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A critical comparison of Instruments of Islamic banking with the commercial

banks in the United Kingdom.

By

Mohammed Zaki

Department of Finance

Dissertation prepared for the partial fulfillment of the requirements for the

Masters of Business Administration

19th September 2011

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Declaration

This Dissertation is a product of my own work and is not the result of anything

done in collaboration.

University ID-1092227297575

Student Signature…………………………………….. Date………………….

I agree that this Dissertation may be available for reference and photocopying,

at the discretion of the university of Wales institute, Cardiff.

Student signature…………………………………….. Date…………………

Mohammed Zaki

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ABSTRACT

The present dissertation topic ‘A critical analysis of Islamic banking instruments with Commercial

banking in the United Kingdom’ has been attempted so as to analyze the basic differences in the

principles of these two systems of banking.

The data reveals that basically the Islamic banking operates on the principles of interest free

banking with a participatory system of sharing of profits and losses with its clients. Conventional

banking in Britain works on interest charging as its basis of finance.

Although Islam has prohibited Riba (interest), the question still remains whether it is the same as

the bank interest.

There are a number of Islamic banks and Islamic ‘Windows’ in commercial banks in the United

Kingdom.

Profit and Loss Sharing principle applies to some major instruments of the Islamic banking system

such as Musharaka and Mudarabah and cost plus profit is applied to Mudarabah.It is argued that

Murabaha is not entirely based on Shariah and Mudarabah though permitted has great

disadvantage attached to the financier. On the Savings account there is no bank guarantee on the

return of principle as per Shariah law.

Critical differences between Islamic and Conventional banks on the whole reveal that profit and

loss sharing system may have greater beneficiary effect upon society than interest based finance.

The future of Islamic banking in the United Kingdom seem bright on account of the fact that there

is a large Muslim population in Britain who want to do financial transaction preferably through

Islamic banking in order to satisfy their religious principles. Further the data also reveals that

Islamic banking has fared better during economic crisis in the recent past.

This research recommends that in view of the benefits associated with the interest free system of

banking, it may be encouraged in its true Shariah form or through a system of Binary Economy

where the products are managed with out involving interest as in conventional banking.

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Table of Content

Introduction 11-17

1.1 Purpose and main objective 12

1.2. Background and preliminary scene setting 13

1.2.1. Emergence of conventional banks in United Kingdom 13

1.2.2. Islamic banks in UK 14

1.3. Instruments of Islamic banking 15

1.4. Outlines of the subsequent chapters 17

Literature Review 18-48

2.1. Britain’s First Islamic Bank 18

2.2. Principles of Islamic Banking System 19

2.2.1. Practice of Interest (Riba) In Early Arabia 19

2.2.1.1. Riba Al Nasiah 20

2.2.1.2. Riba Al Fadal 20

2.2.1.3. Injunctions against Riba in the Quran 21

2.2.1.4. Ill Effects of Riba 22

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2.2.1.5. Comparison between Riba and Trade 23

2.3. How Does Interest Affect Us 24

2.4. Profit And Loss Sharing 27

2.4.1. Instruments of Islamic Banking 28

2.4.1.1. Deposit Accounting 28

2.4.1.2. Investment Financing 28

2.5. Critical Evaluation of Islamic Banking Instruments 35

2.5.1 Murabaha V Conventional Loans 35

2.5.2 Profit And Loss Sharing 36

2.6. Differences between Islamic and Conventional Banking 37

2.6.1. Differences in Concepts and Operations 39

2.7. Risk Management 41

2.7.1. Risks Involved In Islamic Banking 41

2.7.2. Risk Management by Conventional Banks 43

2.8 Future of Islamic Banking in UK 44

Methodology 49-54

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3.1. Sourcing data 49

3.2. Data collection 49

3.3. Qualitative data collection 51

3.4. Quantitative methods 51

3.4.1. To observe ethical procedure and obtain relevant data 51

3.5. Sources of secondary data collection 52

3.5.1. Advantages of quality data 53

3.5.2 .Reasons for preference 53

Data Analysis 54-67

4.1 .Equating riba with bank interest 55

4.1.1 .Critical analysis of profit and loss sharing 56

4.1.2 .Difficulty in implementation 56

4.2 .Critical review of instruments of Islamic banks 57

4.2.1. Murabaha 57

4.2.2 Diminishing Musharaka 57

4.2.3. Modarba 59

4.2.4 .Savings account 59

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4.4. Critical differences between conventional and Islamic banks 63

4.5. Risk management by Islamic and conventional banks 64

4.6. Future of Islamic banking in Britain 65

Conclusion 69-74

5.1. Interpretation of Shariah Law 71

5.2 Conventional Banking 72

5.3 Constrains and Challenges of Islamic Banks in the UK 72

Recommendation 75-77

Bibliography 79-86

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List of Figures

Literature Review

Figure 1-Basic Types of Growth Pattern 25

Figure 2-Constant Growth Curves 26

Figure 3-Examples of the Amount of Interest within the Normal Prices and Fees 27

Figure 4-Musharakah Contract 29

Figure 5-Profit Sharing Contract 31

Figure 6-Diminishing Musharaka 32

Figure 7- Murabaha 33

Figure 8- Global Assets of Islamic Finance 45

Figure 9-Islamic Finance by Country 46

Figure 10-Islamic Banks in UK 47

Figure11- Global Assets of Islamic Finance and Islamic Finance by Country 47

Figure12-Assets of Islamic Banks in UK 48

Data Analysis

Figure 13-Before the Crisis 65

Figure 14-Initial Crisis Effect 66

Figure 15-Deepening Impact 67

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Figure 16-Country Wise market Share of Islamic Banking 68

Figure16.1- Global Islamic Funds Industry 68

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ACKNOWLEDGEMENT

First of all I am grateful to the Almighty God for making me accomplish my dream of studying in London at the University of Wales.

I am indeed grateful to my professor and guide Professor Jim Matthews who has very systematically guided me during the preparation of my dissertation work. His soft approach and timely guidance enabled me to go through the assignment in a methodical manner.

I am very much grateful to my parents for their continued moral support and their constant prayers for my success. May the Almighty God give them health with a long life and happiness.

I am thankful to my friends especially Mr. Sanjay, for helping me to adjust to the London atmosphere.

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INTRODUCTION

Human behaviour over the ages has been guided by great religions of the world. Norms and

standards have been set for man to follow a systematic way of life in tolerance, patience,

perseverance and in all dealings with fellow human beings as well as with his surroundings .These

standards and laws also extend to the economic areas which are the most vital aspect of human

dealings.

All great religious leaders and philosophers from the ancient Greece to the modern day have made

a concerted effort to curb the evil of exploitation of the poor by the rich. However much, one

might try to curb this monetary exploitation; this evil continues to persist in the modern society.

Unfortunately feudal system of exploitation of exorbitant interest has now been extended into a

global arena as a result of which many nations are facing the same plight as did individuals.

Modern economists have predicted that the interest free banking would alleviate many of the

existing financial problems facing mankind. The recent recession through out the world, especially

in advanced countries is linked to the bad effects of interest on society. Thus according to Margrit

Kennedy (1995), the reasons for the accumulations of huge debts and rise in unemployment and

unrest are on account of interest and compound interest. Money should always be going into

circulation rather than remaining in the possession of a few. This can be achieved by an interest

free economy. Therefore it becomes necessary to examine this system now known as Islamic

Banking more critically and compare it with Conventional banking.

RATIONALE

The principle area of research topic pertains to Islamic Banking .The most important aspect of

Islamic banking system is that it is interest free and this is strictly in accordance with the Shariah

which is the Islamic law. My interest in this topic is for finding the main principles of its operation

as it seems to be gaining popularity among Muslims in London and would like to probe whether it

could stand against competition from Conventional banking which has been in existence since a

long time

1.1. PURPOSE AND MAIN OBJECTIVE:

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The main purpose of making this study is not only to know the critical differences but also to know

the basis of its formation and popularity. The United Kingdom has been the major hub of banking

system and it is but natural that Islamic banking which is comparatively a new idea has found its

roots here.

The main foundations are:

• Prohibition of Riba (Interest)

• Prohibition of Miser (Game of Chance)

• Prohibition of Haram (Illegal and unsociable activities)

• Payment of Zakat (Part of bank profits for charity), Solé (2007).

Interest is designated as Riba in Islamic terminology and it would be necessary to explain Riba

because it is based on this objection that the Islamic banks design all their products and activities.

Also to detail the points based on which the scholars have come to a conclusion that Riba, the type

of interest that was practiced in early Arab world, is similar to the interest as charged by the

Conventional banks. Secondly, Islamic banks function on the basis of profit and loss sharing. Here

the purpose would be to find its salient features, how does it applies to various instruments of

Islamic banking and what is its short falls. Finally to get an over all assessment in comparing the

Conventional and Islamic banking systems.

Therefore the area of research would be to assess whether there is any operational difference

between these two systems or not. The following are the points with which an analysis would be

made.

• To study the background of Islamic Banking in the UK.

• To review the definitions by various scholars regarding Riba.

• To study the principles of Islamic Banking.

• To study Islamic Banking Instruments and critically evaluate them.

• To find the critical differences between Conventional and Islamic Banks.

• Comparative risk management

• Future of Islamic Banking in Britain

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1.2 BACKGROUND AND PRILIMINARY SCENE SETTING:

To have a comprehensive study it would be essential to go through the background in order to

form a scene setting of the topic which relates to Conventional and Islamic Banking system in the

United Kingdom.

1.2.1 Emergence of Conventional Banks in United Kingdom:

History of banking in England starts with the legalization of interest by British King Henry the III

in the year 1545, although the Church had opposed it.

The Bank of England was founded in the year 1694 and its monopoly was strengthened with an

Act of Parliament in the year 1709.Later in 1770, Bankers Clearing House was founded as cheques

were being gradually introduced. The Industrial Revolution added strength to the banking industry

and smaller banks came into being. In 1920 the Barclays, Lloyds, National Provision, Westminster

and Midland which was then the largest banks in the world, opened their branches in other towns.

In 1946 the Bank of England was nationalized (Lip comb and Pond 2002, Baron 1958).

Islamic Banking on the other hand is a rather recent phenomenon which is basically based on the

concept of interest free banking.

According to a report in FSA Briefing note (2006) Muslims constitute about 3% of the population

that is about 1.8 million in the United Kingdom. In London itself there are about 50% residents

who call themselves as Muslims. As in other parts of the world, Muslims are trying to live by the

Laws of Islam with its basic principle of prohibition of interest in any form what so ever. This,

they are trying to do by following Shariah Law which describes a framework with in which they

are told to conduct themselves especially in matters relating to finance.

Based on these factors, the United Kingdom has opened its doors to permitting banks to

investments, savings and mortgaged tailored to the needs of the Muslim community as per the

Shariah law. There are wholly Shariah compliant banks operating in Britain. One of the most

prominent banks in Briton is the Islamic Bank of Britain (IBB). Today London has become a very

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important center of finance dealings where international firms as well as the Gulf traditional banks

are offering Islamic based banking instruments. The Financial Services and Market Act 2000 have

welcomed the innovative method of banking with its diversities in the various instruments of

Islamic Banking systems. This encourages as well as strengthens the financial scenario of the

United Kingdom. By permitting Shariah based banking, the UK has enabled its citizens whose

faith prevents them to deal with the products that are normally offered by the UK conventional

Banks and other financial institutions, to deal in financial matters according to their religious

principles.

1.2.2 ISLAMIC BANKS IN UK:

Matthews (2007) reports that there are about five thousand rich Muslims in UK with liquid assets

of around 3.6 million pounds and the expected growth is approximately by 40% by the year

2025.The formation of the Shariah based banks has been encouraged by the UK government to

facilitate the process as it wanted to give its large Muslim community financial services which are

in conformation with their religious belief. The Financial Services Authority as well as the Bank of

Britain have played a major role in these developments. (Ainley.M. (2007).

Briefly speaking one would say that Islamic Bank is an intermediary and a trustee where it shares

the loss as well as the profits with its customers although in practice its overall setup has many

similarities with the conventional banking such as acceptance of deposits, offering loans for

business or housing, letters of credit, over drafts and other banking facilities with the main

difference as said above that it works on the principle of no interest.

In general the salient features of Islamic Banking are:

• No interest on deposits.

• Loans carry a service charge

• Investments are on profit and loss basis.

• Value erosion on capital due to inflation is compensated, (Gafoor, 2008-2009)

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It is a common belief that in the Islamic Banking instruments there is no likelihood of the public

becoming a victim of loans and advances and become insolvent. On the other hand there is every

likelihood of Islamic Banks becoming bankrupt because there is too much of risk of insolvency in

each of its instrument as most of it is based on trust, if followed according to Sharia law.

The basic idea in the Islamic Bank is against fixed interest but on equity participation contracts,

that is profit and loss sharing. And therefore may be a good route to long-term wealth. In view of

the U.S. savings and loan crisis and the present problems confronting the USA, it has been

suggested even by prominent western economists like Simon as early as 1948, Kindelberger in

1985, Khan in 1986, and more recently by Akaoem in 1991(Ibrahim 1993,). That the banking

system based on Islamic profit –loss sharing arrangement could be a better alternative to the fixed

interest rates. This would be possible if the Islamic Banks follow Shariah law in its totality.

The following are the various instruments of Islamic Banking which would be critically compared

with the Conventional Banking.

1.3 INSTRUMENTS OF ISLAMIC BANKING:

A brief introductory note on the instruments of Islamic banking would be helpful in obtaining

preliminary view of their mode of function.

Murabaha:

This term is derived from the Arabic word Ribh which means profit. It is a cost plus profit. In this

case if the customer intends to purchase equipment, He approaches the bank which purchases the

commodity and then sells it to the customer on a pre agreed profit. It is similar to letter of credit.

Mudarabah:

The word Mudarabah is derived from Arabic darb fil-ard (Darb meaning travel, ard meaning land)

that is traveling through land. (Usmani, 2010).All the investments are done by the capital provider,

but he or she has no rights to interfere in the business matters. Both parties agree to divide the

profits but losses if any are to be faced by the investor except those which are caused by

negligence by the entrepreneur (Chapra, 2010).

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Musharaka:

A partnership based instrument which is different from Mudarabah, here the partnership is of

limited time, in basic commercial terminology it would rather be called as a joint venture. It is

sharing partnership where each partner provides a capital and takes part in the day to day activities

or appoints an agent. Thus it is basically different from Mudarabah.

Muqarada:

It focuses on shares. A method to structure a bond where the bondholders have a cash flow from

the project planned intended to be financed.

Ijarah:

A leasing instrument of Islam where the bank buys the property and leases it out under the

installment plans.

Salaam:

This is an instrument which is based on sales. The sale is of a particular commodity which should

be present physically during its sale.

Istinsa:

It plays a vital role in house financing. It is also an instrument based on sales like salaam but it is

of different nature. Here the commodity is transacted before it exists physically.

Bay Bithamin Ajil:

In other words it is differed payment sale. Buying a product or goods and paying the price in

installements .This method is inclusive of profits agreed by both the parties.

1.4 OUTLINES OF THE SUBSEQUENT CHAPTERS:

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Structure of this dissertation constitutes different chapters as per the guide lines of the University.

These are divided into the following chapters each dealing with various aspects of Islamic and

Commercial banking systems .These chapters are as follows:

• The first chapter consists of Introduction. This gives the purpose of the project namely.’ A

critical comparison of Instruments of Islamic banking with the commercial banks in the

United Kingdom, a background to the study, preliminary scene setting about the concept

of financial dealings with out interest, an outline of, aims and objectives, the various

instruments of Islamic Banking.

• The second chapter is review of the relevant academic literature upon which this

dissertation is built in a critical way. Briefly it consists of a brief history of conventional

and fundamentals of Islamic Banking, philosophy of interest free banking, description of

Riba, injunctions in the Quran against interest, comparison between Riba , trade and profit,

modern concept of interest and its impact on economy , current practices in Islamic

Banking and its critical evaluation.

• The third chapter consists of Methodology, the description of quantities and qualitative

analysis, collection of primary and secondary data preferences in methodology of

collecting data with justification.

• The fourth chapter consists of research findings of what has been discovered with critical

analysis of the main topic of dissertation. More emphasis would be made on some of the

main Instruments of Islamic banking.

• The fifth chapter consists of conclusions linking the literature review with research findings

based on arguments with assessments of the main question .It also includes contributions

to general literature and the specific field of research.

• The sixth chapter is the recommendations as a result of the research findings. Here any new

concept that would have emerged would also be mentioned.

• Bibliography as per Harvard method.

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LITERATURE REVIEW

Literature review is confined to the examination of the various instruments of Islamic banking,

reasons of growth in UK, description of Riba, its prohibition and the critical differences between

Conventional and Islamic banking practices with its future prospects.

Before going into this, a brief background of the emergence of Islamic banking would help in

reviewing its system.

2.1 Britain’s first Islamic bank:

In the year 2004 The Islamic Bank of Britain (IBB) was established at Birmingham with a start up

capital of 14 million pounds, from investors in the UK as well as the Gulf. To establish this,

permission was granted by the banking regulators of Britain. Branches in Leicester were also

opened . In 2007 the Bank of London and the Middle East (BLME) was formed. According to

Grose (2008 web 4), London had nearly twenty five companies which offered Shariah based

finance. With in six months, BLME recorded profits up to $ 2.7 million and its assets more than

doubled to $ 931 million.

According to Ainley (2007) the various causes for the growth in the Islamic banking sector in the

UK are:

Markets and skill base:

The UK is an important financial service centre with a proven record with the preference for the

English law as the legal base for many Islamic finance transactions.

Opening of Shariah base ‘windows’:

The Citi bank,HSBC,Deutsche bank which have great experience in the middle east and are very

much knowledgeable about Islamic markets and products, have opened ‘Shariah based windows’

in their banks in UK.

Excess liquidity in the Middle East:

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Due to rise in oil prices there has been a huge liquidity and the market in the Middle East was not

been able to meet this growing demand and UK provided the suitable alternative.

Public policy and taxation:

Since the year 2000, the government in UK has introduced specific legislative and tax change in

order to remove obstacle in the development of Shariah based Islamic finance in the United

Kingdom.

Global expansion of Islamic finance:

This has been due to growth of industry in the Middle East and South East Asia which has

influenced the UK markets.

Institutional Factor :

A single financial regulator, the FSA which was established in 1997 has done much to do all it can

to support this development with in its authority.

2.2 PRINCIPLES OF ISLAMIC BANKING SYSTEM:

Islamic banking is structured on the basis of two major principles

1. Prohibition of Riba which generally regarded as interest.

2. Profit and loss sharing.

2.2.1 PRACTICE OF INTEREST (RIBA) IN EARLY ARABIA:

According to Rahman (1964), in the early Arabia, that is pre Islamic history, interest was of two

types:

1. Riba Al Nasiah

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2. Riba Al Fadal

2.2.1.1. Riba Al Nasiah:

The word Nasiah is derived from Nasih which means to defer or to delay the repayment with an

additional amount. This is a way of getting profit for the period of wait. This is the usual kind of

interest that was followed by the Arabs. The loan was for development as well as consumption, but

mostly it was for development of trade as the central source of income for Arabs over centuries has

always been trade (Udovitch 1981).Through its verse in the Quran, 2:275, God has allowed trade

but has forbidden Riba.

Thus scholars of Islamic jurisprudence have said that Riba al Nasiah is totally prohibited in Islam.

Since it has similarities with the Interest levied by conventional banks and therefore on this basis it

is prohibited.

2.2.1.2 Riba al Fadal:

This relates to the indirect type of usury that was practiced by the Arabs when they were not

dealing with cash. Here the trader would get in exchange a commodity in excess of or in better

quality than what he has given in a trade transaction. Ibn al Arabi in his Ahkam al Quran (Chapra

2010) explains that any thing in excess of what is justified by its counter value is not permitted.

The injunction against Riba al Fadal was executed so as to prevent exploitation by unfair exchange

so that not even an indirect Interest would be practiced. This type of Riba has been referred to by

the second Caliph Umar as Riba, to clear the doubt that arises in the minds of people whether Riba

al Fadal has the resemblance with Riba that is pure interest.

There are three types of Riba al Fadal:

The first being receipt of commodities in excess of what is justified. The second being the

acceptance of reward for making a recommendation .This is actually a charitable act and therefore

should not be used as a means of exploitation. Such acts of apparent charity but having the

motivations towards money making are prohibited. The third type of Riba al Fadal is done during

barter transaction because there is difficulty in measuring the counter value of the commodity.

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Therefore the Prophet of Islam (PBUH) discouraged barter dealings but advised that the

commodity be first sold against cash and this amount used to purchase the required commodity.

Thus it can be seen that Riba al Nasiah is defined quite precisely, Riba al Fadal which involves a

large array of business transactions has to be dealt with great care.

It can be seen from the examples given that in all kinds of Riba,the is a definite advantage for the

lender of cash and the exchanger of commodities ,where there is neither an element of risk or hard

work involved as there is an assurance of positive return to the financier.

2.2.1.3 INJUCTIONS AGAINST RIBA IN THE QURAN:

There are at least twelve verses in the Quran (Pickthal 1994) where there is severe warning and

admonitions against Riba.

1. Chapter II.verses, 275-280.

These verses try to establish that, firstly Riba is totally banned for all, secondly the meaning of

Riba is explained as that which is collected over and above the principle, thirdly it is an unjust

practice, fourthly it is destined to destruction and finally Riba lowers the values of individuals who

deal with it. Further there is a total rejection of the thought or concept that Riba is like trade.

Obviously trade is of mutual benefit while Riba ensure profit to only the lender.

2. Chapter III verse 130.

Muslims are warned not to devour through usury by doubling and quadrupling and that they should

observe their duty to Allah so as to be successful.

3. Chapter IV verse 160,161.Similarly in the fourth chapter it has been informed that Riba is being

prohibited for Muslims so also were to the Jews before them and there is a warning for those who

disbelieve(the injunctions against Riba of a painful doom).

4. Finally in chapter 30, verse 39, it is declared that any increase in wealth through the practice of

Riba cannot and will not be blessed by Allah. (Pickthal1994, Ali 1934)

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2.2.1.4 ILL EFFECTS OF RIBA:

Based on these injunctions, it is possible to deduce why Riba was prohibited. According to

Siddiqui (2005) some of these could be:

1. Riba corrupts individuals and through them society. According to Pickthal (1994) the Quran has

likened the charging of interest with corruption, which is ‘fasad’ in Arabic. In other words wrong

doings lead to wrong behavior and this in turn leads to severing the ties of kinship ,dividing people

into classes and discriminating between them, shedding of blood, arrogance and sexual

perversion’.(The Quran 47:22;28:4;2:30;28:77;’29:28-30 respectively)

2. Riba undervalues the properties of the borrower and places an advantage with the lender.Khan

and Mirakhor (1987) have pointed out that interest levied on money is an unjustifiable and an

immediate right that is handed over to the lender who acquires a right over property as soon as the

contract is signed.

3. Riba, through its devouring tendencies ultimately brings down overall growth.

4. Riba reduces the respect of individuals and diminishes human personality.

According to Ahsan (2006) Shariah as per Quran encourages people to indulge in such transactions

in business which helps them to earn profit through risk taking with out blocking down all risks

with fixed returns.

According to him the wisdom behind this method of wealth creation is the concern for the moral,

economic, social and cultural welfare of mankind.

Moral:

Interest based practice discourages people doing good to people from doing good to one another,

that is when the really needy people take a loan on interest they are required to pay back the loan at

any cost, here there is no mercy shown to the poor and the needy by the money lender, whether it

is a bank or an individual who has offered the loan on interest. This results in huge burden to the

poor individual who has to part with a portion of his belongings in the form of jewels or property.

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Economic:

The general tendency of the people who depend on interest as a source of income discourages

them from working or indulging in trade or business where an effort has to be made and a lot of

risk is involved.

Social:

If interest is allowed, the rich (who are most likely to be lender) will exploit the poor (borrower).

As a result, the rich becomes richer and the poor becomes poorer. This generates envy and hatred

among the poor towards the rich, resulting in social disorders, conflicts and at times breeds and

movements with revolutions. (Uzair 2000)

2.2.1.5 COMPARISON BETWEEN RIBA AND TRADE:

The Arabs who used to indulge in the practice of Riba initially did not understand the basis for the

prohibition of Riba because they regarded Riba as a form of trade. Some argue that when a person

gave money as a loan and charged an interest on it was for the help that he had extended. But the

Quran has bluntly treated Riba as impermissible whereas trade was indeed the mode through

which one should earn a living. As explained above Riba has many bad effects on society and

cannot be likened to trade.

Some of the differences between trade which yields a legitimate profit and Riba which is unlawful

in Islam are as follows.

Comparison between Riba and Profit:

RIBA PROFIT

Riba is defined as the premium received by the

lender from the borrower with the principal

and is the main condition of the loan.

Profit is defined as the difference between sale

and the purchase price which may be positive

or negative.

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The recovery of the capital is assured. The recovery of the capital is not assured.

There is always an assured positive return. There is uncertainty of the nature of returns.

The profits are predetermined. Profits are not predetermined.

There is no particular and definite advantage to

the borrower

There is some perceived advantage for both

parties

The rate of profit goes on increasing with the

passage of time on the initial capital

Once the sale is performed the profit is

obtained and it does not increase with passage

of time

Money is used as a commodity Money is used as a facilitator of transaction

It can be deduced that there is no possibility of

occurrence of losses

It can be said that there is always the

possibility of occurrence of losses

2.3 HOW DOES INTEREST AFFECT US:

Margrit Kennedy (1995) in her book, Interest and Inflation Free Money explains the damage

caused by interest .She refers to money as the unit of economic concept which never stays steady

as another unit like the unit of weight, the Kg The major factor according to her which brings

about huge debt, unemployment, environment degradation with building up of arms and nuclear

proliferation is principally due to interest and compound interest. Money that is used as a

commodity when used for interest purposes grows exponentially rather than through a natural and

physical growth like a cancer tissue as shown in the graph below.

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Courtesy: Margrit Kennedy Interest and Inflation Free Money

The curve A describes normal physical growth, B describes the linear growth exemplified by the

production of more goods by more factories which stop once factories close down and curve C

describes the growth of money, growing exponentially like cancer cells which ultimately kills the

patients.

A graph depicting rate of growth of interest is shown below:

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Courtesy: Margrit Kennedy Interest and Inflation Free Money

The above figure shows that at 12% interest money gets doubled in a mere six years and even at

1% interest rates the initial money gets doubled at 72nd year.

One of the misconceptions about interest, according to the author is that we pay interest only when

we borrow money. The following diagram gives a close look at the way individuals are made to

pay interest, if not directly as interest gets automatically included in the things we use or buy.

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Courtesy: Margrit Kennedy Interest and Inflation Free Money

From the arguments and the points given, it would be beneficial to mankind to create a monetary

system that could follow a natural trend in growth and this can only be done by replacing the

present interest based economy by another suitable mechanism. Based on this, Kennedy

recommends that there should be a mechanism which would create an interest free and through this

inflation free monetary system.

2.4. PROFIT AND LOSS SHARING:

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The other principle of Islamic banking is profit and loss sharing. As explained above; Islam

prohibits finance management based on interest. The idea is that for a successful entrepreneurship

wealth creation should be based on profits alone. According to this concept the profit and loss

sharing leads to progress in society.

Thus profit and loss sharing forms the main structure upon which Islamic banking operates. And

according to Schaik(2001) noted that Profit and Loss sharing (PLS) includes Joint Ventures

(Musharaka) and Trust Financing(Mudarabah).The Non PSL Financing include Markup Finance or

trade finance,(Murabaha).

2.4.1 INSTRUMENTS OF ISLAMIC BANKING:

Gafoor (1995) in his book, Interest Free Commercial Banking has given a review of the current

concept and practices of Islamic banking which are described below.

2.4.1.1 DEPOSIT ACCOUNTING:

Islamic Banks also have three types of deposit account namely, current accounts, saving accounts,

and Investments.

Current Accounts:

In this there is a guarantee for the money deposited and it is a demand deposit and the depositor is

entitled to with draw at any time and in any amount.

Saving Accounts:

In this type, depending upon the bank, there are different operations. In some banks, the bank uses

the money of the depositors, with their permission, giving full guarantee to the depositors that their

amount would be available to them, that is they would get back the money they have deposited.

Some banks use savings as investments, the amount being invested in less risky short term

projects. There are less restrictions on withdrawals and minimum balance. Here only lower rates

of profits could be expected.

2.4.1.2 INVESTMENT FINANCING :

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Investment financing is done in three main ways.

Musharaka:

Here a joint venture is set up by the banks joining another entity with both the parties taking active

part, at various levels, in the activities of the project. Profits and loss are shared in an amicably pre-

agreed principle. This mode of operation is very much similar to the joint venture that is in

operations with respect to the commercial banks.

Courtesy: Islamic Finance made simple

http://islamic-finance-simple.blogspot.com/2010_05_01_archive.html

According to Usmani(2010) the word Musharaka is derived from the word Shirkah which means

in Arabic sharing and the type of Shirkah involved in Musharaka is known as Shirkatul-amwal

which is a relationship established by parties through a mutual contract. This contract should be

entered through free consent with out duress or fraud. The specific ingredients in Musharaka are as

follows:

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1. Distribution of Profit :

Before the contract is made, there should be an agreement on the proportion of the profit to be

distributed between partners.

When deciding upon the ratio of profit distribution, it should be done according to the actual

profits and not on the capital invested. (Agarwal and Yousf 2000)

2. Sharing of loss:

If a loss has occurred then all the partners will suffer in accordance with the ratio of investment.

This means that if the partner has invested forty percentage of the actual capital, then He must

suffer the same portion that is 40% of loss.

3. Nature of Capital:

Capital that is invested should be in liquid form that is in terms of money and not on commodities

or objects. The reason is that commodities, for example cars as a contribution will remain as

property of the donor and if the car is sold then the money will go to the owner. On the other hand

if money is used as the investing means then it would not be possible to distinguish the share

capital of each partner unlike the commodity. However it has also been said that the market value

of the commodity at the time of contribution could be taken as share of the partner.

4. Management:

It is necessary that each and every partner has a right to take part in the management of business

unless there is a previous agreement, but in such a case when one of the partners is unable to take

active part then the sleeping partner would only get profit only to the extent of the ratio of

investment.

Mudarabah:

This is different from the previous type of investment. The bank (Shohbul mal) offers finance to an

individual and the client (Mudorib) in turn provides the expertise with the responsibility to manage

the labour. When profits are obtained, these are shared by the two parties in a pre-agreed upon

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proportion. On the other hand when a loss occurs, then the total loss is bourn by the bank itself and

there is no liability upon the other partner.

Courtesy: Islamic Finance made simple

http://islamic-finance-simple.blogspot.com/2010_05_01_archive.html

I) Difference between Musharaka and Mudarabah;

According to (Usmani 2010) the main differences between these two are:

1. In Musharaka each partner invests his capital where as in Mudarabah the investment comes only

through only one partner (Shohbul mal).

2. In Musharaka each individual partner has a right to participate in the day to day business where

as the investing partner in Mudarabah cannot indulge in day to day business.

3. Loss sharing in Musharaka applies on all the investing partners where as in Mudarabah only the

first partner namely the investor suffers the loss.

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C .Diminishing Musharaka:

Courtesy http://www.emeraldinsight.com/journals.htm?articleid=1744955&show=html

Diminishing Musharaka as practiced by the Islamic bank of Britain (2009) involves the offering of

property and home purchase finance plans through the Diminishing Musharaka (reducing

partnership).Here the bank enters into an agreement for joint purchase of property. The rental

income is received by the bank as per its share. The other party pays separately the rent and also

for the purchase of the proportions of the property from the company so that the ownership share

of the bank is reduced but that of the client is increased till the borrowed amount is fully repaid

.(Ayub 2002)

Murabaha:

Mark up finance (Murabaha) is by far the most popular instrument of Islamic finance. According

to Schaik (2001) the main factors that determine this are, 1.Mark up finance is a short term

finance, which reduces bank risk, where as PLS is a medium or long term proposition. 2. The bank

is also guaranteed a certain profit.3.Risk for the bank is much limited.

Shariah allows the final buyer in a Murabaha contract to refuse the ordered object thus putting the

bank under constrains. In order to avoid this, modern banks have issued two separate contracts. 1.

The promise by the main buyer that he would not go back on the contract signed, 2.A separate sale

contract. This is comparable to a letter of credit.

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. The bank which does this transaction gets its time value of money by in the form of profit margin

but the bank cannot charge additional money for the late payment although the commodity remains

under the possession of the bank until full payment is done.

Courtesy http://www.zawya.com/marketing.cfm?zp&p=/story.cfm/sidZAWYA20071205090150

According to the Islamic Bank of Britain (2010, Annual Report for 2009), Murabaha is a

transaction whereby a commodity is purchased by the company to be sold to the counter party

under the agreement of promise from the counter party to buy the item under certain terms and

conditions. The pre agreed profit margin is fixed to the commodity actual price before the sale is

done.

Compared to this Wakala is an instrument the bank gives money to the agent for investment

according to certain condition so as to achieve a certain specified returns. If there is any

negligence, violations, the agent is obliged to return the amount invested.

E) Other forms of Islamic banking instruments are:

Salam:

This is an instrument which is based on sales. The sale is of a particular commodity which should

be present physically during its sale that is, it cannot take place in its absence.

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Qard-e-Hasna (Benevolent Loan):

This type of loan is regarded as the true transaction as per the Shariah because it is a loan which

does not compensate the creditor for the time value of money. Here the loan is a goodwill loan

given to the needy where in the borrower has to return the loan with out interest .As a token of

appreciation, the debtor may also add some amount and repay the loan but this is not considered

interest as it is as per the discretion of the borrower but this is not a condition.

Baimuajjal :

This is a deferred payment for a sale which could be in instalment as per the agreement between

parties. There is no charge for this delayed payment.

Ijarah :

This leasing product which involves leasing of machinery, buildings or equipment on an agreed

rental contract.

Ijarah wa iqtina :

This is also a leasing product but is coupled with the lessee having the right to purchase the

commodity at the end of the lease period.

Baisalam:

Here the purchaser pays the full amount for a commodity which will be delivered at a later date.

Sukuk:

Shohet (2007) describes Sukuk as Islamic bonds which is relatively a new instrument in the

traditional world of finance management.

Credit ratings are assigned to Sukuk circulation so as to assess their credit worthiness and these are

managed in accordance with the universal standards. Some of the different types of Sukuks are,

lease Sukuk, partnership Sukuk and investment Sukuk.

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Sukuk vary according with the nature of company and nature of assets. London is the main centre

of short and medium term financial transaction, estimated around three billion US dollars per day,

which operates according to Shariah.

However there are certain aspects of Shariah law which require that Sukuk must represent the

ownership of real economic assets which can generate revenue and returns should be linked to

actual profit and not percentage of capital. (Shafiq 2008,)

Many Muslim countries have adopted Islamic Banking System especially those who have a sizable

Muslim population such as Pakistan,Indonesia,Malaysia,Iran,Sudan,Indonesia ,Bangladesh .These

have either full fledged Islamic Banks or have opened services through conventional banking. In

the UK, the Islamic Bank of Britain has a full fledged Sharia based banking operation.

2.5 CRITICAL EVALUATION OF ISLAMIC BANKING INSTRUME NTS:

One of the Islamic banking instruments which has been in frequent demand is the Murabaha

instrument.

Iqbal (2008)contends that in Murabaha which is ‘cost plus profit’ works out to be the same just as

the Conventional bank interest schemes .According to him, the adoption of Murabaha is a

legitimate instrument based on the opinion of just a few Muslim scholars.

2.5.1. Murabaha v Conventional loans:

Contending further, he states that in the execution of Murabaha there is a change in terminology

from interest to profit and in reality these two are the same because the ultimate result is the same.

He places this criticism due to the fact that the profit in Murabaha is usually determined on the

basis of interest benchmark such as London Interbank Offered Rate (LIBOR) which fuels the

criticism of formalism within the contemporary Murabaha.

Shariah, not being a uniform code and therefore Islamic scholars can have their own personal

opinion. They give their opinion based upon an analysis and deductions known as Ijtihad which

they utilize to approve or disapprove any financial matter.

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Hussain (2007) also feels that Islamic financial institutions are engaging in lending money through

a ‘back door entry’ which they call as Murabaha, and He considers it as Riba.His claim is based on

the argument that when the credit price is greater than the cash price, then it implies that time has

value which is the basis of Riba whose essence is that money grows over time..

Application of Time Value of Money:

Sheik (2007) observed that the basic principle of interest is time value of money. Islam prohibits

this because no fixed amount can be charged on money over a certain period. With out money

going through the entire procedure of business activity, any gain on it is considered not permissible

as per the Shariah. Some banks assign weightages to the tenor of investment which is another way

of giving interest based on the time value of money.

2.5.2 PROFIT AND LOSS SHARING:

Dar and Presley (2000) of the Department of economics Loughborough University in their paper

Lack of Profit and Loss Sharing in Islamic Banking, have observed that most of the major financial

transaction that takes place on profit and loss sharing involve two of the instruments of Islamic

banking, namely Mudarabah and Musharaka but unfortunately in actual practice these are far from

models. These two models are mutual arrangements between parties who pool their resources in a

business undertaking and sign a contract for sharing on the basis of profit and loss. According to

the above authors, the poor implementation of Profit and Loss Sharing (PLS) process is the

hesitation by the capitalist as they are less compensated in their contributions in the process of

production activities and since they are also less inclined to share losses that would have taken

place. Further, there is always a stiff competition from the Conventional banks who are well

established and therefore Islamic banks have to offer less risky instruments as compared to

Musharaka or Mudarabah. Participants in business like Mudarabah are only sleeping partners and

non participatory in the business activities or decision making and this accounts for their

dissatisfaction. There is also unfair treatment in case of taxation, that is profits are taxed but

interest is not taxed by the governments.

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2.6 DIFFERENCES BETWEEN ISLAMIC AND CONVENTIONAL BA NKING:

Hussein(2007),Head of Islamic Banking,Maybank Singapore stated that on a general basis most

Muslims have no clear cut concept of the basic differences between Conventional and Islamic

banking systems ,because basically both these banks operate with the main objectives of collection

of funds and generation of profitable revenue and through this they help the countries economy.

But the manner of their revenue generation has many basic differences. These, according to the

author are as follows.

REVENUE GENERATION:

1. Types of Contracts:

Majority of income in Conventional Banks is through lending contracts on interest, where as

Islamic banks generate their revenue from trade contracts with out levy of interest such as:

• Sale based contracts

• Leasing contracts

• Partnership contracts

• Profit and Loss sharing contracts.

2. Sources of Revenue:

In Conventional banks it is the generation of interest, where as in Islamic banks it is,

• Fees

• Rental income

• Profit from sales

• Profits and dividends from investments

3. Risk sharing and Debts:

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Conventional banks do not get involved in any risk sharing activity with their customers. They are

more concerned with the income that is generated from loans and advances which are given on the

basis of interest. They are also not concerned with the fate of the loan or that of the customer.

Islamic banks take risks in most of its instrument thereby they get involved with the fate of their

customers.

The director of The Islamic Bank of Britain in his report lists out the following risks

1. Credit risk:

This could arise from the failure of the customer who fails in his obligation to make necessary

payments. Risk may also arise in the investments of Bank funds in Shariah compliant institutions.

2. Liquidity risk:

Sometimes the bank is unable to meet its financial commitments for want of funds this is due to a

mismatch between available funds and existing liabilities.

3. Market Risk:

This may arise due to unfavorable market situations including foreign rates.

4. Operational Risks:

This may come about due to failure of its internal process, fraud or technology failure.

5. Concentration Risk:

This may occur when investments are made in only one sector with out diversification in

investments.

6. Shariah compliance Risk:

Compliance with Shariah law is vital for the banks to succeed. Some products may have Shariah

compliance in them and therefore does not attract customers.

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As explained above, Islamic banks take as much risk as the customer by operating on profit and

loss sharing basis, and thus the mismatch between assets and liabilities is avoided. This method

provides a minimal chance of facing bankruptcy with the bank or entrepreneur because they share

responsibilities unlike Conventional Banks. This responsibility makes the Islamic banks vigilant

about the utilization of loan funds by entrepreneurs which ultimately helps mutual progress

4. Penalties:

Conventional banks charge penalties where as Islamic systems normally do not allow this.

5. Ethical and Moral issues:

Conventional banks do not make any difference between unsociable business activities like

gambling, liquor trade, prostitution, and fund these ventures where as Islamic Banks screen and

prevent funding of such activities.

2.6.1 DIFFERENCES IN CONCEPTS AND OPERATIONS:

Awan (2009) gives further details of the differences between Conventional and Islamic Banking

systems, in their objectives, approaches, concepts and operations and these are:

OBJECTIVES AND GOALS:

The core difference between the objectives of the Islamic and Conventional banks is that the

former operates for the welfare of the poor so that there is a horizontal distribution of wealth where

as the latter’s aim is to favour the rich bringing about the concentration of wealth in the hands of a

few. According to Kennedy, (1995), Conventional banks favours the rich, helping those who are in

regular business where as Islamic banks share the fate of their clients with their own future through

a system of profit and loss sharing. By this way they help the entrepreneurs with poor capital but

with promising ones so that they are able to obtain finance and growth.

MODE OF BORROWING:

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Conventional banks maintain their margin of profits safe by charging a higher rate of interest from

the borrowers while offering lower rates to the depositors and by this they satisfy their main

objective namely to maximize their profits all the time. In the Islamic banks the basis being Profit

and Loss sharing, there is no undue gain at the cost of the customers.

CONCEPT OF MONEY:

Money is utilized by Conventional Banks as a commodity. It is used merely as a source of huge

profits only. Kennedy and Kennedy (1995 ) that money when allowed to be kept in the hands of a

few who have excess of it creates a toll gate where those who do not have enough but who are in

need are made to pay to those who have more. Due to interest and compound interest, this debt

increases exponentially leading to creating problems. Many people who are unable to pay the

enormous debts commit suicides. Thus according to her, interest grows like cancer and ultimately

finishes the patients.

On the other hand, Kennedy (1995) contrasts this with the concept of money with the Islamic

banks which use money not as a commodity but as medium of exchange so as to enable transaction

while doing business. As its concept of money is the opposite of the one with Conventional Banks,

Islamic banks share the profits and losses and do not allow the public to face insurmountable debts.

DIFFERENT APPROACHES OF INCOME DISTRIBUTION:

Conventional Banks approach towards the rich is a positive one and towards the needy, a negative

one. It can be seen from the fact that in the United Kindom, during the year 1960-1998, among the

super rich which form just 0.002 % of the UK population, there was an increase in income by 30%

which was 15 times as fast as inflation in the year 2003.Considering this fact as well as the similar

scenario in other parts of the world, the World bank had warned against this inefficiency of this

type of wealth concentration in the hands of a few.

In their book, Comparative Economic System, Gregory and Stuart (1992) philosopher John Rawls

noted that the reason for the unequal distribution of wealth persists because the rich do not have

the tendency to enter into schemes which also favour the poor. This brings to a halt to any attempt

for social changes which could bring about any redistribution of wealth to the poor. On the other

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hand, Islamic concept of finance attaches great importance to distribution of wealth between the

rich and the poor, a concept upon which the Islamic banks opertate.For example, the tradition of

Zakat of 2.5% on the year’s savings in the bank, which is a compulsory tax upon the rich. This

amount is collected with an aim to be distributed to the poor. This act also discourages the habit of

hoarding and enables flow of currency in public.

2.7 RISK MANAGEMENT:

2.7.1 RISKS INVOLVED IN ISLAMIC BANKING:

Risks and challenges are common to both Islamic and Conventional.

But as per FSA, there are several risks very specific to Islamic banking. , (Aienly 2007)

Shariah compliance:

Islamic banks face the problem of various interpretation of Islamic law. These may be listed as

below:

1. Some scholars approve a product as Shariah compliant but some others do not approve it. The

FSA is very much concerned about the products that the Islamic banks introduce and would like to

make sure whether it complies with the Shariah.

2. For the products of the Islamic banks, it is necessary that remain compliant with the Shariah that

means that they are continuously being monitored to see whether they are Shariah compliant

through out their productive life.

3. Professional and experienced Islamic financial experts are always in demand, and the banks

have to make sure they get the right people.

4. Shariah contracts face problems while deciding disputes .In the UK the court decides this as per

the British law only. In order to avoid this, documents should be very carefully written.

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5. In the United Kingdom, Murabaha which is the popular product is being developed to have the

same liquidity as conventional banks. This involves Shariah compliance.

7. Conventional banks with Islamic windows normally pool the Islamic business risks with their

own products. This may not be acceptable as per Shariah law.

8. The risk arises when a customer fails in his obligations from either secured or unsecured

obligations.

The Islamic Bank of Britain manages its risks in the following manner:

The following methodology of risk management that the bank faces is explained with respect to

the Islamic Bank of Britain. A few salient features are mentioned below.

Risk management is done through regular reviews of market trends, products and services offered.

These help in setting the limits to risk exposure. This is the responsibility of the Board of Directors

of the bank and the controls are reviewed by an internal audit.

A separate credit committee is set up to manage risks by assessing credits, formulate policies with

other business units it also establishes an authorization for credit exposure limits. They renew the

credit risks before an agreement is signed, and provide guidance expertise to enable the best

methods to be adopted in the management of risks.

When it is decided by the credit department that an amount due cannot be collected or when the

collateral is insufficient to meet the balance, the bank, after getting all the necessary relevant

information writes off the remaining balance.

Against secured advances, the bank obtains the collaterals in the form of assets, guarantees or

registered securities.

Liquidity management is done by the bank by ensuring that it is able to obtain sufficient financial

resources to meet its commitments in case of liabilities.

Rentals for home purchasing and other property financing are bench marked as per the Shariah

Supervisory Committee subject to a minimum level of rent.

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Monitoring of market risk is done by AOCL, which is its principle responsibility. Other risks such

as Operational risk is done by implementing an internal control system so as to reduce the financial

loss and by this way it helps support process efficiency and customer interests. The Board of

Directors is the one which sets the guide lines. Monitoring of operational risk is done by the Risk

Committee.

When the services in an Islamic bank do not comply with the Shariah law, then there is the Shariah

compliance risk. The Islamic Bank of Britain manages its Shariah compliance risk by referring

each of its product and services offered by it to the Shariah Compliance Board. The concerned

officers oversee day to day business in the bank so that no breach is committed.

Concentration risk occurs when there is an inadequacy in diversifying credit risk across sectors. It

is the Board’s duty to set the limits with respects to the assets and to monitor its implementation.

2.7.2 RISK MANAGEMENT BY CONVENTIONAL BANKS:

The overall risk management in Conventional bank is comparatively simpler when compared to

Islamic banks. In Conventional Banks risk arises as a result of lending and borrowing. But

Conventional banks do not bear these risks directly but by shifting the risks to other parties.

Conventional banks are not encouraged to engage in business which would impose unnecessary

risk on itself. However by judicious planning, pricing and product design these banks minimize

risks.

Santomero (1996) describes four essential steps in risk management for Conventional banks. These

are:

• Standards and reports.

• Position limits or rules.

• Investment guidelines or strategies.

• Incentive contracts and compensation.

The first step comprises of standard setting and financial reporting. These two operate together.

This involves the standards set for review, categorization of risks, and underwriting standards.

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There is a constant evaluation and reporting after giving ratings so as to understand the various

risks. It helps to plan as to how these can be absorbed.

The next step that is taken is the allocation of minimum standards of participation in assets .Limit

is placed to cover the exposure to counter parties.

In investment categories, strategies are formulated in respect of concentration in market areas in

order to avoid mismatch between asset and liability.

Incentive schemes for ensuring incentive compatibility between principals and agents in a

desirable way.

From a managerial point of view, managers are able to avoid risks by simple business practice

depending upon their experience, or as said earlier by transferring it to other participants.

2.8 FUTURE OF ISLAMIC BANKING IN UK:

The future of Islamic banking depends upon risk management. As per the report by the Financial

Market 2011,Islamic banks face many challenges and risk in management of liquidity, cost of

ensuing compliance with Shariah , management of Sukuk, and multiple interpretations by Shariah

scholars .The points as described above describe risk factors and its management by Islamic and

Conventional banks.

In the United Kingdom, the promotion of Islamic banking is actively guided and assisted by the

UK Islamic Finance Secretariat which coordinates between government, UK Trade and

Investment, HM Treasury and industries to make UK as the global gateway of Islamic finance. It

runs five working groups in the form of domestic Retail Banking, Islamic Financial Institution,

Legal, Accountancy and Education in training and qualification process.

One of the early indications of bright future for Islamic Banking is the resilience of its assets even

during financial crisis. According to Financial Market Series, The, IMF Survey online October 4,

2010,Islamic financial market reached $1,041 bn at the end of 2009,even when there were global

financial crisis(Chart I).

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It is estimated to grow by 10-15 % during 2010.The report suggests that there would be further

improvement because it seems to have the potential and also because it was less affected by the

global financial crisis. The key centers comprise of Malaysia, UAE, Saudi Arabia and others as

shown in chart 2.

Country wise financial position of some countries is depicted in the chapter 2.

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.

The United Kingdom occupies the ninth place in this lineup but is the leading country amongst the

countries of Europe. It has a greater capacity to further improve.

Another factor which points to a better future in the UK is growing number of banks offering

Shariah complaint products. There are twenty two banks and five with fully Shariah compliance.

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In the UK,Islamic banks are fully supported by the Government as well as nearly twenty Law

firms and four big professional service firms., Global assets of Islamic banking is shown in chart-I.

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Table I shows the UK is placed in the ninth position with 19 bn largely based in HSBCAmanah

bank.

The assets of Islamic banks in the United Kingdom are shown in the table

Although Islamic banks have been less affected by the global crisis, still these face several

challenges as described below.

1. Islamic banks lack products to enable them to manage liquidity effectively

2. Compliance with Shariah with respect to all its products is a constant challenge.

3. Diversification of assets is essential so as to spread risk such as in real estate which have

contributed to fall in asset values.

With the steady growth of Islamic banking in the UK, the future prospects are very bright because

there are a lot of opportunities to improve in the UK mainly on account of the government’s

support and its help in broadening the market for Islamic products.

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METHODOLOGY

Acquisition of data as per the topic on the critical analysis comparing Islamic Banks with the

Commercial Banks in the United Kingdom, the primary concern has been to study the system of

operations in these two banking systems. This comparison has gained great relevance in the

modern era due to the steady rise in the public acceptance of the Islamic Banking system. Data

collection is the major task one has to undertake in analyzing any topic of research. Any research

work requires clarity of research design and this in turn requires the standard methods of data

collection that would be employed to strengthen the conclusions made. (Cameron, 2005),

Therefore the purpose and aim of this study is to analyze how far the banks which claim to have

their instruments based on Shariah law and are they serving their clients with satisfaction in

comparison to conventional banks. An attempt will be made to critically analyze these factors.

3.1. SOURCING DATA:

Data collection technique is a very useful tool in obtaining relevant data and gives one the

opportunity to systematically evaluate the merits or demerits of any information which has been

collected. It should be collected very systematically otherwise it would lead us to wrong

conclusion which would spell disaster to all the efforts that would have gone into the collection

process.

There are two different aspects of data collection. The first is the Technique and the other the Tool.

The techniques involve observations, interviewing’s and written question and the tools are data

compilation formats, senses and other items such as pens, notes, cameras or audio recorders.

Data collection for Islamic Bank performances which is my topic for Dissertation is a challenging

task .I had to visit many places and discuss this issue with a large group of people who are either

customers in Islamic Banks or those who are knowledgeable in this field.

3.2. DATA COLLECTION:

Types of Data:

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Quantitative Data and Qualitative Data:

These could be of the following categories:-

1. Primary Data

2. Secondary Data

1.) Primary:

A.) By Experimental design, this includes Laboratory or Field Experiment.

B.) By Individual survey, this is done by direct contact, telephonic communication, postal messages, on line data collection.

2. Secondary:

Secondary data on the other hand is done by collecting relevant details from the work done by

other researchers in the pertaining field. This may be selected from Annual Reports, Case studies,

statistical data published by private and governmental organizations including international

organizations such as International Monetary Fund, the World Bank, United Nations and the

Organization of Islamic Countries which publish economic statistics from time to time.

Analysis of secondary data is of greater advantage because of the already existing background

work such as literature reviews, statistical work, some conclusions and recommendations for

further study. This type of data collection gives an individual confidence because of the

authenticity as the work would have been critically read and approved. It gives an insight into the

recent and the immediate past scenario of this particular subject of banking .It also helps in

designing the research method such as the present topic where an attempt is being made to

critically evaluate two different concepts in banking systems.

Secondary data would be obtained through publications such as:

• Central, State and local Government body publications.

• Publications by foreign government and international agencies

• Trade journals

• Technical journals

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• Books and periodicals.

• Magazines and News papers

• Case studies and reports

• Reports by agencies, associations connected with banking

• Reports prepared by various scholars, university professors and professionals.

• Reports by economists, bankers and those dealing in financial undertakings

• Historical documents and public records

Other sources through personal notes from knowledgeable sources, research scholar works and trade organizations.

It should be emphasized that care should be taken so as to ensure that the information which has been obtained is authentic and through very knowledgeable sources. Therefore the following points must be kept in mind about the collection of Secondary data.

3.3. QUALITATIVE DATA COLLECTION :

According to Neil (2007), qualitative method of data collection is very suitable for preliminary servey.The researcher would not have a complete idea of the information that he or she would get, and that he or she would have a rough idea only and the full picture emerges as the research progresses. The data has to be done personally by the researcher and the information is in the form of pictures, words or objects. It is possible to do an in dept interview although only generalized information is obtained (web 3).

3.4. QUANTITATIVE METHODS:

This is a method which I will utilize while depicting the dynamics of Islamic banking in the world scenario. The depiction would come in the form of bar and pie diagrams, graphs and other pictorial display. This will help in understanding the future prospects, the share by countries, world wide and also the annual turnover in terms of revenue in the Islamic Banks.

The data comprises of:

• The number of Islamic Banks in UK • The number offering Islamic instrument through a window • Probable increase in Islamic Bank investment corresponding to increase in population • How many commercial banks offer Islamic Shariah based investments.

3.4.1. TO OBSERVE ETHICAL PROCEDURE AND OBTAIN RELE VANT DATA:

• To interview people face to face and get answers.

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• To hand over questioners to individuals with a request for supply of authentic information. • Always to obtain prior permission before engaging in interviewing. • Will avoid loose structured vague questions which might not give concrete replies. • To prevent bias during collection of data by not putting leading and illogical questions. • To select people for questioning those who are having knowledge about the topic of my

research. • To keep in mind the ethical aspects of the data collection like asking sensitive questions,

violating the privacy of the informant and making public what is to be kept as a secret. • To keep in mind the cultural, traditional and religious values of individuals.(Web-4)

The area of research involves more a collection of data as secondary data where there is a fair amount of analysis is of major concern, and therefore I would collect more secondary data which also comprise of the following:

3.5. SOURCES OF SECONDARY DATA COLLECTION:

• Journals • Magazines • News papers • Libraries • Interviews • Questioners • Internet • Visit to Banks, both Islamic as well as commercial Banks in London. • Visit to centers of Islamic studies from where I would get information about the prospects

of Islamic Banking System. • Discuss with peers about this topic.

Qualitative method of analysis would be the most ideal in this research as it would provide

easy access to data which would be conceptual with the researcher fully getting involved in

the process of data collection. There would be no need to obtain data from very large

number of customers and also there would be flexibility in selection of area, customers and

timing of the interviews. It would also provide the degree of acceptability or rejection by

judging from the reaction of the customers. This is a topic which involves bank authorities,

customers and local residents and therefore would be very interesting. Further, it could be

more suitable for a student who may not have to spend too much in order to obtain

information unlike quantitative method where some sort of computer analysis would be

required while computing statistical data. Although qualitative data collection might not be

able to give out figures which can be depicted as graphs and diagrams, but it would

certainly give a better analysis of the results which would help in getting an overall view

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which would in many ways be better than more specific conclusion which by themselves

would not provide any clear view of the entire scenario.

3.5.1. ADVATAGES OF QUALITATIVE DATA:

• It is possible to gain knowledge fully and personally.

• Time and place is as per the interviewers choice.

• Preferences and choices can be assessed more easily between observations.

• Since it will be done only by me, there will be minimum errors while repeating the

interview.

• All questions would be put in a standard manner as it is only by my self.

• Questions would be restructured depending upon the sensitivity of the customer.

• First hand information could be obtained and there will not be any changes while

recording.

I would prefer to mostly collect information through journals and magazines with visit to banks for

information so as to make my comparative study meaningful. Thus my reliance would be more on

Secondary data rather than first .It is also more suitable to my topic of research which is, by and

large, the Critical analysis of Islamic Banking

3.5.2. REASONS FOR PREFERENCE -SECONDARY DATA COLLECTION:

• Secondary data helps in evaluations on the basis of adequacy of the material available as many of the information have been specifically dealt with by other qualified researchers.

• It is more economical and time saving. On the other hand Primary data involves huge expenditure and is also time consuming.

• Secondary data enables the researcher to analyze data by enabling access to information repeatedly, as in the case of journal or book references.

• Obtaining secondary data from government sources as well as other organizations gives a sense of trust as the same would have been collected after wide survey.

• Secondary data helps in the final phases of the research when it is required to define the problems and also when arriving at hypotheses and conclusions.

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• Secondary data also helps to find the general scenario in the past and to arrive at the possible future trends.

• Secondary data may sometimes be just sufficient to come to a conclusion with the primary data.

• Secondary data helps in providing enough time to re evaluate the topic and helps in directing the course of the research work.

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DATA ANALYSIS

Data analysis of the Islamic banking in Britain reveals that this system is of recent phenomenon.

Islamic banks in United Kingdom made their start due to the growth of Muslim populations in

some parts of Britain with a liquid asset of nearly 3.6 million pounds.(Mathews et al 2010).The

first Islamic bank in the United Kingdom was established in the year 2004 with the inception of

Islamic Bank of Britain(IBB). The causes for this has been a growing demand by the large Muslim

community of Britain who were apprehensive of the involvement of Conventional bank interest

which is prohibited as per Islamic Shariah.Fortunately for them, Commercial Bankers found this as

an opportunity to serve their customers in a satisfying manner and they commenced banking

through ‘windows’ based on Shariah with an aim to cater to the needs of the Muslim population.

Thus, international banks such as HSBC, Lloyds TSB, Deutsche banks, and Citi bank having

opened Islamic banking ‘windows’ also helped in their expansion. The Government of the United

Kingdom also helped in removing certain obstacles by introducing certain specific legislatures and

tax changes, for such establishments.

Coupled with this, the British government through its Financial Services Authority act of 2005,

and 2006, put the tax structure on similar basis of Conventional banking.

4.1. EQUATING RIBA WITH BANK INTEREST :

Equating Riba with bank interest is a very important issue. Since the raison d’être of Islamic

banking is prohibition of interest(Riba)and Profit and Loss Sharing it would be worth while to

analyze as to what extent Riba,the prohibited Islamic interest and modern bank interest are

equivalent in the views of scholars and whether there is an unanimous consensus on this issue.

According to Nyazee (2000) there is no standard definition of Riba despite the fact that there is

general agreement about the prohibition of Riba .There are still a number of scholars who do not

agree with equating of Riba with interest(Ali and Kazmi 2011)

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However. the issue of whether Riba and interest are the same was finally settled by the Islamic Fiq

Academy of the Organization of Islamic Conference (OIC) which issued a verdict in its resolution

No:10(10/2)upholding the consensus that interest was prohibited in Islam (Farook,2006).

The other principle of Islamic banking which is Profit and Loss Sharing is discussed critically as

below.

4.1.1. CRITICAL ANALYSIS OF PROFIT AND LOSS SHARING :

4.1.2. DIFFICULTY IN IMPLEMENTATION:

The guiding principles of profit and loss sharing in Islamic banking systems have faced several

challenges. Profit and loss sharing is a noble concept which if implemented and if the public gives

its full support, then the system would be one great success. Unfortunately there are some hurdles.

As reported (Schaik2001) banks do not very much encourage this principle but on the other hand

do encourage such schemes which are of short duration and which fetch them a profit with out

great risk like the Murabaha schemes. Gafoor (1995) observed that in the area of financing, bank

lending is practiced as no cost loan such as consumer loans, or loans where only service charges

are collected. Since these two types of loans do not bring any income to the bank, Islamic Banks

do not show any interest in operating them. Thus the investment and trade financing are the main

sources of income it also helps the bank customers who are investing get their profit which forms

their incentive for investments.

Regarding the public which attains loans for business purposes, Dar and Presley (2009) have

analyzed the Profit and Loss (PLS system and observed that most entrepreneurs may not be

interested to show the complete business gains and would therefore report less profit. Further the

capitalist would also hesitate to invest in PLS because of low incentives and are not prepared to

face losses. In the PLS (Mudarabah) there is restriction of the involvement of shareholders which

makes their role as non participatory in nature. Another factor is that profits from Islamic banks are

taxed where as interest in Conventional banks are tax free as it is considered cost item.

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These are some of the difficulties in the field of implementation of Profit and Loss schemes,

although with respect to deposits they have got some degree of success.Therefor the main

challenge would be to popularize profit and Loss sharing based medium and long term finance. It

would be essential therefore to develop Islamic Money Markets and Capital markets.

4.2. CRITICAL REVIEW OF INSTRUMENTS OF ISLAMIC BANK S:

4.2.1 MURABAHA:

This is Markup finance which according to critics of this instrument regards this as a manipulation

by which interest in the form of profit is collected by the bank.

According to Ashker (1987) when a contract for the promise to purchase is signed then it becomes

compulsory for the client to buy the product which is an illegal act .Further neither the buyer has

seen the object nor the bank actually possesses it. These two acts according to Shariah are illegal’

If credit price is higher than spot price, then the increase becomes Riba. Although the Shariah

requires that there should be a time given to the debtor, in the Mark up finance, a penalty is added

for late remittance.

According to Saeed, (1996,) Mark up finance seems as legal maneuver .It is an interest based loan

in disguise. There is a charge namely the cost of financing (mark up) which is actually the interest

and also the time for repayment is fixed.

Ahmed (2009) also claims that Markup (Murabaha) which is adopted as a substitute of interest

does not actually abolish it. Here a factious deal is entered between the borrower and the bank. The

bank purchases certain goods for the borrower by lending money to him. The bank through an

agreement claims back its loan along with mark up by stipulating in the same agreement that the

person who has borrowed will finally purchase the product after the expiry of a certain period

during which the price of the goods is marked up.

He points out some objections to this type of transaction.

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1. The first objection is the fixing of the markup value at specific level which works out at a

certain percentage of interest .He claims that what has been done in this case is that there is

merely a change in the name of interest to markup. He bases his objection as per the sayings of

the Prophet (PBUH), (Khan 2000), that one cannot sell a thing which one does not possess. In

this case the bank does not possess the commodity which it resells to the borrower at the time

of full payment of the loan with the “mark up value”.

2. There is actually neither sale nor any resale. The banks as well as the borrower enter into an

agreement with out any commodity passing hands.

The above points reveal that Murabaha is an instrument which requires further investigations and

research so that it could become Shariah compliant fully.

Iqbal (2008) observed that in its pure form Murabaha is similar to conventional loan. According to

him decisions on the authenticity of Islamic Shariah law seem variable because there is no uniform

code in Shariah law. In most cases, He observes that only a minority view has been adopted so as

to suit the interest of the banking system. He believes that there is mere change in terminology

from interest to profit although these two are not the same. This view is in concurrence with view

of Hussain who feels that interest in the operation of Murabaha comes through a back door in the

form of legitimate profit.

4.2.2. DIMINISHING MUSHARAKA:

Diminishing Musharaka has invited some criticism from scholars because its mode of operations

resemble hire purchase in Conventional banks.

Sheik (2007), compares the mode of operation of Conventional Mortgage and Diminishing

Musharaka.In Diminishing Musharaka, two agreements are written, the tenancy and sale which

gets together mixed. The arrangements is such that as the ownership of the customer increases

,the rent that he has to pay decreases until full payment is made for the transfer of the property to

him. In the conventional mortgage, the amount collected is the interest plus principle amount and

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these two behave in the same way as rent and ownership. Except procedural differences these,

according to him are the same.

From the above it is quite evident that these types of transactions are the usual way banks offer

loans on credit, calculate the interest rates and advice the borrowers to pay the loan plus interest in

installment and finally the commodity becomes his own. It is similar to hire purchase which works

on interest basis.

4.2.3. MODARBA:

The objection to this instrument, according to Sheik (2007) is based on the following analysis.

1. Modarba is a pre Islamic instrument. The common example that is given is that of the Prophet

(PBUH) who acted as the Modarib, that is fund manager, through a contract with Hazrath Khatija

(RA), a rich widow who funded the business for the Prophet to perform trade .Obviously the flow

of money was from the rich individual for a business undertaking .Since this practice does not go

against the values of Islam, it has been adopted in the modern Islamic banking (Nimrod 2009)

2. The above flow of funds is from the rich entity to the individual who needed money to carry out

the business. In the case of Modarba contract with the Islamic banks, flow of money is from small

pool of investors to the larger financial entity namely the Islamic bank. The bank in turn acting as

Mudarib invests the amount in financial instruments .Here there is no effect with regards to self

employment or productions as in the case of true Modarba.

3. In the case of profits, the fund manager suffers no loss in case of business failures and the

investor alone is made to bear the loss, but when there is gain he shares the profits on the sole

assumption that he is the cause of the profits.

4.2.4. SAVINGS ACCOUNT:

Allowing weightage to saving accounts and awarding benefits is the objection as it is not Shariah

based. In the Islamic Bank of Britain, deposits from customers are utilized under the principle of

Modarba where in the customer is assured of a certain percentage of profits which the bank

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obtains after making Shariah based investements.But if allowances are made as per

weightages,then it calls for objection.

Writing on the Critical Analysis of the current Islamic banking systems Sheikh, (2007) states that

there is not much difference between Term deposit as practiced by Conventional bank and saving

accounts in Islamic banks as these are based on weightages.

4.2.5. TIME DEPOSIT:

The bank acts as Mudarib that is the Fund Manager, and the customer the investor (Rabul mal).The

banks invests the money in Shariah compliant organizations. The money that is deposited is given

weightages in the beginning itself. The profit is calculated through weightage which are assigned

on the basis of period of investment to calculate profits resembles Time Deposit as practiced in

conventional banks. Time value of money is banned in Islam and therefore according to Sheik

(2007), savings account as per the above schemes do not fall under Shariah regulations as these

inherently involve interest which enables the bank to give profits on the basis of the period of

amount kept in the Savings Account.

4.3. CONTROVERSIES AND CHALLENGES FOR ISLAMIC BANKI NG IN UNITED

KINGDOM:

There is no denying the fact that Islamic banking has made great progress in the UK, especially its

continued growth during the recent universal financial meltdown. This has attracted even many

non Muslim countries to introduce this system so as to benefit of the general trends amongst most

of its Muslim population like the UK.Along with this success, there are controversies and

challenges with which this system has to face. Some of these as per Malik et al (2011) are:

• Shariah lacks a single universal authority which can govern its interpretations. Shariah laws

are formulated by the respective Shariah boards formed by the Islamic banks. The problem

is that there is a paucity of scholars who are both well informed of finance management as

well as Islamic laws.

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• 2. Various sects of Islam have their own interpretation of its various laws through their own

authorities. This opens a possibility of complications and even conflict of the rules.

• 3. With out a consensus of religious experts, the Accounting and Auditing Organization for

Islamic Financial Institutions (AAOIF) is facing difficulty in Islamic Standardisation

• 4.Islamic finance industry faces the challenge of Shariah Auditing which is still not fully

developed(SunGard 2009,).There is also a lack of experts who are well versed with

conventional and Islamic banking system so that rules unique to Islam could be better

understood so as to successfully develop and market the products.

• 5. Confidence building in the Islamic system of banking is another challenge (Aioanei,

2007 13).Attempts should be made to keep the customers and depositors educated about

the compliance of Shariah law in its various instruments.

• 6. There is a lack of short term investment products except Murabaha financing. More such

products must be innovated.

• 7. There should be an attempt to have more sophisticated products so as to meet growing

demands. These should not be a replicate of the existing conventional banking instruments

• 8. Attia (2008) observed that the pure result reached in Murabaha which is cost plus profit,

is the same as interest. He feels that a considerable minority view have been adopted for

assessing Murabaha.

Malik et al (2011) stated that the success of Islamic banks depends upon a combination of both

faith and economics unlike conventional banking system which concentrates chiefly upon

economics.

In his book, Interest free Commercial Banking Chapter 4, Gafoor (1995) notes that in nearly all

countries of the world, modern commercial banking system have modelled themselves mostly on

the practices as followed in the United Kingdom on two main principles of certainty on the rate of

return on deposits coupled with capital certainty .This comes under the previews of Central Banks

rules.

Under these circumstances Islamic banks in the United Kingdom have found difficulties in

implementation of these rules. The salient features are as follows:

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CERTAINTY OF CAPITAL AND RETURN:

Unlike conventional banks, Islamic banks cannot guarantee neither any fixed rate of profits on the

deposits nor the capital, as they work on profit and loss sharing. This happens to be the root of the

problem and therefore it is difficult to get the necessary permission to operate under the profit and

loss sharing system under the system of banking in UK.

The Governor of the Bank of England, Sir Leigh Pemberton while addressing the Arab bankers in

London,(Abikan and Jafar 2006)said that although the Islamic banking system was acceptable as a

mode of finance, it may not fall with in the definition of what constitutes banking in UK.He also

said that it was important not to mislead the public by allowing two entirely different systems to

work side by side which is likely to create confusion, this was because of the main feature of the

banking system in UK which assures capital certainty which forms part of the legal system. Since

the bank of England would not legally authorize under the Banking Act He advocated that Islamic

facilities could be provided under other financial areas of finance.

SUPERVISION AND CONTROL :

Regarding liquidity requirements and adequacy of capital which in turn depends upon the

assessment of the bank values, Steele (1984) opened that as per the 1979 Act, the Bank of England

would find it difficult to value the assets of Islamic banks because of the usual tradition of

assessments for the British Government Instruments which are based on fixed interest instruments.

He observed that if the Islamic banks worked as per British Government instrument, then it would

be possible to value the traditional banking assets based on the quoted market value when they

become non productive. On the other hand, assessing Islamic banks would require a team of

experts to each and every bank operating in the UK, under 1979 Act, in order to put a value on

these assets.

Suratgar (1984) stated that it was indeed difficult to make an assessment mainly because a

substantial part of Islamic bank operation is based on venture capital with out any guarantee.

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It is therefore clear that in order to enable the Islamic system to work under the existing banking

law, some kind of relaxation would be required ,in case of an Islamic bank failing, which in turn

would weaken the confidence of the entire financial system.

TAX REGULATIONS :

Profits are earned income where as interest is a passive income and therefore treated differently. In

Islamic banking system, such as trade financing, there are title transfer two times, once when the

bank acquires the assets from a seller, and another when the asset is transferred to the customer

.This means double taxation which reduces the margin of profit.

4.4. CRITICAL DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC BANKS:

Practically speaking, Islamic and Conventional Banking systems work with the same motive, that

is to collect funds, utilize them in various lending and investments by involving the Government,

public, institutions and business establishments. The main difference lies in the manner of their

operations and the motives involved.

Conventional banks maximize their business by increasing the wealth of the shareholders and

through the process of interest collections and accumulate wealth for themselves. On the other

hand, Islamic banking system operating on profit and loss basis with out involving levy of interest.

Comparatively the ultimate gains for the Islamic banks would be less but the principle of avoiding

interest on moral grounds is upheld.

1. Islamic banks help to stimulate business activities and bring about distribution of gains by

profit and loss sharing where as Conventional banks help in concentration of wealth

amongst a few with the wealth increases exponentially amongst them.

2. The net distribution of profit benefits among depositors in the Islamic banks who are

thousands in number where as wealth among shareholders in Commercial banking is

accumulated in a few.

3. Interest collected from borrowers in the Conventional banks who are in large number but

the amount is distributed among a few shareholders.

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4. Conventional banks favour the rich entrepreneurs and are unconcerned with the success of

their business ventures where as Islamic banks through profit and loss sharing activity

attach their own fate with the entrepreneurs and thus remain concerned with their activities.

5. With respect to borrowing, in Conventional banks, the amount received by the depositors is

used to maximize their profits by giving lesser rate of interest to the customers but receive

higher rates from borrowers.

6. In financing process, Conventional banks provide loans to the firms, government, public

sector as well as individuals and charge higher rates of interest which might act as a burden

to the entrepreneur and might result in business failures, where as no such one sided effect

is seen in Islamic banks.

7. The very concept of money itself is different. Money is a commodity in Conventional

banks, which can be bought and sold and they also charge interest on it during transactions.

8. Conventional banks do not entertain any risks. They keep themselves safe from the losses

that the borrower might suffer.

9. Finally Conventional banks mainly work for the specific rich class and they facilitate

accumulation of wealth with the result the rich get richer.

Based on the above it may be said that these two systems have differences in their total outlook

and objectives although they work under similar circumstances.

4.5. RISK MANAGEMENT BY ISLAMIC AND CONVENTIONAL BA NKS:

Risk management by both Conventional and Islamic banks involves judicious planning and

execution. Comparatively, Islamic banks face a far more risk in management than Conventional

banks. First of all there is the question of Riba, which seems to be no uniformity in interpretation

of bank interest although the OIC has clarified by declaring Interest and Riba to be equivalent,

many Muslims still continue to debate this issue. There is also a constant watch by the government

agencies which monitor Shariah compliance in Islamic banks. Islamic banking issues have to be

decided according to Shariah law. Further all banking issues are decided by the British law in case

of disputes and the final result may not be in agreement with the Shariah. There is also a mix up

between conventional and Islamic products in such banks which have Islamic bank ‘windows’

especially while managing risks.

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On the other hand, Conventional banks are not exposed to risk factors mainly because these have

the principle of interest which keeps them safe. All the risks are transferred to customers. They

also do not indulge in unnecessary risky business propositions.

Thus it is clear that Islamic banks have to be careful in dealing with their instruments so that they

remain Shariah compliant.

4.6. FUTURE OF ISLAMIC BANKING IN BRITAIN:

There is ample evidence to suggest that Islamic banks in the United Kingdom as elsewhere will

continue to perform effectively. As per the IMF survey magazine2010, Islamic banks performed

differently than Conventional banks by showing better resilience during global crisis. They were

better placed in the run up to the global crisis as shown in the following chart.

<http://www.imf.org/external/pubs/ft/survey>

During the crisis, Islamic banking model helped to protect the business against the adverse effects

of the down trend.Specifically the smaller investments,lower leverages and Shariah principle

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helped them to contain the global impact during this period.The following chart reveals the overall

impact during the early stages of crisis.

http://www.imf.org/external/pubs/ft/survey

The above chart shows that during the later stages, there was greater impact .But when compared

to Conventional banks their asset growth was at least twice as good despite the fact that their

profitability

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declined. This is shown in the following chart.

<http://www.imf.org/external/pubs/ft/survey>

Thus the above discussions reveal that there is enough of evidence to believe that Islamic banking

has great future in the United Kingdom.

Sole (2007) of the IMF and Capital Market Department reports that the growth of Islamic banks

has been impressive with an increase of 15% globally. There is still a great scope of improvement

in uncharted territories. It has expanded even in countries with a minority Muslim population such

as the UK.

Professor Torre 201, writing in Islamic Column in the International banking, in his article ‘Four

lessons that western banks can learn from Islamic counterparts’ suggests that Islamic banks have

at least four lessons to teach the western counterparts. Pictorial representation of the Islamic and

Conventional present banking scenario is given below.

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Coutersy:www.centerief.org/pdf/prof_de_la_torre_column.pdf

According to him, Islamic banks stabilize economy and credit growth. Conventional banks lend

too much in good times and too little in bad times. This results in an imbalance by an increase in

the non performing loans by there is an exponential credit growth. Islamic banks encourage

finance only if it is linked to value creating real transaction .Islamic banks are also allowed to

invest only in physical assets which would generate further flow of cash. There will be a lessening

of risk if the financial transactions are linked with wealth creating schemes which the Islamic

banks do.

Therefore it can be concluded that the system of interest free banking as per Shariah has a lot of

relevance to modern banking system. It is hoped that there would be an overall assessment of the

basic structure and concept of banking only with the main objective to help people achieve their

goals with out overburdening with undue entanglement in credit.

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CONCLUSION

In order to come to a conclusion it was essential that the two major elements upon which Islamic

banking is based ,namely the question equating Riba with interest and Profit and Loss Sharing

should be considered. These two elements make Islamic banking different from Conventional

banking.

The review of literature reveals that there are still several aspects of Islamic banking which have to

be further researched so as to be totally acceptable to the Muslims and the Non Muslim population

of the society especially the British public who are so much used to the concept of Conventional

banking since a long time .It is also evident that Islamic banking in comparison to Conventional

banking has many similarities of operation but with different principles.

Based on this it was also essential to review the various instruments of Islamic banking so as to

critically analyze them. Finally it was essential how these banks differ from Conventional banks in

their principles and operations so as to critically analyze these two banking system adequately.

Although the question of equating Riba with bank interest is still being debated, Muslim have

preferred the emerging Islamic banks solely on the desire to abide by their religious conviction so

that they do not go against the prohibition of interest in the Quran in any of its forms. Such people

believe that Islamic principles are concerned with issues of fairness and justice and there is less

tendency for exploitation. This makes them feel that a better world order would prevail if this

system is followed.

Basically interest free transaction has been recommended based on the moral economic and social

values. Morally and socially interest based finance encourages people to depend on interest as a

source of income simply because he/she is free of any risk and which also means that there is a

tendency for the rich ,who is the lender to exploit the poor who is usually the borrower.

Profit and loss sharing, where capitol, labour and entrepreneurship are involved, helps people to

invest in productive enterprises and so there would be a flow of funds with added opportunities for

more employments.

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The principal objective of Islamic banking is to distribute losses and gains reasonably by profit and

loss sharing methods so that the public in general is not victimized as in the case of interest based

economy. But this concept however might look noble, has its own problems in implementing it.

Entrepreneurs who enter into this scheme would be hesitant to openly declare their profits

completely and on the other hand there might be falsified statements so that they stand to gain

more than the agreed contract. As this system has low incentives, capitalists would also hesitate to

be a part of these schemes.

However critically analyzing the Islamic banking system which works on the principle of interest

free transaction, reveals that there would be an excessive demand for loanable funds. Savings

would decrease as there is no interest or profits given to the depositor leading to an exhaustion of

funds. Further banks would not entertain this schemes as there is the element of risk and also the

returns are not certain or regular. Also what ever the bank gets as profit, it has to pay a tax on it

where as interest gained in Commercial banks is not taxable. Customers who enter into a profit and

loss agreement with the banks will not be fully willing to share their business information mainly

when it comes to profits which they will have to share. This system is also not suitable for banks

which suffer liquidity shortages because there is no help coming from the central banks.

When it comes to the execution of Islamic banking instruments it is noted that in the saving

accounts and time deposits, the two systems have many similarities for instance the commercial

banks offer a fixed rate of income where as the Islamic bank don’t give a fixed rate of return and

can only give weightages

In the case of Murabaha which works on cost plus profit basis, the commodity’s cost is increased

before being sold to the customer and he in turn is required to pay the amount in instalments.This

seems similar to Conventional banks who offer a percentage of interest on loans.

In the case of Diminishing Musharaka, this is quite similar to conventional mortgage and hire

purchase. In this agreement the profit plus sales is to be paid back by the customer to the bank, as

the loan amount decreases, the hold of the customer over the property increases until the final

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payment when the property is entirely transferred to the customer. In conventional banking, the

same procedure is followed but the difference is that here the cost of the property includes the rate

of interest, there seems to be no difference except procedural ones.

In the case of Mudarabah, the flow of funds should be from the rich to the technically sound but

financially poor so that the investor gets the benefit of the expertise and the expert gets the benefit

from the investements.But when the Islamic banks invest in this manner, the investments are

collected from even small investors .Thus it is not the true type of Mudarabah transaction .Further

there seems a disparity in the division of the returns. If there is a gain, there is a distribution of

profits as per the agreement, but if there is a loss in the business, then it is the investor who has to

suffer it and not the expert. Since this entire procedure is based on trust, the ultimate result rests

with the element of honesty on the part of the person who is entrusted with the business.

5.1. INTERPRETATION OF SHARIAH LAW:

There are various schools of thought that interpret Shariah law differently as there is no universal

authority which can guide these banking principles uniformly. In order to make matters simple,

Islamic banks have their own Shariah boards for guidance. Some times due to pressure from the

banking authorities these boards accord permission as per their wishes.

Further there are various sects amongst Muslims who have their own respective Shariah authorities

and they may not fully agree with the view of the other board. Added to this there is a lack of

consensus amongst religious experts as stated above, there are difficulties in formulating a singular

standard for auditing purpose. Even amongst the experts, not all of them are well versed with

conventional banking system which incidentally happens to the frame work upon which all

banking procedures are executed. There is also a segment of society which is not very confidant

whether the Islamic banks follow Shariah law or not. Since faith and economics are bound together

as in the principles of Islamic Banking, the public should be properly educated to give them greater

confidence so that they are able to participate in these systems for a better future of both the public

and the banking industry.

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5.2. CONVENTIONAL BANKING:

Critical comparison between conventional and Islamic banks reveal that these two have differences

in setting goals and objectives, modes of borrowing, the very concept of money, different

approaches to profit distributions and risk sharing.

The principle aim of the Islamic banking system is to operate on the profit and loss sharing with

the people so that all get opportunities to take part in the business matters on an equal footing.

There is no preference towards the rich over the poor; at least in principle .There are also much

greater safety for the ordinary entrepreneurs as the banks link their own income to that of the

customer.

Conventional banks are always in the positive side of financial balance as they ensure that they get

greater profit than the interest that they pay to the investor. Their concept of money itself is that of

money being used as a commodity and not just a means of exchange where as Islamic banks

merely consider money as an instrument of transactions only.

In risk sharing also, Conventional banks do not entertain risk but on the other hand are more

concerned to make profit at the cost of the public where as Islamic banks share profits and losses

and get fully involved in the risks the customer could face.

Based on the above observations it can be concluded that Conventional banks are more friendly

towards the rich and do not get involved with the losses people suffer and remain safe.

5.3. CONSTRAINS AND CHALLENGES OF ISLAMIC BANKS IN THE UK:

Implementing Islamic rules in secular countries is a great test for executing Islamic banking

principles. In these countries banks work on the principles of rate of return and capital certainty.

This is the British model which banks through out the world follow. In the UK it comes under the

central Banks rules. The difficulty comes when Islamic banks work on profit and loss sharing

because these banks would not fall under the definitions of what constitutes banking in Britain.

Further asset valuation of Islamic system would be difficult.

In order to help the Islamic banking industry to get a proper footing in the UK government has

very skillfully created a mechanism by which other areas of finance facilities were created know

as ‘alternative finance’ through the Finance Act of 2005 and 2006 so as to meet the requirements

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of Islamic bank transactions. This has been necessary mainly on account of the fact that the

Shariah prohibits the unconditional obligation which necessitated the bank to repay what ever

amount it had received from the customer but on the other hand it shares profits and losses as its

basic principle. The finance Act of 2005 in order to equalize with the conventional banks,

considered the Profit Share Return with respect to Murabaha and Mudarabah as payment of

interest under the Alternate Finance Return, This gave the same obligations and rights as an

interest payment under the tax

Further the double stamp duty by way of Stamp Duty Land Tax (SDLT) which the bank

transaction had to incur for example in the Islamic mortgages(Murabaha), the tax being paid by the

bank and then by the end consumer. By enacting a law, the Finance Act 2003 removed this

requirement so that the Islamic mortgages are treated on an equal footing with the conventional

mortgages. In the valuation of assets of Islamic banks, the Bank of England which values assets

based on fixed interest instruments would find it difficult to put value on the Islamic bank assets. If

it were to do so, then there would be a need to send experts teams to each and every bank to value

the assets as per the 1979 Act. Conventional Bank system, as is well known, principally works on

interest based banking. Interest plays a great part in the progress or the difficulties of any nation

which follow this system. Since the economy in any country is principally controlled by bank

interest rates, high interest rates have a negative impact on economy and GDP. A negative GDP

means that there is a lack of production and this means loss of jobs if this continues it leads to

recession. This shrinks the economy and after a continued trend it will lead to depression. This

scenario is accompanied by mass poverty with loss of general morale in society.

A lower interest has a stimulus to economy. It enables people to spend more and the economy

starts to expand again. But if the economy gets growing at a faster rate, it leads to inflation, that is

there is greater demands for products with limited supply, which in turn leads to increase in prices

.High inflation is worse than recession especially for fixed income group. This means that an

individual has to spend more money for the same thing. Therefore in order to curb inflation, the

interest rates are raised by the government so that less is borrowed and spent.

The interest rates for the Bank of England in the UK are set by the Monetary Policy Committee

which is known as the Official Bank Rate. Any change in the rates of interest is reflected upon all

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commercial banks interest rates as well as many financial institutions such as

housing,mortgages,savings account and financial assets such as bonds and shares and finally on the

producer and consumer prices.

This example of low interest rate and flow of money can be given as an example how interest rates

affect the well beings of people. Obviously if there are no interest rates, then there would be

greater flow of money but the inflation could go uncontrolled. From this angle it could be argued

that the profit and loss sharing system is a good alternative to control of economy by levying

interest.

Islamic banks which work on participatory type of economics have to face the challenges of risk

managements. Examining the instruments of Islamic banking it is very clear that there are several

risks involved so as to make the system function properly and profitably.

The Islamic Bank of Britain has its own workable methodology in managing risks. As explained

earlier, it has its separate Credit Committee so as to assess credits and make constant reporting on

risk issues. It obtains collaterals against secured advances in the form of assets. Similarly liquidity

management is done so as to ensure that it has enough resources in emergencies.

From the above discussion it can therefore be seen that control of bank interest rates is the most

important aspect one should consider so as to give protection to a countries economy. Although the

Islamic system of profit sharing economy is still in its infancy, it would still be correct to assume

that this system if properly executed would help prevent recession, improve GDP, create new jobs

and maintain a steady ideal economic state.

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RECOMENDATIONS

Review of literature and the subsequent data analysis reveals that the world banking industry has a

new and effective player competing with the conventional system in the form of Islamic banking

based on Shariah.A system with its own merits and short falls. Improper distribution of monetary

benefits and government over spending has resulted in the world facing a series of recessions. As

observed by Kennedy, people are subjected to great hard ships due to the exponential growth of

interest rates .Further interest is levied more than once in different forms .This system which adds

to the undue expenditure of people accelerates the poverty and deprivation in many countries.

It has been argued by scholars that the global economic crisis is caused by several factors such as

imbalances in country’s budgets, improper expansion of monetary system, large deficits in

payments, inadequate foreign monetary aid and cooperation. It is argued that an interest free

economy would help in establishing well beings on a broad base by a system of partnership

between clients and financial institutions.

Although the future of Islamic banking seem bright, there are still many challenges which have to

be sorted out which could enable Islamic banks to establish a healthy competition with the

Conventional banks.

In view of this, would recommend the following measures.

• The concept of Riba which continues to evade a full fledged explanation and definition

should be resolved. This can be achieved by frequent discussions by those who are well

versed with Shariah and laws governing Conventional banking. And a review, training

programme must be initiated in banks operating as per Shariah so as to keep the employees

updated with latest developments.

• Some instruments of Islamic banking such as Murabaha should be re examined so that a

suitable mode could be developed to fully satisfy clients in its consistency with Islamic

Shariah.

• Profit and loss sharing should be so structured that the all sections of society especially the

capitalists also get themselves involved in it, which would ultimately help equal

distributions of profits to a larger section of people.

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• Newer products should be launched which would attract people of different professions and

age groups. This will help in expansion of Islamic banking in Britain.

• While constituting Shariah boards, only qualified scholars who are well versed in the

Shariah as well as modern banking system should be inducted.

• An attempt should be made at social and educational levels to spread the merits of banking

on profit sharing mechanism so that the society gets rid of greed and exploitation which is

the main cause of suffering.

• 8.In order to bring about a total change of banking system a new concept in profit and loss

sharing with out charging interest be introduced

• Differences between various sects following Shariah law should be sorted out and a

uniform code established.

• Adjustments in the modalities should be made to eradicate cumbersome and burdensome

procedures

• Participatory financing should be made more popular so as to involve socially and

economically rich so that the system is in a better position to offer greater loans to the poor.

• A Shariah Auditing system should be perfected to help guide Islamic banks through out the

world especially in Muslim minority countries such as the United Kingdom.

• Islamic banks do not guarantee any fixed rate of profit or share in their deposits.

Amendments to this rule must be done for the old. The weak and the infirm investors who

cannot do any business activity but who live on a fixed income for a living.

• The Zakat on profits should be used for beneficiary purposes and this activity should be

highlighted so that people especially non Muslims who have charitable instincts get more

inclined to invest on moral grounds. Further although Zakat is an obligatory payment of

religious tax, the government nevertheless applies its own taxations. This brings about

double taxation. This has to be sorted out.

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• Profits on deposits are taxed by the UK government. Suitable recommendation by the

Shariah boards must be made to the Government to abolish this so that the depositors get

full benefit.

• Customers must be informed about the projects and their soundness which the banks can

offer. This will help both the customer and the bank in saving valuable time.

• Venture capital financing which is done through the Islamic banking instruments of

Mudarabah and Musharaka should be made stronger. This should be done through an

active participation of technology, entrepreneurs, financiers and the Government.

• A major inbuilt risk such as in Mudarabah where a financier has to bear all the losses has to

be re-modified .This is because it is difficult to assess the loss as to whether it was due to

negligence, inefficiency or fraud.

• When banks recruit personnel, they should only be those who are well versed with the

Islamic system of banking so that they are able to provide proper guidance to customers.

In the United Kingdom most of the patronage for Islamic banks emanates from Muslims, with a

very few non Muslims taking active participation in it. In order to make it more palatable to all

sections of society a new system of economy may be developed .This system should not only try to

avoid the disadvantages of interest giving but also be a system where the poor and the rich are

given equal opportunities to progress.

American lawyer Louis Kelso (1958, 1961) proposed that a widely distributed capital would create

a more balance of economy and justice. This he proposed in his books The Capitalist Manifesto

and The New Capitalist .The system of economy by which he could achieve this was through

Binary Economics. He also proposed Employee Share Ownership plan which he claimed to be

compatible with Binary Economics.

Binary Economics, according to him took into consideration Productiveness which gave equal and

appropriate evaluation of labour and capital in contrast to Productivity which is the ratio of total

output divided by unit of input.

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Time value of money and interest which is the basic of Conventional banking is rejected by the

concept of Binary Economics. On the other hand an interest free banking system should be

evolved for the development of productive capacity.

In view of the above, there should be a system where the involvement of interest is totally

abolished for obvious reasons as already explained and a system acceptable to all like the Binary

system, to make it acceptable to Muslims and non Muslims alike of economics be adopted. Binary

system as such may be acceptable to the Muslims because it is not a new system to them being

based on interest free with participatory financing very much similar to Islamic system of banking.

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