The Art ofIslamic Banking

and FinanceTools & Techniques for Community-Based Banking

Yahia Abdul-RahmanT

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• Shows how to incorporate the Law (Shari’aa) while operating in American fi nancing and banking systems

• Points to RF (Islamic) fi nance and banking as a way to emphasize socially responsible investing

• And much more

The Art of Islamic Banking and Finance also includes a discussion on the emergence of a culture of RF (Islamic) banking and fi nance today, which is based on the real Judeo-Christian-Islamic spirit and is very reliable when compared to twentieth-century models that use fi nancial engineering and structuring techniques to circumvent the Law (Shari’aa).

Filled with comprehensive case studies based on the author’s actual experiences and detailed analysis of the superior results realized by apply-ing this new brand of banking to fi nancing, The Art of Islamic Banking and Finance will help you gain a fi rm understanding of how effective this proven approach can be.

DR. YAHIA ABDUL-RAHMAN is the CEO and Chairman of the Bank of Whittier, as well as the founder and Chairman of American Finance House: LARIBA, which has offered Islamic fi nance and banking research and instruments since July 1987. Dr. Yahia has more than forty years of highly diversifi ed experience in the banking and oil and gas industries. His area of expertise lies in international, investment, and Islamic bank-ing, project fi nancing, small- and medium-sized business fi nancing, community banking, bank management, and fi nancial services. Dr. Yahia is the author of many papers on faith-based fi nanc-ing and fi nancial instruments, and he speaks regularly at forums focused on Islamic fi nance at many universities, including Harvard University and institutions in Egypt, Malaysia, Singapore, Bahrain, Saudi Arabia, Dubai, and Turkey.

$70.00 USA/$84.00 CAN

The Art of Islamic Banking and Finance is a modern American take on what it means to incorporate Islamic fi nance principles into

everyday banking and investment techniques. It introduces a new brand of banking for people of all faiths: the Riba-Free (RF) banking.

Author Yahia Abdul-Rahman—who is considered the father of RF (Islamic) banking in America—has been a banker and an imam/scholar for over forty years. He is also the founder and Chairman of American Finance House: LARIBA, a compa-ny that has offered Islamic fi nance and banking research and instruments for more than twenty years. Now, in The Art of Islamic Banking and Finance, Abdul-Rahman shares his experiences in this fi eld with you.

This unique guide fi rst traces the Judeo-Chris-tian-Islamic origins of prohibiting “renting” mon-ey at a price, called interest, and overindulging in debt. From there, it quickly moves on to discuss money and how fi at money is created, the role of the Federal Reserve, and the American banking system. Along the way, Abdul-Rahman skillfully addresses how to include an important aspect of RF (Islamic) fi nance using commodity indexation and marking the items to be fi nanced to market in order to avoid participating in economic “bub-bles.” He also examines how these rules work, how they affect consumer behavior, and how they change the role of the banker/fi nancier. The book covers many useful quests like restructuring and operating an RF bank in the United States and the recruiting and training of RF bankers based on the author’s experience.

Chapter by informative chapter, this reliable resource:

• Covers a new pioneering model that is based on the Law (Shari’aa) and how it is applied in every transaction—from joint ventures and portfolio management to home mortgages and personal fi nance

Praise for

The Art of IslamicBanking and Finance

“It is not surprising that The Art of Islamic Banking and Finance provides a defi nitive ex-position of Islamic economics theory and its application in developing Shari’aa-compatible products. The writer, Dr. Yahia Abdul-Rahman, is among the pioneering scholars who showed how Islamic economic concepts, long forgotten, can be revived and applied effectively in today’s fi nancial services industry. His American Finance House: LARIBA has become one of the main driving forces for Islamic fi nance in North America, providing a showcase for how such concepts can be successfully applied.”

—Dr. Saleh Malaikah, Chairman, RUSD Investment Bank Inc.

“The Art of Islamic Banking and Finance is an insightful and sometimes surprising compara-tive study of the impact of Judeo-Christian-Islamic religious principles on the evolution of banking and fi nance in its various forms. One of Dr. Rahman’s key observations is this: it is not so much the fundamental principles that are different between Islamic and conventional fi nance, but rather their interpretation and application in modern practice. This fi ne work will appeal not only to those who wish to understand Islamic banking, but to anyone with an interest in our fi nancial institutions and how and why they have evolved to what they are today.”

—Guy David, Partner, Gowling Lafl eur Henderson LLP

“The Art of Islamic Banking and Finance gives a powerful, practical, and proven answer to the question of the hour: how to make banks responsible to the public they are meant to serve. The book offers not a theory but a report on how Islamic banking has success-fully functioned in modern America.”

—Richard Bushman, Professor of History Emeritus, Columbia University

“Yahia’s discussion of Islamic banking is frank, engaging, and informed by substantial practical experience. For all those who believe that the finance industry should once again serve the wider interests of humanity, this is a welcome guide on changing things for the better.”

—Tarek El Diwany, Senior Partner, Zest Advisory LLP

EAN: 9780470449936 ISBN 978-0-470-44993-6

( c o n t i n u e d o n b a c k f l a p )

( c o n t i n u e d f r o m f r o n t f l a p )

E1FLAST 10/26/2009 17:38:31 Page 36

E1FFIRS 10/26/2009 17:48:55 Page 1

The Art ofIslamic Banking

and Finance

E1FFIRS 10/26/2009 17:48:55 Page 2

Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe,Australia, and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers’ professio-nal and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors. Book topics range from portfolio managementto e-commerce, risk management, financial engineering, valuation, andfinancial instrument analysis, as well as much more.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

E1FFIRS 10/26/2009 17:48:55 Page 3

Tools and Techniques forCommunity-Based Banking

YAHIA ABDUL-RAHMAN

John Wiley & Sons, Inc.

The Art ofIslamic Banking

and Finance

E1FFIRS 10/26/2009 17:48:55 Page 4

Copyright# 2010 by Yahia Abdul-Rahman. All rights reserved.

Published by JohnWiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best

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Library of Congress Cataloging-in-Publication Data:

Abdul-Rahman, Yahia, 1944-The art of Islamic finance and banking : tools and techniques for community-based banking /

Yahia Abdul-Rahman.

p. cm. – (Wiley finance; 504)

Includes index.ISBN 978-0-470-44993-6 (hardback)

1. Banks and banking–Islamic countries. 2. Banks and banking–Religious aspects–Islam.

3. Finance–Islamic countries. 4. Finance–Religious aspects–Islam. I. Title.

HG3368.A6A244 2010332.10917’67–dc22 2009028344

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

E1FTOC 10/26/2009 18:6:39 Page 5

Contents

Preface xiii

Acknowledgments xxix

Chapter 1:Introduction 1

Chapter 2:The Faith-Based Judeo-Christian-Islamic Foundation of the Prohibitionof Interest and the RF (Riba-Free) Banking System 13

An Introduction to the Judeo-Christian-Islamic Foundationsof Faith 16

The Book 16The People of the Faith 18Loans 18Usury/Interest 18

The Judaic Position on the Charging of Ribit (Interest):Money, Lending, and Interest in the Torah and theJewish Tradition 21

Loans to the Poor 21Lending to Non-Jews with Interest 22Business Financing 23

The Charging of Ribit (Interest) in the Roman CatholicTradition: Then and Now 23

Lending to the Poor 24Position of the Contemporary Roman Catholic Church

on Allowing the Charging of Interest 25The Charging of Ribit (Interest) in the Tradition and Teachings

of the Evangelical Christian Church 27Lending to the Poor 27Lending to the Enemy 30

v

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Business Financing and Relaxation of the Rules ofProhibiting the Charge of Interest 30

The Prohibition of Charging of Ribit/Riba (Interest/Usury)in Islam 31

The Development of the Universal Riba-Free Systemin Islam 31

The Concept of God Owning Everything 32Developing the Institution of Giving (Zakah) as a

Required Islamic Ritual (Like Prayers) 34Behavioral Guidelines and the Discipline of Giving 38Business Finance 39Types of Riba 41Shari’aa Prohibits Deceptive and Speculative Activities

in Business Transactions (Gharar) 43

Chapter 3: The Rule of Commodity Indexation andthe Principle of Marking to the Market 47

Development of the Mark-to-the-Market Rule 53Riba-Free Business Transaction Models 54

Cost-Plus (Murabaha) 54Leasing (Ijara) 56Joint Venture (Musharaka) Direct Investment/Equity

Ownership or Partnership 58Money Management (Mudaraba) 59Financing Future Production (Ba’i ul Salam) 59

Chapter 4: Shari’aa: Shari’aa Boards in Islamic Banks: An Overviewand a Vision for the Future 61

The Law: Shari’aa 63Sources of Shari’aa 64Application of Shari’aa 67

The Shari’aa Board in an Islamic Bank or FinanceCompany 75

The Role of the Shari’aa Board 76The Duties of the Shari’aa Board 77Approaches Used to Appoint Shari’aa Boards 78Concerns of Western Central Bankers and Bank

Regulators Regarding Shari’aa Boards 79The Development of Shari’aa Scholars and Shari’aa Compliance

Committees for Riba-Free Banks and Finance Institutionsin the 21st Century 80

The Central Bank and the Regulatory Shari’aa ComplianceCommittee 81

vi CONTENTS

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Chapter 5: Money and Its Creation: The Federal ReserveSystem (Central Banks), Interest Rates, and Commodity Indexation 84

Those Who ‘‘Make’’ Money and Others Who ‘‘Earn’’ Money 84What Is Money? 86The History of Money 87Fiat (Paper) Money 88American Currency Before the Federal Reserve System 89

The Federal Reserve Board of the United States of America 90Function of the Federal Reserve 91Structure of the Federal Reserve Board (America’s

Central Bank) 92Who Owns the Federal Reserve Bank? 93Credit Creation in the Modern Banking System 93

The Dollar Made As Gold! What a Wonderful Place to Be! 96A Brief History of the Bretton Woods Agreement, Which

Changed the World of Money 96The Fed Fund Interest Rates Setting Regime 99Fiat (Paper) Money and the Cyclical Nature of the

Fiat Money Economy 102The Prohibition of Riba/Ribit: Rulings on Riba in Fiqh,

the Science of Shari’aa 105Reason for Prohibition 106Application of Shari’aa using the Commodity

Indexation Rule 108Homes in America 111Price of Coal 113Price of Crude Oil 114Price of Natural Gas 117Price of Rice 118Gold: That Amazing Metal 121

Gold Reserves in the World 123The History of Gold Markets and Prices 124Gold Price Fixing 125

Marking the Investment to the Market 128

Chapter 6: Civility and Social Responsibility of theRiba-Free Banking System 132

The Judeo-Christian-Islamic Values: Civility, Morality,and Social Responsibility 137

The Vision of an Ideal Faith-Based Judeo-Christian-IslamicSociety 140

New Trends that Captured the Imagination of the Pagans ofthe Arabian Peninsula 141

Contents vii

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Elements of the Riba-Free Economic System 142Production 142Distribution 142Consumption 144

The Riba-Free Judeo-Christian-Islamic System and BusinessEthics 144

The Market System 145Management Ethics 145Justice and Fairness on Both Sides: The Bank and the

Customer 146Banking and Investment Banking 147Values and Business Ethics of the RF Banker 149

Professionalism 149Concentration 149Consistency 149Commitment 150

The Ten Golden Covenants of the RF Bank 150Where DoWe Start and How DoWe Realize the Dream? 151

Chapter 7: The Conventional Riba-Based Banking System 154The Banking System of the United States 154Types of Banking Services in the United States 156

National Banks 157State Banks 157Credit Unions 159Investment Banks 160Licensing a Commercial Bank in the United States 160

Government Supervision of the Bank 161The Office of the Comptroller of the Currency 162Insurance of Bank Deposits by the Federal Deposit

Insurance Corporation (FDIC) 163United States Banking Regulations 163

Consumer Compliance Management 164Board of Directors andManagement Supervision

and Administration 164Compliance Program 165Compliance Committee 165Internal Controls 166

Summary of Federal Banking Regulations in theUnited States 168

Regulation B: Equal Credit Opportunity 169Regulation C: HomeMortgage Disclosure Act (HMDA) 172

viii CONTENTS

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Regulation Q: Prohibition Against Payment of Interest onCertain Deposit Account Types 174

Regulation D: Reserve Requirements for DepositoryInstitutions (Banks) 174

Regulation O: Loans to Bank Insiders 175Regulations P and S 175Regulation Z: Truth in Lending Act 178Regulation BB: Community Reinvestment Act (CRA) 179Regulation DD: Truth in Savings Act 180Fair Credit Reporting Act 180Anti-Money-Laundering Program 181Bank Examination for Safety and Soundness by Bank

Regulators 181Bankruptcy Laws 187

Chapter 8: What Is the Difference? Comparing Riba-Free Bankingand Conventional Riba-Based Banking 191

The RF Banking Brand: History, Development, and Stagesof Growth 191

An Overview of RF Banking 196Misnomers in RF Banking 197What Is RF (Islamic) Banking? 199What Is the Difference Between Riba-Based Conventional

Banking and RF (Islamic) Banking? 201

Chapter 9: Islamic Banking in the 20th Century 204Islamic Banking Models 207

The Cost-Plus (Murabaha) Model 207Financial Engineering and Shari’aa 210The Lease-to-OwnModels (Al Ijarah Wal Iqtina or

Al Ijarah Wal Tamaluk) 212The Al Baraka Bank of London Shari’aa-Compliant

Model 212The South Asian Diminishing Musharaka Shari’aa-

Compliant Model 215Court Challenges to the Shari’aa-Compliant ‘‘Contract Fitting’’

Islamic Finance Approach 221Cases Litigated in the U.K. Courts 222Resolutions Taken By ‘‘Islamic’’ Banks to Avoid

Lengthy Trials 222Conclusion 223

Contents ix

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Chapter 10: RF Banking Model for the 21st Century: Developing theShari’aa-Based Finance Model 226

The Puzzle and the Challenge of Developing RF Banking andFinancing 227

Legal and Financial Categories 227Participants in the Development of Modern RF Banking 232RF Banking Consumers and Potential Users 243

Shari’aa and the Laws of the Land 244Developing the Art of Islamic Banking and Finance 245The Approach Used to Develop the Art of Islamic RF

Banking 245Major Objections of Shari’aa Scholars to the Conventional

Riba-Based Finance Contract 249Building the Shari’aa-Based Finance Model 255

The Unique Features of the LARIBA Shari’aa-BasedModel 258

The Stages Used to Implement the Shari’aa-BasedLARIBAModel of Financing 259

The Results 276

Chapter 11: Starting an RF Bank in the United States: Acquiring andRestructuring a Troubled Bank and Operating It Riba-Free 280

Introduction 280Riba-Based Conventional Financing versus RF Financing 283Looking for a Suitable Bank to Acquire 285Making History: Acquiring the Bank of Whittier, N.A. 287Operating the First RF Bank in the United States 295

Our Strategic Approach to Restructure the Bank ofWhittier 296

The Bank Restructuring and Workout Plan: Turning theBank Around 296

Specific Action Plan and Steps Taken by Bank Management 297Strategies Designed and Steps Implemented by the New

Management 303The Staff and Employee Policy: Strategy Used to Build Up

and Train Bank Staff 305The New Staff: A Strategy for Defining Whom to Look

for andWhere to Search 307The Audit Policy: Strategy Used for Auditing Bank Functions

and Operations 307Engagement Letter for External Auditors 309Audit Response by Management 312

x CONTENTS

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Chapter 12: Operating an RF Bank in the United States 315Investing in and Operating a Riba-Free Bank in the

United States 317The Added Value of RF Banking 319What is RF Banking and Finance? 319

U.S. Banking Regulations and Bank Regulators 320U.S. Securities Laws and Regulations 320The Spirit of the Riba-Free and Gharar-Free (Islamic)

Banking and Finance System 321Strategies Used to Build a Viable RF Banking System

in the United States 321Key Internal Controls at the Bank 323

Creating True RF Private Bankers and RF Credit Analysts 324Recruiting and Interviewing RF Bankers 328Community Participation, Networking, and

Customer Service 329Training Program at the Bank of Whittier Open University 331

Reading Discipline 333RF Banking Values and Social Responsibility 333Introduction to Banking 333Character Building: Honesty and Integrity 333Know Your Customers, Privacy, Customer Identification

Policies, and Fraud Prevention 334Understanding Banking Regulations 335Prevention of Money Laundering and Complying

with the Bank Secrecy Act 335Special Courses for Credit Department Personnel 336

The Balance Sheet of the RF Bank 337General Concepts 337

The Need for a Good Detail-Oriented ManagementTeam at the RF Bank 341

Restructuring a Riba-Based Bank to Operate as an RF Bank 342Evaluation and Review of Existing Services 343Deciding on Types of Accounts Offered to Individuals,

Families, and Businesses 347Risk Management for an RF Bank 352

Chapter 13: Case Studies: Developing the RF Banking InvestmentProducts 357

The Investment Pyramid 358Cash and Cash Equivalents 358Short-Term Investments 358

Contents xi

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RF Bonds: Sukuk (RF Income Instruments that ReplaceRiba-Based Bonds) 359

Investment in Stocks 359RF Asset-Backed Bonds (Sukuk) 359

RFMortgage-Backed Sukuk Securities 359The Development of MUIS Waqf Sukuk: RF

Asset-Based Bonds Used to Unlock the Value of Trusts 360RF Stock Market Investments 364

Guidelines for RF Investing in the Stock Market 364Normalization of Various Stock Market Indexes Using

the Commodity Indexation 366

Chapter 14: Visions for the Future of RF Banking 371The 2008 Global Economic and Financial Meltdown 371The Mega-Banks and Financial Institutions 372The Culture of Renting Money with Ribit/Riba 373The Lifestyle of the Judeo-Christian-Islamic Value System 376Some Advice for the Newcomers to the RF Lifestyle 377

Chapter 15: A New Banking Vision for the 21st Century 379

Index 382

xii CONTENTS

E1FPREF 10/26/2009 17:21:27 Page 13

PREFACE

My Story With Islamic Bankingand Finance in America

I came to the United States on my own from Egypt to study for my MS andPhD degrees at the University of Wisconsin, Madison in 1968. I had essen-

tially nothing except my BS degree in Chemical Engineering from Cairo Uni-versity and a letter from the University of Wisconsin, Madison accepting meas an International Special Student on a trial basis. I did not have the fundsto pay for tuition nor for accommodations, books, and other expenses. Itwas a big challenge for me, but I made it, through hard work, to where I amtoday managing a pioneering effort in America to establish what I consider arevival of the banking system that built America. Using a platform we callthe LARIBA system (www.LARIBA.com), we offer socially responsible,faith-based, and riba-free banking. Throughout this book, I will abbreviateit as RF banking.

In 1987, a group of dedicated friends invested $10,000 each to start asmall company we called American Finance House LARIBA. We gathered$200,000 as the startup capital. To my knowledge, this was the first timeever a group of Muslims had bonded together to start a joint projectthat would eventually become an important force in the American Muslimcommunity and in many non-Muslim communities. Our goal was to start afinance company that would operate without the charging of interest andaccording to the foundations of Islamic law (Shari’aa). Today, in 2009, andafter 22 years the LARIBA shareholders own LARIBA (www.LARIBA.com), the oldest Islamic RF finance company in the United States, and theBank of Whittier (www.BankOfWhittier.com), a national bank. The LARI-BA System (the finance company LARIBA and the Bank of Whittier, NA)serves all 50 states in America and services a portfolio of riba-free shari’aa-compliant financing that is worth approximately $400 million. The portfo-lio includes home mortgages, automobiles, fast food franchises, medicaldoctors’ clinics, dialysis centers, commercial buildings, schools, churches,and Islamic centers. It was, and continues to be, a wonderful journey.

xiii