CHAPTER – 1

INTRODUCTION

HIGHLIGHTS

Background of the study.

Main area of research.

Purpose of the report.

Scope of study.

Methodology of the study.

Imitations of the study.

Scheme of the study.

1.1 BACKGROUND OF THE STUDY

Over the last few decades, the Muslims have been trying

to restructure their lives on the basis of Islamic principles.

They strongly feel that the political and economic

dominance of the west, during past centuries, have

deprived them of the divine guidance, especially in the

socio-economic fields. Therefore after acquiring political

freedom, the masses are striving for the revival of their

Islamic identity to organize their collective life in

accordance with the Islamic teachings.

In the economic field, it was the biggest challenge for

such Muslims to reform their financial institutions to

bring them in harmony with the dictates of Shariah. In an

environment where the entire financial system was based

on interest, it was a formidable task to structure the

financial institutions on an interest free basis.

There are however, some sectors where financing on the

basis of musharakah or mudarabah is not workable or

feasible for one reason or another. For such sectors the

contemporary scholars have suggested some other

instruments which can be used for the purpose of

financing, like murabahah, ijarah, salam or istisna.

Musharakah is a word of Arabic origin which literally

means sharing. In the context of business and trade it

means a joint enterprise in which all the partners share the

profit or loss of the joint venture. it is an ideal alternative

for the interest-based financing with far reaching effects

on both production and distribution.

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In the modern capitalist economy, interest is the sole instrument indiscriminately

used in financing of every type. Since Islam has prohibited interest, this

instrument can not be used for providing funds of any kind. Therefore,

Musharakah can play a vital role in an economy based on Islamic principles.

Interest predetermines a fixed rate of return on a loan advanced by the financier

irrespective of the profit earned or loss suffered by the debtor, while Musharakah

does not envisage a fixed rate of return. rather, the return in Musharakah is based

on the actual profit earned by the joint venture. the financier in an interest-bearing

loan cannot suffer loss while the financier in Musharakah can suffer loss, if the

joint venture fails to produce fruits. Islam has termed interest as an unjust

instrument of financing because it results in injustice either to the creditor or to the

debtor. if the debtor suffers a loss,

Islamic banking industry has been trying for the last over two decades to extend

its outreach to bring it at least to the level of conventional banking. But the

absence of Shariah-compliant legal framework needed to make interest-free

banking acceptable is the major snag behind its low penetration in the financial

market.

It is the time to take stock of challenges faced by the Islamic banks as they need a

number of supporting institutions/arrangements to perform functions which are

being carried out by various financial institutions in the conventional framework.

Attempts should be made to modify the existing structure to provide better

products and quality service within the ambit of Islamic laws

Musharakah faces a number of challenges in the market as a universal mode of

financing. It is some time presumed that Musharakah is an old instrument which

cannot keep pace with the ever-advancing need for speedy transactions. however,

this presumption is due to the lack of proper knowledge concerning the principles

of Musharakah.in fact, Islam has not prescribed a specific form or procedure for

Musharakah.rather, it has set some broad principles which can accommodate

numerous forms and procedures. a new form or procedure in Musharakah cannot

be rejected merely because it has no precedent in the past .infect every new form

can be acceptable to the Shariah in so far as it does not violate any basic principle

laid down by the Holy Quran, the sunnah or the consensus of the Muslim jurists.

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therefore it is not necessary that Musharakah be implemented only in its

traditional old form.

Musharakah provides better opportunities for the depositors to share actual profits

earned by the business, which in normal cases may be much higher, then the rate

of interest. Islamic banks should have advanced towards Musharakah in gradual

phases and should have increased the size of Musharakah financing.

1.2 RESEARCH QUESTION

The main focus of this research is about Islamic Modes of financing and

specifically Musharakah financing and its challenges in the market. it provides

findings that how Musharakah financing faces challenges in the market

Following issues will be discussed

What are the Islamic Modes of financing.

How musharakah financing is different from other modes of financing?

What are the main challenges of Musharakah financing?

Whether Musharakah financing successfully cover challenges in the market

or not

1.3 PURPOSE OF THE REPORT

This report is based on a study carried out for the fulfillment of the degree

requirement of the Masters of Business Administration at the Institute of

Management Studies. The study also provided me the opportunity to do

practical work in the field and apply my personal knowledge and

understand Islamic Modes of financing and its challenges in the market.

This experience, as a matter of fact, broadened my vision and added new

dimensions to my thinking and creative aptitude.

The purpose of the study is to analyze and evaluate the challenges in the

market regarding islamic modes of islamic modes of financing and

specifically financing, On the basis of these analysis I have finalized my

recommendations.

1.4 SCOPE OF STUDY

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Now days the ideal instrument of financing according to Shariah is Musharakah

where the profits and losses both are shared by both the parties according to

equitable proportion? Scope of report is limited to musharakah financing and its

challenges in the market Recommendations, compiled on the basis of analysis, if

adopted by the financial institutions would be beneficial to both the institutions

and the customers.

1.5 METHODOLOGY OF THE STUDY

The data collected for analysis and review includes both primary and

secondary data .the methods used for collecting primary and secondary data

are as follows:

Primary Data

Data collected for the first time is called primary data. The methods used to

collect such data include:

Personal observations

Discussions

Interviews with bank’s employees

Secondary Data

The data collected earlier by some one else and which has gone through

mathematical and statistical techniques after its collection, is called secondary

data. Methods used to collect secondary data include:

Annual reports of Islamic banks

Brochures

Manuals of Islamic Banks

Circular and Newsletters

Internship reports on Musharakah Financing

Journals and Newspapers

Internet

1.6 LIMITATION OF THE STUDY

The vast scope of the Musharakah financing is difficult to analyze in such a short

span on two months. Thus the time factor is a basic limitation of this study.

4

Another limitation is lack of required information as all the documents are

kept strictly under lock and key due to their confidential nature.

1.7 SCHEME OF THE REPORT

The report has been divided into five chapters, which are in the following order:

Chapter – 1

Chapter 1 includes the background of the study, purpose, scope, limitations,

merits, methodology and scheme of the report.

Chapter – 2

This chapter is all about Islamic Banking and some misconception about Islamic

banking its clarification.

Chapter – 3

This chapter focus on Islamic Modes of Financing and what are the different

aspects in its implementation.

Chapter – 4

This chapter includes some common market challenges faced by the Islamic banks

in doing musharkah.

Chapter – 5

This chapter focus on various ways through which the different modes of

financing are practically implemented.

Chapter – 6

This is the analysis section of the report. This chapter is focused on the challenges

faced in the market regarding Musharakah financing and Findings and

recommendations are given which the Muslims face.

Chapter – 7

This gives an overview of Islamic Banking Industry of Pakistan and provide

information regarding its development

5

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CHAPTER – 2

INTRODUCTION TO ISLAMIC BANKING

Islamic banking is a new phenomenon that has taken many observers by surprise.

Islamic banking (also called non-interest based, Riba or interest free banking) is

an alternate to interest based banking. Its inspirations and guidance is derived

from the directives of Shariah and has to be conducted rigorously in accordance

with these directions. The key feature of Islamic banking is the prohibition of

Riba. Islamic banking is a system of banking, which is based on Shariah rules and

principles. It is different from current banking system, which is based on interest.

Islamic baking is based on profit and loss sharing.

2.1 WHAT IS AN ISLAMIC BANK?

Islamic bank is a financial and social institution, which sets its objectives and

principles on the basis of principles of Shariah, as lay down by Qur’an and

authentic Sunnah, and carries out its banking practices and operations strictly in

accordance with these doctrines.

Islamic bank operates on the principal of actual profit and loss. They take deposit

and lend money at a pre-determined ratio of profit and loss that they share with

their depositor or debtors on actual profit and loss.

2.2 OBJECTIVES OF ISLAMIC BANKING

The main feature of Islamic banking is prohibition on interest. However the

objective of an Islamic bank is not merely refraining from interest based

transaction but an Islamic bank has to make positive contribution towards the

fulfillment of socio-economic objective of a society and to ensure an exploitation

free society as imaginated in Islam.

An Islamic bank has to contribute positively in all spheres of society and the

economy including trade, industry, agriculture, science and technology etc, with

special focus on human factor.

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2.3 EVOLUTION

The 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 El Najjar, took the form of a savings

bank based on profit sharing in the Egyptian town of Mit Ghamr in l963. This

experiment lasted until l967 (Ready l98l), by which time there were nine such

banks in the country. These banks, which neither charged nor paid interest,

invested mostly by engaging in trade and industry, directly or in partnership with

others, and shared the profits with their depositors (Siddiqi l988). Thus, they

functioned essentially as saving- investment institutions rather than as commercial

banks. The Nasir Social Bank, established in Egypt in l97l, was declared an

interest-free commercial bank, although its charter made no reference to Islam or

Shariah (Islamic law).

The Organization of Islamic Countries (OIC) established the IDB in l974, but it

was primarily an inter-governmental bank aimed at providing funds for

development projects in member countries. The IDB provides fee- based financial

services and profit-sharing financial assistance to member countries. The IDB

operations are free of interest and are explicitly based on Shariah principle.

2.4 SHARIAH PRINCIPLES

In the seventies, changes took place in the political climate of many Muslim

countries so that there was no longer any strong need to establish Islamic financial

institutions under cover. A number of Islamic banks, both in letter and spirit, came

into existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal

Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the

Bahrain Islamic Bank (l979), to mention a few. The Asia-Pacific region was not

oblivious to the winds of change. The Philippine Amanah Bank (PAB) was

established in l973 by Presidential Decree as a specialized banking institution

without reference to its Islamic character in the bank's charter. The establishment

of the PAB was a response by the Philippines Government to the Muslim

rebellion in the south, designed to serve the special banking needs of the Muslim

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community. However, the primary task of the PAB was to assist rehabilitation and

reconstruction in Mindanao, Sulu and Palawan in the south (Mastura l988). The

PAB has eight branches located in the major cities of the southern Muslim

provinces, including one in Makati (Metro Manila), in addition to the head office

located at Zamboanga City in Mindanao. The PAB, however, is not strictly an

Islamic bank, since interest-based operations continue to coexist with the Islamic

modes of financing. It is indeed fascinating to observe that the PAB operates two

'windows' for deposit transactions, i.e., conventional and Islamic. Nevertheless,

efforts are underway to convert the PAB into a full-fledged Islamic bank (Mastura

l988).

Islamic banking made its first appearance in Malaysia in l983, but not without past

history. The first Islamic financial institution in Malaysia was the Muslim

Pilgrims Savings Corporation set up in l963 to help people save for performing

hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the

Pilgrims Management and Fund Board or the Tabung Haji as it is now popularly

known. The Tabung Haji has been acting as a finance company that invests the

savings of would-be pilgrims in accordance with Shariah, but its role is rather

limited, as it is a non-bank financial institution. The success of the Tabung Haji,

however, provided the main momentum for establishing Bank Islam Malaysia

Berhad (BIMB) which represents a full- fledged Islamic commercial bank in

Malaysia. The Tabung Haji also contributed l2.5 per cent of BIMB's initial capital

of M$80 million. BIMB has a complement of fourteen branches in several parts of

the country. Plans are afoot to open six new branches a year so that by l990 the

branch network of BIMB will total thirty-three (Man l988).

Reference should also be made to some Islamic financial institutions established

in countries where Muslims are a minority. There was a proliferation of interest-

free savings and loan societies in India during the seventies (Siddiqi l988). The

Islamic Banking System (now called Islamic Finance House), established in

Luxembourg in l978, represents the first attempt at Islamic banking in the Western

world. There is also an Islamic Bank International of Denmark, in Copenhagen,

and the Islamic Investment Company has been set up in Melbourne, Australia.

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2.5 ISLAMIC BANKING GROWING IN POPULARITY

The future prospects of Shariah complaint banking products largely depend upon

how efficiently and prudently the existing Islamic banking institutions perform in

terms of profitability and growth in their asset and deposit base.

Moreover, committed are the sponsors of the institutions to convince

entrepreneurs and depositors to route all their financial transactions through

Islamic banks.

Keeping in close touch with market requirements and responding to them

promptly could enhance the potential growth of the Islamic banking industry.

Introduction of innovative Shariah complaint products is crucial aspect of such

growth.

It is estimated that there are 267 Islamic banks in over 75 countries, which

manage approximately $202 billion in deposits, $400 billion in investments and

over $262 billion in other assets. Islamic windows of international banks manage

another $200 billion to $300 billion. The average annual rate of growth of Islamic

banking is considered to be over 10 percent per annum since it first emerged in

1960s.

Throughout Asia, the Middle East and Europe, more and more banks and their

customers are turning to Islamic finance. A growing number of the decisions to do

so are increasingly made on commercial rather than religious grounds. The rising

global interest in Islamic finance has led to major expansions in the number of

institutions offering Islamic financial services. Global financial institutions, led by

HSBC, Citigroup, ABN AMRO, Deutsche Bank and BNP Paribas, have now set

up either Islamic divisions or Islamic subsidiaries.

The future of Islamic Banking in Pakistan looks very promising. SBP targets 10

percent of the industry under Islamic banking by 2020. At 98 percent correlation

with GDP growing at 5 percent, the deposit size of Islamic banking is expected to

reach Rs 480.6 billion in 2020 with a growth rate of 18.88 percent. It is

conservative estimate as in Malaysia the industry grew to 10 percent in 15 percent

with a Muslim population at around 60 percent at a growth of 37 percent. In

addition a renowned consultancy firm in Pakistan Ferguson Associates professes a

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similar conclusion. They projected that the deposit with Islamic banks in Pakistan

would reach Rs. 780 billion by 2014 with an average growth of 140 percent.

2.6 GENERAL INFORMATION OF ISLAMIC BANKING DEPARTMENT IN PAKISTAN

Islamic Banking Department was established on 15th September, 2003 and has

been entrusted with the huge task of promoting & developing the Shariah

Compliant Islamic Banking as a parallel and compatible banking system in the

country.

Islamic Banking is one of the emerging field in global financial market, having

tremendous potential and growing at a very fast pace all around the world.

Al-Hamdulillah, the progress of Islamic Banking in Pakistan has also been

commendable during the last two years. Currently there are three licensed Full

fledged Islamic Banks and nine conventional banks with stand alone Islamic

Banking Branches with the total branch network of 175 branches operating in

thirteen cities of all the four provinces in the country as of 30-06-2007 and

applications for few more players are under consideration. The importance of

Islamic Banking is also evident from the fact that the internal and external

stakeholders have given high priority to Islamic Banking during the last Strategic

Management Conference at SBP.

One of the biggest challenges being faced by this growing industry is the dearth of

professional Islamic Bankers and capacity building in this regard is one of the top

most priorities for the promotion of Islamic Banking. In order to play our

regulatory and supervisory role more efficiently we are working on the areas like

Risk Management, Corporate Governance, Prudential Regulations, Accounting

and Shariah Standards etc. regarding Islamic Banking

Currently the Islamic Banking Department (IBD) consists of following three

divisions:

1. Policy Division

2. Shariah Compliance Division

3. Business Support Division

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The conventional banks in Pakistan have 31 dedicated Islamic banking branches

and there is increasing interest from these entities to open branches. With the new

applications for full-fledged Islamic banks show the promising growth. The State

Bank of Pakistan expects the number of total dedicated Islamic branches to grow

substantially by end December 2006.

According to an analyst with the regular entrance of new Islamic Banks, the

market stands to benefit and grow. The injection of new ideas, the investment in

training and infrastructure, and the healthy results that free competition engenders

all coming together within a properly regulated and risk management

environment. "Though the Pakistani market presents its own unique set of

challenges amidst a dynamic and competitive arena, it truly presents the fitting

crucible for the evolution of Islamic banking in its most cogent form".

Meezan Bank, the country's premier Islamic bank said in its recently released

report that soon the "smart branch", though not new concept would be launched.

The concept of self-service branch, using state of the art technologies, the branch

would be equipped with a system through which the customer would immediately

be able to deposit and withdraw cash or make electronic bank transfers. Moreover,

SMS banking is another value added service that would be providing aimed to

give comfort for mobile customers to do banking the way they want to.

According to an analyst a big challenge for SBP is to develop Shariah-complaint

products to enable the monetary management of Islamic Banking Institutions.

Similarly, accounting standards for all modes of Islamic financing need to be

developed, as in the case of Murabaha and Ijara. Increase in the size and volume

of Islamic capital markets also depends on the existence of a secondary market for

trading in Sukuk, which is still to be developed even on an international level.

Another challenge for the industry is the establishment investment banks and

liquidity management institutions exclusively for Islamic banking, following the

models of Bahrain and Malaysia.

The State Bank of Pakistan in report earlier said that the unique distributive and

facilitating nature of Islamic banking products can contribute extensively not only

in the development of the economy but also to the reduction in poverty,

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unemployment and income inequalities. Products based on profit and loss sharing

with emphasis on financing production and not consumption, can have a favorable

impact on savings and investments. If operated efficiently and transparently. In

this respect, Musharaka can especially be used in short, medium and long term

project financing, import and pre-shipment export financing and working capital

requirements.

2.7 RATIONALE

The essential feature of Islamic banking is that it is interest-free. Although it is

often claimed that there is more to Islamic banking, such as contributions towards

a more equitable distribution of income and wealth, and increased equity

participation in the economy (Chapra l982), it nevertheless derives its specific

rationale from the fact that there is no place for the institution of interest in the

Islamic order.

Islam prohibits Muslims from taking or giving interest (Riba) regardless of the

purpose for which such loans are made and regardless of the rates at which

interest is charged. To be sure, there have been attempts to distinguish between

usury and interest and between loans for consumption and for production. It has

also been argued that Riba refers to usury practiced by petty money-lenders and

not to interest charged by modern banks and that no Riba is involved when

interest is imposed on productive loans, but these arguments have not won

acceptance. Apart from a few dissenting opinions, his general consensus among

Muslim scholars clearly is that there is no difference between Riba and interest. In

what follows, these two terms are used interchangeably.

The prohibition of Riba is mentioned in four different revelations in the Qur'an.

The first revelation emphasizes that interest deprives wealth of God's blessings.

The second revelation condemns it, placing interest in juxtaposition with wrongful

appropriation of property belonging to others. The third revelation enjoins

Muslims to stay clear of interest for the sake of their own welfare. The fourth

revelation establishes a clear distinction between interest and trade, urging

Muslims to take only the principal sum and to forgo even this sum if the borrower

is unable to repay. It is further declared in the Qur'an that those who disregard the

prohibition of interest are at war with God and His Prophet. The prohibition of

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interest is also cited in no uncertain terms in the Hadith (sayings of the Prophet).

The Prophet condemned not only those who take interest but also those who give

interest and those who record or witness the transaction, saying that they are all

alike in guilt.

It may be mentioned in passing that similar prohibitions are to be found in the pre-

Quranic scriptures, although the 'People of the Book', as the Qur'an refers to them,

had chosen to rationalize them. It is amazing that Islam has successfully warded

off various subsequent rationalization attempts aimed at legitimizing the

institution of interest.

Some scholars have put forward economic reasons to explain why interest is

banned in Islam. It has been argued, for instance, that interest, being a pre-

determined cost of production, tends to prevent full employment (Khan 1968;

Ahmad n.d.; Mannan l970).

In the same vein, it has been contended that international monetary crises are

largely due to the institution of interest (Khan, n.d), and that trade cycles are in no

small measure attributable to the phenomenon of interest (Ahmad l952; Su'ud

n.d.).

None of these studies, however, has really succeeded in establishing a causal link

between interest, on the one hand, and employment and trade cycles, on the other.

Others, anxious to vindicate the Islamic position on interest, have argued that

interest is not very effective as a monetary policy instrument even in capitalist

economies and have questioned the efficacy of the rate of interest as a determinant

of saving and investment (Ariff l982).

A common thread running through all these discussions is the exploitative

character of the institution of interest, although some have pointed out that profit

(which is lawful in Islam) can also be exploitative. One response to this is that one

must distinguish between profit and profiteering, and Islam has prohibited the

latter as well.

Some writings have alluded to the 'unearned income' aspect of interest payments

as a possible explanation for the Islamic doctrine. The objection that rent on

property is considered halal (lawful) is then answered by rejecting the analogy

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between rent on property and interest on loans, since the benefit to the tenant is

certain, while the productivity of the borrowed capital is uncertain. Besides,

property rented out is subject to physical wear and tear, while money lent out is

not. The question of erosion in the value of money and hence the need for

indexation is an interesting one. But the Islamic jurists have ruled out

compensation for erosion in the value of money, or, according to Hadith, a

fungible good must be returned by its like (mithl): 'gold for gold, silver for silver,

wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal

for equal, and hand to hand ...'.3

The bottom line is that Muslims need no 'proofs' before they reject the institution

of interest: no human explanation for a divine injunction is necessary for them to

accept a dictum, as they recognize the limits to human reasoning. No human mind

can comprehend a divine order; therefore it is a matter of faith (iman).

The Islamic ban on interest does not mean that capital is costless in an Islamic

system. Islam recognizes capital as a factor of production but it does not allow the

factor to make a prior or pre-determined claim on the productive surplus in the

form of interest. This obviously poses the question as to what will then replace the

interest rate mechanism in an Islamic framework. There have been suggestions

that profit-sharing can be a viable alternative (Kahf l982a and l982b).

In Islam, the owner of capital can legitimately share the profits made by the

entrepreneur. What makes profit- sharing permissible in Islam, while interest is

not, is that in the case of the former it is only the profit-sharing ratio, not the rate

of return itself that is predetermined.

It has been argued that profit-sharing can help allocate resources efficiently, as the

profit-sharing ratio can be influenced by market forces so that capital will flow

into those sectors which offer the highest profit- sharing ratio to the investor, other

things being equal. One dissenting view is that the substitution of profit-sharing

for interest as a resource allocating mechanism is crude and imperfect and that the

institution of interest should therefore be retained as a necessary evil (Naqvi l982).

However, mainstream Islamic thinking on this subject clearly points to the need to

replace interest with something else, although there is no clear consensus on what

15

form the alternative to the interest rate mechanism should take. The issue is not

resolved and the search for an alternative continues, but it has not detracted from

efforts to experiment with Islamic banking without interest.

2.8 SOME MYTHS AND MISGIVINGS AND ITS CLARIFICATION

Abolition of Riba is really a very challenging task .for the first time in the modern

world Muslim countries have undertaken to abolish Riba. Since there exists no

experience in Islamic banking in the modern financial system there would surely

arise some myths and misgivings about its viability and practicality. A research of

these myths and misgivings can really contribute constructively to the solution of

the problems with which we face in the elimination of Riba. I have taken these

myths and misgivings in the spirit in which they have been expressed and try to

make whether I can make some clarification about these myths and misgivings

which might really take us towards our objective.

Now with that I would start with the myths and misgivings which have been

expressed in various ways.

1. The first myth and misgiving which has been expressed is whether interest

paid by banks on deposits or charged on advances does not tantamount to Riba

and hence permissible. It is also argued that the Arabic word Riba means usury

and not bank interest.

Clarification

Historical Background

Even prior to the dawn of Islam, over 1400 years ago, the majority of ancient

philosophers and almost all the religions of the world had prohibited money

lending as a business; Riba, interest or usury. If one goes back into history, as far

as one can, it would be found that lending and borrowing as a transaction between

members of a society was started as a commercial operation after the switching

over from the barter system to the money system. Money lending with the earning

motive became a common phenomenon in most of the societies of the world, but

people engaged in this business were generally not regarded respectable during

any period of history.

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The doctrine of famous Greek philosopher Aristotle was, that a piece of money

cannot beget another piece, as the sole natural object of the use of money was to

facilitate exchange and that money cannot be used as a source of accumulating

money at interest. Aristotle, therefore, rejected interest on the basis that ‘money is

sterile’ and accordingly compared money to ‘a barren hen, which lays no eggs’.

Plato too condemned interest. In the early years, the Roman Empire had also

prohibited earnings on money lending.

In Biblical times, all payments for the use of money were forbidden. Earlier in 340

B.C., Lex Genucia prohibited interest in the Republic of Rome. When the Roman

Empire was Christianized in the Fourth Century, the Church forbade the clergy

from taking interest. In the early middle ages, Popes and Councils continued to

oppose all forms of payments for the use of money lent, as the money was mainly

for the purpose of exchange and its principal use was its consumption, whereby it

was sunk in exchange. In those days, governments introduced laws to prohibit

charges for use of money. In AD 1311, Pope Clement V made the prohibition of

usury absolute and declared all legislations in favor of usury as null and void. The

teachings of Jesus on the subject are very clear “Love your enemies and do good,

Lend, expect nothing in return”. The charging of interest has also been prohibited

in Judaism. It says, “If you lend money to any of my people who is poor, you shall

be to him creditor, and you shall not extract interest from him”.

It is interesting to note that in AD 605; just before the dawn of Islam, on a

tempestuous day, a spark of fire caught the curtains of Ka’ba (House of God in

Makkah) resulting in serious damages to the building. For the repair and

reconstruction of the building, contributions were asked from the general public

living in the locality. It was, however, solemnly announced that for the Holy

Building, only pure, clean and honestly earned money should be donated;

prostitutes and usurious people were specifically debarred from contributing

anything. It is, therefore, obvious that even among the pagans of Arabia, in the

dark days of civilization usury and interest was considered to be the money earned

by unethical means.

The end of thirteenth century saw the decline of the influence of Orthodox Church

and the rise of secular powers. As a consequence, the charging of interest, which

17

was forbidden by the Church gradually, started being tolerated. In the Mercantile

Era (1500 – 1700) money began to be used on a large scale for commercial

transactions and assumed the role of a factor of production like land and interest

on capital was equated to t he payment for renting of money, similar to the rent of

land.

In 1740, the city of Verona, issued a bond at 4% interest, which led to a lot of

controversies. The Benadict XIV wrote to the Bishop of Italy, firmly emphasizing

that it was a sin to take profit beyond the principal amount given as loan. He

specifically condemned various pleas such as profit on loan was moderate or that

the loan was given to rich person or that it was to be used for production purposes.

In this connection, it is significant to note that after the establishment of political

supremacy of Islam over a greater part of the world, the prohibition of usury or

interest, which was also considered as undesirable among non-Muslims, was

enforced more strictly. The prohibition of Riba, usury or interest, by Islam is,

therefore, nothing new. Islam allows profits through trade but prohibits interest

because of the negative effects of the fixed interest-being loans.

As the times passed by, Muslims gradually began to lose political supremacy in

places, which were being ruled by them, and accordingly the political ascendancy

passed on to Europe. Although in England during the Middle Ages, charging of

interest was opposed by the Church and prohibited by the state but with the

decline in the influence of the Church and religion, the practice of usury and

interest reappeared notwithstanding the fact that the charging of usury and interest

was still condemned by Christianity. During this period, the doctrine that ‘sale

transaction is similar to interest deal’ was revived and the governments enacted

legislation to legalize interest with new dimensions. Formerly, interest income

was restricted to those individuals who were engaged in the business of money

lending. The western socio-economic structure was then organized in such a

manner that any person who had little savings could be assured of interest income

without investing in any business directly. With the advancement of this system

and growth in economic activity, it has now become almost impossible to

participate in any economic activity without either charging or paying interest.

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The Holy Prophet of Islam, Peace Be Upon Him, had predicted this over 1400

years ago.

In the above paragraph, it has been mentioned that laws were framed for

legalizing interest transactions as a consequence of decline in the influence of the

Church. It was during this period that a step was taken to Christening of interest

(which may originally have been a Hebrew or Greek word) resulting in the

complete transformation of its sense. The two terms, interest and usury, thus

developed were given different treatment, as interest was declared lawful and

usury was prohibited. The word “interest” indicated a reasonable and moderate

rate as against usury, which was symbolized as an excessive rate of return. Laws

were framed for legalizing the charging and paying of interest on money lending

transactions. The rates of interest were, however, controlled. During the reign of

King Henry VIII in 1745, national laws were changed to permit interest but a

maximum rate of interest of 10% per annum was fixed. The economists of those

periods argued that the law must fix lower rates of interest to facilitate growth of

business.

To conclude, it seems interesting to give a brief review of the article on usury in

the Encyclopedia of Religion and Ethics. It says that usury and interest were

considered one and the same thing. Usury was not used in its modern sense of

excessive interest and it meant interest generally. Judaism, however, later allowed

that God could recover interest from non-Jews only as a privilege granted to

faithful Israelite. The Christians had similar views about usury and interest. The

early Fathers totally disapproved usury. The decision of Canonist Conscious was

that money lending did not justify a charge. Augustine placed usury in the

category of crime and denounced the usurers as breed of vipers that gnaw the

womb that bears them. A canon of the third Lateran Council directed that,

manifest usurers shall not be admitted to Communion, nor, if they die in their sin,

shall receive Christian burial. It was, however, not until 1830 that Holy Office

allowed that interest could lawfully be taken for money lent to merchants who

were in profitable trade.

Nature And Meaning

19

Riba is an Arabic word which means “increase”, “addition”, “expansion” or

“growth” and refers to the additional amount, which a lender recovers from the

borrower according to a fixed rate over and above the principal amount. In the

New Encyclopedia Britannica, usury is explained as compensation for the use of

money regardless of the amount, according to earlier English law. The Concise

Oxford Dictionary, however, defines usury ass “Practice of lending money at

exorbitant interest, especially at higher interest than is legal”.

According to Hughes, Riba is a term in Muslim Law as:

“An excess according to legal standard of measurement or weight, in one or two

homogeneous articles opposed to each other in a contract of exchange and in

which such excess is stipulated as an obligatory condition on one of the parties

without any return. The word Riba appears to have the same meaning as the

Hebrew “neshec” which included gain, whether from the loan of money or goods

or property of any kind. In Mosaic Law, conditions of gain for the loan of money

or goods were rigorously prohibited”.

In Oxford Advanced Learner Dictionary, Riba refers to “excess, addition and

surplus” while the associated verb implies “to increase, to multiply, to exceed, to

exact more than was due, to practice usury”. Lane’s, Lexicon presents a synthesis,

which transcends and covers most of the earlier authentic definitions of Riba. It

says that the common meanings that emerge are: ‘to increase”, “to augment”,

“swelling”, “forbidden”, “addition”, “to make more than what is given”, “the

practicing or taking of usury or the like”, “an excess” or “an addition”, “an

addition over and above the principal sum” [that is lent or expended].

It will thus be seen that originally the word usury meant the fact or practice or

lending money at interest. It came to mean, in later use, the practice of charging,

taking or contracting to receive excessive or illegal rates of interest for money

given as loan. Usury before reformation amounted to taking of any amount of

interest than what is authorized by law. It is, therefore, clear that interest charged

on a loan is nothing but usury in the original sense of the word. Subsequently,

laws were enacted specifying the limits within which usury could be tolerated.

These limits prescribed by law came to be known as interest.

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Encyclopedia Americana – International Edition says:

“Interest is a charge for the use of money… Interest has not always been

considered a legitimate or even moral payment. Until the end of middle Ages, any

charge for a loan was generally considered to be usury. The teachings of

Christians, Judaic and Islamic religion, all condemned in varying degrees, the

taking of interest. In more recent times, however, usury has come to be regarded

as only the charging of illegal rates of interest.”

Encyclopedia Americana explains usury as: “previously interest meant payment to

compensate for a loss suffered by the lender, whereas usury signified a charge for

the use of money”.

New Encyclopedia Britannica defines interest as: “the price paid for the use of

credit or money. It maybe expressed either in money terms or as a rate of

payment”, it defines usury as “In the middle ages, practice of charging excessive

interest for the loan of money. Originally all interest was termed usurious, but

with the expansion of trade in the 13th century, the demand for credit increased,

necessitating a modification in the definition of usury”.

According to Stiengass, the word interest by and large has now been accepted and

understood as Riba. It is now proposed to discuss the prohibition of Riba, as

ordained by Islam.

2. The second misgiving which has been often expressed is that interest is the

key player of the modern banking system. How can one run a banking system

without interest?

Clarification

But here the basic question arises that why interest is regarded as the kingpin of

the modern banking system. According to my perspective there are two basic

reasons behind this phenomenon.

i. It is considered that the payment of interest is necessary to call for the

supply of savings and deposits, and for the mobilization of deposits by the

banking system and

21

ii. Interest performs an important allocative function in the allocating the

scarce resources among competing uses.

Now as far as this misgiving is concerned, I think western economic thought itself

is not unequivocal in respect of these propositions. I think we all are aware of the

famous economist Keynes who completely denied the relationship which was

postulated by the earlier economists between saving and the rate of interest.

Classical economists thought that saving is a function of that rate of interest rate.

Symbolically

S = f (I)

But Keynes completely denied this relationship; he said saving is not the only

function of the rate of the interest.

Symbolically

S ≠ f (I)

He further says that saving is a function of income rather than the rate of interest.

There are some other researches and contributions which have made empirical

research on the determinants of savings in various countries by using both time

series data and cross sectional data and none of these studies really has

conclusively demonstrated that savings are highly correlated with interest. In fact,

some of the studies found that the relationship is very tenuous and some of the

other empirical researches have found that there are other determinants of savings

which are more important than the rate of interest, even though that rate of interest

might play some part .but the level of national income, the level of per capita

income, and the pattern of income distribution, these things have vital influence

on the growth of savings in the economy. As far as investment is concerned, there

have been a number of empirical studies which throw doubt on the proposition

that interest is the most important determinant of the investment decisions. In fact

anticipated factors play a very important role in investment decisions.

However, my major observation on this misgiving is that for justifying the

eradication of interest it is not even necessary for Muslim scholars to reject that

interest plays a part in mobilization of resources. As already mentioned, some of

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the empirical studies do show that while the rate of interest is not the main

determinant of savings. We can admit that the rate of interest has a positive

influence on savings. Secondly we can also admit that interest does perform some

sort of alloactive function, particularly in market based economy. But my

proposition is that even though interest might be a factor both in the savings

decisions and the investment decisions, existence of interest is not by itself an

unavoidable necessity for the performance of these two functions. These two

functions, that is, the function of mobilization of savings and the function of

allocation of resources can be performed equally well, and perhaps even better,

under the Islamic banking without interest.

When we talk about the abolition of interest, the idea is not merely to abolish

interest but to replace interest by an alternative system. Now it depends what kind

of alternative system will take but I think it is generally agreed that it will not be a

zero interest banking in the sense that there will be no return on savings and that

person who secure financial assistance from the banks will not have to give

anything to the banks.

The banking so far shows that almost every one who has studied this problem has

come to the conclusion that in the alternative system there will have to be a

system whereby people who put their deposits in the banking system will get

some return but this return will not be interest because it will not have the

attributes which are there in interest i.e. fixed return and return irrespective of risk

of gain and loss. It will be a variable return and the depositor will share both in

gains and losses. So for those who believe that savings is a function of the rate

interest, or the rate of interest is important. For it helps to mobilize deposits and

savings , my answer is that in the alternate system there will be a return on

savings and there will be a return on bank deposits so the savings decisions, if

they are influenced by the rate of interest , will continue to get incentives for

savings . Similarly, as far as the allocative role of interest is concerned in the

alternate system we have to formulate ways in which these alloctive functions will

be performed and if you have a system of profit sharing in the banks, one can

easily see that by prescribing different profit sharing ratios, you can influence the

allocation of resources. Suppose if we take the example of two sectors. In one

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sector the banks decide that they will give financial assistance only if the parties

are prepared to share 80% of their profits with them, while in another sector they

are prepared to participate if the party gives them only 20%. One can easily see

that this will have an allocative effect. It will discourage the securing of assistance

from commercial banks in those cases where the banks are participating to the

extent of 80%and people educed to put in more of their own resources or they will

go in for those lines of activity where banks are taking a comparatively smaller

part of the share of the profit.

3. The third myth about Islamic banking is that this system based on profit-

sharing will result in a diminution of banks profit, and also in diminution of bank

deposits as the system cannot give as much return to the account holders as the

fixed interest system.

Clarification

To clarify this myth about Islamic baking, first of all my question to this kind of

myth is:

Does the fixed interest system really give fair return to the depositors?

Most often in inflationary situation under the present system depositors get a

negative real rate of interest. If the rate of interest on deposits is, say 8%, and if

the rate of inflation is 12%, the depositors get a negative rate of interest of 4%.

Mathematically

Rate of interest = 8%

Inflation rate = 12%

12% - 8% = 4%

As compared to this a system which is based on profit and loss sharing will be

able to capture a part of inflationary profits and hence, if properly worked, is

capable of giving better return to the depositors.

Suppose depositor deposit 100,000 rupees in bank under profit loss sharing system

and the depositor and bank agreed on 30%:70%, so after declaring of profits

suppose six months later the depositor will get 30% profit while the ban k will get

70% profit which can cover all their administrative and daily expenses.

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4. The fourth myth about Islamic banking is related to the third misgiving, is

that it is all right in theory that a system of banking which is based on profit-loss

sharing may be able to give a better return because you will be participating in the

profits of so many trades which are characterized by high margins of profit, like

the distributive trade, might be construction industry. So you should be able to

give to give a better return.

Clarification

Of course it is all right in theory, they say. But will it actually happen in practice?

When you start interest free banking will it really be possible for banks to get

more by way of return, so that they can give better returns to depositors as

compared to the present day interest based system? And this connection they point

out that, as we know there is widespread concealment of profits and the accounts

are not the true accounts of the various concerns. Well I think these kind of

malpractices and stealing are there in the conventional system and these evils do

exists and it is a real problem and this the problem which has to be faced when

Islamic banking is introduced. But I do not regard it as an insurmountable

problem. The problem should not exist at all if, along with the introduction of

institutional reforms by way of abolition of interest and introduction of zakah,

efforts are also made for bringing about those values in our society which Islam

really advocates. If our society is really permeated by Islamic values and ethos,

there should be no problem of this kind that people will try to conceal their profits

from the banks but even in the interim, because nobody perhaps can wait till the

whole society is purified and everybody begins to work according to the ideals

and standards of Islam. Ways can be found through which this problem can be

surmounted. And here I would refer only to three steps that can be taken when

interest free banking is introduced which will minimize the problem which arise

from the concealment of profit. One is a basic reform in income tax system. The

effort should be to so reform the present income tax system that factors

responsible for the concealment of profits are eliminated or at least minimized.

The second thing that can be done is to bring about some important changes in

accounting and auditing systems. For example, when the profit-sharing system

introduced, it can be stipulated that auditors of a firm’s accountants will be

25

appointed with the mutual agreement of the bank and the firm. Some reforms in

the auditing system itself may be needed. And finally, the banks will also be

overseeing the operations of the concerns to which they made financial assistance

available. They can, in the case of big companies, establish their presence in the

management. I might also add that even in the present social environment,

institutions like the NIT and ICP are making profits and declaring dividends. And

when the scope of the interest-free operations is expanded to cover also the

distributive trade, construction industry etc., there is no reason why banks should

not be able to make more profits than NIT and give a positive return on the

savings that are deposited with the banking system.

5. The fifth myth about Islamic banking is:

How the profit –sharing system could work when so many firms and individual

business either do not maintain accounts or cannot maintain accounts due to the

high level of illiteracy.

Clarification

This is the most important myth regarding Islamic banking to be clarified. Here

the thing I have to say is that interest-free banking does not necessarily mean that

no other device can be employed except profit sharing. Obviously the ideal is

profit and loss sharing. When our society gets fully literate and Islam places very

great importance on the abolition of illiteracy this problem will not exist. But in

the meantime when you have this problem of illiteracy and the problem of so

many people who cannot maintain accounts or proper accounts, it is possible that

under the Islamic system of banking, banks deal with these parties on the basis of

certain other modes which have been permitted by Islam and in this respect.

6. The sixth misgiving regarding islamic bankking is very serious one, is that

a system based on profit and loss sharing may lead to the collapse of the banking

system as banks will have to share in losses also.

26

Clarification

According to my openion in thinking such a fair and doubt has no solid basis. It is

true that under the profit loss sharing system some of the concerns to which banks

gives financial assistance may make losses but the important thing to bear in mind

is that the banks will be working on a system of pooling the risk. They will be

giving financial assistance to a large number of concerns in the country. While

some may make losses, other are expected to make profits and substatial profits.

On the basis of principles of averaging even if some losses might be incurred their

is a probability, and a strong probability that a situation will not arise in which

their will be no profit at all in the banking system. It is also been said by some

economists that if you abolish interest and adopt a system based on profit sharing

you will make the banking system crisis-prone. By saying that the system would

become crisis-prone thaey mean that the business cycle will affect the banking

system itself and will create an additional element of instability. Well, i have to

say two things in this respect. We no longer have buiseness cycles of a type in

which there may be virtual collapse of the whole economic system. The whole

post world War-II period demonstrates that there have being periods of inflation

and recession but no period like the depressioin of the thirties. In fact, what we are

now facing are the problems stagflation, in which inflation co-exists with

recession, and in this situation there are some concerns which make losses but

there are others which make profits and a diversified basis. It is not possible that

all the concerns which the banks fianance incure losses. A part from that, even if

it is conceded that the profit-based system will be more disrectly affected by the

buiseness cycles, one may ask the question whether, weighing the relative prose

and cons, the interst system is better suited in a periode of buieness recession or

the profit based system ? we all know what happens in a buiseness recession. The

system of interest really intensifies the buiseness recession. As soon as the banks

finds that the compannies will begin to incur losss they reduce a assistance and

call back their loans, as a result of which some firms have to close down,

unemployment increase, purchasing power and the economy goes down, there is

furthur reduction and demands, other firms get into trouble and the infection

spreads. The fixed interest system thus intensifies the buiseness recession. At the

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same time, the interest system believes in putting the deadweighed of interest even

in times of losses on the shoulders of the companies which are least abled to bear

it so that if the company goes into loss for, sya, five years for genuine reasons,

then there is such a heavy dead weighed of interest that accumulate over time and

it is very difficult for it to recover even after the reasons leading to the loss cease

to exists. As against this, the system of profit sharing and the period of business

cycle recession will be to the advantage of the country when banks will not claim

their pound of flesh in a period when some concerns incur genuine losses. This

will lighten their burdens and will enable these concerns to recover much more

quickly than is possible under the fixed interest system. Thus the problem of sick

industries, will not be there in ana acute form. Morever if in a period of transition

its is desired to ensulate the banks against even sporadic losses, some cushions can

devised within the system of islamic banking. It can be arranged, for example, that

all the banks will be contributing a small amount of premium to some ensurance

organization in respect of assistance that they provide to various firms which itself

becomes a pool from which in time of diffculty the banks can draw the resources.

At the same time, in a system which will be based on profit sharing it is very

natural that the banks themselves may like to build up higher levels of capital and

reserves to cushins the effects of any losses that they might incur in some periods.

7. The seventh myth and misgiving regarding Islamic banking is that profit

loss sharing system will lead to large scale defaults and thereby it will affect the

stability of the banking system.

Clarification

But my query to such kind of myth is why should it be so ? there are three kinds

of factors which are relevant to the possibilities of defaults.

1st, to whom finance is provided

2nd, for what purpose the finance is provided

3rd, what type of supervision is exercised by the financial institutions on the end

use of the resources.

Now these elements are essentially the same whether it is an interest based

banking system or it is a system which is based on profit sharing under Shariah

28

principles. If sufficient care is not exercised in respect of these three elements

defaults are sure to arise and as we know they do arise in the modern systems even

though it is based on interest. In fact, i feel that a system which is not based on

interest will be superior and the chances of default should be minimized if

properly worked. This is because as compared to the fixed interest system, the

banks will be more closely associated with the end-use of funds. In the fixed

interest system tendency is that the banks are satisfied if they get enough security

for the advances and if they feel that the company has profits enough to cover re

payment of its capital and the amount of interest, they are not concerned even if

the profitability is nil after paying interest to banks. But when they begin to share

in the profit they will be more concerned about the efficient working of the

enterprises and, therefore, from that point of view under the new system, the

defaults should be less rather than more.

8. The eighth misgiving which has been expressed that profit loss sharing

system will make the banking system less liquid and hence there will be a great

risk of bank failures due to the inability of the banks to meet the demands for the

withdrawal of funds.

Clarification

Well, this is an argument similar to one which says that since the banks have short

terms liabilities they should not lend on long term basis because this can create a

problem of liquidity. This use to be a fashionable argument a few decades back

but very little really is heard about that now. For one reason we know that in a

number of countries the liabilities of the banking systems are not pre dominantly

sight liabilities. In fact, in our country Pakistan, we find that about fifty percent of

the liabilities are other than demands liabilities. A part from that, with the growth

of central banking and the concept of what we call shift ability of assets, the

liquidity can be ensured by the central bank which is under no constraint as it can

create any amount of credit in times of need. So it can come to the assistance of

the banking systems in time stress.

So think one should not exaggerate the difficulties about liquidity. Moreover, not

all the finance that will b provided by the banks under the Islamic banking

systems will be for long terms because when the whole banking systems switches

29

over to a system which is not based on interest, banks will be expected to provide

both short term finance and long term finance and therefore, by proper

management they should be able to arrange a cash flow which will be quite

adequate to take care of the demands that may be made on the banking systems

for withdrawal of the deposits. I might also add that if you study the history of

grow of banking in the western countries you will find that before central banks

came on the same and before the system of deposits insurance came into fashion,

there were cases of bank failures in a number of countries.

9. The ninth misgiving, which has been expressed by some businessmen, is

that a system based on profit sharing would involve too much interference in the

affairs of the concerns to whom assistance is provided by the banks and this will

militate against the proper functioning of the various business concerns.

Clarification

According to my perspective regarding this query, i am not in the favor of undue

interference by banks under the profit sharing system in the affairs and daily

conduct of the business concerns. It should be possible to have enough safeguards

against too much interference, but some say of the financial institutions and the

running of the business concerns should not be unhealthy. In fact i think it will

have a healthy effect. Even in the present interest based system a trend has been in

evidence that banks and other financial institutions set a number of conditions

while providing finance. And it is not only about Pakistan but a number of

countries in the rest. The trend is that while making finance available, the banks

do make it a condition that the borrowing concern will not incur additional long

term debt obligations without the permission of the bank from which they have

borrowed in the first instance. In some countries banks do establish their presence

on the management of the concerns to whom they provide financial resources. In

some countries the declaration of dividend by a concern is also made conditional

on the banks first formatting the concerns to make that amount of dividend

declaration.

10. Finally the tenth misgiving regarding Islamic banking, it has been pointed

out that interest free banking amounts to capital being provided free while capital

has a scarcity value.

30

Clarification

My perspective regarding this query, it is quite true that under the profit sharing

system there is no stipulation for payment of a fixed return on the funds provided.

In other words, there is no binding commitment beforehand that the business

concerns will make available to the banks a certain amount of return irrespective

of what profit it earns and irrespective of the fact that it may incur a loss. But once

a concern makes a profit the system that we envisage will entitle the banks to

receive and agreed share of the profit of that concern. It can thus be seen that

capital is not been provided free to the business concerns. In fact, in the case of

highly profitable undertakings banks may well earn much more under the profit

sharing system than under the fixed interest systems. So it is not correct to say that

capital is been provided free.

However, when the whole system gets going, one can visualize that while mainly

work on the system of profit and loss sharing there can be some institutional

mechanisms whereby some sectors can be provided finance without any return

whatsoever, that is without claiming any part of the profit even if profits are made.

But this will have to be a conscious decision and it will have to be taken in context

of socio economic objectives of a particular country. For example, if the objective

of economic policy is to bring about a certain transfer of resources from one

section of society to another it is perfectly legitimate to have a system whereby

resources of the bank will be provided completely free without share in the profit

of a particular sector or a particular sub sector, while banks appropriate large parts

of profits that might be made in other sectors, thereby setting up a mechanism of

transfer of resources from certain sectors of high income generation to sectors of

low income generations.

I hope my this Research paper will help in clarifying some of the issues that have

been raised on this very sensitive subject of interest free banking and that they will

provide food fore the further thought.

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CHAPTER – 3

ISLAMIC MODES OF FINANCING

HIGHLITES

Definition of Musharakah

Historical background of Musharakah

Concept of Musharakah

Basic rules of Musharakah

Nature of the capital

Management of Musharakah

Termination of Musharakah

Project Financing

Financing of a Single Transaction

Financing of Working

Capital

Sharing in the Gross Profit Only

Running Musharakah Accounts

Export Financing

Financing of a single transaction

3.1 DEFINITION OF MUSHARAKAH

Musharakah or shirkah can be defined as a form of

partnership where two or more persons combine either

their capital or labour together, to share the profits,

enjoying similar rights and liabilities.

As a Mode of Financing (2007)

Under Islamic jurisprudence, Musharakah means a joint

enterprise formed for conducting some business in which

all partners contribute financially and share the profit as

per pre agreed upon ratios, while the loss is shared

according to the ratios of financial contribution of each

partner. The Musharakah is an ideal alternate to replace

interest based lending with far reaching effects on both

production and distribution of capital

In sharing of profits, most Islamic scholars agree that the

ratio should be decided in advance and may differ from

their investment, but if a partner clearly wished to remain

a ‘sleeping’ partner, then his profit ratio should not be

more than his investment. In case of losses, it is

unanimous that each partner shall suffer the loss exactly

according to the ratio of his investment.

Since it also promotes growth while maintaining financial

stability, musharakah is seen as an ideal alternative for

the interest-based financing with potentially far reaching

effects on both production and distribution.

32

It has proven to be capable of playing a vital role in the development of an

economy, especially a Halal economy that is based on the principles of Islam

3.2 HISTORICAL BACKGROUND OF MUSHARAKAH

From the very inception of human society, the methods to meet day to day needs

have been changing with the change of social, economic, scientific, cultural and

political circumstances, especially habits, fashions and the standard of living.

These methods regulate the commercial activities and vary from place to place

and time to time. The Arab society at the time of the rise of Islam had very simple

financing methods and forms of business peculiar to that society.

The advent of the Holy Prophet saw the practice of musharakah already prevailing

over the commercial activities in Arabia. He not only ratified it, but also himself

did business on the basis of Musharakah.

On Hijra, the muhajireen and the ansar were declared by the Prophet to be

brothers. Subsequently they joined as partners, in the form of musharakah, muzara

and musaqat, in their trade and commerce. The nature of the transaction, in the

different forms, is identical. The different nomenclature in Arabic refers to diverse

activities such as muzara in agriculture, musaqat in gardening and musharakah in

trade. The musharakah of capital and labour is called mudarabah. These four

forms were so developed that they became independent institutions and the jurists

formed detailed rules about them. There is a consensus of opinion among the

jurists of all schools- of thought (including Hanfia, Maleki, Shafei, Hanbali and

Shia) that musharakah is a valid and legitimate contract in Islam. The jurists

however differ over its form conditions and other details.

3.3 WHY ISLAM HAS SUGGESTED MUSHARAKAH AS AN ALTERNATIVE TO THE INTEREST BASED FINANCING?

‘Interest’ predetermines a fixed rate of return on a loan advanced by the financier.

Irrespective of the profit earned or loss suffered by the debtor, while Musharakah

does not envisage a fixed rate of return. Rather, the return in Musharakah is based

on the actual profit earned by the joint venture. The financier in an interest-

bearing loan cannot suffer loss while the financier in Musharakah can suffer loss,

if the joint venture fails to produce fruits. Islam has termed interest as an unjust

33

instrument of financing because it results in injustice either to the creditor or to the

debtor. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a

fixed rate of return; and if the debtor earns a very high rate of the profit, it is

injustice to the creditor to give him only a small proportion of profit leaving the

rest for the debtor. the returns of the financier in Musharakah have been tied up

with the actual profits accrued through the enterprise. The greater the profits of the

enterprise, the higher the rate of return to the financier. If the enterprise earns

enormous profits, the industrialist cannot secure all of it exclusively, but the

common people will share them

As depositors in the bank. In this way, Musharakah has a tendency to favor the

common people rather than the rich only.

This is a basic philosophy, which explains why Islam has suggested Musharakah

as an alternative to the interest based financing. No doubt, Musharakah embodies

a number of practical problems in its full implementation as a universal mode of

financing. It is sometimes presumed that Musharakah is an old instrument which

cannot keep pace with the ever-advancing need for speedy transactions. However,

this presumption is due to the lack of proper knowledge concerning the principles

of Musharakah. In fact, Islam has not prescribed a specific form or procedure for

Musharakah. Rather, it has set some broad principles which can accommodate

numerous forms and procedures. A new form or procedure in Musharakah cannot

be rejected merely because it has no precedent in the past. In fact, every new form

can be acceptable to the Shar’iah in so far as it does not violate any basic principle

laid down by the Holy Qur’an, the Sunnah or the consensus of the Muslim jurists.

Therefore, it is not necessary that Musharakah be implemented only in its

traditional old form.

3.4 THE CONCEPT OF MUSHARAKAH

“Musharakah” is a term frequently referred to in the context of Islamic modes of

financing. The connotation of this term is a little limited than the term “Shirkah”

more commonly used in the Islamic jurisprudence.

Dr Saad Al-Harran (2000): According to him, musharakah (partnership)

financing has generally been avoided on the mistaken presumption that it is an

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economically non-viable (high-risk) instrument. But the experience of the

Sudanese Islamic Bank disproves this proposition. Rather, it testifies to the

relevance of musharakah financing as a tool for rural development and

development of the poorer sections of the population. in fact, musharakah

financing can bring changes and commit the people to work hard (due to the

incentive factor) for the betterment of their own lives

For the purpose of clarity in the basic concepts, it will be pertinent at the outset to

explain the meaning of each term, as distinguished from the other. “Shirkah”

means “Sharing” and in the terminology of Islamic Fiqh, it has been divided into

two kinds:

1. Shirkat-ul-milk

It means joint ownership of two or more persons in a particular property. This

kind of “Shirkah” may come into existence in two different ways: sometimes it

comes into operation at the option of the parties. For example, if two or more

persons purchase equipment, it will be owned jointly by both of them and the

relationship between them with regard to that property is called “Shirkat-ul-milk”.

Here this relationship has come into existence at their own option, as they

themselves elected to purchase the equipment jointly. But there are cases where

this kind of “Shirkah” comes to operate automatically without any action taken by

the parties. For example, after the death of a person, all his heirs inherit his

property which comes into their joint ownership as an automatic consequence of

the death of that person.

2. Shirkat-ul-‘aqd

This is the second type of Shirkah which means “a partnership effected by a

mutual contract”. For the purpose of brevity it may also be translated as “joint

commercial enterprise”.

Shirkat-ul-‘aqd is further divided into three kinds:

i. Shirkat-ul-amwal where all the partners invest some capital into a

commercial enterprise.

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ii. Shirkat-ul-A’mal where all the partners jointly undertake to render some

services for their customers, and the fee charged from them is distributed

among them according to an agreed ratio. For example, if two persons

agree to undertake tailoring services for their customers on the condition

that the wages so earned will go to a joint pool which shall be distributed

between them irrespective of the size of the work each partner has actually

done, this partnership will be a shirkatul-a’mal which is also called Shirkat-

ul-taqabbul or Shirkat-ul-sana’i’ or Shirkatul-abdaan.

iii. Shirkat-ul-wujooh the third kind of Shirkat-ul-‘aqd is Shirkat-ul-wujooh.

Here the partners have no investment at all. All they do is that they

purchase the commodities on a deferred price and sell them at spot. The

profit so earned is distributed between them at an agreed ratio.

All these modes of “Sharing” or partnership are termed as “Shirkah” in the

terminology of Islamic Fiqh, while the term “Musharakah” is not found in the

books of Fiqh. This term (i.e. Musharakah) has been introduced recently by those

who have written on the subject of Islamic modes of financing and it is normally

restricted to a particular type of “Shirkah”, that is, the Shirkat-ul-amwal, where

two or more persons invest some of their capital in a joint commercial venture.

However, sometimes it includes Shirkat-ul-a’mal also where part also where

partnership takes place in the business of services. It is evident from this

discussion that the term “Shirkah” has a much wider sense than the term

“Musharakah” as is being used today. The latter is limited to the “Shirkat-ul-

amwal” only, while the former includes all types of joint ownership and those of

the partnership.

3.5 THE BASIC RULES OF MUSHARAKAH

Islamic Finance(2007): The ideal instrument of financing according to Shariah is

Musharakah where the profits and losses both are shared by both the parties

according to equitable proportion. Musharakah provides better opportunities for

the depositors to share actual profits earned by the business which in normal cases

may be much higher than the rate of interest. Since the profits cannot be

determined unless the relevant commodities are completely sold, the profits paid

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to the depositors cannot be added to the cost of production, therefore, unlike the

interest-based system the amount paid to the depositors cannot be claimed back

that increase in the interest of prices.

This philosophy cannot be translated into reality unless the use of the Musharakah

is expanded by the Islamic banks. It is true that there are practical problems in

using the Musharakah as a mode of financing especially in the present atmosphere

where the Islamic banks are working in isolation and, mostly without the support

of their respective governments. The fact, however, remains that the Islamic banks

should have gressed towards Musharakah in gradual phases and should have

increased the size of Musharakah financing. Unfortunately, the Islamic banks have

overlooked this basic requirement of Islamic banking and there are no visible

efforts to progress towards this transaction even in a gradual manner even on a

selective basis. This situation has resulted in a number of adverse factors :

Musharakah or Shirkat-ul-amwal is a relationship established by the parties

through a mutual contract. Therefore, it goes without saying that all the necessary

ingredients of a valid contract must be present here also. For example, the parties

should be capable of entering into a contract; the contract must take place with

free consent of the parties without any duress, fraud or misrepresentation; etc.,

etc. But there are certain ingredients which are peculiar to the contract of

Musharakah.

1. Distribution of Profit:

Maulana Taqi Usmani(2002)

‘Musharakah’ is a word of Arabic origin which literally means sharing. In the

context of business and trade it means a joint enterprise in which all the partners

share the profit or loss of the joint venture. It is an ideal alternative for the

interest-based financing with far reaching effects on both production and

distribution. In the modern capitalist economy, interest is the sole instrument

indiscriminately used in financing of every type. Since Islam has prohibited

interest, this instrument cannot be used for providing funds of any kind.

Therefore, Musharakah can play a vital role in an economy based on Islamic

principles.

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Hussain G. Rammal writes: “While the concept of interest predetermines a fixed

rate of return on a loan advanced by the financier irrespective of profits or losses,

musharakah does not envisage a fixed rate of return. Rather, the return in

musharakah is based on the actual profits earned by the joint venture. This

presence of risk in musharakah makes it acceptable as an Islamic financing

instrument”.

The proportion of profit to be distributed between the partners must be agreed

upon at the time of affecting the contract. If no such proportion has been

determined, the contract is not valid in Shar’iah. The ratio of the profit for each of

the partner must be determined in proportion to the actual profit accrued to the

business, and not in proportion to the capital invested by him. It is not allowed to

fix a lump sum amount for any one of the partners, or any rate of profit tied up

with his investment.

Therefore if A and B enter into a partnership and it is agreed between them that A

shall be given Rs 10,000/- per month as his share in the profit, and the rest will go

to B, the partnership is invalid. Similarly, if it is agreed between them that A will

get 15% of his investment, the contract is not valid. The correct basis for

distribution would be an agreed percentage of the actual profit accrued to the

business. If a lump sum amount or a certain percentage of the investment has been

agreed for any one of the partners, it must be expressly mentioned in the

agreement that it will be subject to the final settlement at the end of the term,

meaning thereby that any amount so drawn by any partner shall be treated as ‘on

account payment’ and will be adjusted to the actual profit he may deserve at the

end of the term. But if no profit is actually earned or is less than anticipated, the

amount drawn by the partner shall have to be returned.

2. Ratio of Profit

Is it necessary that the ratio of the profit of each partner confirms to the ratio of

the capital invested by him? There is a difference of opinion among the Muslim

jurists about this question.

In the view of Imam Malik and Imam Shafi’i, it is necessary for the validity of

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Musharakah that each partner gets the profit exactly in the proportion of his

investment. Therefore, if A has invested 40% of the total capital, he must get 40%

of the profit. Any agreement to the contrary which makes him entitled to get more

or less than 40% will render the Musharakah invalid in Shari’ah. On the contrary,

the view of Imam Ahmed is that the ratio of profit may differ from the ratio of

investment if it is agreed between the partners with their free consent. Therefore,

it is permissible that a partner with 40% of investment gets 60% or 70% of the

profit, while the other partner with 60% of the investment gets only 40% or 30%.

The third view is presented by Imam Abu Hanifah which can be taken as a via

media between the two opinions mentioned above. He says that the ratio of profit

may differ from the ratio of investment in normal conditions. However, if a

partner has put an express condition in the agreement that he will never work for

the Musharakah and will remain a sleeping partner throughout the term of

Musharakah, then this share of profit cannot be more than a ratio of his

investment.

3. Sharing of Loss

But in the case of loss, all the Muslim jurists are unanimous on the point that each

partner shall suffer the loss exactly according to the ratio of his investment.

Therefore, if a partner has invested 40% of the capital, he must suffer 40% of the

loss, not more, not less, and any condition to the contrary shall render the contract

invalid. There is a complete consensus of the jurists on this principle. Therefore,

according toImam Shafi’i, the ratio of the share of a partner in profit and loss both

must conform to the ratio of his investment. But according to the Imam Abu

Hanifa and ImamAhmad, the ratio of the profit may differ from the ratio of

investment according to the agreement of the partners, but the loss must be

divided between them exactly in accordance with the ratio of capital invested by

each one of them. It is this principle that has been mentioned in the famous

maxim:

Profit is based on the agreement of the parties, but loss is always subject to the

ratio of investment.

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3.6 MANAGEMENT OF MUSHARAKAH

Islamic financial system (2003); most businesses do not want to relinquish

management control of their business which may happen if they enter into

musharakah financing contract with a bank.

The normal principle of the Musharakah is that every partner has a right to take

part in its management and to work for it. However the partners may agree upon a

Condition that the management shall be carried out by one of them and no other

Partner shall work for the Musharakah. But in this case the sleeping partner should

be entitled to the profit only to the extent of his investment, and the ratio of the

profit allocated to him should not exceed the ratio of his investment as discussed

earlier. However, if all the other parties agree to work for the joint venture, each

of them shall be treated as the agent of the other in all the matters of the business

and any work done by one of them in the normal course of business shall be

deemed to be authorized by all the partners.

3.7 TERMINATION OF MUSHARAKAH

Musharakah is deemed to be terminated in anyone of the following events:

1. Every partner has a right to terminate the Musharakah at anytime after

giving his partner a notice to this effect, whereby the Musharakah will

come to an end.

In this case, if the assets of the Musharakah are in cash form, all of them

will be distributed pro rata between the partners. But if the assets are not

liquidated, the partners may agree either on the liquidation of the assets, or

on their distribution or partition between the partners as they are. If there is

a dispute between the partners in this matter i.e. that if partner seeks

liquidation while the other wants the partition or distribution of the non-

liquid assets themselves, the latter shall be preferred, because after the

termination of Musharakah, all the assets are in joint ownership of the

partners, and a co-owner has a right to seek partition or separation, and no

one can compel him on liquidation. However, if the assets are such that

they cannot be separated or partitioned, such as machinery, then they shall

be sold and the sale proceeds shall be distributed.

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2. If any one of the partners dies during the currency of Musharakah, the

contract of Musharakah with him stands terminated. His heirs in this case,

will have the option either to draw the share of the deceased from the

business, or to continue with the contract of the Musharakah.

3. If any one of the partners becomes insane or otherwise becomes incapable

of effecting commercial transactions, the Musharakah stands terminated.

Termination of Musharakah without closing the business. If one of the

partners wants termination of the Musharakah, while the other partner or

partners like to continue with the business, this purpose can be achieved by

mutual agreement. The partners who want to run the business may

purchase the share of the partner who wants to terminate his partnership,

because the termination of the Musharakah with one partner does not

imply its termination between the other partners.

However, in this case, the price of the share of the leaving partner must be

determined by mutual consent, and if there is a dispute about the valuation of the

share and the partners do not arrive at an agreed price, the leaving partner may

compel other partners on the liquidation or the distribution of the assets

themselves.

The question arises whether the partners can agree, while entering into the

contract of the Musharakah, on a condition that the liquidation or separation of the

business shall not be effected unless all the partners, or the majority of them wants

to do so, and that a single partner who wants to come out of the partnership shall

have to sell his share to the other partners and shall not force them on liquidation

or separation.

Most of the traditional books of Islamic Fiqh seem to be silent on this question.

However, it appears that there is no bar from the Shari’ah point of view if the

partners agree to such a condition right at the beginning of the Musharakah. Some

Hanbali jurists expressly permit this.

This condition may be justified, especially in the modern situations, on the ground

that the nature of business, in most cases today, requires continuity for its success,

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and the liquidation or separation at the instance of a single partner only may cause

irreparable damage to the other partners.

If a particular business has been started with huge amounts of money which has

been invested in a long term project, and one of the partners seeks liquidation in

the infancy of the project, it may be fatal to the interests of the partners, as well as

to the economic growth of the society, to give him such an arbitrary power of

liquidation or separation. Therefore such a condition seems to be justified, and it

can be supported by the general principle laid down by the Holy Profit (PBUH) in

his famous hadith:

“All the conditions agreed upon by the Muslims are upheld, except a condition

which allows what is prohibited or prohibits what is lawful.”

2. Murabaha

Murabaha is one of the most commonly used modes of financing by Islamic banks

in financial institutions.

Definition: Murabaha is a particular kind of sale where the seller expressly

mentions the cost of the sold commodity He has incurred, and sells it to another

person by adding some profit there on. Thus, Murabaha is not alone given on

interest; it is a sale of a commodity for cash /deferred price.

The Bai Murabaha involves purchase of a commodity by bank on behalf of a

client and its resale to latter on cost-plus-profit basis. Under this arrangement the

bank discloses its cost in profit margin to the client. In other words rather than

advancing money to a barrower, which is how the system would work in a

conventional banking agreement, the bank will buy the goods from a third party

and sale those goods to the customer for a pre agreed price.

Murabaha is a mode of financing as old as Musharaka. Today in Islamic banks

world over 66% of all investment transaction are through Murabaha.

3.8 DIFFERENCE BETWEEN MURABHA AND SALE

A simple sale in Arabic is called Musawamah- a bargaining sale without

disclosing or referring to what the cost price is. How ever when the cost price is

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disclosed to the client it is called Murabaha. A simple Murabaha is one where

there is cash payment and Murabaha Muajjal is one on deferred payment basis.

3.9 ARGUMENTS AGAINST MURABIHA

An argument that arises in Murabaha is that profit or interest both are the same

and Murabaha financing is the same as conventional banking. Islamic scholars

how ever argue that in several respects a Murabaha financing structure is quite

different to an overdraft organized along conventional lines and the former offers

several benefits to the bank and its customers. Depositors are made to share in

profits of the bank as a result of this financing. The basic difference is however

the Aqd or the contract which covers the Islamic conditions. If the contract has

interest element then it will be void.

3.10 BASIC RULES OF MURABAHA

Following are the rules governing a Murabaha transaction

1. The subject of sale must exists at the time of sale. Thus any thing that may

not exist at the time of sale cannot be sold and its non existence makes the

contract void.

2. The subject matter should be in the ownership of the seller at the time of

sale. If he sells something that he has not acquired himself then the sale

becomes void.

3. The subject of sale must be in physical or constructive possession of the

seller when he sells it to another person. Constructive possession means a

situation where the possessor has not taken physical delivery of the

commodity, yet it has come into his control and all rights and liabilities of

the commodity are passed onto him including the risk of its destruction.

4. The sale must be instant and absolute. Thus a sale attributed to a future date

or a sale contingent on a future event is void.

5. The subject matter should be a property having value. Thus a good having

no value cannot be sold or purchased.

6. The subject of sale should not be a thing used for an un-Islamic purpose.

7. The subject of sale must be specifically known and identified to the buyer.

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8. The delivery of the sold commodity to the buyer must be certain and should

not depend on a contingency or chance

9. The certainty of price is a necessary condition for the validity of the sale. If

the price is uncertain, the sale is void.

10. The sale must unconditional. A conditional sale is invalid unless the

condition is recognized as a part of the transaction according to the uses of

the trade.

3.11 STEP BY STEP MURABAHA FINANCING

1. The client and the institution sign an over all agreement where by the

institution promises to sale and the client promises to buy the commodity

from time to time on an agreed ratio of profit added to the cost. This

agreement may specify the limit up to which the facility may be availed.

2. An agency agreement is signed by both parties in which the institution

appoints the client as his agent for purchasing the commodity on its behalf.

3. The client purchases the commodity on behalf of the institution and takes

possession as the agent of the institution.

4. The client informs the institution that it has purchased the commodity and

simultaneously makes an offer to purchase it from the institution.

5. The institution accepts the offer and the sale is concluded where by owner

ship as well as risk is transferred to the client.

All the above conditions are necessary to affect a valid Murabaha. If the

institution purchases the commodity directly from the supplier, it does not need

any agency agreement.

The most essential element of the transaction is that the commodity must remain

in the risk of institution during the period between the third and the fifth stage.

The above is the only way by which this transaction is distinguished from an

ordinary interest base transaction.

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3.12 ISSUES IN MURABAHA

Following are some of the issues in Murabaha financing:

1. Securities Against Murabaha

Payments coming from the sale are receivables and for this, the client may be

asked to furnish a security. It can in the form of a mortgage or hypothecation or

some kind of lien or charge.

2. Guaranteeing the Murabaha

The seller can ask the client to furnish a third party guarantee. In case of default

on payment the seller may have recourse to the guarantor who will be liable to pay

the amount guaranteed to him. There are two issues relating to this:

a. The guarantor can’t charge a fee from the original client. The reason being

that a person charging of fee for advancing a loan comes under the

definition of Riba.

b. However the guarantor can charge for any documentation expenses.

3. Penalty of Default

Another issue with Murabaha is that if the client defaults in payments of the price

of the due date, the price can’t be changed nor can penalty fees be charged.

In order to deal with dishonest clients who default in payment deliberately, they

should be made liable to pay compensation to the Islamic bank for the loss

suffered on account of default. However these should be made subject to the

following conditions:

a. The defaulter may be given a grace period of at-least one month.

b. If it is proven beyond doubt that the client is defaulting without valid

excuse then compensation can be demanded.

4. Rollover in Murabaha

Murabaha transaction cannot be rollover for a further period as the old contract

ends. It should be understood that Murabaha is not a loan rather the sale of

commodity, which is differed to a specific date. Once this commodity is sold, its

ownership transfers from the bank to the client and it is therefore no more a

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property of the seller. Now what the seller can claim is the only the agreed price

and therefore there is no question of effecting another sale on the same

commodity between the same parties.

5. Rebate on Earlier Payments

Sometimes the debtors want to pay early to get discounts. However in Islam,

majority Muslim scholars including the major schools of thoughts consider this to

be un- Islamic. However if the Islamic bank or financial institutions give

somebody a rebate on its own, it is not objectionable especially if the client is

needy.

6. Calculations of cost in Murabaha

The Murabaha can only be effected when the seller and ascertain the exact cost he

has incurred in acquiring the commodity he wants to sell. If the exact cost can’t be

ascertained then Murabaha can’t take place in this case the sale will take place as

Musawamah i.e. sale without reference to cost.

7. Subject Matter of the Sale

All commodities can’t be the subject matter in Murabaha because certain

requirements need to be fulfilled. The share of lawful company can be sold or

purchased on Murabaha basis because according to the principles of Islam the

shares represent ownerships and the assets of the company provided all others

basic conditions of the transaction are fulfilled. A buy back arrangement or selling

without taking their possession is not allowed at all.

Murabaha is not possible on things that can’t become the subject of sale. For

example, Murabaha is not possible in exchange of currencies.

3.13 BASIC MISTAKES IN MURABAHA FINANCING

Some basic mistakes that can be made in practical implications of the concept are

as follows:

1. The most common mistake is to assume that Murabaha can be used for all

types of transaction and financing. This mode can only be used when a

commodity is to be purchased by the customer. If funds are required for

some other purpose Murabaha can’t be used.

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2. The document is signed for obtaining funds for a specific commodity and

therefore it is important to study the subject matter of the Murabaha.

3. In some cases, the sale of commodity to the client is affected before

commodity is acquired from the suppliers. This occurs when the various

stages of the Murabaha are skipped and the documents are signed all

together. It is to be remembered that Murabaha is a package of different

contracts and they come into claim one after another at their respective

stages.

4. It is observed in some financial institutions that Murabaha is applied on

already purchased commodities, which is not allowed in Shariah and can be

affected on not yet purchased commodities.

3.15 USES OF MURABAHA

Murabaha can be used in following conditions:

Short / Medium / Long term finance for:

Raw material

Inventory

Equipment

Asset financing

Import financing

Export financing

Consumers good financing

House financing

Vehicle financing

Land financing

Shop financing

PC financing

Tour package financing

Education package financing

All other services that can be soled in the form of package(i.e. services like education, medical etc as a package )

Securitization of Murabaha agreement (certificate) is allowed at par value only otherwise certain rules of Islamic financing must be met.

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2. Bai’ Muajjal

Bai Muajjal is the Arabic acronym for “sale on deferred payment basis”. The

deferred payment becomes a loan payable by the buyer in a lump sum or

installment (as agreed between the two parties). In Bai Muajjal all those items can

be sold on deferred payment basis which come under the definition of capital

where quality does not make a difference but the intrinsic value does. Those assets

do not come under definition of capital where quality can be compensated for by

the price and Shariah scholars have an ijmah (consensus) that demanding a high

price in differed payment in such a case is permissible.

3.16 CONDITIONS FOR BAI’ MUAJJAL

1. The price to be paid must be agreed in fixed at the time of the deal. It may

include any amount of profit without qualms about Riba.

2. Complete/ total possession of the object and question must be given to the

buyer, while the deferred price is to be treated as debt against him.

3. Once the price is fixed, it cannot be decreased in case of earlier payments

nor can it be increased in case of default.

4. In order to secure the payment of price , the seller may ask the buyer to

furnish a security either in the form of mortgage or in the form of an item.

5. If the commodity is soled on installments, the seller may put a condition on

the buyer that if he fails to pay any installment on its due date, the

remaining installments will become due immediately.

3. SALAM

This mode of financing can be used by the modern banks and financial institutions

especially to finance the agricultural sector. In Salam the seller undertakes to

supply specific goods to the buyer at a future date in exchange an advanced price

fully paid spot. The price is in cash but the supply of purchase goods is deferred

3.17 PURPOSE OF USE

To meet he need of small farmers who need money to grow their crops and

to feed their family up to the time of harvest. When Allah declared Riba

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haram, the farmers could not take usurious loans. Therefore Holy Prophet

(PBUH) allowed them to sell their agricultural products in advance.

To meet the need of traders for import and export business. Under Salam, it

is allowed for them that they sell the goods in advance so that after

receiving their cash price, they can easily undertake the aforesaid business.

Salam is beneficial to the sellers because he received the price in advance

and it was beneficial to the buyer also because normally the price in Salam

is lower than the price in spot sales. The permissibility of Salam is and

exception to the general rule that prohibits forward sale and therefore it is

subject to strict conditions, which are as follows:

3.18 CONDITIONS OF SALAM

1. It is necessary for the validity of Salam that the buyer pays the price in full

to the seller at the time of affecting the sale. In the absence of full payment,

it will be tantamount to sale of a debt against a debt which is expressly

prohibited by the Holy Prophet (PBUH). Moreover, the basic wisdom for

allowing Salam is to fulfill the “instant need” of the seller. If it’s not paid

on full, the basic purpose will not be achieved.

2. Only those goods can be sold through a Salam contract in which the

quantity and quality can be exactly specified for example precious stones

can’t be sold on the basis of Salam because each stone differed in quality,

size, weight and their exact specification is not possible.

3. Salam can’t be effected on a particular commodity or on a product of a

particular field or farm e.g. Supply of wheat of a particular field or the fruit

of a particular tree since their is a possibility that the crop is destroyed

before delivering and given such possibility, the delivery remains uncertain.

4. All details in respect to quality of good soled must be expressly specified

leaving no ambiguity, which may lead to a dispute.

5. It is necessary that the quantity of the commodity is agreed upon in

absolute terms. It should be measured or weighed in its usual measure only,

meaning what is normally weighed cant be quantified and vice versa.

6. The exact date ion place of delivering must be specified in the contract.

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7. Salam can’t be affected in respect of things, which must be delivered at

spot.

8. The commodity for Salam contract should remain in the market right from

the day of contract up to the date of delivery or at least till the date of

delivery.

9. The time of delivery should be at least 15 days or one month from the date

agreement. Price in Salam is generally lower than the price in spot sale. The

period should be long enough to affect prices. But Hanafi Fiqh didnt

specify any minimum period for the validity of Salam. It is all right to have

an earlier date of delivery if the seller consents to it.

10. Since price in Salam is generally lower than the price in spot sale; The

difference in the two prices may be a valid profit for the bank.

11. A security in the form of guarantee, mortgage or hypothecation may be

required for a Salam in order to ensure that the seller delivers.

12. The seller at the time of delivery delivers commodities and not money to

the buyer who would have to establish a special cell for dealing in

commodities.

3.19 BENIFITS

There are two ways of benefiting from the contract of Salam:

1. After purchasing a commodity by way of Salam, the financial institutions

can sell it through a parallel contract of Salam for the same date of delivery.

The period of Salam in the second parallel contract is shorter and the price

is higher than the first contract. The difference between the two prices shall

be the profit earned by the institution. The shorter the period of Salam, the

higher the price and the greater the profit. In this way institutions can

manage their short term financing portfolios.

2. The institutions can obtain a promise to purchase from a third party. This

promise should be unilateral from the expected buyer. The buyer does not

have to pay the price in advance. When the institutions receive the

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commodity, it can sell at a pre-determined price to a third party according

to the terms of the promise.

3.20 PARALLEL SALAM

1. In an arrangement of parallel Salam there must be two difference and

independent contract; one where the bank is a buyer and the other in which

it is a seller. The two contracts can’t be tied up and performance of one

should not be contingent on the other. For example, if ‘A’ has purchased

from ‘B’ 1000 bags of wheat by way of Salam to be delivered on 31st

December, ‘A’ can contract a parallel Salam with ‘C’ to deliver to him

1000 bags of wheat on 31 December. But while contracting parallel Salam

with ‘C’, the delivery of wheat to ‘C’ cant is conditioned with taking

delivery form ‘B’. Therefore even if ‘B’ didn’t delivered wheat on 31

December, A is duty bound to deliver 1000 bags of wheat to C. He can seek

whatever recourse he has against B, but he can’t rid himself from his

liability to deliver wheat to C. similarly, if B has delivered defective goods,

which don’t conformed to the agreed specifications, A is still obligated to

deliver the goods to C according to the specifications agreed with him.

2. A Salam arrangement can’t be used as a buy back facility where the seller

in the first contract is also the purchaser in the second. Even if the

purchaser in the second contract is a separate legal entity, but owned by the

seller in the first contract; it would not tantamount to a valid parallel Salam

agreement. For example A has purchased 1000 bags of wheat by way of

Salam from B- a joined stock company. B has a subsidiary C, which is a

separate legal entity but is fully owned by B. A cant contract the parallel

Salam with C. However, if C is not wholly owned by B, A cannot parallel

Salam with it, even if some share holders are common between B and C.

4. ISTISNA’

Istisna is a sale transaction where a commodity is transacted before it

comes into existence. It is an order to a manufacturer to manufacture a specific

commodity for the purchaser. The manufacturer uses his own material to

manufacture the required goods.

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In Istisna, price must be fixed with consent of all parties involved. All

other necessary specifications of the commodity must also be fully settled.

3.21 CANCELLATION OF CONTRACT

After giving prior notice, either party can cancel the contract before

manufacturing party has begun its work. Once the work starts, the contract can’t

be cancelled unilaterally.

3.22 TIME OF DELIVERY

As pointed out earlier, it is not necessary in Istisna that the time of delivery

is fixed. However, the purchaser may fix a maximum time for delivery which

means that if the manufacturer delays the delivery after the appointed time, he will

not be bound to accept the goods and to pay the price.

In order to ensure that the goods will be delivered within the specified

period, some modern agreements of this nature contain a penal clause to the effect

that in case the manufacturer dalys the delivery after the appointed time, he shall

be laiable to a penalty which shall be calculated on daily basis. Can such a penal

clause be inserted in a contract of istisna according to shariah ? all though the

classical jurists seem to be silent about this question while they discuss the

contract of istisna, yet they have allowed a similar condition in the case of Ijarah.

They say that if a person hires the services of a person to tailor his clothes, the fee

may be variable according to the time of delivery. The hirer may say that he will

pay Rs.100 in case the tailor prepares the clothes one day and Rs.80 in case he

prepares them after two days.

On the same analogy, the price in istisna may tied up with the time of

delivery, and it will be permissible if it is agreed between the parties that in the

case of delay in delivery the price shall be reduced by a specified amount per day.

3.23 ISTISNA AS A MODE OF FINANCING

Istisna may be used to provide financing for house financing. If the client

owns a land and seeks financing for the construction of a house, the financer may

undertake to construct the house on the basis fo an Istisna. If the client doesn’t

owns the land and wants to purchase that too, the financer can provide with a

constructed house on a specified piece of land. The financer doesn’t have to

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construct the house himself. He can either enter into a parallel Istisna with a third

party or hire the services of a contractor (other than the client). He must calculate

his cost and fixed the price of Istisna with his client that allows him to make a

reasonable profit over his cost. The payment of installments by the client, may

start right from the when the contract of Istisna is signed by the parties. In order to

seucer the payment of installment, the title deeds of the house or land, or any other

prperty of the client may be kept by the financer as a security until the last

intallment is paid by the client. The financer will be responsible to stricly conform

to the specifications in the agreement for the construction of the house. The cost

of correcting any discrepancy would have to be borne by him.

Istisna may also be used for similar projects like installation of an air

conditioner plant in the clients factory, building a bridge or a high way.

The modern BOT (Buy, operate and transfer) agreement may be

formalized through an Istisna agreement as well. So, if the government wants to

build a high way, it may enter into an Istisna contract with the builder. The price

of Istisna may be the right of the builder to operate the high way and collect tolls

for a specific period.

3.24 USES OF ISTSNA

House financing

Financing of plant/ factory/

Factory building

BOT arrangements

Construction of buildings and plants

5. Ijarah (Leasing)

3.25 BASIC RULES

Transferring of usufruct not ownership

In leasing an owner transfers its usufruct to another person for an agreed

period, at an agreed consideration.

Subject of Lessee

Should be valuable, identified and quantified

All consumable things can’t be leased out

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The corpus of the leased property remains in the ownership of the seller,

and only its usufruct is transferred to the lessee. Thus, anything, which can’t be

used without consuming, can’t be leased out. For example money, wheat etc

All liabilities of ownership is born by lessor

As the corpus of the leased property remains in the ownership of the lesser,

all the liabilities emerging from the ownership shall be born by lessor.

Period of lease

The period of leas must be determined in clear terms

It is necessary for a valid lease that the leased asset is fully identified by the

parties.

Lease for Specific Purpose

The lessee can’t use the leased asset for any purpose other than the

purpose specified in the leased agreement. However, if no such purpose is

specified in the agreement, the lessee can use it for what ever purpose it is used in

the normal course.

Lessee As Ameen

The lessee is liable t compensate the lesser for every harm to the leased

asset caused by any misuse or negligence.

The leased asset shall remain in the risk of the lesser throughout the least

period in the sense that any harm or loss caused by the factors beyond the

control of the lessee shall be born by the lesser.

Lease of jointly owned property

A property jointly owned by two or more persons can be leased out, and the

rental shall be distributed between all joint owners according to the

proportion of their respective shares in the property.

A joint owner of a property can lease his proportionate share only to his co

sharer, and not to any other person.

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Determination of rental

The rental must be determined at the time of contract for the whole period

of leas.

It is permissible that different amounts of rent are fixed for different phases

during the least period, provided that the amount of rent for each phase is

specifically agreed upon at the time of affecting lease. If the rent for a

subsequent phase of the lease period has not been determined or has been

left at the option of the lesser, the lease is not valid.

The determination of rental on the basis of the aggregate cost incurred in

the purchase of the asset bye lesser, as normally done in financial leases, is

not against the rule of Shariah, if both parties agreed to it, provided that all

other conditions of a valid lease prescribed by the Shariah are fully adhere

to.

The lesser cant increase the rent unilaterally, in any agreement to this effect

is void.

The rent or any part thereof may be payable in advance before the

delivering of he asset to lessee, but the amount show collected by the lesser

shall remain with him as on account payment and shall be adjusted towards

the rent after its been due.

The lease period shall commence from the date on which th lease asset has

been delivered to the lessee.

If he leased asset has totally loss the function for which it ws leased, the

contract will stain terminated.

The rentals can be used on or benchmarked with some index as well. In this

case the ceiling in floor rentals can be identified for validity of lease.

Lease as a mode of financing

Lease is not originally a mode of financing. It is simply a transaction mean

to transfer the usofruct of a property from one person to another for an agreed

period against an agreed consideration. However, certain financial institutions

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have a adopted leasing as a mode of financing instead of long term landing on the

basis of interest.

This transaction of financial lease may be used for Islamic financing,

subject to certain conditions. It is not sufficient for this purpose to substitute the

name of interest by the name of rent and replace the name of mortgage by the

name of leased asset. There must be a substantial difference between leasing and

an interest bearing loan. That will be possible only by following all the Islamic

rules of leasing, some of which have been mentioned earlier.

To be more specific, some differences between the contemporary financial

leasing and the actual leasing allowed by the Shariah are indicated below.

The Commencement of Lease

Unlike the contract of sale, the agreement of Ijarah can be effected for a

future date. Hence, it is different from Murabaha.

In most cases of the financial lease the lesser i.e. the financial institutions

purchases the assets through the lessee himself. The lessee purchases the asset on

behalf of the lesseer who pays its price to the suppliers, either directly or through

the lessee. In some lease agreements, the lease commences on the very day on

which the price is paid by the lesser, irrespective of whether the lessee has

effected payment to the supplier and taken delivery of the asset or not. It may

mean that lessees liability for the rent starts before the lessee takes delivery of the

assets. This is not allowed in Shariah, because it amounts to charging rent on the

money given to the customer, which is nothing but interest, pure and simple.

Rent should be charged after the delivery of the leased asset.

The correct way, according to Shariah, is that the rent will be charged after

the lessee has taken delivery of the asset, and not from the day the price has been

paid. If the supplier has delayed the delivery after receiving the full price, the

lessee should not be liable for the rent of the period of delay.

Different relation of the parties

It should be clearly understood that when the lessee himself has been

entrusted with the purchase of the asset intended to be leased, there are two

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separate relation between the institutions and the client, which come into

operation one after the other. In the first instance, the client is an agent of the

institution to purchase the asset on latter behalf. At this stage the relation between

the parties is nothing more than the relation of a principal and his agent. The

relation of lesser and lessee has not yet come into operation.

The second stage begins from the date when the client takes delivery from

the supplier. At this stage, the relation of lesser and lessee comes to play its role .

these two capacities of the parties should not be mixed up or confused with each

other. During the first stage, the client can’t be held liable for the obligations of a

lessee. In this period, he is responsible to carry out the functions of an agent only.

But when the asset is delivered to him, he is liable to discharge his obligations as a

lessee.

Expenses consequent to ownership

As the lesser is the owner of the asset and he has purchased it from the

supplier through his agent, he is liable to pay all the expenses incurred in

the process of its purchased and its import to the country of lesser for

example expenses of freight and customs duty etc.

He can, of course, include all these expenses in his cost and can take them

into consideration while fixing the rentals, but as a matter of principle, he is

liable to bear all these expenses as the owner of the asset. An agreement to

the contrary, as is found in the traditional financial lease, is not in

conformity with Shariah.

Lessee as Ameen/ liabilities of the parties in case of loss to the asset;

As mentioned in the basic principles of leasing, the lessee is responsible

for any loss caused to the asset by his miss use or negligence. He can also be made

liable to the wear and tear, which normally occurs during its use. But he cant be

made liable to a loss caused by the factors beyond his control. The agreements of

the traditional financial lease generally don’t differentiate between the two

situations. In a leased based on Islamic principles, both the situations should be

dealt with separately.

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Penalty for late payment of rent

In some agreements of financial leases, a penalty is imposed on the lessee

in case he delays the payment of rent after the due date. This penalty it means to

add to the income of the lesser is not warranted by the Shariah. The reason is that

the end after it becomes due, is a debt payable by the lessee, and is subject to all

the rules prescribed for a debt. A monetary charged from a debtor for his late

payment is exactly the Riba prohibited by the Holy Qur’an. Therefore, the lesser

cant charge an additional amount in case the lessee delays payment of the rent.

Penalty of late payment is given to charity.

In order to avoid the adverse consequences, an alternative may be restored

to. The lessee may be asked undertake that, if he fails to pay rent on its due date,

he will pay certain amount to a charity. For this purpose the financer/lesser may

maintain a charity where such amounts may be credited and disburse for

charitable purposes, including advancing interest free loans to the needy person.

The amount payable for cheatable purposes by the lessee may vary according to

the period of default and may be calculated at percent, per annum basis. The

agreement of the lease may contain the following clause for this purpose;

“the lessee hereby undertakes that, if he fails to pay rent at its due date, he shall

pay an amount calculated at ....% per annum to the charity fund maintained by the

lesser which will be used by the lesser exclusively for charitable purposes

approved by the Shariah and shall in no case form part of the income of the

lesser.”

This arrangement, though doesn’t compensate the lesser for his

opportunities cost of the period of the default, yet it may serve as a strong

deterrent for the lessee to pay the rent from promptly

Terminations of the lease

If the lessee contravenes any term of the agreement, the lesser has a right

to terminate the lease contract unilaterally .however, if there is no contravention

on the part of the lessee the lease cant be terminated without mutual consent. In

some agreements of the financial lease it has been noticed that the lesser has been

given an unrestricted power to terminate the lease unilaterally when ever he

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wishes, according to his sole judgment. This is again contrary to the principles of

Shariah.

In some agreements of the financial lease a condition has been found to the

effect that in case of the termination of lease, even at the option of the lesser, the

lessee shall pay the rent of the remaining least period.

This condition is obviously against Shariah and the principles of equity

and justice. The basic reason for inserting such conditions in the agreement of

lease is that the main concept behind the agreement is to give an interest bearing

loan under the ostensible cover of lease. That is why every effort is made to avoid

the logical consequences of the least contract.

Naturally, such a condition can’t be acceptable to Shariah. The logical

consequence of the termination of lease is that the lesser should take the asset

back. The lessee should be asked to pay the rent as due up to the date of

termination. If the termination has been effected due to the miss use or negligence

on the part of lessee, he can also be asked to compensate the lesser for the loss

caused by such misuse or negligence. But he can’t be compelled to pay the rent of

the remaining period.

Insurance of the assets

If the leased property is insured under the Islamic mode of Takaful, it

should be at the expense f the lesser and not at the expense of the lessee, as is

generally provided in the agreements of the current financial lease.

The Residual Value of Leased Asset

Another important feature of the modern financial lease is that after the

expiry of the lease period, the corpus of the leas asset is normally transferred to

the lessee. As the lesser already recovers his cost along with an additional profit

their on, which is normally equal to the amount of interest which could have been

earned on a loan of that amount advance for that period, the lesser has no further

interest in the leased asset. On the other hand, the lessee wants to retain the asset

after the expiry of the leased period.

For these reasons, the leased asset is generally transferred to the lessee at

the end of the lease, either free of any charge or at a nominal token price. In order

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to ensure that the asset will be transferred to the lessee, sometimes the leased

contract has an expressed clause to this effect. Sometimes this condition is not

mentioned in the contract expressly; however, it is understood between the parties

that title of the asset will be passed on to the lessee at the end of the leased term.

This condition, whether it is expressed or implied, is not in accordance with the

principles of Shariah. It is a well-settled rule of Islamic jurisprudence that one

transaction can’t be tied up with another transaction so as to make the former a

pre-condition for the other. Here the transfer of the asset at the end has been made

a necessary condition for the transaction of lease that is not allowed in Shariah.

The original position in Shariah is that the asset shall be the sole property

of the lesser, and after the expiry of the leased period, the lesser shall be at liberty

to take the asset back, or to renew the lease or to leased it out to another party, or

sell it to the lessee or to any other person. The lessee can’t force him to sell it to

him at a nominal price, nor can such a condition be imposed on the lesser in the

leased agreement. But after the leased period expires, and the lessor wants to give

the asset to the lessee is a gift or to sell it to him, he can do so by his free well.

However, some contemporary scholars, keeping in view the needs of

Islamic financial institutions have come up with an alternative. They say that

agreement of Ijarah itself should not contain a condition of gift or sell at the end of

the leased period. However, the lessor may enter into a unilateral promise to sell

the leased asset to the lessee at the end of the leased period. This promise will be

binding on the lessor only. The principle, according to them, is that a unilateral

promise to enter into a contract at a future date is allowed whereby the promiser is

bound to fulfill the promise, but the promise is not bound to enter into that

contract. It means that he has an option to purchase, which he may or may not

exercise. However, if he wants to exercise his options to purchase, the promiser

cant refuse it because he is bound by his promise. Therefore, these scholars

suggests that the lessor, after entering into the leased agreement, can sign a

separate unilateral promise whereby he undertakes that if the lessee has paid all

the amounts of rentals and wants to purchase the asset at a specified mutually

acceptable price, he will sell the leased asset to him for that price. Once the lessor

signs this promise, he is bound to fulfill it and the lessee may exercise his option

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to purchase at the end of the period, if he has fully paid the amounts of rent

according to the agreement of lease.

6. Ijarah Wa Iqtina

(Leasing and Promise to Gift)

In Islamic Shariah, It is allowed that instead of sale, the lessor signs a

separate promise to gift the leased asset to lessee at the end of the leased period,

subject to his payment of all amounts of rent. This arrangement is called Ijarah

WA Iqtina. It has been allowed by a large number of contemporary scholars and is

widely acted upon the Islamic banks and financial institutions. The validity of this

arrangement is subject to two basic conditions:

a. The agreement of Ijarah itself should not be subjected to signing this

promise of sale or gift but the promise should be recorded in a separate

document.

b. The promise should be unilateral and binding on the promiser only. It

should not be a bilateral promise binding on both parties because in this

case it will be a full contract effected to a future date, which is not allowed

in the =case of sale or gift.

Sub-Lease

If the leased asset is used differently by different users, the lessee can’t

sub-lease the leased asset except with the expressed permission of the lessor. If the

lessor permits the lessee for sub-leasing, he may sub-lease it. If the rent claimed

from the lessee is equal to or less than the rent payable to the owner/ original

lessor, all the recognized schools of Islamic jurisprudence are unanimous on the

permissibility of the sub-lease. However, the options are different in case the rent

charge from the sub-lessee is higher than the rent payable to the owner. Imam

Shafi and some other scholars allow it and hold that the sub-lessor may enjoy the

surplus received from the sub-lessee. This is preferred view in the Hanbali School

as well. On the other hand, Imam Abu Hanifah is of the view that the surplus

received from the sub-lessee in this case is not permissible for the sub-lessor to

keep and he will have to give that surplus in charity. However, if the sub lessor

has developed the least property by adding something to it or has rented it in a

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currency different forms the currency in which he himself pays rent to the owner/

the original lessor, he can claim a higher rent from his sub-lessee and can enjoy

the surplus.

Although the view of Imam Abu Hanifah is more precautious which

should be acted upon to the best possible extent, in cases of need the view of Shafi

and Hanbli schools may be followed because there is no expressed prohibition in

the Holy Qur’an or in the Sunnah against the Surplus claimed from the lessee.

Ibne Qudamah has argued for the permissibility of surplus on forceful grounds.

Assigning of the lease

The lessor can sell the leased property to a third party whereby the relation

of the lessor and lessee shall be established between the new owner and the lessee.

However, a signing of the lease itself( without assigning the ownership in the

leased asset) for a monetary consideration is not permissible.

The difference between the two situations is that in latter case the

ownership of the asset is not transferred to the assignee, but he becomes entitled to

receive the rent of the asset only. This kind of assignment is allowed in Shariah

only where no monetary consideration is charged from the assignee for this

assignment. For example, a lessor can assign his right to claim rent from the lessee

to his son, or to his friend in the form of a gift. Similarly, he can assign this right

to any one of his creditors to set off his debt out of the rentals received by him.

But if the lessor wants to sell this right for a fixed price, it is not permissible,

because in this case the money (the amount of rentals) is sold for money, which is

a transaction subject to the principle of quality. Otherwise it will be tantamount to

a Riba transaction, hence prohibited.

7. Muqarada

Under this technique Islamic bank floats the Islamic bonds to finance a

specific project. The investor who purchase muqarada bonds not only get a share

in the profit of the project being finance but also share the risks of low profit or

even loses. Bondholders have no say in the management of the project but act as

non-voting shareholder.

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These above are the Islamic modes of financing through which an Islamic

bank can finance the companies as well as individuals. Even a system based on

the concept of a normal rate of return can be applied in cases where the accounts

are not kept. The central bank of the country or any other suitable agency can

determined what is the normal rate of profit in particular sectors and the banks can

contract on that basis. If the party pays out that profit no questions are asked, but

if it is claimed that less profit has been made or a loss has been incurred the bank

should be entitled to ask the party to prove his claim and the varsity of this claim

could be judged by an independent agency and on the basis a settlement could be

arrived at. So this is not an insurmountable problem.

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CHAPTER – 4

CHALLENGES ON MUSHARAKAH FINANCING

HIGHLITESChallenges on musharakah financing.Risk of loss.Dishonesty.Secrecy of the Business.Clients' Unwillingness to Share Profits.Potential conflict between domestic banks, foreign banks, and Islamic banks.Absence of accounting (and auditing) standards pertinent to Islamic banks.Shortage of experts in Islamic bankingCommon market challenges.Islamic banking issues.

Islamic banking, possible solutions.

4. CHALLENGES ON MUSHARAKAH FINANCING

After all my efforts and surveys, I realized that these are

actual and real problems to musharakah financing and as

well as Islamic banking.

Let us now examine some objections raised from

practical point of view against using musharakah as a

mode of financing.

Risk of loss

Dishonesty

Secrecy of the Business

Clients' Unwillingness to Share Profits

Risk of Loss:

It is argued that the arrangement of musharakah is more

likely to pass on losses of the business to the financier

bank or institution. This loss will be passed on to

depositors also.

The depositors, being constantly exposed to the risk of loss, will not want to

deposit their money in the banks and financial institutions and thus their savings

will either remain idle or will be used in transactions outside of the banking

channels, which will not contribute to the economic development at national level.

This argument is, however, misconceived. Before financing on the basis of

musharakah, the banks and fdds financial institution will study the feasibility of

the proposed business for which funds are needed. Even in the present system of

interest-based loans the banks do not advance loans to each and every applicant.

They study the potentials of the business and if they apprehend that the business is

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not profitable, they refuse to advance a loan. In the case of musharakah, they will

have to carry out this study with more depth and precautions.

Moreover, no bank or financial institution can restrict itself to a single

musharakah. There will always be a diversified portfolio of musharakah. If a bank

has financed 100 of its clients on the basis of musharakah, after studying the

feasibility of the proposal of each one of them, it is hardly conceivable that all of

these musharakahs or the majority of them will result in a loss. After taking proper

measures and due care, what can happen at the most is that some and them make a

loss. But on the other hand, the profitable musharakahs are expected to give more

return than the interest-based loans, because the actual profit is supposed to be

distributed between the client and the bank. Therefore, the musharakah portfolio,

as a whole, is not expected to suffer loss, and the possibility of loss to the whole

portfolio is merely a theoretical possibility which should not discourage the

depositors. This theoretical possibility of loss in a financial institution is much less

than the possibility of loss in a joint stock company whose business is restricted to

a limited sector of commercial activities. Still, the people purchase its shares and

the possibility of loss does not refrain them from investing in these shares. The

case of the bank and financial institutions is much stronger, because their

musharakah activities will be so diversified that any possible loss in one

musharakah will be more than compensated by the profits earned in other

Musharakahs.

Apart from this, 'an Islamic economy must create a mentality which believes that

any profit earned on money is the reward of bearing risks of the business. This

risk may be minimized through expertise and diversifying the portfolio where it

becomes a hypothetical or theoretical risk only. But there is no way to eliminate

this risk totally. The one who wants to earn profit, must accept this minimal risk.

Since this understanding is already there in the case of normal joint stock

companies, nobody has ever raised the objection that the money of the

shareholders is exposed to loss. The problem is created by the system which

separates the banking and financing from the normal trade activities, and which

has compelled the people to believe that banks and financial institutions deal in

money and papers only, and that they have nothing to do with the actual results

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emerging in trade and industry. Therefore, it is argued that they deserve a fixed

return in any case. This separation of financing sector from the sector of trade and

industry has brought great harms to the economy at macro-level. Obviously, when

we speak of Islamic banking, we never mean that it will follow this conventional

system in each and every respect. Islam has its own values and principles, which

do not believe in separation of financing from trade and industry. Once this

Islamic system is understood, the people will invest in the financing sector,

despite the theoretical risk of loss, more readily than they invest in the profitable

joint stock companies.

1. Dishonesty

Another apprehension against musharakah financing is that the dishonest clients

may exploit the instrument of musharakah by not paying any return to the

financiers. They can always show that the business did not earn any profit. Indeed,

they can claim that it has suffered a loss in which case not only the profit, but also

the principal amount will be jeopardized.

It is, no doubt, a valid apprehension, especially in societies where corruption is the

order of the day. However, solution to this problem is not as difficult as is

generally believed or exaggerated If all the banks in a country are run on pure

Islamic pattern with a careful support from the Central Bank and the government,

the problem of dishonesty is not hard to overcome. First of all, a well-designed

system of auditing should be implemented whereby the accounts of all the clients

are fully maintained and properly controlled. It is already discussed that the profits

may be calculated to the basis of gross margins only. It will reduce the possibility

of disputes and misappropriation. However, if any misconduct, dishonesty or

negligence is established against a client, he will be subjected to punitive steps,

and may be deprived of availing any facility from any bank in the country, at least

for a specified period. These steps will serve as strong deterrent against

concealing the actual profits or committing any other act of dishonesty. Otherwise

also, the clients of the banks cannot afford to show artificial losses constantly,

because it will be against their own interest in many respects. It is true that even

after taking all such precautions, there will remain a possibility of some cases

where dishonest clients may succeed in their evil designs, but the punitive steps

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and the general atmosphere of the business will gradually reduce the number of

such cases (Even in an interest-based economy, the defaulters have always been

creating the problem of bad debts) But it should not be taken as a justification, or

as an excuse, for rejecting the whole system of musharakah. Undoubtedly, the

apprehension of dishonesty is more severe for the Islamic Banks and Financial

institutions working in isolation from the main stream of conventional banks.

They have not much support from their respective governments and central Banks.

They cannot change the system, nor can they impose their own laws and

regulations. However, they should not forget that they are not just commercial

institutions. They have been established to introduce a new system of banking

which has its own philosophy. They are duty bound to promote this new system,

even if they apprehend that it will reduce the size of their profits to some extent.

Therefore, they should start using the instrument of musharakah, at least on a

selective basis. Each and every bank has a number of clients whose integrity is

beyond all doubts. The Islamic banks should, at least, start financing them on the

basis of true musharakah. It will help setting good precedents in the market and

induce others to follow suit. Moreover, there are some sectors of financing where

musharakah can be used easily. For example, the use of musharakah instrument in

financing exports has not much room for dishonesty. The exporter has a specific

order from abroad. The prices are agreed. The cost is not difficult to determine.

Payments are normally secured by a letter of credit. The payments are made

through the bank itself. There is no reason in such cases why the musharakah

arrangement should not be adopted. Similarly, financing of imports may also be

designed on the basis of musharakah with some precautions, as explained earlier

in this chapter.

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2. Secrecy of the Business

Another challenge of musharakah is that, by making the financier a partner in the

business of the client, it may disclose the secrets of the business to the financier,

and through him to other traders. However, the solution to this problem is very

easy. The client, while entering into the musharakah, may put a condition that the

financier will not interfere with the management affairs, and he will not disclose

any information about the business to any person without prior permission of the

client. Such agreements of maintaining secrecy are always honored by the

prestigious institutions, especially by the banks and financial institutions whose

entire business is based on confidentiality.

3. Clients' Unwillingness to Share Profits

Many a time, it is mentioned that the clients are not willing to share with the

Banks the actual profits of their business. The reluctance is based on two reasons:

Even if the above was not a factor, the Clients are afraid to reveal their true profits

to the Banks, lest the information is also passed on to the tax authorities and

Clients' tax liability increases The solution to the first part, though not easy, is not

difficult or impossible either. Such Clients need to be convinced and persuaded

that borrowing on interest is a cardinal sin, unless there is a dire necessity for such

borrowing. Mere expansion of business is not a dire need, by any stretch of

imagination. By making a legitimate arrangement for obtaining funds for their

business, by way of Musharakah, not only do they earn Allah's pleasure but also a

legitimate return for themselves, as well as for the Islamic Banks.

In respect of the second factor, all that can be said is that in some Muslim

countries, rate of taxation are indeed prohibitive and unjust. Islamic Banks as well

as their Clients must lobby with the governments and struggle to change the laws

which hamper the progress towards Islamic banking. The governments should

also try to appreciate the fact that if rates of taxation are reasonable and if the tax-

payers are convinced that they will benefit by honestly paying their taxes, this

would increase, and not decrease, government revenues

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4.1 POTENTIAL CONFLICT BETWEEN DOMESTIC BANKS, FOREIGN BANKS AND ISLAMIC BANKS

It appears that domestic banks and foreign banks will experience continuing

difficulty in adopting practice of Musharakah until they can become more

confident of the results of investing ventures.

Absence of accounting (and auditing) standards pertinent to Islamic banks

Uncertainty in accounting principles involves revenue realization, disclosures of

accounting information, accounting bases, valuation, revenue and expense

matching, among others.

Shortage of experts in Islamic banking

The supply of trained or experienced bankers has lagged behind the expansion of

Islamic banking. The training needs affect not only Arab domestic banks, both

Islamic and non-Islamic, but foreign banks as well.

Common market challenges

1. There had been lack of awareness about the Islamic banking there interest

free financing and there products.

2. So far unlimited discretion has been available both to the bank and

business community to use musharakah financing.

3. The business community thinks that if they enter to musharakah financing

with banks, there may be undue interference by the banks in their

management.

4. The business community is reluctant to make disclosure of its financial

affairs for a number of reasons, essentially due to the implementation of

existing tax system.

5. The perception has developed among bankers as well as business

community due to the lack of correct information that the Islamic system

of musharakah is full of complexities.

6. The business has community has doubts if the banks shall ever participate

in their losses.

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7. There has been a lack of speedy disposal of the disputes. The working of

the banking tribunals has remained ineffective.

8. A proper legal framework for strengthening the institutions of

musharakah has been missing.

9. There has been a lack of any strong affirmative policy action in favor of

profit sharing modes of financing as against other modes of financing based

on fixed rate of return.

10. Proper monitoring system is not available to monitor the transactions.

11. Insufficient and well-trained staff is not available.

12. Specifically in Pakistan the destructive trend of costumer.

4.2 ISLAMIC BANKING ISSUES

1. Human resource for Sharia'h compliance:

Users of Islamic financial services assign primary importance to Sharia'h

compliance of the services they use. It is understandable that Sharia'h

noncompliance entails a serious operational risk and can result in withdrawal of

funds from and instability of an Islamic bank, irrespective of its initial financial

soundness. Sharia'h compliance is hence a serious matter for an Islamic bank, in

addition to its compliance with other regulatory requirements.

2. Unresolved Fiqh Issues

Lack of standard financial contracts and products can be a cause of ambiguity and

a source of dispute and cost. In addition, without a common understanding of

certain basic foundations, further development of banking products is hindered.

3. Legal Framework

An appropriate legal, institutional and tax framework is a basic requirement for

establishing sound financial institutions and markets. Islamic jurisprudence offers

its own framework for the implementation of commercial and financial contracts

and transactions.

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Nevertheless, commercial, banking and company laws appropriate for the

enforcement of Islamic banking and financial contracts do not exist in many

countries.

4. Excess Liquidity

Islamic banks have over 60 % excess liquid funds which cannot be properly

utilized due to non-availability of Sharia'h Compliant products and instruments.

The competitiveness and soundness of financial institutions depend on the

availability of efficient financial products. Islamic banks urgently need Sharia'h

compliant products to meet a number of pressing needs.

5. Technology

Designing technological solutions around a concept requires extensive knowledge

of the domain. Conventional banking today is technologically advanced; however,

for crafting Islamic financial solutions, considerable time and expertise are

required.

4.3 ISLAMIC BANKING, POSSIBLE SOLUTIONS

Establishment of Shari'ah Governance Systems

Settling unresolved Fiqh Issues

A sufficient number of well-trained, competent, high-caliber Islamic

finance professionals and management teams with the required expertise

Well-informed individual and corporate consumers, knowledgeable about

Islamic banking and takaful

The availability of Sharia'h compliant products (Sharia'h Compliant Stocks,

Sukuks, etc.)

Development of a Legal, Regulatory, and Institutional Framework

complying with Sharia'h

Advanced technology solutions designed to support Islamic

Finance

The banks should adopt proper monitoring system.

Making the recovery laws more effective and stringent.

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Reforming the taxation system to suit the applications of

musharakah.

Provision of a review committee apart of musharakah agreement

in order to resolve the disputes that might arise between bank and

the client.

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CHAPTER – 5

HOW IT IS PRACTICALLY IMPLEMENTED

5.1 PROJECT FINANCING

In the case of project financing, the traditional method of musharakah or

mudarabah can be easily adopted. If the financier wants to finance the whole

project, the form of mudarabah can come into operation. If investment comes

from both sides, the form of musharakah can be adopted. In this case, if the

management is the sole responsibility of one party, while the investment comes

from both, a combination of musharakah and mudarabah can be brought into play

according to the rules already discussed.

Since musharakah or mudarabah would have been effected from the very

inception of the project, no problem with regard to the valuation of capital should

rise. Similarly, the distribution of profits according to the normal accounting

standards should not be difficult. However, if the financier wants to withdraw

from the musharakah, while the other party wants to continue the business, the

latter can purchase the share of the former at an agreed price. In this way the

financier may get back the amount he has invested along with a profit, if the

business has earned a profit. The basis for determining the price of his share shall

be discussed in detail later on (while discussing the financing of the working

capital).

On the other hand, the businessman can continue with his project, either on his

own or by selling the first financier’s share to some other person who can

substitute the financier. Since financial institutions do not normally want to

remain partner of a specific project for good, they can sell their share to other

partners of the project as aforesaid. If the sale of the share on one time basis is not

feasible for the lack of liquidity in the project, the share of the financier can be

divided into smaller units and each unit can be sold after a suitable interval.

Whenever a unit is sold, the share of the financier in the project is reduced to that

extent, and when all the units are sold, the financier comes out of the project

totally.

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5.2 SECURITIZATION OF MUSHARAKAH

Musharakah is a mode of financing which can be securitized easily, especially in

the case of big projects where huge amounts are required which a limited number

of people cannot afford to subscribe. Every subscriber can be given a musharakah

certificate which represents his proportionate ownership in the assets of the

musharakah, and after the project is started by acquiring substantial non-liquid

assets, these musharakah certificates can be treated as negotiable instruments and

can be bought and sold in the secondary market. However, trading in these

certificates is not allowed when all the assets of the musharakah are still in liquid

form (i.e., in the shape of cash or receivables or advances due from others).

For proper understanding of this point, it must be noted that subscribing to a

musharakah is different from advancing a loan. A bond issued to evidence a loan

has nothing to do with the actual business undertaken with the borrowed money.

The bond stands for a loan repayable to the holder in any case, and mostly with

interest. The musharakah certificate, on the contrary, represents the direct pro rata

ownership of the holder in the assets of the project. If all the assets of the joint

project are in liquid form, the certificate will represent a certain proportion of

money owned by the project. For example, one hundred certificates, having a

value of Rs. one million each, have been issued. It means that the total worth of

the project is Rs. 100 million. If nothing has been purchased by this money, every

certificate will represent Rs. one million. In this case, this certificate cannot be

sold in the market except at par value, because if one certificate is sold for more

than Rs. one million, it will mean that Rs. one million are being sold in exchange

for more than Rs. one million, which is not allowed in Shar’iah, because where

money is exchanged for money, both must be equal. Any excess at their side is

riba.

However, when the subscribed money is employed in purchasing non-liquid assets

like land, building, machinery, raw material, furniture etc. the musharakah

certificates will represent the holders’ proportionate ownership in these assets.

Thus, in the above example, one certificate will stand for one hundred share in

these assets. In this case it will be allowed by the Shari’iah to sell these certificates

in the secondary market for any price agreed upon in between the parties which

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may be more than the fact value of the certificate, because the subject matter of

the sale is a share in the tangible assets and not in the money only, therefore the

certificate may be taken as any other commodities which may be sold with a profit

or at a loss.

In most cases, the assets of the project are a mixture of liquid and non-liquid

assets. This comes to happen when the working partner has converted a part of the

subscribed money into fixed assets or raw material, while rest of the money is still

liquid. Or, the project, after converting all it’s money into non-liquid assets may

have sold some of them and has acquired their sale proceeds in the form of

money. In some cases the price of it’s sales may have become due on it’s

customers but may have not yet been received. These receivable amounts, being a

debt, are also treated as liquid money. The question arises about the rule of

Shar’iah in a situation where the assets of the project are a mixture of liquid and

non-liquid assets, whether the musharakah certificates of such a project can be

traded in? The opinions of the contemporary Muslim jurists are different on this

point. According to the traditional Shafi’i school, this type of certificate cannot be

sold. Their classic view is that whenever there is a combination of liquid and non-

liquid assets, it cannot be sold unless the non-liquid part of the business is

separated and is sold independently.

The Hanafic school, however, is of the opinion that whenever there is a

combination of liquid and non-liquid assets, it can be sold and purchased for an

amount greater than the amount of liquid assets in the combination, in which case

money will be taken as sold at an equal amount and the excess will be taken as the

price of the non-liquid assets owned by the business.

Suppose, the Musharakah project contains 40% non-liquid assets i.e. machinery,

fixtures, etc. and 60% liquid assets, i.e. cash, and receivables. Now, each

musharakah certificate having the face value of Rs. 100/- represents Rs. 60/-

worth of liquid assets, and Rs. 40 /- worth of non-liquid assets. This certificate

may be sold at any price more than 60/-. If it is sold at Rs.110/- it will mean that

Rs. 60/- of the price are against Rs. 60/- contained in the certificate and Rs. 50/- is

against the proportionate share in the non-liquid assets. But it will never be

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allowed to sell the certificate for a price of Rs. 60/- or less, because in the case of

Rs. 60/- it will not set the amount of Rs. 60/-, let alone the other assets.

According to the Hanafi view, no specific proportion of non-liquid assets in the

whole is prescribed. Therefore, even if the non-liquid assets represent less than

50% in the whole, it’s trading according to the above formula is allowed.

However, most of the contemporary scholars, including those of Shafi’i school

have allowed trading in the units of the whole only if the non-liquid assets of the

business are more than 50%.

Therefore, for a valid trading of the musharakah certificate acceptable to all

schools, it is necessary that the portfolio of Musharakah consists of non-liquid

assets valuing more than 50% of it’s total worth. However, if Hanafi view is

adopted, trading will be allowed even if the non-liquid assets are less than 50%,

but the size of the non-liquid assets should not be negligible.

5.3 FINANCING OF A SINGLE TRANSACTION

Musharakah and mudarabah can be used more easily for financing a single

transaction. Apart from fulfilling the day-to-day needs of small traders, these

instruments can be employed for financing imports and exports. An importer can

approach a financier to finance him for that single transaction of import alone on

the basis of musharakah or mudarabah. The banks can also use these instruments

for import and financing. If the letter of credit has been opened without any

margin, the form of mudarabah can be adopted, and if the L/C is opened with

some margin, the form of musharakah or a combination of both will be relevant.

After the imported goods are cleared from the port, their sales proceeds may be

shared by the importer and the financier according to a preagreed ratio.

In this case the ownership of the imported goods shall remain with the

financier to the extent of the ratio of his investment. This musharakah can

be restricted to an agreed term, and of the imported goods are not sold in the

market up to the expiry of the term, the importer may himself purchase the

share of the financier, making himself the sole owner of the goods.

However, the sale in this case should take place at the market rate or at a

price agreed between the parties on the date of sale, and not at pre-agreed

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price at the time of entering into musharakah. If the price is pre-agreed, the

financier cannot compel the client / importer to purchase it.

Similarly, musharakah will be even easier in the case of export financing.

The exporter has a specific order from abroad. The price on which the

goods will be exported is wellknown before hand, and the financier can

easily calculate the expected profit. He may finance him on the basis of

musharakah and mudarabah, and may share the amount of export bill on a

pre-agreed percentage. In order to secure himself from any negligence on

the part of the exporter, the financier may put a condition that it will be the

responsibility of the exporter to export the goods in full conformity with the

conditions of the L/C. In this case, if some discrepancies are found, the

exporter alone shall be responsible, and the financier shall be immune from

any loss due to such discrepancies , because it is caused by the negligence

of the exporter. However, being a partner of the exporter, the financier will

be liable to bear any loss which may be caused due to any reason other than

the negligence or misconduct of the exporter.

5.4 FINANCING OF WORKING CAPITAL:

Where finances are required for the working capital of a running business, the

instrument of musharakah may be used in the following manner:

1. The capital of the running business may be evaluated with the mutual

consent. It is already mentioned while discussing the traditional concept of

musharakah that is not necessary, according to Imam Malik, that the

capital of the musharakah is contributed in cash form. Non-liquid assets

can also form part of the capital on the basis of evaluation. This view can

be adopted here. In this way, the value of the business can be treated as the

investment of the person who seeks finance, while the amount given by the

financier can be treated as his share of investment. The musharakah may

be effected for a particular period, like one year or six months or less. Both

the parties agree on a certain percentage of the profit to be given to the

financier which should not exceed the percentage of his investment,

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because he shall not work for the business. On the expiry of the term, all

liquid and non-liquid assets of the business are again evaluated and the

profit may be distributed on the basis of this evaluation.

Although, according to the traditional concept, the profit cannot be determined

unless all the assets of the business are liquidated, yet the valuation of the assets

can be treated as “constructive liquidation” with mutual consent of the parties,

because there is no specific prohibition in Shar’iah against it. It can also mean that

the working partner has purchased the share of the financier in the assets of his

business, and the price of his share can be determined on the basis of valuation,

keeping in view the ratio of the profit allocated for him according to the terms of

the musharakah. For example, the total business of the value of A is 30 units. B

finances another 20 units, raising the total worth to 50 units; 40% having been

contributed by B, and 60% by A. It is agreed that B shall get 20% of the actual

profit. At the end of the term, the total worth of the business has increased 100

units.

Now, if the share of B is purchased by A, he should have paid to him 40 units,

because he owns 40% of the assets of the business. But in order to reflect the

agreed ratio of profit in the price of his share, the formula of pricing will be

different. Any increase in the value of business shall be divided between the

parties in the ratio of 20% and 80%, because this ratio was determined in the

contract for the purpose of distribution of profit.

Since the increase in the value of the business is 50 units, these 50 units are

divided at the ratio of 20-80, meaning thereby that 10 units will have been earned

by B. These 10 units will be added to his original 20 units, and the price of his

share will be 30 units.

In case of loss, however, any decrease in the total value of the assets should be

divided between them exactly in the ratio of their investment, i.e., in the ratio of

40/60. Therefore, if the value of the business has decreased, in the above example,

by 10 units reducing the total number of units to 40, the loss of 4 units shall be

borne by B (being 40% of the loss.) These 4 units shall be deducted from it’s

original 20 units, and the price of his share shall be determined as 16 units.

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5.5 SHARING IN THE GROSS PROFIT ONLY

2. Financing on the basis of musharakah according to the above procedure

may be difficult in a business having a large number of fixed assets,

particularly in a running industry, because the valuation of all its assets

and their depreciation or appreciation may create accounting problems

giving rise to disputes. In such cases, musharakah may be applied in

another way.

The major difficulties in these cases arise in the calculation of indirect expenses,

like the depreciation of the machinery, salaries of the staff etc. In order to solve

this problem, the parties may agree on the principle that, instead of net profit, the

gross profit will be distributed between the parties, that is, the indirect expenses

shall not be deducted from the distributable profit. It will mean that all the indirect

expenses shall be borne by the industrialist voluntarily, and only direct expenses

(like those of raw material, direct labour, electricity etc.) shall be borne by the

musharakah. But since the industrialist is offering his machinery, building and

staff to the musharakah voluntarily, the percentage of his profit may be increased

to compensate him to some extent.

This arrangement may be justified on the ground that the clients of financial

institutions do not restrict themselves to the operations for which they seek

finance from the financial institutions. Their machinery and staff etc. is, therefore,

engaged in some other business also which may not be subject to musharakah,

and in such a case the whole cost of these expenses cannot be imposed on the

musharakah.

Let us take a practical example. Suppose a ginning factory has a building worth

Rs. 22 million, plant and machinery valuing Rs. 2 million and the staff is paid Rs.

50,000/- per month . The factory sought finance of Rs. 5,000,000/- from a bank on

the basis of musharakah for a term of one year. It means that after one year the

musharakah will be terminated, and the profits accrued up to that point will be

distributed between parties according to the agreed ratio.

While determining the profit, all direct expenses will be deducted from the

income. The direct expenses may include the following:

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i. The amount spent on purchasing raw material.

ii. The wages of the labour directly involved in processing the raw material.

iii. The expenses for electricity consumed in the process of ginning.

iv. The bills for other services directly rendered for the musharakah.

So far as the building, the machinery and the salary of other staff is concerned, it

is obvious that they are not meant for the business of musharakah alone, because

the musharakah will terminate within one year, while the building and the

machinery are purchased for a much longer term in which the ginning factory will

use them for it’s own business which is not subject to this one-year musharakah .

Therefore , the whole cost of the building and the machinery cannot be borne by

this short-term musharakah.

What can be done at the most is that the depreciation caused to the building and

the machinery during the term of the musharakah is included in its expenses. But

in practical terms, it will be very difficult to determine the cost of depreciation,

and it may cause disputes also. Therefore, there are two practical ways to solve

this problem.

In the first instance, the parties may agree that the musharakah portfolio will pay

an agreed rent to the client for the use of the machinery and the building owned by

him. This rent will be paid to him from the musharakah fund irrespective of profit

or loss accruing to the business.

The second opinion is that, instead of paying rent to the client, the ratio of his

profit is increased. From the point of view of Shar’iah, it may be justified on the

analogy of mudarabah in services which is allowed in the view of Imam Ahmad

bin Hanbal.

5.6 RUNNING MUSHARAKAH ACCOUNTS ON THE BASIS OF DAILY PRODUCTS

3. Many financial institutions finance the working capital of an enterprise by

opening a running account for them from where the clients draw different

amounts at different intervals, but at the same time, they keep returning

their surplus amounts. Thus the process of debit and credit goes on up to

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the date of maturity, and the interest is calculated on the basis of daily

products.

Can such an arrangement be possible under the musharakah or mudarabah modes

of financing? Obviously, being a new phenomenon, no express answer to this

question can be found in the classical works of Islamic Fiqh.

However, keeping in view the basic principles of the musharakh the following

procedure may be suggested for this purpose:

i. A certain percentage of the actual profit must be allocated for the

management.

ii. The remaining percentage of the profit must be allocated for the investors.

iii. The loss, if any, should be borne by the investors only in exact proportion

of their respective investments.

iv. The average balance of the contributions made to the musharakah account

calculated on the basis of daily products shall be treated as the share

capital of the financier.

v. The profit accruing at the end of the term shall be calculated on daily

product basis and shall be distributed accordingly.

If such an arrangement is agreed upon between the parties, it does not seem

to violate any basic principles of the musharakah. However, this suggestion

needs further consideration and research by the experts of Islamic

jurisprudence. Practically, it means that the parties have agreed to the

principle that the profit accrued to the musharakah portfolio at the end of

the term will be divided on the capital utilized per day, which will lead to

the average of the profit earned by each rupee per day. The amount of this

average profit per rupee per day will be multiplied by the amount of the

days each investor has put his money into the business, which will

determine his profit entitlement on the daily product basis.

Some contemporary scholars do not allow this method of calculating profits

on the ground that it is just a conjectural method which does not reflect the

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actual profits really earned by a partner of the musharakah, because the

business may have earned huge profits during a period when a particular

investor had no money invested in the business at all, or had a very

negligible amount invested, still, he will be treated at par with other

investors who had huge amounts invested in the business during that period.

Conversely, the business may have suffered a great loss during a period

when a particular investor had huge amounts invested in it. Still, he will

pass on some of his loss to other investors who had no investment in that

period or their size of investment was negligible.

This argument can be refuted on the ground that it is not necessary in a

musharakah that a partner should earn profit on his own money only. Once

a musharakah pool comes into existence, the profits accruing to the joint

pool are earned by all the participants, regardless of whether their money is

or is not utilized in a particular transaction. This is particularly true of a

Hanafi School which does not deem it necessary for a valid musharakah

that the monetary contributions of the partners are mixed up together. It

means that if A has entered into a musharakah contract with B, but has not

yet disbursed his money into the joint pool, he will still be entitled to a

share in the profit of the transactions effected by B for the musharakah

through his own money. Although his entitlement to a share in the profit

will be subject to the disbursement of money undertaken by him, yet the

fact remains that the profit of this particular transaction did not accrue to his

money, because the money disbursed by him at a later stage may be used

for another transaction . Suppose, A and B entered into a musharakah to

conduct a business of Rs. 100,000/- They agreed that each of them shall

contribute Rs. 50,000/- and the profits will be distributed by them equally.

A did not yet invest his Rs. 50,000/- into the joint pool. B found a profitable

deal and purchased two air conditioners for the musharakah for Rs.

50,000/- contributed by himself and sold them for Rs. 60,000/-, thus earning

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a profit of Rs. 10,000/-. A contributed his share of Rs. 50,000/- after this

deal.

The partners purchased two refrigerators through this contribution which

could not be sold at a greater price than Rs. 48,000/- meaning thereby this

deal resulted in a loss of Rs. 2,000/- Although the transactions effected by

A’s money brought a loss of Rs.2,000/- while the profitable deal of air

conditioners was financed entirely by B’s money in which A had no

contribution, yet A will be entitled to a share in the profit of the first deal.

The loss of Rs.2,000/- in the second deal will be set of from the profit of the

first deal reducing the aggregate profit to Rs. 8,000/-. This profit of

Rs.8,000/- will be shared by both partners equally. It means that A will get

Rs. 4,000/- , even though the transaction effected by his money has suffered

loss.

The reason is that once a musharakah contract is entered into by the parties,

all the subsequent transactions effected for musharakah belong to the joint

pool, regardless of whose individual money is utilized in them. Each partner

is a party to each transaction by virtue of his entering into the contract of

musharakah.

A possible objection to the above explanation may be that in the above

example, A had undertaken to pay Rs. 50,000/- and it was known before

hand that he will contribute a specified amount to the musharakah. But in

the proposed running account of the musharakah where the partners are

coming in and going out everyday, nobody has undertaken to contribute any

specific amount. Therefore, the capital contributed by each partner is

unknown at the time of entering into musharakah, which should render the

musharakah invalid.

The answer to the above objection is that the classical scholars of Islamic

Fiqh have different views about whether it is necessary for a valid

musharakah that the capital is pre-known to the partners. The Hanafi

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scholars are unanimous on the point that it is not a pre-condition. Al-

Kassani, the famous Hanafi jurist, writes:

“According to our Hanafi School, it is not a condition for the

validity of the musharakah that the amount of capital is known, while

it is a condition according to Imam Shafi’i. Our argument is that

Jahalah (uncertainty) in it self does not render a contract invalid,

unless it leads to disputes. And the uncertainty in the capital at the

time of musharakah does not lead to disputes, because it is generally

known when the commodities are purchased for the musharakah,

therefore it does not lead to uncertainty in the profit at the time of

distribution.”

It is, therefore, clear from the above that even if the amount of the capital is not

known at the time of musharakah, the contract is valid. The only condition is that

it should not lead to the uncertainity in the profit at the time of distribution.

Distribution of profit on daily product basis fulfills this condition.

It is true that the concept of a running musharakah where the partners at times

draw some amounts and at other times inject new money and the profits are

calculated on daily product basis is not found in the classical books of Islamic

Fiqh. But merely this fact cannot render a new arrangement invalid in Shar’iah, so

far as it does not violate any basic principle of musharakah. In the proposed

system, all the partners are treated at par. The profit of each partner is calculated

on the basis of the period for which his money remained in the joint pool. There is

no doubt in the fact that the aggregate profits accrued to the pool are generated by

the joint utilizations of different amounts contributed by the participants at

different times. Therefore if all of them agree with mutual consent to distribute the

profits on a daily basis, there is no injunction of the Shar’iah which makes it

impermissible; rather it is covered under the general guide line given by the Holy

Prophet (PBUH) in his famous hadith quoted in this book more than once:

“Muslims are bound by their mutual agreement unless they hold a

permissible thing as prohibited or a prohibited thing as permissible.”

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If distribution on daily products basis is not accepted, it will mean that no partner

can draw any amount from, nor can he inject new amounts to the joint pool.

Similarly, nobody will be able to subscribe to the joint pool accept at the

particular dates of the commencement of a new term. This arrangement is totally

impracticable on the deposit sides of the banks and financial institutions where the

accounts are debited and credited by the depositors many times a day. The

rejection of the concept of the daily products will compel them to wait for months

before they deposit their surplus money in a profitable account. This will hinder

the utilization of savings for development of industry and trade, and will keep the

wheel of financial activities jammed for long periods. There is no other solution

for this problem accept to apply the method of daily products for the calculation of

profits, and since there is no specific injunction of Shar’iah against it, there is no

reason why this method should not be adopted.

5.7 DIMINISHING MUSHARAKAH

Another form of Musharakah, developed in the near past, is ‘Diminishing

Musharakah’. According to this concept, a financier and his client participate

either in the joint ownership of a property or an equipment, or in a joint

commercial enterprise. The share of the financier is further divided into a number

of units and it’s understood that the client will purchase the units of the share of

the financier one by one periodically, thus increasing his own share till all the

units of the financier are purchased by him so as to make him the sole owner of

the property, or the commercial enterprise, as the case may be.

The diminishing Musharakah based on the above concept and has taken different

shapes in different transactions. Some examples are given below:

1. It has been used mostly in house financing. The client wants to purchase

the client wants to purchase the house for which he does not have adequate

funds. He approaches the financier who agrees to participate with him in

purchasing the required house.20% of the price is paid by the client and

80% of the price by the financier. Thus the financier owns 80% of the

house while the client owns 20%. After purchasing the property jointly,

the client uses the house for his residential requirement and pays rent to

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the financier for using his share in the property. At the same time the share

of the financier is further divided in eight equal units, each unit

representing 10% ownership of the house. The client promises to the

financier that he will purchase one unit after three months. Accordingly,

after the first term of three months he purchases one unit of the share of

the financier by paying 1/10th of the price of the house. It reduces the

share of the financier from 80% to 70%.

Hence, the rent payable to the financier is also reduced to that extent. At

the end of the second term, he purchases another unit increasing his share

in property to 40% and reducing the share of the financier to 60% and

consequentially reducing the rent to that proportion. This process goes on

in the same fashion until after the end of the two years, the client

purchases the whole share of the financier reducing the share of the

financier to ‘zero’ and increasing his own share to 100%.

This arrangement allows the financier to claim rent according to his

proportion of ownership in the property at the same time allows him

periodical return of a part of his principle through the purchases of the

units of his share.

2. ‘A’ wants to purchase a taxi to use it for offering transport services to

passengers and to earn the income through fares recovered from them but

he is short of funds. ‘B’ agrees to participate in the purchase of the taxi,

therefore, both of them purchase a taxi jointly. 80% of the price is paid by

‘B’ and 20% is paid by ‘A’. After the taxi is purchased, it is employed to

provide transport to the passengers where by the net income of Rs. 1000/-

is earned on daily basis. Since ‘B’ has 80% share in the taxi it is agreed

that 80% of the fare will be given to him and the rest of the 20% will be

retained by ‘A’ who has 20% share in the taxi. It means that Rs. 800/- is

earned by ‘B’ and Rs. 200 by ‘A’ on a daily basis. At the same time the

share of ‘B’ is further divided into eight units. After three months ‘A’

purchases one unit from the share of ‘B’. Consequently the share of ‘B’ is

reduced to 70% and the share of ‘A’ is increased to 30% meaning thereby

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that as from the date ‘A’ will be entitled to Rs. 300/- from the daily income

of the taxi and ‘B’ will earn Rs. 700/-.

This process will go on until after the expiry of two years, the whole taxi

will be owned by ‘A’ and ‘B’ will take back his original investment along

with income distributed to him as aforesaid.

3. ‘A’ wishes to start the business of ready-made garments but lacks the

required fund for that business. ’B’ agrees to participate with him for a

specified period, say two years. 40% of the investment is contributed by

‘A’ and 60% by ‘B’. Both start the business on the basis of the

Musharakah. The proportion of the profit allocated for each one of them is

expressly agreed upon. But at the same time ‘B’s share in the business is

divided into six equal units and ‘A’ keeps purchasing these units on

gradual basis until after the end of the two years ‘B’ comes out of the

business, leaving it’s exclusive ownership to ‘A’. Apart from periodical

profits earned by ‘B’, he gains the price of the units of his share which, in

practical terms, tend to repay him the original amount invested by him.

Analyzed from the Shar’iah point of view this arrangement is composed of

different transactions which come to pay their role at different stages.

Therefore, each one of the foregoing three forms of diminishing

Musharakah is discussed below in the light of the Islamic principles:

House Financing on the Basis of Diminishing Musharakah:

The proposed arrangement is composed of the following transactions:

1. To create joint ownership in the property (Shirkat-ul-Milk).

2. Giving the share of the financier to the client on rent.

3. Promise from the client to purchase the units of share of the financier.

4. Actual purchase of the units at different stages.

5. Adjustment of the rental according to the remaining share of the financier

in the property.

Let me discuss each ingredient of the arrangement in a greater detail:

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i. The first step in above arrangement is to create a joint ownership in the

property. It has already been explained in the beginning of the chapter that

‘Shirkat-ul-Milk’ (joint ownership) can come into existence in different

ways including joint purchase by the parties. This has been expressly

allowed by all schools of Islamic jurisprudence . Therefore no objection

can be raised against creating this joint ownership.

ii. The second part of this arrangement is that the financier leases his share in

the house to his client and charges rent from him. This arrangement is also

above board because there is no difference of opinion among the Muslim

jurists in the permissibility of leasing one’ s undivided share in a property

to his partner. If the undivided share is leased out to a third party, its

permissibility is a point of difference between the Muslim jurists. Imam

Abu Hanifa and Imam Zufar are of the view that the undivided share

cannot be leased out to a third party while Imam Malik and Imam Shafi’i,

Abu Yusuf and Mohammed Ibn Hasan hold that the undivided share can

be leased out to any person. But so far as the property is leased to the

partner himself all of them are unanimous on the validity of ‘Ijarah’.

iii. The third step in the aforesaid arrangement is that the client purchases

different units of the undivided share of the financier. This transaction is

also allowed. If the undivided share relates to both land and building, the

sale of both is allowed according to all the Islamic schools. Similarly if the

undivided share of the building is intended to be sold to the partner, it is

also allowed unanimously by all the Muslim jurists. However, there is a

difference of opinion if it is sold to the third party.

It is clear from the foregoing three points that each one of the transactions

mentioned here and above is allowed per se, but the question is whether

this transaction may be combined in a single arrangement. The answer is if

all these transactions have been combined by making each of them a

condition to the other, then this is not allowed in the Shar’iah , because it

is a well settled rule in the Islamic legal system that one transaction cannot

be made a pre-condition for another. However, the proposed scheme

suggests that instead of making two transactions conditional to each other ,

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there should be one sided promise from the client, firstly, to take the share

of the financier on lease and pay the agreed rent , and secondly, to

purchase different units of the share of the financier of the house at

different stages. This leads us to the forth issue, which is, the

enforceability of such a promise.

iv. It is generally believed that a promise to do something creates only a moral

obligation on the promisor which cannot be enforced through courts of

law. However, there are a number of Muslim jurists who opine that

promises are enforceable, and the court of law can compel the promisor to

fulfill his promise, especially, in the context of commercial activities.

Some Maliki and Hanifi jurists can be cited in particular, in particular, who

have declared that promises can be enforced through the courts of law in

cases of need. The Hanifi jurists have adopted this view with regard to a

particular sale called ‘bai-bilwafa’.

This ‘bai-bilwafa’ is a special arrangement of sale of a house whereby the buyer

promises to the seller that whenever the latter gives him back the price of the

house, he will resell the house to him. This arrangement was in vogue in countries

of central Asia, and the Hanafi jurists have opined that if the resale of the house to

the original seller is made a condition for the initial sale, it is not allowed.

However, if the first sale is effected without any condition, but after effecting the

sale, the buyer promises to resell the house whenever the seller offers to him the

same price, this promise is acceptable and it creates not only a moral obligation,

but also an enforceable right of the original seller. The Muslim jurists allowing

this arrangement have based their view on the principle that (the promise can be

made enforceable at time of need).

Even if the promise has been made before effecting the first sale, after which the

sale has been affected without a condition, it is also allowed without certain

Hanafi jurists.

One may raise an objection that if the promise of resale has been taken before

entering into an actual sale, it practically amounts to putting a condition on the

sale itself, because the promise is understood to have been entered into between

the parties at the time of sale, and therefore, even if the sale is without an express

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condition, it should be taken as conditional because a promise in an express term

has preceded it.

This objection can be answered by saying that there is a big difference between

putting a condition in the sale and making a separate promise by making it a

condition. If the condition is expressly mentioned at the time of sale, it means that

the sale will be valid only if the condition is fulfilled, meaning thereby that if the

condition is not fulfilled in future, the present sale will become void. This makes

the transaction of the sale contingent on a future event which may or may not

occur. It leads to uncertainty (Gharar) in the transaction which is totally

prohibited in Shar’iah.

Conversely, if the sale is without any condition, but one of the two parties has

promised to do something separately, then the sale cannot be held contingent or

conditional with fulfilling of the promise made. It will take effect irrespective of

whether or not the promisor fulfills his promise. Even if the promisor backs out of

his promise, the sale will remain effective. The most the promisee can do is to

compel the promisor through court of law to fulfill his promise and if the promisor

is unable to fulfill the promise, the promisee can claim actual damages he has

suffered because of the default.

This makes it clear that a separate and independent promise to purchase does not

render the original contract conditional or contingent. Therefore, it can be

enforced. On the basis of this analysis, diminishing the Musharakah may be used

for Housing Finance with following conditions:

a. The agreement of joint purchase, leasing and selling different units of the

share of the financier should not be tied-up together in one single contract.

However, the joint purchase and the contract of lease may be joined in one

document whereby the financier agrees to lease his share, after joint

purchase, to the client. This is allowed because, as explained in the

relevant chapter, Ijarah can be effected for a future date. At the same time

the client may sign one-sided promise to purchase different units of the

share of the financier periodically and the financier may undertake that

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when the client will purchase a unit of his share, the rent of the remaining

units will be reduced accordingly.

b. At the time of the purchase of each unit, sale must be effected by the

exchange of offer and acceptance at that particular date.

c. It will be preferable that the purchase of different units by the client is

effected on the basis of the market value of the house as prevalent on the

date of purchase of that unit, but it is also permissible that a particular

price is agreed in the promise of purchase signed by the client.

Diminishing Musharakah for Carrying Business of Services: The second example

given above for diminishing Musharakah is the joint purchase of a taxi run for

earning income by using it as a hired vehicle. This arrangement consists of the

following ingredients:

i. Creating joint ownership in a taxi in the form of Shirkat-ul-Milk. As

already stated this is allowed in Shar’iah.

ii. Musharakah is the income generated through the services of taxi. It is also

allowed as mentioned earlier in this chapter.

iii. Purchase of different units of the share of the financier by the client. This

is again subject to the conditions already detailed in the case of House

financing. However, there is a slight difference between the House

financing and the arrangement suggested in this second example. The taxi,

when used as a hired vehicle, normally depreciates in value overtime,

therefore, depreciation in the value of taxi must be kept in mind while

determining the price of different units of the share of the financier.

Diminishing Musharakah in Trade: The third example of diminishing

Musharakah as given above is that the financier contributes 60% of the capital for

launching a business of ready made garments, for example. This arrangement is

composed of two ingredients only:

1. In the first place, the arrangement is simply a Musharakah whereby two

partners invest different amounts of capital in a joint enterprise. This is

obviously permissible subject to the conditions of Musharakah already

spelled out earlier in this chapter.

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2. Purchase of different units of the share of the financier by the client. This

may be in the form of a separate and independent promise by the client.

The requirements of Shar’iah regarding this promise are the same as

explained in the case of House financing with one very important

difference. Here the price of units of the financier cannot be fixed in the

promise to purchase, because if the price is fixed before hand at the time of

entering the Musharakah, it will practically mean that the client has

ensured the principle invested by the financier with or without profit,

which is strictly prohibited in the case of Musharakah.

Therefore, there are two options for the financier about fixing the price of his units

to be purchased by the client. One option is that he agrees to sell the units of the

basis of valuation of the business at the time of the purchase of each unit. If the

value of the business has increased, the price will be higher and if it is decreased

the price would be less. Such valuation may be carried out in accordance with the

recognized principles through the experts, whose identity may be agreed upon

between the parties when the promise is signed. The second option is that the

financier allows the client to sell these units to any body else at whatever price he

can, but at the same time he offers a specific price to the client, meaning thereby

that if he finds a purchaser of that unit at a higher price, he may sell it to him, but

if he wants to sell it to the financier, the latter will be agreeable to purchase it at a

price fixed by him before hand.

Although both these options are available according to the principles of the

Shar’iah, the second option does not seem to be feasible for the financier, because

it would lead to injecting new partners in the Musharakah which will disturb the

whole arrangement and defeat the purpose of diminishing Musharakah in which

the financier wants to get his money back within a specified period. Therefore, in

order to implement the objective of diminishing Musharakah, only the first option

is practical.

Carried out in some Islamic Banks. Total number of questionnaires was 15 out of

which 10 were being fit for the analysis. These questionnaires given me the idea

about Musharakah financing and to know its challenges in the market each graph

shows the contents of Musharakah financing.

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Analysis of Musharakah Financing

6HIGLITES:

Introduction.Analysis of

Questionnaires.

Conclusion and proposed strategy:

Establishment of legal structure suitable to Islamic modes of financing

Changing economic policies .

Managing the change.

Introduction:

This chapter contains a discussion of the

Musharakah Financing and its challenges in the

market. This discussion is aimed at introducing

Musharakah as a modern mode of financing without

violating its basic principles in any way. A new form

or procedure in Musharakah cannot be rejected

merely because it has no precedent in the past. In

fact, every new form can be acceptable to the

Shariah in so far as it does not violate any basic

principle laid down by the Holy Quran, the Sunnah

or the consensus of the Muslim jurists. Therefore it

is not necessary that Musharakah be implemented

only in its traditional old form.

It is hoped that this brief discussion will open new

horizons for the thinking of Muslim jurists and

economists and may help implementing a true

Islamic economy.

ANALYSIS OF QUESTIONNAIRES

This questionnaire is designed for the customers who are interested in

Musharakah financing. This activity is carried out. Carried out in some Islamic

Banks. Total number of questionnaires was 15 out of which 10 were being

fit for the analysis. These questionnaires given me the idea about

Musharakah financing and to know its challenges in the market each graph

shows the contents of Musharakah financing.

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1. Are the Islamic banking products satisfying the needs of the market?

No. Of respondents

Agree Disagree Highly agree Neither agree nor disagree

20 7 11 2 -

Percentage 60% 15% 25% -

According to market survey 60% are agree with the statement, while 15%

those who are disagree they say that there are lots of challenges or Islamic

banks to survive in interest based economy.

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2. Are the Islamic banks facing practical problems in musharakah financing? Especially in the present atmosphere where Islamic banks are working in isolation, and mostly without the support of their respective government.

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 10 6 4 –

Percentage 50% 30% 20% –

According to survey 70% people are strongly agree with this statement. There are

lots of challenges for Islamic banking. Which include unawareness? Conventional

banks. Legal framework. etc

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3. The bank and its depositors face high risk when the bank invests in Musharakah financing?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 03 14 1 02

Percentage 15% 70% 5% 10%

This answer is doubtful because 70% are disagree with the statement that

musharakah financing is secure mode of financing. But 20% agree thinks that

there lots of risk involved because banks must share profit as well as losses.

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4. In your opinion is the business community in general aware of Musharakah financing product?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 05 12 0 03

Percentage 20% 60% 0% 15%

This shows that banks knows that people are unaware of there financing modes.

But many bankers think that people are aware of musharakah financing, but banks

are not doing musharakah financing because of risks involved.

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5. By availing Musharakah financing the customer has to disclose all his business inside info, the business community is willing to disclose it?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 4 15 1 0

percentage 20% 75% 5% 0%

Bankers are agree with the statement hat costume are willing to disclose there

business info, but some of them says that there is no such customer who wants to

disclose his business info. They give us fake balance sheet just for the sake of tax

exemption.

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6. Do the Islamic banks have sufficient and well trained staff?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 7 13 0 0

Percentage 35% 65% 0% 0%

With this survey we came to know that banks don’t have enough well trained staff

to deal the Islamic modes of financing, because in Islamic bank is new in market

and people that they have mainly belong to conventional back ground.

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7. Is there proper monitoring system available with the banks so as to manage the Musharakah transactions?

No of respondents Agree Disagree Highly agree Neither agree nor disagree

20 10 3 7 0

percentage 50% 15% 35% 0%

This survey shows that banks don’t want to disclose there secrets that is why they

say that they have proper monitoring system. But in reality proper monitoring

system is a big problem for Islamic banks.

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8. The core purpose and aim of the bank is to make profit on its invested money. Keeping this in mind if the business were to make a genuine loss, will the bank equally share in its losses?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 2 0 15 3

Percentage 10% 0% 75% 15%

With this question all concerned people said that Islamic banking is a name of

profit and loss. And they always share profit as well as loss. But again some them

said that still Islamic banks haven’t seen a loss case.

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9. Especially in Pakistan the customers have a general destructive and default trend. Will the Islamic banks be able to manage this risk while still remaining true to the sharia’h principles?

No. of respondents Agree Disagree Highly agree Neither agree nor disagree

20 4 10 0 6

Percentage 20% 50% 0% 30%

All concerned people are agree with this statement that it is very difficult to

survive in this kind of customer trend. But that said that with the introduction of

privatization the default trend percentage is now very low.

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10. The future of Musharakah financing is bright in Pakistan and will it have a positive impact on the profitability and management of the businesses in particular and the economy as a whole.

No of respondents Agree Disagree Highly agree Neither agree nor disagree

20 5 3 10 2

Percentage 25% 15% 50% 10%

all of the bankers said that we see a very bright future of Islamic banks

and as well as musharakah financing. And it the economy of Pakistan

will change and it will have a positive impact on our economy.

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CONCLUSION AND PROPOSED STRATEGY

Should it be concluded that since there had been no success in eliminating interest

from the economy in the past, we shall also not succeed and hence we should try

to live with it ?no. this would be a defeatist answer. The main point of the

argument is that in the past people tried to eliminate interest through a legal

decree. They did not succeed. Trying to do so now would also not succeed. Now

there is need to re think about the re evaluation of the strategy and that is proposed

under the following main heads:

1. Establishment of legal structure suitable to Islamic modes of financing

2. Changing economic policies

3. Managing the change.

Establishment of legal structure suitable to Islamic modes of financing:

If we have to eliminate interest from the economy, we need to create an

alternative system of finance. There is no disagreement on this. It is proposed that

instead of creating a law to prohibit interest, we should concentrate in creating an

alternative system of finance, which should freely compete, with the interest based

system. Only through free transactions, and based on results of its operations,

people should freely decide to adopt the Islamic system and discard the interest

based system. The interest based system should become redundant through a

voluntary process of human behavior rather than through enforcement of law.

Muslim scholars have done commendable research in proposing an alternative

basis of Islamic finance. Some of the more popular modes of finance and

investment are:

Murabahah, modarabah, musharakah, ijarah, ijarah wa iqtina, bai salam, bai

istisna. There are several variations, combinations and permutations of these

modes. A lot of valuable work has also been done in financial instruments

engineering. The appropriate approach would be to create a legal infrastructure

that defines the rights and obligations of various parties under each type of

transactions, the people should have certainly and confidence in the system. The

judicial system should provide all the assurance that dealing in Islamic finance

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would not lead to under risk, fraud, or deception. The system of Islamic finance

should operate side by side with the interest based system. It would generate a

genuine compaction among the two systems. It would be possible for the Islamic

system to demonstrate, if it is really a better system, with the result that dealing in

Islamic finance makes economic sense. It would be at that stage that people would

no longer appended crutches of creating Islamic system first and then abolishing

interest .the result would attract people and it would not be necessary to be a

Muslim for benefiting from the Islamic system. For this reason, we believe the

probability of success elimination of interest from economies where the two

systems are operating side by side in higher is higher than where it is being

attempted as a global solution. Need not be said that the state bank of Pakistan

should act as a regulator of Islamic financial institutions, as it is a regulator for

conventional banks.

CHANGING ECONOMIC POLICIES

For eliminating interest through as economic process, rather than by a legal

decree, we need to make several changes in our economies. The objective of

change would be to reduce the rate of interest to zero without interfering

artificially with free market forces. The discussion below is only indicative of the

direction that the economy should take in actual practice; the question is: what are

those economic changes that would help reduce the rate of interest gradually until

it withers away as an economic factor? Some tentative are as follows:

One of the elements in the rate of interest is the compensation to cover the debt

risk. The market conditions should be regulated in such a manner that the

phenomenon of bad debt is minimized. Bad debt is complex issue. Bad debts take

place due to several reasons such as dishonesty, natural calamities, sudden market

down turns due to innovations, business failure due to bad management, etc. the

objective of economic planning should be to curtail the possibilities of bad debts.

Necessary legal as well as economic changes would be required to create

circumstances for overcoming business failures. Perhaps we can never create

circumstances where business would not fail. But if we are able to reduce this risk

the rate of interest would come down;

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One of the reasons for interest to sustain in the economy is the dearth of lent

funds. if we are able to increase the size of savings, we can increase the size of

lent funds. Again, saving are a functions of a whole lot of factors such as income

level, transaction needs, emergency needs and investment needs of the savers. The

distinctive feature of Islamic teaching is that it attaches a very high value to

simple and frugal living. For increasing the level of income people will need to

bring changes in there lifestyles. Simple and contended living can help. In this

area, Islamic teaching can provide a good base.

The supply of lent funds can also be increased by suitable monitory policy

measures, such as reducing the reserve requirements by the central bank. This by

it self is linked to prudential requirements of the bank

One the reason that interest is sustaining in the economy is that people with fixed

incomes, pensioners, widows, and other low income group need a risk free return

on their savings. Abolishing interest by a law would hit them very hard. For this

purpose, we need to strengthen the system of social security and income

maintenance. Some of the measures in this area would be:

Reviewing the pension system of government employees, enabling them to

contribute to pension funds which are during there active service enabling the

employee to get pension at a higher then what the government can pay. This

would require a good deal of actuarial work and also a suitable climate for

investment of funds.

Reviewing the provident fund system on lines suggested above in the case of

pension funds.

Creating the infrastructure for providing a house on ownership basis by the time a

person retires from the job. This type of scheme is in vogue in the Pakistan

defense forces and can be expended with some initiative and skill. Streamlining

zakath and other social system so that the poor people do not have to depend on

interest income. In stead, they should be able to make a living through finance. An

important feature of this policy should be to rehabilitate the poor rather than on

continues charity.

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Ensuring an effective system of distribution of inheritance can also help. This

would require an effective implementation of laws, especially, in favor of women

and minor orphans.

Land reforms for empowering the landless. It would require major legal and social

changes to enable poor people to sustain through land cultivation rather then

looking up to interest income.

The limited liability of the debtor increases risk of debt of the lender since the

lender’s position is insecure in case of default. The lender would like to cover then

selves against this risk. Therefore, they add a premium to the interest rate for this

risk as well. If we have to eliminate interest from the economy, we should also do

away with the concept of limited liability. This would lead to reduction in the

market rate of interest from two sides. Firstly it would reduce the risk of the loan

for the lenders. They would have a greater assurance of recovery of there

principal. Thus they would not need to add premium to cover this risk. Secondly

the debaters have the tendency of contracting loans recklessly. Such a tendency

would be put to rest. As a result the demand for lent funds would be reduced. This

would also lead to a reduction in rate of interest.

The credit risk is of two types: debtor-specific and system-specific. The debtor-

specific risk refers to specific circumstances of a debtor, or his capability to pay

back the debt. The system-specific risk refers to the environment and condition of

the economy, both internal and external. Example are inflation, exchange rate

fluctuation, trade-deficit, technological changes leading to business slump in a

certain industry, etc. if an economy has to reduce or eliminate interest, it must

adopt such policies as would reduce the system-specific risk to lenders. The

debtor-specific risk perhaps cannot be reduced by any state policy. This would

always remain a concern of the debtor.

A decline in interest rate forces the capitalist to search for better opportunities. It

persuades them to look for opportunities in real sector and they are tempted to

undertake equity investments. An evidence of this phenomenon can be seen in the

increased inflow of FDI during 1090’s. one of the reasons for such increase in FDI

was a general decline in the international interest rates. It made business

opportunities in the developing countries more attractive to the investors. There

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for once the rate of interest goes sufficiently low. It would make the investors

think for other options. This would discourage investment on interest. In stead, the

investors would be tempted to look for non-interest based real sector-based

options. Thus lowering of interest rates would set in motion a benevolent cycle,

which could reinforce itself.

The environment for FDI has become extremely favorable. Over the years, the

FDI has increased several folds. The reason is that the average return from FDI

has been higher then from investments on interest. It shows that no amount of

legislative changes would do as much as the sheer profit motive can do. So long as

it is more profitable to invest in business, people would need to invest on the basis

of equity-participation.

There are four reasons for changing interest in the capitalist system: a) inflation;

b) risk; c) administrative expenses of the lender; d) pure interest as return for

following use of the money. So far as first two are concerned, proper economic

policies and regulatory and legal frame work need to be developing to reduce

them to zero. Once we are able to reduce the risk to the lender to zero, he cannot

claim return on his money due to the risk ness of the loan. Similarly, if we are able

to bring down inflation to almost zero, the claim for interest does not remain

legitimate. The administrative cost to the borrower remains a legitimate claim.

Almost all Islamic economists accept that the banks can demand for service

charges for providing various services to the borrower. But they should not be

related to time or the principal sum lent. They can and should be equal to the cost.

They should no be a source of earning profits. Once we are able to take care of

three things the rate interest would be reduced to the pure rate of interest, this rate

would have to compare with return on investment on the basis of equity. In all

probability, so far as the empirical evidence goes, the return on equity would be

higher than the rate of interest. Interest would become unattractive for everybody.

At present the taxation accept the interest as an admissible expense while treat

profits to be distributed as dividends as taxable income of the companies. As

result there is an incentive for the companies to borrow money on interest and

reduce there tax burden. This is a negative incentive for investment on equity

basis. If we aim discouraging investment on interest the incentive need to be

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reversed. The interest to be paid should be made taxable and profit to distribute

should be exempted from tax However we can make the dividend taxable as part

of the income of the recipients. The interest earning of the individuals and

corporations should be taxed heavily. And tax rebate should be given to the

dividend income. It will discourage people to invest in interest-bearing assets. At

the same time people will be encouraged to place their saving in equities.

MANAGING THE CHANGE

Elimination of the interest from economy would change a large number of

economist relationship. It would require a care full strategy for managing the

change. The government has already established a permanent commission fro the

islamization of the economy. One of the primary mandates of the commission is to

eliminate interest from the economy. But the commission needs to be

strengthened. All its members including chairmen are working as an additional

responsibility of their full time jobs. For example, the chairmen are the minister of

religious affairs. This is a large ministry within the federal government. Similarly

other members are busy in there respective jobs and attend the meeting of the

commission on request. Thus the mechanism to bring such change is best part

time institution. Of course, the commission has a secretariat but it provides

secretarial support and is not responsible for any actual formulation. We would,

therefore suggest that a permanent commission should de established with proper

legal support and full time members to act as a conduit between the actual

execution and the over all over sight by the parliament. Before we discuss the role

and functions of the commission, we would like to emphasize the need for a

comprehensive legal framework for implementing alternative modes of financing

and not for prohibition of interest.

CONCLUDING REMARKS

Elimination of interest from the economy is no wholly a legal process. Even if

pass a law to abolish it, it will not wither away. Economic compulsions would

sustain it, even though as black-market phenomenon. If we have to abolish

interest, we would need to create such economic conditions that would make

interest redundant. It means that at the end of the day it should not be in the self-

interest of the people to deal in interest. The interest based transaction should be

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more expensive as compare to equity based transactions. So it should be a mark

based solution.

The dilemma of an ordinary is that he is not fully developed and reliable to the

systems of Islamic finance. Any threat to prohibit interest without creating an

Islamic infrastructure runs fear-awes in the hearts of ordinary people. The

appropriate strategy should be to develop Islamic alternatives and make more

option available. Let interest remain an option for people. People should decide

for themselves to abandon it with their free will. They should not be forced to do

so.

Try to eliminate interest from economy through a legal decree is effective

restricting the individual freedom to decide about his financial behavior. This

scarifies of freedom should have adequate incentives for individual. The Islamic

finance should operate in economy and get matured. It should create sufficient

economic incentives for the people foe persuading them to forgo their freedom to

deal in any way they like. The elimination of interest from the economy should be

made effective through as educational process. The government can play a

leadership role by providing necessary incentives in its various policies and by

adopting interest free transactions in its own business. The legal system should

continue supporting the interest-based transactions till the majority of the financial

transactions in the economy are based on Islamic rules. The claims about

superiority of the Islamic finance should be put to real empirical test and people

should experience it. Islamic fiancé should not be adopted on the crutches of law.

However, law should support the Islamic financial transactions sit is supporting

the interest-based system.

One of the implicit advantages of this approach would be that Islamic finance

would compete with interest-based finance. The competition would enable the

alternative system to refine its self in due course of time. Infect, this is the natural

approach for system to take roots.

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CONCLUSION

Musharakah and Mudarabah are the basic methods by which financial resources

are mobilized and combined with entrepreneurial and managerial skills for

purposes of expanding long-distance trade and supporting crafts and manufacture.

They fulfill the needs of commerce and industry and enable them .to thrive to the

optimum level given the prevailing resource environment. These financial

instruments along with others mentioned in this chapter constitute an important

feature of both trade and industry and provide a framework for investment in a

modern Islamic Economy.

To sum up, an Islamic banking system is essentially an equity-based system in

which depositors are treated as if they were shareholders of the bank.

Consequently, depositors are not guaranteed the nominal value, or a

predetermined rate of return, on their deposits. If the bank makes profits then the

shareholder (depositor) would be entitled to receive a certain proportion of these

profits. On the other hand, if the bank incurs losses the depositor is expected to

share in these as well, and receive a negative rate of return. Thus, from the

depositor's perspective an Islamic commercial bank is in many respects similar to

a mutual fund or investment trust Furthermore, to remain consistent with religious

strictures, the bank cannot charge interest in its lending operations, but has to use

special modes of investment and financing that are also based on the concept of

profit and loss sharing business.

No doubt unit trusts and investment trusts are different The value of shares in an

investment trust is determined in the stock market directly. In the case of a unit

trust (e.g. the United States mutual fund) the value is based on a weighted basket

of the underlying shares which are traded in the market. With Islamic deposits, it

is not the market value which matters; there is none as they are not traded. Nor is

it the underlying value of the assets which the bank has invested in unless there

are deposits. What is important is the profitability of the investment Values of

shares do not always reflect profitability. Profit/earnings ratios can vary widely,

and the market accepts this. Similarity with unit trusts relates to the uncertainty

regarding both returns and the value of Islamic deposits. In practice however

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value seldom varies, which is not the case with unit trusts where it is determined

by the market. In general Islamic deposits are less risky than unit trust holdings.

Income oriented unit trusts are most easily compared to the Islamic deposits and

not those which are growth oriented. In this regard there is much confusion in the

Islamic literature on finance. Always reflect profitability. Profit/earnings ratios

can vary widely, and the market accepts this. Similarity with unit trusts relates to

the uncertainty regarding both returns and the value of Islamic deposits. In

practice however value seldom varies, which is not the case with unit trusts where

it is determined by the market. In general Islamic deposits are less risky than unit

trust holdings. Income oriented unit trusts are most easily compared to the Islamic

deposits and not those which are growth oriented. In this regard there is much

confusion in the Islamic literature on finance.

naturally both Musharakah and Modarbah require substantial trust between the

banks and their customers. If a bank acts only as a capital provider as in

Mudarabah or leaves all aspects of management to the customer in terms of

honesty, integrity, management and business skills. Equally problematic is the

aspect of monitoring and supervision. Musharakah in particular requires more

commitment and effort from the banks compared to other forms of financing as

the bank assumes business as well as credit risks. Given the fact that both

Mudharabah and musharakah are equity financing in character, collateral is not a

prerequisite.

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ISLAMIC BANKING BULLETIN

Islamic Banking Bulleting gives an overview of the Islamic Banking Industry of Pakistan and provides information regarding the developments taking place in the industry locally and internationally

Islamic Banking Sector

The Islamic Banking Sector continued to grow at a rapid pace which reflected by the increasing branch network of the Islamic Banking Institutions. Emirates Global Islamic Bank Limited started its operations on 16-02-2007. The network details can be seen at Annexure - I

Comparative Consolidated Balance Sheet (Rs. In million)

Description Dec06 Mar-07 Inc.(Dec.)Assets Cash and balances with treasury banks

15,266 15,505 2%

Balances with other banks 16,383 22,192 35%Due from financial institutions

5,602 8,382 50%

Investments 7,053 8,403 19%Financings 65,137 69,993 7%Operating fixed assets 2,518 4,079 62%Deferred tax assets 192 343 78%Other assets 6,031 6,745 12%Total assets 11,8183 135,641 15%Liabilities Bills payable 1,260 1,528 21%Due to financial institutions 6,547 6,462 (1%)Borrowings from head office 4194 5,743 37%Deposits and other accounts 83,742 93,068 11%Subordinated loans – –Liabilities against assets subject to finance lease

– 40

Deferred tax liabilities 491 832 69%Other liabilities 6,102 7,044 15%Total liabilities 10,2336 114,716 12%Net Assets 15,847 20,925 32%Represented By –Paid-up capital/ head office capital account

14,465 18,944 31%

Reserves 529 531 0%Unappreciated/ unremitted profit

756 860 14%

Sub total 15,750 20,334 29%Surplus / (Deficit) on revaluation of assets

97 590 59%

Equity 15,847 20,925 32%

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ANALYSIS OF THE CONSOLIDATED BALANCE SHEET

The Balance Sheet footing of the Islamic Banking Industry increased

during the past quarter. The total assets portfolio in the Islamic

Banking Sector expanded by 15% to Rs. 135,641 million in March

2007 from Rs. 118,183 million in December 2006.

Financings constituted 52% of the total assets and stood at Rs. 69,993

million in March 2007 as compared to Rs. 65,137 million at the end

of December 2006, showing an increase of 7%.

There was a substantial increase in “Balances with other banks”.

Balances held by Islamic Banking

Institutions at the other Banks increased by 35% to Rs.22,192 million

from Rs.16,383 million, mainly due to introduction of new players in

the market , increased liquidity with IBIs and non availability of

Shariah Compliant government securities.

Deposits increased by 11 % to Rs. 93,068 million as at the end of

March 2007 from Rs. 83,742 million at end December 2006.

Islamic Banking Sector’s equity increased by 32% to Rs. 20,925

million as of March 2007 from Rs.15,847 million at the end of

December 2006. Reasons for this increase are:

A new full fledged Islamic Bank started its operations in February

2007 by the name of Emirates Global Islamic Bank Pakistan

contributing to an increase in equity by Rs. 2,895 million.

Minimum Capital Requirement for conventional banks also applies to

Islamic Banking Institutions in Pakistan because of which the equity

of Islamic Banking Institutions has increased in the first quarter of

2007.

Booking of quarterly profits by the banks.

Unappropriated / unremitted profit as at the end of quarter (March

2007) increased by 14% to stand at Rs. 860 million in comparison to

the previous quarter’s figures of Rs. 756 million.

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INDUSTRY PROGRESS AND MARKET SHARE

Description March07 Dec-06 Dec-05 Dec-04 Dec-03

Total assets 136 118 72 44 13

%age of Banking Industry 3.2% 2.9% 2.1% 1.4% 0.5%

Deposits 93 83 50 30 8

%age of Banking Industry 3.0% 2.8% 1.9% 1.2% 0.4%

Financing & Investment 78 72 48 30 10

%age of Banking Industry 2.5% 2.4% 1.8% 1.3% 0.5%

Full Fledged Islamic Banks 5 4 2 2 1

Conventional Banks with Islamic Banking Branches

13 12 9 7 3

No. of Branches 170 150 70 48 17

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DEPOSITS

(Rs. in million)

Dec-06 March-07 Inc.(Dec.)

Deposits and other accounts 83,742 93,068 11%

A) Customers

Fixed deposits 30,444 35,767 17%

Savings deposits 21,371 24,754 16%

Current accounts – Non Remunerative 18,282 18,681 2%

Others 881 924 5%

Total of A 70,978 80,127 13%

B) Financial Institutions

FI-Remunerative Deposits 12,752 12,872 1%

FI-Non-Remunerative Deposits 12 69 49%

Total ofB 12,764 12,942 1%

Particulars of Deposits

In Local Currency 77,896 86,797 11%

In Foreign Currency 5,846 6,272 7%

Total 83,742 93,068 11%

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MODES OF FINANCING

(Rs. in million)Dec-06 March-07 Inc.(Dec.)

Murabaha 26,506 28,961 9%Ijarah 19,634 20,956 7%Musharaka 533 583 9%Mudaraba – – –Diminishing Musharaka 10,598 12,313 16%Salam 465 583 25%Istisna 900 400 (56%)Qarz/Qarz-e-Hasana 7 8 6%Others 7,100 6,867 (3%)Total 65,742 70,671 7%Amount of Non-performing financing 820 808 (1%)Provision against non-performing financing 605 678 12%Net Non-performing financing 215 130 (40%)Gross financing 65,742 70,671 7%Total number of borrowers / finances 22,243 24,322 9%

Murahaba financing is almost 40% of the total financing by the IBI’s

as of the quarter ending March 2007.

Second most widely used mode of finance is Ijarah financing

accounting for about 30% of the total financing.

Growing interest in diminishing musharakah is depicted representing

17% of the total financing.

The total number of borrowers increased by 9% over the previous

quarter

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RATIO ANALYSIS

Earning and Profitability Dec-06 Mar-07

Mark-up Income to Total Assets 5.4% 7.4%

Mark-up Expense to Total Assets 3.0 4.1%

Net Mark-up Income to Total Assets 2.4 3.3%

Non Mark-up Income to Total Assets 0.9 1.0%

Non Mark-up Expense to Total Assets 2.4 3.2%

Net Mark-up to Gross Income 72.8 76.5%

Non Mark-up Income to Gross Income 27.2 23.5%

Operating Expense to Gross Income 73.1 23.5%

Assets Quality Ratio

NPPs to Financing 1.2 1.1%

Net NPPs Net Financing 0.3 0.2%

Net NPPs to Total Assets 0.2 0.1%

Provisions to NPPs 73.7 83.9%

Net NPPs to Total Capital 1.4 0.6%

The financial position of the Islamic Banking Industry is strong as

depicted by the ratio analysis.

Earning and Profitability Ratios have improved as compared to the

last quarter.

The asset quality ratios reflect that the quality of financing has

improved due to 1% decrease in Non-Performing Portfolios (NPPs)

coupled with 12% increase in provisions there against. Resultantly

NPPs to financing ratio has decreased being otherwise also low.

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DEVELOPMENTS AT ISLAMIC BANKING DEPARTMENT, STATE BANK OF PAKISTAN

Committee to develop the Vision of Islamic Banking Industry

A committee comprising Heads of Islamic Banking Institutions was formed

by State Bank in November 2006. The committee was mandated to identify

the challenges faced by the Islamic Banking Institutions and develop a

strategic plan for the Islamic Banking Industry in Pakistan . The Committee

has till date held 5 meetings and while its Working Group and Sub-

committee have held two meetings each. As a result of these meetings and

subsequent input from Islamic Banking Department of SBP, a brief

regarding the draft Strategic Plan for Islamic Banking Industry in Pakistan

is being prepared.

Draft Instructions and Guidelines for Shariah Compliance in IBI’s

To further strengthen the Shariah compliance framework in Islamic banking

industry, State Bank of Pakistan has prepared a draft of Instructions and

Guidelines for Shariah Compliance in IBIs. Comments on the Guidelines

have been sought from the Presidents/Head of Islamic Banking Divisions as

well as other Stakeholders.

Risk Management Guidelines for Islamic banking

To put in place an effective risk management framework for Islamic banks,

a Draft of Risk Management Guidelines was formulated by IBD, based on

“Guiding Principles of Risk Management for Islamic Financial Institutions”

issued by IFSB. These draft guidelines were placed on SBP Website for

comments from stakeholders in April 2007.

Adoption of Shariah Standards of AAOIFI

To bring harmonization and standardization in the practices and procedures

followed by Islamic Banking industry, Islamic Banking Department is

taking necessary steps for adoption/ adaptation of Shariah Standards issued

by Accounting and Auditing Organization for Islamic Financial Institutions.

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In order to study these standards for possible adoption/adaptation meetings

with the Shariah Advisors of the Islamic Banking Institutions are arranged.

Formation of Task Force for Islamic Agricultural Finance

Task Force for Islamic Agricultural Finance has been constituted which is

chaired by the Director, Islamic Banking Department and Co-chaired by

Director, Agriculture Credit Department. Senior Level Officials from

Commercial and specialized banks have been nominated to be the member

of this task force. TORs of Islamic Agricultural Taskforce, are:

Purpose of this task force is to evaluate possible modes and product

for introduction of Shariah compliant Agricultural Finance products

as well as selection of appropriate channels of distribution of the

proposed products.

On the basis of recommendations of the Task Force, Islamic Banking

Department will formulate “Guidelines for Islamic Agricultural

Finance” to facilitate Shariah compliant agricultural financing in the

market.

Establishment of Team to Conduct Impact Study on IFSB Capital Adequacy Standard

In order to conduct an impact study on IFSB Capital Adequacy Standard for

its adaptability in Pakistan, a team has been formed in State bank of

Pakistan.

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http://www.islamic finance.org/about/faq08.html

http://www .meezanbank.com.pk

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