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INTRODUCTION

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INTRODUCTION

Although the concept of Islamic finance can be traced back about 1,400 years, its

recent history can be dated to the 1970s when Islamic banks in Saudi Arabia and

the United Arab Emirates were launched. Bahrain and Malaysia emerged as

centers of excellence in the 1990s. It is now estimated that worldwide around US

$1 trillion of assets are managed under the rules of Islamic finance.

In the economic field, it is the biggest challenge for Muslims to reform their

financial institutions to bring them in harmony with the dictates of Shari‘ah. In an

environment where the entire financial system was based on interest, it was a

formidable task to structure the financial institutions on an interest free basis. The

people not conversant with the principles of Shari‘ah and its economic philosophy

sometimes believe that abolishing interest from the banks and financial institutions

would make them charitable, rather than commercial, concerns which offer

financial services without a return. Obviously, this is totally a wrong assumption.

According to Shari‘ah, interest free loans are meant for cooperative and charitable

activities, and not normally for commercial transactions, except in a very limited

range. So far as commercial financing is concerned, the Islamic Shari‘ah has a

different set-up for that purpose. The principle is that the person extending money

to another person must decide whether he wishes to help the opposite party or he

wants to share his profits. If he wants to help the borrower, he must rescind from

any claim to any additional amount. His principal will be secured and guaranteed,

but no return over and above the principal amount is legitimate. But if he is

advancing money to share the profits earned by the other party, he can claim a

stipulated proportion of profit actually earned by him, and must share his loss also,

if he suffers a loss. It is thus obvious that exclusion of interest from financial

activities does not necessarily mean that the financier cannot earn a profit. If

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financing is meant for a commercial purpose, it can be based on the concept of

profit and loss sharing, for which Musharakah and Mudarabah have been designed

since the very inception of the Islamic commercial law. There are, however, some

sectors where financing on the basis of Musharakah or Mudarabah is not workable

or feasible for one reason or another. For such sectors the contemporary scholars

have suggested some other instruments which can be used for the purpose of

financing, like Murabahah, Ijarah, Salam or Istisna. Since last two decades, these

modes of financing are being used by the Islamic banks and financial institutions.

But all these instruments are not the substitutes of interest in the strict sense, and it

will be wrong to presume that they may be used exactly in the same fashion as

interest is used. They have their own set of principles, philosophy and conditions

without which it is not allowed in Shari‘ah to use them as modes of financing.

Therefore the ignorance of their basic concept and relevant details may lead to

confusing the Islamic financing with the conventional system based on interest.

Islamic finance rests on the application of Islamic law, or Shariah. Shariah, and

very much in the context of Islamic finance, emphasizes justice and partnership.

The main principles of Islamic finance are that:

Wealth must be generated from legitimate trade and asset-based investment.

(The use of money for the purposes of making money is expressly

forbidden.)

Investment should also have a social and an ethical benefit to wider society

beyond pure return.

Risk should be shared.

All harmful activities (haram) should be avoided

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THE PROBHITIONS

The following activities are prohibited:

Charging and receiving interest (riba). The idea of a lender making a

straight interest charge, irrespective of how the underlying assets fare,

transgresses the concepts of risk sharing, partnership and justice. It

represents the money itself being used to make money. It also prohibits

investment in companies that have too much borrowing (typically

defined as having debt totaling more than 33% of the firm’s stock market

value over the last 12 months).

Investments in businesses dealing with alcohol, gambling, drugs, pork,

pornography or anything else that the Shariah considers unlawful or

undesirable (haram).

Uncertainty, where transactions involve speculation, or extreme risk.

This is seen as being akin to gambling. This prohibition, for example,

would rule out speculating on the futures and options markets. Mutual

insurance (which relates to uncertainty) is permitted if it is related to

reasonable, unavoidable business risk. It is based upon the principle of

shared responsibility for shared financial security, and that members

contribute to a mutual fund, not for profit, but in case one of the members

suffers misfortune.

Uncertainty about the subject matter and terms of contracts – this

includes a prohibition on selling something that one does not own. There

are special financial techniques available for contracting to manufacture a

product for a customer. This is necessary because the product does not

exist, and therefore cannot be owned, before it is made. A manufacturer

can promise to produce a specific product under certain agreed

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specifications at a determined price and on a fixed date. Specifically, in

this case, the risk taken is by a bank which would commission the

manufacture and sell the goods on to a customer at a reasonable profit for

undertaking this risk. Once again the bank is exposed to considerable

risk. Avoiding contractual risk in this way means that transactions have

to be explicitly defined from the outset.

Therefore, complex derivative instruments and conventional short sales

or sales on margin are prohibited under Islamic finance.

The permitted

As mentioned above, the receipt of interest is not allowed under Shariah.

Therefore, when Islamic banks provide finance they must earn their profits by

other means. This can be through a profit-share relating to the assets in which the

finance is invested, or can be via a fee earned by the bank for services provided.

The essential feature of Shariah is that when commercial loans are made, the

lender must share in the risk. If this is not so then any amount received over the

principal of the loan will be regarded as interest.

The Shariah board

The Shariah board is a key part of an Islamic financial institution. It has the

responsibility for ensuring that all products and services offered by that institution

are compliant with the principles of Shariah law. Boards are made up of a

committee of Islamic scholars and different institutions can have different boards.

An institution’s Shariah board will review and oversee all new product offerings

before they are launched. It can also be asked to deliver judgments on individual

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cases referred to it, such as whether a specific customer’s business proposals are

Shariah-compliant.

The demand for Shariah-compliant financial services is growing rapidly and the

Shariah board can also play an important role in helping to develop new financial

instruments and products to help the institution to adapt to new developments,

industry trends, and customers’ requirements. The ability of scholars to make

pronouncements using their own expertise and based on Shariah, highlights the

fact that Islamic finance remains innovative and able to evolve, while crucially

remaining within the bounds of core principles.

Developments

Perhaps the main current problem is the absence of a single, worldwide body to set

standards for Shariah compliance, meaning that there is no ultimate authority for

Shariah compliance. Each Islamic bank’s adherence to the principles of Shariah

law is governed by its own Shariah board. Some financial aspects of Shariah law,

and, therefore, the legitimacy of the financial instruments used can be open to

interpretation, with the result that some Islamic banks may agree transactions that

would be rejected by other banks. Therefore, a contract might unexpectedly be

declared incompatible with Shariah law and thus be invalid.

In Malaysia, the world’s biggest market for sukuk, the Shariah advisory council,

ensures consistency to help creating certainty across the market. Some industry

bodies, notably the Accounting and Auditing Organization for Islamic Financial

Institutions (AAOIFI) in Bahrain, have also been working towards common

standards. To quote the AAOFI website: ‘AAOIFI is supported by institutional

members (200 members from 45 countries, so far) including central banks, Islamic

financial institutions, and other participants from the international Islamic

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banking and finance industry, worldwide. AAOIFI has gained assuring support for

the implementation of its standards, which are now adopted in the Kingdom of

Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and

Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan,

Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based

on AAOIFI’s standards and pronouncements.’ However, despite these movements

towards consistency, some differences between national jurisdictions are likely to

remain.

To gain a good understanding of the burgeoning Islamic finance industry, it is

important to appreciate the diverse range of products that are currently on offer.

Certainly, with a solid foundation of Islamic contract law and the principle of

Islamic finance, one is in a position to explore some of the most popular products.

It is important to appreciate that Islamic finance is more than just financial

contracts. In principle, a great deal of emphasis is placed on responsible

investments; client relationships; capitalism with a moral focus; and eliminating

excessive uncertainty within the markets. These ideals are clearly stipulated within

Islamic law.

Therefore, by increasing our knowledge of Islamic law, we increase our

understanding of Islamic finance.

MARKET DESCRIPTION

More than 300 Islamic Financial Institutions (IFIs) in approximately 50 countries.

Total assets and funds under management (AUM) exceeding USD 300 billion

10-15% growth over past 10 years.

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Prevalent in all dimensions of financial services:

Debt and capital markets including

mutual funds

Insurance

Asset Management

Structured and Project Financing

Market mainly concentrated in Islamic countries of the Middle East, North Africa

and South-east Asia. It has gained popularity in Muslim-minority countries, e.g.

US, UK and Germany.

Note: *GCC countries include Saudi Arabia, Qatar, Kuwait, Bahrain, and Oman

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ISLAMIC FINANCE (FACTS AND FIGURES)

OVER THE YEARS VARIATIONS AND COMPLEXITY OF THE PRODUCT

HAS INCREASED TO THE LARGE EXTENT.

Islamic finance has followed in the wake of innovations in the global financial

services industry. A natural progression of the Islamic finance industry

Competitive retail offerings.

Sophisticated corporate banking products.

Innovative project finance solutions.

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ISLAMIC FINANCIAL INSRTUMENTS

In order to understand the concept of Islamic banking it is of very much

importance that we understand the basic financial instruments used in Islamic

banking. A detailed analysis of these instruments will help us in the comparison of

Islamic banking with conventional banking and also its growth in countries like the

Middle East (GCC), Malaysia, and Europe to name a few.

It is to the credit of Islamic banks around the world that they have, despite their

recent entry in the field, devised many creative financial products based on the

risk-sharing, profit-sharing principles of Islamic banking. For day-to-day banking

activities these instruments are not only practicable but have also proven to be

profitable for the Bank's stakeholders and the beneficiaries. Broadly speaking, the

areas in which Islamic banks are most active are in trade and commodity finance,

property, and leasing.

Some of the basic financial instruments of Islamic banking are the following:

1. Musharakah

2. Mudarabah

3. Murabaha

4. Salam

5. Istisna

6. Takaful

7. Ijarah

8. Sukuk

MUSHARAKAH (JOINT VENTURE)

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‘Musharakah’ is a word of Arabic origin which literally means sharing. In the

context of business and trade it means a joint enterprise in which all the partners

share the profit or loss of the joint venture. It is an ideal alternative for the interest-

based financing with far reaching effects on both production and distribution. In

the modern capitalist economy, interest is the sole instrument indiscriminately used

in financing of every type. Since Islam has prohibited interest, this instrument

cannot be used for providing funds of any kind. Therefore, musharakah can play a

vital role in an economy based on Islamic principles. ‘Interest’ predetermines a

fixed rate of return on a loan advanced by the financier irrespective of the profit

earned or loss suffered by the debtor, while musharakah does not envisage a fixed

rate of return. Rather, the return in musharakah is based on the actual profit earned

by the joint venture. The financier in an interest-bearing loan cannot suffer loss

while the financier in musharakah can suffer loss, if the joint venture fails to

produce fruits.

According to Islamic principles, a financier must determine whether he is

advancing a loan to assist the debtor on humanitarian grounds or he desires to

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share his profits. If he wants to assist the debtor, he should resist from claiming any

excess on the principal of his loan, because his aim is to assist him. However, if he

wants to have a share in the profits of his debtor, it is necessary that he should also

share him in his losses. Thus the returns of the financier in musharakah have been

tied up with the actual profits accrued through the enterprise. The greater the

profits of the enterprise, the higher the rate of return to the financier. If the

enterprise earns enormous profits, all of it cannot be secured by the industrialist

exclusively, but they will be shared by the common people as depositors in the

bank. In this way, musharakah has a tendency to favor the common people rather

than the rich only.

This is the basic philosophy which explains why Islam has suggested musharakah

as an alternative to the interest based financing.

The Concept of Musharakah

‘Musharakah’ is a term frequently referred to in the context of Islamic modes of

financing. The connotation of this term is a little limited than the term “shirkah”

more commonly used in the Islamic jurisprudence. For the purpose of clarity in the

basic concepts, it will be pertinent at the outset to explain the meaning of each

term, as distinguished from the other.

“Shirkah” means “sharing” and in the terminology of Islamic Fiqh, it has been

divided into two kinds:

(1) Shirkat-ul-Milk: It means joint ownership of two or more persons in a

particular property. This kind of “shirkah” may come into existence in two

different ways: Sometimes it comes into operation at the option of the parties. For

example, if two or more persons purchase equipment, it will be owned jointly by

both of them and the relationship between them with regard to that property is

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called “shirkat-ul-milk.” Here this relationship has come into existence at their

own option, as they themselves elected to purchase the equipment jointly.

(2) Shirkat-ul-‘Aqd: This is the second type of Shirkah which means “a partnership

effected by a mutual contract”. For the purpose of brevity it may also be translated

as “joint commercial enterprise.”

Shirkat-ul-’aqd is further divided into three kinds:

(i) Shirkat-ul-Amwal where all the partners invest some capital into a commercial

enterprise.

(ii) Shirkat-ul-A’mal where all the partners jointly undertake to render some

services for their customers, and the fee charged from them is distributed among

them according to an agreed ratio. For example, if two persons agree to undertake

tailoring services for their customers on the condition that the wages so earned will

go to a joint pool which shall be distributed between them irrespective of the size

of work each partner has actually done, this partnership will be a shirkat-ul-a’mal

which is also called Shirkat-ut-taqabbul or Shirkat-us-sana’i’ or Shirkat-ul-abdan.

(iii) The third kind of Shirkat-ul-’aqd is Shirkat-ul-wujooh.

Here the partners have no investment at all. All they do is that they purchase the

commodities on a deferred price and sell them at spot. The profit so earned is

distributed between them at an agreed ratio.

All these modes of “Sharing” or partnership are termed as “shirkah” in the

terminology of Islamic Fiqh, while the term “musharakah” is not found in the

books of Fiqh. This term (i.e. musharakah) has been introduced recently by those

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who have written on the subject of Islamic modes of financing and it is normally

restricted to a particular type of “Shirkah”, that is, the Shirkat-ul-amwal, where two

or more persons invest some of their capital in a joint commercial venture.

However, sometimes it includes Shirkat-ul-a’mal also where partnership takes

place in the business of services.

The Basic Rules of Musharakah

1. Musharakah or Shirkat-ul-amwal is a relationship established by the parties

through a mutual contract. Therefore, it goes without saying that all the necessary

ingredients of a valid contract must be present here also. For example, the parties

should be capable of entering into a contract; the contract must take place with free

consent of the parties without any duress, fraud or misrepresentation, etc., etc.

But there are certain ingredients which are peculiar to the contract of

“musharakah”. They are summarized here:

2. The proportion of profit to be distributed between the partners must be agreed

upon at the time of effecting the contract. If no such proportion has been

determined, the contract is not valid in Shari‘ah.

3. The ratio of profit for each partner must be determined in proportion to the

actual profit accrued to the business, and not in proportion to the capital invested

by him. It is not allowed to fix a lump sum amount for any one of the partners, or

any rate of profit tied up with his investment.

4. Is it necessary that the ratio of profit of each partner conforms to the ratio of

capital invested by him? There is a difference of opinion among the Muslim jurists

about this question. In the view of Imam Malik and Imam Shafi’i, it is necessary

for the validity of musharakah that each partner gets the profit exactly in the

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proportion of his investment. Therefore, if A has invested 40% of the total capital,

he must get 40% of the profit. Any agreement to the contrary which makes him

entitled to get more or less than 40% will render the musharakah invalid in

Shari‘ah. On the contrary, the view of Imam Ahmad is that the ratio of profit may

differ from the ratio of investment if it is agreed between the partners with their

free consent. Therefore, it is permissible that a partner with 40% of investment gets

60% or 70% of the profit, while the other partner with 60% of investment gets only

40% or 30%.

SHARING OF LOSS

But in the case of loss, all the Muslim jurists are unanimous on the point that each

partner shall suffer the loss exactly according to the ratio of his investment.

Therefore, if a partner has invested 40% of the capital, he must suffer 40% of the

loss, not more, not less, and any condition to the contrary shall render the contract

invalid. There is a complete consensus of jurists on this principle.

Therefore, according to Imam Shafi’i, the ratio of the share of a partner in profit

and loss both must conform to the ratio of his investment. But according to Imam

Abu Hanifah and Imam Ahmad, the ratio of the profit may differ from the ratio of

investment according to the agreement of the partners, but the loss must be divided

between them exactly in accordance with the ratio of capital invested by each one

of them.

The Nature of the Capital

Most of the Muslim jurists are of the opinion that the capital invested by each

partner must be in liquid form. It means that the contract of musharakah can be

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based only on money, and not on commodities. In other words, the share capital of

a joint venture must be in monetary form. No part of it can be contributed in kind.

However, there are different views in this respect.

1. Imam Malik is of the view that the liquidity of capital is not a condition for the

validity of musharakah; therefore, it is permissible that a partner contributes to the

musharakah in kind, but his share shall be determined on the basis of evaluation

according to the market price prevalent at the date of the contract. This view is also

adopted by some Hanbali jurists.

2. Imam Abu Hanifah and Imam Ahmad are of the view that no contribution in

kind is acceptable in a musharakah. Their standpoint is based on two reasons:

Firstly, they say that the commodities of each partner are always distinguishable

from the commodities of the other. For example, if A has contributed one motor

car to the business, and B has come with another motor car, each one of the two

cars is the exclusive property of its original owner. Now, if the car of A is sold, its

sale proceeds should go to A. B has no right to claim a share in its price. Therefore,

so far as the property of each partner is distinguished from the property of the

other, no partnership can take place. On the contrary, if the capital invested by

every partner is in the form of money, the share capital of each partner cannot be

distinguished from that of the other, because the units of money are not

distinguishable, therefore, they will be deemed to form a common pool, and thus

the partnership comes into existence.

Secondly, they say, there are a number of situations in a contract of musharakah

where the partners have to resort to redistribution of the share-capital to each

partner. If the share capital was in the form of commodities, such redistribution

cannot take place, because the commodities may have been sold at that time. If

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the capital is repaid on the basis of its value, the value may have increased, and

there is a possibility that a partner gets all the profit of the business, because of the

appreciation in the value of the commodities he has invested, leaving nothing for

the other partner. Conversely, if the value of those commodities decreases, there is

a possibility that one partner secures some part of the original price of the

commodity of the other partner in addition to his own investment.6

3. Imam al-Shafi’i has come with a via media between the two points of view

explained above. He says that the commodities are of two kinds:

(i) Dhawat-ul-amthal i.e. the commodities which, if destroyed, can be

compensated by the similar commodities in quality and quantity e.g. wheat, rice

etc. If 100 kilograms of wheat are destroyed, they can easily be replaced by

another 100 kg of wheat of the same quality.

(ii) Dhawat-ul-qeemah i.e. the commodities which cannot be compensated by the

similar commodities, like the cattle. Each head of sheep, for example, has its own

characteristics which cannot be found in any other head. Therefore, if somebody

kills the sheep of a person, he cannot compensate him by giving him similar sheep.

Rather, he is required to pay their price.

Management of Musharakah

The normal principle of musharakah is that every partner has a right to take part in

its management and to work for it. However, the partners may agree upon a

condition that the management shall be carried out by one of them, and no other

partner shall work for the musharakah. But in this case the sleeping partner

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shall be entitled to the profit only to the extent of his investment, and the ratio of

profit allocated to him should not exceed the ratio of his investment, as discussed

earlier.

However, if all the partners agree to work for the joint venture, each one of them

shall be treated as the agent of the other in all the matters of the business and any

work done by one of them in the normal course of business shall be deemed to be

authorized by all the partners.

Termination of Musharakah

Musharakah is deemed to be terminated in any one of the following events:

(1) Every partner has a right to terminate the musharakah at any time after giving

his partner a notice to this effect, whereby the musharakah will come to an end.

In this case, if the assets of the musharakah are in cash form, all of them will be

distributed pro rata between the partners. But if the assets are not liquidated, the

partners may agree either on the liquidation of the assets, or on their distribution or

partition between the partners as they are. If there is a dispute between the partners

in this matter i.e. one partner seeks liquidation while the other wants partition or

distribution of the non-liquid assets themselves, the latter shall be preferred,

because after the termination of musharakah, all the assets are in the joint

ownership of the partners, and a co-owner has a right to seek partition or

separation, and no one can compel him on liquidation. However, if the assets are

such that they cannot be separated or partitioned, such as machinery, then they

shall be sold and the sale-proceeds shall be distributed.

(2) If any one of the partners dies during the currency of musharakah, the contract

of musharakah with him stands terminated. His heirs in this case, will have the

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option either to draw the share of the deceased from the business, or to continue

with the contract of musharakah.

(3) If any one of the partners becomes insane or otherwise becomes incapable of

effecting commercial transactions, the musharakah stands terminated.

MUDARABAH (TRUSTEE PARTNERSHIP)

Mudarabah is a contract between two parties: One of them provides finance (Rab

ul maal) & other uses his labour and expertise (Mudarib).

Profit, if earned, is distributed between the two parties in accordance with the ratio

as per the agreement. Financial Loss, if suffered is borne by the investor only.

“Mudarabah” is a special kind of partnership where one partner gives money to

another for investing it in a commercial enterprise.

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The investment comes from the first partner who is called “rabb-ulmal”, while the

management and work is an exclusive responsibility of the other, who is called

“Mudarib”.

The difference between Musharakah and mudarabah can be summarized in the

following points:

(1) The investment in Musharakah comes from all the partners, while in

mudarabah; investment is the sole responsibility of rabb-ulmal.

(2) In Musharakah, all the partners can participate in the management of the

business and can work for it, while in mudarabah; the rabb-ul-mal has no right to

participate in the management which is carried out by the Mudarib only.

(3) In Musharakah all the partners share the loss to the extent of the ratio of their

investment while in mudarabah the loss, if any, is suffered by the rabb-ul-mal only,

because the Mudarib does not invest anything. His loss is restricted to the fact that

his labor has gone in vain and his work has not brought any fruit to him.

However, this principle is subject to a condition that the Mudarib has worked with

due diligence which is normally required for the business of that type. If he has

worked with negligence or has committed dishonesty, he shall be liable for the loss

caused by his negligence or misconduct.

(4) The liability of the partners in Musharakah is normally unlimited. Therefore, if

the liabilities of the business exceed its assets and the business goes in liquidation,

all the exceeding Mudarib and the capital of the mudarabah shall be utilized by

both of them jointly, and the share of the Mudarib shall be distributed between

them according to the agreed proportion.

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In this case both the Mudarib shall run the business as if they were partners inter

se. The Mudarib or mudaribs, as the case may be, are authorized to do anything

which is normally done in the course of business.

However, if they want to do an extraordinary work, which is beyond the normal

routine of the traders, they cannot do so without express permission from the rabb-

ul-mal. Distribution of the Profit It is necessary for the validity of mudarabah that

the parties agree, right at the beginning, on a definite proportion of the actual profit

to which each one of them is entitled. No particular proportion has been prescribed

by the Shari‘ah; rather, it has been left to their mutual consent. They can share the

profit in equal proportions, and they can also allocate different proportions for the

rabb-ul-mal and the Mudarib. However, they cannot allocate a lump sum amount

of profit for any party, nor can they determine the share of any party at a specific

rate tied up with the capital. For example, if the capital is Rs. 100000/- they cannot

agree on a condition that Rs. 10000/- out of the profit shall be the share of the

Mudarib, nor can they say that 20% of the capital shall be given to rabb-ul-mal.

However, they can agree on that 40% of the actual profit shall go to the Mudarib

and 60% to the rabb-ul-mal or vice versa. It is also allowed that different

proportions are agreed in different situations. For example the rabbul-mal can say

to mudarib, “If you trade in wheat, you will get 50% of the profit and if you trade

in flour, you will have 33% of the profit”. Similarly, he can say “If you do the

business in your town, you will be entitled to 30% of the profit, and if you do it in

another town, your share will be 50% of the profit.”

Apart from the agreed proportion of the profit, as determined in the above manner,

the Mudarib cannot claim any periodical salary or a fee or remuneration for the

work done by him for the mudarabah.

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All the schools of Islamic Fiqh are unanimous on this point. However, Imam

Ahmad has allowed for the Mudarib to draw his daily expenses of food only from

the mudarabah account.

The Hanafi jurists restrict this right of the Mudarib only to a situation when he is

on a business trip outside his own city. In this case he can claim his personal

expenses, accommodation, food, etc., but he is not entitled to get anything as daily

allowances when he is in his own city.

If the business has incurred loss in some transactions and has gained profit in some

others, the profit shall be used to offset the loss at the first instance, then the

remainder, if any, shall be distributed between the parties according to the agreed

ratio

Termination of Mudarabah

The contract of mudarabah can be terminated at any time by either of the two

parties. The only condition is to give a notice to the other party. If all the assets of

the mudarabah are in cash form at the time of termination, and some profit has

been earned on the principal amount, it shall be distributed between the parties

according to the agreed ratio. However, if the assets of the mudarabah are not in

the cash form, the Mudarib shall be given an opportunity to sell and liquidate them,

so that the actual profit may be determined.

There is a difference of opinion among the Muslim jurists about the question

whether the contract of mudarabah can be affected for a specified period after

which it terminates automatically. The Hanafi and Hanbali schools are of the view

that the mudarabah can be restricted to a particular term, like one year, six months,

etc, after which it will come to an end without a notice. On the contrary Shafi’i and

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Maliki schools are of the opinion that the mudarabah cannot be restricted to a

particular time.

However, this difference of opinion relates only to the maximum time-limit of the

mudarabah. Can a minimum time-limit also be fixed by the parties before which

mudarabah cannot be terminated? No express answer to this question is found in

the books of Islamic Fiqh, but it appears from the general principles enumerated

therein that no such limit can be fixed, and each party is at liberty to terminate the

contract whenever he wishes.

This unlimited power of the parties to terminate the mudarabah at their pleasure

may create some difficulties in the context of the present circumstances, because

most of the commercial enterprises today need time to bring fruits. They also

demand constant and complex efforts. Therefore, it may be disastrous to the

project, if the rabb-ul-mal terminates the mudarabah right in the beginning of the

enterprise.

Combination of Musharakah and Mudarabah

A contract of mudarabah normally presumes that the Mudarib has not invested

anything to the mudarabah. He is responsible for the management only, while all

the investment comes from rabb-ulmal. But there may be situations where Mudarib

also wants to invest some of his money into the business of mudarabah. In such

cases, Musharakah and mudarabah are combined together. For example, A gave to

B Rs. 100000/- in a contract of mudarabah. B added Rs. 50000/- from his own

pocket with the permission of A. This type of partnership will be treated as a

combination of Musharakah and mudarabah. Here the Mudarib may allocate for

himself a certain percentage of profit on account of his investment as a sharik, and

at the same time he may allocate another percentage for his management and

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work as a Mudarib. The normal basis for allocation of the profit in the above

example would be that B shall secure one third of the actual profit on account of

his investment, and the remaining two thirds of the profit shall be distributed

between them equally. However, the parties may agree on any other proportion.

The only condition is that the sleeping partner should not get more percentage than

the proportion of his investment.

Therefore, in the aforesaid example, A cannot allocate for himself more than two

thirds of the total profit, because he has not invested more than two thirds of the

total capital. Short of that, they can agree on any proportion. If they have agreed on

that the total profit will be distributed equally, it means that one third of the profit

shall go to B as an investor, while one fourth of the remaining two thirds will go to

him as a Mudarib. The rest will be given to A as “rabb-ul-mal”.

MURABAHA (MARK UP SALES)

The client orders an Islamic Bank to purchase certain goods at a specific cash price

The Bank purchases these goods from the supplier and sells to the client at a

marked – up price (Cost + Profit).

The differed price may be paid up on lump sum or in installment.

To be in consonance with the principles of Islamic finance governing exchange

transactions every Murabaha transaction must meet the following conditions:

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Murabaha transactions may be undertaken only where the client of a bank, or

financial institution, wants to purchase a commodity. This type of transaction

cannot be affected in cases where the client wants to get funds for a purpose other

than purchasing a commodity, like payment of salaries, settlement of bills or other

liabilities.

To make it a valid transaction it is necessary that the commodity is really

purchased by the bank and it comes into the ownership and possession (physical or

constructive) of the bank so that it may assume the risk of the commodity so far as

it remains under its ownership and possession.

After acquiring the ownership and possession of the commodity it should be sold

to the client through a valid sale. Some quarters have equated Murabahah

transactions to interest-based loans.

Most of the Islamic banks and financial institutions are using murabahah as an

Islamic mode of financing, and most of their financing operations are based on

murabahah. That is why this term has been taken in the economic circles today as a

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method of banking operations, while the original concept of murabahah is different

from this assumption.

“Murabahah” is, in fact, a term of Islamic Fiqh and it refers to a particular kind of

sale having nothing to do with financing in its original sense. If a seller agrees with

his purchaser to provide him a specific commodity on a certain profit added to his

cost, it is called a murabahah transaction. The basic ingredient of murabahah is that

the seller discloses the actual cost he has incurred in acquiring the commodity, and

then adds some profit thereon. This profit may be in lump sum or may be based on

a percentage.

The payment in the case of murabahah may be at spot, and may be on a subsequent

date agreed upon by the parties. Therefore, murabahah does not necessarily imply

the concept of deferred payment, as generally believed by some people who are not

acquainted with the Islamic jurisprudence and who have heard about murabahah

only in relation with the banking transactions.

Murabahah, in its original Islamic connotation, is simply a sale. The only feature

distinguishing it from other kinds of sale is that the seller in murabahah expressly

tells the purchaser how much cost he has incurred and how much profit he is going

to charge in addition to the cost.

If a person sells a commodity for a lump sum price without any reference to the

cost, this is not a murabahah, even though he is earning some profit on his cost

because the sale is not based on a “cost-plus” concept. In this case, the sale is

called “musawamah.” This is the actual sense of the term “murabahah” which is a

sale, pure and simple. However, this kind of sale is being used by the Islamic

banks and financial institutions by adding some other concepts to it as a mode of

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financing. But the validity of such transactions depends on some conditions which

should be duly observed to make them acceptable in Shari‘ah.

In order to understand these conditions correctly, one should, in the first instance,

appreciate that murabahah is a sale with all its implications, and that all the basic

ingredients of a valid sale should be present in murabahah also. Therefore, this

discussion will start with some fundamental rules of sale without which a sale

cannot be held as valid in Shari‘ah. Then, we shall discuss some special rules

governing the sale of murabahah in particular, and in the end the correct procedure

for using the murabahah as an acceptable mode of financing will be explained.

An attempt has been made to reduce the detailed principles into concise notes in

the shortest possible sentences, so that the basic points of the subject may be

grasped at in one glance, and may be preserved for easy reference.

MURABHA AS A MODE OF FINANCING

Originally, murabahah is a particular type of sale and not a mode of financing. The

ideal mode of financing according to Shari‘ah is mudarabah or musharakah which

have been discussed in the first chapter. However, in the perspective of the current

economic set up, there are certain practical difficulties in using mudarabah and

musharakah instruments in some areas of financing. Therefore, the contemporary

Shari‘ah experts have allowed, subject to certain conditions, the use of the

murabahah on deferred payment basis as a mode of financing. But there are two

essential points which must be fully understood in this respect:

1. It should never be overlooked that, originally, murabahah is not a mode of

financing. It is only a device to escape from “interest” and not an ideal instrument

for carrying out the real economic objectives of Islam. Therefore, this instrument

should be used as a transitory step taken in the process of the Islamization of

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the economy, and its use should be restricted only to those cases where mudarabah

or musharakah are not practicable.

2. The second important point is that the murabahah transaction does not come into

existence by merely replacing the word of “interest” by the words of “profit” or

“mark-up”. Actually, murabahah as a mode of finance, has been allowed by the

Shari‘ah scholars with some conditions. Unless these conditions are fully observed,

murabahah is not permissible. In fact, it is the observance of these conditions

which can draw a clear line of distinction between an interest-bearing loan and a

transaction of murabahah. If these conditions are neglected, the transaction

becomes invalid according to Shari‘ah.

SUBJECT MATTER OF MURABAHA

All commodities which may be subject matter of sale with profit can be subject

matter of murabahah, because it is a particular kind of sale. Therefore, the shares of

a lawful company may be sold or purchased on murabahah basis, because

according to the Islamic principles, the shares of a company represent the holder’s

proportionate ownership in the assets of the company. If the assets of a company

can be sold with profit, its shares can also be sold by way of murabahah. But it

goes without saying that the transaction must fulfill all the basic conditions,

already discussed, for the validity of a murabahah transaction. Therefore, the seller

must first acquire the possession of the shares with all their rights and obligations,

then sell them to his client. A buy back arrangement or selling the shares without

taking their possession is not allowed at all.

Conversely, no murabahah can be affected on things which cannot be subject -

matter of sale, for example murabahah is not possible in exchange of currencies,

because it must be spontaneous or, if deferred, on the market rate prevalent on

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the date of the transaction. Similarly, the commercial papers representing a debt

receivable by the holder cannot be sold or purchased except at par value, and

therefore no murabahah can be affected in respect of such papers. Similarly, any

paper entitling the holder to receive a specified amount of money from the issuer

cannot be negotiated. The only way of its sale is to transfer if for its face value.

Therefore, they cannot be sold on murabahah basis

SECURITIZATION OF MURABAHA

Murabahah is a transaction which cannot be securitized for creating a negotiable

instrument to be sold and purchased in secondary market. The reason is obvious. If

the purchaser/client in a murabahah transaction signs a paper to evidence his

indebtedness towards the seller/financier, the paper will represent a monetary debt

receivable from him. In other words, it represents money payable by him.

Therefore transfer of this paper to a third party will mean transfer of money. It has

already been explained that where money is exchanged for money (in the same

currency) the transfer must be at par value. It cannot be sold or purchased at a

lower or a higher price. Therefore, the paper representing a monetary obligation

arising out of a murabahah transaction cannot create a negotiable instrument. If the

paper is transferred, it must be at par value. However, if there is a mixed portfolio

consisting of a number of transactions like musharakah, leasing and murabahah,

then this portfolio may issue negotiable certificates subject to certain conditions

more fully discussed in the chapter of “Islamic Funds”.

SALAM (FORWARD SELLING)

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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.

Areas of Application:

Salam sale is suitable for the finance of agriculture operations, where the bank can

transact with farmers who are expected to have the commodity in plenty during

harvest either from their own crops or crops of others, which they can buy and

deliver in case their crops fail. Thus the bank renders great services to the farmers

in their way to achieve their production targets.

Salam sale is also used to finance commercial and industrial activities, especially

phases prior to production and export of commodities and that is by purchasing

them on Salam and marketing them for lucrative prices.

The scope of Salam sale is large enough to cover the needs of various people such

as farmers, industrialists, contractors or traders. It can cover the finance of

operational costs and capital goods.

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It is one of the basic conditions for the validity of a sale in Shari‘ah that the

commodity (intended to be sold) must be in the physical or constructive possession

of the seller. This condition has three ingredients:

Firstly, the commodity must be existing; therefore, a commodity which does not

exist at the time of sale cannot be sold.

Secondly, the seller should have acquired the ownership of that commodity.

Therefore, if the commodity is existing, but the seller does not own it, he cannot

sell it to anybody.

Thirdly, mere ownership is not enough. It should have come in to the possession of

the seller, either physically or constructively. If the seller owns a commodity, but

he has not taken its delivery himself or through an agent, he cannot sell it.

There are only two exceptions to this general principle in Shari‘ah. One is Salam

and the other is istisna’.

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Salam is a sale whereby the seller undertakes to supply some specific goods to the

buyer at a future date in exchange of an advanced price fully paid at spot.

After the prohibition of riba they could not take usurious loans. Therefore, it was

allowed for them to sell the agricultural products in advance.

Similarly, the traders of Arabia used to export goods to other places and to import

some other goods to their homeland. They needed money to undertake this type of

business. They could not borrow from the usurers after the prohibition of riba. It

was, therefore, allowed for them that they sell the goods in advance.

After receiving their cash price, they could easily undertake the aforesaid business.

Salam was beneficial to the seller, because he received the price in advance, and it

was beneficial to the buyer also, because normally, the price in Salam used to be

lower than the price in spot sales. The permissibility of Salam was an exception to

the general rule that prohibits the forward sales, and therefore, it was subjected to

some strict conditions. These conditions are summarized below:

CONDITIONS OF SALAM

1. First of all, it is necessary for the validity of Salam that the buyer pays the price

in full to the seller at the time of affecting the sale. It is necessary because in the

absence of full payment by the buyer, it will be tantamount to sale of a debt against

a debt, which is expressly prohibited in ISLAM. Moreover, the basic wisdom

behind the permissibility of Salam is to fulfill the instant needs of the seller. If the

price is not paid to him in full, the basic purpose of the transaction will be

defeated. Therefore, all the Muslim jurists are unanimous on the point that full

payment of the price is necessary in Salam.

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However, Imam Maliki is of the view that the seller may give a concession of two

or three days to the buyers, but this concession should not form part of the

agreement

2. Salam can be affected in those commodities only the quality and quantity of

which can be specified exactly. The things whose quality or quantity is not

determined by specification cannot be sold through the contract of Salam. For

example, precious stones cannot be sold on the basis of Salam, because every piece

of precious stones is normally different from the other either in its quality or in its

size or weight and their exact specification is not generally possible.

3. Salam cannot be affected on a particular commodity or on a product of a

particular field or farm. For example, if the seller undertakes to supply the wheat of

a particular field, or the fruit of a particular tree, the Salam will not be valid,

because there is a possibility that the crop of that particular field or the fruit of that

tree is destroyed before delivery, and, given such possibility, the delivery remains

uncertain. The same rule is applicable to every commodity the supply of which is

not certain.

4. It is necessary that the quality of the commodity (intended to be purchased

through Salam) is fully specified leaving no ambiguity which may lead to a

dispute. All the possible details in this respect must be expressly mentioned.

5. It is also necessary that the quantity of the commodity is agreed upon in

unequivocal terms. If the commodity is quantified in weights according to the

usage of its traders, its weight must be determined, and if it is quantified through

measures, its exact measure should be known. What is normally weighed cannot be

quantified in measures and vice versa.

6. The exact date and place of delivery must be specified in the contract.

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7. Salam cannot be affected in respect of things which must be delivered at spot.

For example, if gold is purchased in exchange of silver, it is necessary, according

to Shari‘ah, that the delivery of both be simultaneous. Here, Salam cannot work.

Similarly, if wheat is bartered for barley, the simultaneous delivery of both is

necessary for the validity of sale. Therefore the contract of Salam in this case is not

allowed.

SALAM AS A MODE OF FINANCING

Salam was allowed by Shari‘ah to fulfill the needs of farmers and traders.

Therefore, it is basically a mode of financing for small farmers and traders. This

mode of financing can be used by the modern banks and financial institutions,

especially to finance the agricultural sector. As pointed out earlier, the price in

Salam may be fixed at a lower rate than the price of those commodities delivered at

spot. In this way, the difference between the two prices may be a valid profit for

the banks or financial institutions. In order to ensure that the seller shall deliver the

commodity on the agreed date, they can also ask him to furnish a security, which

may be in the form of a guarantee or in the form of mortgage or hypothecation.

In the case of default in delivery, the guarantor may be asked to deliver the same

commodity, and if there is a mortgage, the buyer / the financier can sell the

mortgaged property and the sale proceeds can be used either to realize the required

commodity by purchasing it from the market, or to recover the price advanced by

him. The only problem in Salam which may agitate the modern banks and financial

institutions is that they will receive certain commodities from their clients, and will

not receive money. Being conversant with dealing in money only, it seems to be

cumbersome for them to receive different commodities from different clients and

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to sell them in the market. They cannot sell those commodities before they are

actually delivered to them, because it is prohibited in Shari‘ah.

But whenever we talk about the Islamic modes of financing, one basic point should

never be ignored. The point is that the concept of the financial institutions dealing

in money only is foreign to Islamic Shari‘ah. If these institutions want to earn a

halal profit, they shall have to deal in commodities in one way or the other,

because no profit is allowed in Shari‘ah on advancing loans only.

Therefore, the establishment of an Islamic economy requires a basic change in the

approach and in the outlook of the financial institutions. They shall have to

establish a special cell for dealing in commodities. If such a special cell is

established, it should not be difficult to purchase commodities through salam and

to sell them in the spot markets.

ISTISNA

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.

Areas of Application:

Istisna contracts open wide fields of application for the Islamic banks to finance

the public needs and the vital interests of the society to develop the Islamic

economy. Istisna contracts are applied in high technology industries such as the

aircraft industry, locomotive and ship building industries, in addition to the

different types of machines produced in large factories or workshops. The Istisna

contract is also applied in the construction industry for apartment buildings,

hospitals, schools, and universities.

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‘Istisna’’ is the second kind of sale where a commodity is transacted before it

comes into existence. It means to order a manufacturer to manufacture a specific

commodity for the purchaser. If the manufacturer undertakes to manufacture the

goods for him with material from the manufacturer, the transaction of istisna’

comes into existence. But it is necessary for the validity of istisna’ that the price is

fixed with the consent of the parties and that necessary specification of the

commodity (intended to be manufactured) is fully settled between them.

The contract of istisna’ creates a moral obligation on the manufacturer to

manufacture the goods, but before he starts the work, any one of the parties may

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cancel the contract after giving a notice to the other.12 However after the

manufacturer has started the work, the contract cannot be cancelled unilaterally.

DIFFERENCE BETWEEN ISTISNA AND SALAM

Keeping in view this nature of istisna’ there are several points of difference

between istisna’ and Salam which are summarized below:

(i) The subject of istisna’ is always a thing which needs manufacturing, while

salam can be effected on anything, no matter whether it needs manufacturing or

not.

(ii) It is necessary for salam that the price is paid in full in advance, while it is not

necessary in istisna’.

(iii) The contract of salam, once effected, cannot be cancelled unilaterally, while

the contract of istisna’ can be cancelled before the manufacturer starts the work.

(iv) The time of delivery is an essential part of the sale in salam while it is not

necessary in istisna’ that the time of delivery is fixed.

DIFFERENCE BETWEEN ISTISNA AND IJARAH

It should also be kept in mind that the manufacturer, in istisna’, undertakes to make

the required goods with his own material. Therefore, this transaction implies that

the manufacturer shall obtain the material, if it is not already with him, and shall

undertake the work required for making the ordered goods with it. If the material is

provided by the customer, and the manufacturer is required to use his labor and

skill only, the transaction is not istisna’. In this case it will be a transaction of

ijarah whereby the services of a person are hired for a specified fee paid to him.

When the required goods have been manufactured by the seller, he should present

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them to the purchaser. But there is a difference of opinion among the Muslim

jurists whether or not the purchaser has a right to reject the goods at this stage.

Imam Abu Hanifah is of the view that he can exercise his ‘option of seeing’

(khiyar-ur-ru’yah) after seeing the goods, because istisna’ is a sale and if

somebody purchases a thing which is not seen by him, he has the option to cancel

the sale after seeing it. The same principle is also applicable to istisna’.

However, Imam Abu Yusuf says that if the commodity conforms to the

specifications agreed upon between the parties at the time of the contract, the

purchaser is bound to accept the goods and he cannot exercise the option of seeing.

This view has been preferred by the jurists of the Ottoman Empire, and the Hanafi

law has been codified according to this view, because it is damaging in the context

of modern trade and industry that after the manufacturer has used all his resources

to prepare the required goods, the purchaser cancels the sale without assigning any

reason, even though the goods are in full conformity with the required

specifications.

TIME OF DELIVERY

As pointed out earlier, it is not necessary in istisna’ that the time of delivery is

fixed. However, the purchaser may fix a maximum time for delivery which means

that if the manufacturer delays the delivery after the appointed time, he will not be

bound to accept the goods and to pay the price In order to ensure that the goods

will be delivered within the specified period, some modern agreements of this

nature contain a penal clause to the effect that in case the manufacturer delays the

delivery after the appointed time, he shall be liable to a penalty which shall be

calculated on daily basis.

ISTISNA AS A MODE OF FINANCING

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Istisna’ can be used for providing the facility of financing in certain transactions,

especially in the house finance sector. If the client has his own land and he seeks

financing for the construction of a house, the financier may undertake to construct

the house at that open land, on the basis of istisna’, and if the client has no land and

he wants to purchase the land also, the financier may undertake to provide him a

constructed house on a specified piece of land. Since it is not necessary in istisna’

that the price is paid in advance, nor is it necessary that it is paid at the time of

delivery, (it may be deferred to any time according to the agreement of the parties),

and therefore, the time of payment may be fixed in whatever manner they wish.

The payment may also be in installments.

On the other hand, it is not necessary that the financier himself constructs the

house. He can enter into a parallel contract of istisna’ with a third party, or may

hire the services of a contractor (other than the client). In both cases, he can

calculate his cost and fix the price of istisna’ with his client in a manner which may

give him a reasonable profit over his cost. The payment of installments by the

client may start, in this case, right from the day when the contract of istisna’ is

signed by the parties, and may continue during the construction of the house and

after it is handed over to the client.

In order to secure the payment of the installments, the title deeds of the house or

land, or any other property of the client may be kept by the financier as a security,

until the last installment is paid by the client.

The financier, in this case, will be responsible for the construction of the house in

full conformity with the specifications detailed in the agreement. In the case of any

discrepancy, the financier will undertake such alteration at his own cost as may be

necessary for bringing it in harmony with the terms of the contract.

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The instrument of istisna’ may also be used for project financing on similar lines.

If a client wants to install an air-conditioning plant in his factory, and the plant

needs to be manufactured, the financier may undertake to prepare the plant through

the contract of istisna’ according to the aforesaid procedure. Similarly, the contract

of istisna’ can be used for building a bridge or a highway.

The modern BOT (Buy, Operate and Transfer) agreements may also be formalized

on the basis of istisna’. If a government wants to construct a highway, it may enter

into a contract of istisna’ with a builder. The price of istisna’, in this case, may be

the right of the builder to operate the highway and collect tolls for a specified

period.

TAKAFUL (INSURANCE)

Takaful, the Islamic alternative to insurance is based on the concept of social

solidarity, cooperation and mutual indemnification of losses of members.

It is a deal among a group of persons who agree to jointly indemnify the loss or

damage that may inflict upon any of them, out of the fund they donate collectively.

Takaful is insurance based on mutual co-operation, responsibility, protection and

assistance between groups of participants. It is akin to a cooperative insurance

wherein members contribute a specific sum of money to a common pool.

Every policyholder pays his subscription to help those that need assistance. Losses

are divided and liabilities spread according to the community pooling system.

The principles of takaful are as follows:

1. Policyholders cooperate among themselves for their common good.

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2. Policyholders contributions are considered as donations to the fund (pool)

3. Every policyholder pays his subscription to help those who need assistance.

4. Losses are divided and liabilities spread according to the community pooling

system.

5. Uncertainty is eliminated concerning subscription and compensation.

6. It does not derive advantage at the cost of others.

Theoretically, takaful is perceived as cooperative or mutual insurance, where

members contribute a certain sum of money to a common pool. The purpose of this

system is not profits, but to uphold the principle of "bear ye one another's burden".

Commercial insurance is strictly disallowed for Muslims (as agreed upon by most

contemporary scholars) because it contains the following elements:

Al-Gharar   (uncertainty)

Al-Maisir   (gambling)

Riba   ( usury )

There are four models (and several variations) of how takaful can be implemented:

Mudarabah model (profit-sharing): the manager (shareholders) are

sharing Profit and Losses with the policyholders; used initially in Far East.

Wakala   model: agency fee received up front from the contributions and

transferred to shareholders fund.

A combination of both: Bahrain, UAE and Middle East countries.

Al Waqf model: mainly used in Pakistan and South Africa.

SUKUK

Generally, Sukuk are asset-backed, stable income, tradable and Shariah compatible

trust certificates. The primary condition of issuance of Sukuk is the existence

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of assets on the balance sheet of the government, the monetary authority, the

corporate body, the banking and financial institution or any entity which wants to

mobilize the financial resources. The identification of suitable assets is the first,

and arguably most integral, step in the process of issuing Sukuk certificates.

Shariah considerations dictate that the pool of assets should not solely be

comprised of debts from Islamic financial contracts (e.g. Murabaha, Istisna).

TYPES OF SUKUK

The proper classification of the asset classes will also determine the type of

certificates to be issued. It is imperative to note that these assets can be prepared

for the issuance of trust certificates in a number of ways conditional to the need of

the issuing entity.

Embedded Sukuk

These could be Sukuk whether zero-coupon, pure-Ijara or hybrid, with the

embedded option to convert into other asset forms depending on specified

conditions.

Pure Ijarah Sukuk

These certificates are issued on stand-alone assets identified on the balance sheet.

The assets can be parcels of land to be leased or leased equipment such as aircrafts

and ships. The rental rates of returns on these Sukuk can be both fixed and floating

depending on the particular originator.

Hybrid/Pooled Sukuk

The underlying pool of assets can comprise of Istisna’, Murabahah receivables as

well as Ijarah. Indeed, having a portfolio of assets comprising of different classes

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allows for a greater mobilization of funds as previously inaccessible Murabaha and

Istisna assets can comprise a portfolio.

IJARAH

“Ijarah” is a term of Islamic fiqh. In other words, it means ‘to give something on

rent’. In the Islamic jurisdiction, the term ‘ijarah’ is used for two different

situations. In the first place, it means ‘to employ the services of a person on wages

given to him as a consideration for his hired services.’ The employer is called

musta’jir while the employee is called ajir. Therefore, if A has employed B in his

office as a manager or as a clerk on a monthly salary, A is musta’jir, and B is an

ajir. Similarly, if A has hired the services of a porter to carry his baggage to the

airport, A is a musta’jir while the porter is an ajir, and in both cases the transaction

between the parties is termed as ijarah. This type of ijarah includes every

transaction where the services of a person are hired by someone else. He may be a

doctor, a lawyer, a teacher, a laborer or any other person who can render some

valuable services.

Each one of them may be called an ‘ajir’ according to the terminology of Islamic

law, and the person who hires their services is called a ‘musta’jir’, while the wages

paid to the ajir are called their ‘ujrah’.

The second type of ijarah relates to the usufructs of assets and properties, and not

to the services of human beings. ‘Ijarah’ in this sense means ‘to transfer the

usufruct of a particular property to another person in exchange for a rent claimed

from him.’ In this case, the term ‘ijarah’ is analogous to the English term ‘leasing’.

Here the lessor is called ‘mu’jir’, the lessee is called ‘musta’jir’ and the rent

payable to the lessor is called ‘ujrah’. Both these kinds of ‘ijarah’ are thoroughly

discussed in the literature of Islamic jurisprudence and each one of them has

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its own set of rules. But for the purpose of the present book, the second type of

ijarah is more relevant, because it is generally used as a form of investment, and as

a mode of financing also.

The rule of ijarah, in the sense of leasing, is very much analogous to the rules of

sale, because in both cases something is transferred to another person for a

valuable consideration. The only difference between ijarah and sale is that in the

latter case the corpus of the property is transferred to the purchaser, while in the

case of ijarah, the corpus of the property remains in the ownership of the

transferor, but only its usufruct i.e. the right to use it, is transferred to the lessee.

Therefore, it can easily be seen that ‘ijarah’ is not a mode of financing in its origin.

It is a normal business activity like sale.

However, due to certain reasons, and in particular, due to some tax concessions it

may carry, this transaction is being used in the Western countries for the purpose

of financing also. Instead of giving a simple interest - bearing loan, some financial

institutions started leasing some equipment’s to their customers. While fixing the

rent of this equipment, they calculate the total cost they have incurred in the

purchase of these assets and add the stipulated interest they could have claimed on

such an amount during the lease period. The aggregate amount so calculated is

divided on the total months of the lease period, and the monthly rent is fixed on

that basis.

The question whether or not the transaction of leasing can be used as a mode of

financing in Shari‘ah depends on the terms and conditions of the contract. As

mentioned earlier, leasing is a normal business transaction and not a mode of

financing. Therefore, the lease transaction is always governed by the rules of

Shari‘ah prescribed for ijarah. Let us, therefore, discuss the basic rules

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governing the lease transactions, as enumerated in the Islamic Fiqh. After the study

of these rules, we will be able to understand under what conditions the ijarah may

be used for the purpose of financing.

Although the principles of ijarah are so numerous that a separate volume is

required for their full discussion, we will attempt in this chapter to summarize

those basic principles only which are necessary for the proper understanding of the

nature of the transaction and are generally needed in the context of modern

economic practice. These principles are recorded here in the form of brief notes, so

that the readers may use them for quick reference.

Basic Rules of Leasing

1. Leasing is a contract whereby the owner of something transfers its usufruct to

another person for an agreed period, at an agreed consideration.

2. The subject of lease must have a valuable use. Therefore, things having no

usufruct at all cannot be leased.

3. It is necessary for a valid contract of lease that the corpus of the leased property

remains in the ownership of the seller, and only its usufruct is transferred to the

lessee. Thus, anything which cannot be used without consuming cannot be leased

out. Therefore, the lease cannot be affected in respect of money, eatables, fuel and

ammunition etc. because their use is not possible unless they are consumed. If

anything of this nature is leased out, it will be deemed to be a loan and all the rules

concerning the transaction of loan shall accordingly apply. Any rent charged on

this invalid lease shall be an interest charged on a loan.

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4. As the corpus of the leased property remains in the ownership of the lessor, all

the liabilities emerging from the ownership shall be borne by the lessor, but the

liabilities referable to the use of the property shall be borne by the lessee.

Example:

A has leased his house to B. The taxes referable to the property shall be borne by

A, while the water tax, electricity bills and all expenses referable to the use of the

house shall be borne by B, the lessee.

5. The period of lease must be determined in clear terms.

6. The lessee cannot use the leased asset for any purpose other than the purpose

specified in the lease agreement. If no such purpose is specified in the agreement,

the lessee can use it for whatever purpose it is used in the normal course. However

if he wishes to use it for an abnormal purpose, he cannot do so unless the lessor

allows him in express terms.

7. The lessee is liable to compensate the lessor for every harm to the leased asset

caused by any misuse or negligence on the part of the lessee.

8. The leased asset shall remain in the risk of the lessor throughout the lease period

in the sense that any harm or loss caused by the factors beyond the control of the

lessee shall be borne by the lessor.

9. A property jointly owned by two or more persons can be leased out, and the

rental shall be distributed between all the joint owners according to the proportion

of their respective shares in the property.

10. A joint owner of a property can lease his proportionate share to his co-sharer

only, and not to any other person.

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11. It is necessary for a valid lease that the leased asset is fully identified by the

parties.

Example: A said to B. “I lease you one of my two shops.” B agreed. The lease is

void, unless the leased shop is clearly determined and identified.

12. The rental must be determined at the time of contract for the whole period of

lease.

It is permissible that different amounts of rent are fixed for different phases during

the lease period, provided that the amount of rent for each phase is specifically

agreed upon at the time of affecting a lease. If the rent for a subsequent phase of

the lease period has not been determined or has been left at the option of the lessor,

the lease is not valid.

Example (1): A leases his house to B for a total period of 5 years.

The rent for the first year is fixed as Rs. 2000/- per month and it is agreed that the

rent of every subsequent year shall be 10% more than the previous one. The lease

is valid.

Example (2): In the above example, A puts a condition in the agreement that the

rent of Rs. 2000/- per month is fixed for the first year only. The rent for the

subsequent years shall be fixed each year at the option of the lessor. The lease is

void, because the rent is uncertain.

The determination of rental on the basis of the aggregate cost incurred in the

purchase of the asset by the lessor, as normally done in financial leases, is not

against the rules of Shari‘ah, if both parties agree to it, provided that all other

conditions of a valid lease prescribed by the Shari‘ah are fully adhered to.

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14. The lessor cannot increase the rent unilaterally, and any agreement to this

effect is void.

15. The rent or any part thereof may be payable in advance before the delivery of

the asset to the lessee, but the amount so collected by the lessor shall remain with

him as ‘on account’ payment and shall be adjusted towards the rent after its being

due.

16. The lease period shall commence from the date on which the leased asset has

been delivered to the lessee, no matter whether the lessee has started using it or

not.

17. If the leased asset has totally lost the function for which it was leased, and no

repair is possible, the lease shall terminate on the day on which such loss has been

caused. However, if the loss is caused by the misuse or by the negligence of the

lessee, he will be liable to compensate the lessor for the depreciated value of the

asset as; it was immediately before the loss.

Lease as a Mode of Financing

Like murabahah, lease is not originally a mode of financing. It is simply a

transaction meant to transfer the usufruct of a property from one person to another

for an agreed period against an agreed consideration. However, certain financial

institutions have adopted leasing as a mode of financing instead of long term

lending on the basis of interest. This kind of lease is generally known as the

‘financial lease’ as distinguished from the ‘operating lease’ and many basic

features of actual leasing transaction have been dispensed with therein.

When interest-free financial institutions were established in the near past, they

found that leasing is a recognized mode of finance throughout the world. On

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the other hand, they realized that leasing is a lawful transaction according to

Shari‘ah and it can be used as an interest-free mode of financing. Therefore,

leasing has been adopted by the Islamic financial institutions, but very few of them

paid attention to the fact that the ‘financial lease’ has a number of characteristics

more similar to interest than to the actual lease transaction. That is why they started

using the same model agreements of leasing as were in vogue among the

conventional financial institutions without any modification, while a number of

their provisions were not in conformity with Shari‘ah.

As mentioned earlier, leasing is not a mode of financing in its origin. However, the

transaction may be used for financing, subject to certain conditions. It is not

sufficient for this purpose to substitute the name of ‘interest’ by the name of ‘rent’

and replace the name of ‘mortgage’ by the name of ‘leased asset’. There must be a

substantial difference between leasing and an interest-bearing loan.

Securitization of Ijarah

The arrangement of ijarah has a good potential of securitization which may help

create a secondary market for the financiers on the basis of ijarah. Since the lessor

in ijarah owns the leased assets, he can sell the asset, in whole or in part, to a third

party who may purchase it and may replace the seller in the rights and obligations

of the lessor with regard to the purchased part of the asset. Therefore, if the lessor,

after entering into ijarah, wishes to recover his cost of purchase of the asset with a

profit thereon, he can sell the leased asset wholly or partly either to one party or to

a number of individuals. In the latter case, the purchase of a proportion of the asset

by each individual may be evidenced by a certificate which may be called ‘ijarah

certificate’. This certificate will represent the holder’s proportionate ownership in

the leased asset and he will assume the rights and obligations of the owner/lessor to

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that extent. Since the asset is already leased to the lessee, lease will continue with

the new owners, each one of the holders of this certificate will have the right to

enjoy a part of the rent according to his proportion of ownership in the asset.

Similarly he will also assume the obligations of the lessor to the extent of his

ownership. Therefore, in the case of total destruction of the asset, he will suffer the

loss to the extent of his ownership. These certificates, being an evidence of

proportionate ownership in a tangible asset, can be negotiated and traded in freely

in the market and can serve as an instrument easily convertible into cash. Thus they

may help in solving the problems of liquidity management faced by the Islamic

banks and financial institutions.

It should be remembered, however, that the certificate must represent ownership of

an undivided part of the asset with all its rights and obligations. Misunderstanding

this basic concept, some quarters tried to issue ijarah certificates representing the

holder’s right to claim certain amount of the rental only without assigning to him

any kind of ownership in the asset. It means that the holder of such a certificate has

no relation with the leased asset at all. His only right is to share the rentals received

from the lessee. This type of securitization is not allowed in Shari‘ah. As explained

earlier in this chapter, the rent after being due is a debt payable by the lessee. The

debt or any security representing debt only is not a negotiable instrument in

Shari‘ah, because trading in such an instrument amounts to trade in money or in

monetary obligation which is not allowed, except on the basis of equality, and if

the equality of value is observed while trading in such instruments, the very

purpose of securitization is defeated. Therefore, this type of ijarah certificates

cannot serve the purpose of creating a secondary market. It is, therefore, necessary

that the ijarah certificates are designed to represent real ownership of the leased

assets, and not only a right to receive rent.

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Head-Lease

Another concept developed in the modern leasing business is that of ‘head-

leasing.’ In this arrangement a lessee sub-leases the property to a number of sub-

lessees. Then, he invites others to participate in his business by making them share

the rentals received by his sub lessees. For making them participate in receiving

rentals, he charges a specified amount from them. This arrangement is not in

accordance with the principles of Shari‘ah. The reason is obvious. The lessee does

not own the property. He is entitled to benefit from its usufruct only. That usufruct

he has passed on to his sub-lessees by contracting a sub-lease with them. Now he

does not own anything, neither the corpus of the property, nor its usufruct. What he

has is the right to receive rent only. Therefore, he assigns a part of this right to

other persons. It is already explained in detail that this right cannot be traded in,

because it amounts to selling a receivable debt at a discount which is one of the

forms of riba prohibited by the Holy Qur’an and Sunnah. Therefore, this concept is

not acceptable.

These are some basic features of the ‘financial lease’ which are not in conformity

with the dictates of Shari‘ah. While using the lease as an Islamic mode of finance,

these shortcomings must be avoided.

Product Name Category/ Nature Characteristics

Murabaha Asset based

Cost Plus Financing

Bank purchases the commodity and resells

it at a predetermined higher price.

To the capital user, disclosing the margin

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of profit included in the sales price.

The client pays for the goods in deferred

payments or over a stated installment

Period.

In case of default the client is liable only

for the contracted sale price.

Mudarabah Asset based

Liability based

Profit Sharing

Under Mudarabah, one party provides

100% capital and the other party manages

the investment project.

Profits are shared in a pre-agreed ratio

whereas losses accrued are borne by the

provider of capital only.

Mudarabah is often used for investment

funds, where investor provides money to

the Islamic bank, which the bank invests

charging a management fee.

Ijarah Asset based

Leasing

The bank buys and leases out the asset for

a rental fee, which includes the capital

cost of the equipment plus a profit margin.

The ownership of the equipment remains

with the lessor bank and in case of finance

lease is transferred on pre-determined

terms.

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Available under both operating lease and

finance lease (Ijara).

Widely used in house and aircraft

financing.

Istisna Asset based

Commissioned

Manufacturing

Under Istisna a party (bank) undertakes to

produce a specific thing that is possible to

be made according to agreed

specifications at a determined price and

fixed date of delivery.

As banks do not normally carry out

manufacturing, a parallel contract for

manufacture is instituted.

The bank charges the buyer the price it

pays to the manufacturer plus a

Reasonable profit (monetary installment)

and takes the risk of manufacture of the

asset.

Musharakah Joint Venture Under Musharakah, all the partners

contribute funds and have right to

participate in the management of the

business.

Profits are shared in an agreed ratio but

losses are shared in the ratio of capital

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invested.

Contributions can be made either in cash

or in kind.

Takaful Islamic insurance Takaful is insurance based on mutual co-

operation, responsibility, protection and

assistance between groups of participants.

It is akin to a cooperative insurance

wherein members contribute a specific

sum of money to a common pool.

Every policyholder pays his subscription

to help those that need assistance.

Losses are divided and liabilities spread

according to the community pooling

system.

The current market size is USD 4.6

billion.

Salam Forward Selling 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.

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Sukuk Islamic Bond Sukuks are similar to conventional bonds

with the difference that these are asset

backed and represent proportionate

beneficial ownership in the underlying

asset.

Sukuk holders are entitled to a share in the

revenues generated and in the proceeds of

the realization of the Sukuk assets.

ISLAMIC BANKING – AN INTRODUCTION

Islamic banks appeared on the world scene as active players over two decades ago.

But "many of the principles upon which Islamic banking is based have been

commonly accepted all over the world, for centuries rather than decades".

Since the mid 1970’s Islamic banks have been growing at a very fast rate. This

banks were not only established in the countries were Islam is the major religion

like Egypt, Syria , Jordan ,United Arab Emirates, Bahrain ,Kuwait Tunisia &

Malaysia but also in the United Kingdom, Denmark & Philippines where it is a

minority religion. An International Islamic bank, The Islamic Development Bank,

whose shareholders are the members of the Organization of Islamic Conference

(OIC), acts as the sponsor of Islamic banking and finance in the wider Muslim

world. This is in addition to the efforts made in the early 1980’s by Pakistan and

Iran to transform the entire financial systems to interest- free (‘Islamic’) systems.

An Islamic Bank is a financial institution that operates with the objective to

implement and materialize the economic and financial principles of Islam in the

banking arena.

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The Organization of Islamic conference (OIC) defined an Islamic Bank as “a

financial institution whose statutes, rules and procedures expressly state its

commitment to the principles of Islamic Shariah and to the banning of the receipt

and payment of interest on any of its operations.”

According to Islamic Banking Act 1983 of Malaysia, an Islamic Bank is a

“company which carries on Islamic Banking business. Islamic Banking business

means banking business whose aims and operations do not involve any element

which is not approved by the religion Islam.”

The objective of Islamic Banking is not only to earn profit, but to do well and bring

welfare to the people. Islamic Banks operate on Islamic principles of profit and

loss sharing and other approved modes of Investment.

An Islamic Bank is committed to do away with disparity and establish justice in

the economy, trade, commerce and industry; build socio-economic infrastructure

and create employment opportunities.

The basic principle of Islamic banking is the prohibition of Riba- (Usury - or

interest).

The Islamic Banking institution is a new and constantly evolving concept. In

relation to the Western way of banking, the Islamic Banking system is free of

interest. One might wonder what the incentive to lend money would be. Others

may not understand what benefits could be had by putting their savings into a bank

account. While Muslims do not believe in charging or earning interest, they have

developed a very complex alternative that is being implemented all over the

eastern world. Started from just an idea, this new way of banking quickly spread

through the Muslim countries, and has continued to expand all over Europe and

Asia.

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While a basic tenant of Islamic banking - the outlawing of Riba, a term that

encompasses not only the concept of usury, but also that of interest - has seldom

been recognized as applicable beyond the Islamic world, many of its guiding

principles have. The majority of these principles are based on simple morality and

common sense, which form the bases of many religions, including Islam.

Islamic Banking as an Idea

The scholar of the recent past in early fifties started writing for Islamic Banking in

place of Interest Free Banking. In the next two decades Islamic Banking attracted

more attention.

Early seventies saw the institutional involvement. Conference of the Finance

Ministers of the Islamic Countries was held. The involvement of institutions and

Government led to the application of theory to practice and resulted in the

establishment of the Islamic Banks. In this process the ‘Islamic Development

Bank (IDB)’ was established in 1975.

EVOLUTION OF INSTITUTIONAL FRAMEWORK

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This overview is to provide deeper or custom research support on this topic.

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FINANCIAL COMPARISON OF ISLAMIC BANKING WITH

CONVENTIONAL BANKING

Before we define what an Islamic bank is like, it is better to give a short

description of conventional banking. Conventional banking does not follow one

pattern. In Anglo-Saxon countries, commercial banking dominates, while in

Germany, Switzerland, the Netherlands, and Japan, universal banking is the rule.

Naturally, then, a comparison between banking patterns becomes inevitable

Commercial banking is based on a pure financial intermediation model, whereby

banks mainly borrow from savers and then lend to enterprises or individuals. They

make their profit from the margin between the borrowing and lending rates of

interest. They also provide banking services, like letters of credit and guarantees. A

proportion of their profit comes from the low-cost funds that they obtain through

demand deposits. Commercial banks are prohibited from trading and their

shareholding is severely restricted to a small proportion of their net worth.

Because of the fractional reserve system, they produce derivative deposits, which

allow them to multiply their low-cost resources. The process of bank lending is,

however, subject to some problems that can make it inefficient. Borrowers usually

know more about their own operations than lenders. Acting as lenders, banks face

this information asymmetry. Because borrowers are in a position to hold back

information from banks, they can use the loans they obtain for purposes other than

those specified in the loan agreement exposing banks to unknown risks. They can

also misreport their cash flows or declare bankruptcy fraudulently. Such problems

are known as moral hazard. The ability of banks to secure repayment depends a

great deal on whether the loan is effectively used for its purpose to produce enough

returns for debt servicing. Even at government level, several countries have

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borrowed billions of dollars, used them unproductively for other purposes and

ended up with serious debt problems. Banks can ascertain the proper use of loans

through monitoring but it is either discouraged by clients or is too costly and,

hence, not commercially feasible. Hence, why the purpose for which the loan is

given plays a minimal role in commercial banking. It is the credit rating of the

borrower that plays a more important role.

By contrast, universal banks are allowed to hold equity and also carry out

operations like trading and insurance, which usually lie beyond the sphere of

commercial banking. Universal banks are better equipped to deal with information

asymmetry than their commercial counterparts. They finance their business

customers through a combination of shareholding and lending. Shareholding

allows universal banks to sit on the boards of directors of their business customers,

which enables them to monitor the use of their funds at a low cost. The reduction

of the monitoring costs reduces business failures and adds efficiency to the

banking system.

One must refrain from making a direct comparison between Islamic banking and

conventional banking (apple to apple comparison). This is because they are

extremely different in many ways. The key difference is that Islamic Banking is

based on Shariah foundation. Thus, all dealing, transaction, business approach,

product feature, investment focus, responsibility are derived from the Shariah law,

which lead to the significant difference in many part of the operations with as of

the conventional

The foundation of Islamic bank is based on the Islamic faith and must stay within

the limits of Islamic Law or the Shariah in all of its actions and deeds. The original

meaning of the Arabic word Shariah is 'the way to the source of life' and is now

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used to refer to legal system in keeping with the code of behavior called for by the

Holly Qur'an (Koran). Amongst the governing principles of an Islamic bank are:

The absence of interest-based (riba) transactions;

The avoidance of economic activities involving oppression (zulm)

The avoidance of economic activities involving speculation (gharar)

The introduction of an Islamic tax, (zakat)

The discouragement of the production of goods and services which

contradict the Islamic value (haram)

On the other hand, conventional banking is essentially based on the debtor-creditor

relationship between the depositors and the bank on one hand, and between the

borrowers and the bank on the other. Interest is considered to be the price of credit,

reflecting the opportunity cost of money.

Islamic law considers a loan to be given or taken, free of charge, to meet any

contingency.  Thus in Islamic Banking, the creditor should not take advantage of

the borrower. When money is lent out on the basis of interest, more often that it

leads to some kind of injustice. The first Islamic principle underlying for such kind

of transactions is "deal not unjustly, and ye shall not be dealt with unjustly" which

explain why commercial banking in an Islamic framework is not based on the

debtor-creditor relationship.

The other principle pertaining to financial transactions in Islam is that there should

not 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.

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Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-

mentioned principles. Consequently financial relationships in Islam have been participatory in nature.

Conventional System Islamic System

Money is a product besides medium of

exchange and store of value.

Real Asset is a product. Money is just

a medium of exchange.

Time value is the basis for charging

interest on capital.

Profit on exchange of goods &

services are the basis for earning

profit.

Interest is charged even in case, the

organization suffers losses. Thus no

concept of sharing loss.

Loss is shared when the organization

suffers loss.

While disbursing cash finance, running

finance or working capital finance, no

agreement for exchange of goods &

services is made.

The execution of agreements for the

exchange of goods & services is must,

while disbursing funds under

Murabaha, Salam & Istisna contracts.

Due to nonexistence of goods &

services behind the money while

disbursing funds, the expansion of

money takes place, which creates

inflation.

Due to existence of goods & services

no expansion of money takes place

and thus no inflation is created.

Due to inflation the entrepreneur

increases prices of his goods &

services, due to incorporating

Due to control over inflation, no extra

price is charged by the entrepreneur.

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inflationary effect into cost of product.

Bridge financing and long term loans

lending are not made on the basis of

existence of capital goods. Rather, they

are disbursed on the basis of Window

Dressed project feasibility and

credibility of the entrepreneur.

Musharakah & Diminishing

Musharakah agreements are made

after making sure the existence of

capital good before disbursing funds

for a capital project.

Government very easily obtains loans

from Central Bank through Money

Market Operations without initiating

capital development expenditure.

Government cannot obtain loans from

the Monetary Agency without making

sure the delivery of goods to National

Investment fund.

The expanded money in the money

market without backing the real assets,

results deficit financing.

Balance budget is the outcome of no

expansion of money.

Real growth of wealth does not take

place, as the money remains in few

hands.

Real growth in the wealth of the

people of the society takes place, due

to multiplier effect and real wealth

goes into the ownership of lot of

hands.

Due to failure of the projects the loan is

written off as it becomes non-

performing loan.

Due to failure of the project, the

management of the organization can

be taken over to hand over to a better

management.

Debts financing gets the advantage of Sharing profits in case of

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leverage for an enterprise, due to

interest expense as deductible item

form taxable profits. This causes huge

burden of taxes on salaried persons.

Thus the saving and disposable income

of the people is affected badly. This

results decrease in the real gross

domestic product.

Mudarabah and sharing in the

organization of business venture in

case of Musharakah, provides extra

tax to Federal Government. This leads

to minimize the tax burden over

salaried persons. Due to which

savings & disposable income of the

people is increased, this results the

increase in the real gross domestic

product.

Due to decrease in the real GDP, the

net exports amount becomes negative.

This invites further foreign debts and

the local-currency becomes weaker.

Due to increase in the real GDP, the

net exports amount becomes positive,

this reduces foreign debts burden and

local-currency becomes stronger.

The functions and operating modes of

conventional banks are based on fully

manmade principles.

The functions and operating modes of

Islamic banks are based on the

principles of Islamic Shariah.

The investor is assured of a

predetermined rate of interest.

In contrast, it promotes risk sharing

between provider of capital (investor)

and the user of funds (entrepreneur).

It aims at maximizing profit without

any restriction.

It also aims at maximizing profit but

subject to Shariah restrictions.

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It does not deal with Zakat. In the modern Islamic banking system,

it has become one of the service-

oriented functions of the Islamic banks

to be a Zakat Collection Centre and

they also pay out their Zakat.

Lending money and getting it back

with compounding interest is the

fundamental function of the

conventional banks.

Participation in partnership business is

the fundamental function of the Islamic

banks. So we have to understand our

customer's business very well.

It can charge additional money

(penalty and compounded interest) in

case of defaulters.

The Islamic banks have no provision to

charge any extra money from the

defaulters. Only small amount of

compensation and these proceeds is

given to charity. Rebates are given for

early settlement at the Bank's

discretion.

Very often it results in the bank's own

interest becoming prominent. It makes

no effort to ensure growth with equity.

It gives due importance to the public

interest. Its ultimate aim is to ensure

growth with equity.

For interest-based commercial banks,

borrowing from the money market is

relatively easier.

For the Islamic banks, it must be based

on a Shariah approved underlying

transaction.

Since income from the advances is

fixed, it gives little importance to

developing expertise in project

appraisal and evaluations.

Since it shares profit and loss, the

Islamic banks pay greater attention to

developing project appraisal and

evaluations.

The conventional banks give greater The Islamic banks, on the other

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emphasis on credit-worthiness of the

clients.

hand, give greater emphasis on the

viability of the projects.

The status of a conventional bank, in

relation to its clients, is that of creditor

and debtors.

The status of Islamic bank in relation

to its clients is that of partners,

investors and trader, buyer and seller.

A conventional bank has to guarantee

all its deposits.

Islamic bank can only guarantee

deposits for deposit account, which is

based on the principle of al-

wadiah, thus the depositors are

guaranteed repayment of their funds,

however if the account is based on the

mudarabah concept, client have to

share in a loss position.

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RESEARCH METHODLOGY

METHODOLOGY / DESIGN OF THE STUDY

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TITLE OF THE STUDY

A COMPREHENSIVE ANALYSIS ON ISLAMIC FINANCIAL

PRODUCTS, ITS FEATURES AND AN OVERVIEW OF ISLAMIC

BANKING WITH SPECIAL REFERENCE TO MIDDLE EAST AND

OTHER COUNTRIES

Statement of the problem

The study was conducted to analyze the importance and impact of Islamic financial

instruments in the world of Islamic Banking and to gain knowledge on the concept,

growth and importance of Islamic banking as a form of Banking especially in the

countries like The Middle East, Malaysia including European countries. The study

tries to shed light on its concept and the need to implement Islamic Banking and

the roadblock it would face in its implementation in India.

Scope of the study

The study on ‘Islamic Financial Products and Islamic Banks’ is subject to the

analysis of the Financial instruments and confined with its comparison with

conventional banks, its implementation in various countries. It covers the

consolidated balance sheet, the Deposits made by customers and the Financial

Institutions of the Islamic Banking Sector.

Objective of the Study

Primary objective

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To study the Islamic financial products, its system and merits

Secondary objective

To study the uses of financial techniques.

To analyze the feature of Islamic instruments with conventional financial

instruments.

To show the growth and development of Islamic banking in middle east and

other parts of the world.

To bring about an awareness of Islamic banking in India.

To explore the perception of people regarding Islamic Banking.

To find out which Islamic Banks do people know of.

To see how many people use Islamic Banking and why.

Limitations of the study

The coverage area or the ambit of the study is confined to Bangalore only.

Data was collected on random basis.

Limit sample size of twenty five.

Biased responses from the respondents.

The study is a worm’s eye view of ISLAMIC BANKING.

Methodology

For the purpose of preparing the report the necessary information collected are

divided into two heads i.e. Primary Data and Secondary Data.

Primary Data is collected through a telephonic interview.

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Secondary Data is collected through

1. Magazines

2. Newspapers (eg., Economic times, Deccan Chronicle, etc.)

3. Internet

4. E-Books.

Sample Size: Twenty Five

Area of coverage: Bangalore

Sample Unit: It consisted of people from banks, qualified personnel of educational

institutions and general public.

Analytical Tools Used:

Consolidated Balance Sheet

Statement of Deposits

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DATA ANALYSIS AND INTERPRETATION

DATA ANALYSIS AND INTERPRETATION

GLOBAL TAKAFUL CONTRIBUTIONS

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TABLE 1.1

Year Compound Annual Growth Rate

GCC South East

Asia

Africa Indian Sub-

Continent

Levant

2008 770 474 121 5 14

2009 1239 544 181 8 17

2010 2089 695 256 11 18

2011 2846 901 276 76 22

2012 3742 1146 299 104 28

GRAPH 1.1

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INTERPRETATION

The global Takaful contribution in Islamic banking has shown an increasing trend

over a period of time. From this we can interpret that the GCC countries have

made majority contributions to the TAKAFUL (Insurance) industry when

compared to other countries and continents.

The Indian sub-continent has the major CAGR of 135%. Thus showing an

impressive growth rate in the field of TAKAFUL (Insurance)

AVERAGE RETURN ON EQUITY FOR THE TAKAFUL OPERATORS IN

GCC AND MALAYSIA

145

GRAPH 1.2

INTERPRETATION

In Malaysia the average ROE has shown a constant growth over the numbers of

years as there has been strong contribution from its consumers/customers.

Whereas on the other hand GCC countries ROE is not constant and stable due to

the changes in the consumer/ customer behavior pattern. In GCC countries ROE

was most affected during the year 2008-2010 due to the Global Financial

Meltdown. The percentages shown the graph depicts the fair and true picture of

ROE in Malaysia and GCC.

GLOBAL SUKUK(ISLAMIC BONDS) ISSUANCE

TABLE 1.2

145

YEAR

(IN BILLION $)

MENA*

(IN BILLION $)

REST OF THE

WORLD

(NO OF SUKUK

ISSUED)

SUKUK ISSUANCE

2002 1 2 25

2003 2 4 27

2004 3 5 28

2005 2.5 4 45

2006 4 7.5 100

2007 12 20 100

2008 18 35 125

2009 8 15 160

2010 7 24 200

2011 (QUARTER1) 2 5 55

2011* 7 26 125

MENA – MIDDLE EAST AND NORTH AFRICA

2011* - DEALS RUMOURED/ ANNOUNCED

GRAPH 1.3

145

INTERPRETATION

The Islamic bond, or sukuk, market experienced a very mixed year in 2010. Global

offerings of sukuk picked up by 43 per cent from the 2009 level, but this

performance was marred by two defaults. Up until the middle of 2009, the sukuk

market enjoyed a bull run in parallel with the rapid expansion in the global

economy. But it also suffered in the downturn as well; after a record-breaking $1.1

billion sukuk issued in August 2008, the market collapsed and has been struggling

to revive ever since. By the end of 2009, global sukuk offerings had fallen to

$14.1bn, down from the record high achieved in 2008 of $27.2bn. The market

fared slightly better last year, as the global economy started its slow recovery and

by year-end, the global issuance of sukuk had risen to $20.2bn. This turnaround

145

has continued into 2011; up to May this year, some $4.6bn in Islamic bonds had

been issued, a rise of almost a quarter on the corresponding period in 2010.

Malaysia still leads the sukuk market by a long way, making up for nigh on two-

thirds of the total market. Collectively, the Gulf states are the second largest issuer,

but the United Arab Emirates (UAE) accounts for the lion’s share of this, issuing

almost a quarter of all global sukuk. The UAE’s sukuk market is certainly the most

developed in the Gulf. Not only has it issued the largest ever Sukuks–in 2005,

Dubai Civil Aviation Authority issued the first $1bn sukuk, and in December 2007,

Nakheel far surpassed this with its own $3.5bn sukuk – but it has also proved the

most innovative.

Saudi Arabia’s sukuk market is underdeveloped; prior to 2010, it had only issued

four sukuk of note. But its sukuk market picked up in 2010 and it issued close to

$3bn worth of sukuk, a similar level to the value of sukuk in the UAE. Because of

the size of the Saudi market, its sukuk are generally large, proving that it is likely

to quickly become a major player in the global sukuk market.

The Gulf sukuk market remains a potent force in the global Islamic debt industry.

The Gulf Co-operation Council as a whole constitutes around 40 per cent of the

global total, although, on account of a 4.3 per cent drop in GCC sukuk issuance as

liquidity in the region tightened, its share slipped slightly to 39.6 per cent in 2010,

from 41 per cent the previous year. However, in the final quarter of last year, both

the regional and global sukuk market showed signs of revival. Global offerings

rose to over $8bn in the final quarter, with the government of Dubai issuing the

largest single sukuk, worth $1.3bn.

TOTAL ASSESTS OF ISLAMIC BANKS IN THE GCC (GULF CO-

OPERATION COUNCIL) REGIONS

145

TABLE 1.3

YEAR

(IN BILLIONS)

SUKUK ISSUANCE

(IN BILLIONS)

CUMULATIVE SUKUK

ISSUANCE

2004 1 0.5

2005 1 1.5

2006 2 2.5

2007 2 3

2008 4 5

2009 19 24

2010 30 62

2011 18 78

2012 21 100

GRAPH 1.4

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INTERPRETATION

The graph and the table represents the increasing trend and growth of sukuk

(Islamic Bonds) issuance and cumulative sukuk issuance over a period of time.

Every year it can be noted that more and more sukuks(islamic bonds).

Even during the period of economic downturn the number of sukuks issued kept

rising.

It can be inferred from the table (1.3) that during 2012 sukuks worth 21 billion $

were issued and sukuks worth 22 billion $ were added which made the cumulative

sukuk issued by the end of 2012 to rise up to 100 billion $.

BREAKDOWN OF BANKING ASSETS IN GCC COUNTRIES

TABLE 1.4

145

YEAR

(IN BILLION $)

ISLAMIC

BANKING

ASSETS

(IN BILLION $)

CONVENTIONAL

BANKING ASSETS

(IN BILLION $)

TOTAL GCC*

2007 50 400 450

2008 75 425 500

2009 125 500 625

2010 175 635 810

2011 200 900 1100

2012 300 1000 1300

*GCC – GULF CO-OPERATION COUNCIL

GRAPH 1.5

145

INTERPRETATION

This graph and table depicts the breakdown of banking assets in GCC countries.

The conventional banking assets has got a majority share as and when compared to

Islamic banking assets, this shows that there is still dominance of conventional

banking over Islamic banking. The main reason behind this scenario is that

Conventional banking has got various avenues when compared to Islamic banking.

However we can say that Islamic banking assets have grown over the years

showing an increasing trend.

MARKET PENETRATION OF ISLAMIC BANKING IN GCC (GULF CO-

145

OPERATION COUNCIL) COUNTRIES

TABLE 1.5

COUNTRIES

(IN BILLIONS)

TOTAL BANKING

ASSETS

(IN BILLIONS)

ISLAMIC BANKING

ASSETS

UAE 400 60

SAUDI ARABIA 340 125

BAHRAIN 250 25

KUWAIT 140 50

QATAR 110 25

OMAN 40 -

GRAPH 1.6

INTERPRETATION

145

The graph and the table depicts the comparison of total banking assets and Islamic

Banking assets.

It can be interpreted that Total Banking Assets are more in UAE where as Islamic

Banking Assets are more in Saudi Arabia.

It can be also noted that there is no presence of Islamic Banking Assets in OMAN.

BREAKDOWN OF TOTAL BANKING ASSETS IN THE GCC

GRAPH 1.7

INTERPRETATION

145

The launch of new asset classes suggests that many Gulf investors have lost

interest in yet another GCC -focused real estate fund.

Global Islamic fund assets stagnated at $52.3 billion in 2012, barely registering an

increase on the $51.4bn posted in 2011. In contrast, the global conventional mutual

fund assets under management exhibited signs of recovery from their lows of $19

trillion in 2011, reaching $22 trillion in 2012. The research reveals that only 29

new Islamic funds were launched in 2012, almost offsetting the 27 Islamic funds

that were liquidated during the same period. This compares to 173 that were

launched in the market’s 2010 peak. This slowdown has corrected a steady growth

in the Islamic asset management industry over the past two decades, reflecting a

longer-term trend that has seen an increasing spread of asset classes available for

Islamic investors since Saudi Arabia’s National Commercial Bank of Saudi Arabia

launched the first Sharia-compliant fund back in 1987. New investment banks have

sprung up to service robust demand for Sharia funds, while international banks

have reengineered their existing asset management services to suit the needs of this

market.

Almost 70 per cent of Islamic fund managers are struggling to build scale and have

under $75m in assets under management, while 55 per cent have less than $50m.

Yet, the Islamic fund industry has significant room to grow if assets are reallocated

from investment accounts to funds.

ISLAMIC FUNDS LAUNCHED BY ASSET CLASS

TABLE: 1.6

145

YEAR REAL

ESTATE

COMMODITIES BALANCED MONEY

MARKET

OTHER FIXED

INCOME

EQUITY

2010 18 13 11 18 20 14 79

2011 10 3 3 5 15 5 37

2012 3 3 2 4 4 3 3

GRAPH 1.8

145

INTERPRETATION

The Islamic fund has been raised from various classes of assets such as real estate,

commodities, money markets, fixed income securities, equties and other

incomes.The majority of funds has been raised from equties where as the least has

been from the commodities market.During the year 2011-2012 there was a dcrease

in the income of funds from these assets as the reason for this was Global Financial

Meltdown.

ISLAMIC BANKINGS EUROPEAN MARKET SHARE

TABLE 1.7

145

Country Population (millions)

Muslim

Population

(millions)

Percentage

France 61.00 6.10 10%

UK 60.00 1.8 3%

Germany 83.6 3.25 3.89%

Italy 56.00 1.39 2.5%

Spain 42.10 0.60 1.43%

Belgium 10.70 0.39 3.65%

Sweden 9.30 0.31 3.33%

Austria 8.50 0.22 2.6%

Denmark 5.60 0.19 3.4%

Cyprus 0.95 0.24 25.26%

Turkey 72.10 72.00 99.89%

Switzerland 7.80 0.25 3.2%

INTERPRETATION

There are more than 14.74 million Muslims in Europe, of which 1.8 million are

resident in the UK plus an additional 72 million in Turkey. There are 360,000

Muslim households in the UK.

145

The following table illustrates the potential market size in mainland Europe for an

Islamic bank, as well as highlights the potential for extra-European expansion in

countries such as Turkey.

The UK is the first country in Europe to promote and encourage retail Islamic

banking and it is in the process of embracing Islamic financial techniques by

introducing new laws to facilitate further market entry and practice of Islamic

finance in the UK.

The Muslims from Middle East and Africa represent 24% of the total Muslim

population in the UK.

Islamic banking in Europe will inevitably focus on both the retail and institutional

customers as these are the two major dominant players in the market. As the table

clearly illustrates there is a significant retail market opportunity in Europe for new

retail banks, but in terms of sheer volume of transactions the institutional market

provides the more lucrative opportunity for the Islamic banks.

MARKET SHARE OF ISLAMIC BANKING

GRAPH 1.9

145

INTERPRETATION

Islamic banks are located in 50 countries worldwide and can be found in countries

like Algeria, Azerbaijan and Yemen. Major Islamic Banking hubs are Malaysia,

Bahrain, UK and UAE.

Conventional banks try to extend their line of service by Islamic Banking. And

Islamic banks are expanding their network globally.

Recently there is a lot of talk about Islamic Banking as it seems to have proofed

more resilient than conventional banking.

145

However the total number of Islamic banks is still small and according to online-

researches conducted by Shariah-Fortune estimated at around 350-400 institutions

worldwide. Compared to around 9,500 banks located in the USA the Islamic

Banking sector still seems pretty small.

But its relative small numbers bear potential for extraordinary growth rates.

According to estimates Islamic Banking is one of the world's fasted growing

financial sectors; rising 15-20 % p.a. Asian Banker Research Group found out that

growth rate is as high as 26.7 % among the 100 largest Islamic banks.

GROWTH OF ISLAMIC BANKING

GRAPH 2.0

INTERPRETATION

145

The deposits of Islamic banking have increased from 28650 billion $ in the year

2011 to 34730 billion $ in the year 2012. The Investments of Islamic banking too

have increased from 26540 billion $ in the year 2011 to 34910 billion $ in the year

2012. This statistics shows that there has been a stable growth and development of

Islamic banks globally.

Islamic Banking in the Middle East

Though Islamic banking has been around for quite some time, the first experiment

in modern times began in 1963 in Egypt. Now, local players led by Saudi Arabia’s

Al Rajhi Banking & Investment Corporation and Islamic Development Bank,

Kuwait’s Kuwait Finance House, Bahrain’s First Islamic Investment Bank and Al-

Baraka Islamic Investment Bank, and UAE’s Dubai Islamic Bank and Abu Dhabi

Islamic Bank have been joined by global financial institutions across the Middle

East.

Attracted by the region’s $1.5-trillion funds, Western banks such as HSBC,

Citigroup, Society General, ABN AMRO, Deutsche Bank, Standard Chartered, and

BNP Paribas have set up Islamic divisions or even spun off separate banks to cater

to this unique segment.

The key drivers behind this gold rush are clearly the recent economic boom in the

Gulf region, a steep rise in per capita income and large volume repatriation of

funds long parked overseas.

With rising crude prices, oil revenue is surging to fill companies’ and investors’

treasure chests further. Among other sectors such as realty, the boom has

145

triggered new growth in the financial sector with a rise in demand for Sharia-

compliant products. The total bank deposits in the region are expected to increase

at a cumulative annual growth rate.

While some consumers opt for a pure-play bank, a hybrid one may be sufficient to

satisfy others. In Saudi Arabia, 75 percent of consumer deposits and half of all

bank deposits are in non-interest bearing accounts. In the UAE, such accounts

constitute only 25 percent of total deposits.

From Jakarta to Jeddah to Jordan, 280 Islamic banks operate in over 50 countries,

with assets estimated between $250 billion and $300 billion. Some 35 percent of

these institutions are in the Middle East. It is estimated that Islamic banks will

account for 40 to 50 percent of the total savings of Muslims in 8 to 10 years.

According to the International Islamic Finance Forum, the banks’ holdings are

growing by 15 percent a year. The value of Islamic loans is growing at an annual

rate of 40 percent, which is likely to increase. With rising demand, the number of

banks offering Islamic products worldwide is expected to grow more than 50

percent in this fiscal.

Islamic Banking in the GCC (Gulf Cooperation Council) Countries

145

Propelled by rising oil prices and economic diversification, GCC countries are

growing rapidly. Islamic banks that offer Islamic banking units, have a market that

holds half of the world’s oil reserves and whose citizens have an estimated $1.5

trillion in private wealth, according to the International Monetary Fund. Research

predicts that Gulf banks will continue to display solid financials, capitalization and

liquidity in the foreseeable future.

GCC’s financial strength has attracted local, regional and international players who

are offering Islamic products either through Islamic ‘windows’ or by setting up

fully Islamic banks.

Up until 2004, Kuwait had allowed only one Islamic banking institution to operate

within its borders. The oil-rich nation has since relaxed its rules allowing new

banks such as the Boubyan Bank to set up shop. The Kuwait Real Estate Bank has

moved on to being an Islamic entity.

In the UAE, the Abu Dhabi Islamic Bank and Dubai Islamic Bank have dominated

the financial market for years. However, there is more competition now with banks

like the Emirates Bank Group setting up Islamic divisions. The three major banks

in Qatar (Qatar National Bank, Doha Bank and Commercial Bank of Qatar)

entered the Islamic banking sector.

In Saudi Arabia, the Al Rajhi Bank has enjoyed a virtual monopoly position for

decades. But the story has changed with Al Jazira turning into an Islamic bank and

the National Commercial Bank all set to become a full-fledged player in five years.

A new bank, Al Bilad, will focus on developing retail products in this space.

Banks complying with Sharia now account for over a quarter of all banking

assets within the Gulf Co-operation Council

145

Islamic banks in the Gulf may count their blessings that the tenets of Sharia

prevented them from investing in sub-prime mortgages and so from falling victim

to the crisis which caused so much pain among conventional lenders.

Islamic banks in the capital markets may have drawn solace from the fact that the

value of sukuk, or Islamic bonds, issued worldwide during 2010 rebounded to

$23.3 billion, up from a paltry $14.9bn the year before. The total was short of the

record value of $34.3bn seen in 2009. Asian issuers accounted for more than 60

per cent of the total value of sukuk issued around the world in 2012, with Malaysia

alone making up just over half of the total.

It is worth noting, too, that governments and entities related to governments,

accounted for most of the issuance of Islamic bonds during 2010. This is good in

one way because it gives the market more breadth and depth. The more sukuk that

governments issue, the easier it is for riskier borrowers to price their own issues

thanks to the benchmark established by the sovereign or quasi-sovereign sukuk.

Yet it also reinforces the fact that issuers from the private sector, particularly those

in the Gulf, have yet to regain their zeal.

Islamic financial services turning on regulation and governance

The assets (loans) boasted by the world’s top 500 Islamic banks rise to a total of

$822 billion during 2010, compared with $639 billion the year before. The value of

those of banks in the six countries of the Gulf Co-operation Council (GCC)

reached a total of $285 billion at the last count. That gives them 22 per cent of the

worldwide market for Islamic finance, more than double the total five years earlier.

More important still is the fact that banks complying with Sharia now account for

just over a quarter of all banking assets within the GCC. Yet this is still less than

145

the share of Islamic assets accounted for by the Islamic windows of conventional

banks.

The result is that Islamic funds under management still account for a mere 5.5 per

cent of the total market for finance complying with Sharia. Small wonder then that

the value of assets worldwide held by funds complying with Sharia, at $52 billion,

remained more or less flat during 2010. Or that the industry itself faces difficult

choices. Some 70 per cent of firms managing Islamic funds have less than $100

million under their charge.

Profitability is also in question among Islamic insurers .Takaful as an industry has

grown at a compound annual rate within the GCC of 40 per cent in recent years, a

pace that outstrips that of conventional insurance even in budding markets such as

Asia. Yet such is the proliferation of business models and tactics employed within

the industry that its profitability varies widely.

Competition is so fierce in certain parts of the Gulf that motor insurance has

become largely a loss leader. In other words, takaful operators have cut their rates

so low that they expect to make money only from selling other forms of cover to

existing clients. So far, the growth in other markets has more than compensated.

Partly this is because economies in the region such as Saudi Arabia have made

medical insurance compulsory; partly also because of the growing popularity of

what is known as family takaful – protection for life and individual savings, some

of them linked to education. Together, these two sectors now account for nearly

half of all contributions to takaful companies in the Middle East and North Africa.

Islamic banking extends beyond the Middle East

145

The Islamic finance industry has started to gain major momentum outside of the

Middle East. As more financial institutions begin to introduce Sharia-compliant

banking products and services, the growth of this market segment provides a new

opportunity for financial institutions located in the Middle East to export their

business outside of the region to serve the more than 1 billion Muslims living

worldwide.

For instance, in November 2011, the Central Bank of Malaysia announced that

before the end of 2011 it would issue a license to a new Islamic bank, jointly

established by institutions from the Middle East and Asia. Currently, Malaysia is

responsible for more than 60 percent of the world’s $130 billion outstanding

Islamic bonds, allowing the new bank the ability to facilitate the larger issuance of

such notes.

Additionally, Malaysia has shown an increased interest in Islamic finance and has

taken significant actions to help make it more widely available throughout the

country through international road shows, training programs aimed at regulatory

bodies (such as the Islamic Markets Program organized by the Securities Industry

Development Corporation), and public engagements.

Even amidst the global financial crisis, Islamic banking has remained steady and

largely unshaken by the economy primarily due to its more cautious attitude

towards money. Instead of using financial instruments as derivatives, Sharia law

bans insurance and investment gains, as well as excessive risk-taking and trading

in debt. Islamic banks also do not collect late payment fees.

145

Therefore, when the economy suffers, individuals are protected from losing out as

well. The resilience of the Islamic banking market in spite of the global crisis has

encouraged more countries to use Islamic principles to help run their economies.

The security of the Islamic banking market has drawn in many countries from

outside of the Middle East, who are showing an increased willingness to embrace

Sharia-compliant banking products and services. By introducing new laws and

regulations to permit the practice of Islamic banking, countries have simplified

the process that Middle Eastern banks must follow to open new branches and

introduce Sharia-compliant banking products and services to customers.

To ensure that financial institutions in the Middle East will be successful in

taking their products and services abroad, it is important that they implement

comprehensive training for their employees. Through training, banks will be able

to build a well-educated staff that is familiar with Sharia-compliant banking

products and services and prepared to effectively communicate them to their

customers.

With the number of Islamic banks growing throughout the world, it is important

for Islamic financial institutions to offer banking products that are competitive

with conventional products offered by other retail banks. It is also important for

employees to become familiar with the appropriate laws and regulations that are

specific to each country.

145

Islamic Banking in the European Countries

Islamic Banking – a golden opportunity for European banks

The Islamic banking market continues to flourish around the world with current

estimates suggesting that assets managed by Islamic banks are in excess of $700

billion - predominately concentrated in the Middle East.

It is a fact that there are sufficient Muslim investors and borrowers in both Islamic

and non-Islamic countries to warrant the attention of traditional banks that seek to

serve such clients and capture a potentially profitable slice of a still relatively

untapped market. This is corroborated by the growth of Islamic finance in the US,

which has a population of over 7 million Muslims.

The challenge for European financial institutions is how to leverage their banking

knowledge and expertise in developing sufficient products and services that fulfill

the requirements of their Islamic customer base while being compliant with Islamic

finance principles.

Trends in Islamic Banking in Europe

The UK has taken a major lead in Europe in promoting and encouraging Islamic

banking activities but this has mainly focused on retail banking and only more

recently on investment banking.

The Financial Services Authorities (FSA) in the UK has only authorized one

Islamic retail bank which is the Islamic Bank of Britain (IBB). Although other

investors have looked into the retail banking arena, no other dedicated competitors

have entered the retail market, mainly due to the level of investment required to

acquire the critical mass customers that are needed to ensure the retail bank is

145

profitable. There is potentially one Islamic retail bank in France called Tayseer

Bank with is going through the authorization process from regulators and should

be operational in the near future.

The major hurdle for any new Islamic retail bank in the UK and Europe is having

banking products that are competitive with conventional products offered by other

retail banks. Also, competitive product development provides opportunities for

potential new entrants into the market to differentiate themselves and add

competitive advantage against existing banks in the market.

More recently in the UK, there have been new Islamic investment banks authorized

by the FSA (Financial Service Authority) including the European Islamic

Investment Bank and the most recent entry, Gatehouse Bank.

In total, there are five Islamic investments banks in the UK focusing on

institutional investors in Europe and also looking to gain institutional funding from

organizations in the Middle East. The Islamic investment banking sector in the UK

has flourished enormously with other potential new entrants in the pipeline.

The trend in the UK seems to be that bankers believe it will be more difficult to

make profitable businesses from the retail customer base while the institutional

market is seen as an area where Islamic banks can make significant inroads into the

European market

STATEMENT OF FINANCIAL POSITION ANALYSIS: ISLAMIC VS

CONVENTIONAL

145

The goal of financial risk management is to maximize the value of a financial

institution as determined by its level of profitability and risk. Since risk is inherent

in banking and unavoidable, the task of the risk manager is to manage the different

types of risk at acceptable levels to achieve optimal profitability. Doing so requires

the continual identification, quantification, and monitoring of risk exposures,

which in turn demands sound policies, adequate organization, efficient processes,

and skilled analysts and elaborates computerized information systems. In addition,

risk management requires the capacity to anticipate changes and to act in such a

way that a bank’s business can be structured and restructured to profit from the

changes or at least to minimize losses. Regulatory authorities should not prescribe

how business is conducted; instead, they should maintain prudent oversight of a

bank by evaluating the risk composition of its assets and by insisting that an

adequate amount of capital and reserves is available to safeguard solvency.

Although the approaches to risk management are diverse, a good starting point is

to undertake a top-down approach starting with the Statement of Financial

Position. One cannot underestimate the importance of understanding the structure

and composition of the Statement of Financial Position of a financial institution.

It is critical to assess the ways in which a bank’s risk managers and analysts can

analyze the structure of Statement Of Financial Positions and Statement Of

Comprehensive Incomes, as well as individual Statement Of Financial Position

items with specific risk aspects so that the interaction between various types of risk

is understood to ensure that they are not evaluated in isolation. The relative share

of various Statement of Financial Position components – assets and liabilities – is a

good indication of the levels and types of risk to which a bank is exposed.

Statement of Financial Position of a conventional bank – based on functionality

145

Assets Liabilities

Loans and advances to customers Customers’ deposits

Cash and cash balances with other

banks

Due to banks and other financial

institutions

Investments in associates,

subsidiaries and joint ventures

Other liabilities

Financial assets held for trading Sundry creditors

Cash and cash balances with the

central bank

Equity and reserves

On the asset side, there is much more diversity and options in the form of

marketable securities, trading accounts, lending to corporations and to consumers.

From the risk point of view, two observations can be made.

First, the deposits create instantaneous pre-determined liabilities irrespective of

the outcome of the usage of the funds on the asset side, thus creating an asset-

liability mismatch.

Second, medium- to long-term assets are financed by the stream of short-term

liabilities, exposing the bank to a maturity mismatch risk and discouraging the

bank from investing in long-term non-liquid projects. An increase in the level of

non-retail deposits or funding could expose a conventional bank to greater

volatility in satisfying its funding requirements, requiring increasingly

sophisticated liquidity risk management. Certain funding instruments also

145

expose a bank to market risk. For Islamic financial institutions, the nature of

financial intermediation, including the function of banking, is different from that of

conventional financial institutions. This is the key to understanding the difference

in the nature of risks in conventional and Islamic banking.

For Islamic banks, the Mudarabah contract is the cornerstone of financial

intermediation and thus of banking. The basic concept is that both the mobilization

and (in theory) the use of funds are based on some form of profit sharing among

the depositors, the bank, and the entrepreneurs (users of funds). The financial

intermediation is merely a ‘pass-through’ arrangement similar to funds

management, with the difference that there are multiple portfolios on the asset side.

Statements of Financial Position of an Islamic bank.

Display of different activities and financial instruments. It serves as a good starting

point for understanding the dynamics of the risks inherent in Islamic banks. This

Statement Of

Financial Position classifies the functionality and purpose of different instruments

– a common practice among Islamic banks.

Statement of Financial Position of an Islamic bank – based on Functionality

Application of funding Sources of funding

Cash balances Demand deposits (Amanah)

Financing assets (Murabaha,

salaam, Ijara, Istisna)

Investment accounts (Mudarabah)

145

Investment assets (Mudarabah,

Musharakah)

Special investment accounts

(Mudarabah, Musharakah)

Fee-based services Reserves

Non-banking assets (property) Equity capital

The structure of a typical Statement of Financial Position has demand deposits and

investment accounts from customers on the liability side and Islamic financing and

investing accounts (the equivalent of conventional banks’ loans to customers) on

the asset side. This pattern reflects the nature of banks as intermediaries, with

ratios of capital to liabilities at such a low level that their leverage would be

unacceptable to any business outside the financial services industry. The analyst

should be able to assess the risk profile of the bank simply by analyzing the

relative share of various asset items and changes in their proportionate share over

time. While the types of liabilities present in an Islamic bank’s Statement of

Financial Position are nearly universal, their exact composition varies greatly

depending on a particular bank’s business and market orientation, as well as the

prices and supply characteristics of different types of liabilities at any given point

in time. The funding structure of a bank directly affects its cost of operation and

therefore determines a bank’s potential profit and level of risk. The structure of a

bank’s liabilities also reflects its specific asset-liability and risk management

policies. When compared with conventional banks, Statement of Financial Position

risk profile of Islamic banks is different.

First, the foremost feature of an Islamic bank is the ‘pass-through’ nature of the

Statement of Financial Position. This feature removes the typical asset-liability

145

mismatch exposure of a conventional bank, as the Islamic bank’s depositors’ return

is linked to the return on the assets of the bank. However, this feature also

introduces some operational issues, such as estimation and accrual of ex-post

returns and the treatment of intra-period withdrawal of deposits.

Second, the nature of assets of two institutions is different. Whereas a

conventional bank tends to stay with fixed income very low credit risk debt

securities, an Islamic bank’s assets are concentrated on the asset-based investments

which has credit risk but are also backed by a real asset. As a result, the lending

capacity of the Islamic banking sector (at least for commercial banks) is bound by

the availability of real assets in the economy. Thus, there is no leveraged credit

creation.

Third, the assets of Islamic banks contain financing assets where tangible goods

and commodities are purchased and sold to the customers. This practice creates

distinct exposures. For example, in case of conventional banking, the asset is

financed by a loan from the bank to the customer whereas in case of an Islamic

bank, the asset and the financing are coupled together. The bank is not limited to

the exposure as a financier but can develop additional exposures resulting from

dealing with physical assets. Another feature which distinguishes the risks of an

Islamic bank from a conventional bank is the general lack of liquid securities on

the asset side. This feature is not a design issue but is a temporal phenomenon until

a well-functioning securities market for Shariah-compliant instruments is

developed.

Finally, due to prohibition of interest, Islamic banks cannot issue debt to finance

the assets which consequently discourages creation of leverage. Due to the lack of

leverage, Islamic banks can be considered less risky during a time of financial

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crisis. The current financial crisis was precipitated by excessive leverage and

complexity in the financial system, which had developed multiple layers of

intermediaries. Hence, the financing – or the claims on assets – became remote

from the underlying assets. For Islamic banks, the financial intermediary is closely

associated with the asset and is able to perform better monitoring of the asset as

well as the obligor. These features can enhance the stability of the banking system.

POTENTIAL GROWTH OF ISLAMIC BANKING IN INDIA

The current Muslim population of the world is 1.8bn and Muslims are about 13.4

% of total population of India, approximately 152mn as per CIA

Given the above mentioned statistics, it becomes imperative to introduce this form

of Banking in India as there exist wide disparity in terms of regions, religions,

languages etc. This disparity provides us with a blue ocean which can be exploited

to make a positive mark on the banking landscape of our country. It would help to

increase the size of the banking industry manifold and prove to be a foundation for

many more innovations to be introduced in future.

The Sachar committee report highlighted that approximately 50% Muslims are

financially excluded. The long held issue of financial inclusion can be taken care

of by introducing Islamic Banking. Majority of Indian Muslims are so poor that

they are not targeted by the Commercial Banks and whose savings lie idle at home.

Muslims in India generally lack credit worthiness primarily because they form part

of “Ghettos” or negative areas, which were drawn back and are still in vogue. It is

here where the actual market potential of Islamic Baking lies.

One may argue that Indian Muslims are satisfactorily u sing the existing

Conventional Banking system. A one to one interview with Bank executives of

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Personal banking division of many Banks revealed that a significant Muslim

population is:

1. Not investing in mutual funds with a debt component

2. Donating the interest on their salary savings account to charity

3. Using a zero-interest current account instead of a savings account

The above steps are diligent efforts made by man y Indian Muslims to make the

current conventional Banking ‘Shariah’ compliant in their own way. This is the

huge market which can be tapped by Islamic Banking.

World over, the Monetary Authority of Singapore has made the develop men t of

Islamic finance as one of its priorities and has accordingly aligned tax policies.

Malaysia has pioneered the art of Islamic Banking. There are currently 11 banks

operating on a full Islamic banking license in Malaysia and eight others that offer

Islamic banking products through a conventional bank window. Malaysian banks

do minted the top ten in The Asian Banker’s 2007 “Top 40 Islamic Banks in Asia

Pacific” report. Even China has opted for Islamic banking to pool Islamic

Investment Funds. This proves the potential of Islamic Banks and definitely India

needs to taste this as well. Islamic Investment business is gaining considerable

grounds and companies like

McKinsey & Company Inc. and Bearys Group have started doing big businesses

through Shariah Investments funds. ‘East wind’ launched Islamic Index; and

‘Reliance Money’ and ‘Religare’ have launched Shariah Complaint Portfolio

Management Services. As a result Indian Stock market is also observing some

better trends in Shariah complaint stocks. According to Sabry Ghouse, head of

retail banking at Al Rajhi in Malaysia, non-Muslim customers now make up a

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sizeable proportion of the entire customer base. “We opened a branch in Puchong,

a suburb in Kuala Lumpur, to specifically target the non-Muslim market,” he says.

Angelo Vernados, author of Islamic Banking and Finance in Southeast Asia: Its

Development and Future, estimates that 75 percent of products sold by May bank

and OCBC Malaysia are to non-Muslims. “It’s not just about Muslim investors,”

he says.

Islamic Banking has a huge market potential in India as India is the 3rd largest

Muslim populated country in the world. It can address the long drawn issue of

‘Financial inclusion’ and will create a feel good factor among Muslims. Muslims

would come out of ‘isolation’ and it can be used as a facilitating tool to combat

terrorism in few states of India. Indian government can gain diplomatic advantages

to make financial dealings with Muslim dominated nations and can attract equity

finance from gulf countries for infrastructure development, thereby financing the

fiscal deficit.

There exist significant challenges to materialize the objective of expansion of

Islamic Banking in India. Lack of experts in this field leads to differences in

interpretation and compliance with Shariah laws. Moreover in case of India,

Banking regulation Act of 1949 needs to be suitably modified to introduce Islamic

Ban king. New Standard Accounting practices have to be developed. Islamic

Banking per say goes against the secular framework of our nation and can create

financial segregation. It can also be exploited politically, so it has to be seen in the

right light.

There is a need to customize and advertise Islamic banking to make it equally

attractive to Non- Muslims. The product trends are positive in India and given the

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double digit growth of Islamic Banking in other Asian countries like Asia and

Singapore, it is definitely available option for India.

SWOT ANALYIS

As per the SWOT Analysis of Islamic Banking done above, it is clear that it faces

many challenges in India. Banks will have to come out of Religious set up and offer

products of wider spectrum to a wider audience. It’s a challenge to provide a

solution that adheres to the basics of the Islamic finance concept and at the same

time remains flexible enough to meet the demands of the changing environment.

There is a need to advertise Islamic Banking so that it could be used by Non-

Muslims as well.

PORTERS FIVE MODEL FORCES SHOW

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IT application has to be strengthened for supporting such a complex business

model. All major IT providers like TCS, Infosys etc. do provide such solutions to

overseas clients, but keeping in mind the strong Regulatory framework of India, IT

process will have to be customized.

Islamic banking experts will have to be brought in and a ‘standard’ accounting and

auditing practice across geographies will have to be introduced and therefore, there

exists a need for improvement of corporate governance and risk management. Due

to scholastic differences within Islam, there exist different interpretations on

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the definition of a product being Shariah compliant. The four teachings, “shafi,

hanafi, hanbali and maliki”, all have subtle differences. There have been many

standardization initiatives, one of which is initiated by the Accounting and Auditing

Organization for Islamic Financial Institution (AAOIFI). The Islamic Financial

Services Board is also working to create common financial reporting standards for

Islamic banks.

There are several other areas that Islamic banks need to strengthen, ranging from

IAS39 based classification and provisioning to SOX compliance and KYC norms.

In the face of the global banking crisis emanating out of subprime mortgage

financing, there will be greater pressure on banking formats like Islamic finance to

propagate them by creating a positive perception among customers while ensuring

adequate and effective risk management Mechanisms. Though much work is being

done, it’s still not known clearly how Basel II will affect Islamic banks and how

exactly risk capital will be derived for better risk management.

FINANCIAL STATEMENT OF ‘THE ISLAMIC BANKING INDUSTRY’

Consolidated Balance Sheet of 3 rd and 4 th quarter

Rs. In ‘000’

Description Sept 12 Dec 12 % change

ASSETS

Cash and balances with treasury bank 12,164,803 15,266,243 25%

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Balances with other banks 15,191,421 16,383,041 8%

Due from financial institutions 300,000 5,602,000 1767%

Investments 6,642,160 7,053,163 6%

Financings 52,620,814 65,137,207 24%

Operating fixed assets 2,151,084 2,517,543 17%

Deferred tax assets 123,189 192,259 56%

Other assets 5,826,290 6,031,374 4%

Total Assets 95,019,761 118,182,830 24%

LIABILITIES

Bills payable 1,127,126 1,259,513 12%

Due to financial institutions 5,052,380 6,547,021 30%

Borrowings from Head office 2,858,400 4,193,833 47%

Deposits and other accounts 66,010,905 83,741,910 27%

Deferred tax liabilities 431,746 491,450 14%

Liabilities against assets subject to

finance lease

- - -

Deferred tax liabilities 431,746 491,450 14%

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Other liabilities 6,762,028 6,101,835 -10%

Total Liabilities 82,242,585 102,335,562 24%

NET ASSETS 12,777,176 15,847,268 24%

REPRESENTED BY

Paid-up capital/Head office capital

account

11,087,161 14,465,290 30%

Reserves 735,463 528,851 -28%

Unappropriated/Unremitted profit 829,239 756,148 -9%

Sub Total 12,651,863 15,750,289 24%

Surplus /(Deficit) on revaluation of

assets

125,313 96,979 -23%

Equity 12,777,176 15,847,268 24%

Analysis of the Consolidated Balance Sheet

The Balance Sheet footing of the Islamic Banking Industry increased during

the past quarter. The total assets portfolio in the Islamic Banking Sector

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expanded by 24% to Rs. 118.183 billion in December 2012 from Rs. 95.020

billion in September 2012.

Financings comprised of 55% of total assets and stood at Rs. 65.137 billion

In December 2012 compared with Rs. 52.621 billion in September 2012

showing an increase of 24%.

Total assets have shown an increase and there is substantial increase in

“Cash and Balances with Treasury Banks” and “Balances with other banks.”

Cash held by Islamic Banking Institutions at the Treasury Banks increased

by 25% to Rs.15.266 billion from Rs. 12.164 billion.

This shows that banks have excess liquid funds which could not be properly

utilized due to non-availability of Shariah Compliant money market

instruments.

Deposit liabilities increased by 27 % to Rs. 83.742 billion as at the end of

December from Rs. 66.011 billion in September 2012.

Islamic Banking Sector equity increased by 24% to Rs. 15.847 billion in

September from Rs. 12.777 billion in September.

Minimum Capital Requirement for conventional banks also applies on

Islamic Banking Institutions because of which the equity of Islamic Banking

Institutions has increased in the last quarter of 2012.

Unappropriated / unremitted profit for the quarter ending December 2012

decreased by 9% to stand at Rs. 756,148 billion compared to last quarter

which was at Rs. 829,239 billion.

STATEMENT OF DEPOSITS OF ‘THE ISLAMIC BANKING INDUSTRY’

Statement of Deposits

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Rs in ‘000’

Sep-12 Dec-12 %Change

Deposits and Other Account 66,010,907 83,741,909 27%

A)Customers

Fixed deposit 24,079,859 30,444,259 26%

Savings deposits 18,849,292 21,371,285 13%

Current accounts -Non

Remunerative

15,083,576 18,281,568 21%

Others 1,064,078 881,083 -17%

Total of A 59,076,805 70,978,195 20%

B) Financial Institutions

FI-Remunerative deposits 6,621,735 12,752,137 93%

FI-Non Remunerative

deposits

312,367 11,577 -96%

Total of B 6,934,102 12,763,714 84%

Particulars of deposits

In local Currency 61,483,322 77,896,068 27%

In Foreign currency 4,527,585 5,845,841 29%

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Total 66,010,907 83,741,909 27%

Analysis of Deposits

Total Deposits have increased by 27% from 66.011 to 83.742 Rupees.

Deposits by customers have increased by 20 % and by financial institutions

by 84%.

The increase in Remunerative Deposits by Financial Institutions has been

the most substantial increase which is almost 93%.

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FINDINGS AND SUGGESTIONS

FINDINGS FROM THE ANALYSIS OF ‘THE ISLAMIC FINANCIAL

PRODUCTS & THE ISLAMIC BANKING INDUSTRY.’

Islamic finance rests on the application of Islamic law, or Shariah. Shariah, and

very much in the context of Islamic finance, emphasizes justice and partnership. In

accordance with the major principles of the Islamic Financial Instruments Wealth

must be generated from legitimate trade and asset-based investment. (The use of

money for the purposes of making money is expressly forbidden.) Investment

should also have a social and an ethical benefit to wider society beyond pure return

and there should be sharing of risk.

Charging and receiving interest (riba) is prohibited. The idea of a lender making a

straight interest charge, irrespective of how the underlying assets fare, transgresses

the concepts of risk sharing, partnership and justice. It represents the money itself

being used to make money. It also prohibits investment in companies that have

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too much borrowing (typically defined as having debt totaling more than 33% of

the firm’s stock market value over the last 12 months). Investments in businesses

dealing with alcohol, gambling, drugs, pork, pornography or anything else that the

Shariah considers unlawful or undesirable (haram).Uncertainty, where transactions

involve speculation, or extreme risk. This is seen as being akin to gambling. This

prohibition, for example, would rule out speculating on the futures and options

markets. Mutual insurance (which relates to uncertainty) is permitted if it is related

to reasonable, unavoidable business risk. It is based upon the principle of shared

responsibility for shared financial security, and that members contribute to a

mutual fund, not for profit, but in case one of the members suffers misfortune.

Uncertainty about the subject matter and terms of contracts which is inclusive of

the prohibition on selling something that one does not own. There are special

financial techniques available for contracting to manufacture a product for a

customer. This is necessary because the product does not exist, and therefore

cannot be owned, before it is made. A manufacturer can promise to produce a

specific product under certain agreed specifications at a determined price and on a

fixed date. Specifically, in this case, the risk taken is by a bank which would

commission the manufacture and sell the goods on to a customer at a reasonable

profit for undertaking this risk. Once again the bank is exposed to considerable

risk. Avoiding contractual risk in this way means that transactions have to be

explicitly defined from the outset.

Therefore, complex derivative instruments and conventional short sales or sales on

margin are prohibited under Islamic finance.

Twenty-five years ago Islamic banking was considered a wishful thinking.

However, serious research work of the past two and half decades has shown that

Islamic banking is a feasible and viable way of financial intermediation. A

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number of Islamic banks have also been established during this period under

heterogeneous social and economic milieu. The successful operation of these

institutions and the countrywide experiences in Pakistan, Iran, and Sudan and

partly in Malaysia are sufficient to show that Islamic banking offers an alternative

method of commercial banking.

The commendable achievements during the last twenty years should not lead ONE

to ignore the problems that Islamic banking is facing. While many problems are a

result of the inappropriate environment in which Islamic banks are working, there

are others which have arisen from the practices of Islamic banks themselves.

The real and ideal instruments of financing in Shari‘ah are Musharakah and

Mudarabah. When a financier contributes money on the basis of these two

instruments it is bound to be converted into the assets having intrinsic utility. Profits

are generated through the sale of these real assets.

Financing on the basis of Salam and Istisna also creates real assets. The financier in

the case of Salam receives real goods and can make profit by selling them in the

market. In the case of Istisna, financing is affected through manufacturing some real

assets, as a reward of which the financier earns profit.

Financial leases and murabahah are not originally modes of financing. But, in order

to meet some needs they have been reshaped in a manner that they can be used as

modes of financing, subject to certain conditions, in those sectors where

Musharakah, Mudarabah, Salam or Istisna are not workable for some reasons. The

instruments of leasing and murabahah are sometimes criticized on the ground that

their net result is often the same as the net result of an interest based borrowing.

INFLUENCE OF ISLAMIC BANKING ON CONVENTIONAL BANKING

SYSTEM

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Conventional banking is struggling with its own destructive baggage and

increasing loss of jobs while the Islamic banking market has seen expansion of

almost 35%.

Especially in America and Britain, conventional commercial banking and

investment bankers are seeing continued pressures and contraction of demand for

services along with a declining market. Islamic sources see nothing but promise for

the future in an area that is vastly under-served. Conventional bankers are looking

to expand continually into emerging markets in an effort to save themselves and

spread the risk. Some are even attempting to break into the Islamic banking market

with new thinking based on sharia law.

Commercial conventional bankers in the U.S. and Britain are firmly addicted to the

liquidity of auctions from central bankers in those countries. International bankers

and bank holding companies are not so fortunate in terms of easy cash. Instead,

they are forced to seek investment from global sovereign powers in an effort to

save their skin from an untimely demise, as they seek to prop up their failing bonds

and investments. The dilemma stems from the excessive use of securitized bonds

across the board as a means to boost profits. The cancer of these failing and often

outright fraudulent bonds threatens to tumble the global commercial banking

economy.

Global central bankers often referred to on this website as the International Society

of Bankers, have taken a step back from investing using the same parameters of the

past. Instead they are either holding on to their money or finding new sources of

investment like insurance and hedge funds.  Like the precarious global situation,

this too will change. Meanwhile, central bankers hold on to the majority of gold

and precious metals as they seek more of the same, viewed as the only truly secure

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means of monetary commerce. As they seek to increase their wealth and hold of

power using paper money, most Muslim bankers seek to keep themselves free from

the hold of global central bankers.

Era of Competition

With new entrants and foreign banks now seeking a piece of the action, GCC’s

established Islamic banks are facing competitive pressures. Large banking entities

in the GCC like Al Rajhi, the Kuwait Finance House and the Dubai Islamic Bank

have a bright future. But several start-ups – like Al Rayan Bank (which has $2

billion in capital), Gulf Finance House, Arcapita Bank, Unicorn Investment Bank,

Al Masref, Boubyan Bank, and Bank Albilad – are now shaking up the market.

At the same time, there are signs of consolidation in the market: Recent examples

include the March 2007 merger between the National Bank of Dubai and the

Emirates Bank International, which created the largest bank in the Middle East by

total assets.

Adding to the action in the region are some of the largest international banks

including Citibank, HSBC and Standard Chartered. Although their market share

here is small when compared to local counterparts, these global players are at the

forefront in offering new products, such as credit cards.

In this scenario, as competition increases, small local players may face

sustainability issues. While some may merge, others may become targets for

foreign takeovers. Some banks, on the other hand, may opt for joint ventures. For

instance, in June 2006, Deutsche Bank announced a joint venture with Ithmaar

Bank of Bahrain and Abraaj Capital of Dubai to launch a $2-billion Islamic fund.

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HSBC has established a strong presence through its UAE and Saudi Arabia-based

subsidiary, Amanah. UBS has an Islamic bank in Dubai while Citigroup offers

Islamic mortgages in UAE. Citigroup, Merrill Lynch, Morgan Stanley and

Deutsche Bank are gearing up to list Islamic structured products on the Dubai

International Financial Exchange.

The Islamic banks and its financial instruments face a number of problems.

First, they have not yet been successful in devising an interest-free mechanism to

place their funds on a short-term basis. They face the same problem in financing

consumer loans and government deficits.

Second, the risk involved in profit-sharing seems to be so high that most of the

banks have resorted to those techniques of financing which bring them a fixed

assured return. As a result, there is a lot of genuine criticism that these banks have

not abolished interest but have in fact only changed the nomenclature of their

transactions.

Third, the Islamic banks do not have the legal support of central banks of their

respective countries (except in Pakistan and Iran), which exposes them to great

risks.

Fourth, the Islamic banks do not have the necessary expertise and trained

manpower to appraise, monitor, evaluate and audit the projects they are required to

finance. As a result, they cannot expand despite having excess liquidity. The future

of Islamic banks hinges, by and large, on their ability to find a viable

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alternative to interest for financing all types of loans. They should recognize that

their success in abolishing interest has been at least partial and they have yet to go

a long way in their search for a satisfactory alternative to interest. Simultaneously,

Islamic banks need to improve their managerial capabilities by training their

personnel in project appraisal, monitoring, evaluation and performance auditing.

Fifth Musharakah provides better opportunities for the depositors to share actual

profits earned by the business which in normal cases may be much higher than the

rate of interest. Since the profits cannot be determined unless the relevant

commodities are completely sold, the profits paid to the depositors cannot be added

to the cost of production, therefore, unlike the interest-based system the amount

paid to the depositors cannot be claimed back through increase in the prices. This

philosophy cannot be translated into reality unless the use of the Musharakah is

expanded by the Islamic banks. It is true that there are practical problems in using

the Musharakah as a mode of financing especially in the present atmosphere where

the Islamic banks are working in isolation and, mostly without the support of their

respective governments.

Sixth by ignoring the instrument of Musharakah the Islamic banks are forced to

use the instrument of murabahah and ijarah and these too, within the framework of

the conventional benchmarks like Libber etc. where the net result is not materially

different from the interest based transactions.

Unfamiliarity with the Islamic Banking and its Financial System

The first problem is that despite the growth of Islamic banks over the last 30 years,

many people in the Muslim and non-Muslim world do not understand what Islamic

banking actually is. The basic principle is clear, that it is contrary to Islamic law to

make money out of money and that wealth should accumulate from trade and

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ownership of real assets. However, there does not appear to be a single definition

of what is or not an Islamic-banking product. A major issue here is that it is the

Shariah Councils or Boards at individual Islamic banks that actually define what is

and what not Islamic banking is, and what is and what is not the acceptable way to

do business, which in turn can complicate assessment of risk for both the bank and

its customer

The Regulatory environment  

The relationship between Islamic banks and monetary authorities is a delicate one.

The central bank exercises authority over Islamic banks under laws and regulations

engineered to control and supervise both traditional banks. Whatever the goals and

functions are, Islamic banks came into existence in an environment where the laws,

institutions training and attitude are set to serve an economy based on the

principles of interest. The operations of Islamic banks are on a profit and loss share

basis (PLS), which actually does not come fully under the jurisdiction of the

existing civil laws. If there are disputes to be handled, civil courts are not

sufficiently acquainted with the rationale of the operations of Islamic Banking.

Regarding the protection of depositors, Islamic Banks are required to let the

authorities know the difference between money paid into current accounts and

money paid into investment accounts.

Absence of Liquidity Instrument

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;

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the resulting non-compatibility prevents the central banks from controlling or

giving support to Islamic banks if a liquidity gap should occur. So the issue of

liquidity management must come under active discussion and scrutiny by the

authorities involved is Islamic banking

Use of Advanced Technology and Media

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

growing need of their clients. The importance of using proper advanced technology

in upgrading the acceptability of a product and diversifying its application cannot

be over emphasized. Given the potentiality of advanced technology, Islamic banks

must have to come to terms with rapid changes in technology, and redesign the

management and decision-making structures and, above, all introduce modern

technology in its operations. Many Islamic banks also lack the necessary expertise

and institutional capacity for Research and Development (R & D) that is not only

necessary for the realization of their full potential, but also for its very survival in

this age of fierce competition, sophisticated markets and an informed public.

Islamic banking cannot but stagnate and wither without dynamic and ongoing

programmes. 

Islamic banking presence in world economy

During the past decade, the assets of Islamic banks have grown at an average rate

of 15%. Many developed countries of the world, such as Germany, UK, USA,

France and Singapore have embraced Islamic Banking to take the tally of countries

where this form of banking is already operational as an alternative system.

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The robust performance of the Islamic Banking and Finance sector during the

recent financial downturn has attracted the attention of several other nations.

Major multinational banks including HSBC Amanah, Standard Chartered Saadiq,

Lloyds TSB Bank and Citigroup offer products in accordance with Islamic

Banking principles.

Western nations like the UK are promoting Islamic Finance following the principle

of “no favor, but no discrimination”. Former Prime Minister Gordon Brown, who

was Finance Minister when Islamic Banking was introduced in the UK, was so

confident of the system that he predicted London would become its future gateway.

The results today vindicate his predictions. This is why, at a time when other banks

are facing closure, the Islamic Bank of Britain is expanding its network in the UK

and being asked to do the same in Europe.

SUGGESTIONS FROM THE ANALYSIS OF ‘THE ISLAMIC FINANCIAL

PRODUCTS & ISLAMIC BANKING.’

Despite all the progress, Islamic banks and their financial instruments have a long

way to go. To keep on a sustainable growth track, they must address critical issues.

One key challenge arises from the varying interpretations of the Sharia across

regions, countries and sometimes even within the same country. What constitutes

an Islamic practice is determined by a bank’s Sharia council, an independent bank-

appointed panel of scholars.

Therefore, what is considered Islamic in Malaysia, may be ‘haram’ (or prohibited)

in Saudi Arabia. This absence of uniform standards affects the banks’ ability to

replicate and implement Islamic products across geographies, attract external

investors and expand to newer markets.

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The council must approve all innovative Islamic instruments but, without a

uniform interpretation, it is difficult for banks to know whether the committee will

give its nod for a particular region or country.

Another challenge is that of the regulatory frameworks that govern Islamic banking

and its Instruments. These frameworks are often at variance leading to operational

road-blocks. This is further compounded by the absence of accounting, auditing

and credit analysis standards for Islamic banks. Not only must Islamic banks

satisfy the Sharia, but they also need to measure up to national policies.

To operate in the globalized economy, these banks must also meet international

requirements such as IAS 39 and Basel II. While the AAOIFI(Accounting and

Auditing Organization for Islamic Financial Institutions) has formulated its own

accounting standards, several Islamic banks also have to work in accordance with

GAAP or International Financial Reporting Standards (IFRS).

The future of Islamic banks also depends on developing and putting into practice

such accounting standards which provide timely and reliable information of the

type that the Islamic banks would require for profit-sharing, rent-sharing or for

cost-plus financing. These standards are yet to be developed. The Islamic banks

would have to work hard to pursue their clients to accept these standards so that a

reliable information base is established. They should introduce their own bench

mark for deciding profit sharing other than the conventional KIBOR.

According to the Islamic principles, business transactions can never be separated

from the moral objectives of the society. Therefore, Islamic banks were supposed

to adopt new financing policies and to explore new channels of investments which

may encourage development and support the small scale traders to lift up their

economic level. A very few Islamic banks and financial institutions have paid

attention to this aspect. Unlike the conventional financial institutions who

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strive for nothing but making enormous profits, the Islamic banks should have

taken the fulfillment of the needs of the society as one of their major objectives and

should have given preference to the products which may help the common people

to raise their standard of living. They should have invented new schemes for

house-financing, vehicle financing and rehabilitation-financing for the small

traders. This area still awaits attention of the Islamic banks.

The case of Islamic banking cannot be advanced unless a strong system of inter-

bank transactions based on Islamic principles is developed.

While Islamic finance originates from religious principles, it is also a workable

model of investment, based on risk sharing. The nations, which have adopted

Islamic finance, have done so because it makes business sense.

Islamic finance is all about encouraging and facilitating investment in real

economic activity and societal welfare, while prohibiting investment in reckless

businesses such as gaming, alcohol and adult entertainment or risky financial

products like derivative contracts of the kind which led to the 2008 sub-prime

crisis.

Apart from being a viable alternative to capitalist financial systems prone to

extreme risks, the interest-free solutions of Islamic Banking could restore

equilibrium in Indian society by providing succor to debt-ridden farmers, labourers

and other marginalized groups. Hence, Islamic Banking has potential as a tool of

financial inclusion.

RECOMMENDATIONS FOR THE IMPLEMENTATION OF ISLAMIC

BANKING IN INDIA.

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As per the Pew Research Centre, India was home to nearly 177 million Muslims in

2010, making it the country with the third largest Muslim population in the world.

A considerable number of Indian Muslims either invest in non-interest bearing

accounts or donate the interest from interest-bearing accounts to charity.

There is an opportunity for Islamic banks to attract funds that interest paying

conventional banks cannot.

As per the Pew Research Centre, India was home to nearly 177 million Muslims in

2010, making it the country with the third largest Muslim population in the world.

A considerable number of Indian Muslims either invest in non-interest bearing

accounts or donate the interest from interest-bearing accounts to charity. There is

an opportunity for Islamic banks to attract funds that interest paying conventional

banks cannot.

According to the Planning Commission, India is facing a funding gap of US$ 300

billion – or 30% – in meeting its infrastructure funding requirement until 2017.

Following the example of countries such as Malaysia, Indonesia, UK, France and

Germany, India could use Islamic financial products such as Sukuk (long term

bond) to fund infrastructure and other sectors. Specifically, India could attract the

Middle East’s high investible surplus through Islamic banking and finance.

The latest RBI directive is clear that Islamic banking can’t be adopted in India

under the current legal framework. India needs to follow the UK example and

introduce new laws to govern the Islamic Banking business.

WORKING MODEL OF ISLAMIC BANKING IN INDIA

A Shariah Supervisory Board will have to monitor the activities of the Islamic

Banks. The funds from Islamic Banking will have earmarked separately,

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thereby allowing better transparency. As a working model, Islamic banks may

operate under any of the following two structures:

1. The Two-Windows Approach

This approach emphasizes on classification of deposits and therefore is divided

into two sections:

One for ‘Chequing’ and the other investments option being left to the client.

Current deposits are guaranteed by the bank, being held in trust and are repayable

in full on demand. This type of deposit earns no revenue by virtue of its

availability.

2. The Two-Tier Approach

The two-tier approach offers a wider array of investment options with the intent to

attract customer whose main objective is growth and income options. It can be

preferred by specialized investment firms and wealth management consultancies

offering expertise and investment vehicles to mobilize surplus funds.

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CONCLUSION

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CONCLUSION

Islamic banks and its financial instruments have proved to be a viable and efficient

way of financial intermediation in the Middle East. According to a recent IMF

study, the probability for Islamic banking to develop in a given country rises with

the share of Muslim population, per capita income, and the country’s net export of

oil. The distance to the two main Islamic financial centres, Bahrain and Malaysia,

does matter for the diffusion of Islamic banks across countries. Islamic banks

diffuse faster when a country is closer to one of the above two centres. If the

importance of Islamic banks and their instruments in the economy by assets is

measured, in almost all countries having Islamic banks, except Iran, the ratio of

credit of conventional banks to GDP is substantially higher than the investment to

GDP ratio of Islamic banks, which accounts for less than 20 percent of GDP in

most countries.

Islamic banking has become today an undeniable reality. The number of Islamic

banks and the financial institutions is ever increasing. New Islamic Banks with

huge amount of capital are being established. Conventional banks are opening

Islamic windows or Islamic subsidiaries for the operations of Islamic banking.

Even the non-Muslim financial institutions are entering the field and trying to

compete each other to attract as many Muslim customers as they can. It seems that

the size of Islamic banking will be at least multiplied during the next decade and

the operations of Islamic banks are expected to cover a large area of financial

transactions of the world. But before the Islamic financial institutions expand their

business they should evaluate their performance during the last two decades

because every new system has to learn from the experience of the past, to revise its

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activities and to analyze its deficiencies in a realistic manner. It is in this

perspective that we should seek to analyze the operation of Islamic banks and

financial institutions in the light of Shari‘ah and to highlight what they have

achieved and what they have missed.

Another major contribution of the Islamic banks is that, being under supervision of

their respective Shari‘ah Boards they presented a wide spectrum of questions

relating to modern business, to the Shari‘ah scholars, thus providing them with an

opportunity not only to understand the contemporary practice of business and trade

but also to evaluate it in the light of Shari‘ah and to find out other alternatives

which may be acceptable according to the Islamic principles.

Another major contribution of the Islamic banks is that they have now asserted

themselves in the international market, and Islamic banking as distinguished from

conventional banking is being gradually recognized throughout the world. On the

other hand there are a number of deficiencies in the working of the present Islamic

banks which should be analyzed with all seriousness.

Western financial markets such as London have evolved regulatory guidelines on

Islamic banking products/instruments and services. India with sizeable Muslim

population offers enormous opportunities for growth in this segment. In 2008, a

Planning Commission panel on financial sector reforms headed by Dr Raghuram

Rajan recommended introduction of interest-free banking. The committee opined

that the non-availability of interest-free banking results in some Indians, including

those in the economically disadvantaged strata of society, not being able to access

banking products and services due to reasons of faith. This non-availability also

denies India access to substantial sources of savings from other countries in the

region.

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Islamic Banking has good prospects in India, given the diverse Indian canvas and

holds good for India from a development point of view. It is presently faces many

challenges that needs to be addressed. This requires a dedicated effort of a strong

committee which can take a unbiased stand, both from economic and secular

perspective and recommend changes to be brought in ‘Banking Regulation Act’ for

introduction of Islamic Banking in India. Growth of Islamic finance depends on two

important factors: domestic demand and India’s role in the globalization of the

financial sector. By not introducing Islamic finance, India is losing the opportunity

of garnering capital from a large section of the Muslim population as well as from

Islamic nations in the Middle East and elsewhere. Islamic finance is an idea whose

time has come. It is time the Indian Government recognized this significant

opportunity.

Twenty-five years ago Islamic banking was considered a wishful thinking.

However, serious research work of the past two and half decades has shown that

Islamic banking is a feasible and viable way of financial intermediation. A number

of Islamic banks have also been established during this period under heterogeneous

social and economic milieu. The successful operation of these institutions and the

countrywide experiences in Pakistan, Iran, and Sudan and partly in Malaysia are

sufficient to show that Islamic banking offers an alternative method of commercial

banking.

The commendable achievements during the last twenty years should not lead us to

ignore the problems that Islamic banking is facing, and there is no dearth of those.

While many problems are a result of the inappropriate environment in which

Islamic banks are working, there are others which have arisen from the practices of

Islamic banks themselves.

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Lastly, the Islamic banks should develop their own culture. Obviously, Islam is not

restricted to the banking transactions. It is a set of rules and principles governing

the whole human life. Therefore, for being ‘Islamic’ it is not sufficient to design

the transactions on Islamic principles. It is also necessary that the outlook of the

institution and its staff reflects the Islamic identity quite distinguished from the

conventional institution. This requires a major change in the general attitude of the

institution and its management. Islamic obligations of worship as well as the

ethical norms must be prominent in the whole atmosphere of an institution which

claims to be Islamic. This is an area in which some Islamic institutions in the

Middle East have made progress. However, it should be a distinguishing feature of

all the Islamic banks and financial institutions throughout the world. The guidance

of Shari‘ah Boards should be sought in this area also.

The myth that Islamic banking is only for Muslims must be dispelled, and

awareness of Islamic Banking as an alternative, ethical form of banking should be

created. Public seminars and discussions are a good way to do this.

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APPENDIX

APPENDIX

GLOSSARY ON ISLAMIC BANKING

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Amanah: It refers to deposits in trust

Muajjal: Literally it means a credit sale.

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

delivered later on.

Gharar : It means any element of absolute or excessive uncertainty in any

business or a contract about the subject of contract or its price, or mere speculative

risk. It leads to undue loss to a party and unjustified enrichment of other, which is

prohibited.

Hibah: Hibah means Gift.

Ijarah: Letting on lease. Sale of a definite usufruct of any asset in exchange of

definite reward. It refers to a contract of land leased at a fixed rent payable in cash

and also to a mode of financing adopted by Islamic banks. It is an arrangement

under which the Islamic banks lease equipment’s, buildings or other facilities to a

client, against an agreed rental.

Ijarah: A mode of financing, by way of Hire-purchase, adopted by Islamic banks.

Istisna: 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.

Mudarabah: 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 by the provider(s) of the capital.

Murabaha: Literally it means a sale on mutually agreed profit.

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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.

Riba: Prohibition of interest.

Shariah: The term Shariah refers embodies all aspects of the Islamic faith,

including beliefs and practice.

Takaful: Insurance

INTERVIEW WITH MR.NAWAF.H.al.SENAN

Assitant Relationship Manager

Corporate Banking Group

Bank AlJazira

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Saudi Arabia

Q: What is Islamic banking?

A: This is a banking activity based on Islamic principles, which do not allow the

paying and receiving of interest (riba’) and promotes profit sharing in the conduct

of banking business.

Q: Is Islamic banking meant for Muslims only?

A: No. Islamic banking is for all individuals regardless of their religious belief.

Q: What are the differences between Islamic and conventional banking?

A: The most important difference between Islamic and conventional banking is the

prohibition of interest.

Q: How would you define Islamic Finance?.

A: Islamic finance is about bringing faith based ethics into finance. The term

Islamic finance is generally meant to be banking, capital market, and insurance.

One way to describe it is to say that it is finance that is not inconsistent with the

teachings of Islam.

Q: What role do you see Islamic finance playing on a global scale in the next 5

to 10 years?

A: Islamic Finance will play a major role both globally within the banking

industry, and on regional level in the Middle East and South East of Asia. England

and France are currently opening the doors for Islamic finance so we will also see

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growth in Europe. Newcomers with large Muslim populations like China and India

may join the Islamic finance growing trend.

Q: What trends and challenges would you predict for Islamic Finance? 

Islamic Banking will continue to grow in the future. There will be challenges faced

against regularization vs. diversification and channels saturation vs. new products.

Q: Does the operations of the Islamic Banks fully comply with the

requirements of Shariah?

A: All Islamic banks are required to set up Shariah Committees to advise them and

to ensure that the operations and activities of the bank comply with Shariah

principles. All products and services offered by the Islamic banks and IBS banks

must be approved by their respective Shariah Committees.

Q: What distinguishes Islamic Finance from mainstream finance?

A: Islamic finance puts constraints on both the purpose of financing and the

structure of financing. To give a simple example, it cannot be used to build a

casino through interest bearing loans because gambling (purpose) and lending

money on interest (structure) are considered prohibited in Islam.

REVIEW OF LITERATURE

Title : ISLAMIC FINANCE OUTLOOK

Author: Paul Coughlin, Executive Managing Director, Standard & Poor’s

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Source: STANDARD AND POOR’S – ISLAMIC FINANCE OUTLOOK

2009

Document Type: MAGAZINE

Title : Why India needs Islamic banking

Author: Riaz Akhtar, Senior Consultant, Infosys

Source: Infosys Finacle

Document Type: Thought Paper

Title : Study Shows Larger Islamic Banks Need Prudential Eye

Author: By Martin Cihak and Heiko Hesse, IMF European Department

Source: IMF SURVEY MAGAZINE, IMF RESEARCH

Document Type: Survey Magazine

Title : Lack of standardization hobbles Islamic banking and finance

Author: Shaheen Pasha and Liau Y-Sing

Source: Financial Regulatory Forum, Reuters.com

Document Type: Blog

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Title : Annual Review of Islamic Banking and Finance

Author: Mark Summers

Document Type: GULF-BUSINESS NEWS AND ANALYSIS, NOV

2010- Magazine

Source: thegulfonline.com

Title : An Introduction to Islamic Finance

Author: Mufti Muhammad Taqi Usmani

Document Type : An Introduction to Islamic Finance – E-Book

Source: muftitaqiusmani.com

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BIBLOGRAPHY

BIBLIOGRAPHY

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NEWSPAPERS

ECONOMIC TIMES

INTERNET

www.islamic finance.com

www.reuters.com

www.gulfonline.com

www.economictimes.com

www.muftitaqiusmani.com

www.infosys.com/finacle/solutions/thought-papers

MAGAZINES

The Gulf Business News and Analysis - Annual review of Islamic

Banking and Finance – November 2010

Standard and Poor’s – Islamic Finance Outlook 2009

IMF Survey Magazine