Comparative Study Between Islamic Banks and Conventional Banks in Tanzania

Comparative study between Islamic and conventional banks; case study Islamic banks Tanzania

2012

INTRODUCTION

1: PREFACE.

All praise be to Allah. We praise Him and seek His help, forgiveness and guidance. We seek refuge with Allah from the evil of our own selves and from our evil deeds. Whomsoever Allah guides, none can lead astray, and whosoever He sends astray none can guide. I bear witness that there is no God but Allah alone, with no partner or associate, and I bear witness that Muhammad is His slave and messenger.

The following study is conducted due to the presence of one important economic instrument which has different system of management hence to show the similarities and differences between these instruments.

Islamic and conventional banks are all banks but having different system of managements, aspects, history, products and even acceptance according to laws. The research will discuss these aspects and more to make people aware of these instruments so as to remove the confusion on them and make them choose the best with the best reasons.

This study will be divided in to three chapters.

Chapter one will be all about Islamic and Conventional banks, theirs nature, history, products offered and many more.

Chapter two will discuss and show the similarities and differences of these banks.

Chapter three as the final chapter will discuss the case study of Islamic banks in Tanzania.

I pray to Allah to make this study be the sources of awareness about these banks especially in Tanzania where by people haven’t got exactly meaning and differences of these banks.

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2) JUSTIFICATION OF THE RESEARCH:

i. The research will define, show and explain the short history of Islamic and Conventional banks.

ii. This research will show the comparison of Islamic and Conventional banks.iii. The research will show roles and activities of Islamic and Conventional

banks in the community.iv. In this research products offered by these banks will be shown and

discussed.v. This research will show number of Islamic and conventional banks in

Tanzania.vi. This research will show the case study of Islamic banks in Tanzania.

3) OBJECTIVES OF THE RESEARCH ARE

This Research bases on the following objectives

i. To show, define and explain history of banks and the role it play in economic development.

ii. To show similarities and differences between Islamic and conventional banks.

iii. To give people awareness that will make them choose the best banking system for their development.

iv. Additional knowledge on banks to the researcher and those who will read the research.

v. Showing how Islamic banks entered in Tanzania.

4) RESEARCH PROBLEM

Banks are instruments that facilitate economic development in any country due to their roles in an economy. Due to development of knowledge and economic systems lead to emerging of new kind of banks that offer services on different way to the earlier existing ones. These development lead to confusion among people over these two kinds of banks. What are the similarities and differences between Islamic and conventional banks?

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5) RESEARCH HYPOTHESIS

Several similarities and differences on Islamic and conventional banks exist.

6) RESEARCH METHODOLOGY

The nature of this study bases on descriptive and analytical method of covering the study. The research project draws its information from published books, journals, reports, seminars, internet and other research projects.

7) STRUCTURE OF THE RESEARCH.

1) CHAPTER ONE: Islamic and Conventional banks. It provides an overview of the history of banking, history of both Islamic and conventional banks, discusses about interest and its reasons for banning, roles and objectives of Islamic banks and conventional banks and how they are operating today.

2) CHAPTER TWO: Comparison between Islamic and conventional banks. It shows the similarities and differences between Islamic and conventional banks.

3) CHAPTER THREE: PRESENTS ISLAMIC BANKS IN TANZANIA.

It explains basic country data, the general banking status, the key challenges and the history and current status of Islamic banks in Tanzania. Also it discusses future prospects of Islamic banks in Tanzania and case study of Amana bank Tanzania. In addition to the study there is conclusion and recommendations from the study above.

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1. General history of banking.

Banking operations were practiced by almost all known early civilizations, long before 12th AD.

Most economists maintainthat “Banking was Italian by birth”. Firstly, because the technical World Bank is derived from the Italian world Banco which means a table or a bench in which Italian money changers used to display their monies and records and conduct their transactions.Secondly,because they considered that the first bank worth of the name were those established in Venice,Florence,genoa and Lucca in Italy, during the 12th century1.banking is often considered as a modern device of recent origin, but a glance through the pages of financial history dispels the notion of novelty.

In order to accomplish the purpose of this research paper I will divide banking in two groups as follows

1) Islamic Banking2) Conventional Banking.

1.1-ISLAMIC BANKING.

When we discuss about Islamic banking we have first to discuss about Islamic financial system in brief.

Islamic financial system overview:

A financial system that is based on Islamic principles and values,which eliminates Riba and ensure a profit sharing mechanism in the financial system.

It is characterized by the absence of interest based financial institutions and transactions, doubtful transactions or Gharar,stock of companies dealing in 1 Abdel kaderChachi,(2005) origin and development of commercial and Islamic banking operations, Islamic economics research Centre king Abdul Aziz Universityvol.18, Jeddah Saudi, page no22.

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unlawful activities,unethical or immoral transactions such as market manipulation,insider trading short-selling etc.1

1.1.1 ISLAMIC BANKS(INTEREST FREE COMMERCIAL BANKS):

Islamic banking (or participant banking) (Arabic: اإلسالمية is banking (المصرفيةor banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees (known as Riba or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also Haraam (forbidden). While these principles may have been applied to historical Islamic economies, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.2

Islamic banking is a banking based on Islamic law(shariah) it follows shariah calledfiqhmuamalat(Islamic rules on transactions) the rules and practices of fiqhmuamalat came from the quran and sunnah,and other secondary sources of Islamic law such as opinions collectively agreed among shariah scholars(ijma’),analogy(qiyas) and personal reasoning(ijtihad).3

Islamic banking is a banking system that was developed based on the sharia (law) of Islam. Establishment of business system is based on the Prohibition in the Islamic religion to collect and borrow with interest or so-called "usury" as well as investment restrictions for businesses, categorized illegitimate in Islamic law (such as businesses associated with food production / "drink unclean", the business un-Islamic media, etc.), where this cannot be guaranteed by the conventional banking system4

1Dr.MdNurul Islam(2012),Islamic financial system,slide share.net,4th April 2012,03:402 En.wikipedia.org/wiki/Islamic_banking,march 25 2012,04:303 What is Islamic banking,www.bankinginfo.com,march 25 2012,10:124Introduction of Islamic banking, Islamicbankinwiki.blogspot.com,march 25 2012,12:10

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1.1.2 HISTORYOF ISLAMIC BANKSThe history of Islamic banking can be divided in to two parts, first when it was still as an idea and second when it became to reality.

1.1.2.1 Islamic banking as an idea

Interest-free banking seems to be of very recent origin. The earliest references to the reorganization of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), NajemSiddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961). Muhammad Hamidullah’s 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha- profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), NejatullahSiddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. 1

1A.L.M.AbdulGafoor(1995),Interest-free commercial banking,apptecpublications,Groningen,Netherlands

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1.1.2.2 The coming into being of Islamic banking

The first Islamic bank was started in Myt.Ghamar savings bank in Egypt in 1963 by the efforts of Ahmad El Najjar.Islamic banking movement achieved steady progress and assumed significant dimension and role the establishment of the Nasser social bank in 1972,Dubai Islamic bank in 1975,and Faisal Islamic bank in Egypt and Sudan in 1977.The banking system of Iran and Pakistan were Islamized while that of Sudan has been totally remodeled based on the principles of the Islamic shariah. Latter on the establishment of Bank Islam Malaysia Bahad(BIMB) IN 1983,Al-Baraka bank Bangladesh ltd in 1987,social investment bank and Al-Arafa Islamic bank in 1995 in Bangladesh. The Islamic development bank (IDB) was established in 1975 with the aim of fostering the development and cooperation among its members which reaches approximately to 50 recently.The development of Islamic financial system lead to establishment of these banks in western countries, in London England there is Al-Baraka international bank, inDenmark, the Islamic bank international of Denmark and many more banks in western.1

1Dr.MuhammedLoqman and KaziDeen Mohammad (2002), Islamic banking for economic development (paper in wamy’s ninth International Conference) Riyadh Saudi Arabia.

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Figure no1

Figure below shows the history and development of Islamic banking.

1.1.3 INTEREST (RIBAA)

Since interest (ribaa) is the main different between Islamic and conventional bank,I see the importance of discussing it for the better understanding of it.Riba literally means increase, addition, expansion or growth. It is however, not every increase or growth which has been prohibited by Islam. In Shari'ah, Riba technically refers to the premium that must be paid on a financial transaction without any consideration.

1 Islamic banking,slideshare.net,march 26 2012,09:20.

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It is the addition of premium paid to the lender in return for the waiting period as a condition for the loan. Riba has the same meaning and import as interest in accordance with the consensus of all fuqaha (jurists) and is haram.1

1.1.3.1 Types of interest (ribaa)

Scholars have divide ribaa in two main typesi) Ribaa al-fadlii) Ribaa an-nasiyah

Firstly:Ribaa al-fadl,Al-fadl in the language means az-ziyaadah(increase).Technically it refers to the increase in two homogenious,instantribaaitems. Example of this is twenty grams of gold exchanges with fifteen grams of gold. Another example exchanging an amount of money notes for lesser amount of crispy new money notes. So if you exchange gold or money of same value, withits like and with addition, you have fallen into ribaa al-fadl as long as exchange is instant. However if you exchange twenty with fifteen in defferement, then it is ribaa al-fadl and naseeah.2

From 'Umar ibn al-Khattab: The last verse to be revealed was on riba and the Prophet, , was taken without explaining it to us; so give up not only riba but also raibah [whatever raises doubts in the mind about its rightful-ness]. (IbnMajah,)The Prophet, , said, "Sell gold in exchange of equivalent gold, sell silver in exchange of equivalent silver, sell dates in exchange of equivalent dates, sell wheat in exchange of equivalent wheat, sell salt in exchange of equivalent salt, sell barley in exchange of equivalent barley, but if a person transacts in excess, it will be usury (riba). However, sell gold for silver anyway you please on the condition it is hand-to-hand (spot) and sell barley for date anyway you please on the condition it is hand-to-hand (spot)."3

1 Islamic banking,www.gulfafricanbank.com,march 28 2012,05:082 Rules of business in islam An-Naseehah 2008 3Guide to Islamic banking,www.gulf African bank.com,april 1 2012,05:30

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Secondly:Ribaa an-Nasiyah(ribaa al Quran):

Technically refers to the deferment of taking the possession of one of the two ribaa items thjat agree in the reason of ribaa al-fadl.So when we have two ribaaa items that agree in the reason of ribaa al-fadl even if they are not the same,it is obligatory when exchanging both of them that they are hand to hand.For instance you have gold which you want to exchange with silver, here they are not the same but agree in reason, so they have to be hand to hand (instant reciprocal taking of position).On the exchange of Sudanese pounds with usdollar, here the kind is different but they agree in reason which is the fact that they are both money. In this case it is obligatory that they are hand to hand when being exchanged.1

The Prophet,said: "There is no riba except in Nasiyah [waiting]."2

Any loan that charges interest has this kind of ribaa.

Ribaa is totally banned in Islam, it is haraam.so many texts from Quran, hadeeth of the holly prophet even the Christianity texts revealed the banning of ribaa.

1.1.3.2 Text evidence for banning of ribaa (usury, interest) according to the holly Quran:i) "That which you give as interest to increase the people’s wealth increases not with God; but that which you give in charity, seeking the goodwill of God, multiplies manifold."3

ii) "O believers, take not doubled and redoubled interest, and fear God so that you may prosper. Fear the fire which has been prepared for those who reject faith, and obey God and the Prophet so that you may receive mercy."4

iii) "Those who benefit from interest shall be raised like those who have been driven to madness by the touch of the Devil; this is because they say: "Trade is like interest" while God has permitted trade and forbidden interest. Hence those who have received the admonition from their Lord and desist, may keep their

1Op.cit,p10,2Bukhari, Kitab al-Buyu', Bab Bay' al-dinari bi al-dinar nasa'an; also Muslim and Musnad Ahmad3Surah al-Rum, verse 394Surah Al 'Imran, verses 130-132)

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previous gains, their case being entrusted to God; but those who revert shall be the inhabitants of the fire and abide therein forever, God deprives interest of all blessing but blesses charity; He loves not the ungrateful sinner, those who believe, perform good deeds, establish prayer and pay the zakat, their reward is with their Lord; neither should they have any fear, nor shall they grieve, 0, believers, fear Allah, and give up what is still due to you from the interest (usury), if you are true believers, If you do not do so, then take notice of war from Allah and His Messenger. But, if you repent, you can have your principal. Neither should you commit injustice nor should you be subjected to it, If the debtor is in difficulty, let him have respite until it is easier, but if you forego out of charity, it is better for you if you realize, And fear the Day when you shall be returned to the Lord and every soul shall be paid in full what it has earned and no one shall be wronged.”1

1.1.3.3 Text evidence for banning of ribaa (usury, interest) according to hadeeth(traditions)of the holly prophet:

i) From Jabir:The Prophet cursed the receiver and the payer of interest, the one who records it and the two witnesses to the transaction and said: "They are all alike [In guilt]."2

ii) From Abu Hurayrah: The Prophet, , said: "There will certainly come a time for mankind when everyone will take riba and if he does not do so, its dust will reach him."3

1.1.3.4 Text evidence for banning of ribaa (usury, interest) according to the Christian books.i) “Those who don’t charge interest on the money they lend, and who refuse to accept bribes to testify against the innocent. Such people will stand firm forever “psalm 15:5ii) “…..oppressing your own relatives by charging them interest when they borrow money…”Nehemiah 5:74

1Surah al-Baqarah, verses 275-2812Muslim, Kitab al-Musaqat, Bab la'niakili al-ribawamu'kilihi; also in Tirmidhi and Musnad Ahmad3Abu Dawud, Kitab al-Buyu', Bab fi ijtinabi al-shubuhat; also in IbnMajah

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“You shall not lend upon interest to your brother, interest on money, intereston victuals, interest on anything that is lent for interest. To a foreigner youmay lend upon interest, but to your brother you shall not lend upon interest;that the Lord your God may bless you in all that you undertake in the land whichyou are entering to take possession it.”Deuteronomy 23:19-201

1.1.4REASONS FOR BANNING INTEREST

Interest is prohibited because it is unfair (zulm )

In the case of productive loans the borrower may sometime lose, yet interest based lending obliges him/her to repay the principal plus interest. Sometime the borrower may reap huge profits, yet the lender gets only the stipulated rate of interest which is usually a very small part of the actual profits.

Modern researches have shown that interest has bad consequences for the economy. It results in inefficient allocation of society’s resources. It contributes to the instability of the system. Also, it increases the inequality in the distribution of income and wealth as it guarantees a continuous increase in the monies lent out, mostly by the wealthy, and puts the burden of bearing the losses on entrepreneurs and, through loss of jobs, the workers.2

Like many other evils, the practice of charging a fixed positive return to loan capital has survived strictures from all world religions and condemnation by all moral philosophers. In the earlier days the role of capital in the economy was much less important than it is today. Humanity has much more to suffer because of making interest the linchpin of its financial system in a globalized world using huge quantities of capital. As briefly mentioned above much of the inequity, inefficiency and instability of the modern economy owes itself to interest. It is also a major stumbling block in the way of a moral approach to the global economy based on sharing of resources and caring about the weak and the poor. It is time the negative economic role of interest and its immoral nature was realized by all.

4El Safi Fateh Al rahmanAbdalla Mohammed (2009),” A macroeconomic model of interest-free and open economics,AnEmpericalAnalisys for Sudan economy(1990-2004)”A thesis submitted to the university of Khartoum for degree of PHD(economics),p 18.1 Larry Burkett, what the bible say about money,www.kantakji.com,april 2 2012 2Mohammad NejatullahSiddiqi(2002), THE WISDOM OF PROHIBITION OF INTEREST, paper Presented at LaRiba annual meet at Los Angeles, CA, on 30 March 2002,p 45

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The wisdom of prohibition of interest lies in the divine hand guiding men and women towards a better economy and a better society.

Simply I can say these are few reasons for prohibition of ribaa:

Unjust Corrupts society Unlawful appropriation of other people’s property Its system results on negative growth Demines and diminishes human personality.

1.1.5SIX KEYS ISLAMIC BANKING PRINCIPLES.

Six key principles drive the activities of Islamic banks are:

Predetermined loan repayments as interest(riba)is prohibited; Profit and loss sharing is at the heart of the Islamic system; Making money out of money is unacceptable; all financial transactions

must be asset-backed; Speculative behavior is prohibited;1

Only sharia’a-approved contracts are acceptable; Contracts are sacred.

1.1.5.1 Predetermined payments are prohibited.

Any predetermined payment over and above the amount principle is prohibited. Islam allows only one kind of loan and that is qard al Hassan (meaning good loan).where by the lender does not charge any interest or addition amount over the money lent. Traditional Muslim jurists have construed this principal so strictly that, according to one Islamic scholar

The prohibition applies to any advantage or benefit that the Leander might secure out of the qard(loan) such as riding the borrower’s mule, eating at his table or even taking advantage of the shade of his wall.

1Brian B.Kettell(2011).Introduction to Islamic banking and finance. John Willey and sons publishers.

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The principle, delivered from this quotation,emphisises that any associated or indirect benefits that could potentially accrue to the Leander, from lending money, are also prohibited.

1.1.5.2 Profit and loss sharing:1

The principle here is that the lender must share in the profit or losses arising out of the enterprise for which the money was lent. Islamic encourages Muslims to invest their money and to become partners in order to share profits and risks in a business instead of becoming creditors. Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business venture, whether those are industries, service companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the reward of financial business ventures.

This is unlike the interest-based commercial banking system, where all the pressure is on the borrower who must pay back the loan, with the agreed interest regardless of the success or failure of his venture.

The central principle is that under any Islamic financing arrangement the financier is only entitled to returns if risk is involved. If a return is expected there must be risk. If there is no relationship between risk and return, then this financial arrangement is not permitted Islamically. It is lack of risk, which takes place with allowing riba. That makes interest so anathema to Muslims.

The resulting principle is that in order to ensure that investments are made into productive enterprises, Islam encourages particular types of investments so that the community may ultimately benefit however Islam is not willing to allow a loop hole to exist for those who do not wish to take risks with their investment but are instead on hoarding money or deposition money in a bank in return for receiving interest (riba) on these funds for no risk (other than the bank becoming insolvent).

Accordingly, under Islam, people invest with risk or suffer loss by keeping money idle. Islam encourages the motion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective of all this is to encourage investment and thereby provide a stimulus to the economy and encourage entrepreneurs to maximize their efforts to make them succeed.

1Ibid,p 14

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1.1.5.3 Making money out of money is not acceptable.

Making money out of money is not Islamically acceptable money in Islam, is only a medium of exchange, a way of determining the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via fixed interest payments, simply by being deposited in a bank or lent to someone else.

The human effort-that is, the initiative and risk involved in a productive venture become more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as loan is regarded as a debt of the business and not capital as, such it is not entitled to any return(such as interest). Muslims are encouraged to spend and /or invest in productive investments and are discouraged from keeping money idle. Hoarding money is regarded as being Islamically unacceptable in Islam, money represents purchasing power, which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the creation of goods and services.

1.1.5.4 Uncertainty is prohibited1

Gharar(uncertainty, risk or speculation) is also prohibited, and so any transaction entered should be free from these elements contracting parties should have perfect knowledge of the counter-values intended to be exchanged as a result of their transactions. In this context the term counter-value is used in the sense of something being differed, either the price paid or the commodity received. Deferral of payment is an acceptable form of debt under Islam, in contrast to predetermined debt in conventional finance. Also, parties cannot predetermined a guarantee profit. The rationale behind the prohibition of gharar is the wish to protect the weak from exploitation. Therefore, options and future, considered to be very risky, are deemed to be forbidden as are forward foreign exchange transactions, given that forward exchange rates are determined by interest rate differential.

1.1.5.5 Only sharia approved contracts are acceptable

Conventional banking is secular in its orientation. In contrast, in the Islamic system, all economic agents have to work within the ethical system of Islam. 1Ibid,p 15

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Islamic banks are no exception. As such, they cannot finance any project that conflicts with the Islamic moral value system. For example Islamic banks are not allowed to finance a wine factory, a casino, a night club or any other activity prohibited by Islam or known to be harmful to society.

1.1.5.6 Sanctity of contract.1

Many verses in the Holy Qur’an encourage trade and commerce, and the attitude of Islam is that there should be no impediment to honest and legitimate trade and business. It is a duty for Muslims to earn a living, support their families and give charity to those of less fortune.

Just as Islam regulates and influence all other spheres of life so it also governs the conduct of business and commerce. Muslims have a moral obligation to conduct their business activities in accordance with the requirements of their religion. They should fair, honest and just towards others. A special obligation exists upon vendors because there is doctrine of caveat emptor in Islam. Monopolies and price-fixing are prohibited.

These basic principles of the law are laid down in the four root transactions of:

Sales(bay):Transfer of ownership or corpus of property for a consideration Hire (Ijara): transfer of the usufruct (right to use)of property for a

consideration. Gift(Hiba):gratuitous transfer of the corpus or property Loan(ariyah):gratuitous transfer of the usufruct of property

These basic principles are then applied to the various specific transaction of, for example,pledge,deposit,guarantee,agency,assignment,land tenancy,waaf foundations(religious or charitable bodies) and partnerships.Islam upholds contractual obligation and the disclosure of information as a sacred duty.This feature is intended to reduce the risk of asymmetric information and moral hazard.

1.1.6Objectivesand roles of Islamic banks.

The objectives of Islamic banks in general is to promote, foster and develop the application of Islamic principles, law and tradition to the transaction of financial,

1Ibid,p 16

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banking and related business affairs and to promote investment companies, enterprise and concerns which shall themselves be engaged in business activities as are acceptable and consistent with Islamic principles, laws and traditions and in no event engaged in the alcoholic beverages trade, the receipt of interest forbidden by Islam, the gambling industry or the pork meat or any other un-Islamic activity.1

Also we can find these banks having other objectives like poverty eradication through the activities or services offered by these banks. Since these banks gives loans without interest and enters in partnership with its customers this gives them an ability to start several projects latter solves poverty problem.

Islamic banks plays big role in economy, these banks reduces poverty level through all activities offered, in Islamic countries where by many banks are Islamically we can see easy capital creation and investments. It is easy to invest because these banks offer partnership and loans without interest.

1.1.7: PRODUCTS, ACTIVITIES OFFERED BY ISLAMIC BANKS (HOW ISLAMIC BANKS OPARATES).

Since Islamic banking do not clash with normal banking activities, Islamic banks have adopted the current banking tools and procedures. Where any clash arises, the Islamic banks have devised their own tools and procedures to accomplish their banking activities. Such tools and procedures that have been devised so far are enumerated here:

A. DEPOSITSB. INVESTMENTS ACTIVITIES

A: DEPOSITS

This refers to an act of placing money or valuable item like gold or papers in a bank or other financial institution.2

1. Khan Mohammad.Fahim(1981),”Islamic banking as practiced now in the world”,paper presented at the international seminar on monetary and fiscal economics of islam (January 1981.)held in Islamabad,Pakistan p 102 Encarta dictionaries

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Islamic banks receive two types of deposits:

I. Deposits not committed for investment which take the form of current accounts or saving account(savings account)

II. Deposits committed for investment.(investment accounts)

Current account is operating on the same way as it is operating in conventional banking system

I. Saving accountsIn this account customers can deposit their savings. Though these depositors allow the bank to use their money, they get a guarantee of getting their full amount bank from the bank.in this case bank guarantees their savings but is not obliged to pay any rewards to the saver.however,most of the banks are still paying either a cash reward from their profit at the end of their financial year or are giving some privileges to the holders of these accounts,e.g. providing financial support for small projects, sale of consumer durables or producers goods by installment, distributing gifts etc. These rewards are discretionary and not obligatory and are paid only in case the bank is earning substantial profits. 1

II. Investment accountsInvestment accounts can be of two types,a. Accounts with authorizationHere account holders authorize the bank to invest the money in any of its projects. After the expiry of a specified period, the account holder will get the profit.b. Account without authorizationIn investment accounts without authorization, the account holder may choose any particular project for investment of his deposited money. He may or may not specify the period of deposit. The bank will give share to the account holder from the profit particular project which has been chosen by him according to agreed percentage. If the investment accounts are opened for a fixed period, the

1Op.cit,p 18

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customer is not allowed to withdraw his money before the lapse of specified period. If he does so, the customer either is not entitled to the share of in profit at all or may be entitled to receive some discounted profit depending upon the duration of the deposit with the bank.These deposit schemes of Islamic banks have been able to attract a substantial number of depositors.1

B.INVESTMENT ACTIVITIESAs the bank cannot earn interest by lending the money, therefore the Islamic banks have to undertake investment to earn profit not only for the bank itself but also for the depositors in the investment account. Below are the investment procedures on the Islamic principles:

A. MUSHARAKAH(EQUITY PARTIPATION,JOINT VENTURE):A joint venture based on musharakainvolves a partnership in whichboth the bank and its customer-client contribute to entrepreneurship and capital.2

The banks and their clients agree to join in a temporary participation (not quite different from joint venture) for effecting a certain operation within an agreed period of time. Both parties contribute to the capital of the operation (meanly assets and managerial expertise working capital etc.) in varying degrees and agree to divide the net profit in proportions agreed upon in advance. There is no set formula for profit sharing and each case is dealt with on its own merits.3

Types of Musharaka partnerships4

There are many types of Musharaka ranging from traditional types of partnerships to modern corporations. Musharaka could either be:

Permanent musharaka: An Islamic bank participates in the equity of a project and receives a share of the profit on a prorata basis. The time length of the contract is specified, making it suitable for financing projects where funds are committed over a long period.

1 Op.cit,p142Mohammed Obaidullah(2005),Islamic financial services,Islamic economics research centre king Abdulaziz university Jeddah,SaudiArabia,march.p 453Op,cit,p 184Introduction to Islamic banking www.gulfafricanbank.com,may15 2012,12:44

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Diminishing musharaka: This allows equity participation and sharing of profits on a prorata basis, and provides a method through which the bank keeps on reducing its equity in the project, ultimately transferring ownership of the asset to the customer. The contract provides for payment over and above the bank's share in the profit for the equity held by the bank. Simultaneously the entrepreneur purchases some of the banks equity, progressively reducing it until the bank has no equity and thus ceases to be a partner.

B. MUDARABAH OR QIRADH(Agencies):It is a partnership in profit whereby one party provides capital (rab al-maal-the bank) and the other party provides the know how/labor (Mudharib).1

In this procedure of investment, bankcontributes all the financing (and customer contributes only his managerial efforts or labor) and gets again an agreed proportion of the profit actually realized.in both mudarabah and musharakah, both sides stand to incur any profit depending on the actual performance of the operation. In the mudarabah contract however, themudarabah (the partner offering his efforts) will lose nothing but his labor (as the principle capital is not his) in case of financial loss resulting from normal business conditions. The bank that has financed the capital bears all the finance risks. This financial risk justifies the bank to claim his share in the profit. The client is however held responsible for loss of capital, should this be the result of his negligence or willful act.to guard against this,the bank may require a security from the customer.

C. MURABAH(mark-up sale):This is a procedure where a partner approaches the bank that certain items(be a commodity or otherwise) be bought for him and he agrees to pay the bank later on, upon the fulfillment of the actual buying, an agreed percentage of profit.in order to avoid any riba element one of the banks provides that the agreement of the bank and the actual execution of buying do not contribute any legal obligation(according to shariah) on the partner to buy. Hence the risk is still that of the bank’s. Until the partner fulfills his original promise of “rebuying” the commodity, the risk remains with the bank which justifies the profit.2

D. BAI SALAM (post-delivery sale):

1 Introduction to Islamic banking,www.gulfafricanbank.may15 2012,01:502Op,cit,p 18

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The bank buys certain goods on post-delivery and pays the cost immediately or sells certain goods on post-delivery and receives its cost immediately.in this sale, cost of goods is fixed and paid in advance but the delivery of the sold items is postponed or delayed up to a certain period. Similarly, the place of delivery, its expenses and quantities of the sold goods should also be fixed and defined as they are conditions for such a sale.1

E. IJARAH(LEASE,RENT):

Is the same as leasing thus leasing practiced in interest – free banks are similar to its conventional practice. During the life of the asset, the risk of ownership remains with the bank, while the lessee is liable for misuse of the asset.

Ijarahthumma al bai' (hire purchase)2

Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price.

The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract.

This type of transaction is similar to the contractumtrinius, a legal maneuver used by European bankers and merchants during the middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being

1Op,cit,p 182 Islamic banking,www.en.wikipedia.org,may 15 2012,05:00

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the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.

Ijarah-wal-iqtina1

A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

F. ISTISNA’A

Istisna’a is a contract whereby a party undertakes to produce aspecific thing which is possible to be made according to certainagreed-upon specifications at a determined price and for a fixed dateof delivery. This undertaking of production includes any process of manufacturing, construction, assembling or packing.2

The Arabic word “Istisna’a” means “asking someone to manufacture”. It may be further defined and elaborated as a sale contract between the seller and the buyer for the sale of an asset described in the sale contract and transacted before it comes into existence. To fulfill its obligation, the seller can either manufacture/construct it by itself or can get it manufactured/constructed by someone else to deliver it to the buyer on the date described in the sale contract. The buyer can pay the sale price in lump sum at the time of signing the contract or later in different stages as the manufacturing/construction process proceeds.3

1Islamic banking,www.en.wikipedia.org,may 15 2012,08:09.2Istisna’a www.isdb.org may 15 2012,02:223 Major real estate products,www.sib.ae/en, may 15 2012,01:09.

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The bank can utilize Istisna'a in two ways:

It is permissible for the bank to buy a commodity under Istisna'a contract and sell it on receipt of cash installment or deferred payment basis. It is also permissible for the bank to enter into Istisna'a Contract in the capacity of seller to those who demand a purchase of a particular commodity and then draw a parallel Istisna'a Contract in the capacity of a buyer with another party to make (manufacture) the commodity agreed upon in the first contract. 1

1.1.8.ISLAMIC BANKS TODAY:Muslim economists have been trying to present the interest-free economy in theoretical models but unless some successful working example is presented to both businessmen and economists their logic, no matter how convincing, will remain doubtful.During 1960’s and 1970’s individual efforts were made in various Muslim countries to establish interest free banks. These efforts presents not only an excellent working example for those who did not believe in the practically of the institution but also provide a spade-work over which the infrastructure of interest=free banking for a country could be built up.

Recently in the world Islamic banks are widely spread all over it.before Islamic banks where mostly seen in Arabic and Islamic countries, so far countries like Malaysia,iran,sudan,Pakistan,Bahrain,Kuwait,united Arab emirates and Egypt are mostly developed in Islamic economy since they started earlier than other countries. Countries like Britain, Usa also are improving due to the people’s need of this new financial experience without interest.In Africa Islamic banks is widely growing through so many banks and adopting of Islamic windows on non-Islamicbanks. These windows works as like an Islamic bank.

Islamic windows in conventional banks:

1 Istisna’a www.barakaonline.com, May 15, 2012,11:23

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An Islamic window is generally defined as part of a conventional financial institution that undertakes Shariah-compliant deposit-taking, financing, investment and/or fund management activities. In principle, Islamic windows are potentially self-contained in their Shariah -compliant financial intermediation activities, and the funds mobilized are invested in Shariah -compliant assets. Thus, an Islamic window is a virtual branch without separate legal existence within the parent institution. Being a separate business unit that undertakes a complete range of financial intermediation activities, from sourcing of funds to extension of financing, an Islamic window shall be responsible to its fundproviders in the same way as a full-fledged Islamic bank.1

Globally now many of giant financial institutions and banks in the industry are using Islamic mode of financial so that they can be more competitive and due to development of industry and challenges they face.

Although it is difficult to know with certainty how many conventional banks around the globe use Islamic instruments of banking and finance, the list includes among others some of the world giants such as Kleinwort Benson, ChemicalBan, City Bank(usa),Bankers Trust, ChaseManhattan,Honkong and Shanghai banking corporation, union bank of switzerland,ABNamro(Netherlands),HSBC(uk),Deutche bank(Germany),and Societe General(France).2

Islamic financial industry is valued at $1.14 trillion and is growing at a rate of 10%. The industry is gradually building the depth, quality and quantity of its product portfolio and entering into new, previously unfounded fields in the financial markets. There are new-fangled Shari'a compliant derivatives, innovations in asset and wealth management, improvements in efficiency of banking and the creation of products which satisfy regulatory requirements.3

There are more than 350 Islamic financial institutions in more than 55 countries worldwide.

1 Policy dialogue paper no1(2007),Islamic financial industry services development, ten years framework and strategies, may.2 Muhammad al-bashirMuhammad al-Amine(2002)”,Islamic banking and finance and the challenges of globalization”,atwamy’s ninth international conference(29.10-1.112002),Riyadh Saudi Arabia.3“ Global Islamic financial report”2011http://www.zawya.com(asseced May 16, 2012) 11:20.

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1.2 CONVENTIONAL BANKS (UNIVERSAL AND COMMERCIAL BANKS)

1.2.1 Introduction and definition.

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.

Definition:

Universal bank is a banking system in which banks provide a wide variety of financial services, including both commercial and investment services. Universal banking is common in some European countries, including Switzerland. In the United States, however, banks are required to separate their commercial and investment banking services. Proponents of universal banking argue that it helps banks better diversify risk. Detractors think dividing up banks' operations is a less risky strategy1

Commercial bank A financial institution that provides services, such as accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment products like savings accounts and certificates of deposit. The traditional commercial bank is a brick and mortar institution with tellers, safe deposit boxes, vaults and ATMs. However, some commercial banks do not have any physical branches and require consumers to complete all transactions by phone or Internet. In exchange, they generally pay higher interest rates on investments and deposits, and charge lower fees.

What we can find here is commercial bank’s services are done by those universal banks but universal banks activities some are not done by those commercial banks. Universal banks are wider than commercial banks.

Therefore we see a conventional bank comprises both universal and commercial banks.

But many writes takes the name of conventional banks as same as commercial banks.

1 Universal banking,www.investopedia.com,26/05/2011,10:45

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1.2.2 Objectives and roles of conventional banks

As we saw from the introduction the main objective of conventional banks is profit gaining, whatever activity it does must bear profit. Through this objective conventional banks came to play big role in the community which leads to development due to some extra activities done for the community. Activities like giving social services to the community.

1.2.3 Products activities offered by conventional banks.1

Conventional banks offer several activities as an important financial institution in the economy. These activities are divided in to two groups

I. Primary functionsII. Secondary functions.

Primary functions of conventional (commercial) banks include:

a) Accepting deposits; andb) Granting loans and advances.

a) Accepting deposits.

The most important activity of a commercial bank is to mobilizedeposits from the public. People who have surplus income andsavings find it convenient to deposit the amounts with banks.Depending upon the nature of deposits, funds deposited withbank also earn interest. Thus, deposits with the bank grow alongwith the interest earned. If the rate of interest is higher, publicare motivated to deposit more funds with the bank. There is alsosafety of funds deposited with the bank.

b) Grant of loans and advancesThe second important function of a commercial bank is to grantloans and advances. Such loans and advances are given tomembers of the public and to the business community at a higherrate of interest than allowed by banks on various deposit accounts.

1 Function of commercial banks,www.nios.ac,28/5/2012,12:13

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The rate of interest charged on loans and advances variesdepending upon the purpose, period and the mode of repayment.The difference between the rate of interest allowed on depositsand the rate charged on the Loans is the main source of a bank’sincome.

i) LoansA loan is granted for a specific time period. Generally,commercial banks 1grant short-term loans. But term loans,

that is, loan for more than a year, may also be granted.The borrower may withdraw the entire amount in lumpsumor in installments. However, interest is charged on the fullamount of loan. Loans are generally granted against thesecurity of certain assets. A loan may be repaid either inlumpsum or in installments.

ii) AdvancesAn advance is a credit facility provided by the bank to itscustomers. It differs from loan in the sense that loans maybe granted for longer period, but advances are normallygranted for a short period of time. Further the purpose ofgranting advances is to meet the day to day requirementsof business. The rate of interest charged on advances variesfrom bank to bank. Interest is charged only on the amountwithdrawn and not on the sanctioned amount.

Modes of short-term financial assistanceBanks grant short-term financial assistance by way of cash credit,overdraft and bill discounting.

a) Cash CreditCash credit is an arrangement whereby the bank allows theborrower to draw amounts up to a specified limit. The amount iscredited to the account of the customer. The customer canwithdraw this amount as and when he requires. Interest is chargedon the amount actually withdrawn. Cash Credit is granted as peragreed terms and conditions with the customers.

1Ibid p 27

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b) OverdraftOverdraft is also a credit facility granted by bank. A customerwho has a current account with the bank is allowed to withdrawmore than the amount of credit balance in his account. It is atemporary arrangement. Overdraft facility with a specified limitis allowed either on the security of assets, or on personal security,or both.

c) Discounting of Bills1

Banks provide short-term finance by discounting bills, that is,making payment of the amount before the due date of the billsafter deducting a certain rate of discount. The party gets thefunds without waiting for the date of maturity of the bills. Incase any bill is dishonored on the due date, the bank can recoverthe amount from the customer.

ii) Secondary functionsBesides the primary functions of accepting deposits and lending money,banks perform a number of other functions which are called secondaryfunctions. These are as follows -a) Issuing letters of credit, travelerscheque, circular notes etc.b) Undertaking safe custody of valuables, important documents, andsecurities by providing safe deposit vaults or lockers;c) Providing customers with facilities of foreign exchange.d) Transferring money from one place to another; and from onebranch to another branch of the bank.e) Standing guarantee on behalf of its customers, for makingpayments for purchase of goods, machinery, vehicles etc.f) Collecting and supplying business information;g) Issuing demand drafts and pay orders; and,h) Providing reports on the credit worthiness of customers.

1.2.4 Conventional banks today.

1Ibid,p 28

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Conventional banking is the widely, worldwide spread product. Everywhere in the world conventional banks are found and controls business activities all over the world.

Today when you talk about conventional banks with its development you come back to the banking without interest (Islamic banks).These are new version of conversion bank according to many scholars.

2.1 Similarities between Islamic and conventional banks.Islamic and conventional banks as the important financial institutions in the economy have several similarities which are discussed below:2.1.1 Environmental they are operatingIslamic financial institutions (Banks) are operating in the same society where conventional banks are operating and perform all those functions which are expected from financial institutions.All these financial institutions are operating in the world to run the economic activities and bring benefits to the people in the world.1

1 Muhammad Hanif(feb 2011),” differences and similarities in Islamic and conventional banks” , International journal of business and social science, vol 2, no 2

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2.1.2 Commercial institutions.2

Both commercial institutions licensed to offer deposit investment schemes to customers.Deposits are collected from savers on both type of institutions for rewards irrespectively a bank is under Islamic or conventional system.Both are providing financial services to productive channel with rewards.Both invests with its customers in different economic activities.

2.1.3 Inter-bank facilities.2

Both have same temporary source of finance for liquidity management purpose.

2.1.4 Current account/ demand deposits.Both offer these services for safe keeping and convenience in payment. They are not offering return or profit. The face value of the deposit is guaranteed by the bank.

2.1.5 Investment accounts.

They are both offering this service, where by investors committed for a certain period of time. These accounts are usually not checkable and early withdrawal may be denied by bank, but usually allowed as per industry practice.

2.1.6 Retail servicesThey both offer similar forms of retail services like checking accounts, money transfer trade finance services, lockers, on line services, debit cards and Atm services.

2.2 Differences between Islamic and conventional banks.

2 Introduction to Islamic finance(28 April 2009), 1st East and Central Africa Islamic banking conference.2Ibid,p 30

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Islamic and conventional banking has some basic difference in theory and practice which draws a line of demarcation between the two entities. Although the basic function of the two institutions is to collect savings and transform them into junk amount and then lend to business firms, government, public sector organizations and individuals, yet the mode of the collection of surplus funds from the savers and lending it to the borrowers is different.

In the same way, the two institutions used to lend money to the borrowers but the objective of lending money is also different. For instance, the objective of the conventional bank is to maximize the wealth of the shareholders and in this way accumulate wealth through the institution of interest while the objective of Islamic bank is to stimulate business activities through profit-and-loss sharing and in this way it accelerates circulation of wealth and facilitate distribution of income. The mood and target of credit allocation is different The conventional bank helps concentration and accumulation of wealth in the sense that the net profit is distributed among shareholders which are few in number and in this way the wealth of shareholders rises exponentially year after year while the profit of Islamic bank is distributed among the depositors which are thousands in number and in this way Islamic bank helps widen distribution of wealth in the society. In other words, Conventional bank accumulates wealth by charging interest from its borrowers who are thousands in number but distributes it among few shareholders. Warde (2006:136) argues that “Conventional banking favors the rich, and those who are already in business, and is only marginally concerned with the success of ventures it finances. In contrast, under profit-and-loss sharing (PLS) system Islamic institutions as well as their depositors link their own fate to the success of the projects they finance. The system allows a capital-poor, but promising, entrepreneur to obtain financing.” 1

These differences make the two institutions totally different from each other. The two institutions operate in the same environment but with different modes of operation and opposite objectives Let us see how Islamic and conventional banks are different in their objectives and operations.

2.2.1 DIFFERENT MODE OF BORROWING1 Abdul GhafoorAwan(2009),”comparison of islamic and conventional banking in Pakistan”,proceedings 2ndCBRC,Lahore,Pakistan,November 14,

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Conventional banks offer different deposit schemes and borrow funds from the depositors. The rates of interest on these schemes are fixed and the banks are liable to pay these fixed rates of interest to depositors at the completion of term whether they earn profit or suffer loss. The depositors have nothing to do with the loss of bank. However, conventional banks used to pay low return to their depositors and charge high interest from their borrowers in order to maximize their profit.

In contrast, Islamic banks pays high return to their depositors since there is no fixed rate of interest on depositing. Islamic banks uses profit and loss sharing mode which earns more than one percent high return than interest-bearing deposits.

2.2.2 DIFFERENT MODE OF FINANCING

Conventional banks provide loans to government, business firms, public sector organizations and individuals. These loans are provided for project-financing, consumer financing and working capital on fixed interest basis. The conventional banks charge high rates of interest on all these types of loans. High rate of interest results in failure of businesses and default of loans.

Islamic bank also provides funds for project financing, consumer financing and for working capital. But its practice of financing is different from conventional bank. It provides loans on profit-and-loss (PLS) basis. Moreover, Islamic banks provide loans only for productive purpose and can be used for specific objective. The funds provided by Islamic banks cannot be used for gambling, speculation, pornography, alcohol, prostitutions and other such immoral purpose because Islam has prohibited such activities.1

2.2.3 DIFFERENT MODES OF INVESTMENTConventional banks make more than 50 percent investment in government Treasury bills, bonds and term finance certificates for security and smooth return. They also earn huge profit from stock market in case of bull-run and suffer badly in case of its crash.Islamic banks also make investment out of their deposits in different sectors. But this investment is different from conventional banking in a sense that Islamic banks cannot invest in government treasury bills, bonds and Term Finance 1Op,cit,p 32

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Certificates which carries fixed rate of interest. Because under Islamic laws Islamic banks can only invest in non-interest bearing financial instruments like equity market and they are prohibited to invest in government bonds and treasury bills. On account of this, Islamic bank has to face twin problems of excess liquidity and market risk. These two factors in past were responsible for low profitability of Islamic bank. But now the situation has been changed and Islamic bank faces no more such problem due to existence of well-established Islamic money market, Islamic Sukuk and Islamic mutual funds in almost all Muslim countries. Since 2000 about all central banks of Muslim countries have started issuing Islamic Sukuks (bonds) and it has provided an opportunity to Islamic banks to invest their surplus funds in these Sukuks. During 1999 and 2006 four Muslim countries, Pakistan, Malaysia, Bahrain and Qatar issued US$6.036 billion of sovereign Sukuks(see the table 1bellow).

Figure 2SOVEREIGN SUKUKS ISSUED BY DIFFERENT MUSLIM COUNTRIES

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Source: SelimCakir and FaezehRaei, “:Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk? IMF working paper No. WP/07/237, Middle East and Central Asia Department, Washington D.C., October 2007.1

2.2.4 DIFFERENT CONCEPT OF MONEYConventional bank and Islamic bank uses the money in different way and they have different approaches about the use of money. The conventional bank uses the money as a commodity which is bought and sold and on such two-way transactions they charge interest on it and make huge profit. Margrit Kennedy and Declan Kennedy (1995:17) maintains that “Every day almost everyone on this planet uses money. Yet few people understand how money works and affects their lives directly and indirectly. Money is one of the most ingenious inventions of humankind as it helps the exchange of goods and services and overcomes the limits of barter, that is, the direct exchange of goods and services. This is good news. But bad news is that money does not only help the exchange of goods and services but can also hinder the exchange of goods and services by being kept in the hands of those who have more than they need. Thus it creates a private toll gate where those who have less than they need pay a fee to those who have more money than they need. The growth of cancer disease and interest bearing money has similarly in a sense cancer follows exponential growth pattern. It grows slowly first, although always accelerating, and often by the time it has been discovered it has entered a growth phase where it cannot be stopped. Exponential growth in the physical realm usually ends with the death of the host and the organism on which it depends. Based on interest and compound interest, our money doubles at regular intervals, i.e., it follows an exponential growth pattern. This explains why we are in trouble with our monetary system today. Interest, in fact, acts like cancer in our social structure.”

This is a good example how conventional banking system works and uses interest to make money out of money. People who borrow money on interest sometimes commit suicide when they have lost all their assets and have nothing to pay off their loans. In other words, interest is just like cancer and it cripples the human being in the same way as cancer disease.

1Ibid,p 32

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In contrast, Islamic bank use money as a medium of exchange to facilitate trade transactions. Islamic bank supplies money to traders to purchase real assets and to industrialists to purchase plants or raw material to augment production process and produce value-added products. If the finance-takers generates profit from their business activity they will share it with Islamic bank according to proportion of bank’s financing. If he suffers losses the bank will share the loss. Thus, Islamic bank does not use money to multiply its wealth and it has opposite concept of money.

2.2.5 DIFFERENT CONCEPT OF RISK-SHARINGIslamic banking is perfectly a risk-sharing (PLS) system because both investor (lender) and entrepreneur (borrower) equally share risk. There is no mismatch between the asset and liabilities of Islamic bank or business firm because their 1depositors or investors are ready to share loss in case of economic shock. Thus, there is very minimal chance of bankruptcy of Islamic bank or business firm because they have inherent strength to cope with the onslaught of financial turmoil or market disturbance. Whereas the conventional banking is non-risk-sharing system as the investors or lenders have nothing to do with the loss of borrower. They receive fixed rate of interest on their investment and they are not bother where the borrowed money is being spent. In conventional banking, the borrowers are fully responsible to take every kind of risk and bear loss. In case of business failure, he has to loose collateral. Opposite to this practice, Islamic bank or investor is vigilant about the proper use of loan and watch the activities of the borrower because his risk is involved and he can lose total investment in case of business failure or misuse of loan.

2.2.6 DIFFERENT APPROACHES OF INCOME DISTRIBUTIONThe interest-based financial system is a pro-rich and anti-poor because it facilitates accumulation of wealth and resources. The study of advanced capitalist economies has proved that the rich are becoming richer while poor have been kept at subsistence level. During 1960 and 1998 the income of poorest 20 percent of the world population was reduced from 2.3 percent to only 1.2 percent more than 100 percent fall in their income. Whereas the income of the top 20 percent of the world’s population jumped to 89 percent, an increase of about 26 percent. In some countries the concentration of wealth and power has become so enormous that the World Bank has warned of the “inefficiently of such wealth concentration”. Gregory and Stuart (1992:87) in their book “Comparative Economic System” quoted the philosopher, John Rawls, who argues that “an unequal distribution of 1Ibid,p 32

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income persists because those who benefit from income inequality are unwilling to accept changes that favor the poor. People are unwilling to agree to redistribution because those who will be rich know fairly early in life their chances of being rich. For this reason, a social consensus can never be formed whereby the rich agree to redistribute income to the poor”.Contrary to conventional financial system, Islamic financial system has a clear vision about equitable distribution of resources and amelioration of human being particularly poor class. Zakat, a compulsory tax on the wealth of rich, plays a vital role in eradication of poverty and uplift of the living standard of the poor. The underlying objective of Zakat is to collect money from the rich and distribute it among the poor. The Second Caliph, Hazrat Umar, who first introduced “social security system” in the world, fixed cash allowance and a quantity of essential food items for each citizen including women, children, infants and minorities and distribute extra revenue among them. It made the whole society prosperous and happy. The 2.5 percent Zakat on the wealth of the rich is aimed at discouraging hoarding and concentration of wealth.

2.2.7 HAVING DIFFERENT OBJECTIVES AND GOALSThe goals of Islamic banking are quite different from the goals of Conventional banking. The core difference between the goals of these two financial systems is that the former works for the benefit of overall society and for equitable allocation of resources through credit distribution while the latter works for the financial uplift of the rich and their owners. Islamic bank works for everyone, needing money to start or expand his business or produce value-addition whereas Conventional bank works for a specific class that is rich. The underlying objective of Islamic bank is to earn profit through horizontal distribution of financial resources while the objective of Conventional banks is to maximize its profit by concentrating the resources and charging high rates of interest. Margrit Kennedy (1995) in her book “Interest & Inflation Free Money” highlights of the goals of Conventional banking by arguing that “Most often bankers impress people with the idea that money should ‘work’ for them. However, nobody has ever seen money working. Work has always been done by people with or without machines. They conceal the fact that dollar which goes to the investor of money is the accomplishment of another person from whom this amount is being taken away, no matter in which way that might happen. In other words, people who

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work for their money are getting poorer at the same rate at which the investment of those who own money doubles. That is the whole mystery of how money ‘works’ which banks do not like to have uncovered.” She means that the banks make fortune from the money of the poor people who generate it through their physical work but could not prosper due to the manipulation of bankers. Thus, in conventional banking the flow of resources is towards rich class and ultimate objective of conventional financial system is to concentrate wealth and financial resources into few hands, keeping the majority of the people at subsistence level.1

As it has been discussed above Islamic and conventional banks have many differences. Here is a summary of these differences:

Figure3.SUMMARY OF DIFFERENCES BETWEEN ISLAMIC AND CONVENTIONAL BANKS2

Conventional Banks Islamic Banks

1. The functions and operating modes of conventional banks are based on fully manmade principles.

1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.

2. The investor is assured of a predetermined rate of interest.

2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).

3. It aims at maximizing profit without any restriction.

3. It also aims at maximizing profit but subject to Shariah restrictions.

4. It does not deal with Zakat. 4. In the modern Islamic banking system, it has become one of the service-oriented functions of the

1Ibid,p 322UsthjZaharuddinHj A bdArhman,differences between islamic and conventional banks.

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Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat.

5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks.

5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer's business very well.

6. It can charge additional money (penalty and compounded interest) in case of defaulters.

6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are give for early settlement at the Bank's discretion.

7. Very often it results in the bank's own interest becoming prominent. It makes no effort to ensure growth with equity.

7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.

8. For interest-based commercial banks, borrowing from the money market is relatively easier.

8. For the Islamic banks, it must be based on a Shariah approved underlying transaction.

9. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations.

9. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.

10. The conventional banks give greater emphasis on credit-worthiness of the clients.

10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.

11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors.

11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.

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12. A conventional bank has to guarantee all its deposits.

12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position..

3.1 BASIC COUNTRY DATA. Tanzania is a union country formed in 1964 between the mainland a Germany colony and later a British protectorate formally known as Tanganyika and the islands of Zanzibar, Pemba and several smaller islands. Tanzania covers an area of about 945,100 square kilometers, which is the largest in East and Central Africa except The Democratic Republic of the Congo. Tanzania’s capital city is Dodoma; Dar-es-Salaam is the main port, the dominant industrial center and commercial center. Near its north boarder there is a permanent ice-cap reaching 5,895 meters above sea level of mountain Kilimanjaro, the highest mountain in Africa. The country stretches to the trough like-depression of Lake Tanganyika the world’s second deepest lake and it is about 7,724 meters deep. Tanzania has common boarders with eight countries which are Kenya and Uganda in the north, The Democratic Republic of the Congo, Rwanda, Burundi in the west, and Zambia, Malawi and Mozambique in the south.

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Tanzania has a population of about 43,601,796, growing at a rate of 1.96% (2012 est.)per year. (1) There are approximately 120 different ethnic groups, each with its own language. The Kiswahili language is a lingua-franca all over the country; it is also the most widely spoken African language with more than 70 million speakers. In addition to that, the English language is used as an official language and in administrative functions. The French and Arabic languages are also in use in certain places such as in International hotels. (2)

Tanzania’s location is strategic as an outlet to several land locked countries such as Burundi, Rwanda, Malawi, Uganda, Zambia and The Democratic Republic of the Congo.

Tanzania economy depends heavily on agriculture primarily coffee, cotton, tea, cashew nuts, sisal, maize, rice, wheat, cassava, and tobacco. The composition of GDP is such that, agriculture sector accounts for about 42 percent, provides 85 percent of exports and is by far the largest employer. Industry accounts for some 18 percent of GDP, and the service sector accounts for about 40 percent of GDP. The GDP growth in 2011 - 2012 was a respectable 6.1(2011 est) percent per year due to high gold prices and increased production. (3)

3.2 GENERAL BANKING STATUS.Tanzania is a country which its banking system comprises of many commercial banks with the central bank (BOT) controlling banking system in Tanzania. Bank of Tanzania (BOT)was established in june 14 1966 by the late Mwalimu Julius K.Nyerere the first president of the country after the dissolving the earlier East African Currency Board(EACB) in 1966 after coming on existence of central banks in each country of east African meaning Kenya, Uganda and Tanzania4. This industry grows each year due to its important to the community, also due to reformation and increase on its need. But banks are mainly found in the urban areas where many trading activities take place. Poor banking in rural areas is due to several factors like, infrastructure, technology in rural areas,desire to bank the unbanked, also poor knowledge on banking.

1 ) Central Intelligence Agency (US), CIA World Factbook, May 19, 2012, 09:53. http:// www.cia.gov2 ) President’s Office, Planning Commission,(1996) “The National Investment Promotion Policy”, Dar-Es-Salaam,. 3 ) op,cit,p 404 History of the bank of tanzania,may,19,2012.www.bot-tz.org,10:37.

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Tanzania have 22 commercial banks,7 regional unit banks1,5 financial institutions2, having its branches countrywide.

3.3 KEY CHALLENGES IN BANKING.Banking industry worldwide faces several challenges; here are some of challenges that face the banking industry in Tanzania.

a) Technology.Poor technology on many area in Tanzania became a big challenge to the banking industry since its development goes hand to hand with technological advancement.

b) Banking infrastructure

Banks needs its own kind of equipments,trainees,and more.in Tanzania banking infrastructure is not well developed, this lead to poor banking system and lack of banking services in other places.

3.4: History of Islamic banks in Tanzania.

On June 10 2008 the East African newspaper under the heading of “KCB cleared for Islamic banking in Tanzania” this was the first time to experience these banks in Tanzania; KBC opened just an Islamic window.3

So in 2008 we saw the first Islamic window to be opened in KBC bank under the name KBC Amana Bank, this was followed by opening of other Islamic windows in Stanbic Bank, People’s Bank of Zanzibar (PBZ) and National Bank of Commerce (NBC) which launched Islamic window in May 2010.

1 A regional unit bank is an institution that is licensed to operate as a regional unit bank. The institution may receive money on current account subject to withdrawal by cheque.2 A financial institution is an institution licensed by Bank of Tanzania and authorized to engage in banking business not involving the receipt of money on current account subject to withdrawal by cheque3 KBC cleared for Islamic banking in Tanzania.(25/05/2012)www.Global-Islamic-finance.com12:40

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The first fully shariah compliant bank in Tanzania came in incorporation on 25 February 2011. This bank is called called Amana Bank. It will be discussed below.1

3.5: Current status of Islamic banks in Tanzania

Recently Tanzania have one fully shariah compliant bank (Amana Bank) and other three conventional banks having Islamic windows.

Banks like Gulf African which is fully shariah compliant is interested to open its branch in Tanzania like the way it is in Kenya.

3.6 Challenges facing Islamic banks in Tanzania3.6.1Legal Support: Islamic law offers its own framework for execution of commercial and financial contracts and transactions. Nevertheless, commercial banking and company laws appropriate for implementation of Islamic banking and financial contracts do not exist. Islamic banking contracts are treated as buying and selling properties and hence are taxed twice.The commercial, banking and company laws contain provisions that are narrowly defined and prohibit the scope of Islamic banking activities within conventional limits. It is necessary that special laws for the introduction and practice of Islamic banking be put in place.

3.6.2 Risks: The nature of risk in Islamic banking is different from those of conventional banking and therefore some special prudential, accounting and auditing standards should be applied to them.

3.6.3 Benchmark: Taking the conventional interest based benchmarks (Kibor etc.,) as the base of pricing an Islamic financial product puts Islamic banks at the mercy of their conventional peers. A negative perception is created among the clientele that there is no prudent difference in Islamic bank products as these are also using the same interest based benchmark. The mechanism for long-term financing could be devised on the basis of prevailing renting system adopted by the private landlords while renting their assets/properties etc.

3.6.4 Few specialists on this field. In Tanzania Islamic banks are new product so there is lack of well-trained specialists to run this business.

1 Origin of amana bank,(26/05/2012),amanabank.co.tz,2:20

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3.6.5 Government monetary laws. Islamic banks existences have become difficulty due to Tanzania’s monetary laws being not suitable with running of shariah compliant banks.

3.7: Future prospects of Islamic banks in Tanzania.

Since people are becoming aware of Islamic banks and growth of this industry. An Islamic bank seems to have good future and bringing competition against conventional banks. As we can see on Amana bank which is growing and opening new branches, hence after few years we can find like all conventional banks having Islamic window and many other fully shariah compliant banks.

AMANA BANK TANZANIA

Origin of Amana Bank

Amana Bank is the first fully Sharia compliant bank in Tanzania. Its beginning can be traced back to October 2009 when a group of prominent Tanzanian business personalities met and set in motion the establishment of an Islamic bank. Today, Amana Bank is wholly owned by a diverse base of Tanzanian businessmen who are committed to the success thereof.

The Bank was granted a provisional license by Bank of Tanzania on 4 February 2011 and then incorporated on 25 February 2011 with an Authorized Share Capital of TZS100billion and Paid-Up Capital of TZS21.5billion.

Shareholding Structure

The shareholding of Amana Bank comprises prominent Tanzanian business people who subscribe to Sharia principles. The shareholding structure is as follows:

NAME OF SHAREHOLDER %

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SHAREHOLDINGCamel Oil (T) Limited 20.0Mohyadin Mohamed Hussein 14.9Highland Estates Limited 12.0Tanga Petroleum Company Limited 11.0MrAmer Mohamed 8.0S T Abri Limited 5.0Mr Joseph Anthony Gonsalves 5.0Mr Andrew Succour De Mello 5.0MrFarough Ahmed Baghozah 5.0MrAddulkadir Sheikh Mohamed 5.0Home Shopping Center Company Limited 5.0MrAbubakari Ali Bahdela 2.6Management 1.5TOTAL 100.0

Corporate Governance

Our Board of Directors is made up of prominent business people and professionals from different backgrounds who provide guidance to the Bank. The board members are as follows:_

MrHaroonPirmohamed Businessman ChairmanMrAbdallaNahdi Businessman Deputy ChairmanDrIdris Rashid Banking Managing DirectorMr Joseph Gonsalves Businessman DirectorMr Andrew De Mello Businessman DirectorMr Ally Said Hemed Businessman DirectorMr Mohamed Ismail Legal Independent DirectorMrSalumShamte Businessman Independent DirectorDrMuhsinMasoud Finance Independent Director

The second board is the Sharia Supervisory Board. As the pioneer in Sharia compliant banking, the Sharia Supervisory Board approves all our products, services and processes. The Sharia Supervisory Board is made up of prominent

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Islamic scholars drawn from within and outside Tanzania namely Dr. MukhawiMudawiMukhawi Ismail from Tadamon Bank, Sudan, Proffesor Mohamed SalimBadamana from Kenya and Dr. Abdallah Tego from Tanzania. All of them are very conversant with Islamic finances.

Employees

Amana Bank (an equal opportunity employer) has a dedicated, experienced and professional team of employees who are well trained and ready to deliver the highest levels of service to its customers. The management team is led by DrIdrisRashidi who has a vast experience in the banking sector as well as the private sector. The other members of the management team comprise highly experienced professionals in banking and are well prepared for the rollout of our products and services. Training of all our staff will be given high priority as we aim to provide the best customer service to our customers.

Products

Amana Bank will offer several innovative products which are Sharia Compliant and have been approved by the Sharia Supervisory Board. The Bank offers products and services that meet the needs of not just the Muslims but everyone. Whether you are an individual or corporate, you can be rest assured that Amana Bank can provide you with a full range of world-class financial solutions which include the following:-

1. Personal Savings Account2. Term Deposits3. Current Accounts4. Anissaa (Ladies) Account5. Nuru (Children) Account6. Hajj Savings Account; and7. Various financing (riba free) products

The bank is determined to offer these halal products and services in the most friendly manner possible. Moreover there will be specialized areas for women where they will get personalized and private services.

Amana Bank has a fully-fledged Treasury Department which also deals in foreign currency. We are in a position to remit funds to any destination through our correspondent banks.

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The Leader

One of the main motivating factors for establishing Amana Bank has been the need to provide an alternative to conventional banking, thus providing an ethical and fair mode of banking for all. Amana Bank is well aware of its responsibility of being the trailblazer in leading the growth of a stable and dynamic Islamic banking system leveraged on cutting-edge technology. Amana Bank has implemented the latest Flex cube Islamic core banking system specifically to cater for Sharia banking operations, thus enabling the Bank to offer internet and mobile banking products.

Branch Rollout

The Bank intends to spread its wings throughout Tanzania and beyond over a period of time, thus providing customers easy accessibility and convenience through various delivery channels.

The first branch will be located at Tandamti Street, Kariakoo, which has opened its doors to the public today. Before the end of the year, the second branch will open along Nyerere Road and more branches are planned to be opened next year and beyond.

The Meaning of Amana

In the Kiswahili language, amana means trust. Our brand is a sign of security and prosperity, with Amana Bank, you are in safe hands. Our brand stands for security, fairness, ethical world-class financial solutions, economic empowerment to all stakeholders, partnership, social responsibility and superior performance.

CONCLUSION.Banking services facilitates the economic developments by the services they offer in the community. Conventional banks as the earlier founded before Islamic banks played these roles for long time and showed some economic developments and crises in the community. So far due to the presence of interest charging we see very few especially those who have wealth capability takes loans to invest, puts

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money in the bank to earn profit. This leads toan increase on the poverty gape, this leads to fail on whole community development.Islamic banks as we discussed above supports all groups in the community and all people either rich or poor gets access to the financial aid, this helps them to invest and develop their financial lives. Through mudarahab,musharakah,ijara,istisnaa,etc we find all groups in the community getting loans, invests and share profits. If Islamic banks have to wide spread in Africa, after 50 years we will find poverty gape falls to the extent that the poorest person have more than basic needs. The equality and justice in the Islamic banks is what exactly enhances these developments.After the study we have revealed justice and equal access to financial aids and loans have the significant impact on economic, social development in the community.On Tanzania we found that slow growing of Islamic banks is due to the financial laws within. Before the law was not suitable for the practicing Islamic banking, but now since the government have made some changes we will see several banks growing in this country. People on their side they like this system since it opens gates to financial aids like loans which will lead to their development and ending poverty.

Recommendations1. Further studies on Islamic banks should be made so as to develop the best way of giving services to the community since it is on development of its theory.

2. Central banks should change their financial laws to enhance development of Islamic banks in the countries.

3. Many colleges and priority should be made for the development of Islamic banks so as to make many specialists to serve for the community.

4. Conventional banks should change their system since in Islamic financial system they earn both profit and security in their wealth invested and stability in the economy.

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5. Several short courses should be made and special programs in television, radio and newspapers so as to educate people about these banks in Tanzania.

References.

1. Abdel Kader Chachi(2005) “origin and development of commercial and Islamic banking operations”, Islamic economics research Centre, king Abdul Aziz university vol 18,Jeddah Saudi Arabia.

2. A.L.M.AbdulGafoor(1995)” interest-free commercial banking”,apptecpublications,Groningen,Netherlands .

3. Abdul GafoorAwan(2009)”comparison of Islamic and conventional banking in Pakistan”.

4. Brian B.Kettel(2011)”introduction to Islamic banking and finance,John Willey and sons publishers.

5. DrFateh Al RahmanAbdalla Mohammed El Safi(2009) “A macro economics mode of in terestfreeand open economics,An empirical analysis for Sudan economy(1990-2004)” A thesis submitted to the university of Khartoum for degree of phd.

6. Dr.NatalieSchoon.Introduction to Islamic banking and finance.Published by spiramus press.

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7. Dr.MuhammedLoqman and KaziDeenMohammad(2002) Islamic banking for economic development,Riyadh,Saudi Arabia.

8. DrM.FahimKhan(1981)Islamic banking as practiced now in the world,international seminar on monetary and fiscal economics of Islam.

9. IqbalM,and Philip Molyneux(2005).Thirty years of Islamic banking.History,performance and prospects.Palgrave-Macmillan publishers.

10.Isa M.M,and Ahmed Kaleem(2003) “casual relationship between Islamic and conventional banking instruments in Malaysia”International journal of Islamic finance services,vol4,no4.

11.MajakD’Agoot(2008) Islamic Theocracy and the art of central banking.Degree of doctor of philosophy in finance economics of the university of London.

12.Mohammad NejatullahSiddigi(2002) the wisdom of prohibition of interest.Lariba Annual meeting los Angeles.CA.

13.Mohammad Obaidullah(2005)Islamic financial services,Islamic economic research centre,kingAbdula Aziz university,Jiddah,Saudi Arabia.

14.Muhammad El-Bashir Muhammad Al-Amine(2002)Islamic banking and finance and the challenges of globalization,wamy’s ninth international conference,Riyadh,SaudiArabia.

15.ManorajamSharma.Studies in money finance and banking.16.Muhammad Hanif(2011) difference and similarities in Islamic and

conventional banks,international journal for businessand social science vol2,no2.

17.Rules of business in islam,anNaseehah paper 200818.Tanzania president’s office, planning commision1996.

References from net side:

19.www.slideshare.net 20.www.wikipedia.org 21.www.bankinginfo.com 22.www.gulfafricanbank.com 23.www.kantakji.com 24.www.isdb.org 25.www.sib.ae/en

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26.www.barakaonline.com 27.www.zawya.com 28.www.nios.com 29.www.investopedia.com 30.www.cia.gov 31.www.bot-tz.org 32.www.amanabank.co.tz 33.Encarta dictionaries.

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Comparative Study Between Islamic Banks and Conventional Banks in Tanzania

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