Islamic Banking

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Project on “Islamic Banking ” “Islamic Banking ” Bachelor of Management Studies Semester Vth 2009-2010 Submitted In Partial Fulfillment of the Requirements for the Award of the Degree of Bachelor of Management Studies By Tanveer Ali Roll no. 50 BIRLA COLLEGE OF ARTS, SCIENCE, COMMERCE 1
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Transcript of Islamic Banking

Project on

Islamic Banking Bachelor of Management Studies Semester Vth 2009-2010

Submitted In Partial Fulfillment of the Requirements for the Award

of the Degree of Bachelor of Management Studies

By Tanveer Ali Roll no.




BIRLA COLLEGE OF ARTS, SCIENCE, & COMMERCE, KALYAN (Conducted by Kalyan Citizens Education Society) (Affiliated by University of Mumbai)

BACHELOR OF MANAGEMENT STUDIES (BMS) CERTIFICATE This is to certify that Tanveer Ali. Roll No.50 has satisfactorily carried out the project work on the topic Islamic Banking for the Vth semester of T.Y.B.M.S., in academic year 2008-09. Place: - __Kalyan___________ Date: - _____________ ____________________ ________________


Signature of Examiner coordinator



I, Ms. Hema Tahilramani hereby certify that Tanveer Ali Student of T.Y.B.M.S (SEMESTER V), Roll. No.50 has completed project on Islamic Banking in the academic year 2009-10.The information submitted is true and original to the best of my knowledge.

Place: Kalyan. Date: ___________ Signature of project guide.3


I, Tanveer Ali, student of T.Y.B.M.S Semester V (2009-2010) hereby declare that I have completed the project on Islamic banking. I further declare that the information contained in this project report is genuine, true and the fair to the best of my knowledge.


Tanveer Ali


Roll No. 50

ACKNOWLEDGEMENTI take this opportunity to express my deep sense gratitude to Ms. Hema Tahilramani for her valuable guidance, encouragement and support extended to me during the course of completion of this project report. It has been an honor to work under her guidance throughout the project span. I am very grateful to my parents, friends, and relatives for helping in my project. I am also thankful to all who have either directly or indirectly supported me in shaping the project very well. At last, I would also like to thank our coordinator Mr. Anil Tiwari for his timely co-operation and support extended all the way.



Index Contents.1. Preface. 2. Islamic banking in detail. 3. Islamic banking from theory to practice. 4. Prohibition of usury in Islam. 5. Islamic banking: A variation of conventional banking? 6. Responsibilities of Islamic banking. 7. Growth of Islamic Banking. 8. Islamic of banking is not for Muslims alone. 9. India is the best contender for Islamic Banking. 10. Islamic banking gain momentum. 11. Islamic banking Resistant to crisis. 12. Islamic banks, future of financial industry. Conclusion. 10 26 30 34 52 54 56 58 62 71 78 Page no



The Islamic banking experiment is still new and is still in the early stage of application. So it is not surprising that members of the public have many questions to ask as they are keen on understanding Islamic banking principles and interested in dealing with Islamic institutions. The Islamic banking experiment is not an innovation but is indeed a continuation of economic thought that has prevailed and survived for many years during which it proved its success in the filed of practical application for many centuries during the early Islamic era. Islamic economic thought has been characterized by the continuation and variety of its interpretation and development of its tools. During the last fourteen years Islamic banks underwent a number of tests, some of which were fairly difficult that could not be overcome by well-established banks which rely on usury in their transactions. However, with the grace of God, foresight of Islamic bankers and hard work of the bank employees such tests were successfully overcome which proves the sound principles and foundations of the Islamic banking experiment. Since the problems faced by certain Islamic banks influence other similar banks either in a negative or positive manner. Such problems also influence the Islamic economic pursuits in general, and the activities of Islamic banks wherever, and the activities of Islamic banks where they based in particular. Therefore, there is a need for Islamic banks to adopt a position, reflecting the unity and solidarity of Muslims and demonstrating their profound belief. Their attitude is one which reflects their common destiny and their pursuit of an economic and financial strategy that is based upon their Islamic religion which regulates, in a 8

comprehensive way, their financial life. but it is a concept that has been put in practice. Nowadays Islamic banking. . There are Islamic banks effectively operating in three continents of the world. As they entered the second decade, the Islamic banking experience has proved its existence in the financial activities involving both the private and public sectors. Through the adoption of Islamic finance methods, they have been able to introduce financial tools that are acceptable in today's world and these facilities are less burdensome to the owners of development projects. Through encouraging participation in projects, Islamic banks have highlighted the key to Third World developing efforts. Short term finance aiming at making secure quick profit that is remote from accepting any risks is not in any way appropriate for development. Without participation in risks, Western Europe for example would not have accomplished this level of development nor would the dreams of the earlier generation of the Japanese people have become a reality. Islamic economists look forward to establishing a dynamic global economy in which capital interacts with human efforts and thought without depending on rates of interest fixed well in advance. With this aspiration, the soundness of which is confirmed by many western and eastern thinkers, the whole world will enjoy greater economic prosperity. This project throws some light on the activities of Islamic banks while outlining the philosophy of these activities.



1. To know about ISLAMIC BANKING. 2. To know whether Islamic Banking will be beneficial for the country in future. 3. To know about Islamic finance sector. 4. To know about development and growth in Islamic banking. 5. To know whether Islamic Banking will be beneficial for the

customer in future. METHODOLOGY The sources used for collecting the data are as follows: 1. Books & Magazines. 2. Newspaper. 3. Internet. 4. Visited Islamic Research Foundation (IRF).



CH. 1 . Islamic bankingIslamic banking refers to a system of banking or 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 payment of fees for the renting of money (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semiprivate commercial institutions within the Muslim community.

History of Islamic banking Classical Islamic bankingDuring the Islamic Golden Age, early forms of proto-capitalism and free markets were present in the Caliphate, where an early market economy and an early form of mercantilism were developed between the 8th-12th centuries, which some refer to as "Islamic capitalism". A vigorous monetary economy was created on the basis of the expanding levels of circulation of a stable high-value currency (the dinar) and the integration of monetary areas that were previously independent. A number of innovative concepts and techniques were introduced in early Islamic banking, including bills of exchange, the first forms of partnership (mufawada) such as limited partnerships (mudaraba), and the earliest forms of capital (al-mal), capital accumulation (nama al-mal), cheques, promissory notes, trusts (see Waqf), startup companies, transactional accounts, loaning, ledgers and assignments Organizational enterprises similar to corporations independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.


RibaThe definition of riba in classical Islamic jurisprudence was "surplus value without counterpart." or "to ensure equivalency in real value" and that "numerical value was immaterial." During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself (ex natura sua) made no logical sense as its value remained constant relative to all other materials: these metals could be added to but not created (from nothing).Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, no jurist ever thought that "paying a debt in a higher number of units of this fiat money was riba" as they were concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).

Modern Islamic bankingThe first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, 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 (Ready 1981), by which time there were nine such banks in the country.


In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, till date, is still in business in Egypt. In 1975, the Islamic Development Bank was set-up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services.Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, plus an additional 250 mutual funds that comply with the Islamic principles. The relative stability of Islamic banking institutions in current recession has gained it attention. Even The Vatican said banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. The World Islamic Banking Conference, held annually in Bahrain since 1994, is internationally recognized as the largest and most significant gathering of Islamic banking and finance leaders in the world.


PrinciplesIslamic banking has the same purpose as conventional banking except that

it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower forms a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rent out the property to the borrower and charges rent. The bank and the borrower will then share the proceed from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share on the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receives the proceeds from an auction based on the current equity. This method allows for floating rates according to current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.


There are several other approaches used in business deals. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.And finally, Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only acceptable form of investment, and moral purchasing is encouraged. In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. However, in practice, this is not the case, and no examples of 100 per cent reserve banking are observed. Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).


PRINCIPLES OF INVESTMENT IN ISLAMLet us after all this try to see the basis on which Islamic investment is preferable. When we asked for Islamic banks to be established, some interest taking bankers suggested opening a branch for Islamic transactions and said that there was not need for Islamic banks to be established. They say this so easily, inferring that Islamic transactions are shallow and easy to shrug off and as if the mere opening of an Islamic branch would be acceptable. By doing this they are trying to exploit us and do not fully understand Islam. Islamic investments are base mainly on good faith not dealing with the taking and giving of usury, not trading nor participating in the sale of any prohibited goods and no excessive mark-up by exploitation of the market, as these things are harmful to society. Just by not dealing with usury does not automatically make any bank an Islamic bank is there is not certainty that its other dealings are in accordance with the Islamic concepts.Islam must be taking as a whole, all Islamic orders must be observed, and any Muslim cannot live a dual personality. It might be easy to wear more than one hat in the normal business day, but when comes to principles and particularly religious principles only one hat could be worn.

Shariah advisory concil / consultanyIslamic banks and banking institutions that offer Islamic banking products and services (IBS banks) are required to establish Shariah advisory committees/consultants to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. On the other hand, there are also those who believe that no form of banking can ever comply with the shariah.[16]

In Malaysia, the National Shariah Advisory Council, which additionally set up

at Bank Negara Malaysia (BNM), advises BNM on the Shariah aspects of the operations of these institutions and on their products and services. (See: Islamic


banking in Malaysia)A number of Sharia advisory firms (like BMB Islamic[17]) have now emerged to offer Sharia advisory services to the institutions offering Islamic financial services.

Bai' al-Inah (Sale and Buy Back Agreement)The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the bank to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency. Some scholars believe that this is not compliant with Shariah principles.

Bai' Bithaman Ajil (Deferred Payment Sale)This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. This is similar to Murabahah, except that the debtor makes only a single installment on the maturity date of the loan. By the application of a discount rate, an Islamic bank can collect the market rate of interest.

Bai muajjal (Credit Sale)Literally bai muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabaha muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.


Mudarabah (Profit Sharing)Mudarabah is an arrangement or agreement between the bank, or a capital provider, and an entrepreneur, whereby the entrepreneur can mobilize the funds of the former for its business activity. The entrepreneur provides expertise, labor and management. Profits made are shared between the bank and the entrepreneur according to predetermined ratio. In case of loss, the bank loses the capital, while the entrepreneur loses his provision of labor. It is this financial risk, according to the Shariah, that justifies the bank's claim to part of the profit. The profit-sharing continues until the loan is repaid. The bank is compensated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits.

Murabahah (Cost Plus)This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the Murabaha is paid in full.This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are very common in North American stores.

MusawamahMusawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference


in obligation by the seller is the key distinction between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Bai salamBai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.

Basic features and conditions of salam1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. 2. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. If the price were not paid in full, the basic purpose of the transaction would have been defeated. Muslim jurists are unanimous in their opinion that full payment of the purchase price is key for Salam to exist. Imam Malik is also of the opinion that the seller may defer accepting the funds from the buyer fr two or three days, but this delay should not form part of the agreement. 3. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. For example, precious stones cannot be sold on the basis of salam, because every piece of precious stones is normally different from the other 20

either in its quality or in its size or weight and their exact specification is not generally possible. 4. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. 5. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. 6. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa. 7. The exact date and place of delivery must be specified in the contract. 8. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.

Hibah (Gift)This is a token given voluntarily by a debtor to a creditor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their


customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities.It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion, and cannot be 'guaranteed.' However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.

IjarahIjarah means lease, rent or wage. Generally, Ijarah concept means selling benefit or use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price.

Advantages of IjarahIjarah provides the following advantages to the Lessee:Ijarah conserves the Lessee' capital since it allows up to 100% financing.Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This is important as it is the access and use (and not ownership) of equipment that generates income.Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible termsIjarah is not considered Debt Financing so it does not appear on the Lessee' Balance Sheet as a Liability. This method of "off-balance-sheet" financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating.All payments towards Ijarah contracts are treated as operating expenses and are therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations.Many types of equipment (i.e computers) become obsolete before the end of their actual economic life. Ijarah contracts allow the transfer of risk from 22

the Lesse to the Lessor in exchange for a higher lease rate. This higher rate can be viewed as insurance against obsolescence.If the equipment is used for a relatively short period of time, it may be more profitable to lease than to buy.If the equipment is used for a short period but has a very poor resale value, leasing avoids having to account for and depreciate the equipment under normal accounting principles.

Ijarah Thumma Al Bai' (Hire Purchase)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 contractum trinius, 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 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-IqtinaA contract under which an Islamic banks 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.

Musharakah (Joint Venture)Musharakah is a relationship between two parties or more, of whom contribute capital to a business, and divide the net profit and loss pro rata. This is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assess an imputed rent and will share it as agreed in advance. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans).

Qard Hassan (Good Loan)This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money.


Sukuk (Islamic Bonds)Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.Conservative estimates suggest that over US$500 billion of assets are managed according to Islamic investment principles.

Takaful (Islamic Insurance)Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers

Wadiah (Safekeeping)In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.

Islamic equity funds.Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100


Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 1215% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products.Despite these successes, this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high net worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting local markets and have been accused of failing to serve Muslim communities.Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series. The Web site monitors the performance of Islamic equity funds and provide a comprehensive list of the Islamic funds worldwide.

Islamic laws on tradingThe Qur'an prohibits gambling (games of chance involving money) and insuring ones health or property (also a game of chance). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty). The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with


the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.What gharar is, exactly, was never fully decided upon by the Muslim jurists.


MicrofinanceMicrofinance is a key concern for Muslims states and recently Islamic banks also. Islamic microfinance tools can enhance security of tenure and contribute to transformation of lives of the poor.

ControversyIn Islamabad, Pakistan, on June 16, 2004: Members of leading Islamist political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against what they termed derogatory remarks by a minority member on interest banking:Taking part in the budget debate, M.P. Bhindara, a minority MNA [Member of the National Assembly]...referred to a decree by an Al-Azhar University's scholar that bank interest was not un-Islamic. He said without interest the country could not get foreign loans and could not achieve the desired progress. A pandemonium broke out in the house over his remarks as a number of MMA members...rose from their seats in protest and tried to respond to Mr Bhindara's observations. However, they were not allowed to speak on a point of order that led to their walkout.... Later, the opposition members were persuaded by a team of return to the house...the government team accepted the right of the MMA to respond to the minority member's remarks.... Sahibzada Fazal Karim said the Council of Islamic ideology had decreed that interest in all its forms was haram in an Islamic society. Hence, he said, no member had the right to negate this settled issue. [ Some Islamic banks generate profits by charging for the time value of money, the common economic definition of Interest (Riba). These institutions are criticized in some quarters of the Muslim community for their lack of strict adherence to Sharia.The concept of Ijarah is used by some Islamic Banks (the Islami Bank in Bangladesh, for example) to apply to the use of money instead of the more accepted application of supplying goods or services using money as a vehicle. A fixed fee is added to the amount of the loan that must be paid to the bank regardless if the loan


generates a return on investment or not. The reasoning is that if the amount owed does not change over time, it is profit and not interest and therefore acceptable under Sharia. Islamic banks are also criticized by some for not applying the principle of Mudarabah in an acceptable manner. Where Mudarabah stresses the sharing of risk, critics point out that these banks are eager to take part in profit-sharing but they have little tolerance for risk.


Ch. 2. ISLAMIC BANKING FROM THEORY TO PRACTICE.Certain universities sponsored this concept on the theoretical level. The first Islamic Economy Department was set up in the Umm Durman Islamic University, in Sudan in 1967. This move was followed by efforts made by leading Muslim intellectuals who embraced this particular concept, and their academic works provide concrete evidence in this area. Specialized studies by academics seeking to obtain M.A. and Ph. D. degrees dealt with the theoretical and applied aspects of this emerging concept.

ROLE OF MONEY IN ISLAMIC BANKINGIndeed, Islam views money as a means of serving the humanity rather than being served by mankind. So wealth is held by the wealthy as a trust rather than enjoying absolute ownership that could be disposed off in any manner. Obviously, this gives a new dimension to the philosophy of funds and to the nature and role of Islamic banks in the international community.

INSTRUMENTS OF ISLAMIC INVESTMENTThanks to Islamic banks, the world markets became acquainted within a few years only with new Islamic investment instruments and different forms of financing were introduced. The most important of these are the following :-


Islamic Modaraba :

This form of finance relies upon combining

knowledge, know-how and human efforts as well as available funds to produce the expects fruits for human happiness.



Forms of Islamic Sales : The most important forms are :(a) Morabaha which allows a bank customer the opportunity to plan for the future through a regulated financial programme providing for honoring obligations when they become due without allowing for any complacency or laxness to the practice created by the conventional banking methods of overdraft financing; (b) Al Sulam sale gives the opportunity to a farmer to look after his crops with the use of finance provided by Islamic banks prior to the harvest season so that the latter would recover their capital finance after the harvest and a settlement becomes possible; (c) Factoring sale (Bai Al Estisna') is a form which encourages Islamic industries to boost their productivity. This particular from of financing is combined with Morabaha sale provided by Islamic banks to allow industries to operate more efficiently and effectively as production financed by (Bai Al Estinsna') and buyer of the factory production is financed by Morabaha. In addition to the above forms, there are other instruments which are not

dealt with here. The most interesting of the applicable instrument is that of options. In Islam, options are governed by fair and just rules and regulations seeking to establish an international economic order. I do not have any doubt that this approach will enable a more appropriate application of the optional transactions in the near future. As regards attracting cash liquidity their banking methods have greatly developed especially in the Arabian Gulf region, and area which is characterized by the availability of cash funds as well as the presence of several Islamic banks and innovative Islamic banking instruments. Now a depositor has numerous


alternatives offering him the normal saving account which permits participation in profit and loss, and there are the investment deposits the period of which could extend from one month to a year. There are also the short and medium - term investment certificates of deposits (Bonds). Also there are what is called specific deposits which allow the depositor to participate in more specialized portfolios involving a higher degree of risk in consideration of participating in receiving higher returns on his investment. Furthermore, Islamic companies with floating capital were introduce for the first time in Bahrain giving individuals and Islamic financial institutions a greater opportunity to investment will provide the basis for the future Islamic stock market. If successful we will completely overcome the liquidity problem in Islamic banks. All these Islamic financial instruments, in addition to other existing forms that we have not dealt with, are being used in practice not only in the Islamic capital market but also in the world's major capital markets. With the growth and advancement of telecommunications, today's world has become smaller than it used to be. However, it remains for the efforts of Islamic banks' officials to promote and market such financing forms and investment instruments, so that they would reflect the attractive aspects and effectiveness of such instrument. I do not have any doubt that these methods and instruments will appeal to rational people who think with a balanced and scientific mind.




Muslims of today have several ways of investing their money but our duty as Muslims is to think carefully before choosing, in order to avoid things forbidden under Islam, such as usury. In fact is the most important thing to avoid as it is expressly prohibited under Islam as well as being unethical. By its nature usury is a negative force and has bad moral effects and creates economic disadvantages. Usury is an old economic phenomenon which originated from unscrupulous individuals and Islam should seek to end this phenomena. Islam arrived at a time when evil practices were already firmly rooted in society and it is not always easy to eradicate these practices. In some cause Islam has to totally rebuild the very fabric of society. The Quran has dealt with this problem in a marvelous way because it takes into consideration the human situation. Islam is not so much concerned about actions as it is about intentions. Since Almighty God knows the nature of human beings and since we need a radical change it is not merely a matter of obeying a dictate but rather a true acceptance of these things in one's heart. When God set out these rules in the Quran he took into consideration human limitations by gradually introducing prohibitions. When Islam arrived, usury was already very prominent and so well entrenched in society that it was impossible to eradicate immediately but had to be phased out gradually in order to


avoid serious damage to the fabric of society. We see from the Quran that the prohibition of usury came in four stages. The first verse which relates to usury in the Quran was merely the introduction to its prohibition and was dictated to Mohammad (peace be upon Him) in Mecca. All the verses which were dictated in Mecca are characterized by the consideration for human nature and seek to purify the human soul of the sins remaining from the pre-Islamic era.

In sura Rom ( 30) we read :"Whatever usury you take for increase through property of other people will have no increase with God." This verse is drawing people's attention, in a gentle manner, to the fact that if people take interest from others now, that interest in their reward resulted in increasing their wealth but they will not be entitled to any reward in the afterlife. So we can see that the verse contains no threat of punishment of warning but is simply a statement that one should not expect further reward. Sometime later in the Quran another verse shows God's anger towards the Israelis who were taking usury against his wishes and thereby deserving punishment.

From Sura Nissa (chp no...4) Verse 160 - 161 God says :"For the iniquity of the Jews we made unlawful for them certain foods good and whole-some which had been lawful for them; In that they hindered many from God's way that they took usury, though they were forbidden, and that they devoured men's substance wrongfully, we have prepared for those among them who reject faith a grievous punishment."


There are certain orders from God and other prophets who believe in God, which do not contradict in spite of great time lapses; therefore whatever is prohibited is prohibited no matter how much time has elapsed. Thus the Muslim people were made ready to accept the radical change no the subject of usury and they were eager to know God's final decision on this matter. Even the third verse showed people the disadvantages of usury and told them how exploitative this system was.

In sura Al-I-Umran :"Ye who believer! Devour not usury doubled and multiplied; but fear God that ye may really prosper" What we should not in this verse is the clear reference to the worst images of usury in the pre-Islamic period as the worst type of financial agreement between two parties; thus it becomes clear to the Muslim how he used to sin against his own brother. But the picture does not finish here when one thinks of the effect is has on society as a whole. Therefore, the Quran in these three previous verses states the case as an outstanding problem and the Muslim knows, the Islamic way of solving this problem is radical and that its rules cannot be constructed in any other way when it comes to the things which are prohibited. The first thing which comes to mind when one thinks of usury and its disadvantages is that it leads to economic and social pressure and leads to paralysis of the efforts of those that lend because they just sit and wait for their money and reap the profits which is undeniably unlawfully earned money. Obviously the disadvantages of usury are vast and we can see from the economic situation of today that usury is one of the main causes of inflation, if not the main cause. It has direct negative impact on national economy. We see that the rates of interest cause continuous increase in debit figure of all borrowing countries. Therefore, if we have to put an end to inflation then we have to deal with the


problem of interest rates. This is one of the negative aspects of usury and its effect on the economy but there are many other aspects which we are going to discuss. Usury creates a paralyzed group who sits and wait and therefore they refrain from the usual activities which might be of use to society. Usury also puts and end to informal borrowing and if usury becomes common amongst people, human nature becomes avaricious and it becomes very difficult for anyone to loan anything even to his own parents without expecting something in return. Now that it is clear to us all how bad usury is so we are prepared to accept some orders from God which prohibit the dealings in usury.

We read in Sura Buqara(chp no.. 2) verse 275 ""Those who devour usury will not stand except as stands one whome the evil one by his touch hath driven to madness. That is because they say "trade is like usury, but God hath permitted trade and forbidden usury". Those who after receiving direction from their Load, desist, shall be pardoned for the past, their case is for God to judge. But those who repeat the offence are companions of that fire; they will abide therein forever. A marvelous description of the lender by usury and the kind of society made by so many people like this is to be found in this verse of the Quran.

The verse 278 from same Sura puts an end to such transactions inorder to purify the human soul.


"Ye who believe; Fear God and give up what remains of your demand For usury, if ye are Indeed believers". Therefore, we are not allowed to take interest on capital no matter how long the period of lending is. It is addressed to the believers and starts with the words 'those who believe' and ends with the same words and anyone who deals with usury is then a non-believer as this verse is addressed to only those who believe. Those who ignore this are at war with God as clearly stated in verse 279 of Sura Buqara. "If ye do it not, Take notice of war From God and His apostle; But if ye turn back, Ye shall have Your capital sums; Deal not unjustly, And we shall not Be dealt with unjustly". The punishment for anyone disobeying this command is very serve. Other wrong-doings are punished during this life, but for usury the punishment comes during and after the life. The punishment is grave because the effects of usury extend to the whole society and to the economy of the country and even to the economy of the whole world so the punishment should be equal to the Crime. The verse covers the whole subject of usury and leaves no place for doubt, confusion or discussion. By this He gives final solution to eradicate such dealings in society. This verse of the Quran was reaffirmed by one of the sayings of the Prophet Mohammad (peace be upon Him) when he said that those who are involved in usury including those who take, give, write or witness transactions, would be demand.


Thus we see that in prohibiting this evil transaction society is saved from economic, social and moral disaster. In Islam other evils such as deceit, hoarding goods and exploitation are not given such prominence, as is the subject of usury, as these are more obvious evils. But the subject of usury is given such prominence as man can try to justify it and to make its presence in various ways.


Ch.4 Islamic banking: A variation of conventional banking?The Encyclopaedia Britannica defines a bank as an institution that deals in money and itssubstitutes and provides other financial services. Banks accept deposits and make loans andderive a profit from the difference in the interest rates paid..Islamic bank will fit thisdescription only just even if one replaces interest rates paid with profit-shares and fees.1Then what is the difference between a conventional bank and this new form of banking underwidespread public discussion today? A bank is an institution because, similar to any others ocietally-sanctioned institutions such as an insurance company, a bank is heavily regulatedby a set of laws (see passed by a society in which the bank operates.The same is also true of the Islamic banks: see Mulijan, Dar and Hall (2004) on capitaladequacy as an example of rules. In addition to the normal banking laws and prudential laws,an Islamic bank is supervised by a Shariah Board to enforce the application of fair-dealingand avoidance of a number of prohibited financial transactions. Having thus given a simplebut yet satisfactory definition, the motivation for this paper is to introduce the quintessence ofIslamic banking in the broader context of conventional banking to lay bare the essentialprinciples and practices involved.First and foremost banking is a modern human invention within the financial sector of aneconomy as opposed to the real sector of an economy - with specific aims to fulfilthreesocially beneficial functions: (i) efficient payment system that expedites payments to be madeto parties to economic activities; (ii) intermediation function (see any standard banking bookor for Islamic banking, see Chapra, 2002) that is to channel savings of households in aneconomy to the producer units (businesses and government) for reinvestment as capital, ascarce resource of mankind; and (c) other financial transactions, which are a whole range ofspecialised activities such as mortgage creation, cross-border trade guarantee (letter or credit), securities trading such as in common stocks and others. The Islamic bank fulfils thesethree broad functions as well as does a conventional bank: Islamic bank also engagesinMonash Business Review Volume 3 Issue 1 April 2007 2investment 40

financing, which a conventional bank generally avoids. An Islamic bank has afourth function .


which is absent, to a large extent, in

conventional banking.The above discussion of what a bank is but brief. In the last 100 years, banks have becomemore specialised thus complex: it is also the case with the Islamic banks over the last 40years, which has led to newer specialised entities of Islamic are banking-finance-insurance.Broadly by several specialised defined financial transactions performed bank-likeinstitutions:

commercial banks; investment banks; savings institutions; credit unions; bankholdingas well as financial-holding companies; development banks; and all of them areregulated heavily.2 In the case of Islamic bank-like activities too, newer form of financialactivities undertaken by banks are licensed separately; Islamic Mutual funds; Islamic IndexFunds; Islamic Development Bank; Islamic or Takaful Insurance; etc. In this article, not muchwill be discussed about these specialised forms of banking-financial entities.

Binding principles of financial transactionsEthical principle 1 is that the profits earned by a bank from its activities and returns made by abank to the depositors shall be (a) from sharing of risk in the project and (b) profit-shareagreements and not pre-agreed fixed interest payments, which is considered as prohibitedearnings because pre-agreed interest agreement has no sharing of risk of investment ofmoney.3 Principle 2 is the avoidance of financing any economic activity considered not in thelong-term interest of society (examples are prostitution; gambling; production and sale ofliquor for intoxication; etc).4 Principle 3 is avoidance of earnings from extremely uncertainrisky financial activities bordering closely to a level of risk of loss of money as in gambling:this principle arises from the mandate in Koranic law that requires parties to contracts to avoidextreme risk.The first principle is identified as avoidance of interest receipts and payments in financial transactions as agreed among contemporary jurists interpretation since the 1960s.6 InearlierIslamic era, this principle was enunciated as avoidance of usury


or excessive interest (riba)and there is a continuing debate about this question among the Muslim jurists as well as layscholars (a long line of commentators from Aristotle to modern day Benjamin Franklin and achairman of Bank of England) on how to deal with what is interest and what is excessiveinterest.

29Although for practical purposes today, avoidance of any form of interest received orpaid is considered as a must in Islamic banking, a position that has led to the devising Islamic banking as a solution. In place `of a pre-agreed interest payment/receipt, a pre-agreedprofit-share formula conditional on the outcome of the end-result of financial lending activities by sharing in riskisconsidered as permissible in Islamic banking.The second principle is akin to the enunciation of a pro-society social movement in recenthistory. In the 1970s in the U.S., there was a movement that started ethical investment funds,and created what were then termed ethical mutual funds. That movement also considerefinancing anti-societal activities (as well as investment by funds in firms producing weapons ofmass destruction) as not-pro-society. An Islamic bank will not engage in financingactivities that are considered unequivocally as illegal (haram) for an adherent to Islam. Hence, nofinancing activities considered anti-society are permittedinfinancialtransactions.The thirdprinciple is that a contract of financial service must have upfront all dangers pre-announced ordeclared: that is, as in modern finance, there ought to be transparency in financial contractsthat reduces asymmetric information advantage of parties to the contract. Hence, it isconsidered that a contract that is likely to result in loss of capital, and the level of risk (garar)borders that of gambling (gain always for the gas operator, and a sure loss for almost allothers), an Islamic bank is not permitted to offer such a financial product.Monash .



OperationsFirst, by practice over many centuries, certain forms of financial transactions have been vested as consistent with this form of banking. The overriding criteria are: is money begetting money without risk-sharing?; is the socioethical value of a financial transaction prosociety?By answering these two critical criteria, new products are being financially engineered in addition to the ones that had existed in historical time. What a bank is as a business can be conceived by referenced a balance sheet of a banklikebusiness: see Chart 1. On the left side of the balance sheet (which describes the financial position of a bank at the end of, say, a year) are the assets that earn income. These are the loans marked A (that offer interest income to a conventional bank and profit-share income ton Islamic bank). Fixed assets are marked B (some of which, for example, the office space, issued to produce the financial products and services while some assets may provide capital gains if owned by a bank while such a building also saves the rent that needs to be paid).While a conventional bank would call loan as shown in the Performa as an earning assets from making loans, an Islamic bank would not call it a loan asset, and may prefer to call it financing or profit-share agreements as loan has the connotation of interest being attached tout. A and B together add up as the total assets of a bank bait a conventional or an Islamic bank: how these items are classified are controlled by the accounting standards: for Islamic banking standards, see Rifaat (2001).


The Sample Balance Sheet of a Banking BusinessA : loan B : fixed assets Total assets. = C : Deposits D : Capital Liabilitys + equity

Item C on the right-hand side is the deposit from the members of the public either as time/savingsdeposits or checking deposits In the case of checking deposits for safekeeping and convenience(wadiah), no return is guaranteed: however, an Islamic bank may make ex gracia payments, which ispermitted. 31 In that case, in a conventional bank, a time deposit will earn a small interest preagreed withthe depositor while, in an Islamic bank, the depositor receives a profit share declared at the end of each month on the basis of profits made on the deposits by the bank if the loan is profitshare basis(mudaraba) or joint venture return if on joint venture basis (murabaha). A point to remember here is that, by engaging in profit-sharing funding/financing agreements, the fundprovided Islamic banks thereby takes on the character of investment which a conventional bank doesnot do. Please refer to Footnote No. 1 for elucidation. If the deposit is a checking account, then anIslamic bank ensures its safekeeping and return, but does not guarantee a return although the bank isfree to make a donation; most conventional banks used to pay nothing, but since the 1980s Item C on the right-hand side is the deposit from the members of the public either as time/savings deposits or checking deposits In the case of checking deposits for safekeeping and convenience(wadiah), no return is guaranteed: however, an Islamic bank may make ex gracia payments, which ispermitted. In that case, in a conventional bank, a time deposit will earn a small interest pre-agreed withthe depositor while, in an Islamic bank, the depositor receives a profit share declared at the end of


eachmonth on the basis of profits made on the deposits by the bank if the loan is profit-share basis (mudaraba) or joint venture return if on joint venture basis (murabaha).A point to remember here is that, by engaging in profit-sharing funding/financing agreements, the fundprovided Islamic banks thereby takes on the character of investment which a conventional bank doesnot do. Please refer to Footnote No. 1 for elucidation. If the deposit is a checking account, then anIslamic bank ensures its safekeeping and return, but does not guarantee a return although the bank isfree to make a donation; most conventional banks used to pay nothing, but since the 1980s.

Table 1: A Simple Classification of Islamic Banking Using Financial Statements Financial Statement items CONVENTIONAL BANK ISLAMIC BANK Panel A: Performance of a bank Profit & LossNet interest income

Financial services income Capital gains Less -Operating expenses -Amortisation of goodwill -Charge for doubtful loans = Gross Profits - Income taxes = Net Profits Net income (profit shares) a Financial services incomea Capital gains


Less -Operating expenses -Amortisation of goodwill -Charge for doubtful loans = Gross Profitsa - Income taxes = Net ProfitsaPanel B: Financial Position of a Bank Balance Sheet Assets: Liabilities and Shareholder capital Loans and Advances (after provisions for NPL) Fixed assets Total Assets Total Risk-weighted Assetsc Deposits & other borrowing Bonds, notes & subor debt Floating Rate Notes Ordinary SharesEquity instruments Total Equity Loans & Advances b (after provisions for NPL) Fixed assets Total Assets Total Risk-weighted Assetsc Deposits & other borrowing Bonds, notes & subor debtb Floating Rate Notesb Ordinary Shares (musharaka) Equity instruments Total Equity (musharaka)


A Income earned by an Islamic bank is from profit-shares, services fee and the excessover all expenses.b Can be any or all of: profit shares (mudarabah); cost plus services (murabaha); joint-venture (musaraka);safekeeping (wadiah); and leasing of assets (ijarah).c This refers to the requirement of both conventional and Islamic banks to risk-weight the assets as per Basel I or IIaccord. These accords at the Bank for International Settlements (BIS) in Basel Switzerland requires that the value of assets are adjusted downwards by a system of risk evaluation of the assets so that the adjusted figures could thenbe compared as assets adjusted to account for risk. Please note that the spelling of the concepts used in this paper vary as in the literature. I have chosen the mostsimple spelling to keep this readable, thus incurring the mistake of incorrect pronunciation.The Table includes two financial statements: Panel A refers to the performance of a bankover a reporting period (Profit and Loss); and Panel B is a financial position. The of areporting period in a balance sheet.A conventional bank reports net income on loans net of interest paid to the depositors andloan capital providers. An Islamic bank does not accept or pay interest but reports net incomefrom profitshares agreements (see footnotes a and b to the Table for the Islamic bankterms used) and fee incomes from sale-like or lease-like or banking services fees. Profit shareincome may be from different forms of lending (more correctly financing) activities such asprofit shares (mudarabah) or joint-venture (musaraka) or some specialised form of financingnot described here. Or it may be from services fees for safekeeping (wadiah), cost plusservices (murabaha, and leasing of assets (ijarah). One final item (not shown in the pro-formaabove) is a portion compulsorily deducted from profits for charitable purposes. In practice itamounts to a tiny fraction of the pre-tax profits.Continuing the other items in the Panel A, all items are similar, but for the exception we havenoted that the entire report is conditional on income reporting that (i) avoids interest, (ii)financing activities that are not in the long-term interest of society (no funds for liquorproduction for consumption, no gambling, etc.) and (iii) prohibitions of financial products 48

withextreme information asymmetry bordering near gambling, hence dangerously risky as aninvestment. Looking at the balance sheet in Panel B, the Islamic bank would have the sametype of entries (the actual items will have some technical terms equivalent to them). Depositsand other borrowings would mean that these borrowings are consistent with the threeprinciples discussed earlier: for example a bank may hold a bond, and but it is called a sukukbond as it is issued with no pre-agreed interest coupons as is the case in conventional bondsthat offersa pre-agreed interest payment. There are finer points to consider here. The issuerof sukuk (say a central bank) has some real assets, which provides periodic rental incomes,which income is then used to provide returns to the investor in a sukuk bond. Similarly, theequity may be referred to as the musaraka fund but it means exactly the same as equity.The identical nature9 of the column entries to explain the terms in Table 1 for the conventionaland the Islamic banks may convince once again that the latter is a newer form of banking. As such it is yet another specialised bank offering newer products in the same way as investmentbanking started to offer opportunities for securitisation of assets some decades ago. Newerforms of banking fulfil the demand by clients who would not otherwise participate in thebanking activities of a typical

conventional bank Islamic banks provide for their clients secularsatisfaction that their financial activities is carried out in a manner that is socio-ethicallyconsistent with their beliefs of avoidance of interest (riba), pro-societal financing(non-haram)and avoidance of extreme risk (garar). The nature of profits therefore takes a different formfrom than the pre-agreed, pre-fixed, non-risk-shared rewards that has been promoted by thefinancial institutions for four centuries. Over the historical time, banks have tended to seek profits by distancing their monitoringfunction by going from fixed to variable interest, and switching from engaging in monitoringaggressively to securitising their risky products and taking such products off the balancesheet. This results in firms with bank loans relaxing their management oversight or in somefamous cases engaging in outright fraud unknown to the bank that lends! These moderninnovations have tended on the other hand to reduce the burden imposed by modern andcomplex societies on


banks to perform the function of delegated monitors. It must also besaid that the same forces have diminished the social responsibility of modern banks, andhelped them to be more focused on profits without due consideration of the end-use to which the humanitys accumulated scarce capital is being deployed. From the outset historically,banks have not been conditioned to promote broader social goals.10 Is ethical banking thewedge that would make banking more socially responsible?


Term Structure of Investment by 20 Islamic Banks, 1988Type of Investment Short-term Social lending Real-estate investment Medium- and long-term investment Amount* % of Total 68.4 0.9 20.9 9.

4,909.8 64.2 1,498.2 707.7

Contemporary sceneIn this context, Islamic banking with its orthodoxy may appear to be a revisionist banking. Yes, it is and if the customer requires that, the banks are willing to provide that service wholeheartedly. Islamic banking is growing at a rate of about 15% per annum, about four times faster than conventional banking: see Islamic Development Bank website and Internet sources. From just a handful of institutions mostly in the Arab countries in the 1960s, it has innovated itself to be accepted by the bastions of banking in England and Switzerland. Both these countries appear to be doing the big-ticket Islamic banking and their major banks have begun to join in the chase for a slice of the business: Citigroup; HSBC; UBS; DresdnerBank;ABN-Amro are the big ticket banks doing large-ticket banking and, importantly, having the expertise to financially engineer new products that are exciting for the customers with deeper pockets but demanding Islamic financial products. There are about 400-over banks licensed as Islamic banks or many have operating divisions with a Shariah Board in about 44countries or more. The total assets of these banks are estimated at around US$ 7 trillion witan equity capital base of some US$ 400 billion.11.A number of institutions have been organised to supervise these banks. Apart from theircompliance with the laws (licensing-


operation laws; prudential supervision laws; international supervision rules), these supra-national bodies provide a degree of standardization in accounting treatments of numbers (Accounting and Auditing Standards Organization for Islamic Financial Institutions, AASOIFI); in financial service provision (Islamic Financial Services Board, which also works with the BIS on Basel II, and on capital adequacy). The Islamic Development Bank (IDB) is another organization that promotes this new form of banking. An international body named General Council for Islamic Banks and Financial Institutions (GCIBFI) is a self-regulating information gathering body that promotes some degree of homogenization of this new form of banking-finance-insurance. On the training of human resources, not much has been done till recently as the provision Islamic finance expertise has been left to the private sector with very few countries or institutions (exception are Indonesia, Malaysia and Islamic Development Bank) allocating resources for. the very specific purpose of training in this new form of banking. The scholar strained in religious studies has adequate training contracts based upon the interpretations of legal schools in Islam. There are plenty of resources in this regard since Arabic studies and religious studies have been adequately catered for in major universities. However, training in banking, finance and insurance remains inadequate. In 2006, a body has been formed (INCEIF for International Centre for Education

Risk Management Issues in Islamic BankingIn the following pages, well look at examples of some different risks faced by Islamic banks Impacts of sharia compliance on credit, market, and operational risk Not exhaustive list of all unique Islamic risks Based mainly on observations in Saudi Arabia and GCC


Islamic law sharia has several clearProscriptions on financial activity The requirement to pay zakat Prohibitions on financing prohibited activity, such as alcohol or prostitution Prohibition of: Qimar (gambling) Myisur (deceptive gaming) Gharar, or speculative outcomes Riba, usually translated as interest

Riba implies unfairly getting a return on funds without sharing in the risk Riba comes from the root for increase or grow meaning increase in money value in and of itself Early Muslim scholars considered money a symbol of value but not a store of value in itself An increase in money without an underlying increase in the value of the symbolic good was unfair

To most observers, riba sounds like interest on debt A few scholars believe that riba means usury, i.e. inequitable interest rates The great majority of scholars define riba more closely to interest rent on money Concept of risk sharing i.e. if enterprise loses money, unfair to expect the same back Seems to rule out classic deposit-taking and lending institution


At first glance, seems classic division between debt and equity, but in fact more complicated.

Commercial and investment banks are separated by the difference between debt and equity

Commercial and investment banks are separated by the difference between debt and equity I give you a loan of 100 I expect 100 back, no matter what I am willing to accept a lower (but sure) return in exchange for my expectation I give you equity of 100 I share in your ownership I expect to participate in the ups and downs of your enterprise But I have a much greater (unsure) upside potential to compensate me for my risktaking Commercial Banking Intermediary Investment Banking Intermediary


Most governments distinguish between deposittaking banks and investment companies

Until recently, the Glass-Steagall Act segregated US commercial banks from investment banks In most countries, including Saudi Arabia, separate agencies regulate each conventional or Islamic.

We all know there is not a hard line between debt risk and equity risk The two are increasingly blended and interdependent Low risk equity may be safer than high risk debt But contractually they differ and deposits above all are seen as different.

Governments are universally keen to protect depositors

When deposit-taking banks fail, especially systemically, governments typically protect depositors The Basel accords (I and II) evolved to agree on a global approach to assigning bank capital to risk.


In the following pages, well look at a few bank credit products, as well as some broader risk issues Islamic banking Products.

The classic murabaha is closest to the risk profile of a standard bank credit. Client specifies goods to be purchased, e.g. raw material or capital goods. Contracts with Bank to acquire on client account. Bank buys goods and acquires title of ownership from seller. Client takes delivery. Client contracts to pay on deferred basi.

Murabaha of some kind of credits in Saudi Arabia and the GCC represent the vast majority

May be over 90% of assets in some banks Very high in consumer lending, with most credits guaranteed by garnished salaries Believed to be over 80% of total system Islamic credits Remainder mainly ijara (e.g. cars) in consumer and musharaka in corporate Not often widely touted, since many feel this is not the most ideal Islamic investment.


Most important, the bank must own the asset, even if momentarily If ownership does not pass through the bank, becomes a cash loan and so haram The degree of proof of ownership differs by Sharis Board, and so with it the risk.

Payments may not include interest, however finance charges may be included in the installments Not charged separately (as is interest) but as part of Total fees. May reflect prevailing interest rates, as a market Reference.

If a murabaha defaults, the Bank cannot compensate itself by running penalty charges

Otherwise it would be riba Sharia Boards feel differently about levying a onetime late fee.


In Saudi Arabia and the GCC, a large share of transactions are commodity murabaha Back-to-back commodity trade which effectively permits a cash deposit or a cash credit For foreign currency, typically on London Commodity Exchange (copper, palladium, etc.) For domestic currency, may be with local broker (e.g. rice, coffee) Interbank placements are usually commodity murabaha Most consumer credits and many corporate credits are structured in this way.

The direct credit risk of a tawarruq is similar to a conventional cash credit, but with some added risks The extra group of contracts adds operational risk, which may lead to other risks Market risk (e.g. settlement risk) Credit risk (e.g. counterparty risk) Again, the degree and timing of ownership required changes the risk Similar to simple murabaha, penalty charges may not be added.


Ijara are leases and their risks are comparable to conventional leases

Bank owns asset, with all that implies Often must be in separate leasing company If leased to purchase, economically very similar to a conventional credit Financial charges may be built into rental fees Mainly used for cars, but some attempt to set up ijara to buy homes May be set up to be variable rate re-priced against a reference rate Less popular among corporates, due to zakat Disadvantages.

Treasury risks Treasury and, more broadly, market risk management is complicated by sharia compliance Most derivative contracts typically not permitted Swaps (e.g. foreign exchange) Options Some synthetic products have been created and are being tested in more liberal regimes Strong need for sharia compliant instruments to manage liquidity: Short-term placements and borrowings Government and investment grade sukuk


Ch .5 RESPONSIBILITIES OF ISLAMIC BANKSIn fact, Islamic banks have a major responsibility to shoulder for the fate of the community and for rescuing it from the threats posed by economic problems confronting it. In view of this responsibility, emphasis must be laid in the forthcoming stage on a number of points, the most important of which are as follows:1. Enforcing the teachings of Islam in all transactions concluded provided that all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching and Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God, the Almighty, for the purposes allowed in this worldly life. 2. Stressing that spiritual and religious values and good conduct and behavior are the essential prerequisites for the happiness of the community, and that any amassing of funds and any capital growth at the expense of our Islamic ideals are contrary expense of our Islamic ideals are contrary to divine laws and in the process are destructive to the human community. 3. Advising Muslims to develop savings and savings habit regardless of how small such savings are, since through the promotion of saving awareness Muslims will be able to plan their development projects. 4. Seeking to improve the economic and social standards of Muslim peoples and realization of solidarity and social cohesion among them.



Striving to set up Islamic financial institutions and promoting them throughout the world in order to achieve their missionary role and in order to complement the services needed by Islamic financial institutions.


Establishment of Islamic financial markets such as Islamic stock market and commercial centers and introducing such other financial instruments required for the recycling of capital.


Seeking to establish an Islamic common market which is believed to be one of the most important means leading to the cohesion of Islamic peoples, eliminating barriers between them and eventually benefiting from their capabilities.



In 1975 the first Islamic commercial bank opened for business in Dubai, United Arab Emirates under the name of Dubai Islamic Bank and within twelve years the number of Islamic banks grew to almost sixty. And interested observer will note that the balance sheets of these banks showed a rapid and steady growth when we compare the figures for the two Hijri year 1405 and 1406. In spite of the prevailing economic recession in the world, Islamic banks recorded a remarkable growth in the items of their balance sheets. Information obtained from the International Association of Islamic Banks (IAIB) indicates that the consolidated total balance sheets of Islamic banks rose from US$ 7,548.3 million at the end of 1405 to US$ 8,787.4 million at the end of 1406, and increase of US$ 1,239.1 million or 16.4%Total customer deposits at the 62

end of 1406, were US$ 6,683.8 million, compared with US$ 5,752.3 million at the end of 1405, showing an increase of US$ 931.5 million or 16.2%Shareholders' equity recorded and increase of US$ 90.7 million. It rose from US$ 784.6 million at the end of 1405 to reach US$ 87.3 million at the end of 1406, showing an increase of 11.6%.

SPREAD OF ISLAMIC BANKINGThis advanced and remarkable trend is accompanied by another noteworthy development, which is reflected in the diversity of the geographical areas where Islamic3 banks are based. Within a few years they managed to make their presence felt in three of the world's major continents, namely Asia, Africa and Europe. This geographical diversification serves as proof of the viability of the Islamic economic system for every geographical region. In addition, it will serve to enhance economic co-operation based upon Islamic law (Shariaa) amongst the peoples of these continents. This will undoubtedly give Islamic economy a further boost and significant dimensions in actual practice and application.

SURVIVAL OF ISLAMIC BANKINGIslamic banks have succeeded within a brief span of time in influencing existing methods of business dealings in the world capital market and to create new investment channels that are acceptable to and recognized by Muslims and non-Muslims. This phenomenon has been of special interest to international banks which respond to this Islamic revival by introducing specialist departments for studying this emerging trend and for creating channels for co-operating with Islamic banks. Furthermore, they have gone as far as to alter their accounting policies in order to cancel their interest calculations from their accounting systems.


Instruction were given to their accounting departments to do without the element of usury in term of "giving and taking". Parties doing business with Islamic banks have shown mounting interest in their proposed financial transactions, which reflect the tolerance of Islam and its response to the needs of the community. Moreover, such transactions are believed to be the most regulated manner for the management of funds by well considered and planned practices. While conventional banking institutions basically rely on the creditworthiness of the borrower and the size of the available securities provided by borrowers, Islamic banks pursue another policy that does not ignore the borrower's credit-worthiness and his financial reputation but at the same time they do not overestimate these factors. They pay more attention of the feasibility of the proposed project, how beneficial it is to the community and the management and scientific qualifications enjoyed by the persons proposing a particular project.Even where the borrower lacks the necessary financial capabilities and securities but has the necessary management and scientific qualifications guaranteeing the success of a well planned project, an Islamic bank will participate as a financial institution providing the necessary funds that will be combined with the efforts and available know-how of the parties proposing the project. In this Islamic modaraba (participation financing), so that the Muslim community or even the global community will not be deprived of a project that is beneficial to the whole world.


Ch.7 Islamic banking is not for Muslims aloneFiled under: Islamic Banking News, Qatar The Qatar International Islamic Bank (QIIB) is keen to tap the vast expatriate population in the country, non-Muslims in particular. QIIB strategists hope to reach out to the expatriate communities by spreading general awareness about Islamic banking. Islamic banking is not for Muslims alone. This is the first and foremost thing that needs to be made clear, says Abdul Basit Al Sheibi, general manager of QIIB. The basic difference between conventional and Islamic banking is that the latters focus is on making a society savings-oriented rather than encouraging people to spend. In that sense, you can say that Islamic banks basically follow the concept of investment banking as they do not preach and encourage spending, stresses Abdul Basit. And, that is precisely the reason why Islamic banks do not lend. That they do not deal in interest-based banking, is


common knowledge. QIIB, says the general manager, is the only bank in the country that shares profits with customers four times in a year, on a quarterly basis. Other banks disburse returns twice a year. Return by way of profits is 4.25 per cent annual on term deposits of a year. The percentage is four for six-month deposits and 3.5 and 3.25 per cent, respectively, for three and one month deposits. Savings bank deposits carry a return (profits) of three per cent a year. Anyone can open term and savings deposit accounts with QIIB, says the GM. As conventional banks have been permitted to set up Islamic banking windows and some have been allowed to open full-fledged Islamic banking branches in the country, the competition has become fierce. It is a good sign, though, for the opening of so many Islamic banking windows and branches point to the fact that there is growing demand for its products and services, says Abdul Basit. Additionally, the competition has prompted us to learn and enhance our own products and services, he adds. Qatar was the only country in 1991 to have two Islamic banks, he said. Islamic banking is growing at a rate of 15 per cent worldwide annually. The figure is much lower for traditional banks. There are an estimated 235 Islamic banks in some 40 countries, including outside the Muslim world. Their total assets were worth $250bn until recently. However, with the opening of Islamic banking windows and full fledged branches by some conventional banks around the world, the assets have risen to $350bn presently, said Abdul Basit. Bahrain continues to be the country with the maximum number of Islamic banks.


Ch.8 India is the Best Contender for Islamic Banking-- Dr. Hussein Hamid Hassan, Chairman Dubai Islamic Bank

Looking at its past, the present economic growth, and the future with Manmohan Singh, the world renowned economist as its Prime Minister, India becomes the best contender for the Islamic Banking and Finance, opined Dr. Hussein Hamid Hassan, father of Islamic Banking and financial products, opined in Mumbai on December 3. Speaking at a Consultation Meeting with professional bankers, conventional as well as Islamic, organised by the Islamic Banking


Committee Jamaat-e-Islami Hind, Dr. Hassan explained that Islamic Banking is the most equitable form of financing since it enables the creation of wealth without fuelling inflation or stoking financial crisis. He also believed that introduction of Islamic Banking in India would attract billions of dollars into India. Detailing about the Islamic banking and financial products like Murabahah and Mudarabah which can convert a failed conventional bank into a booming Islamic Bank, he shared his experiences of working with the Banks of Japan, Deutsche Bank. He said, Islamic Banking is not for the Muslims only it is a better alternative to the conventional banking and it is for investment, development and financing. Differentiating Islamic banking from a conventional one, he explained, On the asset side conventional banks have only one product thats loan with interest. Islamic Banking has unlimited product to suit every customer, every project, under any circumstances. "font-size: Professional bankers shared mix reaction. Pitambar Choudhry, Vice President and Head International Business Division, TATA Asset Management Limited and Arun Chatterjee, Vice President, Planning& budgeting: nIndus Ind bank also attended and were keen to know about the Islamic Banking Products and their demands in India and world over. H.Abdur Raqeeb, Convenor Islamic Banking Committee, Jamaat-e-islami Hind said, " Most of the 150 million Muslims in India do not deposit their savings in the saving bank account and Fixed deposit because of the interest and Islamic Banking will boost up the Domestic Saving rate in India. It will also attract funds from the other communities and Petro Dollars as well." Renowned Islamic Bankers also share their experiences and the problems they faced while practicing Islamic Banking in India. Rashid Umer, Managing Director of Al Barka informed that since Islamic Banking