Islamic Banking Projeect
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Transcript of Islamic Banking Projeect
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CHAPTER NO. 01
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1-PROBLEM & ITS BACKGROUND
1.1 Introduction
In any economy banks play very important role. A bank is a reliable financial institution,
which has core business of mobilizing the savings of people for investment purposes. It
receives the money from one group and lends to other group of people. So bank performs
the duty of financial intermediary.
Usually there are two types of banks, conventional banks and Islamic banks. In simple
words Islamic banks operate in interest free system. Prohibition of interest is ordained in
Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous.
The Holy Qur'an in verse 278 of Surah Al-Baqarah states:
"O ye who believe! Fear Allah and give up what remains of your demand for Riba, if ye
are indeed believers."
Verse 2: 279 says:
"If you do it not, take notice of war from Allah and His Messenger. But if ye turn back,
ye shall have your capital sums. Deal not unjustly and you shall not be dealt with
unjustly."
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It therefore, follows that interest is prohibited as it leads to injustices and Islam is against
all forms of injustices and exploitations and pleads an economic system, which aims at
securing extensive socio-economic justice. The Islamic law of prohibition of Riba, which
includes interest, was originally not based on economic theory but on Divine Authority,
which considers the charging of interest as an act of injustice (Dr. Siddiqui).
The main issue here is to know about the differences between operations of a
conventional bank and an Islamic bank by focusing on the principles and instruments of
Islamic banking.
It is difficult to say with accuracy, which was the first such company or bank that
pioneered this concept of Islamic banking in practice. Some analysts and experts in the
field are of the opinion that, Islamic banking and finance, in the modern context, first
emerged in 1963, when Mit Ghamr Saving Bank began an experimental project offering
interest free banking in Egypt. The project was a success and lead to the bank opening
four new branches by 1967. In the same year, eight new banks mushroomed offering
interest free banking. Due to the political climate prevailing in Egypt during that period,
the success of these Islamic banks was seen as a threat, and they were forced to close
down in 1971.
Some observers are of the opinion that the concept of an "Islamic bank" was born at the
Islamic Summit of Lahore,Pakistan in 1974, which recommended the creation of an
Islamic Development Bank. Since then Islamic banking and financial institutions have
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grown rapidly. In 1993 report from the International Association of Islamic Banks
estimated the then industry to be valued at $80 billion. A more recent article appearing in
the Wall Street Journal estimates the potential market for Islamic investments to be up to
$150 billion.
Malaysia in 1983 passed an Islamic Banking Act to facilitate the growth of indigenous
Islamic banks and finance companies thus became the first Muslim economy to issue
bonds on an Islamic basis. Since then, some 50-60 institutions have been established, and
are now in the process of forming an Islamic inter-bank market (i.e. in which banks
borrow or lend to each other). Within 10 years of introducing the Islamic Banking Act,
the Malaysian government has taken further steps to popularize Islamic banking and
finance, by allowing conventional banks to offer Shariah-compliant instruments. The
most distinctive feature of Islamic banking in Malaysia is that it is being embraced by its
Chinese and non-Muslim population who are opting to deposit their savings or borrow
money on an Islamic basis.
The momentous decision of the Pakistani Supreme Court, in Ramadan 1420, to strike
down all laws that condone interest and their orders to the Federal government to bring
all existing financial organizations in line with Islamic principles is truly path breaking.
The world is watching with bated breath to see how the whole economy faces this
challenge (www.alrajhibank.com.sa/islamicebanks.htm).
These trends in Malaysia and elsewhere are having a profound effect on the banking and
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financial world as a whole. For example, America's Citibank was the first major
conventional bank to establish an Islamic bank in Bahrain, with an operating capital of
$20 million (The Economist, 1996). It may be a puny sum, but it does suggest to some
degree that conventional banks have begun to embrace Islamic banking on a moderate
scale. Here again the point arises, that, there is some difference between the operations of
two banking systems and also there is something, which is attracting conventional banks
towards Islamic banking system.
A significant proportion of the banking system has been Islamized in Pakistan. Recently
the State Bank of Pakistan has allowed Commercial Banks to set up Islamic banking
subsidiaries or provide full Islamic banking facilities through dedicated branches (Dawn
economic & business review).
Meezan Bank of Pakistan had conducted a research last year to ascertain, is Islamic
banking really a need of the people? The main findings of the research were that there is
a strong need for a Riba-free banking system. People perceive a number of emotional
benefits from a product that is based on the tenets of Islam. The objective is to alleviate
the feeling of guilt by following the tenets of Islam. There is also a belief that Islamic
banking will help fight the ills of the economy of the country.
1.2 Rationales for the Study
An Islamic bank is a financial institution which identifies itself with the spirit of Shariah,
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as laid down by the Holy Qur'an and Sunnah. Normally from Islamic banking it is meant
the interest free banking system, while conventional banking is perceived as interest
based banking system. To replace interest, the ideal mode of financing under the Islamic
banking system is "Financing on Profit & Loss Sharing" (PLS) basis.
There could be no denying of the fact that under the interest-based system of banking or
in a system not strictly based on the principles and spirit of Shariah, depositors as well as
borrowers are exploited in one form or the other. (Dr. Siddiqui)
Interest is usually paid on borrowed money or in other words on debt. In last decades
debt is considered as most effective resource of financing. It was contended that debt has
a better control function because the threat of failure to make debt-service payments
serves as a strong motivating force (Jensen, 1988).
On the other hand it is considered that, although an increasing level of debt helps the
economy grow faster for a while, it foments endogenous instability and financial fragility.
Minsky (1982) has propounded and popularized the idea of endogenous instability and
financial fragility. That is, initially when the debt equity ratio of a corporate is low, it
really pays to finance expansion by borrowed funds. At this stage, expectations of both
borrower and lender are usually satisfied, or existing debt is validated without any
problem, which provides the basis to go further deep in debt. As a result, demand for
borrowed funds grows faster than the ability to pay, or in Minskian terminology, the
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economy moves from hedge to Ponzi finance. Also demand for further borrowing
becomes inelastic because initially, due to the positive slope of term structure, borrowers
themselves prefer to borrow on a short-term basis, but later they have to borrow to keep
their existing debt rolling and to fulfill their other committed payments, which in turn,
pushes the interest rate up. However, the problem starts when at some point along the
line, the supply of credit lags behind the demand. This happens because on one hand
lenders become pessimistic about future prospects of underlying projects or they no
longer share euphoric expectations with borrowers or, on the other hand, the net worth of
borrowers and the value of their collateral erode because of high interest rates. As a
consequences, their relationship become strained, lenders may want to extend minimum
credit or may even want to liquidate what they have already loaned, while debtors
scramble for liquidity. Minsky calls this a financially fragile situation because borrowers
become vulnerable to disruption of their economic activity.
1.3 Problem Statement
From the rationale given in the previous section, it is now clear that attention must be
given to the viability of Islamic banking as compared to conventional banking system
while focusing on the problem statement:
Comparison of conventional banking system with Islamic banking system
Focusing the problem this study will answer the following questions:
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1. What is Islamic banking system with respect to its principles and instruments?
2. How Islamic banking system is different from conventional one?
3. What are the advantages of Islamic banking system, and what is its future?
4. Why Islamic banking is more viable than conventional banking system?
1.4 Objectives
This research report or thesis is the basic requirement ofFederal Urdu University Arts,
Science and Technology Islamabad, for any student to obtain the degree. This is a way
to help students enhance their knowledge by making them learn from the practical
environment and also to apply the learned theoretical concepts in the practical field.
Thus, the main objective of this research is to fulfill the partial requirement of the
University for obtaining the degree.
An attempt is made in this research:
To highlight salient features of Islamic banking system.
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To compare Islamic banking system with conventional banking system.
To investigate whether Islamic banking is at least as viable as
conventional banking system on economic grounds.
To simulate future prospects of Islamic banking system, if people are
made aware of the difference between Islamic banking system and
conventional banking system.
To simulate future prospects of Islamic banking system, if people are
made aware of the viability of Islamic banking system.
1.5 Significance of the Study
It is true that external financing is utmost important almost for every kind of business in
an economy and banking industry is the main facilitator in this regard. Islamic banking
system plays its role in the banking industry as its minor part. Even though its a minor
part it cant be left behind because banks are the citadels of the economic growth. So,
studying Islamic banking system in detail will not only benefits the researcher but also
will be a source of effective information for many classes of bank customers. It will help
better understanding Islamic banking system and its salient features.
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Only a minority of Muslims strongly believes in efficacy of Islamic banking system,
whereas a majority of Muslims and non-Muslims have doubts about its viability on
economic grounds. They are not convinced to its practicality and viability. Description of
Islamic banking in this study will clarify such doubts about the system and will speed up
the process of Islamizing of banking industry. This study will be of great help for
students of banking to understand deeply the Islamic banking and to differentiate it from
conventional banking system. It will be a contribution to the existing literature of
administrative sciences and will serve as a base for further research. This project will also
give the idea to reader, which type of investment is forbidden in Islam and which type is
good for Muslim investors. It will be helpful for bankers and investors too.
1.6 Limitations of the Study
The research is conducted within the following limitations:
To keep the study manageable research is conducted on limited grounds.
The study is conducted on small level and only the important aspects are
considered.
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There was a shortage of time thats why limited data is collected. Still the
researcher has tried to collect sufficient data to make an effective analysis.
1.7 Definition and Meanings of Terms
Al-wadiah; means safekeeping.
Bai'muajjal; means deferred-payment sale.
Bai'salam; means pre-paid purchase.
Baitul mal; means treasury.
Fiqh; means jurisprudence.
Hadith; means prophet's commentary on Qur'an.
Halal; means lawful.
Haram; means unlawful.
Ijara; means leasing.
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Iman; means faith.
Mudaraba; means profit sharing.
Mudarib; means entrepreneur-borrower.
Murabaha; means cost-plus or mark-up.
Musharaka; means equity participation.
Qard hasan; means benevolent loan (interest free).
Rabbul-mal; means owner of capital.
Riba; means interest.
Shariah; means Islamic law.
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CHAPTER NO.02
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2-LITERATURE REVIEW
This chapter deals with two parts, first part consists of basic explanation of Islamic
banking system its principles and instruments and the second part is concerned with
summary of previous researches being done on these respective research areas. It
includes the general information about the banking sector and Islamic banks.
2.1 Banking and Financial System (Fredric Mish-kin)
A healthy and vibrant economy requires a financial system that moves funds from people
who save to people who have productive investment opportunities.
There are many different types of institutions: banks, insurance companies, and so on, all
of which move funds from savers to investors.
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SOURCES OF EXTERNAL FUNDS
0
0
0
0
0
loans Bonds Stock Other
Series1
Series2
Series3
Series4
Series5
Series6
The system based on these institutions is called the financial system. And this Financial
System is complex in structure and function throughout the world.
Figure 2.1 indicates how the different countries financed their business activities using
external funds, in the period of 1970-1985.
1) Loans Made up primarily of bank loans but also includes loans by other
non-bank institutions.
2) Stock Consist of stock market-shares
3) Bonds Includes marketable debt securities.
4) Others Includes govt. loan and Foreign loan etc.
As seen in the picture the main source of fund has been loan and mostly banks make
loans. So this institution will be discussed in detail.
Figure 2.1
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2.2 What is Bank? (Fredric Mish-kin)
Bank is defined as an institution, which deals with money. The bank draws the surplus
money from the people i.e. excess of income over consumption, which is a form of loan
to the bank and in return pays interest on it for the loans of those who have saved or
deposited their money. The bank then gives out loans to those who need it particularly for
productive purposes, and charges interest on returning it.
In present days the banking system has been familiarized as an organized organization.
This organization by giving greed of different benefits induces peoples to deposit their
money in banks. Then the bank lends this money on huge interest to others. A portion of
the interest money is awarded to the creditors of savings and the rest of money is spent by
bank for its own expenditures.
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2.3 What are Islamic Banks (RIIC by Prof. Khursheed)
Unlike their counterparts elsewhere, Islamic bankers do not expect to advance money and
receive a predetermined sum on a fixed date in the future. Under the Shariah, the bedrock
of the Islamic faith, they are instead responsible for ensuring that money is invested in
viable projects, with reliable borrowers. If the project succeeds the banker shares in the
profit. If it fails he suffers the losses.
The Shariah, which dictates the activities of the banks as well as forming the basis of the
daily lives of all Muslims, requires that reward come from risk sharing. Profit must be
justified through the creation of value that the banker brings to complement the value of
the borrowers efforts and skill as mentioned in report on Islamic ideology council.
Islamic financial techniques have been employed successfully in a growing number of
major projects in the West. Al Rajhi Bank has completed deals for the financing of ships
and aircraft (using the Ijara - lease financing technique), and many industrial projects
including the building of power stations, a refinery and schools, and the expansion of an
aluminium smelter in Bahrain (using the Istisna - deferred financing technique).
Given the huge potential for development in the Islamic world and the increasing amount
of funds being invested according to the Shariah, it seems perfectly reasonable to suppose
that the recent growth in Islamic banking will continue at an accelerated pace. (Colin
Willis).
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2.4 Knowledge about Islamic Bank
A research on Bank Patronage Factors of Muslim and Non-Muslim Customers
Conducted in Malaysia in 1994 shows that almost 100 per cent of the Muslim population
was aware of the existence of the Islamic bank; the sources of knowledge are mainly
newspapers and magazines, television and radio, and family members. Many of the
Muslim respondents visit the banks branch and seek information about the bank services
and operations on their own initiative. For non-Muslims, about 75 per cent of the
respondents know of the existence of the Islamic bank from information derived mainly
from newspapers and magazines. Other sources of information are not so effective for the
non-Muslims.
Even though it has been nearly a decade since the Islamic bank was first established in
the country, only about 63 per cent of the Muslims have understood either partly, or
completely, the differences between the Islamic bank and conventional banks. Non-
Muslims showed much less understanding. Only 12 per cent of the Muslims and 32 per
cent of the non-Muslims believe that the Islamic bank is for Muslims customers only. In
terms of why people patronized the Islamic bank, about 39 per cent of the Muslim
respondents believe that religion is the only reason why people patronize the Islamic
bank, and, surprisingly, the percentage is much lower for non-Muslims. More than half of
both respondent groups have indicated the possibility of establishing a relationship with
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the Islamic bank if they have a complete understanding about the operations of an Islamic
bank (International journal of bank marketing, 1994).
The changes in the banking system have created a new dimension in the banking industry
within which the institutions in the banking system have to compete, not only with
financial institutions outside the banking system, but also with themselves to remain in
business. Indeed, the fiercer level of competition is not only faced by the banking
industry in Pakistan, but also it is becoming the most influential factor in the structure
and activities of the banking system around the globe.
2.5 History of Islamic Banking
Haqiqi & Pomeranz in their article Accounting Needs of Islamic Banking gave the
history of Islamic banking. They explained that, In Muslim communities, limited banking
activity, such as acceptance of deposits, goes back to the time when the Prophet
Muhammad was still alive. At that time, people deposited money with the Prophet or
with Abu Bakr Sedique, the First Khalifa of Islam. The first modern Islamic bank,
established in Egypt in 197, was called Nasser's Social Bank. Islamic accounting, an
essential tool for the success of Islamic banks, is said to have been developed
contemporaneously at the University of Cairo (Crane).
The desirability of abolishing fixed interest rates and the Islamization of financial
systems were discussed at the first meeting of the Islamic Organization Conference (IOC)
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in Jeddah in 1973. Subsequently, many Islamic banks were founded under the profit-and-
loss sharing system (PLS), which will be discussed below.
Modern Islamic banking has undergone three phases of development:
Emergence-1972 through 1975: This period was marked by a surge in oil
revenues and great liquidity. Parallel events included a resurgence of
fundamentalist Muslim movements, reemphasis on the Wahabi School of
Brotherhood and Pan-Islamism, and establishment of IOC.
Expansion-1976 to the early 1980s: Islamic banking spread from the: Arabian
Gulf eastward to Malaysia, and westward to England. More than Accounting
Needs of Islamic Banking 155 20 Islamic banks were established, including
international and intercontinental institutions.
Maturity--1983 to the present: The Arab world was confronted by economic
setbacks, including slowdowns in oil revenues, the collapse of Kuwait's Souk al-
Manakh, the relative strength of the U.S. dollar, higher interest rates in the United
States, and capital outflows from OPEC nations. At the same time, Arab banks
opened branches in the United States and Islamic banking practices were
implemented in both Pakistan and Iran.
Islamic banking operations are not limited to Arab soil, or Islamic countries, but are
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spreading throughout the world. One reason is the "growing trend toward transcending
national boundaries, and unifying Muslims into a political and economic entity that could
have a significant impact on the pattern of world trade. ...Since Muslims are inclined to
follow Islamic traditions, there is a tendency to establish an Islamic economic system in
every Islamic nation, And to restore Shariah Law as the basic source for legislation"
(Abdul-Magid).
2.6 Islamic Banking System (Fredric Mish-kin)
Islamic banking system deal with money and not deal in money
It is argued by Muslim scholars that whereas traditional banking is concerned with
financial intermediation on the basis of lender-borrower relationship between depositors
and banks, on one hand, and banks and the fund-seekers, on the other hand, Islamic
banking is about addressing genuine concerns of the owners of funds and needs of the
resource-strapped through Shariah permitted forms of transactions.
The argument is built on the following premise.
What is permitted for an individual is also permissible for the banks (that are groups of
individuals shareholders) unless there are reasons to conclude otherwise.
2.7 Instruments of Islamic Banking. (Fredric Mishkin)
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The Islamic instruments which govern the operations of Islamic banks are also known as
Shariah instruments. The applicable instruments are called Mudharabah, Musharakah,
Murabahah, Al-Bai Bithaman Ajil, Al-Ijrah, Al-Takjiri, Qard Hasan, Al-Wakalah, Al-
Kafalah and Wadiah.
Foundations for modern banking operation in Shuriah are defined in terms of trade,
leasing and partnership based arrangements and collateral and guarantees. The following
options are pro-posed to be initially made available for banking system.
Trade-related modes. Bai-muajjal (sale on deferred payment basis),
Baisalam (sale with cash payment with future
delivery)
Leasing modes... Ijarah (operating on lease)
Partnership modes..Modarabahah & Mosharakah
Lending Qard (loan)
Collateral and Guarantees
Shariah requires that not only the ends be Shuriah compatible but that the means to
achieve those ends be right as well. In the light of this principal the above modes can be
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adopted.
2.7.1 Trading-based arrangements
Baimuajjal is the Arabic acronym for sale on deferred payment becomes debt against
the buyer payable in lump sum or in installments (as per agreement with the seller). In
addition to the concurrence of the seller, conditions for a valid Baimuajjal are as
follows:
1. The price to be paid must be agreed and fixed at the time of the deal. It may
include any amount of profit without qualms about Riba.
2. Complete/total possession of the thing in question must be given to the buyer,
while the deferred price is to be treated as debt against him.
Bai salam involves advance payment to a party for delivery of a thing in future a
converse of Baimuajjal. It applies to the case in which things come into the possession
of the seller due to his being their producer or towards discharging his occupational
functionsfor instance, wholesaler acquiring goods from a manufacturer and supplying
them to the retailers.
Baisalam is a valid transaction with the following three basic conditions:
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1. The nature, quality and quantity of the merchandise (to be delivered in future)
must be clearly specified along with the delivery date.
2. The price to be paid in advance should also be fixed.
3. The transaction should be settled with the delivery of goods, not on the margin.
2.7.2 Leasing-based arrangements
Ijarah or leasing is a contract for the usufruct of an asset while its ownership still remains
with the original owner, i.e., the lessor. In this case, the lessor leases his asset to another
party, the lessee, against a predetermined rental for a prescribed period. Thus, besides the
concurrence of the concerned parties, there are three fundamental conditions for a valid
Ijarah contract:
1. The asset is the property of the lessor.
2. The period of contract is specified.
3. The rental and its payment schedule are precisely stated.
That the asset remains in working condition (during the period of lease is the lessors
responsibility.
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2.7.3 Partnership-based arrangements
Modarabah and Musharakah are two partnership modes that allows two or more parties to
share both the contributions to and the fruits of economic activity, albeit in varying
degrees, trough mutually agreed arrangements. The bank can adopt both of these modes.
It can act as Mudarib as well as a partner.
Critical points and conditions about Modarabah and Musharakah from the Shariah
perspective are as follows:
1. All these arrangements represent a situation in which (a) ownership of capital is
shared, albeit for the duration of the contract, (b) rewards are addressed through a
share in the outcome of the activity, and (c) material losses are shared in
proportion to ownership stakes of the various partners along with labour going
totally unrewarded.
2. The Mudarib should not lay any material claims against the joint venture except
those necessary for discharging the required functions according to the letter of
the contract.
3. In the settlement of accounts, the first claim on revenues, over and above the
operating costs, would be in lieu of the capital contributions. After this, the
residual or operating profit can be distributed among all partners according to the
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prescribed profit-sharing ratios.
2.7.4 Collateral (Rehn) guarantees
Creditors may seek collateral to protect their interests. In this regard, the following
principles need to be observed:
Collateral should not be of the same kin as the object of the loan/debt.
Creditors may not draw benefits from the object of collateral.
The collateral may be liquidated as per agreement. However, if the liquidation proceeds
exceed the quantum of debt, the balance has to be paid to the debtor. Likewise, if the
value of liquidated collateral falls below the amount of debt, the balance would stand as
unpaid debt against the debtor.
2.10 Commercial Banks or Conventional Banks (Fredric Mish kin)
Despite the classical origin, banking in its modern form and structure started in Britishwhen many of the Lombardy merchants came to England and settled here. They were soresourceful that even the kings had to depend on them for loans despite the fact that thechurch was firmly against usury. They dealt with not only keeping the money safe butalso changing money for travelers etc.
Consequently this business was taken over by the goldsmiths, who up to that time, weredealing only in gold & silver.
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Over a period of time, these goldsmiths discovered that large sums of money were left intheir custody for long periods therefore, they started the use of this cash to advance loansto others persons for a fixed period of time & at high rate of interest. Thus began the
issue and deposit banking of modern times up to non, this institution, bank becamethe need of the time and it provides so many functions for the economic activities of anycountry.
2.10.1 Objectives of commercial banking
Main objectives of commercial banks are as follows; earning profit, that is the mainpurpose of banks. For this purpose the bank charges very high rate of interest in itbusinesses.
With this main objective, the bank has to full fill some other commitments also e.g.
Issuing new currency
Providing loans to businesses
Operate for the stability of economy
Benefited their major clients who pay more interest.
And providing a set of services like check clearing, record keeping, creditanalysis and soon.
2.10.2 Function of Commercial Banking
As we already know that how banks performs their i) primary and ii) secondaryfunctions. Hove the most important point is to make clear how these banks operates.
To understand how a bank operates, first we need to examine its Balance Sheet a listof the banks assets and liabilities, i.e.
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1-Accepting DepositsFixed
Deposit
Saving AccountsCurrent Account
Total assets = Total liabilities + Capital,
This sheet lists sources of bank funds (liabilities) and uses to which they are put (assets).
a) Liabilities
A bank acquires funds by issuing (selling) liabilities. These funds are used to purchaseincome earning assets.
b) Bank Capital
It is a banks net worth, which equals the difference between total assets and liabilities itis a cushion against a drop in the value of its assets, falls below its liabilities, meaningthat the bank is bankrupt.
c) Assets
Bank assets are referred to as else of funds and the interest payments earned on themare what enable, banks to make profit.
In general terms the basic operation of a bank is that it makes profits by selling liabilitieswith one set of characteristics (a particular combination of liquidity, risk and return) andusing the proceeds to buy assets with a different set of characteristic this process is oftenreferred to as asset transformation.
A COMMERCIAL BANK GENERALLY PERFORMS THESE FUNCTIONS
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2-Advancing of LoansBy over drafting
Purchasing bonds and securitiesning a loan account Discounting bill of exchange
3 Transference of money
4 Creation of safest medium of exchange
5 Agency services
6 General utility services
7 Financing of foreign trade
These functions are briefly discussed as under:
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1. Accepting deposits
Main function of commercial banks is to receive surplus balances of the individuals,
public institutions and households there are three types of accounts in which it receives
deposits i.e. current account consist of those deposits that can be drawn at any time. Bank
do not pay interest money can be drawn with out notice.
Fixed deposits are repayable after the contracted period. High rate of interest is allowed
at their deposits.
In saving account, it is the responsibility of the bank to repay deposit on demand up to a
certain limit. Further withdrawal needs permission from bank.
2. Advancing of loans
Bank advances loans against securities at certain fixed rate of interest. It takes none
interest from people on loans and gives low to depositors. And the difference between
these two is the profit of the bank.
Bank gives loans by opening new account it do not gives money in cash form same time
for reliable customers, bank with draw money by over drafting their accounts i.e.
withdraw money none than amount saved in the account.
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Bank may also give out loans against bills of exchange presented before it upon which
these bills are discounted at their market work.
Same times it purchases bonds and securities in the stock market. For record of
transaction the bank then requires who sold shares to open account in the bank.
3. Transference of money
The bank also transfers the money internally and externally for different purposes.
4. Creation of safest medium of exchange
It creates safe medium of exchange by means of cheque, because it represents very high
value with one not etc.
5. Agency services to customers
It may act as an agent by collecting and paying money on cheque for its customers.
6. Utility services
It also provides services like locker services foreign exchange business etc.
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7. Financing of foreign trade
It provides incentives to be involved in the export business by lowering interest rate on
loan for this business
2.11 Concerns with Financial Stability (Abbas Mirakhor & Mohsin Khan, 1986)
For a number of reasons Islamic finance has become relevant for the stability of the
global financial system. Financial stability is an important prerequisite for sustained
economic growth and social development. Experiences of past financial crises show that
economic progress achieved over several years can be significantly reversed during a
very short period of time. The international financial system has been experiencing
recurring crises over the last two decades. As a result, there have been large losses in
gross domestic product of the countries concerned with a serious adverse implication for
the stability and growth of the world economy.
In response to these crises, the international financial community has reiterated the need
to strengthen financial institutions by appropriate measures including effective regulation
and supervision, better corporate governance, risk management and enhanced disclosures
and transparency so that the crises can be prevented from occurring and they can be
managed efficiently if they happen.
The implication of Islamic finance for stability of Islamic financial markets has some
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special considerations. First, investment deposits of Islamic banks are based on risk
sharing and the financing extended by the Islamic financial institutions is asset-based. For
this reason, Islamic finance has inherent positive implications for financial stability.
Second, the practices of the Islamic principles of finance have taken a number of forms.
Some Muslim countries have made an endeavor to implement the Islamic principles
economy-wide. A number of countries have allowed establishment of Islamic financial
institutions side by side with conventional institutions. Some other countries have
allowed their traditional financial institutions to write Islamic banking contracts as well.
As a result, Islamic banking and finance has become important for the stability of
financial systems in several countries.
Finally, the infrastructure of the Islamic financial system is in the evolutionary process.
Hence despite the fact that the industry is fully regulated and supervised, there could be
unwarranted misconceptions in some circles due to the lack of familiarity with the
industry. Due to the requirements for financial transactions to comply with the Shari'ah,
some risks of the Islamic financial contracts are unique. The Islamic financial industry
can be strengthened by suitably adapting the international standards to its unique risk
characteristics. In its part, the inherent features of the Islamic financial industry can
contribute to strengthening the global financial architecture provided the basic supportive
infrastructure is established.
2.12 Causes of Financial Instability(Abbas Mirakhor & Mohsin Khan, 1986)
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Various causes of financial crises can be identified depending on the specific situations
and circumstances in which the crises might have occurred. Some common causes of
financial crises are:
(a) Lack of proper regulation and supervision
Due to lack of proper regulation and supervision, in several developing countries
financial institutions are not properly capitalized, loan loss provisions are not prudentially
maintained, there are large amounts of imprudent connected lending, transparency and
disclosure standards are low, risk management and internal control systems are weak, and
the public sector's influence is large. As a result, financial institutions at times are not
able to absorb even small shocks from internal or external sources.
(b) Non-compliance with standards
For a sound financial system, compliance with the international standards on the part of
governments as well as public and private sector institutions is extremely important.
Noncompliance by public and private sector institutions with the best practice standards
in financial reporting, accounting, auditing, transparency and disclosures make financial
systems vulnerable to instabilities.
(c) Currency crises
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As a result of an unrealistic exchange rate regime or excessive speculation, the exchange
rate of a currency may depreciate below normal levels. Consequently, the value of
financial assets/liabilities held in foreign currency will appreciate and the value of those
held in local currency will depreciate. Since in the developing countries there is always a
scarcity of foreign exchange, a currency mismatch leads to banking and payments crises
and creates contagion effects.
(d) Maturity mismatch
Maturity mismatch between short-term liabilities and short-term assets of the public and
private sectors is also known to be an important cause of financial crises. If short-term
foreign exchange liabilities are high as compared to the availability of liquid foreign
exchange assets, foreign contractual obligations cannot be met in time, causing a larger
financial crisis.
(e) Moral hazard
Considerable part of financial instability is attributed to deposit insurance schemes and to
not allowing inefficient financial institutions to fail. As a result of such policies, some
financial institutions are motivated to practice imprudent policies, which weaken the
overall state of the financial system. Several other causes of financial crises can be cited
depending on the circumstances of their occurrences. It can be seen that the interest-
mechanism is central to most of these causes. As mentioned above the fast movement of
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short-term interest-based funds is an important cause of financial instability. Furthermore,
high leverage and expansion of credit without any linkage to the real sector of the
economy also contributes to instability. Interest based credit finances undesirable
speculative activities in stock, commodity and foreign exchange markets. Hence if the
interest mechanism is avoided, the major cause of financial crises may be contained.
2.13 Overall Effects of Interest
(Text from Historic judgment on interest given by Supreme Court of Pakistan)
Section Written by Justice Muhammad Taqi Usmani. Interest-based loans have a
persistent tendency in favor of the rich and against the interests of the common people.
It carries adverse effects on production and allocation of resources as well as on
distribution of wealth. Some of these effects are the following:
(a) Evil effects on allocation of resources
Loans in the present banking system are advanced mainly to those who, on the strength of
their wealth, can offer satisfactory collateral. Dr. M, Umar Chapra (Senior Economic
Advisor to Saudi Arabian Monetary Agency) who appeared in this case as a juris-consult
has summarized the effects of this practice in the following words:
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Credit, therefore, tends to go to those who, according to Lester Thurow, are lucky
rather than smart or meritocratic. The banking system thus tends to reinforce the unequal
distribution of capital. Even Morgen Guarantee Trust Company, sixth largest bank in the
U.S. has admitted that the banking system has failed to finance either maturing smaller
companies or venture capitalist and though awash with funds, is not encouraged to
deliver competitively priced funding to any but the largest, most cash-rich companies.
Hence, while deposits come from a broader cross-section of the population, their benefit
goes mainly to the rich (Dr. Chapras written statement under the caption Why has
Islam prohibited Interest?).
The veracity of this statement can be confirmed by the fact that according to the statistics
issued by the State Bank of Pakistan in September 1999, 9269 account holders out of
2,184,417 (only 0.4243% of total account holders) have utilized Rs.438.67 billion which
is 64.5% of total advances as of end December 1998.
(b) Evil effects on production
Since in an interest-based system funds are provided on the basis of strong collateral and
the end-use of the funds does not constitute the main criterion for financing, it encourages
people to live beyond their means. The rich people do not borrow for productive projects
only, but also for conspicuous consumption. Similarly, governments borrow money not
only for genuine development programs, but also for their lavish expenditure and for
projects motivated by their political ambitions rather than being based on sound
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economic assessment. Non-project-related borrowings, which were possible only in an
interest-based system have thus helped in nothing but increasing the size of our debts to a
horrible extent. According to the budget of 1998/99 in our country 46 percent of the total
government spending is devoted to debt servicing, while only 18% is allocated for
development, which includes education, health and infrastructure.
(c) Expansion of artificial money and inflation
Since interest-bearing loans have no specific relation with actual production, and the
financier, after securing a strong collateral, normally has no concern how the funds are
used by the borrower, the money supply affected through banks and financial institutions
has no nexus with the goods and services actually produced on the ground. It creates a
serious mismatch between the supply of money and the production of goods and services.
This is obviously one of the basic factors that create or fuel inflation.
2.14 The Viability of Islamic Finance (Nejatullah Siddiqi)
It has been demonstrated that all market activities can be financed by using the various
Islamic modes, such as Musharaka, Mudaraba, Murabaha, Salam, istisnac, andIjara. No
stratagems are needed. The author has argued that interest-free Islamic modes of finance
can replace the conventional interest based finance with certain added advantages. By
synchronizing entrepreneurial payment obligations and accrual of revenues, sharing-
based modes of finance remove a major source of instability from freely functioning
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markets. Also by linking financial intermediaries' returns to the actual revenue of the
fund users, allocation of funds to invest is redirected to projects expected to produce
more value than their alternatives.
CHAPTER NO.03
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3-RESEARCH METHODOLOGY AND DESIGN
The following chapter presents the detail of the research approach adopted, methods and
instruments exploited and the techniques used for analysis. First of all the problem is
identified. Then related data is collected and then the collected data is analyzed &
interpreted and finally conclusions have been made.
3.1 Type of the Study
This study is basically descriptive in nature, and this would explore & review the
research done on Islamic banking by different researchers and scholars.
This study would describe mainly what Islamic banking is all about, its instruments,
principles, viability, riskyness as compared to conventional banking system, and
difference between the two systems.
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3.2 Methods of Study
This study utilized the descriptive technique because its main objective is to find out
what exists and what is about a certain existing problems. Different theories were
compared and contrasted with one another to know the causes of existing problem and to
get final conclusions.
The information regarding the Islamic banks has been collected from Secondary Data.
Different books by famous scholars and researchers are reviewed and most of data is
collected from net after the detailed discussion with the supervisor.
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CHAPTER NO. 04
4-INTERPRETATION AND ANALYSIS OF DATA
Basically in this chapter the collected data is analyzed and interpreted. As this is
descriptive research so this section will only give the answers of the research questions
given in first chapter in the light of the research done previously in the same area.
The findings of the studies are as follows:
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1. What is Islamic banking system with respect to its principles and
instruments?
Islamic banking, an alternate to interest based banking is not banking in the traditional
sense of the word. It derives its inspirations and guidance from the religious edicts of
Islam and has to conduct its operations strictly in accordance with the directives of
Shariah.
It is, therefore, not merely refraining from interest based transactions but the objective is
to make a positive contribution to the fulfillment of socio-economic objectives of the
society in all spheres, including trade industry, agriculture, science, technology,
employment, benevolent sector and the environment, with special focus on the human
factor.
An Islamic bank is a financial and social institution which identifies itself with the
principles of Shariah, as laid down by the Holy Qurans and Sunnah, as regards its
objectives, principles, practices and operations. An Islamic bank does not normally lend
money except the interest-free loan, which is termed as Qard Hasan. Islamic bank is a
partner in trade, industry and agriculture for production and development financing. This,
therefore, implies that an Islamic bank should also share in the risk with the entrepreneur,
which is in sharp contrast with interest-based bank. Islamic banking implies zero rate of
interest but no zero rate of return as Islamic banks do not deal in money but deal with
money.
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Islamic banks are required to pay Zakat (poors due) @2.5% of their capital and profits
each year for the poor and needy. It will also be observed that by their very nature of
operations, Islamic banks have to be more cautious and more efficient, as they transact
business on profit and loss sharing. They are subject to the supervision and control of the
Central Bank as is the case with other interest-based banks. Further, in addition to
internal and external audit, Islamic banks are also generally subject to supervision by an
Islamic Religious Board. The Islamic banks obtain their inspiration from ethical values of
Islam and do not deal in business declared illegal like alcohol, drugs and gambling, etc.
It can, therefore, be concluded that Islamic banks, in essence, are development
institutions, which are established according to the objectives of Islamic economics.
Islamic banks, therefore, not only refrain from involving themselves in interest
transactions, but also adhere to the Islamic principles of social justice. These banks,
therefore, introduce systems, procedures, practices and products, which contribute to the
attainment of the socio-economic objectives prescribed by Islam.
The investors and depositors are thus able to participate in the development and
production process for the benefit of the community as a whole, as well as have a share in
the profits of the institutions with which funds are placed or invested. Islamic banks like
other conventional banks publish audited balance sheets and profit and loss accounts.
They are owned by shareholders who expect sufficient dividends on their holdings. The
depositors of Islamic banks, on the other hand, hope to get higher returns on their
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investments with these banks. The higher returns announced by a bank would obviously
attract more funds from depositors and investors.
The real aims and objectives of establishing Islamic banks are to put the Islamic
economic system into practice through banking and financial institutions. These banks
operate within the framework of Shariah and their systems and procedures are tailored to
meet the challenges posed by the present complex and competitive market. At present,
there are bout 100 Islamic banks and financial institutions in different parts of the world.
Principles and Instruments
Different writers explained the principles and instrument of Islamic banking in different
way but the basic idea is same, both principles and instrument are described in details in
literature review, so here they are summed up briefly.
The board principles of Islamic banking system are:
a) Any predetermined payment over and above the actual amount of
principal is prohibited.
b) The lender must share in the profits or losses arising out of the
enterprise for which the money was lent.
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c) Making money from money is not Islamically acceptable.
d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.
e) Investments should only support practices or products that are not
forbidden in Islam.
(For details look at section 2.8)
The instruments of Islamic banking system are: Mudharabah, Musharakah,
Murabahah, Al-Bai Bithaman Ajil, Al-Ijarah, Al-Tijarah, Qarad Hasan, Al-wakalah and
Wadiah.
a) Mudharabah
This is basically an agreement between a lender and an entrepreneur, in which the lender
agrees to finance the entrepreneurs project on a profit sharing basis according to a pre-
determined ratio agreed on in the negotiation between the two parties. The lender will
bear any loss incurred.
b) Musharakah
This is a partnership for a specific business activity with the aim of making profit,
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whereby the lender not only provides the capital but also may also participate in the
management. As in the case of Mudharabah, all parties agree, through negotiation, on the
ratio of distribution of profits generated from the business activity, which need not
coincide with the ratio of participation in the financing of the activity. However, in the
event of a loss, all parties bear the loss in proportion to their shares in the financing.
c) Murabahah
This is basically the sale of goods at a price covering the purchase price plus the profit
margin agreed on by both parties concerned, which transforms a traditional lending
activity into a sale and purchase agreement, under which the lender buys the goods
wanted by the borrower for resale to the borrower at a higher price agreed on by both
parties.
d) Al-Bai Bithaman Ajil
This is a variant of the concept of Murabah, whereby the borrower is allowed to defer
settlement of the payment for the goods purchased within the period, and in the manner,
determined and agreed on by both parties.
e) Al-Ijarah
This is the Shariahs concept of leasing finance whereby the bank purchases the asset
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required by the customer and then leases the asset to the customer for a given period, the
lease rental and other terms and conditions having been agreed on by both parties. Al-
Takjir: This is a variant of the concept of Al-Ijarah, which, however, provides for the
acquisition of the leased asset by the lessee.
f) Qard Hasan
This is a benevolent loan which obliges a borrower to repay the lender the principal
sum borrowed on maturity of the loan. However, the borrower has the discretion to
reward the lender for his/her loan by paying any sum over and above the amount of the
principal.
g) Al-Wakalah
This is an agreement between a customer and his/her bank in which the former appoints
the latter as his/her agent in undertaking a certain transaction on his/her behalf.
h) Al-Kafalah
This is an agreement between a customer and the bank whereby the later guarantees the
fulfillment of the obligation of the former to a third party.
i) Wadiah
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This is an agreement to deposit an asset, excluding immovable fixed assets, in the
custody of another party who is not the owner, or any such asset deposited with a non-
owner for custody.
2. How Islamic banking system is different from conventional one?
Islamic Bank system & conventional Bank system can be compared by identifying
similarities and differences between both of the banks.
a) Similarities
Both are governed by the general rules of the regularity authority covering
establishment, control and general operations.
Both operate within the context of professional efficiency cost effectiveness
and lost / benefit.
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Both are directed towards useful employment of resources for the society.
Both are usually established as shareholding companies.
Both types of banks give incentive to increase the level of savings in the
country.
Provide training facilities to their employees.
Motive of profit maximization is same for both banks.
Both banks try to maximize the utility of their customers to attract and
increase their client.
Both banks increase investment modes of financing.
Both try to prevent the crisis & stabilize the economy.
Both provide the security services like lockers for the ornament etc, to their
customers.
Providing loan to customers is the main function of both banks, despite their
difference in operation.
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Both promote business activities in a country.
b) Differences
Islamic bank has a different moral basis i.e. jurisprudence (Shariah)
Consequently, targets, objectives and mode of operations are different.
Islamic bank is universal comprehensive bank where as in conventional
framework; there is commercial, investment, merchant or specialized bank.
Structures of assets and liabilities i.e. sources and uses of funds are different
and consequently the earnings and expenses structures are different.
In Islamic Banking, Bank play a role of a trader or an entrepreneur but in
conventional banking system, bank just play a role of issuing loans to
customers, Modern Banks issue loans and they are not very much interested in
what the borrower will do with that money. Thats why, there is always a risk
of not getting back the loan but it is not so in Islamic banking. As it provide
Finance on participatory basis or it directly links Finance to the economic
activity so in this case both the lender and borrower has to share risk equally.
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It also increased the scope of economic activity in economy.
In conventional banking system interest rate is involved on the other hand in
Islamic banking system involved partnership, so the advances of Islamic
banks are contingent on profit & loss sharing basis. Interest based system
encourage instability in the economy because there is a chance of high
inflation etc, but on the other hand Islamic banking system encourages a
stability in the economy
Islamic banking system increases the investment. In conventional banking
system, higher the level of interest the lower the level of investment and vice
versa. Thus financing the business on the basis of profit and loss sharing
instead of interest will increase level of productive investment.
Today all costs for example those occurred due to time log in a deferred
payment, default risk and the inflation rate are covered under the interest rate
and margins added to it. Such costs are likely to appear in an Islamic Riba free
framework too, but the media through which there costs will be met is
different.
At present, commercial banks are mostly financing to the large size or
medium to large size projects but in Islamic framework it is not so. The
management of Islamic banking system has to give incentive to increase small
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and medium size investment to generate revenue and profits so they give
incentives to small and medium size entrepreneurs and in turn the prospects
for mudarabah and Musharaka will increase.
It is important to appreciate the high interest rates penalize entrepreneurs, as
the cost of borrowed funds goes up. The low interest rate on the other hand,
hurts the savers who place funds with interest based institutions, as the net
interest rate further go down and even may become negative due to inflation.
There is injustice in both situations in conventional financing system. The
Islamic system of financing may not eliminate or change the level of these
uncertainties in all cases and at all times, but would definitely redistribute the
consequences of these uncertainties over all the concerned parties in a just
manner.
Because of the Shariah restrictions and the prohibition of usury the detailed
relationship to the Regulatory Authority is different.
Target customers are partly different.
In a conventional interest-based banking system the revenue of a bank arises
from market imperfection as well as fees and commissions while in an
Islamic-based banking system the revenue is generated by fees and
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commissions (administered prices).
In Islam, there is a clear difference between lending and investing; lending
can be done only on the basis of zero interest and capital guarantee, and
investing only on the basis of Mudaraba (profit-and-loss-sharing).
Conventional banking does not, and need not, make this differentiation. But
an Islamic bank has to take this into consideration in devising a system to
cater to the Muslims. Therefore such a system has to provide for two sub-
systems, one to cater to those who would lend and another for those who
wish to invest.
3. What are the advantages of Islamic banking system, and what is its future?
This section examines Islamic banking from several sides, including efficiency, stability,
moral hazard, role in economic development, integrity, equity and sustainability. All
these are the characteristics of Islamic banks which help in proving that Islamic banking
system is less prone to business cycles which is the main advantage of Islamic banking
system, along with this these characteristics give many advantages to the economy of a
country and the bank itself.
a) Efficiency
As the modern banking system is interested based but, the economies which are
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default can be expected at times of crises, be it of macroeconomic nature or caused by
circumstances specific to the bank. A bank operating according to Islamic rules of
finance has liabilities of different nature. Only demand deposits are guaranteed.
Meanwhile, investment deposits are placed on profit-and-loss-sharing basis. When such
bank faces macroeconomic or specific crises, investment depositors automatically share
the risk. The bank is less likely to fall and a bank run is less probable. It can therefore be
said that an Islamic banking system is relatively more stable when compared to
conventional banking.
c) Morality hazard and selection
It is mentioned above that Islamic banks hold equity and trade in goods and services as
they operate as universal rather than commercial banks. Universal banks are defined as
"large-scale banks that operate extensive networks of branches, provide many different
services, hold several claims on firms (including equity and debt), and participate directly
in the corporate governance of the firms that rely on the banks as sources of funding or as
securities underwriters" (Calomiris, 2000).
d) Economic development
Given the characteristics of Islamic banks mentioned above, particularly the fact that
Islamic banks operate according to the rules of universal rather than commercial banking,
it can be conclude that the practice of universal banking by Islamic banks put their
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financing activities right in the center of the development process. Bankers in this case
become both partners and financiers of entrepreneurial efforts to develop the economy.
e) Integrity
Risk is known to be one of the most important ingredients of making investment. Those
who finance investment share a good part of the risk involved with those who carry out
actual investment activities. Conventional banks leave risk to be borne by specialists.
Banks provide investors with loans guaranteed by collateral. In this fashion, they keep
themselves apart from certain kinds of risk, like those attached to production, marketing
and distribution, and limit their exposure to risk related to collateral only.
Islamic banks allow savers who deposit their funds to share with banks the risks
associated with choosing the right investment and how successful it would be. Banks
advancing funds share risk with those receiving finance, including producers, traders etc.
Islamic bank with proper corporate governance allows depositors some influence on
banks investment decisions and allows a share in the decision-making process. Thus the
risk as well as decision-making is spread over a much larger number and wider variety of
concerned people. Risk sharing is balanced by sharing in decision-making. This allows
for wider involvement in economic activities, so that people will eventually feel they are
partners rather than spectators. The benefit of wider involvement goes beyond the mere
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feeling of involvement. It adds to the stability of banks. Holders of investment deposits
with banks share in both the profits and losses.
f) Equity
Islamic financial institutions and Islamic banks must be viewed as basically private
profit-seeking business enterprises that operate according to the market mechanism. By
themselves, they cannot reduce or eradicate poverty. However, if given the right tools,
they can contribute to the efforts taken by the whole society in that regard. Islam
prescribes a tax-subsidy approach to reducing poverty. A levy called Zakat is paid out by
the wealthy (those whose wealth exceeds a certain minimum level) in proportion to their
Property. Zakat collection would be expected to be carried out mostly by
nongovernmental and sometimes by governmental organizations. Islamic banks can help
by acting as custodians and in the disbursement of the proceeds. In addition, non-banking
financial institutions can also take part in collecting Zakah, using Islamic banks as
depositories, and invest the proceeds allocated to the poor in special accounts with
Islamic financial institutions, to which they would also add a proportion of Zakat due on
their shareholders equity.
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Income maintenance is provided within narrow limits to those incapable of work and
wealth maintenance is provided to the rest of the poor. The latter policy entails giving the
poor productive assets, which they can use to produce goods and services and sell them
for profit. This method of poverty reduction can be closely intertwined with that of
economic development, as redistribution is mostly directed towards making the poor
more productive, which in turn contributes to economic development. Income
maintenance would involve regular (monthly) payments to the needy. Wealth
maintenance, meanwhile, involves transferring to the poor a combination of productive
resources, which would be capable of generating sufficient income to maintain at least
one household. As to income maintenance, Islamic banks can credit the accounts of the
prescribed poor with monthly payments. Wealth maintenance can be implemented
through the establishment of micro enterprises that would be owned and operated by the
poor. While, the titles to such enterprises are transferred to the poor, certain measures
must be taken to insure that the new businesses would not be immaturely liquidated to
finance consumption outlays for their owners. The experience of Islamic banking in
project financing should come in handy in eradicating poverty and increasing equity
through proper use of Zakah proceeds.
Conventional lending gives utmost attention to the ability to repay loans. To ascertain
such ability, it depends overwhelmingly on the provisions of collaterals and guarantees.
Thus those already rich would have most access to finance. In contrast, Islamic banks
provide funds on equity or profit-sharing basis would be more concerned about
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profitability and rate of return and less concerned about collateral as the primary
consideration. Those who are not wealthy, but have worthy investment projects, would
have more access to finance. So this characteristic is another advantage of Islamic
banking and society itself.
g) Sustainability
Conventional debt has certain characteristics that could place debtors in difficulties if
circumstances do not allow them to repay in time. Interest is usually calculated on the
outstanding balance of debt, usually compounded annually and sometimes at shorter
intervals. Delinquent debtors are often subjected to penalty rates of interest, which are
higher than regular rates. It is not uncommon to find borrowers who end up paying debt
service that is many folds the original principal they borrowed. This is particularly
symptomatic of developing countries debt, as they continue to face debt problems that
sometimes reach crisis levels. Creditor countries and institutions have often sought to
find ways and mechanisms to provide debt relief to debtor countries. Despite continuous
efforts, the debt problems faced by developing countries seem to be ever-present. Thus it
can be concluded that interest based banking and finance lacks a great deal of
sustainability. Creditors have to stop every few years to give debtors relief in terms of
rescheduling and forgiveness.
Unconventional debt created through Islamic banks has characteristics with which debt
crises are less likely to rise. Particularly, the total value of debt, the total value of debt can
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be repaid in installments, without increase in its total value, as there is no compounded
interest to pay on outstanding balance. When debtors face unavoidable circumstances that
would make them temporarily insolvent, they are often granted grace periods to help
them bring their finances back to order. No penalty fees can be levied in this case. In
other words, debt rescheduling, when justifiable, would be granted at no extra cost to
borrowers. Therefore, it can be concluded that Islamic banking and finance is sustainable
and less liable in itself to cause undue hardship to debtors.
4. Why Islamic banking is more viable than conventional banking system?
From the characteristics and the advantages of Islamic banking given in the previous
section, it can be easily concluded that Islamic banking is more viable than conventional
banking system. The main reasons for its viability are:
a. Islamic banks have some definite edge over conventional banks because
their capital is secure. While, the capital of the conventional banks is at
risk, due to high leverage with their liabilities. The investments and
deposits in an Islamic bank are not the liability of the bank and can, at
best, be termed as a contingent liability as these funds are in trust with the
bank. The liability of the Islamic bank arises only when gross negligence
is proved in carrying out the trust functions as distinct from business
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losses. Islamic banks are, therefore, highly leveraged institutions, unless of
course their current account balances are several times their paid up
capital and reserves.
b. Secondly, the main selling point of Islamic banking, at least in theory, is
that, unlike conventional banking, it is concerned about the viability of the
project and the profitability of the operation but not the size of the
collateral. Good projects which might be turned down by conventional
banks for lack of collateral would be financed by Islamic banks on a
profit-sharing basis. It is especially in this sense that Islamic banks can
play a catalytic role in stimulating economic development. In many
developing countries, of course, development banks are supposed to
perform this function. Islamic banks are expected to be more enterprising
than their conventional counterparts. In practice, however, Islamic banks
have been concentrating on short-term trade finance which is the least
risky.
c. Thirdly, it is less cyclical as compared to conventional banking system
because of interest free trend as high interest is considered the basic cause
of business cycles in any economy.
d. As Islamic banks do not have to pay fixed amount to borrowers, they need
not to keep additional liquidity with them. Thus they can lend more as
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compared to conventional banks because they do not have to keep excess
money with them.
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CHAPTER NO.05
5-SUMMARY, CONCLUSION AND RECOMMENDATIONS
This section consists of the conclusion and recommendations of the addressed problem.
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5.1 Conclusion
Findings and conclusion are in fact the summary of chapter 4.
Theoretically speaking, there is no concept of loans and credits in Islam for financing
trade, industry and agriculture except Qard Hasan and where profit and loss sharing is not
feasible like interest-free loans by the federal government to provincial governments for
their developmental needs. Islamic banks, therefore, involve themselves in financing
(short, medium and long term) for the working capital requirements, and also contribute
to the capital of an enterprise by participating in its equity. These financings are on profit
and loss sharing basis. Islamic banks also mobilize resources on profit and loss sharing
basis as distinct from interest payments to depositors on predetermined rates.
Islamic banking is a part of over-all value system of Islam. It is, therefore, imperative
that simultaneously genuine efforts are made to ensure that the people are imbued with
honesty of purpose and their actions conform to Islamic values. The basic values that
Islam seeks to establish are: (a) Freedom (b) Brotherhood (c) Equality (d) Justice (e)
Trust i.e. treating the God given capabilities and resources as trust. (f) Honest
Consciousness i.e. sense of responsibility and care for ones obligations.
In a system based on profit and loss sharing, it is to the advantage of banks and financial
institutions to invest in those projects where higher rates of profits are anticipated. The
financing by Islamic banks under this system is done within the framework and keeping
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in view the social considerations, the requirements of priority sector and the safety of
funds. The Islamic banking system, therefore, induces savings and capital formation and
lead to optimum allocation of resources.
Islamic banks operating on profit and loss sharing basis are definitely in a stronger
position to absorb the shocks to their assets position (banks financing), as the losses are
simultaneously absorbed by the changes in the value of deposits placed with the banks.
The nominal value of deposits of Islamic banks is not guaranteed like investment in
shares of a bank or for that matter of a joint stock company. The real value of Assets and
Liabilities (Uses of Funds and Sources of Funds) of Islamic banks is, therefore, equal at
any point of time. It is, however, to be ensured through prudent and professional banking
practices, procedures and systems that the losses in the financing portfolio are as low as
possible and that highest possible returns are paid to the depositors and investors.
It emerges from all this that Islamic banking has following distinguishing features: (a)
Islamic banks deal with money and do not deal in money, (b) it is interest-free, (c)
Lending and investing are treated differently; loans are interest-free but carry a service
charge, while investing is on a profit-and-loss-sharing (Mudaraba) basis, (d) it is multi-
purpose and not purely commercial, (e) it is strongly equity-oriented, and (f) Value
erosion of capital due to inflation is compensated.
Theoretically and empirically, it is not difficult for specialists in economics and finance
to find Islamic banking in not only viable and acceptable, but also efficient and
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significantly effective. It is not therefore surprising to see large multinational banks and
institutions are providing Islamic financial services to their customers in significant
amounts. As an innovation, Islamic banking has been practiced for more than a quarter of
a century.
Theories reviewed in chapter 2 show that interest is the basic cause of business cycles
and financial instability, these theories also prove the bad effects of the interest on
resources, production, distribution, and on the economy as whole. On the other hand
theories presented by Fisher, Minskyetc show the bad effects of debt, Similarly the
research and work of many researchers and scholars like Lloyd Metzler, Mohsin Khan,
Nejatullah Siddiqietc have also proved that Islamic banking system is more stable than
conventional banking systems. The problem statement of this research was why some of
conventional banks moving towards Islamic banking system, findings of all these
theories and answers of all research questions discussed previously clearly show that
Islamic banking system is more stable, secure, sustainable, less cyclical in nature and
better for economy, thats why Islamic banking system is becoming more popular and
many of conventional banks are moving towards Islamic banking system.
Islamic banks share with their conventional counterparts similar specialization and
business interests. Differences that exist between their modes of operations afford them
excellent opportunities to cooperate and collaborate. Areas like joint financing and
financial market operations can be the stage of daily collaboration. As conventional
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banks have been first in the field, they can be a valuable source for professional
techniques and standards. In other words, Islamic banks have a lot to learn from
conventional banks in this regard. Islamic banks, being aware of their innovative
methods, have toiled to develop the new modes of finance. That included a lot of work to
formulate new contractual arrangements on both their asset and liability sides. In
addition, they have been able to acquire a niche that conventional banks do not have. The
latter can participate and make use of such new and innovative techniques that would
help them better serve their customers.
Although, Islamic banking system is more viable than conventional banking system it has
some challenges also, like: The well-known fiscal prejudice against profit and in favor of
interest is just an example, where interest payments are partially or fully tax exempt, and
profit gets no such advantage. Similarly New instruments are needed, a uniform
regulatory environment and legal framework have yet to be developed. The total
implementation and success of Islamic banking in a country needs re-shaping the society,
re-structuring of the economic system and re-framing of the laws according to the
dictates of Islam. Islamic banks also face a challenge of developing innovative services
and products for mobilizing deposits and utilizing them effectively and efficiently for
financing under profit and loss sharing system. Islamic banks like all other modern
conventional banks under interest-based system have to remain competitive and tailor
their services and products according to the needs and requirements of their clients,
ensuring that the products designed by them remain within the framework of Shariah.
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International operations would have to be continued on interest basis till such time, that a
suitable and mutually acceptable alternate is found. This will, however, depend upon the
success of Islamic banking on the domestic fronts in a large majority of Muslim countries
of the world. While taking steps to enforce Islamic banking, it will have to be seen that
interest is eliminated in such a way that it does not abruptly disturb the basic structure of
the economy. It has also to be ensured that initially the confidence of the people is
developed and strengthened in the new system. This approach would also provide an
opportunity to refine the newly formed laws to support the Islamic system of banking in
the light of experiences gained during the process. The development of an interbank
market is another challenge. With the establishment of the Islamic Fiqh Academy (IFA)
in Jeddah and wide spread growth of specialized training centers dedicated to train people
in Islamic Finance and banking practices, and a series of International conferences, the
challenges are being addressed with vigor. With the forced opening up of the economy
and gradual removal of barriers, Governments and regulatory bodies, too, are co-
operating in making Islamic banking a part of mainstream banking. In the years to come,
as Islamic banking breaks new ground and expands into new areas, there is sure to be an
increased effort in broadening its principles and scope.
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5.2 Recommendations
It, however, appears that although tremendous efforts for Islamization of banking system
and for streamlining and enhancing the scope of the activities of Islamic banks are beg
made in many Muslim countries, but effective steps for reformation of the societies in the
respective countries are not being taken up with the same zeal and enthusiasm. This is an
essential prerequisite for the success of Islamic banking and deserves serious
considerations by all those who are involved in the process of Islamic banking.
The following are the suggestions for future growth and success of Islamic banks. Which
be successful and produce full dividends, if the society in which it operates, is geared on
Islamic principles. It is, therefore, of utmost importance that sincere and effective efforts
are simultaneously made to transform the existing societies, in the Muslim countries, into
truly Islamic societies.
1. A basic tenet of commercial banking is capital guarantee. The capital entrusted to
the bank by a depositor must be returned to him in full. Conventional banking
system fully complies with this requirement. While Islamic banking as practised
today does not provide capital guarantee in all its deposit accounts. In many
countries, this is one of the two main objections to permitting the establishment of
Islamic banks. There is no objection to paying zero interest on deposits. Thus, by
paying zero interest and guaranteeing capital, the proposed system satisfies both
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the Riba-prohibition rule of Islam and the capital guarantee requirement of
conventional Banking Acts. This enables it to obtain permission to set up and
operate as a deposit bank in all countries of the world, while obeying the Riba-
prohibition rule and qualifying to be an Islamic bank.
2. All relevant laws in Muslim countries who have established or are in the process
of establishing Islamic banks should be reviewed so as to bring them in
conformity with the Shariah. Necessary laws also need to be framed for providing
legal cover to the transactions, services and products developed under the Islamic
banking system.
3. The research and training centers for Islamic banking established in various
Muslim countries should pass on their findings to their Muslim countries to assist
them in establishing new Islamic banks and enhancing their existing capabilities.
4. Muslim scholars, bankers and economists should explain, to their counterparts in
Western / American countries as also to various international financial and
monetary agencies like The World Bank and International Monetary Fund, the
salient features of Islamic banking. It should also be a good idea to invite their
suggestions for achieving the objective of socio-economic justice, in the context
of Islamic baking.
5. There is an urgent need for more extensive cooperation among Islamic banks
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throughout the world. There should, therefore, be more organized and systematic
meetings, seminars, conferences and wo