Hussain Shahid Thesis, Sadiq

8/4/2019 Hussain Shahid Thesis, Sadiq

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1. Introduction

The first official experiment with Islamic Banking in the modern era can be traced back

to 1963 in the form of Mit Ghamr Bank in Egypt. From that time to the present decade,

Islamic Banking has experienced phenomenal growth both in terms of size and the

number of players in the market. Islamic Banking is currently being practiced in more

than 50 countries. This includes Muslim countries like Malaysia, Pakistan, Saudi Arabia,

U.A.E, Iran, Egypt, Bangladesh and Jordan etc as well as Non-Muslim countries like

U.K, U.S.A, Luxembourg, Australia, France and Italy etc. In almost all the countries,

Islamic Banking is being practiced along with the traditional banking with the exception

of Iran where only Islamic Banking is allowed. Recent figures show that Islamic Banks

are managing assets worth more than $260 billion according to 2006 figures and is

currently growing at around 20%, which is twice more than the growth of conventional

banking. This rapid growth of Islamic Banking shows that it is being accepted widely all

over the world, which is due to a number of reasons.

The potential of Islamic Banking can be recognized from the fact that the banking giants

in all parts of the world have also started their Islamic Banking operations and

collectively the total assets being managed under Islamic financial services are reportedly

exceeding $500 billion, of which almost half the amount is being managed byconventional banks.

The objective of this study is to see the evolution of Islamic Banking in different

countries including both Muslim and Non-Muslim countries, their current progress and

their future prospects regarding Islamic Banking. The countries that have been chosen for

this study are Pakistan, Malaysia, Turkey, Iran, U.S.A, U.K, Indonesia and the GCC etc.

In the last part, along with the major differences between the two banking systems, the

important characteristics of the Islamic Banking System have been highlighted which

have enabled it to become an attractive banking system and have helped it achieve the

phenomenal growth rate.

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2. Research Methodology

2.1 The Purpose of the Study

The purpose of this study is to show the reasons, which have been the backbone of therecent success of Islamic Banking over conventional banking operations. For this

purpose, Islamic Banking Industry growth in different parts of the world had to be

analyzed and so explorative study was a better option as the analysis had to be done on

the data already available on the Internet and the books written on Islamic Banking.

2.2 Data Collection

For the purpose of Data Collection, the following secondary sources have been used;

2.2.3 Articles on Islamic Banking

For the purpose of analysis of the undertaken study, articles written by different

renowned scholars have been analyzed. These include Muslim as well as Non-Muslim

scholars. Most of the articles have been gathered through the Internet and some of them

have been gathered for the Central Library of International Islamic University,

Islamabad.

2.2.4 Books on Islamic Banking

Various books have been studied in order to complete the analysis. Books from local as

well as foreign authors have been analyzed. The books were obtained from Central

Library of the International Islamic University Islamabad and the Library of NUST

Institute of Management Sciences. Some of the books were also accessed through the

Internet.

2.2.4 Research papers on Islamic Banking

In order to complement the findings of the study, help was also taken from the research

papers written by different learned scholars. These papers were gathered mainly from theInternet as well as from the Central Library of the International Islamic University,

Islamabad.

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2.3 Limitations

There are certain limitations, which may have affected the results of the study;

Firstly, this study has been completed in a limited time frame.

Secondly the data, available both from the books and the Internet, was not up-to-

date in quite a few cases.

Finally, the data available on Islamic Banking has mainly been obtained only

from the following three sources;

o Central Library of International Islamic University, Islamabad.

o Library of NUST Institute of Management Sciences, Rawalpindi.

o Internet.

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3. Literature Review

This research paper presents a theoretical model of an interest-free banking system

consistent with the principles of Islam. The main purpose of the paper is to show that the

Islamic banking system can be rationalized in a neoclassical framework and that the

model underlying Islamic Banking is not different from Western Economic thinking. It

has also been argued in the paper that in many circumstances, Islamic banking system

would be relatively more stable than the traditional system in face of certain types of

shocks. (Islamic Interest-free Banking: A Theoretical Analysis By Mohsin S.Khan)

The study evaluates inter-temporal and inter-bank performance of Islamic bank, Bank

Islam Malaysia Berhad (BIMB) in profitability, liquidity, risk and solvency and

community involvement for the period 1984-1997. Financial ratios are applied in

measuring these performances. T-test and F-test are used in determining their

significance. The study found that BIMB is relatively more liquid and less risky

compared to a group of 8 conventional banks (The performance of Malaysian Islamic

bank during 1984-1997: An exploratory study by Abdus Samad & M. Kabir Hassan).

With the exception of a study conducted by Metawa and Almossawi (1997), which shows

religion as a factor of customers choice of Islamic bank in Bahrain, other studies proved

otherwise. The evidence from studies conducted in Sudan and Turkey, for example, show

that religion is not the main reason for customers selecting Islamic banks (Erol and El-

Bdour, 1989). Similarly, studies conducted in Malaysia and Singapore find both religion

and profit as the reason for people maintaining their relationship with Islamic banks

(Haron et. al., 1994; Gerrad and Cunningham, 1997).

At present, there are more than 200 interest-free institutions operating in 40 nations

worldwide and providing services that are compatible to those services offered by

conventional banks. In 1985 this system mobilized an estimated US $5 billion funds,

which currently has increased to US $ 80 billion. Western conventional based financial

institutions such as Citibank, JP Morgan, Deutsche Bank, ABN Amro and American

Express have started introducing interest-free products to customers. Similarly,

multinational corporations such as General Motors, IBM and Daewoo Corporation have

begun to use interest-free services. (The effects of conventional interest rates and rate of

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profit on funds deposited with Islamic banking system in Malaysia by Dr.Sudin Haron &

Norafifah Ahmad).

According to the Office for National Statistics and recent research led by Lloyds TSB

show that over 75 percent of British Muslims would prefer a banking system that

conforms to Islamic laws rather than adopting Western financial services.( U.K. the

Global Center for Islamic Finance? By James Fontanella)

According to estimates provided by the General Council for Islamic Banks and Financial

Institutions (GCIBFI), pure-play Islamic banks and financial institutions today manage

some $260 billion of assets. The Islamic windows and subsidiaries of international banks

in the worlds major financial centers; such as New York, London, Paris, Geneva and

Tokyo manage a further $200 billion to $300 billion.

Islamic Banking did take off, and has in fact enjoyed an average annual growth rate over

10% per annum since it first emerged in the 1970s, according to the GCIBFI. Hayes

attributed much of this success to the increasing sophistication of Shariah scholars and

the effort put into Islamic financial engineering, as well as the vital motivator of market

demand.

Though the option of Shariah-compliant banking is to give Muslims an alternative to

interest-based conventional finance, Hayes remarked that the series of scandals in

corporate America has helped to close the gap between the ethical demands of Muslim

and non-Muslim investors. Unconsciously, conventional finance has been moving

towards the societal values of Islamic finance, he said.

In fact, Hayes said that investors in the US are increasingly keen to invest on an ethical

basis: $1 in every $8 invested in the US now follows moral investment criteria. Such

criteria commonly include a prohibition on investing in tobacco stocks or firms

publishing pornography. (Drawing the roadmap for Islamic banking 2003 source: website

failaka).

Islamic Banking is emerging as a small but growing trend among lenders in the United

States, as niche players create specialized products and services for Muslims that fall

within the tenets of Islamic law, or Shariah.

Currently there are three banks that offer Islamic Banking in the U.S., including

international giant HSBC (Research), but experts expect that number to rise as the

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Muslim population grows and the community begins to demand more specialized

services.

"The rise of Islamic Banking is a sign of the maturity of the Muslim community in

America," said Rabiah Ahmed, spokeswomen for the Council of American-Islamic

Relations. " The trend is definitely increasing."

Pirker said that regional and community banks that have stronger ties to the Muslims in

their community would lead the charge. But larger banks are going to have to start

branching out to remain competitive. (CNN Money)

International banks have already dipped their toes into Islamic financing abroad and

found success. Banks such as Citigroup (Research), HSBC and Deutsche Bank

(Research) have created Islamic subsidiaries focused on the Middle East and Asia.( Niche

banks find growth in Muslim market By Shaheen Pasha)

Interest-free banking seems to be of very recent origin. The earliest references to the

reorganisation of banking on the basis of profit sharing rather than interest are found in

Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late

forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961).

Muhammad Hamidullahs 1944, 1955, 1957 and 1962 writings too should be included in

this category. They have all recognised the need for commercial banks and the evil of

interest in that enterprise, and have proposed a banking system based on the concept of

Mudarabha - profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of

the political interest it created in Pakistan and partly because of the emergence of young

Muslim economists. Works specifically devoted to this subject began to appear in this

period. The first such work is that of Muhammad Uzair (1955). Another set of works

emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah

Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main

contributors.

A recent International Monetary Fund study by Iqbal and Mirakhor (l987) has found

Islamic Banking to be a viable proposition that can result in efficient resource allocation.

The study suggests that banks in an Islamic system face fewer solvency and liquidity

risks than their conventional counterparts. The multi-purpose and extra-commercial

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nature of the Islamic Banking operation does not seem to pose intractable problems. The

abolition of interest makes it imperative for Islamic banks to look for other instruments,

which renders operations outside the periphery of commercial banking unavoidable.

Islamic banks are no exception, having capitalized on the tremendous boom in the Middle

East in general, and Islamic Banking in particular. Take some of the larger players as

examples: Qatar Islamic Bank (QIB) made $129 million, Dubai Islamic Bank (DIB)

made $192 million, Kuwait Finance House (KFH) made $259 million, Bank AlJazira

made $359 million, and Al Rajhi Bank made a staggering $941 million. (Robin

Wigglesworth 2006)

Most of the major Islamic banks in the region are investing tremendous resources into

becoming regional, even international, banking players. Bahrain-based ABG is probably

the most geographically diversified Islamic bank, with subsidiaries in Egypt, Lebanon,

Sudan, Tunisia, Turkey, Jordan, Algeria, and South Africa, and has invested in the

Islamic Bank of Britain and the European Islamic Investment Bank.

Al Rajhi has announced plans to open 50 branches in Malaysia, arguably the world's most

advanced country within Islamic finance, and as in Saudi Arabia, Al Rajhi's focus in

Malaysia will be on retail.(Source: Website cpifinancial.net)

Khan (1986) has noted that the abolition of interest-based transactions is not a subject

alien to Western economic thought. Fisher (1945), Simons (1948), and Friedman (1969)

have argued that the current one-sided liability, interest-based financial system can be

fundamentally unstable. There are many such examples; the German hyperinflation of the

1920s, oil shock inflations in Europe of the 1970s; and banking crises in Japan, East

Asia, Russian and Argentina default and Enron bankruptcy, and so on. The occurrence of

crises is the result of a complex of factors emanating from over exuberance, greed,

underestimation of risk, overexposure, currency failures, asset depreciation, faulty

regulation, illiquidity, macroeconomic shocks and accountancy maladministration. Zarqa

(1983), Khan (1986), Chapra, (2000) El-Gamel (2000) and Abdul Gafoor (1997), have

illustrated the macroeconomic stability that can form a profit and loss sharing system, an

Islamic form of banking would replace interest-based transactions that characterize

Western transactions.

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Although Islam excludes interest earnings from financial activities, it does not necessarily

mean that the financier cannot earn a profit. In order to do so, the financier has to ensure

that gains made on the original amount are directly related to the risk undertaken on the

investment (Siddiqui 1987). If there is no risk involved, the gains made represent interest

rather than profit.

The paper discusses the efficiency of eighteen different banks and concludes that the

efficiency of the Islamic banks has been better than the conventional counterparts. The

author has used Data Envelopment Analysis technique to arrive at this conclusion. The

Islamic banks have performed better than their conventional banking rivals after the

1998-99 crises. (Efficiency in Islamic Banking: An empirical analysis of eighteen banks,

Islamic Economic Studies by Donsyah Yudistra 2004)

Following a framework of functional perspective suggested by Merton and Bodie (1993)

the writers argue that one hundred percents reserve narrow banking provides a basis for

banking reforms and an alternative to reduce the likelihood of systemic financial crisis.

Both the narrow banking and the Islamic system (equity based system) provide more

stability to a banking sector than a conventional banking system does. Banking crisis

have provoked immediate proposals from a multitude of foreign advisors as well as from

international institutions. To resolve the crisis and to prevent future ones these advisors

have called for more and better bank regulation, more and better supervision and more

and better enforcement. The authors of the research paper also says that the policy of

more regulation does not address two fundamental problems: The asymmetry between

the real value of banks assets and liabilities when there are macro-economic shocks and

the inherent stability of system of fractional reserve requirements, the Achilles heel of

any banking system. As stated by sjaastad (1997) both deposit insurance and the lender

of last resort facility offered by central banks have evolved as devices to stabilize an

inherently unstable institution: fractional reserve banking.

During the last centuries countries worldwide experience many episodes of several

banking distress and crisis. The US for instance after experiencing bank panics in 1884,

1890, 1893 and 1907 implemented a corrective measure creating in 1913, the federal

reserve system. It also imposed a system of deposit insurance as a mechanism to

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counteract a banking instability. Nonetheless, the Federal Reserve System failed to

prevent the worst banking crisis in US history, the great depression of 1930s.

In response to this situation, during the 1930s a group of economists affiliated with the

University of Chicago launched a proposal for the alternative banking reform now known

as narrow banking. The advocated financial system one based on equity thereby

separating the creation of money from the creation of credit.

Equity based banking system have never explicitly being out into effect in the western

world. Nonetheless in some countries with Islamic population due to religious concerns

with the payment of interest there are banks based on equity under the Islamic law. Those

banks have instituted a scheme that the liability side overcomes the payment of interest

through a profit loss-sharing (PLS) scheme. For very different reason the Islamic

Banking system and the western call for banking reforms meet on a common ground:

equity.

One of the most critical features of Islamic Banking is that all the players share profit and

losses. The Islamic Banking system avoids one of the most important causes of banking

distress that is the asymmetry between the value of assets and the value of liabilities.

Muslims are one of the many minorities in Australia. Though there are no Islamic banks

in Australia at the moment but a study has shown that there is great potential that if

Islamic Banking were introduced in the country, the Muslim community of Australia

would appreciate it. Today Australias Muslims come from diverse social political and

ethnic backgrounds. In 1991 there were 147,500 Muslims in Australia, and in 1996 the

number stood at 200,900. In 2001 (the last official census date), there were 281,578

Muslims representing 1.5% of the total population. This studied showed that the majority

of the Muslim community is demanding Riba free banking and if offered, would switch

to the Islamic Banking products (Islamic Banking in Australia: Challenges and

Opportunities by Abdul Malik Mirza And Abdel-Karim Halabi)

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4. Concept of Riba in Islam

4.1 Riba and Its Types

The word "Riba" means excess, increase or addition, which if correctly interpreted

according to Shariah terminology, implies any excess compensation without due

consideration.

This definition of Riba is derived from the Quran and has been unanimously accepted by

all Islamic scholars. There are two types of Riba, identified to-date by Islamic scholars,

namely 'Riba An Nasiyah' and 'Riba Al Fadl'.

'Riba An Nasiyah' is defined as excess, which results from predetermined interest, which

a lender receives over and above the principal.

'Riba Al Fadl' is defined as excess compensation without any consideration resulting

from a sale of goods.

During the dark ages, only the first form (Riba An Nasiyah) was considered to be Riba.

However the Holy Prophet also classified the second form (Riba Al Fadl) as Riba.

The meaning of Riba has been clarified in the following verses of Quran:

"O those who believe, fear Allah and give up what still remains of the Riba if you are

believers. But if you do not do so, then be warned of war from Allah and His Messenger.

If you repent even now, you have the right of the return of your capital; neither will you

do wrong nor will you be wronged."Al Baqarah 2:278-9

These verses clearly indicate that the term Riba means any excess compensation over and

above the principal which is without due consideration. However, the Quran has not

altogether forbidden all types of excess; as it is present in trade as well, which is

permissible. The excess that has been rendered haram in Quran is a special type termed as

Riba. In the dark ages, the Arabs used to accept Riba as a type of sale, which

unfortunately is also being understood at the present times. Islam has categorically made

a clear distinction between the excess in capital resulting from sale and excess resulting

from interest. The first type of excess is permissible but the second type is forbidden and

rendered Haram.

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"Seized in this state they say: 'Buying and selling is but a kind of interest', even though

Allah has made buying and selling lawful, and interest unlawful."Al Baqarah 2:275

4.1.1 Classification of Riba

The first and primary type is called Riba An Nasiyah or Riba Al Jahiliya.

The second type is called Riba Al Fadl, Riba An Naqd or Riba Al Bai.

Since the first type was specified in the Quranic verses before the sayings of the Holy

Prophet, this type was termed as Riba Al Quran. However the second type was not

understood by the Quranic verses alone but also had to be explained by the Holy Prophet,

so it is also called Riba Al Hadith.

Riba An Nasiyah is the real and primary form of Riba. Since the verses of Quran havedirectly rendered this type of Riba as haram, it is called Riba Al Quran. Similarly, since

only this type was considered Riba in the dark ages, it has earned the name of Riba Al

Jahiliya. Imam Abu Bakr Hassas Razi has outlined a complete and prohibiting legal

definition of Riba An Nasiyah in the following words:

"That kind of loan where specified repayment period and an amount in excess of capital

is predetermined."

One of the Hadith quoted by Ali Ibn at Talib (RAA) has defined Riba An Nasiyah in

similar words. The Holy Prophet said:

"Every loan that draws interest is Riba."

The famous Sahabi Fazala Bin Obaid has also defined Riba in similar words:

"Every loan that draws profit is one of the forms of Riba"

The famous Arab scholar Abu Ishaq Az Zajjaj also defines Riba in the following words:

"Every loan that draws more than its actual amount"

Riba An Nasiyah refers to the addition of the premium, which is paid to the lender in

return for his waiting as a condition for the loan and is technically the same as interest.

The prohibition of Riba An Nasiyah is one of those issues, which have been confirmed,

in the revealed laws of all Prophets (AS). Some of the old testaments have rendered Riba

as haram (Exodus 22:25, Leviticus 25:35-36, Deuteronomy 23:20, Psalms 15:5, Proverbs

28:8, Nehemiah 5:7 and Ezekiel 18:8,13,17 & 22:12). The Quran has also stated the

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prohibition of Riba in various verses has warned those, who persist in practicing it, of a

war which is certain to be declared on them by Allah Himself and His messenger and has

seriously threatened those engaged as writer, witness and dealer in Riba transactions.

4.2 Riba in Quran and Hadith

The debate on definition of Riba, particularly in context of present interest-ridden

economic and financial system, is almost settled among overwhelming majority of the

Islamic scholars since late 1970s. Considering that modern institutionalized form of

interest falls under absolute prohibition of Riba, efforts have been going on for about

three decades for implementing Islamic Banking System. However, still there might be

some confusion in the minds of some individuals. Although some indications of

displeasure against Riba were given in the Makkan period, but Islam imposed the

prohibition sometime before the battle ofOhudin year 3 A. H.

Owing to the fact that interest is a focal point in modern economic life, and specially that

it is embedded in operations of existing financial institutions, a number of Muslims have

been interpreting it in a manner which is radically different from the understanding of

Muslim scholars throughout the last fourteen centuries and that is also sharply in conflict

with the categorical statements of the Holy Prophet (peace be upon him). According to

Islamic teachings, any excess on the capital is Riba (interest). Islam accepts no

distinction, in so far as prohibition is concerned, between reasonable and excessive

rates of interest and interest in any case is prohibited.

4.2.1 Riba in the Quran

Riba has been clearly and explicitly prohibited in the Quran and Sunnah. Allah and His

Messenger, Prophet Muhammad (P.B.U.H), have declared war on those who do not

abstain from it. These are some of the relevant verses regarding Riba. Allah says in the

Qur'an:

First Revelation (Surah al-Rum, verse 39)

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"That which you give as interest to increase the peoples' wealth increases not with

God; but that which you give in charity, seeking the goodwill of God, multiplies

manifold."(30: 39)

Second Revelation (Surah al-Nisa', verse 161)

"And for their taking interest even though it was forbidden for them, and their

wrongful appropriation of other peoples' property. We have prepared for those

among them who reject faith a grievous punishment"(4: 161)

Third Revelation (Surah Al 'Imran, verses 130-2)

"O believers, take not doubled and redoubled interest, and fear God so that you may

prosper. Fear the fire which has been prepared for those who reject faith, and obey

God and the Prophet so that you may receive mercy."

Fourth Revelation (Surah al-Baqarah, verses 275-81)

"Those who benefit from interest shall be raised like those who have been driven to

madness by the touch of the Devil; this is because they say: "Trade is like interest"

while God has permitted trade and forbidden interest. Hence those who have

received the admonition from their Lord and desist, may keep their previous gains,

their case being entrusted to God; but those who revert shall be the inhabitants of the

fire and abide therein forever."(275)

"God deprives interest of all blessing but blesses charity; He loves not the ungrateful

sinner."(276)

"Those who believe, perform good deeds, establish prayer and pay the zakat, their

reward is with their Lord; neither should they have any fear, nor shall they grieve."

(277)

"0, believers, fear Allah, and give up what is still due to you from the interest (usury),

if you are true believers."(278)

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"If you do not do so, then take notice of war from Allah and His Messenger. But, if

you repent, you can have your principal. Neither should you commit injustice nor

should you be subjected to it."(279)

"If the debtor is in difficulty, let him have respite until it is easier, but if you forego

out of charity, it is better for you if you realize."(280)

"And fear the Day when you shall be returned to the Lord and every soul shall be

paid in full what it has earned and no one shall be wronged"(281).

4.2.2 Riba in Hadith

The Prophet (P.B.U.H) has also expressed his view on Riba on different occasions. These

views can be categorized as follows:

4.2.2.1 General

The following hadith are those which have been quoted by various suhabaa and refer to

Prophets general views on Riba:

From Jabir: The Prophet, said about the receiver and the payer of interest, the one

who records it and the two witnesses to the transaction: "They are all alike [in

guilt]." (Muslim, Kitab al-Musaqat, Bab la'ni akili al-Riba wa mu'kilihi; also in

Tirmidhi and Musnad Ahmad)

Jabir ibn Abdallah, giving a report on the Prophet's Farewell Pilgrimage, said:

The Prophet addressed the people and said, "All of the Riba of Jahiliyyah is

annulled. The first Riba that I annul is our Riba, that accruing to 'Abbas ibn 'Abd

al-Muttalib [the Prophet's uncle]; it is being cancelled completely." (Muslim,

Kitab al-Hajj, Bab Hajjati al-Nabi, ; may also in Musnad Ahmad)

From 'Abdallah ibn Hanzalah: The Prophet, said: "A dirham of Riba which a man

receives knowingly is worse than committing adultery thirty-six times"(Mishkat

al-Masabih, Kitab al-Buyu', Bab al-Riba, on the authority of Ahmad and

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Daraqutni). Bayhaqi has also reported the above hadith in Shu'ab al-iman with the

addition that "Hell befits him whose flesh has been nourished by the unlawful."

From Abu Hurayrah: The Prophet, said: "On the night of Ascension I came upon

people whose stomachs were like houses with snakes visible from the outside. I

asked Gabriel who they were. He replied that they were people who had received

interest."(Ibn Majah, Kitab al-Tijarat, Bab al-taghlizi fi al-Riba; also in Musnad

Ahmad)

From Abu Hurayrah: The Prophet, said: "Riba has seventy segments, the least

serious being equivalent to a man committing adultery with his own mother."

(Ibn-e- Majah)

4.2.2.2 Riba an Nasiyah

These are the Hadith that are specifically related to Riba an Nasiyah and have been

quoted by Prophets suhabaas.

From Usamah ibn Zayd: The Prophet, said: "There is no Riba except in Nasiyah

[waiting]."(Bukhari, Kitab al-Buyu', Bab Bay' al-dinari bi al-dinar nasa'an; also

Muslim and Musnad Ahmad) "There is no Riba in hand-to-hand [spot]

transactions."(Muslim, Kitab al-Musaqat, Bah bay'i al-ta'ami mithlan bi mithlin;

also in Nasa'i)

From Ibn Masud: The Prophet, said: "Even when interest is much, it is bound to

end up into paltriness."(Ibn Majah, Kitab al-Tijarat, Bab al-taghlizi fi al-Riba;

also in Musnad Ahmad)

From Anas ibn Malik: The Prophet, said: "When one of you grants a loan and the

borrower offers him a dish, he should not accept it; and if the borrower offers a

ride on an animal, he should not ride, unless the two of them have been

previously accustomed to exchanging such favours mutually."(Sunan al-Bayhaqi,

Kitab al-Buyu', Bab kulli qardin jarra manfa'atan fa huwa Riban)

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From Anas ibn Malik: The Prophet, said: "If a man extends a loan to someone he

should not accept a gift."(Mishkat, on the authority of Bukhara's Tarikh and Ibn

Taymiyyah's al-Muntaqa)

From Abu Burdah ibn Abi Musa: I came to Madinah and met 'Abdallah ibn Salam

who said, "You live in a country where Riba is rampant; hence if anyone owes

you something and presents you with a load of hay, or a load of barley, or a rope

of straw, do not accept it for it is Riba." (Mishkat, reported on the authority of

Bukhari)

4.2.2.3 Riba al FadI

The following are the Hadith that have been quoted by different suhabaas related to the

concept of Riba al Fadl

From 'Umar ibn al-Khattab: The last verse to be revealed was on Riba and the

Prophet, was taken without explaining it to us; so give up not only Riba but also

raibah [whatever raises doubts in the mind about its rightful-ness]. (Ibn Majah,)

The Prophet, said: "Sell gold in exchange of equivalent gold, sell silver in

exchange of equivalent silver, sell dates in exchange of equivalent dates, sell

wheat in exchange of equivalent wheat, sell salt in exchange of equivalent salt,

sell barley in exchange of equivalent barley, but if a person transacts in excess, it

will be usury (Riba). However, sell gold for silver anyway you please on the

condition it is hand-to-hand (spot) and sell barley for date anyway you please on

the condition it is hand-to-hand (spot)."

From Abu Sa'id al-Khudri: The Prophet, said: "Do not sell gold for gold except

when it is like for like, and do not increase one over the other; do not sell silver

for silver except when it is like for like, and do not increase one over the other;

and do not sell what is away [from among these] for what is ready. "(Bukhari,

Kitab al-Buyu', Bab bay'i al-fiddati bi al-fiddah; also Muslim, Tirmidhi, Nasa'i

and Musnad Ahmad)

From 'Ubada ibn al-Samit: The Prophet, said: "Gold for gold, silver for silver,

wheat for wheat, barley for barley, dates for dates, and salt for salt - like for like,

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equal for equal, and hand-to-hand; if the commodities differ, then you may sell as

you wish, provided that the exchange is hand-to-hand." (Muslim, Kitab al-

Musaqat, Bab al-sarfi wa bay'i al-dhahabi bi al-waraqi naqdan; also in Tirmidhi)

From Abu Sa'id al-Khudri: The Prophet, said: "Gold for gold, silver for silver,wheat for wheat, barley for barley, dates for dates, and salt for salt - like for like,

and hand-to-hand. Whoever pays more or takes more has indulged in Riba. The

taker and the giver are alike [in guilt]."(Muslim, ibid; and Musnad Ahmad)

From Abu Sa'id and Abu Hurayrah: A man employed by the Prophet, in Khaybar

brought for him janibs [dates of very fine quality]. Upon the Prophet's asking him

whether all the dates of Khaybar were such, the man replied that this was not the

case and added that "they exchanged a sa' [a measure] of this kind for two or three

[of the other kind]". The Prophet, replied, "Do not do so. Sell [the lower quality

dates] for dirhams and then use the dirhams to buy janibs. [When dates are

exchanged against dates] they should be equal in weight."(Bukhari, Kitab al-

Buyu', Bab idha arada bay'a tamrin bi tamrin khayrun minhu; also Muslim and

Nasa'i)

From Abu Said: Bilal brought to the Prophet, some barni [good quality] dates

whereupon the Prophet asked him where these were from. Bilal replied, "I had

some inferior dates which I exchanged for these - two sa's for a sa'." The Prophet

said, "Oh no, this is exactly Riba. Do not do so, but when you wish to buy, sell the

inferior dates against something [cash] and then buy the better dates with the

price you receive."(Muslim, Kitab al-Musaqat, Bab al-ta'ami mithlan bi mithlin;

also Musnad Ahmad)

From Fadalah ibn 'Ubayd al-Ansari: On the day of Khaybar he bought a necklace

of gold and pearls for twelve dinars. On separating the two, he found that the gold

itself was equal to more than twelve dinars. So he mentioned this to the Prophet,

who replied, "It [jewellery] must not be sold until the contents have been valued

separately."(Muslim, Kitab al-Musaqat, Bab bay'i al-qiladah fiha khara-zun wa

dhahab; also in Tirmidhi and Nasa'i)

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These verses from the Quran and the Hadith taken from different sources show the orders

for prohibition of Riba and the consequences if a Muslim deliberately indulges in it.

Therefore, these verses clearly indicate that a Conventional Banking System is

inadequate for the Muslims and should be replaced with a system conforming to their

faith.

5. Islamic Banking

Islamic Banking refers to a system of banking or banking activity that is consistent with

Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic

law prohibits usury, the collection and payment of interest, also commonly called Riba in

Islamic discourse. Generally, Islamic law also prohibits trading in financial risk (which is

seen as a form of gambling). In addition, Islamic law prohibits investing in businesses

that are considered haram (such as businesses that sell alcohol or pork, or businesses that

produce un-Islamic media).

5.1 The Rationale of Islamic Banking

It has been seen that the role and functions of the conventional banks are indeed highly

useful and socially desirable, but unfortunately, interest plays a central role in each of

their functions, which is prohibited, for all the Muslims. Islamic Banking services

endeavor to replace interest by other modes and instruments both for mobilizing savings

and for putting those savings to productive use. People need banking services. Now, since

the banking services are needed but interest is prohibited, Islamic economies have to find

alternative ways of performing various banking functions. This challenge provides the

Rationale of Islamic Banking.

5.2 History of Banking in Islam

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Historically, the role of a financial intermediary in the Islamic economy has been found

in the principle of al Mudarib udarib. It is a practice which has existed in Islamic history

since early centuries. Al Mudarib is the one who mobilizes funds on profit-sharing basis

and extends these funds to the users on the same basis. Similarly in leasing, the lessee

who possesses the goods may sell them against a higher price and create additional value.

In the early Islamic period, most caravan trades were financed by Mudarabah. In trading

it is possible to purchase something on order at a given price and resell it to the other at a

higher price. Islamic scholars consider the earnings of profits from an intermediary role

as a genuine occupation. It should be noted that this concept of financial intermediation is

related with the production and exchange of real goods and services. In short, it can be

said that the concept of financial intermediary has existed in Islamic world since

centuries.

5.3 Evolution of Modern Islamic Banking

The latter half of the twentieth century witnessed a distinctly separate line of thinking on

banking. This was institutionalized at the end of third quarter and subsequently emerged

as a new system of banking called Islamic Banking, which is also called Profit-Loss

Sharing (PLS) Banking. The world has now been experiencing operations of as many as

250 Islamic Banks and financial institutions in more than 50 Muslim and Non-Muslim

countries.

There are religious as well as economic reasons which have contributed to the emergence

of PLS system as an alternative to its conventional counterpart. It is the prohibition of

Riba in the Quran that according to the proponents of the PLS system was the source of

inspiration for establishing banks in line with Islam. The basic intention behind

establishing Islamic banks was the desire of Muslims to reorganize their financial

activities in a way that do not contradict the principles of Shariah and enable them to

conduct their financial transactions without indulging into Riba.

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The economic reason derived from a verse of the Quran providing inspiration to devise

an interest-free financial system has been substantiated in the way that interest instead of

increasing wealth, reduces it [30:34]. The primary reason of why the Quran has taken

such a strict approach towards prohibition of interest is that Islam stands for establishing

a just economic system free from all kinds of exploitation.

Summing, Islamic Banking emerged as a response to both religious and economic

demands while religious demand calls for avoiding any transaction based on interest,

economic exigencies on the other hand provide a new outlook to the role of banking in

promoting productive investment activities, influencing distribution of wealth and adding

stability to the economy. Islamic Banking is thus perceived as an improved system in all

dimensions.

5.3.1 First Islamic Banking Experiment

The pioneering experiment of putting the principles of Islamic Banking and finance into

practice was conducted in Egypt from 1963 to 1967 through the establishment of the Mit

Ghamr Savings Bank in a rural area of the Nile Delta. Although the project made a good

start and initial results were more than encouraging, it suffered a setback owing to

changes in the political atmosphere. Nevertheless the project was revived in 1971 under

the name of Nasser Social Bank. This was the first Islamic bank in an urban setting based

in Cairo. The bank has been established as a public authority with an autonomous status.

The principles of operation of the Nasser Social Bank are very similar to those of the Mit

Ghamr Savings bank. However the latter offers a full range of normal banking services

and a wide range of investment activities through equity participation.

5.3.2 Tabung Hajji: The First Successful Attempt

Islamic Banking with a very different approach from that in Egypt emerged in Malaysia.

It was a financial institution developed for the pilgrims of Malaysia. Consequently

pilgrims saving corporation was established in 1963 which was later on incorporated into

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the pilgrims management fund board by the name Tabung Hajji in 1969 (A.Ahmad

1993).

Other attempt next to follow was the Dubai Islamic bank in 1975. The Dubai Islamic

bank was established as a public limited company having its office in Dubai U.A.E. Since

then, a number of Islamic banks and financial institutions have been established in

different parts of the world and have been functioning successfully. A significant

development in Islamic Banking was the granting of an Islamic bank license in Saudi

Arabia to the fifty-year-old Al-Rajhi Company which became the countrys first

Islamic bank.

An example of multi-cooperation at the government level in the field of Islamic Banking

is the Islamic Development Bank, which was founded in 1975 as a multi-national

corporation by several Muslim countries. The purpose of the bank is to support social and

economic development in Muslim nations within an Islamic framework. The subscribers

of the capital are the founder governments and as such it was established by government

treaty.

In addition an Islamic bank and Investment company was established in Bahamas in 1977

as a multinational holding company under the name of Islamic Investment Company

Limited. Another example of Islamic Banking in the west comes from Luxembourg

where the Islamic Banking System international holding was established in 1978 as a

joint-stock company. As a holding company, it established a new affiliated company in

London in June 1983 under the name of Islamic finance house and another in Denmark in

1982 under the name of the Islamic bank international of Denmark.

Dar-al-mal-al-islami (DMI) based in Geneva was established in 1981. Another major

group is the Kuwait finance house (KFH). It was established in 1978. The Kuwait

Government was the major shareholder whereas private Kuwait investors owned the

remainder of Forty-nine percent of the KFH.

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Another dynamic Islamic Banking conglomerate is the Al-Baraka group, which operates

banks, investment companies, and financial advisory and management companies in

more than a dozen countries. It launched its activities only in 1982 but the group now has

a total asset base of over $ 8.64billion. It was the first group to obtain a license to launchIslamic Banking in London.

5.4 Objectives of Islamic Banking

The primary objective of establishing Islamic banks all over the world is to promote,

foster and develop the application of Islamic principles in the business sector. More

specifically, the objectives of Islamic Banking when viewed in the context of its role in

the economy are listed as following:

To offer contemporary financial services in conformity with Islamic Shariah

To contribute towards economic development and prosperity within the principles

of Islamic justice.

Optimum allocation of scarce financial resources and

To help ensure equitable distribution of income.

These objectives are discussed below;

5.4.1 Offer Financial Services

Interest-bearing banking, which is considered a practice of Riba in financial transactions,

is unanimously identified as anti-Islamic. That means all transactions made under

conventional banking are unlawful according to Islamic Shariah. Thus emergence ofIslamic Banking is clearly intended to provide for Shariah approved financial

transactions.

5.4.2 Islamic Banking for Development

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Islamic Banking is claimed to be more development-oriented than the conventional

counterpart. The concept of profit sharing is a built-in development promoter since it

establishes a direct relationship between the banks return on investment and the

successful operation of the business by the entrepreneurs.

5.4.3 Optimum Allocation of Resources

Another important objective of Islamic Banking is the optimum allocation of scarce

resources. The foundation of the Islamic Banking system is that it promotes the

investment of financial resources into those projects that are considered to be the most

profitable and beneficial to the economy.

5.4.4 Islamic Banking for Equitable Distribution of Resources

Perhaps the most important objective of Islamic Banking is to ensure equitable

distribution of income and resources among the participating parties: the bank, the

depositors and the entrepreneurs.

5.5 Modes of Islamic Banking

The main modes in Islamic Banking are discussed below,

5.5.1 Mudarabah

Mudarabah is a profit sharing enterprise. It is an arrangement or an agreement between

two parties where one acts as the capital provider while the other is the entrepreneur. The

capital provider is called the rass al-mal while the entrepreneur is called the Mudarib. The

Mudarib mobilizes the funds for a previously agreed upon business venture. Any profits

from this venture are shared between both the parties in an agreed upon ratio. Any losses,

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if incurred are born by the capital provider. This arrangement continues until such time as

the loan is repaid. An executive partner can also put-in his capital if others agree.

5.5.2 Musharakah

A Musharakah agreement operates in the same way as a joint venture. It is a partnership,

normally of limited duration. Some regard it as the purest form of Islamic financial

instrument, since it conforms to the underlying partnership principles of sharing in and

benefiting from risk. Profits are divided on a pre-agreed upon basis, and any losses are

shared according to the equity participation ratio. This concept is distinct from fixed-

income investing (i.e. issuance of loans).

5.5.3 Murabahah

Murabahah can be called a cost plus profit contract. This concept refers to the sale of

goods at a price, which includes a profit margin agreed by both parties. The purchase and

selling price, other costs and the profit margin must be clearly stated at the time of the

sale agreement. The bank is compensated for the time value of its money in the form of

the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real

estate or a vehicle), with a fixed rate of mark-up determined by the profit margin. The

bank is not compensated for the time value of money outside of the contracted term (i.e.

the bank cannot charge additional interest on late payments), however the asset remains

in the ownership of the bank until the loan is paid in full.

5.5.4 Ijarah

Islamic banks frequently practice Ijarah or Islamic leasing. Ijarah as applied by Islamic

banks include the requirement that the leased items be used productively and in ways

permitted by Islamic law. Under this mode, the banks buy the equipment or machinery

and lease it out to their clients. Ijarah customers have an option for eventually purchasing

the leased product in which case the monthly payments consist of rental payments plus

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installments toward the purchase price. Lessor throughout the lease period retains

ownership, risk and ownership, except in the case when loss is caused by misuse or

negligence by lessee. Consumable items cannot be leased.

5.5.5 Al-Wadiah

In Al-Wadiah mode of financing, a bank is deemed as a keeper and trustee of funds. A

person deposits funds in the bank and the bank guarantees refund of the entire amount of

the deposit, or any part of the outstanding amount, when the depositor demands it. The

depositor, at the bank's discretion, may be rewarded with a gift termed hibah as a form

of appreciation for the use of funds by the bank. In this case, the bank compensates

depositors for the time-value of their money (i.e. pays mark-up) but refers to it as a "gift"

because it does not officially guarantee payment of the gift.

The bank may also at its absolute discretion pay the depositors a positive return

periodically, depending on its own profitability. Such payment is considered lawful in

Islam since it is not a condition for lending by the depositors to the bank, nor is it pre-

determined. The savings account holders are issued with savings books and are allowed

to withdraw their money as and when they please.

5.5.6 Bai' muajjal

Islamic banks have also been resorting to purchase and resale of properties on a deferred

payment basis, which is termed bai' muajjal. It is considered lawful in fiqh

(jurisprudence) to charge a higher price for a good if payments are to be made at a later

date. According to fiqh, this does not amount to charging interest, since it is not a lending

transaction but a trading one. The risk stays with the seller until the time of delivery and

the purchaser has a right of inspection and may reject on sight if he doesnt agree with the

description as specified at the time of contract.

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5.5.7 Bai' salam

Pre-paid purchase of goods is also an area where Islamic banks are particularly active.

This is termed bai'salam and is a means used by Islamic banks to finance production.

Here the price is paid at the time of the contract but the delivery would take place at a

future date. This mode enables an entrepreneur to sell his output to the bank at a price

agreed upon in advance. Islamic banks, in keeping with modern times, have extended this

facility to manufacturers as well.

5.5.8 Muqarada

Muqarada allows banks to float specific type of Islamic bonds, which are then used to

finance specific projects. In keeping with Islamic principles, these are no interest bonds.

The investors obtain their return through the profits that the investments generate. The

profit- sharing is done through a predetermined ratio and at the same time the investors

also share any losses that might result from the investment. The investors have no share

in the management of the project.

5.6 Challenges Faced By Islamic Banks

5.6.1 Central Banks and Supervision

Many central banks in region where Islamic banks are functioning do not have

legislations or the tools and procedures needed to supervise those Islamic banks. Lack of

understanding and experience of Islamic banks transactions as well as the lack of

regulations make it difficult for Islamic banks to adapt to the structure and procedures

specified by the central banks. This situation has changed in many countries notably

Turkey, Jordan and Malaysia where specific laws for the establishment of Islamic banks

have already been issued. In many other countries the regulations for Islamic banks are

being finalized.

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5.6.2 Shortage of Experts in Islamic Banking

The supply of trained or experienced bankers is lagging behind the expansion of Islamic

Banking. The training needs are affecting the operations of Islamic Banks in both,

Muslim as well as Non-Muslim Countries. There are very few institutes all over the

world, which are providing education in Islamic Banking. This number should be

increased and this can be done through funding of international organizations such as

Islamic Development Bank etc.

5.6.3 Accounting Principles and Procedures

Due to the fact that balance sheet of an Islamic banks and the nature of items on it havedifferent interpretations and impact than those of conventional banks, there is a need to

understand financial statement from its own perspective. Reliable decision-making can be

affected if the statements do not present information fairly i.e. in a way that can be

understood by all the interested parties. It seems from the past experience of many

accounting firms in auditing the accounting of Islamic banks that certain accounting

difficulties had developed specially in matter of due to a lack of accounting standards

specific to Islamic banks. In 1989, thus, was established an accounting standard to cater

for such rules. Since then, The Accounting And Auditing Organization For Islamic

Financial Institutions (AAOIFI) has published several standards, which are being

followed by the Islamic banks all over the world.

5.6.4 Absence of Liquidity Instruments

Many Islamic banks lack liquidity instruments such as treasury bills and other marketable

securities, which could be utilized either to cover liquidity shortages or to manage excess

liquidity. This problem is aggravated since many Islamic banks work under operational

procedures different from those of the central banks. The resulting non-compatibility

prevents the central banks from controlling or giving support to Islamic banks if a

liquidity gap should occur.

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5.6.5 Risk Analysis and Measurement

Thepresent infancy of Islamic banks means that their risk analysis and risk measurement

techniques have not been developed to an extent necessary. Risk analysis is very

important in conventional banking operations and central banks impose certain measures

to endure that the banks do not exceed an allowable risk. Though both conventional and

Islamic banks share similar risk that needs to be managed such as credit and foreign

exchange risk, the Islamic banks differ in the level of such risk. Islamic banks expect to

be active in project financing and are expected to monitor investment risk carefully and

more prudently than their conventional counterparts.

5.6.6 Product Diversification and Service Quality

Many Islamic banks do not have the diversity of products essential to satisfy the growing

needs of the client such as structured instruments for financing, trade, leasing and money

market instruments. The importance of technology and information in upgrading the

acceptability of the product and diversifying its application cannot be over emphasized.

Many Islamic banks do not have the necessary expertise and institutional capacity for

R&D, which would allow them to develop the needed products. So its not surprising that

most depend on conventional banks in this regard, hence there is a need to pay significant

attention for the development of new innovative Islamic products.

5.6.7 Cost Effectiveness

Current competition in the global market makes awareness of the cost effectiveness of

banks operations essential requirement for the survival of Islamic banks. As competition

increases the spread and returns will make banks less competitive. So they could

subsequently lose their customer base, it is therefore necessary for Islamic banks to have

very efficient costing system and implementation of appropriate advanced technology in

order to compete in the global market.

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5.6.8 Social Role and Duty

Many researchers have anticipated and emphasized the social role of Islamic banks that

they should contribute positively to essential social needs such as poverty alleviation,

granting credit to the poor, donating to charities and helping to achieve real distribution

of income. Others have felt that Islamic banks should put the emphasis on social

considerations in training and in their operations and play a more dynamic role in the

achievement of socio-economic growth. Many banks have been trying to fulfill these

expectations but their efforts have been modest and fallen short of the level required.

Therefore, Islamic banks should try to justify its true spirit and play its social role.

5.6.9 Competition

In todays world, competition is one of the major forces in any field. In banking too, its

importance cannot be under-emphasized. Conventional banks always have the option of

copying and introducing similar products as the Islamic banks have in the market. Not

only the banks but also the anti-Islamic organizations make it difficult for Islamic banks

to grab their respective market share. Therefore, competition is also one of the major

challenges.

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6. Islamic Banking Growth Worldwide

In the last decade, Islamic Banking has seen an enormous growth all over the world;

according to the statistics the growth rate has been around 20% for the last couple of

years. Some of the important countries with respect to the scope of Islamic Banking are

discussed below:

6.1 Pakistan

The transformation of banking and financial system of Pakistan was started in 1977 in the

regime of Gen.Zia-ul-Haq. Pakistan was one of the very few countries that had been

trying to implement interest free banking at massive level. The legal framework of

Pakistan's financial and corporate system was amended in 1980 to permit issuance of a

new interest-free instrument of corporate financing named Participation Term Certificate

(PTC). Amendments were also made in the Banking Companies Ordinance, 1962. From

July 1, 1985, all commercial banking in Pak Rupees was made interest-free. From that

date, no bank in Pakistan was allowed to accept any interest-bearing deposits and all

existing deposits in a bank were treated to be on the basis of profit and loss sharing.

Deposits in current accounts continued to be accepted but no interest or share in profit or

loss was allowed to these accounts. In 2001, the Government decided to open up full-

fledged Islamic banks. The State Bank issued detailed criteria in December 2001 for

establishment of full-fledged Islamic commercial banks in the private sector. Al Meezan

Investment Bank received the first Islamic commercial banking license from State Bank

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of Pakistan in January 2002. A new clause was also inserted in the Banking Companies

Ordinance 1962 by an amendment, which provided that conventional banks could form

Islamic Banking branches. From the introduction of Islamic Banking in 2002, the number

of Islamic banks has increased to 6, which have opened up 99 branches collectively all

over Pakistan. Not only these, but 13 leading conventional banks have also opened up

their 58 Islamic Banking branches. The list of these banks and their respective branches

can be seen in the appendix.

The banking assets of the Islamic banks increased by about 24% in the last quarter of

2006 to about Rs.118 billion. According to the latest figures, around 3% of the banking

deposits are with the Islamic banks. Out of the total financing done, 40% of the financing

is Murabahah based whereas second is the Islamic leasing, Ijara that is 30% of the total

financing.

Looking at the progress of Islamic Banking in Pakistan, it can be said that it has a great

future in Pakistan and it may be likely in the future that a greater amount of deposits will

flow to the Islamic Banking system.

6.2 Malaysia

In Malaysia, the introduction of Islamic Banking came with the passing of IslamicBanking Act of Malaysia 1983. The Islamic Banking Act specified four approved modes

of Islamic finance i.e. Mudarabah, Murabahah, Musharakah, and Wadia. No return is

allowed to be paid on current accounts, although banks are allowed to give customers

gifts. The introduction of the new Islamic financial regulations were not aimed at

restricting the activities of the existing conventional banks, but at providing a framework

within which new, Islamic institutions could operate. The passing of a new Investment

Act under which the government undertook to issue short-term certificates paying

dividends rather than interest solved the problem of Islamic banks access to short-term

funds. It is extremely rare that financial authorities in conventional banking markets are

willing to develop new regulations to accommodate this liquidity problem. This

encouragement from the financial authorities has enabled Malaysia to become the hub of

Islamic Banking.

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Malaysia has used a unique approach of a dual banking system where conventional and

Islamic Banking systems exist side by side, and opportunity has been given to all banks

to practice Islamic Banking Every bank has to meet certain terms and conditions. Islamic

Banking in Malaysia is unique also for the reason that their market is very well developed

and has a huge future potential.

There are many factors that contribute to the successful growth of Islamic Banking in

Malaysia. The first is the encouragement and support of monetary authorities. The second

factor is the creativity of financial engineering in designing new products. The third

factor at work is the favorable economic conditions of Malaysia, which have resulted in

the growth of banking sector as a whole.

The Malaysian experience of Islamic Banking has had a spectacular impact on

neighboring countries. Brunei Darussalam created its first Islamic bank in 1993.

Indonesia established its first Islamic bank in 1992 i.e. Bank Muamalat but the success

Malaysia has achieved has been phenomenal.

Performance of Malaysian Islamic Banking during Asian Financial Crisis

During the Asian Financial Crisis, more than 23 banks and financial institutions in the

country were offering Islamic Banking facilities. However, only one of these could be

considered as an Islamic bank (Bank Islam Malaysia), while the others were mainly

conventional institutions.

During the year 1997, Islamic Banking in Malaysia reported progress despite financial

crisis:

Assets expanded by 76.5% to RM7.9 billion.

Financing recorded a strong growth of 75% to RM10.8 billion.

Total deposits mobilized registered a growth of 36.2% to RM9.9 billion

The shareholders funds of the Islamic bank and the interest-free banking fund

amounted to RM1.3 billion, while profit before taxation and zakat amounted to

RM153 million in 1997. Growth in total Islamic financing rose sharply,

particularly in the second half of 1997. It recorded a moderate growth of 29.5% in

the first half of 1997 and was much stronger in the second half of 1997, increasing

by 36.7%.

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Islamic Banking continued to record moderate growth in the next year too. Total deposits

mobilized registered a strong growth of 59.1% to RM 16.4 billion during the year. The

shareholders funds of Islamic bank and the Islamic Banking fund increased by 23% to

RM 1.6 billion, while profit before taxation and zakat decreased by 3.3% to RM 148

million in 1998. Total assets expanded by 21% to RM21.6 billion due mainly to the

increase in holdings of securities (162.4% or RM3.1 billion). Total financing recorded a

growth of 1.8% to RM10.9 billion (For more information, refer to the appendix).

Total deposits recorded a strong growth in 1998, particularly in the second half of the

year. The increase was partly due to the migration of deposits from conventional banking

to Islamic Banking in view of the better investment deposit rates. Investment deposits

constituted the bulk of deposits (60.5%), which recorded a growth of 108.9% to RM9.9

billion. In the latest development, Islamic financial systems in Malaysia has grown and

improved significantly compared to 23 years ago, went it was first promulgated.

Currently there are 35 commercial banks, of which 22 are domestic banks and 13 are

foreign-controlled (or 44 percent of total financial system assets), 39 finance companies

(14 percent), 12 merchant banks (4 percent), 7 discount houses (2 percent), and money

and exchange Brokers. Of these, there are 4 Islamic banks, 12 commercial banks, 7

discount houses, 4 merchant banks and one finance company offering Islamic financial

services and products with an estimated total asset amounted US$ 106 billion at the end

of 2005. Bank Negara Malaysia (BNM) has also issued three new Islamic Banking

licenses to foreign Islamic financial institutions from the Middle East, namely Al Rajhi

Banking and Investment Corporation, Kuwait Finance House (Malaysia) Bhd and a

consortium of Islamic financial institutions led by Qatar Islamic Bank (inclusive of Qatar

Islamic Bank 70%, RUSD Islamic Bank Inc 20% and Global Islamic House 10%). The

Malaysian Islamic Banking Industry is one of the most dynamic industries and is leading

the Islamic finance right now. There banking model has been very effective and though

only 10% of the banking assets are Shariah Compliant currently but there is a huge

potential in the future.

6.3 Turkey

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Islamic banks operate in Turkey under government act 1983. Two authorities make the

regulations covering the operations of Islamic banks, one from the Treasury and Foreign

Trade Secretariat and the other from the central bank. The two authorities provide very

specific guidelines for the operations of the banks. The activities, which the banks are

permitted to undertake, are clearly those, which characterize Islamic institutions. The new

institutions are licensed as Special Finance Houses rather than banks. In the beginning

though the growth of Islamic Banking in Turkey was not very significant and was around

3% only but in recent couple of years the situation is turning around and the total deposit

amount has crossed 2 billion Turkish Liras.

Before 2003, there were four SFHs in Turkey: Al-Baraka Turkish Finance House, the

Faisal Finance Institution, the Kuwaiti Turkish Finance House, and the Anatolian Finance

House. After 2003, two more institutions have come i.e. Ihlas Finance Company and

Asya Finance Company.

6.4 Jordan

In Jordan also, there is a plural system which accommodates both Islamic and traditional

banking and financial transactions. The Shariah Law of 1978 has been passed for the

establishment of Islamic banks. As a result of passing of this law, the Jordan IslamicBank was launched in 1978. In 1985 the Jordan Central Bank issued a law called the

Jordan Islamic Bank (JIB) for Finance and Investment Law of 1985 which specifies the

way the Jordan Islamic Bank could operate.

The JIB, the only Islamic bank in Jordan, has an extensive and relatively large branch

network. In 2006, it had an asset base of about JD 1.5 billion.

6.5 Iran

Islamic Banking in Iran has flourished after the restructuring of the economy after the

1979 revolution. The structure of the Islamic Banking system was put in place in 1983 by

issuing the Interest-Free banking Law of 1983. This law was implemented 1984 and

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banks were given 18 months to complete transformation to Islamic Banking principles.

This shows that the Iran Government was very strict about the implementation of the

interest free Islamic Banking system according to the true spirit of Islam.

The main Islamic banks of Iran are Bank Saderat and Bank Melli. Though Iran has some

differences with that of other countries Islamic Banking Systems which are due to its

majority of 89% shiaah community, but still it was the first country in the world to switch

its banking system to interest-free Islamic Banking System and since then, it has not

suffered any crisis, which denotes its success.

6.6 Gulf Coastal Countries

The GCC region financial market as a whole is over-banked, and competition for retail

customers is intense. The development of new technological banking products is a

priority for many institutions. For this reason, Islamic banking has been seen as a healthy

addition to the banking sector of these countries and has seen an enormous growth over

the last few years.

Regulatory authorities in different countries of the Gulf have dealt with Islamic banks in

different ways. But in each case, the main issue has been to make Islamic banks conform

to the same liquidity and reserve requirements as conventional banks, which have access

to short-term, fixed-interest funds.

Islamic banks in the Gulf offer broadly the same range of products as their conventional

rivals. There has been great competition among Islamic and conventional banks in the

Gulf. This has been due to the fact that Islamic financial institutions are restricted in the

kinds of instruments they can offer, whereas their conventional rivals can adapt a

financing technique to suit any requirement. Islamic banks are now well-established

feature of the banking framework in the Gulf. They have significant market share and a

clear niche role. Right now, almost one-third of the Islamic banking assets are from the

GCC countries.

Below some of the major GCC countries have been discussed;

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6.6.1 Saudi Arabia

Saudi Arabia is a country with about 25 million and a GDP of about $287 billion. Over

the years there have been great changes in the banking sector of the Saudi Arabia. The

number of products offered by them has increased. According to a survey, it had been

seen that the Credit card usage was only 22% and only 11% had personal financing with

banks. Penetration of value-added services such as Investment and saving / Insurance

Products was very low in 2000, primarily due to the problem of Riba. But gradually with

the introduction of Islamic banks the situation has changed a lot and peoples interest in

the banking service has improved. More than 30 per cent of bank assets in Saudi Arabia

are now classified as Shariah compliant. Officially all the banks are considered to be

Islamic but in reality there is only one Islamic bank Al-Rajhi banking investmentCorporation. Banks are also not allowed to use the word Islamic with their banks.

6.6.2 U.A.E

The banking sector is one of the healthiest sectors of the UAE economy. The number of

commercial banks in the UAE has been very steady at 46 banks over the period 1999-

2004. The number of branches has increased by 25% during the same period, to reach

449 branches in 2004. Islamic banking started in the U.A.E in 1975 by the establishment

of Dubai Islamic Bank. Today about 5 of the banks are registered as Islamic banks

including Dubai Islamic Bank, Abu Dhabi Islamic Bank, Emirates Islamic Bank and

National Bank of Sharjah and the National Bank of Dubai whereas many other local and

international banks are offering Islamic financial products. Around 20% of the assets are

Shariah compliant.

6.6.3 Bahrain

Islamic banking entered the country in the form of Bahrain Islamic Bank in 1979 and

since then the number of Islamic banks has been increasing. Bahrain right now has the

largest number of Islamic banks in the world with almost 26 different financial

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institutions offering Islamic products. The important Islamic institutions are Al-Baraka

bank, First Islamic Investment Bank, Bahrain Islamic Bank, Shamil Bank, Al-Amin

Bank. Al-Baraka bank is also one of the largest Islamic institutions in the world. Geneva

based UBS launched its Islamic private banking subsidiary, Noriba, which is also based

in Bahrain. Other major global players include Citigroup and First Islamic Investment

Bank. Bahrain is the only country to have created a legal framework for Islamic banks.

The consolidated total assets of the Islamic banks operating in Bahrain as of end-2002

stood at US$2.91bn, an increase of 18.5% over the previous year. The total assets of the

Islamic banks grew at a rate of 21.2% for the last five years, and it almost doubled in the

past three years.

6.7 U.S.A

Islamic Banking has also been introduced to the U.S.A financial market and is being

appreciated there as well. The most noticeable is Devon State Bank in Chicago. The

Islamic Banking operations of this bank are being run by a prominent Jewish family.

The main branch of the bank is situated in a neighborhood of Chicago that has now been

transformed into an Indo-Pakistani business hub. The Federal Reserve Banks of Chicago

and of New York have taken a keen interest and have been conducting serious research

into Islamic Banking. The original work was done at the Federal Reserve Bank of

Minnesota almost three years ago. It is interesting to report that the Federal Reserve Bank

of New York, in this respect also conducts regular seminars on the subject in New York

City to understand what the needs and the compliance hurdles are, while trying to

implement Islamic Banking in the US. It is believed that the experience of the Islamic

Bank of Britain and the interest of some of the Gulf banks in tapping the US Islamic

Banking market are some of the reasons for such an interest.

Currently there are three banks that offer Islamic Banking in the U.S.A, including

international giant HSBC, but experts expect that number to rise as the Muslim

population grows and the community begins to demand more specialized services. Many

industry giants for example, G.E and Microsoft have switched over to Islamic financing

for their upcoming projects.

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Though Industry experts are of the opinion that the size of the Islamic Financial market is

difficult to determine, yet the growing Muslim population that is almost reaching 7

million is likely to demand Shariah compliant financial products in the future.

One of the institutions, University Bank recently formed the University Islamic Financial

Corp., a subsidiary that offers Muslims home financing, deposit accounts and Islamic

mutual fund shares. It expects to increase its assets to about $100 million by 2010.

6.8 United Kingdom

Today United Kingdom has a Muslim population of about 2.5 million with an estimated

savings of 1 billion Euros whereas around 500000 Muslim tourists visit the country

spending around 600 million Euros. There are almost 360000 Muslim households

residing in United Kingdom. According to a survey, the richest 5000 Muslims in the

United Kingdom manage assets of around 3.6 Billion Euros. According to a survey, out

of the total Muslim population, more than 300000 adults have annual income of more

than 30000 Euros, which makes 25% of the adult Muslims attractive customers for

financial products and services. In some of areas for example Leicester and Luton, the

Muslims have increased to about 20% of the whole population. In fact by another decade,

Leicester will become the only city of United Kingdom with more than 50% Muslims. It

has been estimated that 8% of the population in London is Muslim, amounting to

approximately 725,000 persons. This means that over 30% of the Muslims in the UK live

in the London area.

The group earning 30000 or more per year basically comprises of these educated

professionals. Researches also indicate that these professionals are more knowledgeable

of their religious and social roots. Thus, there is a natural inclination among them to align

their financial decisions with the Islamic faith. This has resulted in the opening up of

Islamic Banking branches in United Kingdom. Islamic Banking in the United Kingdom

has been more than a decade old now. Al-Baraka Group of Bahrain was the first

institution to enter the market and introduce its Islamic Banking products. Second Islamic

bank is the Islamic bank of Britain. Islamic bank of Britain has opened its three branches

in London, Leicester and Luton. Other banks to offer Islamic products are HSBC and

Lloyds LSB.

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In 2002, only the Shariah compliant market for mortgages was estimated to be around 7

billion Euros. Of the Muslims earning more than 3000 Euros have around 182000 savings

accounts, which if converted to Islamic accounts could make a huge market for Islamic

Banking. So in short we can say that the market of United Kingdom possesses a huge

potential for Islamic Banking Products and has the potential to maintain its leadership in

Non-Muslim countries involved in Islamic Banking practices.

6.9 Other Western Countries

Though there are many potential markets where Islamic banks can enter and reap

considerable profits but till now, the number is very limited. This can be analyzed from

the fact that the European Union has a population of around 20 million out of which only

about 2.5 million people reside in United Kingdom. The majority of Muslims is in France

and Germany. Taking example from the case of United Kingdom, it is quite evident that

there may be a lot of untapped potential in rest of the European countries and if properly

utilized could result in a lot of profits for Islamic banks.

Another important country, which has given considerable attention towards Islamic

Banking, is Luxembourg. In Luxembourg, the Islamic Banking System international

holding was established in 1978 as a joint-stock company. As a holding company, it

established a new affiliated company in London in June 1983 under the name of Islamic

finance house and another in Denmark in 1982 under the name of the Islamic bank

international of Denmark. Deutsche Bank of Germany has already many Islamic markets

and is offering Shariah compliant products but not in their own country. Italy and Austria

have also initiated Islamic banking. So we see that there is a scope but the progress has

been a bit slow. But there is a huge potential for Islamic banking in rest of the Europe

too.

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7. Findings

7.1 Differences between Conventional and Islamic Banking

Conventional Banking is essentially based on the debtor-creditor relationship between the

depositor and the bank on one hand and between the borrower and the bank on the other.

Interest is considered to be the price of credit reflecting the opportunity cost of money.

Islamic Banking, on the other hand considers a loan to be given or taken to be free of

charge to meet any contingency. Thus in Islamic Banking the creditor shouldnt take the

advantage of borrower. When money is lent out on the basis of interest more often it

happens that it leads to some kind of injustice. The first Islamic principle underlines such

kind of transactions is that deal not unjustly and ye-shall not be dealt with unjustly

[2:279]. Hence commercial banking in Islamic framework is not based on the debtor-

creditor relationship.

Another principle regarding financial transactions in Islamic Banking is that there

shouldnt be any reward without taking a risk. This principle is applicable to both labor

and capital. As no payment is allowed for labor unless it is applied to work there is no

reward for capital unless it is exposed to business risk.

Thus financial intermediation in an Islamic framework has been developed on the basis

of above two principles. Consequently, financial relationships in Islam have been

participatory in nature. Several theorists suggest that commercial banking in an interest

free system should be organized on the principle of profit and loss sharing. The

institutions of interest are thus replaced by a principle of participation in profit and loss.

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That means a fixed rate of interest is replaced by a variable rate of return based on real

economic activity. The distinct characteristics, which provide Islamic Banking with its

main points of departure from the traditional interest based commercial banking system,

are:

The Islamic Banking system is essentially a profit and loss sharing system and not

mainly an interest (Riba) banking system.

Investment (loans and advances in conventional sense) under this system of

banking must serve simultaneously both the benefit to the investor and benefit of

local community as well. The financial relationship as pointed above is referred to

in Islamic Banking as Mudarabah.

The distinguishing differences of conventional and Islamic Banking are as below,

Firstly we see that the conventional banks borrow funds from the depositors

paying interest on the liability side of the balance sheet. Whereas in Islamic

Banking, the majority of funds consists of the Partnership (Mudarabah) or profit

and loss sharing arrangement between the bank and the depositors.

In Conventional Banking, the banks lend the funds to the borrowers, charging

higher interest on the asset or investment side. On the other hand, Islamic banks

use Profit and loss sharing (Musharakah) or trade based financing arrangement

(Mubadalah) between the bank and its investment clients.

In Conventional Banking, the depositors are not told where there funds are being

invested whereas in Islamic Banking, the banks entitle the depositors

To be informed of what the bank does with their money

To have a say in where their money would be invested (Mudarabah-e-

Muqayyidah)

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In the traditional system, the interest or the return is predetermined or fixed in

advance whereas in Islamic system, the profit or the return is based on the actual

investment outcome.

Transactions are financial asset based in Conventional Banking whereas these

transactions are real asset based in Islamic Banking.

The functional and operating modes of conventional banks are based on man-

made principle. Whereas the functions as operating modes of Islamic banks are

based on the principles of Shariah.

The investor is assured of predetermined rate of interest in Conventional Banking

hence not encouraging risk taking. In contrast Islamic Banking promotes risk

sharing between provider of capital (investor) and user of funds (entrepreneur).

Conventional banks aim at maximizing profits without any restrictions. Whereas

Islamic banks aims at maximizing profits subject to Shariah restrictions.

Conventional banks dont deal with zakat. Whereas in the modern Islamic

Banking System, it has become one of the service-oriented functions of the

Islamic banks to collect and distribute zakat.

Lending money and getting it back with interest is the fundamental function of

conventional bank. Whereas participation in partnership business is the

fundamental function of the Islamic banks.

The scope of activities of Islamic banks is wider when compared withconventional bank. It is in effect, a multipurpose institution.

Conventional banks can charge additional money (compound rate of interest) in

case of defaulters. Whereas the Islamic banks have no provision to charge any

extra money from the defaulters.

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Conventional banks growth is mainly based on its interest earnings whereas

Islamic banks give

Hussain Shahid Thesis, Sadiq

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