Project Report - Islamic Finance
92
Islamic Financing AN ALTERNATE FINANCING TECHNIQUE SAHEEBA SABAKKA
description
A Project report on Islamic Finance, which touches every aspect of Islamic finance
Transcript of Project Report - Islamic Finance
Islamic Financing AN ALTERNATE FINANCING TECHNIQUE
SAHEEBA SABAKKA
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ISLAMIC FINANCING AN ALTERNATE FINANCING TECHNIQUE
A PROJECT REPORT
Under the guidance Of
Mrs. Neena P. G
Submitted By
SAHEEBA SABAKKA
Roll No. 510915516
In partial fulfillment of the requirement
For the award of the degree
Of
MBA
in
FINANCE
DEC 2010
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ACKNOWLEDGEMENT
I express our deepest gratitude to our Advisor and Counselor Mrs. Roshini P. K, for her invaluable guidance and blessings.
I am very grateful to our Principal and Head of Department Mr.
Vinod C. T for providing with an environment to complete this project
successfully. I especially thank Project Coordinator Ms. Neena for all
the support she had extended to complete the project.
I express our sincere thanks to Mr. H. Abdul Raqeeb Jeneral
Secretary ICIF, for his constant encouragement and support throughout
the course of the project. I am immensely grateful to Mr. Abdussalam
K. M Trustee ICIF, for his unwavering support throughout the entire
course of the project. I would also like to thank all the staff at ICIF who
have co-operated with me for the completion of this project.
I would also like to thank Ms. Gopika and all other staff at
Mercy Institute of Technology who have extended their help and support
throughout the project.
Finally, I take this opportunity to extend our deep appreciation to
our family and friends, for all that they meant to us during the crucial
times of the completion of our project.
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BONAFIDE CERTIFICATE
Certified that this project report titled “ISLAMIC FINANCE” is the
bonafide work of “SAHEEBA SABAKKA” who carried out the project
work under my supervision.
SIGNATURE SIGNATURE
Vinod C. T Neena P. G
HEAD OF THE DEPARTMENT FACULTY IN CHARGE
MBA MBA
Mercy Institute of Technology Mercy Institute of Technology
Punnathoor Rd. Punnathoor Rd.
Puthanpally (P. O) Puthanpally (P. O)
Guruvayur – Thrissur Guruvayur - Thrissur
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EXECUTIVE SUMMARY
Uncontrolled capitalism has caused the global economy into a plunge into
an unprecedented crisis. Adding to the distress, economists worldwide are
expecting the global economy to experience a double dip in the near
future. This calls in for a need for eradicating huge bubbles of fiat money
and assets brought in by capitalism and build up a real and stable
economy.
In this project, we try to study Islamic banking and financing as an
alternate mode of financing as a remedy. In the wake of crisis, world has
slowly started to shifting to this alternate financing model which offers a
wide range of complexly engineered tools viz., Mudaraba, Murabaha,
Musharaka, Istisna, Musaqat, Ijara and a lot more as has been discussed
in the upcoming chapters. Salient features of each have also been
studied.
Though Islamic financing has been creating waves in the global
economy, it is yet to unveil in our much potential Indian economy, owing
to its non-consonance with the prevailing provisions of Banking
Regulations Act. Even though remedies are available as has been studied
in the project, our Central Bank is yet to sanction this model of financing
which promises a new era of bright future for Indian economy.
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TABLE OF CONTENTS
1. INTRODUCTION
1. 1 An Introduction to financial system
1.1.1 Importance of financial system
2.1 Islamic financial system
2.1.1 Need for Islamic banking
2. ISLAMIC FINANCE
2.1 Basic Tenets of Islamic Banking and Finance
2.1.1 Riba
2.1.2 Gharar
2.1.3 Zakaat
2.1.4 Haram
2.2 Principles of Islamic Banking
2.2.1 Prohibition against the payment and receipt of a fixed
or pre- determined rate of interest
2.2.2 Sharing risks and rewards
2.2.3 Permissible forms of businesses
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2.2.4 Making money from money is not acceptable
2.3 Islamic Financial Institutions
2.3.1 Islamic Banking
2.3.2 Islamic Insurance (Takaful Institutions)
2.3.3 Investment Banking and Mutual Funds
2.4 Tools and Techniques of Islamic Financing
2.4.1 Murabaha (Cost plus Finance)
2.4.1.1 Steps in Murabaha
2.4.1. 2 Subject of Murabaha
2.4.1.3 Specification of price
2.4.2 Mudaraba (Trustee Finance Contract)
2.4.1 Participatory Financing
2.4.2 Preconditions of Mudaraba Contract
2.4.3 Restricted and Unrestricted Mudaraba
2.4.4 Two tier Mudaraba
2.4.5 Termination of Mudaraba
2.4.3 Musharaka (Joint Venture)
2.4.3.1 Different types of Musharaka
2.4.3.2 Diminishing Musharaka
2.4.3.3 Management of Musharaka
2.4.3.4 Termination of Musharaka
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2.4.4 Muzara’at and Musaqat (Agricultural Partnership)
2.4.4.1 Contracting Musaqat
2.4.4.2 Conditions of Musaqat
2.4.4.3 Termination of Musaqat
2.4.5 Ijara (Islamic Lease)
2.4.5.1 Basic Rules governing leasing
2.4.5.2 Types of Ijara
2.4.6 Qard Hassan (Benevolent Loan)
2.4.6.1 Objectives of Qard Hassan
2.4.6.2 Conditions of Qard Hassan Transaction
2.4.6.3 Application of Qard Hassan
2.4.7 Salam or Bai’ Salam (Forward Contracts)
2.4.7.1 Conditions of Salam
2.4.8 Takaful (Islamic Insurance)
2.4.8.1 Principles of Takaful
2.4.8.2 Modules under Takaful
2.4.8.3 Tabarru’ to eliminate Uncertainity
2.4.8.4 Issues in conventional Insurance
2.4.8.5 Distinguishing features of Takaful
2.4.9 Istisna
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2.4.9.1 Ways of effecting Istisna Sale Contract
2.4.9.2 Termination of Istisna
2.4.9.3 Istisna as a Deferred Payment Scheme
2.4.9.4 Application of Istisna
2.4.10 Sukuk (Islamic Bonds)
2.4.10.1 Difference between Sukuk and Conventional
Bonds
2.4.10.1 Features of Sukuk
2.4.10.2 Uses of Sukuk Funds
2.4.10.3 Types of Sukuk
2.5 Functioning of Islamic Banks
2.5.1 Current Accounts
2.5.2 Savings Accounts
2.5.3 Investment Accounts
2.5.3.1 Equity Fund
2.5.3.2 Ijara Fund
2.5.3.3 Commodity Fund
2.5.3.4 Murabaha Fund
2.5.3.5 Mixed Fund
2.6 Rise and Scope of Islamic Banking
2.6.1 History of Islamic Banking
2.6.2 Growth of Islamic Banking
2.6.3 Reasons for popularity of Islamic Banking
2.7 Viability of Islamic Finance in India
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2.7.1 Hurdles on the way of introducing Islamic Banking in
India
2.7.2 Risks inherent in Islamic Banking
3. CONCLUSION
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LIST OF TABLES
Table 1 : Financing Options for Capital Holders
Table 2 : Financing Options for Entrepreneurs
Table 3 : An Example of Payment Schedule under Musharaka
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LIST OF FIGURES
Figure 1 : Working of Mudaraba
Figure 2 : Bar Diagram showing Banking reach in India
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LIST OF ABBREVIATIONS AND NOMENCLATURE
SYMBOLS
1. Rs. Rupees
2. & And
3. % Percent
4. @ at the rate
5. $ Dollar
6. i.e that is
7. viz namely/ that is to say
ABBREVIATIONS
8. SRI Socially Responsible Investments
9. SSB Sharia’ Supervisory Board
10. QIB Qualified Institutional Buyers
11. LIBOR London Inter Bank Offer Rate
12. P/L Profit and/or Loss
13. ROSCA Rotating Savings and Credit Association
14. UK United Kingdom
15. PLS Profit Loss Sharing
16. IDB Islamic Development Bank
17. GCC Gulf Cooperation Council
18. OPEC Organization of Petroleum Exporting Countries
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19. USA United States of America
20. BRA Banking Regulation Act
21. RBI Reserve Bank of India
22. IPO Initial Public Offering
NOMENCLATURE
1. Sharia’ (shariah/sharia) Islamic Rules and Regulations
2. Riba Interest
3. Gharaar Uncertainity
4. Zakat Islamic tax
5. Haram Prohibitted/ Unethical
6. bai' bithaman ajil Sales wih advance Payment
7. nisab basic amount excepted out of tax or zakat
8. halal permitted/ encouraged
9. israf wa traf luxurious activity
10. Maisir gambling
11. Murabaha Cost-plus Financing
12. Mudaraba Trustee Finance Contract
13. Rabb ul Mal Owner of the capital
14. Mudarib Fund Manager
15. Mudaraba Al-Mutlaqa Restricted Mudararaba
16. Al-Muqayyada Restricted
17. Musharaka Joint Venture
18. Shirkat-ul-milk Partnership based on joint ownership
19. Shirkat-ul-‘aqd Partnership based on contractual
relationship
20. Shirkat-ul-Mufawadah full authority and obligation partnership
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21. Shirkat-ul-Inan restricted authority and obligation
partnership
22. Shirkat-ul-Wujuh goodwill/ credit worthiness partnership
23. Shirkat-ul-Abdan labor, skill and management partnership
24. Mazara'at and musaqat Agricultural partnership
25. Baligh Major/ Mature
26. Ijara Islamic lease
27. Ijara Thumma Al- Baai Hire Purchase
28. Ijara Wa Iqtina A form of Islamic lease
29. Qard Hassan Benevolent Loan
30. Aqil person with sound mind
31. Rashid person capable of sound judgment
32. Ijab offer
33. Qabul acceptance
34. Sanduq Box
35. Amana/Wadia Pure Deposit
36. Salam Forward Contract
37. Bai’ Salam Forward Contract
38. Takaful Islamic Insurace
39. Ra’s ul Mal Islamic Insurance Contributions
40. Retakaful Reinsurance
41. Wakala Islamic Agency Insurance
42. Tabarru’ Contract in writing in Takaful
43. Istisna Manufacture Financing
44. Suku k Islamic Bonds
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AN INTRODUCTION TO FINANCIAL SYSTEM
A financial system is a system that allows transfer of money between
savers and borrowers. It normally comprises of a set of closely
interconnected financial institutions, markets, instruments, savers,
practices, transactions etc.
Financial system in the modern day serve as a channel through which
household savings are distributed to corporate sector for productive
utilization for the ultimate good, consequently, of the economy at large. It
allocates investment funds among firms, and allows inter temporal
smoothing consumption by household and expenditure by firms. In effect,
an efficient financial system is a tool of running the economy smoothly,
ensuring stability and growth.
Importance of financial system
• Provides framework for carrying out economic transactions and
monetary policies
• Helps efficiently channel savings to investments
• Sound financial system is essential for promoting economic
growth.
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Sound financial system can be considered as the back bone of a
prospering economy. A defective one could reduce effectiveness of
monetary policy and deepen or prolong economic downturn. It creates a
capital flight ( or large fiscal costs related to rescuing troubled institution)
on a large scale. To add to it, in the modern liberal world scenario,
weakness of one country can rapidly spill over across national borders
and result in a global economic slump as we’ve seen in the recent past.
That is to say, a sound financial system is essential for the domestic as
well as the countries those that have trade or financial linkages with the
country concerned.
Thinkers of the recent and ancient past have devised several forms of
financial system to keep large economies on its heels. The most popular
of them are capitalistic and communist system of finance, both of which
in the present scenario have proven to fail on account the unprecedented
economic crisis that the planet plunged into.
This situation calls out for a need for alternative financial system for a
healthy and sustainable global economy. Islamic finance is an answer to
that quest.
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ISLAMIC FINANCIAL SYSTEM
Islamic finance is based on principles of shariah, or “Islamic law.” Major
principles of shariah are a ban on interest, a ban on uncertainty,
adherence to risk- sharing and profit sharing, promotion of ethical
investments that enhance society, and asset backing. The international
market for Islamic finance has grown between 10% to 15% annually in
recent years. Islamic finance historically has been concentrated in the
Persian Gulf countries, but has expanded globally to both Muslim and
non-Muslim countries. There is huge and growing market potential for
Islamic finance in the India. Through international and domestic
regulatory bodies, there has been effort to standardize regulations in
Islamic finance across different countries and financial institutions,
although challenges remain.
Islamic banking is essentially banking in consonance with the ethos and
value system of Islam and governed in addition to the conventional good
governance and risk management rules, by principles laid down by
Islamic law, Shariah. It is, however, not confined to interest free banking,
which is a narrow concept. In addition to non-acceptance of interest-
based transactions, the fundamental tenet is that of fairness. It envisages
ethical practices, contributions towards a more equitable distribution of
income and wealth and active participation in achieving the goals and
objectives of an Islamic economy.
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The history of non-interest banking in its present day incarnation is of
recent origin. In the second half of the 20th century, efforts were made to
adopt Islamic finance in Egypt. It slowly spread to Middle East and then
to other parts of the world. Today approximately 700 registered Islamic
finance institutions are said to exist covering 51 countries. The annual
growth rate of Shariah compliant assets is more than 15% on year-to-year
basis. At this rate, it is the world’s fastest growing financial sector and is
becoming an increasingly important component of the international
financial system.
Need for Islamic Banking
The collapse of major Wall Street institutions, notably Lehman Brothers,
and the subsequent global financial crisis and economic recession,
Islamic banking is seriously being considered and has emerged as a
possible alternative to the conventional banking because of the following
reasons:
• It is based on Ethical and Socially Responsible Investments (SRI)
• It aims at Equity and Justice and leads to poverty alleviation
• It acts to new imension to assets andactual projects aiming to
support real economic growth instead of financial engineering
• It provides services to under banked populations ignored by
conventional banks
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BASIC TENETS OF ISLAMIC BANKING AND FINANCE
The basic tenets of Islamic banking and finance can be put down as
under;
1. Prohibition of interest-based (riba) transactions;
2. Ban on speculation and excessive risk taking (gharar);
3. Islamic tax system (zakat);
4. Discouragement of the production of goods and services which
contradict the value pattern of Islam (haram)
Riba
Perhaps the most far reaching of these is the prohibition of interest (riba).
The payment and acceptance of riba, which are the fundamentals of
conventional banking system is explicitly prohibited in Islamic banking
and thus investors must be compensated by other means. Technically,
riba refers to the addition in the amount of the principal of a loan
according to the time for which it is loaned and the amount of the loan.
While earlier there was a debate as to whether riba relates to interest or
usury, there now appears to be consensus of opinion among Islamic
scholars that the term extends to all forms of interest.
In banning riba, Islam seeks to establish a society based upon fairness and
justice. A loan provides the lender with a fixed return irrespective of the
outcome of the borrower's venture. It is much fairer to share the profits
and losses. Fairness in this context has two dimensions: the supplier of
capital possesses a right to reward, but this reward should be
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commensurate with the risk and effort involved and thus be governed by
the return on the individual project for which funds are supplied.
Hence, what is forbidden in Islamic precepts is a predetermined return.
The sharing of profit is legitimate and that practice has provided the
foundation for Islamic banking.
Gharar
Another feature condemned by Islamic banking is economic transactions
involving elements of speculation, gharar. Buying goods or shares at low
price and selling them for higher price in the future is considered to be
illicit. Similarly an immediate sale in order to avoid a loss in the future is
condemned. The reason is that speculators generate their private gains at
the expense of society at large.
Under this prohibition any transaction entered into should be free from
uncertainty, risk and speculation. Contracting parties should have perfect
knowledge of the counter values intended to be exchanged as a result of
their transactions. Also, parties cannot predetermine a guaranteed profit.
This is based on the principle of 'uncertain gains' which, on a strict
interpretation, does not even allow an undertaking from the customer to
repay the borrowed principal plus an amount to take into account
inflation. The rationale behind the prohibition is the wish to protect the
weak from exploitation. Therefore, options and futures are considered as
un-Islamic and so are forward foreign exchange transactions because
rates are determined by interest differentials.
A number of transactions are treated as exceptions to the principle of
gharar: sales with advanced payment (bai' bithaman ajil); contract to
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manufacture (lstisna); and hire contract (jIara). However, there are legal
requirements for the conclusion of these contracts to be organized in a
way, which minimizes risk.
Zakat
A mechanism for the redistribution of income and wealth is inherent is
Islam, so that every Muslim is guaranteed a fair standard of living, nisab.
An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning
"pure") is the most important instrument for the redistribution of wealth.
This tax is a compulsory levy, one of the five basic tenets of Islam and
the generally accepted amount of the zakat is one fortieth (2.5 per cent) of
Muslim's annual income in cash or kind from all forms of assessed wealth
exceeding nisab.
Every Islamic bank has to establish a zakat fund for collecting the tax and
distributing it exclusively to the poor directly or through other religious
institutions. This tax is imposed on the initial capital of the bank, on the
reserves, and on the profits as described in the Handbook of Islamic
Banking.
Haram
A strict code of 'ethical investment' is prescribed and hence it is forbidden
for Islamic banks to finance activities or items forbidden in Islam, haram,
such as trade of alcoholic beverage and pork meat. Investments should
only support practices or products that are not forbidden or even
discouraged by Islam.
Islamic banks are required to give priority to the production of essential
goods which satisfy the needs of the majority of the Muslim community,
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while the production and marketing of luxury activities, israf wa traf is
considered as unacceptable from a religious viewpoint.
In order to ensure that the practices and activities of Islamic banks do not
contradict the Islamic ethical standards, Islamic banks are expected to
establish a Sharia Supervisory Board, consisting of Muslim
jurisprudence, who act as advisers to the banks.
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PRINCIPLES OF ISLAMIC BANKING
Islamic banking has its own unique principles that clearly distinguish it
from the rest of the financial system. Principles of Islamic banking and
finance are largely value based and as per the guidelines prescribed by
the sharia law. These principles form the basis for the tools and
techniques of Islamic financing.
Prohibition against the payment and receipt of a fixed or pre-
determined rate of interest
The essential feature of Islamic banking is that it is interest free. Islam
prohibits Muslims from taking or giving interest regardless of the purpose
for which such loans are made and regardless of the rates at which
interest is charged. However, 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 does not allow the factor to make a prior or pre-
determined claim on the productive surplus in the form of interest. Islam
allows the owners of capital a share in the surplus, which is uncertain.
Profit sharing permissible in Islam, while interest is not, as in the case of
the former, it is only the profit sharing ratio, not the rate of return itself
that is pre-determined.
Profit- making is acceptable in Islamic society as long as these profits are
not unrestricted or driven by the activities of a monopoly or cartel. Islam
deems profit, rather than interest, to be closer to its sense of morality and
equity because earning profits inherently involves sharing risks and
rewards. Profit making addresses the Islamic ideals of social justice
because both the entrepreneur and the lender bear the risk of investment.
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Thus the interest is replaced by profit and loss sharing arrangements,
where the rate of return on financial assets held in banks is not known
and not fixed prior to the undertaking of the transaction. The actual rate
of return can be determined only ex-post, on the basis of actual profits
accrued from real sector activities that are made possible through
productive use of financial assets.
Sharing risks and rewards
The prohibition of a risk free return and permission of trading makes the
financial activities in an Islamic set-up real asset-backed with ability to
cause 'value addition'. Islamic banking system is based oh risk sharing,
owning and handling of physical goods, involvement in. the process of
trading, leasing and construction contracts using various Islamic modes
of finance.
As such, Islamic banks deal with asset management for the purpose of
income generation. They will have to prudently handle the unique risks
involved in management of assets by adherence to best practices of
corporate governance. Once the banks have stable stream of Halal
income, depositors will also receive stable and Halal income.
Permissible forms of businesses
The forms of businesses allowed under Islamic banking include joint
ventures based on sharing of risks 8 profits and provision of services
through trading, both cash and credit, and leasing activities.
Though the apparent similarity between trade profit in credit sale and
Riba in loaning is not denied in literature, trade has been permitted and
Riba is prohibited. Profit has been recognised as 'reward' for (use of)
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capital and Islam permits gainful deployment of surplus resources for
enhancement of their value. However, alongwith the entitlement of profit,
the liability of risk of loss on capital rests with the capital itself; no other
factor can be made to bear the burden of the risk of loss. Financial
transactions, in order to be permissible, should be associated with goods,
services or benefits.
Besides trading, Islam allows leasing of assets and getting rentals against
the usufruct taken by the lessee. All such things/assets corpus of which is
not consumed with their use can be leased out against fixed rentals. The
ownership in leased assets remains with the lessor who assumes risks and
gets rewards of his ownership.
Making money from money is not acceptable
Money is only a medium of exchange, a way of defining the value of a
thing; it has no value in itself, and therefore should not be allowed to give
rise to more money, via fixed interest payments, simply by being put in a
bank or lent to someone else. The human effort, initiative, and risk
involved in a productive venture are more important than the money used
to finance it.
Muslim jurists consider money as potential capital rather than capital,
meaning that money becomes capital only when it is invested in business.
Accordingly, money advanced to a business as a loan is regarded as a
debt of the business and not capital and, as such, it is not entitled to any
return (i.e. interest).
Muslims are encouraged to purchase and are discouraged from keeping
money idle so that, for instance, hoarding money is regarded as being
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unacceptable. In Islam, money represents purchasing power which is
considered to be the only proper use of money. This purchasing power
(money) cannot be used to make more purchasing power (money)
without undergoing the intermediate step of conversion into kind; i.e. by
acquisition of goods and services.
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ISLAMIC FINANCIAL INSTITUTIONS
While the Islamic financial institutions started almost fifty years back, the
growth was slow in the early stages and it is a system, which is still
young, evolving and expanding in terms of innovation and geographical
location. It is estimated that as of now there are more than three hundred
Islamic financial institutions spread across both the Islamic and non-
Islamic countries. Some of the major forms of Islamic financial
institutions are;
a) Islamic Banking
Islamic banking is the most popular form of financial institution and it is
estimated to be into several hundred billion dollars. There are different
models of Islamic banking;
wherein the Islamic banking is a private institution with a traditional
conventional economy
a nationalized Islamic banking and third is the existence of both the
Islamic and conventional banking system running parallel
Many commercial banks have innovated and engineered new products,
which have led to their impressive growth. In traditional system, stress is
on efficiency and productivity, the basic thrust of an Islamic financial
system is ethical code of conduct with an underlying idea of equitable
and just distribution of resources to achieve an equitable society.
The concept of efficiency and productivity of resource comes later in this
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system. The islamic banking is currently undertake through two channels;
• Islamic banks and ;
• Islamic windows.
Islamic banks are purely based on Islamic principle and all their
operations are in conformity with sharia. Islamic windows are services
provided by the traditional commercial banks to Muslim customers who
engage in Islamic banking through exclusive window.
b) Islamic Insurance (Takaful Institutions)
Risk sharing and management is an important constituent of any financial
system. There are scholars who believe that insurance can never find
place in an Islamic financial system as a Muslim should be dependent
upon God and getting insured amounts to challenging the will of Allah.
But there is another school of thought, which believes that a Muslim
should take all precautions to mitigate the risk and then not worry about
the outcome and leave it to the wilt of Allah.
The traditional concept of insurance is considered to be Maisir
(gambling) and a contract, which has lot of gharar (uncertainty), Islamic
insurance is based on takaful wherein every person participating gives a
donation or tabarru, all these donations together constitute the fund from
which any participant that suffers a loss or damage gets reimbursement.
The balance amount, if any, left in the fund is returned back to the
participants.
c) Investment Banking and Mutual Funds
The conventional investment banking deals with raising capital for a
business either through sale of shares to the public or allotting the shares
to certain Qualified institutional Buyers (QIB). Investment banks also
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create venture capital funds wherein they provide seed capital for the
start-up business growth stages of the business.
An investment banker raises money through equity, debt and other
investments like derivatives. An islamic investment banker cannot deal in
debt instruments and derivatives. In case of equity and preference shares,
the majority of islamic scholars permit it on the ground that it involves
pro rata ownership of assets of the company. But the investment bankers
must deal with only those companies, which are engaged in sharia
compliant business.
Venture capital financing by investment bankers should be after fully
appraising and evaluating the venture, which will eliminate uncertainty
(gharaar) and therefore permissible. Investment in the form of
venture capital without analyzing the business proposition is outside the
preview of an Islamic investment banker as it has lot of uncertainty
involved in it.
Dealings in the secondary market by fund managers, which are purely
speculative in nature, are un-Islamic. The pre-condition for Islamic
mutual funds is that there can be no assured profits and the profits and
losses from the investment of the pooled funds will have to shared on a
pro rata basis.
Though this type of fund resembles a traditional mutual fund but the
funds have to be invested in a company only if it fulfills certain
conditions prescribed in the sharia laws.
One of these conditions for the company is that its principal business
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must be halal that is, it should not be dealing in business like pork selling,
liquor, gambling.
Secondly, the company should not be using debt, in other words having
no borrowed money on which it is paying interest and it should not be
keeping its money in a bank, which pays interest on these deposits.
These two conditions, especially the second one about interest on
deposits and borrowings make it almost impossible for the followers of
Islam to invest their money in stock markets through pooled funds.
However, certain scholars have advocated that if the business of the
company is halaal and it is a zero debt company and it receives a small
amount from its deposits with banks, then if an investor who receives
dividends, gives away that part of the dividend which is attributable to the
interest on deposits, then such income will be considered ha1al.
Thirdly, the shares of company can be purchased only if the company
holds a combination of liquid and illiquid assets.
If all the assets are in money then the shares will have to be purchased at
par. There has been a huge growth in Islamic equity funds and there are
islamic indexes, one of the popular ones is the Dow Jones islamic index.
Even though a fund may be tracking an Islamic index, this by itself does
not make the profits fully sharia compliant.
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TOOLS AND TECHNIQES OF ISLAMIC FINANCING
In order to cater to the needs of the modern world, Islamic financing puts
forwards a wider range of tools and techniques of financing. These while
ensuring to meet the needs of the financial world, also takes care to
adhere to rules of sharia, which is primarily staying off interest system.
As per the rules of sharia, any addition to the principal amount which
adds up without creation of real wealth amounts to riba. That is to say,
the amount earned without sharing of risks or losses would in effect
amount to riba.
Engineers of Islamic financing tools have been careful enough to meet up
the requirements of its tenets and basic principles. In effect, what they put
forward to us is a wide range of new techniques of financing which are
complex in its very own nature and application. At the same time, there’s
ease and simplicity at the side of the customer of the banker.
Islamic financial tools function basically on;
1. Profit sharing (mudaraba)
2. Buy and sell back (murabaha)
3. Venture Capital (musharaka)
Many tools might resemble the conventional tools of financing as they
might look, but might differ in it simply because it don’t cater to riba.
A wide range of tools and techniques of Islamic financing has been listed
in the upcoming chapters.
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MURABAHA
(Cost Plus Finance)
Murabaha is a form of cost plus or mark up financing where an asset id
acquired by the bank and sold to the customer. No money is loaned to the
client. Rather, the financing party purchases the goods himself, based on
the requirement of the client. This ensured that financing is always asset-
based. In effect, this type of financing creates real assets and inventories.
It is understood that most of the financing operations in Islamic banking
are based on Murabaha.
Steps in Murabaha
1. The client indicates an interest in purchasing a particular asset from
the bank for a certain price (a combination of cost price plus profit)
at a certain time (the utilization date).
2. The client identifies the vendor, selects the goods and advises its
particulars, including the vendor's name and its cost price to the
bank in writing. Often the bank will appoint the client as its wakil
(agent) to acquire the asset on the bank's behalf.
3. The bank acquires the asset and offers to sell it to the client. The
vendor will typically make delivery of the asset to the client (as the
bank's agent). Delivery need not be physical; it can also be
constructive (i.e. evidenced by delivery of documents of title).
4. The agency contract comes to an end. The client accepts the offer
and the bank immediately sells the asset to the client through a
34
valid sale contract, with payment due on the agreed date in the
future.
Fig 1: Working of Murabaha
Subject of Murabaha
The assets (mal), which are the subject of the sale, must fulfill the
following requirements:
• The subject of sale must exist and be in the ownership (physical or
constructive) of the bank at the time of sale. In other words, the
second contract must "follow" the first contract. This risk- bearing
by the bank - even if for a short or fleeting time period - legitimizes
banks' profits under Shari'ah as distinct from prohibited riba.
• They must be something of value that is classified as property in
fiqh (Islamic jurisprudence) and must not be forbidden
commodities, such as alcohol, pork etc.
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Specification of price
The sale price and payment terms must be known. The price is fixed at
the time of contracting, as is the mode of payment, e.g. frequency and
quantum of installment payments. This is to avoid any gharar or
uncertainty. Where the sale price includes a known profit or mark-up, the
profit rate can be determined or expressed in relation to the market
interest rate such as LIBOR. The price may not always be specified in the
main murabaha documentation but can often be the subject of side
letters/agreements between the parties.
36
MUDARABA
(Trustee Finance Contract)
Mudaraba is essentially an agreement between a financier and an
entrepreneur — the principals. It is a contract whereby one side the
investor or Rabb ul Mal contributes money and the other side work, being
the manager or Mudarib. The Rabb ul Mal bears all losses, and the
Mudarib earns a profit share. Mudaraba is a concept to provide capital to
somebody undertaking the work. It could be understood as being similar
to the function of an asset manager or employed manager of a company.
Participatory Financing
The central idea in the concept of mudaraba is that two parties, one with
capital and the other with know- how, get together to carry out a project.
The financier provides the capital and plays no further part in the project;
specifically, he does not interfere in its execution, which is the exclusive
province of the entrepreneur.
If the project ends in profit they share the profit in a pre-arranged
proportion. If it results in loss the entire loss is borne by the financier, and
the entrepreneur gains no benefit out of his effort, which was his part of
the investment. However, in cases of proven negligence or
mismanagement by the entrepreneurs, they may be held responsible for
the financial loss incurred.
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Mudaraba is usually translated as profit-and-loss-sharing but, as far as the
financier is concerned, it is in fact profit-sharing-and-loss-absorbing.
Preconditions of Mudaraba contract
1. The financial risk is entirely and exclusively born by the banker,
and as such there’s no scope for reducing credit risk by requesting
collateral security.
2. The rate of profit should be determined strictly as a percentage and
not as a lumpsum.
3. The entrepreneur has absolute freedom to manage the business.
Restricted and Unrestricted Mudaraba
Where the capital is provided as being unrestricted for any purpose the
manager deems fitting is called Unrestricted Mudaraba or ‘al-mudaraba
al-mutlaqah’.
The banker may also grant it upon conditions what has to be made with it
which would then constitute what is called Restricted Mudaraba
(Mudaraba al Muqayyadah), e.g. all investment funds.
Two -Tier Mudaraba
The structure of Mudaraba transactions is such that the banker is involved
in two different mudaraba transactions, and hence the name two-tier
mudaraba. The first Mudaraba is between the bank and the client with
surplus capital (depositors) and the second one is between the bank and
the clients who require financing.
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The first tier Mudaraba between depositors and the Islamic has those
depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The
depositors place their funds with the bank with no guarantee of principal
and a return based on the profitability of the investments made by the
bank on their behalf. As with other Mudaraba, the depositors bear any
losses and share profits with the Islamic bank according to a pre-agreed
ratio.
The second tier Mudaraba between the Islamic bank and those receiving
financing has the bank acting as Rabb ul Mal and the customers acting as
Mudarib. The bank bears all losses except in cases of fraud by the
Mudarib and share profits with the customer according to a pre-agreed
ratio.
Table No. 1
Investment options of capital- holders
Type of
Investment
Mode of
Investment
Type of return on
Capital Rule
Active
investment
In own
enterprise
Profit or Loss from the
enterprise Allowed
Shares in a
Company
Dividend (P/L) from the
company Allowed
Bonds/
securities Fixed positive return (riba) Prohibitted
Passive
investment
Bank deposit Fixed positive return (riba) Prohibitted
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Table No. 2
Financing options for entrepreneurs
Type of
financing
Mode of
financing
Type of return on
Capital Rule
Active
finance Own funds
Profit or Loss from the
enterprise Allowed
Share Capital Dividend (P/L) from the
company Allowed
Bonds/
securities
Fixed positive return
(riba) Prohibitted
Passive
finance
Bank loans Fixed positive return
(riba) Prohibitted
Termination of Mudaraba
The contract of Mudaraba can be terminated at any time by either of the
parties. The only condition is to give a notice to the other party. If at the
time of termination, assets of the mudaraba are not in cash form, the
mudarib shall be given an opportunity to liquidate them so as to
determine the amount of profit, which shall then be divided as per the
agreed ratio.
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MUSHARAKA
(Joint Venture)
Musharaka is a contract whereby the bank and a customer agree to
combine their financial resources for the establishment or running of a
business or project, or for undertaking any type of business activities. The
two parties agree to manage the project in accordance with the terms of
the contract.
The profit or loss will be apportioned between the parties, according to a
mutually agreed proportion, which need not coincide with the ratio of
amount of capital invested. Losses are shared by all parties in proportion
to their investment. Banks have a legal authority to participate in the
management of the project, including representation on the Board of
Directors.
Different types of Musharka
There are two basic types of Musharaka;
1. Shirkat-ul-milk (Partnership based on joint ownership) – This a
voluntary Musharaka, which come into existence at the option of
the participants.
2. Shirkat-ul-‘aqd (Partnership based on contractual relationship) –
This partnership is based on contractual relationship.
They are further divided into 5;
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1. Shirkat-ul-Mufawadah (full authority and obligation) – This is a
limited partnership with equal capital contributions, responsibility,
full authority on behalf of others, along with responsibility for
liabilities incurred through the normal course of business.
2. Shirkat-ul-Inan (restricted authority and obligation) – This too is
a limited form of partnership, but with unequal capital
contributions. They do not share equal responsibility, and this
reflects their share of profits.
3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) – This is a kind of
partnership entered into with companies based on reputations of
one of both parties, typically small scale business.
4. Shirkat-ul-Abdan (labour, skill and management) – Partnership
with a company based on the contribution of human efforts with no
capital contributions. These are again typically small scale
business.
5. Shirkat-ul-Mudaraba – This is a partnership for a Mudaraba
contract.
Diminishing Musharakah
This is a derived form of Musharakah and was developed in the near past.
According to this concept, the financier-and the client participate either in
the joint ownership of a property or an equipment, or in a joint
commercial enterprise, on a diminishing share basis. The share of the
financier would be divided into a number of units and the contract is on a
condition that the client purchases the units of the share of the banker 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. At the same
42
time, the share of ownership of the financier in the property keeps
diminishing and hence the name ‘Diminishing Musharaka’.
Table No. 3
An example of Payment Schedule under Musharaka
Month Rent (Rs.)
Extra
Payment
(Rs.)
Total Fixed
Payments
(Rs.)
Bank’s
ownership
(Rs)
opening 120000
1 800 347 1147 119653
2 789 349 1147 119304
…. ….. ….. 1147 …
176 37 1110 1147 4439
177 30 1117 1147 3322
178 22 1125 1147 2197
179 15 1132 1147 1065
180 7 1065 1072 0
Management of the Musharaka
Every partner has a right to take part in the management and to work for
it. However, the partners may agree upon a condition that the
management shall be carried out by one of the and not by other partners.
In that 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.
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Termination of Musharaka
Every partner has a right to terminate the Musharaka at anytime after
giving his partner a notice to this effect, whereby the Musharaka with
come to an end. Termination of one partner need not terminate the whole
agreement and others may purchase the terminating partners share and
continue the business.
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MAZARA'AT AND MUSAQAT
(Agricultural Partnership)
Mazara'at and musaqat are two types of partnership. They are similar to
mudarabah, in that they are both types of partnerships between capital
and labour. The difference is that mudarabah is relevant to trading
whereas muzara'at is for farming.
If a person leaves his trees with someone for a specified period of time,
so that he cares, tends and waters them, and in return, that person will
take an agreed quantity of fruits, this transaction is called Musaqat.
In partnerships between capital and labour, whether mardarabah
agreements or mazara'at or musaqat, any kind of harm or loss the capital
is subject to is born by the owner of the capital, the investor. And, as
such, there is also no certainty of making a profit on the capital. The only
profit that is returned to the owner of the capital is in accordance to the
profit made by the partnerships and to his specified proportion of those
profits. Here it is that the financer, just like the worker, might make no
profit, and it is even possible that he may lose his capital and even
become bankrupt.
Contracting Musaqat
While concluding a transaction of Musaqat, the prescribed formula can be
recited in any language, or without reciting the formula, if the owner of
trees hands over them, with the intention of Musaqat, to the person who
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has agreed to take care of them, and he also receives them with the same
intention, the transaction will be in order. (Of course, the necessary talks
about the duration and the conditions, etc. should have taken place
earlier).
The following points need to be considered;
1. If a clear agreement, in respect of melon, cucumber vines etc., in
which the number of times of picking and the share of each one are
specified, is made.
2. Trees that need not be irrigated and benefit from rainwater or the
moisture of the earth, but need other work to be done for them, like
turning up with a spade, fertilizing and spraying which will make
their fruits or their quality to be increased, it will be in order.
3. The work to be done by each of the parties involved should be
specified in advance, like, repairing the subterranean canals, or the
water well engine, also the supply of the manure, spray
equipments, etc., and if there is a local practice and rule in this
respect, that will suffice.
4. It is possible that the other party in Musaqat be more than one, that
is, the owner of the trees may leave them in the hands of several
people, and conclude the contract of Musaqat with them.
Conditions for Musaqat
1. The owner of the trees and the person who undertakes to tend and
care for them, should be Baligh and sane.
2. No one should have compelled them to do so.
3. They should not have been banned from having discretion over
46
their own property.
4. The period of Musaqat should be specified, and if the beginning of
it is specified, and its end is fixed to be the time when fruits for that
year become available, the contract is in order.
5. It is necessary that the share of each one of them be fixed as 1/2 or
1/3 etc. of the crop.
6. It is necessary that the contract of Musaqat be concluded before the
appearance of the crop. And if the contract is made after the
appearance of the fruits and before they are ripe, the contract will
be in order, provided that some work like, watering and spraying
which are required for increasing the crop and protecting the trees,
still remain to be done. And if the work required to be done, is
merely plucking the fruits and looking after them, the contract is in
order but it is not Musaqat.
Termination of Musaqat
The parties involved can cancel the transaction of Musaqat with mutual
consent, and also if, when concluding the contract, they had agreed that
one or both of them would have the right to cancel it, then, he can do so
according to the agreement. And if in the contract of Musaqat, they had
laid a condition and that condition is not fulfilled, and if the person who
benefits from the condition is not able to compel the other party to fulfill
it, then, he can cancel the transaction.
The Musaqat transaction will not terminate with the death of the owner of
the orchard, and his heirs will act on his behalf. However, if the person
who has undertaken to look after the trees, dies and if they had agreed
47
that he himself would do the job, the contract will become cancelled, but
if they have not laid such a condition, his heirs will take his place.
48
IJARA
(ISLAMIC LEASE)
Ijara is an agreement wherein the Bank leases movable and immovable
assets to its customers, with the option that the customer may or may not
own the leased asset at the end of the term of the lease as per the
agreement singed between the two parties. Ijara means lease, rent or
wage.
Basic rules governing Leasing
1. Contract should be for an agreed period, at an agreed
consideration; determined at the time of contract.
2. The consideration should in monetary form.
3. The object being leased must have a valuable use; and it should not
be perishable.
4. The leased asset should remain in the ownership of the lesser; only
its usage is transferred to the lessee
5. All the liabilities arising out of the ownership shall be borne by the
lesser, but the liabilities arising from the use of the property shall
be borne by the lessee.
6. The lessee cannot use the leased asset for any other purpose than
specified in the agreement.
7. Damages to the asset owing to misuse or negligence shall be borne
by the lessee asset caused by any misuse or negligence on the part
of the lessee; whereas that which is beyond the control of lessee
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shall be borne by the lesser.
8. A property under joint ownership can be leased out and the lease
amount distributed between the owners In proportion to their
shares in the property.
9. The leased asset should be fully identified by all the parties.
10. If variable rentals are fixed different phases, the particulars should
be agreed upon at the time of the lease; else the agreement would
not be valid.
11. The lease period commences on the delivery of the asset.
12. If the leased asset loses the function for it was leased, provided it
can’t be repaired and it didn’t occur due to negligence on part of
the lessee, the lease is terminated.
Types of Ijara
Ijara Thumma Al- Baai’ (Hire Purchase)
These are variations on a theme of purchase and lease back transactions.
There are two contracts involved in this concept. The first contract, an
Ijarah contract (leasing/renting), and the second contract, a Bai contract
(purchase) are undertaken one after the other. For example, in a car
financing facility, a customer enters into the first contract and leases the
car from the owner (bank) at an agreed rental over a specific period.
When the lease period expires, the second contract comes into effect,
which enables the customer to purchase the car at an agreed price. In
effect, the bank sells the product to the debtor, at an above market-price
profit margin, in return for agreeing to receive the payment over a period
of time; the profit margin on the lease is equivalent to interest earned at a
fixed rate of return.
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Ijara- Wal- Iqtina
A contract under which an Islamic bank provides equipment, building or
other assets to the client against an agreed rental together with a unilateral
undertaking by the bank or the client that at the end of the lease period,
the ownership in the asset would be transferred to the lessee. The
undertaking or the promise does not become an integral part of the lease
contract to make it conditional. The rentals as well as the purchase price
are fixed in such manner that the bank gets back its principal sum along
with profit over the period of lease.
51
QARD HASSAN
(Benevolent Loan)
Islam allows loan as a form of social service among the rich to help the
poor and those who are in need of financial assistance. Loan in Islam may
be obtained in two ways: (i) Loan with condition of repayment, and (ii)
gratuitous loan without any compensation or gift. However, Islam does
not recognize any loan with interest for the benefit of the debtor. It only
recognizes gratuitous loan or better known as al-qard al-hasan.
M. Umer Chapra has given the definition of qard al hasan as: "Qard al-
hasan is a loan which is returned at the end of the agreed period without
any interest or share in the profit or loss of the business." Therefore, qard
al- hasan is a kind of gratuitous loan given to the needy people for a fixed
period without requiring the payment of interest or profit. The receiver of
qard al-hasan is only required to repay the original amount of the loan.
Objectives of Qard Hassan
1. To help the needy fellow people.
2. To establish better relationship among poor and the rich.
3. The mobilization of wealth among all people in the society.
4. To strengthen the national economy.
5. To facilitate the poor to create new jobs market and business
ventures by using their merits, skills and expertise.
6. To establish a caring society.
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7. It can remove social and economical discrimination from the
society.
8. To eradicate unemployment problem from the society.
Conditions of Qard Hassan Transaction
1. Both parties should be legally (shari'ah) capable to enter into
the qard contract
It is unanimously agreed by the four schools of law that to enter into a
contract, parties should be baligh, 'aqil and rashid (major with sound
judgment). The age of marriage and the sound judgment is the age of
majority, and thereby a major person is capable to enter into any
transaction validly. A person, who has not attained the age of puberty ,
may not be a responsible party for al-qard al- hasan transaction.
2. Ijab (offer) and qabul (acceptance) of the qard must be clearly made before entering into the loan contract
Ijab and qabul should be clearly indicated in the contract, otherwise, the
loan contract may create dispute in future. In the loan agreement, there
should have clear expression, collation and conjunction of the ijab and
qabul between the parties.
3. The date of payment must be specified
The date of payment should be mentioned in the loan agreement. If no
date is specified, the transaction may lead to ambiguity and dispute in
future between the lender and the borrower.
53
4. The loan contract should be written down
In order to avoid chances of any future dispute, it is necessary that the
contract be made in writing.
However, some opine that it is not obligatory but strongly recommended.
The reason given by them is that if both parties agree not to write, then it
is no longer an obligation upon them to write down. The reason behind
the writing down is to avoid future dispute. On the contrary, a minority of
the scholars are of the opinion that it is obligatory upon the parties to
write down the contract.
5. Getting two witnesses
There must be two male witnesses to make any contract valid. Witnesses
are of great importance in sharia compliant contracts. If two men are not
available, then one man and two women will suffice. This will help avoid
any chance of future disputes which disrupt the whole functionality of
Qard Hassan.
6. Administrative fee / Service charge
To obtain some compensation for offering al-qard al-hasan facilities, the
banks demand some charges and fees. These expenses incurred by banks
on providing al-qard al- hasan are collected from the borrowers, and the
basis for the calculation of these expenses is laid down by the central
bank.
If any bank or other institutions give al-qard al-hasan, they may require
service charge or administrative fee. However, there is no scope for an
54
individual lender to demand this charge unless any amount incurred due
to procedural requirements of the loan agreement, such as lawyer's fee,
stamp duty etc.
7. Extra Payment
It is very clear that in the loan agreement, there will be no condition for
extra payment, otherwise, it will be riba . It is however, permissible for
the debtor to give some sort of gift to the creditor as a sign of
appreciation of his voluntary deed.
It is exclusively up to the borrower whether to pay extra or not, regardless
the loan was for consumption or commercial purpose and the lender
cannot demand it, as it is only a virtue on part of the borrower on
repayment and not a right of the lender. Added, there should not be any
stipulation for extra benefit in the loan agreement.
8. Early demand to pay back
Loan is a voluntary act by the creditor. However, it is not encouraged for
early demand to pay back the loan from the debtor. The creditor should
not demand the loan amount from the debtor before the agreement
matures or lapses.
9. Guarantors:
In the case of the al-qard al-hasan, there can be guarantors. The
guarantors of the borrower may be any person or the property of the
borrower that is collateral security, such as, mortgage, charge etc. In case
of the borrower's failure to pay back the loan after the expiration of the
55
time specified, his guarantor has to pay or the collateral security is to be
valued for the repayment of the loan. But, Muslims should remember that
a true believer should not delay to pay back his obligations.
Application of Qard Hassan
1. Friends and Families
The application for interest free loans is relevant especially among larger
families, which may put in place a private “box” called Sanduq among
them where needy family members could draw out an interest free credit.
Wealthy member may draw out a finance facility against profit/loss
sharing explained later on.
2. Qard Hassan for Deposit Taking
Islamic banks to provide finance do not use the instrument of Qard
Hassan widely, rather it is used to accept deposits. Such a deposit loan is
permissible and could be used to be invested in other projects of the bank,
while a pure deposit (Amanah / Wadiah) is cannot be used in the same
way.
3. ROSCA - Rotating Credit and Saving Associations
Another potential application for the Qard Hassan technique is the
savings/lending model. The loan depositor receives instead of interest,
saving points for the size and duration of the funds provided. After
achieving a sufficient number of those points, he should able to take out a
56
loan himself. The administration of such a model could be subject to fees
which are not bound by time and size of the credit.
Another positive factor to be seen is the effect of a stress test for the
borrower – having savings over a period time is a good way to know the
own repayment capacity. Further a credit history is no longer an absolute
must. It is a called in the conventional sector a rotating savings and credit
association (ROSCA ), and reported to be practiced in the informal sector
even in UK and Australia but not on a professional basis.
57
SALAM or BAI’ SALAM
(Forward Contracts)
Salam or Bai'Salaam as it is also called, is a sale whereby the seller
undertakes to supply some specific goods to the buyer at a future date in
exchange for a price fully paid in advance. It is similar to a forward
contract with the buyer paying the seller, the negotiated price of a product
that the seller promises to deliver at a future date. The quality and
quantity of the products involved in this type of transaction must be
capable of being specified at the time of the contract.
Condition of Salam
• The buyer should pay the price in full to the seller at the time of
effecting the sale. Else, it will be tantamount to a sale of debt
against debt, which is expressly prohibited. Moreover, the basic
wisdom behind the permissibility of Salam is to fulfill the instant
needs of the seller. If the price is not paid to him in full, the basic
purpose of the transaction will be defeated.
• Salam can be effected in those commodities only whose quality
and quantity can be specified exactly. For example, the precious
stones cannot be sold on the basis of Salam, because every piece of
precious stones is normally different from the other and their
specifications need to drawn differently.
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• Salam cannot be effected on a particular commodity or on a
product of a particular field or farm. Because it is possible that
field is destroyed before the delivery, and in the presence of this
possibility the delivery remains uncertain.
• The same rule is applicable to every commodity whose supply is
not certain. It is necessary that the quality of the commodity be
fully specified leaving no ambiguity that may lead to dispute.
• It is a necessary that the quantity of the commodity be agreed upon
in unequivocal terms.
• The exact date of delivery must be specified in the contract.
• Salam cannot be affected in respect of those commodities that must
be delivered at the spot. For example, if gold is purchased in
exchange for silver, it is necessary, according to Shariah, that the
delivery of both be simultaneous. Here, Salam cannot work.
• Salam sale is not permissible on existing commodities because
damage and deterioration cannot be assured before delivery on the
due date.
• Salam is permissible on a commodity of a specific locality, if it is
assured that it is almost always available in that locality and it
rarely becomes unavailable.
• The place of delivery must be stated in the contract, if the
commodity needs loading or transportation expenses.
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• It is not permissible for the buyer of a Salam commodity to sell it
before receiving it because that is similar to the prohibited sale of
debts before holding.
• Salam sale is suitable for the finance of agriculture operations,
where the bank can transact with farmers who are expected to have
the commodity in plenty during harvest either from their own crops
or crops of others, which they can buy and deliver in case their
crops fail.
• Salam sale is also used to finance commercial and industrial
activities, especially phases prior to production and export of
commodities and that is by purchasing them on Salam and
marketing them for lucrative prices.
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TAKAFUL
(Islamic Insurance)
Takaful is an Arabic word which means “guaranteeing each other” or
joint guarantee as against guarantee or mutual security. Takaful or
Islamic Insurance is basically based on the concept of mutual or
cooperative insurance and it takes care of all the Shariah related concerns
including ensuring investment to be made in Shariah compliant
instruments.
The concept of Takaful as such is not new in Islamic Commercial Law.
Islam accepts the principle of reciprocal compensation and joint
responsibility. The system of Takaful insurance tends to achieve self-
reliance through a self-sustaining insurance system based on community
pooling, solidarity and joint guarantee for the well being of community
and individuals in need, the entire system and operation being based on
Islamic principle.
Principles of Takaful
• Policyholders cooperate among themselves for their common good.
• Every policyholder pays his subscription to help those that need
assistance.
• Losses are divided and liabilities spread according to the
community pooling system.
• Uncertainty is eliminated in respect of subscription and
compensation.
• It does not derive advantage at the cost of others.
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Modules under Takaful
1. Mudaraba - By this principle, the entrepreneur or al-Mudharib
(takaful operator) will accept payment of the takaful installments
or takaful contributions (premium) termed as Ra's-ul-Mal from
investors or providers of capital or fund (takaful participants)
acting as Sahib-ul-Mal. The contract specifies how the profit
(surplus) from the operations of takaful managed by the takaful
operator is to be shared, in accordance with the principle of al-
Mudharabah, between the participants as the providers of capital
and the takaful operator as the entrepreneur.
2. Wakala - Here the Takaful provider act as an agent for the
participants and manages the Takaful/Retakaful (Reinsurance) fund
for a fee. This model is generally used in middle-east region.
3. A combination of both Mudaraba and Wakala
Tabarru’ to eliminate uncertainity
Takaful companies normally divide the contributions into two parts,
1. Donations for meeting mortality liability or losses of the fellow
policyholders.
2. Investment fund to be invested in halaal business on a non-interest
basis.
Accordingly, the clause of Tabarru is incorporated in the contract. How
much of the contribution is meant for mortality liability and how much
for investment account is based on a sound technical basis of mortality
tables and other actuarial requirements. Both the accounts are invested
62
and returns thereof distributed on Mudarabah principle between the
participants and the Takaful operators. The profit attributable to the
participants is credited into the two accounts separately.
Issues in Conventional Insurance
1. Riba (interest) – Conventional life insurance schemes can be
considered to contain riba in that the claim is much higher than the
premium amount paid. As about general insurance, the fund is
invested in instruments that are interest based.
2. Maisir (gambling) – There can be cases where there’s no claim and
the policy holder loses all money, and where there’s claim, its
much higher than the amount contributed and hence gambling. Life
insurance as such is a contract of wager on the death of the policy
holder.
3. Gharaar (uncertainty) – The benefits on insurance are dependent
upon the outcome of a future event, which is uncertain.
Conventional insurance in itself is a game of uncertainty.
Distinguishing features of Takaful
1. The policyholders are the participants to the Takaful / Retakaful
fund
2. The contribution so received are not aimed at making profit per se
but are more in the nature of pooling the risk and risk management
rather than risk taking.
3. The Takaful operator is not the owner of the fund but merely its
custodian.
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4. The surplus generated belongs to the contributor (i.e.
policyholders) solely under wakala model and to both i.e.
policyholder and Takaful Company under mudarba model. This is
a unique feature of Takaful insurance
5. Since the surplus goes back to the participants in proportion to
their contribution, there is an inbuilt check on over-pricing.
6. Funds are invested in Shariah compliant instruments / avenues.
7. Incidentally, Reliance Life has come out with a plan called RSIP
where the investment is made in non-banking sector excluding
liquor, cigarette, tobacco, entertainment, gambling, etc.
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ISTISNA
Istisna is an Islamic form of financing used to finance construction and
industrial projects, such as the construction of buildings and so on. The
unique feature of Istisna'a is that it allows the selling of an asset, which
does not exist at time of the contract. The payment can be in immediate
cash or may be in the form of deferred payments.
Ways of effecting Istisna sale contract
1. It is permissible for the bank to buy a commodity on Istisna
contract then sell it after receipt for cash or deferred payment.
2. It is also permissible for the bank to enter into a lstisna contract in
the capacity of seller to those who demand a purchase of a
particular commodity and then draw a parallel istisna contract in
the capacity of a buyer with another party to manufacture the
commodity agreed upon in the first contract.
Each transaction is deemed a separate contract with payment being made
in cash either immediately or on a deferred basis. Any disagreements that
may arise are settled under each contract separately according to the
provisions therein.
Istisna is, thus, an exceptional mode of sale, at an agreed price, whereby
the buyer places an order to manufacture, assemble or construct, or cause
so to do anything to be delivered at a future date. It means to place an
order with a manufacturer to manufacture a specific commodity for the
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purchaser. If the manufacturer undertakes to manufacture the goods
for him, the transaction of Istisna comes into existence. But it is
necessary for the validity of Istisna that the price is fixed with the consent
of the parties and that necessary specification of the commodity (intended
to be manufactured) is fully settled between them.
Termination of Istisna
The contract of Istisna creates a moral obligation on the manufacturer to
manufacture the goods, but before he starts the work, any one of the
parties may cancel the contract after giving notice to the other. But after
the manufacturer has started the work, the contract cannot be cancelled
unilaterally.
However, the party placing the order has the right to retract, if the
commodity does not conform to the specifications demanded..
Istisna as a Deferred Payment Scheme
Since it is not necessary in Istisna that the price is paid in advance, nor is
it necessary that it is paid at the time of the delivery, rather, it may be
deferred to any time according to the agreement of the parties, therefore,
the time of payment may be fixed in whatever manner they wish. The
payment may also be in installments.
Application of Istisna
Istisna contracts are applied in high technology intensive industries such
as the aircraft industry, locomotive and ship building industries. In
addition, this type of business transaction is also used in the production of
large machinery and equipment manufactured in factories and workshops.
Finally, the istisna contract is also applied in the construction industry
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such as apartment buildings, hospitals, schools, and universities to
whatever that makes the network for modern life. The Istisna contract is
best used in those transactions in which the product being purchased can
easily be measured in terms of the specified criteria of the contract.
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SUKUK
(Islamic Bonds)
Sukuk in general may be understood as a shariah compliant ‘Bond’. In its
simplest form sukuk represents ownership of an asset or its usufruct. The
claim embodied in sukuk is not simply a claim to cash flow but an
ownership claim. This also differentiates sukuk from conventional bonds
as the latter proceed over interest bearing securities, whereas sukuk are
basically investment certificates consisting of ownership claims in a pool
of assets.
Sukuk (plural of word sak) were extensively used by Muslims in the
Middle Ages as papers representing financial obligations originating from
trade and other commercial activities. However, the present structure of
sukuk are different from the sukuk originally used and are akin to the
conventional concept of securitization, a process in which ownership of
the underlying assets is transferred to a large number of investors through
certificates representing proportionate value of the relevant assets.
Distinction between Sukuk and conventional Bond
• A bond is a contractual debt obligation whereby the issuer is
contractually obliged to pay to bondholders, on certain specified
dates, interest and principal, whereas, the sukuk holders claims an
undivided beneficial ownership in the underlying assets.
Consequently, sukuk holders are entitled to share in the revenues
generated by the sukuk assets as well as being entitled to share in
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the proceeds of the realization of the sukuk assets.
• A distinguishing feature of a sukuk is that in instances where the
certificate represents a debt to the holder, the certificate will not be
tradable on the secondary market and instead is held until maturity
or sold at par.
Features of Sukuk
• Tradable shariah-compliant capital market product providing
medium to long-term fixed or variable rates of return. Assessed
and rated by international rating agencies, which investors use as a
guideline to assess risk/return parameters of a sukuk issue.
• Regular periodic income streams during the investment period
with easy and efficient settlement and a possibility of capital
appreciation of the sukuk.
• Liquid instruments, tradable in secondary market.
Uses of Sukuk Funds
The most common uses of sukuk can be named as project specific, asset-
specific, and balance sheet specific.
1. Project-specific Sukuk
Under this category money is raised through sukuk for specific project.
2. Assets-specific Sukuk
Under this arrangement, the resources are mobilized by selling the
beneficiary right of the assets to the investors.
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3. Balance Sheet-specific Sukuk
This is an arrangement wherein the Islamic bank mobilizes funds by
issuing sukuk and these funds are used to finance various projects of the
member countries.
Types of Sukuk:
Sukuk takes several innovative Shariah compliant forms that combine
various particles of Islamic forms of finance together.
1. Ijarah Sukuk
Ijarah Sukuk are related to leased properties and assets, they carry equal
values, and are issued by the owner of the leased property or his agent.
The aim of the transaction at the end is to sell the leased property through
issuing Sukuk, accordingly, the holders of the certificates or Ijarah Sukuk
own the asset and its charges during the rental period, each in proportion
to the certificates of Sukuk held in the leased asset.
2. Usufructs of Existing Assets:
Usufructs of existing assets' Sukuk certificates carry equal values and are
issued by the owner for an existing asset or by sublease at the consent of
the owner or by both. The certificates represent the rights on the service
or usufruct of an asset that could either be directly or indirectly hired to a
second or a third party. A house could either be rented by its owner or
agent to a second party or sub rented by the second party to a third party.
In both cases the lessee owns the right to enjoy the service of the asset
during the lease period while not owning the asset itself.
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3. Usufructs of Future Assets:
The usufruct could also be futuristic for a specified period of time for a
specified asset which would not be ready at the time of issuing the Sukuk
certificates but, it could be under construction or contracted for
construction and delivery at a future time. This is analogous to the Salam
contract.
4. Contractor's Sukuk:
A contractor's or a supplier's Sukuk can be issued by a contactor or a
supplier of a good or a service. The Sukuk could be for existing
commodities or those, which would be offered during a contracted time
in future. These sukuk carries equal values issued by a covenanter to
provide or sell services described in the security, such services are to be
sold in a form of sukuk, so that the holders of the same shall to be the
owners of such services and shall gain the proceeds from selling the same
in the markets.
5. Potential Services Sukuk:
These Sukuk carries equal values issued by a contractor (or a supplier) or
an agent having a saleable services to Sukuk holders and such holders
shall have the right to sell the same in the stock market.
6. Salam Sukuk
Sukuk or certificates of Salam carry equal values for mobilizing the
capital necessary to produce some specified commodities contracted for
deliverance at specified periods of time in future while their value prices
are fully paid in advance. A separate parallel Salam contract could be
signed by the Salam item buyer with a third party, without linking it to
the first contract. Ethically, the contractors should be committed towards
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their contract parties, and should not transfer their own responsibilities in
a contract to their parties in another one.
7. Istisna Sukuk
Sukuk or certificates of Istisna carry equal values for mobilizing capital
necessary to produce some specified commodities. Such commodities
could be sold with partial advance payments according to Istisna
contracts in order to be delivered at a specified period of time in future.
Istisna is applicable on building and establishing ships, airplanes, bridges,
roads, power generation stations, water supply stations and the alike
according to a specific specifications stipulated in the contract and
according to a pre-stated delivery date and value. It is possible to
synthesize another formula with the same to respond to the requisites of
the process and finance. This type is amongst the most active instruments
in world of Sukuk.
A separate parallel Istisna contract could be signed by the Istisna item
buyer, with a third party, without linking it to the first contract, as it is the
case with the parallel Salam contracts. Wherein the supplier enters into a
contract with an entity to manufacture a specified merchandise for them,
then the supplier enters into a contract with a third party to manufacture
the product to deliver the same for the demanding party on the stipulated
time.
8. Murabaha Sukuk
These Sukuk carry equal values and are issued by the merchant or his
agent in order to finance the purchasing a commodity then to sell the
same at a known Murabaha as for equipments required within an Istisna’a
contract weher the equipments shall be purchased on a known Murabaha
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and the holders of Sukuk will be the owners of such equipments and of
the sales income from the same.
9. Musharakah Sukuk
These Sukuk carry equal values and are issued by the supplier
(entrepreneur or a covenanter )or his agent, to finance a project or
projects where the holders of Sukuk will be the owners of such projects,
this is far similar to partnership companies although they might differ if
the Sukuk issuer is authorized to select the projects which are transferred
and constructed.
10. Mudarabah Sukuk
This type of Sukuk, carry equal values issued by the contractor to provide
the entrepreneurship and to manage the proposed project, for the purpose
of financing such project or a combination of projects which are specified
or those in which he is authorized to act upon. Thereby, the Sukuk
holders shall be the owners of the capital of the project and the project
shall remain a partnership between them and between the entrepreneur at
an agreed portion of the profits and shall bear the expected losses in
capital.
11. Muzaraa Sukuk:
These Sukuk carry equal values issued by the owner of the agricultural
land in order to finance the agricultural costs according to a Muzaraa
contract where the holders of Sukuk become partners in the produced
crops as per the terms stipulated in the contract.
12. Musaqat Sukuk:
These Sukuk carry equal values, issued by the owner of the plants, the
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subject of the contract, in order to finance the processes of irrigation and
cultivation, where the holders of Sukuk become partners in the produced
crops as per the terms stipulated in the Musaqat contract.
13. Musharakah Sukuk in Investment Agency:
These Sukuk carry equal values and are issued by an investment agent.
They represent projects and activities, where the investment agent shall
be appointed as a mediator who manages the investment on behalf of the
Sukuk holders in consideration of a percentage out of the profits.
14. Mugharasah Sukuk (Planting):
These Sukuk carry equal values and are issued by the owner of the land
subject of the contract for financing the costs of plantation under
Mugharasa contract. The holders of the Sukuk shall jointly share the
ownership of the trees planted together with the ownership of the land on
which such trees were planted according to the contract.
15. Sukuk of Reducing Ownership:
These Sukuk carry equal values issued by the owner of the innovated
idea, the subject of the contract, in order to finance a project pursuant to
the establishment contract ending by transferring the ownership of the
assets or services to the owners of the idea or to the founding after a
specified period of time. The owners of the innovated idea shall be
partners in the project either by employment (work), by capital or both
together. i.e, the partner shall be an employee who entitles a wage against
his work, or a partner by business who shall start paying for the value of
the project to the holders of Sukuk out of his share in the profit in a
manner reducing the number of Sukuk holders making him a partner with
an increasing share, the more he is able to pay out of his share. Thus the
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shares of Sukuk holders diminishes, while the shares of the working
partners increases ending to stage where the ownership of the assets and
its associated services, the asset alone or the services alone in favor of the
partners. This formula combines the limited period lease Sukuk for assets
and services.
The above could be summarized as, funds would be mobilized for
establishing companies that could be partially owned by the holders of
the Sukuk certificates. Gradually, the Sukuk holders can buy the capital
share of their partners in the company so that they entirely own the
company, as per the agreed contractual conditions.
The market for sukuk is now maturing and there is an increasing
momentum in the wake of interest from issuers and investors. sukuk have
confirmed their viability as an alternative means to mobilise medium to
long-term savings and investments from a huge investor base.
Different sukuk structures have been emerging over the years but most of
the sukuk issuance to date have been ijara sukuk, since they are based on
the undivided pro-rata ownership of the underlying leased asset, it is
freely tradable at par, premium or discount. Tradability of the sukuk in
the secondary market makes them more attractive. Although less
common than Ijara sukuk, other types of sukuk are also playing
significant role in emerging markets to help issuers and investors alike to
participate in major projects, including airports, bridges, power plants etc.
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FUNCTIONING OF ISLAMIC BANKS
It can be seen that in any banking business, there exist two aspects - at the
one end is the deposit aspect and at the other end is the lending or
investment aspect. At the deposit end of the scale, Islamic banks normally
operate three broad categories of accounts, namely, current, savings, and
investment accounts.
1. Current accounts
Current accounts are based on the principle of al-wadiah, whereby the
depositors are guaranteed repayment of their funds. At the same time, the
depositor does not receive remuneration for depositing funds in a current
account, because the guaranteed funds will not be used for PLS ventures.
Rather, the funds accumulating in these accounts. can only be used to
balance the liquidity needs of the bank and for short term transactions on
the bank's responsibility.
2. Savings accounts
Savings accounts also operate under the al-wadiah principle. Savings
accounts differ from current deposits in that they earn the depositors
income: depending upon financial results, the Islamic bank may decide to
pay a premium, riba, at its discretion, to the holders of savings accounts.
3. Investment accounts
An investment account operates under the mudaraba-al-mutlaqa
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principle, in which the mudarib (active partner) must have absolute
freedom in the management of the investment of the subscribed capital.
The conditions of this account differ from those of the savings accounts
by virtue of: a) a higher fixed minimum amount, b) a longer duration of
deposits, and c) the depositor may lose some of or all his funds in the
event of the bank making losses; ie, the principal or the rate of return on
the deposits is not guaranteed. The only contractual agreement between
investment depositors and banks is the proportion according to which
profits or losses are to be distributed between the parties of the deposit
contract.
The amounts so pooled are invested in a business acceptable to Shariah.
The investment funds so created may be invested in varied forms:
a. Equity Fund
• In an equity fund the amounts are invested in the shares of joint
stock companies. The profits are mainly derived through the capital
gains and dividends earned on the equity shares.
• Dealing in shares or acquisition of shares of companies can be
acceptable under Shariah, subject to the following conditions:
• The main business of the company is not violative of Shari'ah.
• If the main business of the companies is ha/al, like automobiles,
textile, etc. but they deposit their surplus amounts in an interest
bearing account or borrow money on interest, the shareholder must
express his disapproval against such dealings, preferably by raising
his voice against such activities in the annual general meeting of
the company.
• If some income from interest-bearing accounts is included in the
income of the company, the proportion of such income in the
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dividend paid to the shareholder must be given in charity, and must
not be retained by him.
• The shares of a company are negotiable only if the company owns
some illiquid assets.
The subscribers to the fund will be treated in Shari'ah as partners’
interest. All the subscription amounts will form a joint pool and will be
invested in purchasing the shares of different companies. The profits can
accrue either through dividend distributed by the relevant companies or
through the appreciation in the prices of the shares. In the first case i.e.
where the profits are earned through dividends, a certain proportion of the
dividend, which corresponds to the proportion of interest earned by the
company, must be given in charity. The contemporary Islamic Funds
have termed this process as 'purification'.
The management of the fund may be carried out in two alternative ways.
The managers of the Fund may act as mudaribs for the subscribers. In this
case a certain percentage of the annual profit accrued to the fund may be
determined as the reward of the management. The second option for the
management is to act as an agent for the subscribers. In this case, the
management may be given a pre-agreed fee for its services. This fee may
be fixed in a lump sum or as a monthly or annual remuneration.
According to the contemporary Shari'ah scholars, the fee can also be
based on a percentage of the net asset value of the fund.
b. Ijarah Fund
In this fund the subscription amounts are used to purchase assets like real
estate, motor vehicles or other equipments for the purpose of leasing
them out to their ultimate users. The ownership of these assets remains
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with the Fund and the rentals are charged from the users. These rentals
are the source of income for the fund which is distributed pro rata to the
subscribers. Each subscriber is given a certificate to evidence his
proportionate ownership in the leased assets and to ensure his entitlement
to the pro rata share in income. These certificates may preferably be
called 'sukuk' -a term recognized in the traditional Islamic jurisprudence.
Since these sukuk represent the pro rata ownership of their holders in the
tangible assets of the fund, and not the liquid amounts or debts, they are
fully negotiable and can be sold and purchased in the secondary market.
Anyone who purchases these sukuk replaces the sellers in the pro rata
ownership of the relevant assets and all the rights and obligations of the
original subscriber are passed on to him. The price of these sukuk will be
determined on the basis of market forces, and are normally based on their
profitability.
c. Commodity Fund
Another possible type of Islamic Funds may be a commodity fund. In the
fund of this type the subscription amounts are used in purchasing
different commodities for the purpose of their resale.
d. Murabaha Fund
If a fund is created to undertake Murabaha, it should be a closed-end fund
and its units cannot be negotiable in a secondary market. The reason is
that in the case of murabaha, as undertaken by the present financial
institutions, the commodities are sold to the clients immediately after their
purchase from the original supplier, while the price being on deferred
payment basis becomes a debt payment payable by the client. Therefore,
the portfolio of murabaha does not own any tangible assets. It comprises
either cash or the receivable debts, therefore, the units of the fund
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represent either the money or the received debts are not negotiable. If
they are exchanged for money, it must be at par value.
e. Mixed Fund
Another type of Islamic Fund may be of a nature where the
subscription amounts are employed in different types of investments, like
equities, leasing, commodities, etc. This may be called a Mixed Islamic
Fund. In this case if the tangible assets of the Fund are more than 51%
while the liquidity and debts are less than 50%, the, units of the fund may
be negotiable. However, if the proportion of liquid assets and debts
exceeds 50%, its units cannot be traded according to the majority of the
contemporary scholars. In this case the Fund must be a closed-end fund.
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RISE AND SCOPE OF ISLAMIC BANKING
Since the early 1980s, Islamic banking has developed into a multi-billion
dollar business. The Western world is realizing that, even in its own
cities, it is no longer a ‘fringe’ business.
History of Islamic Banking
The creation of the Islamic Development Bank (IDB) in Jeddah in 1975
was a landmark for Islamic banking. The IDB was the first development
institution dedicated to the financial requirements of Muslim countries.
The bank's articles of association stipulate that all its business should be
conducted in accordance with Islamic Shari'a law. Its success can be
measured by the Saudi government's decision in 1992 to double the
subscribed capital of the IDB to $5.7bn, making it the largest inter
government agency in the Muslim world.
Commercial Islamic banking took off in the 1970s when a number of new
institutions were established in the Gulf, including the Dubai Islamic
Bank (1975), the Kuwait Finance House (1977) and the Bahrain Islamic
Bank (1979). However, the most significant developments took place in
Saudi Arabia, aided by its huge economic infrastructure. One of the prime
movers of such developments was Prince Mohammad Al-Faisal, whose
ambition was to create a network of Islamic banks across the Muslim
world - a process which saw the founding of the Faisal Islamic Bank in
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Egypt in 1977 and the Faisal Islamic Bank in Sudan in 1978. But it was
Prince Al Faisal's Geneva-based Dar Al Mal Al Islami, founded in 1981
that brought Islamic banking to the attention of those Western bankers
who, previously, had little or no knowledge of Islam or Middle Eastern
countries. The Geneva office of Dar Al Mal is now the centre of a
network of 43 branches in 20 countries with assets under management in
excess of $3bn.
The assets of Islamic banks incorporated in the Middle East rose from
$4.4bn in 1985 to $15.7bn in 1994, although total assets controlled by
Islamic financial institutions, including assets under management and the
activities of banks based outside the Middle East, are estimated to be in
the order of $80-$100bn. Compared with conventional banking this is a
relatively small sum, but the overall demand for Islamic banking products
is probably much greater than banks have so far been able to tap.
Growth of Islamic Banking
In recent times, Islamic banking and financing services have increased
phenomenally around the world. There now exist 150 such banks spread
over most countries of the world. Yet, the same trend in financing with a
concentration around murabaha (trade financing) is found to intensify.
Equity participation and profit sharing have remained distant minimum in
the total allocation of resources. Secondary financial instruments in
accordance with Shari’ah could not be developed so as to give rise to a
viable Islamic capital market. Islamic financial instruments are therefore
traded in conventional stock markets. As a result, neither the
developmental aspects of Islamic banking in favor of realizing an Islamic
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economy nor the distributive goals for the poor and marginal enterprises
could be attained.
Reasons for the popularity of Islamic Banking
Some possible reasons of the popularity and acceptability of the Islamic
Banking are as under:
1. Evils of interest based system
Interest based economic and financial system of the world has caused
havoc and that Islamic system has the ability to prevent the recurrence of
the global financial crisis and resolve all related issues. But the world is
not ready to do away with the system it is following. The truth is that the
Islamic system has not been fully and effectively introduced, presented
and popularized in the world to merit any worthwhile attention towards it.
2. Attractive performance of Islamic banking
Islamic banking has not yet been fully implemented anywhere in the
world, except as a system complementary to the conventional interest-
based system. However, where this alternative system has been
implemented successfully has proven the unthinkable to the modern
financial system. Such attractive performance has in effect popularized
Islamic banking, so much that they accommodate
3. Extended reach of Banking activity
The reach of banking activity in many of the non-Muslim countries like
that in the Muslim countries is very poor and a vast majority of
population is not bankable. For example it is estimated that not more than
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15 per cent of Indians have any bank account. In other words the
overwhelming majority of Indians, say 85 per cent, are outside the net of
banking activities – they are not bankable. This is a precarious situation
for any country because normally when a person becomes bankable he
also brings his savings in the main stream of economy. As Islamic
Banking is genuinely expected to attract savings of Muslims living in
non-Muslim countries it will increase the bankability in a country and
will have direct positive effect on the economy of the countries.
4. Invites Petrodollar
It is said that introduction of Islamic Banking in any country will serve as
the drain through which petrodollar will flow through. As the economy of
the members of Gulf Cooperation Council (GCC) countries in particular
and other members of Organisation of Petrol Exporting Countries
(OPEC) in general is rentier based the fund saved in these countries are
mostly invested outside their own respective countries. Till 9/11 a major
portion of those savings were being invested in the USA and other
Western countries. But now the situation has changed and the Arab
investors have started looking around for other possible opportunities. If
Islamic banks are opened in non-Muslim countries, including India, such
funds will be attracted and this will ultimately give a boost to economy
and a fillip to the overall welfare of the states.
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VIABILITY OF ISLAMIC FINANCE IN INDIA
Like how the emerging Islamic finance world has shown us, it is clear
that banking without interest can take care of any kind of financing which
the conventional banks are indulged in. This may also save thousands of
needy people to come forward to borrow from the banks and can free the
banks from the clutch of Non-Performing Assets to a large extend;
ultimately resulting in complacency amongst the customers of the bank as
well as for the banks themselves.
It is reported that in India, thousands of crores earned in interest is kept
in suspended accounts, as believers do not claim it. The assets controlled
by Muslims are estimated to be $1.5 trillion and growing at 15% a year.'
In Kerala alone, it is reported that this money could be above Rs. 40,000
crore. Research reveals that a handsome bulk of money in. India owned
by the believers is lying idle, which if invested in profit sharing basis -
and utilized properly, can have a major impact on the Indian economy.
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Fig : Bar diagram showing extend of banking reach in India
Data Source: www.rbi.org
There are several moral and religious arguments on the concept of
Islamic Banking and its introduction in India. However, the economic
argument, which has been welcomed across the globe, has also set its foot
in India.
Hurdles on the way of introducing Islamic Banking in India
1. Islamic Banking does not adhere to BRA, 1949
Many a critical issues emerge in introducing islamic Banking in india
since the concept of Islamic Banking is not in consonance with the
provisions of the Banking Regulation Act, 1949, which is the prevailing
Act over the banks in the country.
2. Role of RBI as the Central Bank
Issues also emerge as to the role of the Reserve Bank of India as the
0% 20% 40% 60% 80% 100%
Northern Region
North Eastern Region
Eastern Region
Central Region
Western Region
Southern Region
Rate of @inancial Inclusion Rate of @inancial exlusion
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Central Banker the context of Islamic Banking. Though the basic
functions of a modern Central Bank may be relevant also for an Islamic
monetary system, the mechanisms may have to be different.
For instance, in terms of Central banking functions the bank rate
Instrument cannot be used as it entails interest.
In this regard the Scholars in the field of Islamic Banking' has suggested
that adjustments in profit-sharing ratios can be substituted for bank rate
manipulations by the Central Bank.
3. Issue of Credit
According to Scholars, credit can be tightened by reducing the share
accruing to the businessmen and eased by increasing it. It is also
proposed that the Central Bank should acquire an equity stake in
commercial banking by holding, say, 25 per cent of the capital stock of
the commercial banks which would give-the Central Bank access to a
permanent source of income so that it effectively act as lender of last
resort could.
4. Inability to maintain interest-based Reserves
Another issue is that the Islamic banks if set up cannot maintain cash
reserve and SLR since these involve interest.
5. Inability to maintain capital adequacy
The other constraints may be their inability to maintain capital adequacy
and would be unable to interact with interest based banks and money
market in India.
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The problems of liquidity shortage or surplus would have to be handled
differently in Islamic banking, since the ban on interest rules out resort to
the money market and the Central Bank.
However, Scholars have suggested a solution in such cases i.e.
arrangement for reciprocal accommodation among banks without interest
payments and creation of a common fund at the Central Bank into which
surpluses would flow and from which shortages could be met without any
interest charges.
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RISKS INHERENT IN ISLAMIC BANKING
There are some unique risks in Islamic banking in additional to the risks
faced by conventional banks:
1. Credit risk
While the profit — loss sharing modes of financing may shift the direct
credit risk of these banks to their investment depositors, they-may also
increase the overall risk on the asset side of the balance sheet. This
significantly increases the potential for moral hazard and creates an
incentive for risk taking and operating financial institution without
adequate capital. This risk arises when the bank is under pressure to pay a
rate that exceeds the return that has been earned on assets financed by
their investment depositors. The breach of the investment contract for
management of investor's funds may also lead to fiduciary risk.
2. Market risk
Owing to the Sharia's prohibition against interest-based instruments,
interest rate risk affects Islamic banks only indirectly through the mark-
up price of deferred sale and lease-based transactions. This risk arises
from exposures to the price volatility of the underlying "real" assets
inherent in some financing modes, which are in the form of trading and
real investment. Similarly, the bank has to share any increase in earnings
with investment depositors, but cannot, at the same time, re-price its
receivables on the asset side at higher rates. The bank, is therefore,
exposed to mark-up price risk due to this pricing mismatch.
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These banks are directly exposed to commodity price risk because, unlike
conventional banks, they typically carry, inventory items on their books.
They are exposed to a greater extent than conventional banks to equity
price risk as the very nature of Islamic banking is equity financing
through the PLS modes.
3. Operational risk
The unique activities that these banks perform like administration of
profit loss sharing modes of financing — which includes determination of
profit and loss sharing ratios in investment projects in various sectors of
the economy, as well as on-going auditing of financed projects to ensure
proper governance and appropriate valuation, is more complex and these
activities that are not normally performed by conventional banks. This is
compounded by the non-standard nature of some Islamic financial
products and lack of an efficient and reliable Sharia litigation system to
enforce financial contracts.
4. Shariah compliance risk
This risk arises from non-compliance with Shariah principles in
conducting the Islamic banking business, which may lead to reputation
risk. The interpretation of Shariah also differs across countries.
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CONCLUSION
Global finance today dominates the world economy. Western economies
are characterized with financial sectors which generate billions for the
economy. Stock Markets, multinationals, companies raising billions,
initial public offerings (IPO) and so on, all symbolize the apparent
success of Capitalism.
Over a period of 300 hundred years the emergence of fiat currencies (i.e.
currency without an intrinsic value), the role of compound interest and
the development of limited liability company structures have shaped
western finance.
Such developments have also been the sole reason why the West has
come to be characterized with regular financial crises. This is because the
financial sector moved away from raising finance to fund business start-
ups and projects to speculating on company share prices and the
movement of currencies. In this way trading in the financial sector ceased
to be about purchasing currency or buying shares in the hope of receiving
a dividend to purchasing financial commodities in the hope they could be
sold for a higher price.
The financial economy that doesn't produce anything has become so
sophisticated that various products have been created which allow an
investment in a paper with no real asset represented.
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The problems that the world economy faced caused hues and cries about
an alternative financial system for smoother and healthier economy. The
answer to this human quest was Islamic Banking and Finance.
With its peculiar features of being interest-free primarily, rationally
ensures “real” economic activities. Its various unique forms of trade, once
unfolded to the world under crisis opened a brand new way of more
stable economy. All tools of it viz., Mudaraba, Murabaha, Musharaka,
Ijara etc. all form the discussion of world economies.
Its basis laid down centuries ago, and practiced for once at the time it was
opened to the world, it was soon forgotten for the greed of money and
sheer selfish ends. Now that on the verge of crisis, some entities
practically reminded the world of this wonderful system of finance, lets
hope that the world will receive it a warm welcome, like it apparently
does now.
However, introduction of this complex, yet rational system of financing
and banking, is still at the doorstep of our Indian economy. Even after
proving its viability and scope, our own financial conservatism is
allowing us to neither shift on to nor to leave little room for this new
system.
For better health and stability of our economy, we do need an alternative,
and lets hope that the Indian government soon resolves the current issues
and receive Islamic banking into our economy.
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REFERENCES/ BIBLIOGRAPHY
1. Bernard Lietar “Future of Money”
2. Bindu Vasu “Islamic Banking- Banking for a Change”
(RBI Legal News and Reviews- Jounal Section)
3. Mufti Barkatulla “Ethical Fusion”, Islamic Banking and
Finance Vol.7 Issue 3 No.23
4. Niladri Bhattacharya “Islamic funds likely to invest $1 bn”,
Business Standard (2008. 10th Jan)
5. Rodney Wilson “Islamic Finance and Ethical Investment”
6. Syed Zahid Ahmed, “Economics of Islamic Banking in India”,
RGE Monitor (2008, 11th Sept)
7. Report of the Working Group to examine financial instruments
used in Islamic Banking, RBI
8. Report on the Committee on Financial Sector Reforms, Planning
Commision, Govt. of India, “A hundred Small Steps”
9. www.icif.in
10. www.rbi.org
11. http://www. newhorizon-islamicbanking.com/index.cfm
12. www.islamic-finance.com
13. en.wikipedia.org/wiki/Islamic_banking
14. www.islamicfinance.de
15. www.islamicfinancenews.com
