08 June 2005Muamalat Institute, Jakarta(First-time Presentation)*Theory of Islamic BankingProf. Dr. Sayyid TahirIIIE, IIUI (1981-2011), IIUM (since 2011)Amanah

Muamalat Institute, Jakarta(First-time Presentation)

*In the real life, there are:Needs at fund-seekers endConcerns at the level of savers the ultimate investorsBanks address concerns of the owners of funds and help to meet needs of the fund-seekersInterest-based banking has a long tradition. Interest is price of capital, and helps in efficient allocation of scarce capital.Some Points for Reflection

*Banks borrow from savers (depositors) and lend to investors (fund-seekers).There is a lender-borrower relationship between banks and savers and also between banks and investors.Existing banking, therefore, rests on loantransaction and its variants. Interest-based banks are both financial intermediaries and financial institutions.Interest-Based Banking

*Rationale for Islamic Banks 1(same as that for interest-based banking)Whenever there exists some gap or space between two parties, a third party can come into the picture!Likewise, whenever there is a financial gap, a role for a financial institution exists. This is the rationale for modern banking.There can always be argument about the way in which financial institutions may come into the picture and perform their role, because most of the time there exist more than one ways of doing anything.

*That Shariah is a way of doing things, implies that Islamic banking is a real possibility. Thus, there can be no qualms about the existence of Islamic banks that would plug financial gaps in the economy whether an Islamic economy or otherwise.The only questions that call for answers are: How would Islamic banks come into thepicture? How would they perform their role?Rationale for Islamic Banks 2

*Foundations for Shariah-Compliant Thinking [: 27]We have put forth for men, in this Quran every kind of parable, in order that they may receive admonition. [Az-Zumur 39: 27]See also Al-Kahf, 54 and Al-Asraa, 89.The basic Ahkam of the Shariah are given at the micro (individual) level for the primary cases trading, leasing, partnership, loaning, etc.All other Ahkam are generalizations of the said Ahkam.3.Logically speaking, Islamic alternatives in the domain of banking ought to be developed in the light of the aforesaid Ahkam.

*Foundations for Shariah-Compliant ThinkingSome Parameters for Thinking:1.No riba.No ghararGeneral Shariah-compliance, in addition to no riba and no gharar. For example, avoidance of haram, not clubbing two mutually exclusive exchanges in a single transaction, respect of Ahkam for trading, etc.The Shariah is about pursuing legitimate goals in Shariah-recognized ways.

*A Suggested Approach for Defining Role Function of Islamic Banks and Islamic Financial InstrumentsTake a real life case.See how an Islamic bank might come into the picture in a gainful manner.Identify the transaction modes that might facilitate the banks role.Check the Shariah conditions for those transaction modes.See how the overall transaction may work.Work out the financial instrument.

*Potential Cases with Some Role for Islamic BanksSome Instances in which financial gaps exist:A person wants to buy a thing while he does not have cash to meet payment needs.A producer needs working capital.A party, without sufficient means, wants a thing on lease.A businessman (or, a mill) needs working capital.An individual wants to invest his savings, while he has other commitments.

*Role Function of Islamic Banks - 1Case 1:A Client wants to buy, say, a fridge while he does not have cash to meet payment needs. Murabahah Financing

*Case 2:A Client (Producer) wants working capital Trade-based Mode: Salam FinancingRole Function of Islamic Banks - 2

*Case 3:A Client, say PIA, wants to lease planes from Cathy Pacific Airways but does not have the required cash. Ijarah (or, Lease) FinancingRole Function of Islamic Banks - 3

*Case 4:A Client (Businessman) needs working capital Partnership Mode: Musharakah FinancingRole Function of Islamic Banks - 4

*Case 5:An individual wants to invest his savings while he has other commitments Modarabah or MusharakahRole Function of Islamic Banks - 5

*Islamic Financial InstrumentsWhat is a financial instrument?A financial instrument is a piece of paper or a set thereof based on one or more underlying exchanges between two parties that gives rise to financial rights and obligations for the concerned parties.A financial instrument is based on contract(s) between two parties.A financial instrument replicates the associated transaction process.

*A Simple Murabahah Financing Instrument (MFI)

*Structures of Other Financial InstrumentsSalam Financing

A Purchase Agreement between the Bank and the Producer seeking working capitalA Sale Agreement between the Bank and the Final Buyer.Note:Obligations of the Producer seeking financing, would stand discharged with delivery of the merchandize.Ijarah Financing

A Purchase Agreement (or a Lease Agreement with provision of sub-leasing) between the Bank and the Owner of the asset.A Lease Agreement between the Bank and its Client.Note:The Bank may need to enter into separate agreements with third parties for maintenance and similar other requirements for lessors.

*Musharakah FinancingA single partnership agreementbetween the Bank and theClientNote:With zero capital contributionby the Client, the samewould become ModarabahFinancing agreement.

Deposits SideModarabah Agreements with return-conscious depositorsMusharakah Agreements with return-conscious but somewhat risk-averse depositorsLoan Agreements with depositors interested in safe-keeping of their money with flexibility in its use.Structures of Other Financial Instruments

*A Set of Islamic Financial InstrumentsMurabahah Financing Instrument (MFI)Salam Financing Instrument (SFI)Ijarah Financing Instrument (IJFI)Musharakah Financing Instrument (MUFI) or Modarabah Financing Instrument (MOFI)Some other financial instruments are alsoconceivable.The MUFI and MOFI are to be seen as financialinstruments when applied to deposit mobilization.

*Working of the Islamic Banking ModelFINANCINGMute InvestmentsMFI, IJFIInvestments involving MFI, SFI,Value-added ActivityIJFI, MUFIMOFIDEPOSITSCurrent AccountsTerm DepositsGeneral Savings DepositsDeposits with Stable Income Flows

*While Islamic banks will come into the picture as trader, lessor, partner, etc., they will nevertheless be pure financial institutions.The above will happen because economic considerations will encourage Islamic banks to delegate jobs demanding material () commitments to third parties for a feeCaution:Islamic banks cannot pursue the delegation course to the point of negation of their own role function.Nature of Islamic Banks

*Islamic Banking Model vs. The Conventional Banking Model 1Note:Islamic banking should not be confused with universal banking.

*The Differences:There shall be at least one most of the time more than one financial instrument to address any conceivable need.The role function of the banks will change: Islamic banks will be economic agents, not just financial intermediaries.There may be debt but no credit in the economy.Financial flows will be tied to real flows, and will bring about greater harmony between financial and real sectors of the economy.Islamic Banking Model vs. The Conventional Banking Model 2

*Standardization or financial instruments, their pricing formulas and associated proceduresCredit rating system for the clients, besides innovative financial productsDevelopment of real market linkages to support trade-, lease- and partnership-based financingSome Fresh Requirements for Islamic Banking 1

*Institutionalization of recovery of debt: Recognition of debt as first charge on the debtors assets (beyond a prescribed minimum), pre-registration of financing agreements, debt-collection agenciesAccountingReorientation and training of bank staffPublic awarenessSome Fresh Requirements for Islamic Banking 2

*Shariah compliance in both letter and spiritMeasures against misuse of Islamic financingFresh approach to risk management and capital adequacy requirementsNew prudential regulations, with renewed and sharper focus on accounting mattersModified approach to reserve requirementsSome Regulatory Issues

*Islamic banking started in the 1970s without a proper working model.The existing Islamic banking is Banking under Shariah Supervisory. The Shariah side is exclusive prerogative of the Shariah scholars.From a legal and banking point of view, the difference is thin between deposit products offered by conventional banks and Islamic banks.Islamic banks are mostly relying upon trade- and lease-financing.Review of Selected Existing Practices of Islamic Banking

*Murabahah Financing Theory

*Murabahah Financing Practice

*Existing Interest-based Financing

*Bai bi Thaman AjilThe presenter would like to stand correctedon the following points:1.The Client buys a thing from the Supplier in his name.2.The Bank buys the same thing from the Client at his cost price to the Supplier.3.The Bank sells back the same thing to the Client at a marked-up price to be paid latter in installments.Thus, the Bank is buying and the selling from thesame party.

*Ijarah Financing Theory

*The existing lease financing is a hire-purchase arrangement that is negation of the Shariah principle of not combining two mutually exclusive exchanges in one contract.The rental is fixed at some benchmark (such as central banks lending rate) plus some percentage points. This is contrary to the Shariah notion of fixing the rent in advance.Directly or indirectly, all responsibility for maintenance of the asset is placed on the shoulders of the Client, against the Shariah principle for leasing.Sometimes lease agreements go into effect before delivery of the asset, while the lease period is counted from the date of signing of the lease contract.Ijarah Financing in Practice

10 June 2005Muamalat Institute, Jakarta*THANK YOU

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