Fundamentals of Interest free banking (islamic Banking)

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Fundamentals of Interest Free

BankingBy: Abraham Redi

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contents1. INTRODUCTION ,

2. CONCEPTS OF IFB’S,

3. PRODUCTS/SERVICE MODELS OF IFB,

4. ACCOUNTING STANDARDS,

5. RISKS IN IFB, and

6. ELIGIBILITY FOR IFB SERVICES.

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Introduction1.1 Interest Free Banking

Interest Free Banking (IFB): Is ‘a banking business in which mobilizing or advancing of

funds taken in a manner consistent with Islamic Finance

Principles and mode of operation that avoids receiving or

paying interests’, (NBE’s Directive No.SBB 51/2011);

The general secretariat of the Organization of the Islamic

Conference, defines an Islamic bank as “a financial

institution whose statutes, rules, and procedures

expressly state its commitment to the principle of

Shari’ah and to the banning of the receipt and payment of

interest on any of its operations” (Ali and Sarkar 1995, p.

22).

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The Central Bank Law of Kuwait (1968, as amended in

2003) stipulates that Islamic banks “exercise the

activities pertaining to banking business and any

activities considered by the Law of Commerce or by

customary practice as banking activities in compliance

with the Islamic Shari’ah principles.”

Interest Free Banking Windows:

‘Units within a conventional bank that

exclusively offer IFB services’ (NBE’s Directive

No.SBB 51/2011); .

IntroductionInterest Free Banking…

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Riba is Arabic for “growth” or “increase” and

denotes the payment or receipt of interest for

the use of money. A loan with a fixed return to the lender

regardless of the outcome of the borrower’s

course of action is viewed as unfair. Riba is also believed to represent sure gain to

the lender without any possibility of loss as

well as a reward in return for no work.

IntroductionInterest Free Banking…

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Interest/Riba- two Common Types:

A. Rate-for-duration (Riba Al Jahiliyah or Riba Al Nassee’aa)-

Specified, predetermined repayment in excess of loan/capital. (Fixed, Guaranteed, Increases with the increase of time) E.g. Simple & Compound interest

B. Excess Exchanges (Riba Al Fadl)- When specified items are exchanged for the same kind at

unequal measures or on deferred basis, this is Riba. Eg One Kg of salt is exchanged for two kg. One kg of dates is exchanged for two kg of dates, irrespective of quality

IntroductionInterest Free Banking..,

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CONVENTIONAL BANKING

&

INTEREST FREE BANKING

8

Bank

Client

money

money + money (interest)

ConventionalBanking System

Interest Free Banking…

9

Bank

Client

Goods &

Services

money

Interest Free Banking System

Interest Free Banking…

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Characteristic


Conventional Banking System(interest based)

Business framework

Functions and operating modes are based on Shari’a, and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements.

Functions and operating modes are based on secular principles, not religious laws or guidelines.

Interest charging

Financing is not interest (riba) oriented and should be based on risk-and-reward sharing.

Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money.

Interest on deposits

Account holders do not receive interest(riba) but may share risk and rewards ofinvestments made by the Islamic bank.

Depositors receive interest and a guarantee of principal repayment.

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Characteristic



Risk sharing in equity financing

Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio.

Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management.

Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol.

Conventional banks may finance any lawful product or service.

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Characteristic



Penalty on default

Islamic banks are not allowed to chargepenalties for their enrichment. They may,however, allow imposition of default or late payment .Penalties may be donated to a charity

Conventional banks normally charge additional Interest in case of late payments or defaults.

Avoidance of gharar

Transactions with elements of gambling or speculation are discouraged or forbidden.

Speculative investments are allowed.

Customer relationships

The status of an Islamic bank in relation to its clients is that of partner and investor.

The status of a conventional bank in relation to its clients is one of creditor and debtor.

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Characteristic



Shari’a supervisoryboard

Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements.

Conventional banks have no such requirement.

Statutory requirements

An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines.

A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities.

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Introduction1.2 Motivations

1. Access to formal financial service is low in Ethiopia;

2. Existence of large Potential demand, can be inferred from:

Request for IFB service for long Target population represent large group SDD customers & deposit has been growing NBE’s authorization directive.3. IFB is increasingly common Globally: 80-

Countries, 500 institutions, USD 1 trillion assets, 15% growth per annum; (estimate)

4. Suitable Regulatory and legal environment.

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1. Demand cannot cater with conventional banking;

2. Tailor-made banking services facilitate financial inclusion;

3. Financial inclusion helps for high deposit resource

4. For customer satisfaction-retain existing, expand base.

INTRODUCTION 1.3 OBJECTIVES & BENEFITS OF IFB

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The pioneering effort, led by Ahmad Elnaggar (Ahmed Al Nejjar), took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 by the time there were nine such banks in the country.

1973 ( Philippines) Philippines Amanah Bank was established. Designed to serve the special banking needs of the Muslim community.

On 1975, the Islamic Development Bank (IDB) was setup.

1978 ( Luxembourg) Islamic Finance House was established.

On 1979 (Bahrain) Bahrain Islamic Bank was established.

INTRODUCTION1.4 History of IFB’s

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•The first Islamic bank in Malaysia was established in 1983. •On 1993, commercial & merchant banks were allowed to offer Islamic banking products and services under the Islamic Banking Scheme (IBS).•These institutions however, are required to separate the funds and activities of Islamic banking transactions from that of the conventional banking business. •1984 (Sudan) launches Islamic Banking•Today (Western banks) Citibank, Merill Lynch, HSBC, UBS, Standard Chartered Bank, the Royal Bank of Scotland, JPMorgan Chase, Barkley’s offering Islamic Financial services. IB Britain, Lariba (America) were established

INTRODUCTION1.4 History of IFB’s (cont..)

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Subsequently, ethical Banks and financial institutions, based on Islamic principles, spread in countries where Muslims are minorities, such as UK, Luxemburg, Denmark, Australia, India and the United States.

On the year 1991 (Bahrain) Recognizing the need for standards. Accounting and Auditing organization for IFI ((AAOIFI (pronounced “a-yo-fee”)) was established

On the year 2002 (IFSB) was established. Sets and disseminates the prudential and supervisory standards and core principles that are in compliance of Shar’iah.

INTRODUCTION1.4 History of IFB’s (cont..)

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1.INTRODUCTION1.4 History of IFB’s (cont..)

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1. INTRODUCTIONModels of IFB Banking Islamic banking takes different forms within banks. The following

structures are practiced internationally :

A. DEDICATED WINDOW MODEL:

Refers to conventional banks that offer Islamic banking products

and services using their existing infrastructure, including staff and

branches.

Usually assurance is given for the segregation of client’s funds

with any interest-based funds. E.g. ABSA Islamic Bank south

Africa, Citibank, HSBC, Lloyds of London

B. DEDICATED BRANCH MODEL:

This model is similar to the windows model, however, in the case dedicated branch are established for the delivery of

Sheri’ah compliant products.

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C. SUBSIDIARY MODEL: In this Scenario, a conventional Bank develops a subsidiary

under its entity to deliver Sheri’ah compliant products, advantage can establish its own process and an independent operating structure.

It can also formulate it own policies that are in line with sheri’ah but still manage to fall within the parent company’s strategies.

D. FULLY FLEDGED ISLAMIC BANK MODEL:

Operations and management are clearly separated between

the subsidiary Islamic bank and the parent conventional

bank. E.g Albaraka Bank Limited in South Africa

1. INTRODUCTIONModels of IFB Banking…

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1.INTRODUCTIONARGUMENTS FOR INTEREST FREE BANKING

WINDOW MODEL1. Gradual implementationIt takes time to

• Build a customer base• Educate people• Change regulatory environment• Develop human resource capabilities• Acquire adequate infrastructure

2. Efficiency• Lowest cost within the shortest period of time• Leverage on existing infrastructure (people

and physical resources)• Avoid duplication of resources

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1.INTRODUCTIONARGUMENTS FOR INTEREST FREE BANKING WINDOW MODEL…

3. Effective development

• Variety of products• Market familiarization of products• Wider marketing base

4. Take advantage of technological

advancement of conventional banks

• Standard operating procedures, information systems, control and monitoring systems

5. Capture non-muslim market

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1. Ensure implementation more in line with the Sharia’h

2. Easier regulation and assurance of compliance to Sharia’h requirements

3. Preserve image of Islamic banking

4. Attract international (esp. Middle East) investors

5. Windows may undermine development of fully fledged Islamic banks

1.INTRODUCTIONARGUMENTS FOR IFB FULLY FLEDGED MODEL

Muamalat

Political Economic Social

Muamalat Ammah

Munakahat Muamalat Jinayat

Sheri’ah

Ibadat (Man-to-God Worship) Muamalat Ammah (Man-to-Man – to- Nature Activities)

ISLAM

Aqidah (Faith and Belief)

Sheri’ah (Practices and Activities)

Akhlaq (Morality and Ethics)

25Tuesday, May 2, 2023

2.CONCEPTS OF IFB…

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VI. Sources of Shariah (LAW)

A. Al-Qur’anThe Quran stated that

"0h believers, fear Allah, and give up what is still due to you from the interest (usury), if you are true believers." [Surah 2 Verse 278]

B. Sunnah (Method/Tradition) qual/fi’l/taqrir Prophet Muhammad (PBUH) said:

“Exchange of gold with gold, silver with silver, wheat with wheat, barley with barley, dates with dates and salt with salt should be of equal quantities and spot. Anyone who varies the quantities or allows one side of the exchange to be different, indulges in riba for which buyer and seller are both equally responsible.”


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.C. Ijma (Consensus) It is a consensus on various issues amongst

the ably-recognized scholars that provide guidance to the Muslim Ummah (nation) on various issues.

D. Qiyas (Analogy/comparison) Qiyas refers to analogy that is extrapolated

from a juristic rule derived from the Qur’an, Sunnah, or through Ijma on the basis of an underlying principle or ‘illah’(underlying rationale for a legal rule)


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2. Fundamental Principles of IFB

Any predetermined, conditional payment over and above the actual Principal amount is prohibited

Islam allows only one kind of loan and that is Qard-al-hasan (goodly loan) whereby the lender does not charge any interest or additional amount over the money lent.

Profit and loss principle is proportional to the risk

Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the 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 ventures.

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2. Fundamental Principles of IFB… Making money from money is not Islamically

acceptable◦ Money is only a medium of exchange, a way of

defining the value of a thing; but it does not view money as a commodity that should be bought and sold at a profit, simply by being placed at a bank or lent to someone else.

◦ The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.

Gharar (Uncertainty, Speculation, Ignorance, Deception) is also prohibited◦ The prohibition of a Gharar transaction is due to

deception. ◦ This can arise either through ignorance of the

goods, the price, or through an inaccurate description of the goods

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2. Fundamental Principles of IFB… There are several types of gharar, all of which are haram. The following

are some examples:

Selling goods that the seller is unable to deliver. Selling goods without proper description, such as

shop owner selling clothes with unspecified sizes Selling goods without specifying the price, such as

selling at the 'going price' Making a contract conditional on an unknown event,

wherein the time is not specified Selling goods on the basis of false description Selling goods without allowing the buyer the properly

examine the goods

Gharar is present in contracts where the object of the sale is not in the

possession of the seller or does not exist at the time the parties enter

into the contract but such contracts are permissible.

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2. Fundamental Principles of IFB…Maysir/Qimar: (Gambling)

◦ Gambling is a form of Gharar because the gambler is ignorant of the result of his gamble.

◦ It can also be regarded as a transaction in which there is a possibility that one party can suffer a total loss.

◦ It must be noted that while gambling has an element of uncertainty, not every type of uncertainty is gambling.

◦ It should be noted that maysir is one of the key elements in the prohibition of conventional insurance.

Products & Services invested in, must be permissible◦ Trading in Pork, dead animals, alcohol, pornography,

brothels for example would not be financed by an IFB;

◦ property financing could not be made for the construction of a casino; and an IFB could not lend money to other banks at interest.

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Profit in a business venture is determined ex post—that is, depending on the outcome of the venture but based on the predetermined profit/loss ratios. (for partnership contracts)

On the other hand, interest, which is determined ex ante—that is, predetermined regardless of the outcome of the venture.

Profit in a trade or a sale may be determined ex ante, but it is based on trading real assets between contracting parties, not lending of money on interest.

2.CONCEPTS OF IFB…INTEREST/USURY AND A “RATE OF RETURN/PROFIT FROM CAPITAL.”

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THE THREE LEGAL MAXIMS:

A. Al Asl fil uqud al ibahah:

◦ General Permissibility of contracts unless specifically prohibited

B. Al Kharaju bid dhaman (PLS):

◦ The one who takes the risk shares in the reward◦ Profit follows responsibility.C. Asset-Backed Financing: ◦ Money is not a rentable commodity◦ Financing provided on commodity via contracts


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Think Point !

“All that we had borrowed up to 1985 or 1986 was

around $5 billion and we have paid about $16 billion yet

we are still being told that we owe about $28 billion.

That $28 billion came about because of the injustice in

the foreign creditors' interest rates. If you ask me what

is the worst thing in the world, I will say it is compound

interest.” So $5 billion was borrowed and, fifteen years

later, $44 billion was due (either paid or due to be paid) !

!

(President Obasanjo of Nigeria, G8 summit, Okinawa, 2000)


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IV. IFB ContractsFirst we shall discuss, explicitly Forbidden Acts Over

Contracts:

Selling forbidden items; (by law);Two Sales in one Contract; e.g

◦ Combining a loan contract with the receipt of a gift

◦ Combining the sale of an item on the condition of the use of another item

Back-to-back sale; it is sales of the same object between the same contracting parties, changing roles in a contract, the second sale being dependent on the first. For example, a precondition of a sale in another sale.


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Contract/aqd =lit. tie or a knot/ A contract is a transaction that is executed between two

or more parties for mutual benefit For a contract to be valid At least two independent parties Material effect following the exchange of item

under consideration Offer and acceptance relating to the item and

the price of the item IFB contracts begin with making promises


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…

V. Types of IFB Contract Modalities

There are four Basic categories of IF Banking Legal Contracts ,and are commonly called SPAS

1. Sales/Exchange Contracts: A. Markup (Murabaha ) Contract- for purchase & sell

of goodsB. Forward Sale (Salam) Contract- For produce and

Sale;C. Leasing (Ijarah) Contract- For Make/buy and

lease of durable, fixed assets;D. Work-in-Progress Financing (Istisna) Contract -

for Construction/Assembly/manufacturing of assets


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2. Partnership Contracts:A. Profit and Loss Sharing (Mudaraba) Silent partnershipB. Profit/Loss Sharing (Musharaka) Joint Venture

Supporting Contracts 3. Agency Contracts (Wakalah): Assignment of rights and obligations to other party,4. Security Contracts:A. Surety (Kafala) Contracts- for performance

guarantees;B. Transfer of debt (Hawalah) contracts - for

Local/Foreign Money Transfer;C. Pledge and mortgage (Rahn) contracts - for debt

collateral


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Penalty Payments for Late/ Defaults.Three Views:

1. The principle doesn’t allow to penalize defaulters;

2. The defaulters have to be fined for fairness reason;

3. Can be fined using initial agreement but exclude from income (-Charity and also for goodly loan)

Default Recovery: Collateral- depending on the degree of risk involved; Penalized based on prior agreements; Rescheduling –Without additional payments; Recoverable amounts -actual costs opportunity costs.

Compensation to PLS-Deposits Profit Equalization (Stabilization) Reserve (PER) Investment Risk Reserve (IRR) for protection of mudaraba pool;


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3.1 DEPOSIT PRODUCTS:1. (Wadi’ah Amanah ) Safekeeping Deposit

◦ Guarantee is given for the principal amount,◦ No agreed benefit to depositors ;◦ Purpose: Safety and convenience ;◦ The fund can be deployed by the bank in any

‘permissible’ activities ◦ The account can be operated with passbook and vouchers

.2. (Qard) Current/Checking/Demand Deposit Account-i◦ Can be operated similar to the conventional Checking

account◦ Principal is guaranteed; ◦ The fund can be deployed in any ‘permissible’ area chosen

by the bank;◦ Benefit payment is not obligatory .

3.Products OF IFB

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3. Mudarabah Saving:◦ No prior guarantee for principal & benefit;◦ The fund can be deployed in any

‘permissible’ activities selected by the bank.

4. Mudarabah Fixed time Deposit Account◦ Is time bound. i.e., the deposit period is

determined in the contract to be made between the depositor and the bank;

◦ No prior guarantee for principal and benefit ;

◦ Limitations on withdrawal during specified period based on prior agreement;

3.Products OF IFB…

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3.2 Financing products

1) Trade Finance,

2) Equity or Investment Participation Finance ;3) Lending Money. 1. Trade Finance:

Generally involve participation in buy-and sale, buy/make-and-lease, sale-and-buy as well as manufacture/produce-and –sale contracts.


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Trade Financing Contracts have the following varities:A. Murabahah/Markup/Cost-Plus-

profit/ based on client’s promise to buy

goods, bank buys an item identified by and for a client. The client agree to repay the bank the price and an agreed profit later either on installment or lump sum bases

B. Ijarah/Leasing/ is where the bank buys/prepares an

item for a client and leases it to him/her for a special rent and term. The term may be the assets’ expected/economic life.


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◦ The owner of the asset (the bank) bears all the risks associated with ownership.

◦ Initial ‘promise to give’ or ‘promise to sale’ is required when the agreement is either to finally give or sale the leased item to the lessee.

C. Istisna’/Work-in- Progress/◦ Involves advance payments for future delivery of

goods. It can also involve future payment and future delivery of goods. In this case, Banks pre-sell the goods to a client for cash on delivery basis, and negotiate the purchase of the commodities with the supplier


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D. Salam/Advance Payment against-deferred-delivery-of-goods/

◦ Agreement to purchase at a predetermined price, a specified kind of commodity, not available with the seller, which is to be delivered on a specified future date, in a specified quantity.

2. Investment Participation /Equity Financing Models

There are mainly two Partnership financing models: A. Joint-Venture(Musharakah);B. Profit Sharing (Mudarabah).

3. Lending Money. (only Qard Al Hassen)


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3.3 Trade Service products Murabahah L/C Wakalah L/C Musharakah L/C

3.4 Money Transfer Services/Hawalah Local Money Transfer Services International Money Transfer Services

3.5 FOREX Services/Sarf3.6 Guarantee Services /Kafalah, etc


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Mainly similar with the commonly known IFRS

(International Financial Reporting Standards);

Financial Statements Structure –similar

Transaction entries-Double Entry-similar

‘Permissible‘ Income recognition -accrual base –

similar

Two organizations are known globally in

design of Accounting and Auditing

Standards:

1. AAOIFI (Accounting and Auditing Organization for

Islamic Financial Institutions) Based in Bahrain

◦ Standard-setting organization for the Islamic

banking and finance industry that is recognized

globally.

4.Accounting standards of IFB

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◦ Issued 56 standards, and membership consists of over 110

institutions spanning over 28 countries .

◦ AAOIFI Standards can be applied in line with the

requirements of the IFRS (International Financial Reporting

Standards) issued by the International Accounting

Standards Board .

2. IFSB (Islamic Financial Services Board) Based in Malaysia The IFSB has 110 members including 27 regulatory and

supervisory authorities as well as the International

Monetary Fund, World Bank and the Islamic Development

Bank By December 2005 IFSB (Islamic financial service Board)

has issued two standards

4.Accounting standards of IFB…

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Principles of risk management, and Capital adequacy standards for Islamic

financial services Other publications include ‘Issues in

Regulation & Supervision of Takaful’Two noticeable differences of IFRS and AAOFI:

Customers deposits in IFRS = Liability, In AAOIFI =Not when it is PLS.

Leased Asset –in AAOFI- operating Lease , in IFRS finance lease;

Adopting either of the standard is optional to any Bank;

4.Accounting standards of IFB…

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Unlike conventional banks, IFB share business

risks with investors and borrowers.

All risks faced by conventional banks, Liquidity

risk, credit risk, market risk including exchange

rate volatility, legal risk and operational risks, the

measurements and mitigations are common.

The following risks are termed as peculiar to IFB’s.

Displaced commercial Risk- when clients does not

receive what a market offering them;

5. Risks in IFB

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Withdrawal Risk- shifting for better profit share; DCR lead to withdrawal then liquidity risk then

bankruptcy risk Governance Risk-failure to govern the

institution, Fiduciary Risk - deviations from entrusted

responsibilities; Sheri’a -non -compliance risk Reputational Risk–defamations due to

irresponsible actions of management

5. Risks in IFB…

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THANK YOU FOR YOUR ATTENTION

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COMMENTS!!!

Fundamentals of Interest free banking (islamic Banking)

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