equitable Option Islamic Development

Bank, Islamic Research and Training Institute. 11. Fry, Maxwell (1978), “Money and Capital or Financial Deepening in Economic Development?”

Journal of Money, Credit and Banking, 446-75. 12. Hassan, M. Kabir (1995), Banking and Finance in Bangladesh, pp. 232, Dhaka, Bangladesh:

Academic Publishers. 13. Hassan, M. Kabir (1999), “Islamic Banking in Theory and Practice: The Experience of

Bangladesh,” Managerial Finance, 25(5), 60-113. 14. Hassan, M. Kabir and Adnan Q. Al-Dayel (1998/1999), “Stability of Money Demand Under

Interest-Free Versus Interest-Based Banking System”, Humanomics, 14(4) and 15(1). 15. Henry, M. Clement & Wilson, Rodney (eds). (2004) The politics of Islamic finance. Edinburgh:

Edinburgh University Press Ltd. 16. Iqbal, Munawar & Llewellyn, T. David (eds). (2002) Islamic banking and finance: New

perspectives on profit-sharing and risk. Cheltenham: Edward Elgar Publishing Ltd. 17. Iréne Björklund And Lisbeth Lundström, Islamic Banking, An Alternative System, Fec 685

Bachelor Dissertation, International Business Program, The Department Of Business Studies, Kristianstad University, December 2004



18. Khan, M. Fahim (1987), “Concept of Time in Islamic Economics”, Mimeo, Islamabad: International Institute of Islamic Economics.

19. Khan, M. S. and Abbas Mirakhor (1987), “Theoretical Studies in Islamic Banking and Finance”,

Houston, Texas: The Institute for Research and Islamic Studies. 20. Khan, Mohsin S (1986), “Islamic Interest-Free Banking: A Theoretical Analysis”, Staff Papers,

33, 1-27, International Monetary Fund. 21. Khan, W. M (1984), “Towards an Interest-Free Islamic System: A Theoretical Analysis of

Prohibiting Debt Financing”, Ph.D. Dissertation: Boston University. 22. Langton, Michle J. (1995), “Impact of Islamic Banking” in The Bangladesh Observer, June 30. 23. Mabid Ali Al-Jarhi And Munawar Iqbal, Islamic Banking: Answers To Some Frequently Asked

Questions Occasional Paper No.4 Islamic Development Bank, Islamic Research And Training Institute

24. Mangla, I. U. and Uppal, J. Y. (1990), “Islamic Banking: A Survey and Some Operational Issues”,

Research in Financial Services, 2, 179-215. 25. Maududi, S. A (1987), Tafhimul Qur’an, A Commentary on the Holy Qur’an. English Translation,

1, by Zafar Ishaq Ansari, Leicester: The Islamic Foundation. 26. Munawar Iqbal, Ausaf Ahmad and Tariqullah Khan, Challenges Facing Islamic Banking,

Occasional Paper No. 1, Islamic Development Bank, Islamic Research And Training Institute 27. Nienhaus, Volker (1994), “Conceptual and Economic Foundations of Islamic Banking”, Thoughts

on Economics, 3 and 4, 1-37. 28. Nomani, Farhad & Rahnema, Ali. (1994) Islamic economic systems. London: Zed Books Ltd. 29. Prof. Dr. Abdel Hamid El-Ghazali, Islamic Economics Translation Series, No. 2, Profit versus

Bank Interest in Economic Analysis and Islamic Law, Islamic Development Bank, Islamic Research and Training Institute.

30. Ray, Nicholas Dylan. (1995) Arab Islamic banking and the renewal of Islamic Law. London:

Graham & Trotman Ltd. 31. Siddiqi, M. Nejatullah (1983), Banking Without Interest, Leicester: The Islamic Foundation. 32. Saeed, Abdullah. (1996) Islamic banking and interest: A study of the prohibition of riba and its

contemporary interpretation. Leiden: E.J. Brill 33. Samuelsson, Jan. (2000) Islamisk ekonomi. Lund: Studentlitteratur. 34. Saunders, Mark, Lewis, Philip & Thornhill, Adrian. (2003) Research Methods for Business

Student (3rd edn). Harlow: Pearson Education Ltd. 35. Warde, Ibrahim. (2000) Islamic finance in the global economy. Edinburgh: Edinburgh University

Press. 36. Zineldin, Mosad. (1990) The economics of money and banking: A theoretical and empirical study

of Islamic interest-free banking. Stockholm: Almqvist & Wiksell International.



Websites: http://www.isdb.org http://www.islamic-banking.com http://www.ifsb.org http://www.irti.org.sa http://www.islamicity.com Http://www.meezanbank.com http://www.en.wikipedia.org/wiki/Islamic_banking#History_of_Islamic_banking http://www.dowjones.com/corp/index products.htm http://www.ftse.com/ebox/TII.html



Questioner Analysis This questionnaire is prepared to collect the information regarding an examination of

factors affecting to

Attitude of Conventional and Islamic Bank Customers towards Islamic

Banking Practices in Sri Lanka. to the research study for the completion of Bachelor of Business Administration

degree in South Eastern University of Sri Lanka. Therefore, I kindly request you to

indicate the correct answer to the following questions.

Please selects your most preferred an answer and put mark in the appropriate box given below.

1. Type of Customer by Profession`

Service holder Businessman Self Employed Housewife Others

2. Age

20 – 29 30 – 39 40 – 49 50 – 69 More then 70

3. Sex Male Female

4. Education Level Under Graduate Graduate Post Graduate Other

5. What type Account you are keeping?

Saving Account Fixed Deposit



6. What you are expecting from your money? Interest Profit

7. Profit and Loss Sharing System is the Essence of Islamic Finance. Which is the major cause?

Islamic finance cannot earn riba in any way. Islam permits profit and forbids riba Islamic finance aims at both profit and losses. Islamic finance is always meant for investment.

8. Benefits Accrued to the Society from Islamic Banking.

Which is the major benefit? Zakath Fund has been mobilized through banking system Welfare activities are organized through banking system The concept of Halal and Haram in case of investment/buying and selling has been introduced Mobilization of Financial resources to the real sector of the economy has been introduced New products of banking have been introduced.

9. Which is the major Basis of Development of Islamic Banking?

Mere faith in Islam; Intention to earn profit; To avoid interest; To ensure justice in the financial transactions; To contribute to the welfare of the economy

10. Which is the major Causes of Continuation of Interest-based Transaction

through Back Door by Islamic Banking system? Trading and Rental based modes of investment do not differ much from the interest-based transactions. Products of present Islamic Banking are similar to those of interest-based banking system. Risk-sharing in current practices of Islamic Banking is not proportional to its profiteering. Islamic banks are working along with the interest-based banks.



11. Which is the major Causes of Interest Creeping into the Islamic Banking System?

Exploitation is going on through Islamic system of banking Products of Islamic Banking have failed to remove the curse of interest from financial transactions. Banking professionals have led Islamic system of Banking to the garb of interest based banking. Islamic system of Banking was introduced in a society, which was not re-organized on Islamic ideology.

12. Present Success of Islamic Banks is not in Conformity with Shariah.

Which is the major cause? The status of Shariah Council/ Department is advisory, not supervisory in the system Islamic Banking. Earning of profit cannot be the success criterion. Justice and welfare in financial transactions are not ensured by Islamic Banks. Exploitation still remains in Islamic banking system.

13. Which is the major Cause of Not Patronizing the Islamic Banks by Rich and Prominent Muslim Businessmen and Industrialists?

They do not find any real business differences between Islamic and conventional banking Not conscious about Islamic banking. Confused about Islamic Banking. They are not motivated to I-Banking.

14. Most of Investment Financing Techniques by Islamic Banks do Not Share

Risk Proportionally Which is the major cause?

The Insurance Company covers risks of Islamic banks’ loans. Islamic Banks do not always buy for sale. Buying and selling arrangements by Islamic banks are almost risk-free. Islamic banks do business with depositors money and share risk

15. Many Customers are not interested in Dealing with Islamic Banks as they feel

that only the Name has been changed and Interest in Real Sense has not been eliminated. Which is the major cause?

Mark-up profit makes customers liable for additional payment, which is same as that of conventional bank’s fixed interest-based loan. Customers are required to repay banks money on installment basis Failure of installment payment creates additional liability The Islamic Banks in most cases do not consider business loss.



16. Possibility of Loss of Deposit is not Detrimental to Deposit Mobilization. Which is the major cause?

PLS system of banking does not lead to loss of value of deposit ultimately. It is realized profit of investment which makes return on bank deposit Halal. A true Muslim is not concerned about deposit loss, because he expects Haven in the life hereafter. It does not mean total loss of deposit.

17. Present Modes of investment of Islamic Banks are Compromised Modes of

Financing with Interest. Which is the major cause?

Both gives same effect on business results Both are justice and Welfare free. Both are working side by side. Both are working in the same value loaded society.

18. Moral Uplifting of the Society Will Pave the Way for Islamic Banking.

Which is the major cause? Islamic banks cannot work well in an immoral society. False values of life give detrimental environment to Islamic Banking. Governmental power can change the social values. Governmental reformation measures are powerful to build a moral society.

Thank you very much for corporate with me to completing this questionnaire

attitude of conventional and islamic bank customers towards islamic banking practices in sri lanka

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