isalmic banking vs conventional banking

7/28/2019 isalmic banking vs conventional banking

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Islamic banking and interest based banking

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CHAPTER 1 ............................................................... ERROR! BOOKMARK NOT DEFINED.

1.1 EXECUTIVE SUMMARY ............................................................................................................. 5

1.2 SCOPE OF THE STUDY .......................................................................................................... 7

1.3 O BJECTIVES OF THE STUDY ................................................................................................. 8

1.4 M ETHODOLOGY ................................................................................................................... 8

CHAPTER 2 ................................................................................................................................... 9

LITERATURE REVIEW .............................................................................................................. 9

2.1 WHAT IS BANK? ................................................................................................................... 9

2.2 H ISTORY OF BANKING ............................................................................................................ 9

2.3 ISLAMIC BANKING .......................................................................................................... 11

2.4 INTRODUCTION ..................................................................................................................... 12

2.5 H ISTORY OF ISLAMIC BANKING ........................................................................................... 13

ISLAMIC BANKING : O RIGIN , SCOPE , AND G ROWTH .................................................................. 13

TABLE 1 ....................................................................................................................................... 15

2.6 COUNCIL FOR ISLAMIC IDEOLOGY .......................................................................... 16

2.7 ISLAMIC BANKING G LOBAL SCENARIO ............................................................................. 19

Table of contents


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2.8 MODES OF ISLAMIC FINANCE ..................................................................................... 23

M URABAHA .................................................................................................................................. 23

I JARAH .......................................................................................................................................... 23

I JARAH -W AL-IQTINA .................................................................................................................. 23

M USHARAKAH ............................................................................................................................ 24

M USAWAMAH .............................................................................................................................. 24

ISTISNA 'A ..................................................................................................................................... 25

BAI M UAJJAL ................................................................................................................................ 25

M UDARABA .................................................................................................................................. 25

BAI SALAM ................................................................................................................................... 26

2.9 ISLAMIC BANKING ISSUES ........................................................................................... 27

H UMAN RESOURCE FOR SHARIA 'H COMPLIANCE ................................................................... 27

UNRESOLVED FIQH ISSUES ........................................................................................................ 28

LEGAL FRAMEWORK .................................................................................................................... 28

EXCESS LIQUIDITY ....................................................................................................................... 28

2.10 INTEREST BASED BANKING ....................................................................................... 29

THE ROLE OF INTEREST BASED BANKS ...................................................................................... 30

2.11 PRODUCTS OF INTEREST BASED BANKING ....................................................................... 31

TRANSACTIONAL ACCOUNT ...................................................................................................... 31

SAVINGS ACCOUNT ..................................................................................................................... 32


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CERTIFICATE OF DEPOSIT ........................................................................................................... 33

CREDIT CARD ............................................................................................................................... 34

D EBIT CARD ................................................................................................................................. 34

M ORTGAGE LOAN ....................................................................................................................... 35

UNSECURED DEBT (PERSONAL LOAN ) ....................................................................................... 36

LOAN ............................................................................................................................................. 36

2.12 ISLAMIC BANKING VS INTEREST BASED BANKING ........................................ 37

2.13 SIMILARITIES AND D IFFERENCES ...................................................................................... 39

D EPOSITS ..................................................................................................................................... 40

FINANCING AND INVESTMENTS ................................................................................................ 41

O VERDRAFTS / CREDIT CARDS .................................................................................................. 42

SHORT TERM LOANS ................................................................................................................... 43

M EDIUM TO LONG TERM LOANS ............................................................................................... 45

LEASING ....................................................................................................................................... 45

AGRICULTURAL LOANS .............................................................................................................. 46

H OUSE FINANCING ..................................................................................................................... 47

INVESTMENTS .............................................................................................................................. 47

2.14 ISLAMIC BANKING PLAYING ROLE IN THE ECONOMIC DEVELOPMENT OF THE WORLD

....................................................................................................................................................... 49

O PERATIONAL CHALLENGES AND PROSPECTS ....................................................................... 52

T HE CHALLENGES FACING INDIVIDUAL ISLAMIC BANKS ........................................................ 53

THE CHALLENGE OF ADOPTING AN ISLAMIC FINANCIAL SYSTEM ........................................ 54


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M OTIVATING FACTORS FOR ISLAMIC BANKING .................................................................... 56

CHAPTER 3 ................................................................................................................................. 57

3.1 CONCLUSION .......................................................................................................................... 57

3.2 BIBLIOGRAPHY ....................................................................................................................... 58


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CHAPTER 1

1.1 Executive summary

This study is undertaken to understand the concept of Islamic banking and interest

based banking, the difference between the two systems and their economic implications

for an economy. In general terminologies, a financial institution or a financial

intermediary that accepts deposits and channels those deposits into lending activities,

either directly or through capital markets is given the name of bank. The prime source

of revenue and cost of funds to conventional banks (interest based banks) is charging

interest through lending and accepting deposits for interest respectively. Interest is the

major driver of operations of conventional banks although other valuable services

including guarantees, funds transfers, safety of wealth, facilitation in international trade

etc. also form a substantial part of income of banks. Islamic banking, on the other hand,

is a banking system which is in consonance with the spirit, ethos and value system of

Islam and governed by the principles laid down by Islamic Shariah. Interest free

banking is a narrow concept denoting a number of banking instruments or operations

which avoid interest. Islamic banking, the more general term, is based not only to avoidinterest-based transactions prohibited in Islamic Shariah but also to avoid unethical and

un-social practices. In practical sense, Islamic Banking is the transformation of

conventional money lending into transactions based on tangible assets and real services.

The model of Islamic banking system leads towards the achievement of a system which

helps achieve economic prosperity.

The origination of term interest dates back to 17th century with the emergence of

banking system at global level. Interest means giving and/or taking of any excess

amount in exchange of a loan or on debt. Hence, it carries the same meaning/value as

that of Riba. Further, it is narrated that the loan that draws interest is Riba. There is

consensus among the Muslim scholars of all the fiqhs that interest is Riba in all its

forms and manifestations.


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Islamic Financial Institutions (IFIs) are operating in the same society where

conventional banks are operating and perform all those functions which are expected

from a financial institution. IFIs are assisting business world by providing all the

services required to run the economy smoothly, however, the philosophy and operations

are different. In this study I will analyze the operations and products of IFIs in

comparison with traditional conventional banks. Any financial system is expected to

assist in running the economy by providing the following services grouped in two

headings. First; Savings mobilization from savers to entrepreneurs and Second;

Provision of general utility services including transfer of funds, facilitation in

international trades, consultancy services, safekeeping of valuables, and any other

service for a fee. There is no restriction on provision of such services by IFIs as for theservice is not against the Sharia. However there exists difference in mechanism of

funds mobilization from savers to entrepreneurs as described following. Savings

mobilization consists of two phases i.e. accepting deposits and extending financing an d

investments.


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1.2 Scope of the Study

The focus of the study will be on:

Introduction to Islamic banking and interest based banking

Products if Islamic and interest based banking

Difference between interests based and islamic banking.

Major modes of Islamic banking and finance

Practical aspects of Islamic banking and its economy wide implications.


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1.3 Objectives of the Study

What are Islamic Banking and its philosophy?

What are interests based banking and its philosophy? What are the basic principles of Islamic banking?

What is the difference between interests based banking and Islamic banking?

1.4 Methodology

The material of the study will authentically be obtained from secondary sources such as

books, research reports, and research articles taken from Internet


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Chapter 2Literature review

2.1 What is bank?

A bank is a financial institution and a financial intermediary that accepts deposits

and channels those deposits into lending activities, either directly or through

capital markets. A bank connects customers that have capital deficits to

customers with capital surpluses.Due to their critical status within the financial system and the economy generally,

banks are highly regulated in most countries. Most banks operate under a

system known as fractional reserve banking where they hold only a small reserve

of the funds deposited and lend out the rest for profit. They are generally subject

to minimum capital requirements which are based on an international set of

capital standards, known as the Basel Accords.

2.2 History of banking

The History of Banking begins with the first prototype banks of merchants of the

ancient world that made grain loans to farmers and traders carrying goods

between cities; recorded as having occurred at about 2000 BC within the areas

of Assyria and Babylonia. Later on, in ancient Greece and during the Roman

Empire, lenders based in temples made loans and added two important

innovations: the accepting of deposits and the changing of money. Archaeology

from this period in ancient China and India shows the existence also of money

lending activity.


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Banking, in the modern sense of the word, can be traced to medieval and early

Renaissance Italy, to the rich cities in the north such as Florence, Venice and

Genoa. The Bardi and Peruzzi families dominated banking in 14th century

Florence, establishing branches in many other parts of Europe. Perhaps the most

famous Italian bank was the Medici bank, established by Giovanni Medici in

1397.

The development of banking spread through Europe also and a number of

important innovations took place in Amsterdam during the Dutch Republic in the

16th century and in London in the 17th century. During the 20th century,

developments in telecommunications and computing resulting in major changes

to the way banks operated and allowed them to dramatically increase in size and

geographic spread. The Late-2000s financial crisis saw significant number of

bank failures, including some of the world's largest banks, and much debate

about bank regulation.


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2.3 Islamic banking

Islamic banking is based on the principles of Islamic economics an economic

framework in accordance with Islamic law (Sharia'h).

There are two types of Islamic economics:

Caliphate , the Islamic form of government representing the political unity

and leadership of the Muslim world (Islamic political framework) Assuming the political framework is non-Islamic, therefore, seeking to

integrate some prominent Islamic tenets into a secular economic

framework

Caliphate is the absolute Islamic rule, thus the economy focuses on distribution

of resources in order to meet the basic and luxurious needs of individuals in

society, and the state has a clear role in policing, taxation, managing publicassets, and ensuring the circulation of wealth. Such a political framework in its

true form does not exist in today's world.

Assuming non-Islamic political framework simply proposes two main tenets: no

intere st can be earned on loans and socially responsible investing. This is the

way interest based banking is Islamized the first step towards an Islamic

economic framework.

Modern day Islamic scholars and academics have developed various modes of

Sharia'h complaint financing that are designed to work within the prevailing

capitalist economic framework. In order to achieve this balance numerous

concessions have been afforded to financial institutions that would not apply if a
http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Interest


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viable interest free economic system existed. The intention behind making these

concessions is to encourage the evolution of this type of alternative system.

2.4 Introduction

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. Generally, Islamic law also prohibitstrading in financial risk (which is seen as a form of gambling). In addition, Islamic

law prohibits investing in businesses that are considered unlawful, or haraam.

Islamic finance has been gaining momentum on a global scale for the last 30

years.

Many Islamic Banks have sprung up over the last few years. These changes areoccurring both in Muslim and in western countries, and are driven by a global

trend amongst Muslims to become more observant of their faith. It might have

been the reason why Islamic Banking emerged, however, today Islamic Banking

is sought by Muslims and non-Muslims due to the benefits it offers.

Industry size is currently estimated at more than $400 billion, with projected

growth of 15% per annum.


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Financial institutions around the globe are trying to keep pace with the growing

demand for Shariah compliant products and services.

2.5 History of Islamic banking

ISLAMIC BANKING: ORIGIN, SCOPE, AND GROWTH

The first modern experiment with Islamic banking was undertaken in Egypt

under cover, for fear of being labeled as a manifestation of Islamic

fundamentalism, which was anathema to the government in power. It took the

form of a saving bank based on profit-sharing in the town of Mit Ghamr, lasted

until 1967, by which time there were nine such banks in the country. These

banks neither charged nor paid interest, invested mostly in trade and industry,

directly or in partnership with others, and shared profits with depositors. The

1970s heralded the arrival of a new age in Islamic finance witnessing the

establishment of the Nasr Social Bank in 1971 (Egypt), Philippine Amanah Bank

in 1973, the Dubai Islamic Bank in 1975, the Kuwait Finance House, the Faisal

Islamic Bank of Sudan, and the Faisal Islamic Bank of Egypt, all in 1977, the

Bahrain Islamic Bank in 1979, and the Qatar Islamic Bank in 1981, to mention a

few. By the end of 1996 the number of Islamic banks, IBs, rose to 166 with a

total paid-up tier-one capital of $7.3 billion, and total assets of $137 billion.Moreover, if one excludes the Iranian and Pakistani IBs, the countries that

operate under the Islamic system of banking (along with Sudan), only 40 percent

of the paid-up capital and 30 percent of total assets are commanded by those


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from other countries. These percentages do not tell the whole picture. The 19

Gulf Cooperative Council, GCC, states command 18 percent of the total paid-up

capital, and 13 percent of total assets of all IBs. In other words, 10 Iranian, 46

Pakistani, and 19 GCC IBs totaling 75 out of 166, command 78 percent of total

paid-up capital and 83 percent of total assets for the IBs. These numbers appear

impressive if one ignores the size of a single large commercial bank in many

developed economies of the West. Thus, it is quite obvious that IBs are relatively

very small and a few of them are not even profitable

Table 1 shows the number of IBs by region, their capital, total assets, and

capital-to-asset ratios for the year-end 1996. Of the 50 financial institutions in

South Asia, 5 are in Bangladesh (total capital of $20.6 million, total assets of

$594 million), 1 is in India (total capital of $1.2 million, total assets of $3.5

million), and the remaining 46 are in Pakistan. Of the 35 institutions in Africa,

Algeria, Djibouti, Gambia, Guinea, Mauritania, Niger, South Africa, Senegal, and

Tunisia have 1 bank each, and the remaining 26 are in Sudan. Total capital of

those 9 countries' institutions is $102 million with assets of $376 million

representing roughly 48 and 19 percent respectively of those of all Africa. Of the30 IBs in Southeast Asia, 3 are in Brunei, 4 are in Malaysia, 1 is in the

Philippines, and the remaining 22 are in Indonesia. Two Malaysian Banks-Bank

Islam Malaysia Berhad and Lembaga Tabung Haji-together account for $3.3

billion of the total assets of $3.8 billion for the entire region.

Middle East is defined here as Egypt, Iran, Iraq, Jordan, Lebanon, Turkey and

Yemen. Egypt has 4 IBs (total capital of$337 million with assets totaling $4.

billion), Iran has 10 (total capital of $32.4 billion with assets totaling $50.2

billion), Iraq has 1 (capital $402 million with assets of $9.9 billion), Jordan has 2

(capital of $23.5 million


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TABLE 1

ISLAMIC BANKS AND FINANCIAL INSTITUTIONS AT YEAR-END 1996 (in $

million)

Region # of

Banks

Capital Total

Assets

Total

Deposits

Net

Profit

Capital

to

Assetin %

Net

Profit

as %of

Total

Assets

South Asia 50 962 45,201 27,042 350 2.1 0.8

Africa 35 213 1,951 603 39 10.9 2.0

Southeast Asia 30 136 3,801 1,572 184 3.6 4.8

Middle East1

24 4,060 67,142 54,288 373 6 0.6GCC 2 19 1,340 18,084 16,494 686 7.4 3.8

Europe &

America

8 559 952 1,164 54 58.7 5.7

Total 166 7,270 137,131 101,163 1,686 5.3 1.2

1 -Middle East includes Egypt, Iran, Iraq, Jordan, Lebanon, Turkey, and Yemen.

2- GCC stands for Gulf Cooperation Council, consisting of Bahrain, Kuwait,

Qatar, Saudi Arabia, and United Arab Emirate (UAE).

SOURCE: International Association of Islamic Banks, Jeddah, Saudi Arabia,

quoted by Timewell (1998).


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2.6 COUNCIL FOR ISLAMIC IDEOLOGY

In 1980, a think tank by the name Council of Islamic Ideology (C.I.I.), consisting

of 15 eminent jurists, scholars, economist and bankers was formed. Their task

was to recommend to the Federal Government all possible avenues and

amendments to bring the existing laws and practices of the country in conformity

with the injunctions of Islam. C.I.I., after several meetings and extensive brain

storming, apart from recommendations in lieu of other civil and criminal laws,

suggested to the Federal Government that an interest free banking system

should be introduced in the country.

Their first recommendation was that Interest, referred to as "Riba" in the Holy

Quran, based on Verses 278 and 279 of Surah Al Baqarah, is Haram. Allah

Almighty and his Messenger (PBUH) have declared war on those who indulge

themselves in Riba. C.I.I, recommended that instead of lending money on basisof interest/ Riba, the financing in the shape of Islamic financing Bai Muajjal

(deferred sale) should be adopted.

In furtherance to the above, the Federal Government adopted the system of

mark-up in January, 1981 and repealed Interest Act, 1839.

On the basis of the foregoing recommendations of the C.I.I., agreed to by theFederal Government, the State Bank of Pakistan's Banking Control Department,

issued Circular Nos.13 and 32, dated 20th June, 1984 and 26th November,

1984, respectively. Through the earlier circular, the intention of the government

to shift the interest based banking to Islamic modes of financing was revealed. In


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that circular, the financial institutions/banks were barred from receiving any

interest bearing deposits from July 1, 1985. As regards the loaning, it was

suggested that the banks should adopt the Islamic mode of financing, mentioned

in the 1st Annexure of the circular, i.e. mark-up (Bai Muajjal), Musharika (profit

loss sharing), Morabaha (hire purchase, leasing etc). The second circular barred

the banks from charging mark-up on mark-up on overdue loans as penalty.

The C.I.I., in order to establish interest free/Riba free banking system in Pakistan,

proposed amendments in the following laws:

(a) The Interest Act of 1839

(b) The Government Saving Banks Act of 1873 (Section-10)

(c) The Negotiable Instrument Act of 1881 (Sections-79, 80, 114 & 117)

(d) The Land Acquisition Act, 1894 (concerned provisions)

(e) The Code of Civil Procedure, 1908 (concerned provisions)

(f) The Cooperative Societies Act, 1925 (concerned provisions)

(g) The Cooperative Societies Rules, 1927 (concerned provisions)

(h) The Insurance Act, 193 8 (concerned provisions)(i) The State Bank of Pakistan Act, 1956 (Section-22(l)

(j) The West Pakistan Money Landers Ordinance, 1960 (concerned

provisions)

(k) The West Pakistan Money Lenders Rules, 1965 (concerned provisions)

(1) The Punjab Money Lenders Ordinance, 1960 (concerned provisions)

(m) The Sindh Money Lenders Ordinance, 1960 (concerned provisions)

(n) The NWFP Money Lenders Ordinance, 1960 (concerned provisions)

(o) The Baluchistan Money Lenders Ordinance, 1960 (concerned provisions)

(p) The Agricultural Development Banks Rules 1961 (Rule No. 17 (1) (2) & (3)

(q) The Banking Companies Ordinance, 1962 (Section 25 (2a&b)) (r) The

Banking Companies Rules, 1963 (Rule No.9 (2&3)


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(s) The Banks (Nationalization) Payment of Compensation Rules, 1974 (Rule

9)

(t) The Banking Companies (Recovery of Loans) Ordinance, 1979 (Section

8(2a&b)

(u) The Constitution of Pakistan 1973 (Article No.203 (a) to 203(j) and 270(a)


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2.7 Islamic Banking Global Scenario

Over the last three decades Islamic banking and finance has developed into a

full-fledged system and discipline reportedly growing at the rate of 15percent per

annum. Today, Islamic financial institutions, in one form or the other, are working

in about 75 countries of the world. Besides individual financial institutions

operating in many countries, efforts have been underway to implement Islamic

banking on a country wide and comprehensive basis in a number of countries.The instruments used by them, both on assets and liabilities sides, have

developed significantly and therefore, they are also participating in the money

and capital market transactions. In Malaysia, Bahrain and a few other countries

of the Gulf, Islamic banks and financial institutions are working parallel with the

interest based system

Bahrain with the largest concentration of Islamic financial institutions in the

Middle East region, is hosting 26 Islamic financial institutions dealing in

diversified activities including commercial banking, investment banking, offshore

banking and funds management. It pursues a dual banking system, where

Islamic banks operate in the environment in which Bahrain Monetary Agency

(BMA) affords equal opportunities and treatment for Islamic banks as for interest

based banks. Bahrain also hosts the newly created Liquidity Management Centre

(LMC) and the International Islamic Financial Market (IIFM) to coordinate the

operations of Islamic banks in the world. To provide appropriate regulatory set

up, the BMA has introduced a comprehensive prudential and reporting

framework that is industry-specific to the concept of Islamic banking and finance.

Further, the BMA has pioneered a range of innovations designed to broaden the


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depth of Islamic financial markets and to provide Islamic institutions with wider

opportunities to manage their liquidity.

Another country that has a visible existence of Islamic banking at comprehensive

level is Malaysia where both interest based and Islamic banking systems are

working in a competitive environment. The share of Islamic banking operations in

Malaysia has grown from a nil in 1983 to above 8 percent of total financial

system in 2003. They have a plan to enhance this share to 20 percent by the

year 2010. However, there are some conceptual differences in interpretation and

Shariah position of various contracts like sale and purchase of debt instruments

and grant of gifts on savings and financial papers.

In Sudan, a system of Islamic banking and finance is in operation at national

level. Like other Islamic banks around the world the banks in Sudan have been

relying in the past on Murabaha financing. However, the share of Musharaka and

Mudaraba operations is on increase and presently constitutes about 40 percent

of total bank financing. Although the Islamic financial system has taken a good

start in Sudan, significant problems still remain to be addressed.

Like Sudan, Iran also switched over to Usury Free Banking at national level in

March 1984. However, there are some conceptual differences between Islamic

banking in Iran and the mainstream movement of Islamic banking and finance.

Owing to the growing amount of capital availability with Islamic banks, the

refining of Islamic financing techniques and the huge requirement of

infrastructure development in Muslim countries there has been a large number of

project finance deals particularly in the Middle East region. Islamic banks now

participate in a wide financing domain stretching from simple Shariah-compliant

retail products to highly complex structured finance and large-scale project


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lending. These projects, inter alia, include power stations, water plants, roads,

bridges and other infrastructure projects. Bahrain is the leading centre for Islamic

finance in the Middle East region. The establishment of the Prudential

Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in

conjunction with AAOIFI has gone a long way towards establishing a legal and

regulatory framework to meet the specific risks inherent in Islamic financing

structures.

The BMA has quite recently signed MoU with the London Metal Exchange (LME)

to pool assets to develop and promote Shariah compliant tradable instruments

for Islamic banking industry. The arrangement is seen as a major boost for

industrys int egration in the global financial system and should set the pace for

commodity-trading environment in Bahrain. BMA has also finalized draft

guidelines for issuance of Islamic bonds and securities from Bahrain. In May 03,

the Liquidity Management Centre (LMC) launched its debut US$ 250 million

Sukuk on behalf of the Government of Bahrain.

National Commercial Bank (NCB) of Saudi Arabia has introduced an AdvanceCard that has all the benefits of a regular credit card. The card does not have a

credit line and instead has a prepaid line. As such, it does not incur any interest.

Added benefits are purchase protection, travel accident insurance, etc and no

interest, no extra fees with any conditions, the card is fully Shariah compliant. It is

more secure than cash, easy to load up and has worldwide acceptance. This

prepaid card facility is especially attractive to women, youth, self employed and

small establishment employees who sometimes do not meet the strict

requirements of a regular credit card facility. Saudi Government has also

endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector

and opened it for foreign investors.


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Islamic banks have also built a strong presence in Malaysia, where Standard &

Poor's assigned a BBB+ rating to the $600 million Sharia-compliant trust

certificates (called Sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara

Malaysia (BNM) has announced to issue new Islamic Bank licenses to foreign

players. The Financial Sector Master plan maps out the liberalization of

Malaysia's banking and insurance industry in three phases during the next

decade. It lists incentives to develop the Islamic financial sector and enlarge its

market share to 20 percent, from under 10 percent now. A dedicated high court

has been set up to handle Islamic banking and finance cases.

In United Kingdom, the Financial Services Authority is in final stages of issuing its

first ever Islamic banking license to the proposed Islamic Bank of Britain, which

has been sponsored by Gulf and UK investors. The United States of America has

appointed Dr. Mahmud El Gamal, an eminent economist/expert on Islamic

banking to advise the US Treasury and Government departments on Islamic

finance in June 2004.


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2.8 Modes of Islamic Finance

Murabaha

Literally it means a sale on mutually agreed profit. Technically, it is a contract of

sale in which the seller declares his cost and profit. Islamic banks have adopted

this as a mode of financing. As a financing technique, it involves a request by the

client to the bank to purchase certain goods for him. The bank does that for a

definite profit over the cost, which is stipulated in advance.

Ijarah

Ijarah is a contract of a known and proposed usufruct against a specified and

lawful return or consideration for the service or return for the benefit proposed to

be taken, or for the effort or work proposed to be expended. In other words,

Ijarah or leasing is the transfer of usufruct for a consideration which is rent in

case of hiring of assets or things and wage in case of hiring of persons.

Ijarah-Wal-Iqtina


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A contract under which an Islamic bank provides equipment, building or other

assets to the client against an agreed rental together with a unilateral

undertaking by the bank or the client that at the end of the lease period, the

ownership in the asset would be transferred to the lessee. The undertaking or the

promise does not become an integral part of the lease contract to make it

conditional. The rentals as well as the purchase price are fixed in such manner

that the bank gets back its principal sum along with profit over the period of

lease.

Musharakah

Musharakah means a relationship established under a contract by the mutual

consent of the parties for sharing of profits and losses in the joint business. It is

an agreement under which the Islamic bank provides funds, which are mixed with

the funds of the business enterprise and others. All providers of capital are

entitled to participate in management, but not necessarily required to do so. Theprofit is distributed among the partners in pre-agreed ratios, while the loss is

borne by each partner strictly in proportion to respective capital contributions.

Musawamah

Musawamah is a general and regular kind of sale in which price of the

commodity to be traded is bargained between seller and the buyer without any

reference to the price paid or cost incurred by the former. Thus, it is different from

Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah

is not obliged to reveal his cost. Both the parties negotiate on the price. All other


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conditions relevant to Murabaha are valid for Musawamah as well. Musawamah

can be used where the seller is not in a position to ascertain precisely the costs

of commodities that he is offering to sell.

Istisna'a

It is a contractual agreement for manufacturing goods and commodities, allowing

cash payment in advance and future delivery or a future payment and future

delivery. Istisna'a can be used for providing the facility of financing the

manufacture or construction of houses, plants, projects and building of bridges,

roads and highways.

Bai MuajjalLiterally it means a credit sale. Technically, it is a financing technique adopted by

Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which

the bank earns a profit margin on his purchase price and allows the buyer to pay

the price of the commodity at a future date in a lump sum or in installments. It

has to expressly mention cost of the commodity and the margin of profit is

mutually agreed. The price fixed for the commodity in such a transaction can be

the same as the spot price or higher or lower than the spot price.

Mudaraba


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A form of partnership where one party provides the funds while the other

provides expertise and management. The latter is referred to as the Mudarib.

Any profits accrued are shared between the two parties on a pre-agreed basis,

while loss is borne only by the provider of the capital.

Bai Salam

Salam means a contract in which advance payment is made for goods to be

delivered later on. The seller undertakes to supply some specific goods to the

buyer at a future date in exchange of an advance price fully paid at the time of

contract. It is necessary that the quality of the commodity intended to be

purchased is fully specified leaving no ambiguity leading to dispute. The objects

of this sale are goods and cannot be gold, silver or currencies. Barring this, BaiSalam covers almost everything, which is capable of being definitely described

as to quantity, quality and workmanship


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2.9 Islamic Banking Issues

Human resource for Sharia'h compliance

Users of Islamic financial services assign primary importance to Sharia'h

compliance of the services they use. It is understandable that Sharia'h

noncompliance entails a serious operational risk and can result in withdrawal of

funds from and instability of an Islamic bank, irrespective of its initial financial

soundness. Sharia'h compliance is hence a serious matter for an Islamic bank, inaddition to its compliance with other regulatory requirements.


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Unresolved Fiqh Issues

Lack of standard financial contracts and products can be a cause of ambiguity

and a source of dispute and cost. In addition, without a common understanding

of certain basic foundations, further development of banking products is

hindered.

Legal framework

An appropriate legal, institutional and tax framework is a basic requirement for establishing sound financial institutions and markets. Islamic jurisprudence offers

its own framework for the implementation of commercial and financial contracts

and transactions.

Nevertheless, commercial, banking and company laws appropriate for the

enforcement of Islamic banking and financial contracts do not exist in many

countries.

Excess Liquidity

Islamic banks have over 60 % excess liquid funds which cannot be properly

utilized due to non-availability of Sharia'h Compliant products and instruments.

The competitiveness and soundness of financial institutions depend on theavailability of efficient financial products. Islamic banks urgently need Sharia'h

compliant products to meet a number of pressing needs.


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2.10 Interest based Banking

Interest based banking is based on the principle that the more you have, the

more you can get. In other words, if you have little or nothing, you get nothing. As

a result, more than half the population of the world is deprived of the financial

services of the interest based banks. Interest based banking is based on

collateral. Interest based banks look at what has already been acquired by a

person Interest based banks go into punishment mode when a borrower is

taking more time in repaying the loan than it was agreed upon. They call these

borrowers defaulters. When a client gets into difficulty, interest based banks get


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worried about their money, and makes all efforts to recover the money, including

taking over the collateral. In interest based banks charging interest does not stop

unless specific exception is made to a particular defaulted loan. Interest charged

on a loan can be multiple of the principal, depending on the length of the loan

period.

The role of interest based banksInterest based banks engage in the following activities:

Processing of payments by way of telegraphic transfer, internet banking,

or other means

Issuing bank drafts and bank cheques

Accepting money on term deposit

Lending money by overdraft, installment loan, or other means

Providing documentary and standby letter of credit, guarantees,

performance bonds, securities underwriting commitments and other forms

of off balance sheet exposures

Safekeeping of documents and other items in safe deposit boxes

Sales, distribution or brokerage, with or without advice, of: insurance, unit

trusts and similar financial products as a financial supermarket
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Cash management and treasury

merchant banking and private equity financing

Traditionally, large interest based banks also underwrite bonds, and make

markets in currency, interest rates, and credit-related securities, but today

large interest based banks usually have an investment bank arm that is

involved in the mentioned activities

2.11 Products of interest based banking

Products offered by mostly interest based banking usually called interest based

banking are given below

Transactional account Savings account Certificate of deposit Credit card Debit card Mortgage loan

Unsecured debt(personal loan) Loan

Transactional account
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A transactional account is a deposit account held at a bank or other financial

institution, for the purpose of securely and quickly providing frequent access tofunds on demand, through a variety of different channels.

Transactional accounts are meant neither for the purpose of earning interest nor

for the purpose of savings, but for convenience of the business or personal client;

hence do they tend not to bear interest. Instead, a customer can deposit or

withdraw any amount of money any number of times, subject to availability of

funds.

Savings account

savings accounts are accounts maintained by retail financial institutions that

pay interest but cannot be used directly as money in the narrow sense of

a medium of exchange (for example, by writing a check) . These accounts let

customers set aside a portion of their liquid assets while earning a monetary

return. For the bank, money in a savings account may not be callable

immediately and therefore often does not incur a reserve requirement freeing up

cash from the bank's vault to be lent out with interest.

Withdrawals from a savings account are occasionally costly, and they are more

time-consuming than withdrawals from a demand (current) account. However,

most saving accounts do not limit withdrawals, unlike certificates of deposit. Inthe United States, violations of Regulation D often involve a service charge, or

even a downgrade of the account to a checking account. With online accounts,

the main penalty is the time required for the Automated Clearing House to
http://en.wikipedia.org/wiki/Deposit_accounthttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Checkhttp://en.wikipedia.org/wiki/Reserve_requirementhttp://en.wikipedia.org/wiki/Certificates_of_deposithttp://en.wikipedia.org/wiki/Automated_Clearing_Househttp://en.wikipedia.org/wiki/Automated_Clearing_Househttp://en.wikipedia.org/wiki/Certificates_of_deposithttp://en.wikipedia.org/wiki/Reserve_requirementhttp://en.wikipedia.org/wiki/Checkhttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Deposit_account


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transfer funds from the online account to a "brick and mortar" bank where it can

be easily accessed. During the period between when funds are withdrawn from

the online bank and transferred to the local bank, no interest is earned.

Certificate of deposit

A certificate of deposit (CD) is a time deposit, a financial product commonly

offered to consumers in the United States by banks, thrift institutions, and credit

unions.

CDs are similar to savings accounts in that they are insured and thus virtually risk

free; they are "money in the bank". CDs are insured by the Federal Deposit

Insurance Corporation (FDIC) for banks and by the National Credit Union

Administration (NCUA) for credit unions. They are different from savings

accounts in that the CD has a specific, fixed term (often monthly, three months,

six months, or one to five years), and, usually, a fixed interest . It is intended that

the CD be held until maturity, at which time the money may be withdrawn

together with the accrued interest.

In exchange for keeping the money on deposit for the agreed-on term,

institutions usually grant higher interest rates than they do on accounts from

which money may be withdrawn on demand, although this may not be the case

in an inverted yield curve situation. Fixed rates are common, but some

institutions offer CDs with various forms of variable rates.
http://en.wikipedia.org/wiki/Time_deposithttp://en.wikipedia.org/wiki/Savings_and_loan_associationhttp://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporationhttp://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporationhttp://en.wikipedia.org/wiki/National_Credit_Union_Administrationhttp://en.wikipedia.org/wiki/National_Credit_Union_Administrationhttp://en.wikipedia.org/wiki/Savings_deposithttp://en.wikipedia.org/wiki/Savings_deposithttp://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Interest_(finance)http://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Variable_ratehttp://en.wikipedia.org/wiki/Variable_ratehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Interest_(finance)http://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Savings_deposithttp://en.wikipedia.org/wiki/Savings_deposithttp://en.wikipedia.org/wiki/National_Credit_Union_Administrationhttp://en.wikipedia.org/wiki/National_Credit_Union_Administrationhttp://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporationhttp://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporationhttp://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/Savings_and_loan_associationhttp://en.wikipedia.org/wiki/Time_deposit


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Credit cardCredit card is a small plastic card issued to users as a system of payment. It

allows its holder to buy goods and services based on the holder's promise to pay

for these goods and services. The issuer of the card creates a revolving

account and grants a line of credit to the consumer (or the user) from which the

user can borrow money for payment to a merchant or as a cash advance to the

user.

A credit card is different from a charge card: a charge card requires the balance

to be paid in full each month. In contrast, credit cards allow the consumers acontinuing balance of debt, subject to interest being charged. A credit card also

differs from a cash card, which can be used like currency by the owner of the

card. Most credit cards are issued by banks or credit unions, and are the shape

and size specified by the ISO/IEC 7810 standard as ID-1. This is defined as

85.60 53.98 mm (3 3/8 2 1/8 in) in size.

Debit card

A debit card (also known as a bank card or check card) is a plastic card that

provides the cardholder electronic access to his or her bank account( s) at a

financial institution. Some cards have a value with which a payment is made,

while most relay a message to the cardholder's bank to withdraw funds from a

designated account in favor of the payee's designated bank account. The card

can be used as an alternative payment method to cash when making purchases.

In some cases, the primary account number is assigned exclusively for use on

the Internet and there is no physical card.
http://en.wikipedia.org/wiki/Plastichttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Revolving_accounthttp://en.wikipedia.org/wiki/Revolving_accounthttp://en.wikipedia.org/wiki/Line_of_credithttp://en.wikipedia.org/wiki/Consumerhttp://en.wikipedia.org/wiki/Merchanthttp://en.wikipedia.org/wiki/Cash_advancehttp://en.wikipedia.org/wiki/Charge_cardhttp://en.wikipedia.org/wiki/Cash_cardhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/ISO/IEC_7810http://en.wikipedia.org/wiki/Bank_accounthttp://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Primary_account_numberhttp://en.wikipedia.org/wiki/Primary_account_numberhttp://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Bank_accounthttp://en.wikipedia.org/wiki/ISO/IEC_7810http://en.wikipedia.org/wiki/Credit_unionhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Cash_cardhttp://en.wikipedia.org/wiki/Charge_cardhttp://en.wikipedia.org/wiki/Cash_advancehttp://en.wikipedia.org/wiki/Merchanthttp://en.wikipedia.org/wiki/Consumerhttp://en.wikipedia.org/wiki/Line_of_credithttp://en.wikipedia.org/wiki/Revolving_accounthttp://en.wikipedia.org/wiki/Revolving_accounthttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Plastic


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In many countries, the use of debit cards has become so widespread that their

volume has overtaken or entirely replaced checks and, in some instances, cash

transactions. The development of debit cards, unlike credit cards, has generally

been country specific resulting in a number of different systems around the world,

which were often incompatible. Since the mid 2000s, a number of initiatives have

allowed debit cards issued in one country to be used in other countries and

allowed their use for internet and phone purchases.

Unlike credit cards, the funds paid using a debit card are transferred from the

bearer's bank account, instead of having the bearer pay back the money at a

later date.

Debit cards usually also allow for instant withdrawal of cash, acting as the ATM

card for withdrawing cash. Merchants may also offer cash back facilities to

customers, where a customer can withdraw cash along with their purchase

Mortgage loan A mortgage loan is a loan secured by real property through the use of

a mortgage note which evidences the existence of the loan and

the encumbrance of that realty through the granting of

mortgage which secures the loan. However, the word mortgage alone, in

everyday usage, is most often used to mean mortgage loan.

The word mortgage is a Law French term meaning "death contract," meaning

that the pledge ends (dies) when either the obligation is fulfilled or the property is

taken through foreclosure.

A home buyer or builder can obtain financing (a loan) either to purchase or

secure against the property from a financial institution, such as a bank, either

directly or indirectly through intermediaries. Features of mortgage loans such as
http://en.wikipedia.org/wiki/Chequehttp://en.wikipedia.org/wiki/Credit_cardhttp://en.wikipedia.org/wiki/ATM_cardhttp://en.wikipedia.org/wiki/ATM_cardhttp://en.wikipedia.org/wiki/Debit_card_cashbackhttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Collateral_(finance)http://en.wikipedia.org/wiki/Real_propertyhttp://en.wikipedia.org/wiki/Mortgage_notehttp://en.wikipedia.org/wiki/Encumbrancehttp://en.wikipedia.org/wiki/Security_interesthttp://en.wikipedia.org/wiki/Law_Frenchhttp://en.wikipedia.org/wiki/Foreclosurehttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Foreclosurehttp://en.wikipedia.org/wiki/Law_Frenchhttp://en.wikipedia.org/wiki/Security_interesthttp://en.wikipedia.org/wiki/Encumbrancehttp://en.wikipedia.org/wiki/Mortgage_notehttp://en.wikipedia.org/wiki/Real_propertyhttp://en.wikipedia.org/wiki/Collateral_(finance)http://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Debit_card_cashbackhttp://en.wikipedia.org/wiki/ATM_cardhttp://en.wikipedia.org/wiki/ATM_cardhttp://en.wikipedia.org/wiki/Credit_cardhttp://en.wikipedia.org/wiki/Cheque


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the size of the loan, maturity of the loan, interest rate, method of paying off the

loan, and other characteristics can vary considerably.

In many jurisdictions, though not all (Bali, Indonesia being one exception ), it isnormal for home purchases to be funded by a mortgage loan. Few individuals

have enough savings or liquid funds to enable them to purchase property

outright. In countries where the demand for home ownership is highest, strong

domestic markets have developed.

Unsecured debt (personal loan)n finance, unsecured debt refers to any type of debt or general obligation that is

not collateralized by a lien on specific assets of the borrower in the case of

a bankruptcy or liquidation or failure to meet the terms for repayment.

In the event of the bankruptcy of the borrower, the unsecured creditors will have

a general claim on the assets of the borrower after the specific pledged assets

have been assigned to the secured creditors, although the unsecured creditors

will usually realize a smaller proportion of their claims than the secured creditors.

In some legal systems, unsecured creditors who are also indebted to the

insolvent debtor are able (and in some jurisdictions, required) to set-off the debts,

which actually puts the unsecured creditor with a matured liability to the debtor in

a pre-preferential position.

Loan A loan is a type of debt. Like all debt instruments, a loan entails the redistribution

of financial assets over time, between the lender and the borrower.
http://en.wikipedia.org/wiki/Balihttp://en.wikipedia.org/wiki/Home_ownershiphttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Collateral_(finance)http://en.wikipedia.org/wiki/Lienhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Secured_loanhttp://en.wikipedia.org/wiki/Set-off_(law)http://en.wikipedia.org/wiki/Debthttp://en.wiktionary.org/wiki/lenderhttp://en.wiktionary.org/wiki/borrowerhttp://en.wiktionary.org/wiki/borrowerhttp://en.wiktionary.org/wiki/lenderhttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Set-off_(law)http://en.wikipedia.org/wiki/Secured_loanhttp://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Lienhttp://en.wikipedia.org/wiki/Collateral_(finance)http://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Home_ownershiphttp://en.wikipedia.org/wiki/Bali


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In a loan, the borrower initially receives or borrows an amount of money, called

the principal , from the lender, and is obligated to pay back or repay an equal

amount of money to the lender at a later time. Typically, the money is paid back

in regular installments , or partial repayments; in annuity, each installment is the

same amount.

The loan is generally provided at a cost, referred to as interest on the debt, which

provides an incentive for the lender to engage in the loan. In a legal loan, each of

these obligations and restrictions is enforced by contract, which can also place

the borrower under additional restrictions known as loan covenants. Although this

article focuses on monetary loans, in practice any material object might be lent.

2.12 Islamic Banking Vs Interestbased banking

The main difference between Islamic and interest based banking is that Islamic

teaching says that money itself has no intrinsic value, and forbids people from

profiting by lending it, without accepting a level of risk in other words, interest

(known as "riba") cannot be charged.

To make money from money is prohibited wealth can only be generatedthrough legitimate trade and investment. Any gain relating to this trading is

shared between the person providing the capital and the person providing the

expertise.
http://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Loan_covenanthttp://en.wikipedia.org/wiki/Loan_covenanthttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Money


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At Islamic Bank of Britain, we generate all our profit through Shariah compliant

trading and investment activities. We then share the profits with our customers at

a pre-agreed ratio. In order to share profits you must hold one of our savings or

investment accounts

There are two major differences between Islamic Banking and Interest based

banking:

1. Interest based banking practices are concerned with "elimination of

risk" where as Islamic banks "bear the risk" when involve in any

transaction.

2. When Interest based banks involve in transaction with consumer they

do not take the liability only get the benefit from consumer in form of

interest whereas Islamic banks bear all the liability when involve in

transaction with consumer. Getting out any benefit without bearing its

liability is declared Haram in Islam.

While the basics of what the business is are the same, the term refers tooperating the business within Islamic law. The main thing that affects this

business under that law is that Islam prohibits the charging of interest. Certainly a

problem in modern banking!

However, what is considered to be interest has different definitions by different

Islamic scholars...some say it can only be considered on gold and silver...but

paying back the same weight as you borrowed (the same weight of paper money

for example), is not interest. Like in all religious things, there would seem to be

some conflict and differences between followers that may seem strange to

outsiders.


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So basically, modern Islamic banking may take many forms, each of which

strives to adhere to it understands of Islamic law.

2.13 Similarities and Differences

Islamic Financial Institutions (IFIs) are operating in the same society where

interest based banks are operating and perform all those functions which are

expected from a financial institution. IFIs are assisting business world by

providing all the services required to run the economy smoothly, however,

the philosophy and operations are different. In this section I will analyze

the operations and products of IFIs in comparison with traditional

Interest based banks. Any financial system is expected to assist in running the

economy by providing the following


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Services grouped in two headings. First; Savings mobilization from savers to

entrepreneurs and Second; Provision of general utility services including

transfer of funds, facilitation in international trades, consultancy services,

Safekeeping of valuables, and any other service for a fee. There is no restriction

on provision of such services by IFIs as for the service is not against the

Sharia. However there exists difference in mechanism of funds mobilization

from savers to entrepreneurs as described following. Savings mobilization

consists of two phases i.e.

Accepting deposits and extending financing and investments.

DepositsDeposits are collected from savers under both types of institutions for reward

irrespective a bank is operating under interest based system or Islamic system.

The difference lies in agreement of reward. Under interest based system

reward is fixed and predetermined while under Islamic deposits are accepted

through Musharaka and Mudaraba where reward is variable. Under interest

based banking return is higher on long-term deposits and lower for short-

term deposits. Same is the practice in Islamic banking to share profit with

depositors. Higher weight for profit sharing is assigned to long-termdeposits being available to bank for investing in longer term projects

yielding superior returns and lower weight for short-term deposits which cannot

be invested in long term projects. The only difference in interest based and


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Islamic system lies in sharing of risk and reward. Under interest based

system total risk is born by the bank and total reward belongs to it after

servicing the depositors at fixed rate while under Islamic system risk and

reward both are shared with depositors. Reward of depositors is linked with

outcomes of investments made by IFIs. Under Islamic financial system only

those IFIs will be able to collect deposits who can establish trust in the eyes

of masses hence leading to optimal performance by financial industry. So for

IFIs workings in Pakistan have succeeded in establishing their credibility in the

eyes of savers.

Financing and Investments

The second phase in savings mobilization process is extension of credit

facility to business and industry for return. Both types of institutions

(Islamic and Interest based) are providing financing to productive channels

for reward. The difference lies in financing agreement. Interest based banks are

offering loan for a fixed reward while IFIs cannot do that because they cannot

charge interest. IFIs can charge profit on investments but not interest on loans. In

interest based banking three types of loans are issued to clients including shortterm loans, overdrafts and long-term loans. Islamic banks cannot issue loans

except interest free loans (Qarz e Hasna) for any requirement however they

can do business by providing the required asset to client. In following


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paragraphs I present the comparative working of different products (financing

scheme) of both systems.

Overdrafts / Credit Cards

Interest based banks offer the facility of overdrawing from account of the

customer on interest. One of its form is use of credit card whereby limit of

overdrawing for customer is set by the bank. Credit card provides dual facility

To customer including financing as well as facility of plastic money whereby

customer can meet his requirement without carrying cash. As for facility of

financing is concerned that is not offered by Islamic banks except in the

form of Murabaha (which means IFI shall deliver the desired commodity

and not the cash) however facility to shop/meet requirement is provided

through debit card whereby a customer can use his card if his account carries

Credit balance. Under interest based banking a customer is charged with

interest once the facility availed however under Murabaha only profit is duewhen the commodity is delivered to the customer. Furthermore in case of

default customer is charged with further interest for the extra period under

interest based system however extra charging is not allowed under Murabaha.

Third under interest based system customer can avail the opportunity of

rescheduling by entering into a new agreement to pay interest for extended

period which is not the case under Murabaha. IFIs can claim only the

original receivable amount agreed in initial contract. Another practical issue

under Murabaha is how to deal with intentional defaulters. Different options are

lying with IFIs including to blacklist the defaulter for any further financing


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facility, to stipulate in the contract that in case of default all installments will be

due at once, to stipulate in the contract a penalty shall be imposed but the same

shall not form income of IFIs rather it will go in charity

Short term loans

Short term and medium term loans are provided to customer to meet

working capital requirements of firm by interest based banks. Working

capital is required by firms to invest in inventories and accounts

receivables and meet the expenses. As for inventory investment is concerned

that is provided by Islamic banks through Murabaha. As for meeting of day to

day expenses of business is concerned financing is provided through

participation term

certificates where by profit of a certain period (e.g. quarter, six month,

one year) is shared by IFIs on prorate basis. However financing through

participation term certificates is not as easy as a short term loan from

interest based bank due to risk involved for IFIs in the transaction. Firm

seeking short-term facility from IFIs has to prove the viability of theproject/business to the satisfaction of investor. For meeting the working

capital requirements of nonprofit organizations to date there is no

arrangement under Islamic financial system. Personal consumption loans are

also not issued by IFIs how ever any individual of sound financial position

can acquire anything for his personal use under Murabaha financing whereby a

certain percentage of profit is added on cost by IFIs. Murabaha financing is

very useful for short to medium term financial requirements of business/nonprofit organizations and individuals. Murabaha financing is asset

based financing and anyone can request to an IFI for provision of an asset

generally used for Halal (lawful) purposes. By default under Islamic financial

system IFIs cannot lend cash for interest (only exception is Qarz e Hasna


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Charity loan). One of the features of Murabaha is in case of delay in payment

by customer IFI cannot ask for extra amount as time value of money like interest

based banks. However penalty is imposed on defaulter if stipulated in original

contract of Murabaha duly signed by the customer but same cannot be

included in the income of IFI. This penalty must be spent for charitable

purposes. Under Murabaha scheme of financing facility is linked with assets

which leads to economic stability and creates

linkage between real and financial sector. It is not zero sum game because

utility is created through services and products and not by mere building

the blocks of wealth through dealing in paper money. Although Murabaha is

being used by IFIs successfully and have succeeded in meeting short to

medium term requirements of firms by providing a successful replacement

of interest based loans yet certain differences exist in both type of

financing. First is one cannot get cash under Murabaha. Second asset is

purchased by IFI initially then transferred to customer hence IFI participate

in risk.

Third refinancing facility is not available under Murabaha. Fourth in case

of default price of the commodity cannot be enhanced however penalty maybe imposed if stipulated in original contract of Murabaha however same

cannot be included in income of IFI. Fifth only those assets can be

supplied by IFIs under Murabaha whose general and/or intended use is not

against the injunctions of Sharia (e.g. supply of a machine to produce liquor)


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Medium to long term loans

Medium to long-term loans are provided for purchase or building of fixed assetsby firms to expand or replace the existing assets. Under Islamic financial

system requirement of firms and individuals are fulfilled through Murabaha,

Bai Muajjal and Istasna (discussed in appendix B). Another financing option for

long-term financing is profit sharing under Musharaka and Mudaraba (discussed

in appendix B). Although financing under Murabaha, Bai Muajjal and Istasna

is very much look like interest based loans with the only difference of

provision of asset and not cash to client however differences exist in the

contracts which alter the nature of risks and returns. Financing under

Musharaka and Mudaraba is challenging for IFIs and firms as well. Under Sharia

based financing

schemes firms have to prove the viability/profitability of the project/business to

the satisfaction of IFIs to get the finance because risk of losing the amount is

involved.

LeasingLeasing is relatively recent source of financing whereby usufruct of an

asset is transferred to lessee for agreed amounts of rentals. Under leasing

ownership may or may not be transferred.

Same facility is provided by IFIs under agreement of Ijara. Under Ijara asset is

provided to customer for use with out transfer of ownership for a specific period

of time in exchange for agreed rentals. Ownership of asset can be

transferred to customer through mutual agreement at the completion of leaseterm. All ownership risks are born by IFIs during Ijara tenure. Certain

differences exist in the transaction under both systems. First is rental under


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Ijara are not due until asset is delivered to the lessee for use. Second

additional rent cannot be demanded in case of default except a penalty (if

stipulated in original contract of lease) which is not the income of IFI. Third during

period of major repair rent cannot be demanded by IFI. Fourth if asset is lost or

destroyed IFI cannot claim further installments hence all risks of ownership are

born by IFI.

Agricultural Loans

Agricultural loans include both types of loans short-term as well as long-term.

Short-term loans are required by farmers for seeds and fertilizers and long-

term loans are required to develop additional lands and purchase of

equipments. Normally farmers return these loans after selling the finished

crops. Interest based banks are providing credit facility by charging interest.

Same facility is provided by IFIs to the farmers under Bai Slam, Bai Murabaha

Musharaka and Mudaraba (discussed in appendix B). Under Bai Salam cash isprovided to farmers for purchase of seeds and fertilizers however this is not

loan rather purchase of finished crops to be delivered by farmers. For

purchase of equipments Murabaha facility is used and for development of

additional land Musharaka and Mudaraba is used by IFIs. To get finance for

land development farmers have to convince the IFIs about profitability of the

venture due to risk involved in the transaction.


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House financing

Housing finance/Mortgages is the more secured form of financing for bothinterest based banks and IFIs. Under interest based system loan is provided for

interest while under Islamic financial system facility is provided through

diminishing Musharaka. Under diminishing Musharaka house is purchased

jointly by IFI and customer. IFI rents out its share in property to customer for

an agreed amount of rent. Share of financier is divided in units of small

denomination. Customer pays the installments to IFI consist of rentals plus

purchase price of a unit. Stake of customer in property is increasing while

of IFI is decreasing with payment of every installment. Finally with the

payment of last installment stake of IFI reaches to zero and property is

transferred in the name of customer.

Diminishing Musharaka model can help out in avoiding the real estate crisis (like

of 2008) because when market value of property decreases both IFI and

customer suffers according to their share in property and whole burden is

not shifted on customer alone. Hijazi, & Hanif (2010) have raised certain

questions about the existing practice of IFIs working in Pakistan and needs to beaddressed by policymakers, Sharia boards and management of IFIs.

InvestmentsIn order to maintain liquidity interest based banks have many avenues

including government securities, shorter term loans and money at call and

short notices, leasing companies bonds, investment in shares etc. Interestingly

mandatory reserve maintenance by interest based banks with central banks is

also rewarded in the form of interest. Interest based banks can also create

liquidity by issuing the bonds against their receivables. Commercial banks are

also protected by central bank by providing liquidity in rainy days for


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interest. Interbank deposits are also rewarded in the form of interest by

commercial banks.For IFIs avenues are very limited to create required

liquidity at the same time to earn some revenue by investing in short term and

liquid securities. IFIs cannot invest in government securities, short term loans,

bonds and money at call and short notices because of interest based

transactions.

Mandatory reserve with central bank is maintained by IFIs but they are

not rewarded like interest based banks. Looking towards central bank in

rainy days to maintain liquidity is also not as straightforward due to

interest demand of central bank. IFIs cannot demand interest on interbank

deposits. As for investment in market able securities are concerned again

IFIs are not free to invest in any equity security due to two reasons. First

Halal business of the underlying firm is required. Second financial operations of

underlying firm should be interest free.

Keeping in view the dominance of interest based banking and existing business

practices one can conclude safely that a very negligible number of firms

meet both conditions. The much appreciable job has been done by

Almeezan investment management limited (AIML) a subsidiary of leadingIslamic bank in Pakistan (Meezan bank) in this regard. A list of Sharia

compliant securities is being maintained and updated every six monthly out

of which 30 companies are selected for Kse Meezan Index (KMI). KMI

was established in June 2008.IFIs can invest only in those securities which

are declared Sharia compliant securities through filtering of Sharia

compliance criteria.


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2.14 Islamic banking playing role in the

economic development of the world

Islamic banking is unique, but by no means anomalous. It is neither at odds

with nor incomparable to interest based banking. Is it possible to contrast the

two models?

I-They are both financial intermediations. A financial intermediary is the

institution that acts as a middleman between cash surplus units (savers) anddeficit spending units (users of fund). It is quite obvious that the main function

of interest based banks is financial intermediation. However, there are those

who would like to think that there is no such thing in the Islamic economic

system as financial intermediation and that an Islamic bank can only be

sufficiently Islamic if it can operate like a trader, one who buys and s ells

goods and commodities.

The financial intermediary in interest based banking is a borrower -lender

institution. Since such institution will not survive unless it at least covers

expenses, then an income must be generated from such arrangement. This is

where interest appears. An Islamic bank, on the other hand, is based on a

multi-tier Mudarabah. A Mudarabah is a partnership in profit where capital and

management may joint together to create value. The income accruing to the

Islamic financial intermediary is coming out of profit not from interest. The root

of such a conception is the fact that Shari'ah doesnt distinguish between a

seller being a trader or a final intermediary, unlike positive law where civil law

is different from commercial law. In Shari'ah all people stand against one legal

code.


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II- A case in mind is Murabaha. There are those who say if an Islamic bank

does Murabaha any other form but the traders way of doing things it will not be

permissible from Shari'ah point of view, and an Islamic bank would be in their

view a dubious interest based bank. They say: since it is never the intention

of the bank, to own there assets and hold on to them then, such bank is not

sufficiently Islamic.

According to this viewpoint, an Islamic bank must have huge warehouses and

elegant stores full of goodies for sale. This is not valid and those who think so

miss two important points:

Intention is of no consequence on the permissibility or otherwise of any

exchange contract in Shari'ah. In an authentic Hadith, the Prophet (PBUH)

showed one companion how to substitute a usurious transaction by another

non usurious to reach the same purpose, He (PBUH) didnt object to the

intention nor that he nullified the contract on the basis of intention. Rather he

corrected the form of contract.

If the anatomy of the contract is in line with Shari'ah requirements, then the

transaction is acceptable. Hence, if bank actually buys and then sells, with

ownership passing from seller to buyer and that the subject of contract is a

good or commodity then the transaction is correct. In interest based banking

the subject of contract is money hence any increase is usurious.

III-The way interest based banks render financial intermediation is very simple.

They borrow money and lend money. Both assets and liabilities are one form

of lending. Islamic banking function in a rather elaborate (not perplexing)

way. They have to continuously innovate to satisfy the needs of their clients. It


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is because of this we see Mu rabaha, Musharakah, Mudarabah, Istisnaa,

Salam to name just a few Islamic modes of finance. This makes the job of an

Islamic banker not all roses, but certainly a more interesting one.

IV- A interest based banker is a risk manger. He is concerned with all kind of

credit, market, interest rate, legal and other risk factors. An Islamic banker

should be just as concerned. However, there is one added risk for the Islamic

banker, this is what we may call Shari'ah disobservance risk. Risk analysis

refer to the forces that may cause the outcome of investment to be sub

optimal. Certainly an Islamic investor earning non-permissible income is an

outcome that is most undesireous, and it may cause the value of his

investment to be reduced.

V-Contrary to popular opinion, being concerned about time value of money is

a similarity not a difference between Islamic and interest based banking.

There is no basis for the current thinking that Shari'ah doesnt allow the

attachment of monetary value to time in the contracts exchange. The contract

of Salam and differed-payment sales fly in the face of this argument. It is onlyin loans that Shari'ah requires that no time value of money is considered (but

replaced by great rewards in the hereafter).

VI- A major difference, however, remains in the handling of delinquency and

default. When a borrower delays payment of debt, interest will accrue on his

delayed portion. Unless, such borrower defaults and become incapable of

paying back his debt, such interest will compensate the interest based bank

for lost business. This cant be done in Islamic banking as this is considered

usurious.


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