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  • 1.ISLAMIC BANKING AND FINANCEIN THE CONTEMPORARY WORLD DISSERTATION Shakeel Ahmad ( Facilitator: Dr. H. K. Pradhan ( Executive Post Graduate Program (Ex-PGP) in ManagementXLRI (, Dubai ( for submission: February 2004 Acknowledgements I am grateful to Dr. H.K. Pradhan, my guide, for his continuous encouragement that enabled this study of a subject that had remained within my heart, since early ages. His teachings of International Financial Management provided insights beyond theoretical concepts, and his friendly style inspired the quest for excellence. I am thankful to XLRI, an institution thatprovided me with the opportunity to pursue this post graduate study in management, for which this dissertation project was undertaken.I take this opportunity to express my sincerest gratitude to all the members of IslamicBanking and Finance Community (IBFnet) in the Yahoogroups mailing list. Islamic finance community has worked hard in providing a wealth of resources on the internet. They deserve appreciation and rewards from no less an entity than Allah SWT Himself.Special thanks go to Dr. Obaidullah, the IBFnets founder. This dissertation work would not have been possible without the special help and encouragement from Dr. Shahid Ebrahim it is difficult to express my special thanks for him, in a few words.

2. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Finally, the time that I devoted on the Ex-PGP, and this project, was taken away from myfamily whose support acted not only as facilitator but also was a source of continuous inspiration. Exploratory Channel:Sequence Title Page1Introduction 32Why Islamic Banking? 43Islamic Banking and Finance (IFB) Sector, now64Why is Islamic Banking and Finance (IBF) creating ripples? 66Literature Review77Islamic Banks 108Brief History 119Concepts behind Islamic Banking and Finance 1310 Distinguishing Features 1311 Role of Islamic Banks 1412 Prohibition of Interest 1413 Table-2: Comparison between Riba and Profit 1514 Table-3: Differences between Islamic & Conventional Banking 1615 Key Islamic Financial techniques/ Products1716 Box-1: Islamic Financial Instruments1917 Islamic Derivative Products 2118 Advantages of Islamic Finance 2119 Box-2: Landmark Islamic finance deal inked2320 Perceived Disadvantages of IBFs 2421 Impediments to the growth of IBFs 2422 Recommendations to counter Impediments to growth of IBFs3623 Latest Developments 3824 Box-3: How Islamic is Bank Negaras IIMM? 4025 Islamic Bonds (Sukuk) Funds 4126 Box-4: Conventional Investors find Islamic Bonds attractive 4127 Box-5: US$250 Government Islamic Leasing Securities 4228 Box- 6: Islamic Development Bank launches bond issue worth $400m4329 Box-7: Latest Trends & Challenges 4530 Box-8: Bahrain: LMC to issue $1.2b bonds4631 Rating Agencies 4832 Basel II Implications 4933 Important Institutions4934 Conclusion5135 References5436 Appendix-A0: Estimation of TAI for UAE59 APPENDIX-A: Competitiveness of Banking Sector In Case of Opening Local37 59 Markets to GCC Banks38 APPENDIX-B: Islamic Financial Institutions in the World 61Submitted by: Shakeel AhmadPage 2 of 77 3. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus APPENDIX-C: Islamic Equity Funds in the World3968 40APPENDIX-D: The Dow Jones Islamic Market Indexes7241APENDIX-E1: Assets, Deposits and Loans of 53 Conventional local Banks in GCC7342APENDIX-E2: Assets, Deposits and Loans of 8 Islamic local Banks in GCC74Introduction: To start with graphics may not be a novel idea, but if you are associated in any way with promoting deposits or instruments of a conventional bank anywhere in the world, these graphics must already have left some alarm bells ringing in your mind. 32.83% CAGR in Deposits and 24.69% CAGR in total assets over a four-year period in a country which was written off the books of financial wizards and stock-market punters after the Asian Currency Crisis. In figure1, the rapid rise can be seen not in one aspect but in all major aspects of banking and finance reinforcing the belief that the growth rate witnessed was an all encompassing one. The question that arises at this moment is whether this growth rate is450,000 18,000,000 400,000 16,000,000 350,000 14,000,000 300,000 12,000,000 250,000 10,000,000 200,000 8,000,000 150,000 6,000,000 100,000 4,000,000 50,0002,000,000 0 01998 1999 200020012002 Deposits from Customers Financing of Customers InvestmentsRevenue Total AssetsFig-1: Revenue (RM '000) (Left Scale) and Assets/ Investments/ Financing/ Deposits (RM '000) (Right Scale)for Bank Islam Malaysia Berhad (BIMB), Malaysias oldest Islamic bank (established on July 1st 1983) Source: BIMB Annual Report 2002sustainable. An answer to that would be premature without looking at the reasons behind this phenomenon, and whether the same success story is repeated anywhere else in the world. We will try to answer some of the above questions, and also try to see if the growth in Islamic banking and finance sector could have been better. If yes, we will try to peep into the reasons behind less than expected growth. Much has been written by historians about the feudal lords who by virtue of charging high interest rates controlled those in desperate need to finance their survival. Financial clout led to political clout and ended up in enslaving the masses. Before the historians touched upon this exploitation of the masses, religious scriptures had already warned of usurious acts existing in the society. In the Old Testament (King James Version), Exodus, Chapter 22, verse 25: If you lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury.Submitted by: Shakeel AhmadPage 3 of 77 4. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai CampusLeciticus, Chapter 25, verses 34-36: And if thy brother be waxen poor, and fallen in decay by thee; then thou shalt relieve him: yea though he be a stranger, or a sojourner, that he may live with thee. Take thou no usury of him, or increase: but fear thy God; that thy brother may live with thee. Why Islamic Banking? The New Testament also contains edicts on the same line. Thus the very mention of usury and the suggestion to avoid indulging in this act in Judaism and Christianity implies its existence in ancient times and the ills that it carried along for the society. Despite the warning against this practice, the system prospered. Modern financial system learnt a lesson from these religious warnings and tried to adopt a system that limited the extent of usurious exploitation to a great extent. By creating a market for debt, based upon perfect competition, it propounded an end to exploitative nature of usury and thus evolved the system of interest rates which was supposed to be determined by the market forces freely competing with each other. What we see today is an expansion of the ancient feudal system into a global arena with nations facing the same plight as did individuals earlier. From the traditional Jewish lending system of the Shylocks to the Indian feudal system, there is no need to strain our memories much. What is definitely cause for stress is the false claim of the contemporary world order to have relieved the masses of this burden of debt. Figures 2a and 2b show how countries, instead of individuals, are getting trapped into slavery. There is no doubt that Debt to GDP ratio is a robust indicator of the Debt burden of countries. If we compare the ratios that triggered the 1980s Debt crisis with the levels being experienced, now, we can see that the situation is no better, and could be enough cause for the unipolar world of the day. Despite the claim that modern interest-based system is not exploitative or usurious, because the interest rates or debt-service payments are within limits, Figures 2c and 2d provide a different picture altogether. Submitted by: Shakeel AhmadPage 4 of 77 5. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus F Fig-2a: Debt to GDP Ratios for Developing countries & HIPCFig-2b: Debt to GDP Ratios of crisis-ridden c countries during the Debt Crisis of 1980s F Fig-2c: Amortization paymentsFig-2d: Interest Payments Source: For Fig-1a: IMF World Economic Outlook 1999 & 2003- Statistical Appendix; For Fig-1b: Sachs and Larrain (1993)The transition of the world from a multipolar world order to a unipolar one has not been without pain and suffering. It is not easy to emphatically pronounce that the cause for this has been the interest-based system, but nobody should doubt that the cause has been the financial system as a whole. Interest-based system is one component of the economic system where the concept of money itself, as a worthless piece of paper carrying immense power, may be ill- conceived. Submitted by: Shakeel Ahmad7Page 5 of 77 6. Dissertation: Islamic Banking and Finance in the Contemporary World Program: Ex-PGP (2001-04), XLRI, Dubai Campus Fig-3a and 3b: Interest rates and export prices in Latin America (1972-1986) Source: Andres Bianchi et al., Adjustment in Latin America, 1981-86, in V. Corbo, M. Goldstein, and M. Khan, ed., Growth Oriented Adjustment Programs, Washington, D.C.: International Monetary Fund and The World Bank, 1987. Similarly, the argument that low interest rates cannot cause countries to lose their sovereignty also does not hold much ground. The diagnosis of the Debt Crisis of early 80s suggests that even low interest rates (Figure-3a), acting as a trap (particularly when they are floating rate, as majority of debt was) could cause countries to come down to their knees. Flushed with funds, due to the sharp oil price increa