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Economic Substance or Legal Form: An Evaluation of

Islamic Finance Practice

Muhammad Hanif FCMA1

Abstract

Islamic banking, based on principles of Islam, was started in last quarter of twentieth century

and got momentum in first decade of twenty first century. By the end of December 2011, Global

volume of assets, under Islamic financial system, have reached to US $ 1,289 Billion. This study

is conducted to examine legal form as well as economic substance of contracts used by Islamic

financial industry. Five most widely used contracts including Murabaha, Ijarah, Diminishing

Musharaka, Skuk and deposits, were selected to test against the theory of Islamic financial

system. It is found in the process that legally contracts are in line with theory, however economic

substance is not very different from conventional counter parts. Through application of

alternative calculation measures and proper training of human resources, Islamic financial

Institutions can shift economic substance of contracts in line with theory of Islamic finance.

I-Introduction

Islamic banking was started in last quarter of 20 th century and got momentum in first decade of

21st century. Global volume of assets under Islamic financial system has reached to US$ 1,289/-

billion by the end of December 2011 (IFSL-2012) with above 300 institutions operating in more

than 50 countries. Islamic banking was emerged as a reaction to Haram (prohibited by Islamic

code of life) practices in financial sector including Riba (interest & usury), Gharar (uncalculatedrisk) Myser (game of chance) and financing for Haram (prohibited) businesses2.

In order to address these issues especially Riba (interest & usury) a modified model of

banking was required. Riba is the foundation on which whole structure of modern conventional

1 Assistant Professor, FSM, National University of Computer & Emerging Sciences, Islamabad

2 Examples of prohibited businesses include liquor, pork, pornography, promotion of adultery etc.

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banking stands. Thus existing contracts (including overdraft, credit card, export financing,

agricultural loans, short, medium and long term loans, leases and mortgages etc) of conventional

banking primarily based on Riba was not suitable in their original form for Islamic banking.

Hence, modified business contracts (between bank and customers) were introduced based on

principles of Islamic financial system. Major contracts introduced by Islamic financial system

are categorized as asset based financing (trade & rentals), profit and loss sharing (Musharaka &

Mudaraba) and capital market (equity funds, Skuk).

Analysis of these contracts suggests that nature and role of Islamic banking is different

from conventional banking. Islamic banks are not dealers in money rather dealers in goods (asset

based financing), business partners sharing risk and rewards (Musharaka & Mudaraba),

investment companies (equity funds & Skuk). In spite of difference in nature and role, Islamic

banks are also meeting the same needs of customers as conventional banks do, albeit in a

different way, hence both are competitor. Competition between Islamic and conventional

banking is major driving force in operations of Islamic banks as for provision of services and

earning of returns is concerned.

Islamic financial industry has knowingly and willfully benchmarked its operations to

conventional banking being immediate competitor. During this process through financial

engineering many products were developed within Shari’a constraints matching with the

alternative products of conventional financial industry. This led the industry to focus on legal

form and ignore economic substance of underlying transactions. This practice of being

competitive with conventional banking raised questions in the minds of common man as what is

the difference between conventional and Islamic banking. Confusion also arose to expert (in

Shari’a) level; as a result a Fatwa against current Islamic banking was issued by Jamia Banori

Town, Karachi in 20083. Also market participants [finance professionals] are skeptical about

operations of local Islamic financial industry (Hanif, 2012). One of the issues in Islamic financial

industry is application of conventional banking based calculation software to determine financial

rights and obligations, which definitely bring the installments payable by customers and profit

allocated on deposits very close to conventional banking. Furthermore, these software were

designed keeping in view time value of money which is rejected by Islamic financial system

theoretically, however study is needed to comment on practice.

3 Murawajja Islami Bankari (Urdu), Maktaba Bayyanatt, Jamia Benori Town, Karachi, Pakistan.

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Haram (prohibited), and ordered the government to take drastic measures for implementation of

interest free banking as agreed in constitution of Pakistan. After receiving the order of court

government of Pakistan analyzed its strengths and weaknesses and once again lack of trained

human resources hindered the state from converting conventional system into Islamic.

Government of Pakistan responded through two pronged strategy. First; a commission was set up

under the able chairmanship of Raja Zafar ul Haq to analyze whether interest free system is

workable (in fact to re-invent the wheel, as same job had been done by CII in 1980). Second;

government went into appeal against the federal Shari’a court decision in Shari’a appellate bench

of supreme court of Pakistan (to get some time in implementation of decision). It is interesting to

note there was above 60 appeals, against the decision of federal Shari’a court, in Supreme Court

of Pakistan which were heard by honorable court as a single case. This shows the deep roots and

resistance level displayed by promoters of conventional financing in Pakistan. Government failed

on both fronts. Commission recommended the applicability of interest free system, and in 1999,

Supreme Court issued a detailed decision favoring application of interest free economy (Supreme

Court of Pakistan 1999).

By early 2000, state bank of Pakistan (SBP) adopted a different strategy, of promoting

Islamic banking, as parallel to conventional banking. Islamic banking department (IBD) was set

up in SBP to guide, facilitate and regulate Islamic banking stream. By the end of June 2011, 17

(5+12) banks are operating in Pakistan with a branch network of 799, assets under operation are

PKR 560 Billion, deposits PKR 452 Billions, financing and investments PKR 420 Billions.

Islamic banking is covering approximately 8% of market share (SBP-2011).

IIB-Principles of Islamic Finance

Islamic finance is based on Shari’a (Islamic law). Ulema (Clerics in Islamic law) have identified

objectives of Shari’a including safety of faith, Life, property, next generation and intellect (Hifz

ul Eemaan, Jan, Maal, Nasal and Aqal) [Siddiqi 2010]. Every design of community institution

should at least ensure conformity with objectives of Shari’a if not enhance performance on these

fronts. Based on these objectives of shari’a following principles of Islamic finance have been

documented by Clerics.

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1. First is prohibition of interest and usury in financial dealings. In Qura’n four sets of

verses have been identified dealing with the charging of Riba 4 (30:39, 4:161, 3:130, & 2:275-

281). Several Hadiths (traditions of Prophet Muhammad PBUH) clearing the meanings of Riba

in various transactions have been reported (khan, 1989). Furthermore resolutions of council of

Islamic Fiqh Academy are very much qualifying the status of Ijma’a (consensus) on the issue of

Riba. Also there are several Ulema (clerics) who declared both usury and commercial interest

Haram (Unlawful) (e.g. see Usmani 1999, 2002 & Usmani 2003, Qarzawi, Maudoodi 1961,

Rehman, Siddiqi 2006, Chapra, Zaman 2010, Ayub 2007). Implication of this principle of

Islamic finance is discouraging time value of money in its conventional banking sense. Under

Islamic financial system money is mere a medium of exchange and not a factor of production.

Human labor is required in addition to money to earn a return, hence there is no fixed return for

capital, however capitalist can participate in business under profit and loss sharing with or

without participation in management of entity.

2. Second principle of Islamic finance is avoidance of Gharar (uncertainty) in a business

transaction (Ayub 2007,page 57; Mansoori 2007, page 179; Ghazi 2010, page 237). Ayub 2007

defines “Gharar refers to entering into a contract in absolute risk or uncertainty about the

ultimate result of the contract and the nature and/or quality and specifications of the subject

matter or the rights and obligations of the parties [page 75]. Mansoori 2007, documented that

Gharar contains [certain] characteristics such as risk, hazard, speculation, uncertain outcome, and

unknown future benefits.

3. Third principle of Islamic finance is avoidance of Myser (speculation) or any game of

chance (Ghazi 2010). Ayub 2007, documented that Maisir refers to easily available wealth or

acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar (similar to

Myser) means the game of chance; one gains at the cost of other(s) right [page 62]. Myser is

prohibited by Holy Qura’n [ 2: 219 and 5: 90] as well as in Hdiths (Khan 1989, page 92)

4. Fourth principle is profit and loss sharing. According to this principle capitalist

demanding profit on capital should also participate in loss as well (Khan 1989, page 71; Usmani

2002, page 87; Ghazi 2010, page 386; Khan 2007, page 307 & Shari’a standard 12). According

to this principle an investor can earn return on his investment subject to risk of loss, hence

concept of risk free return is disappeared under Islamic financial system.

4

Reported in the order of revelation. First Surah (chapter) number then Aya (verse) number.

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5. Fifth principle of Islamic finance is financing for only Halal (permitted) businesses.

According to Qardawi5 “Nothing is Haram except what is prohibited by a sound and explicit Nas

(Verse of Qura’n and an authentic Sunnah) from the law-Giver Allah SWT. Ulema has made the

list of prohibited businesses in which investment for Muslims (Islamic banks) is prohibited.

Activities such as liquor, pork, pornography, adultery, dance clubs, conventional banking,

insurance etc are unlawful, hence earning return through investment in any of these activities is

not allowed under Islamic financial system (KMI-30).

To conclude Islamic financial system ensures justice between savers and investors. By

demolishing risk free return and promotion of profit and loss sharing, justice is ensured for both

parties i.e. capital supplier as well as capital user. As a model of modern commercial banking,

initially capital is supplied by depositors and later on by bank to business community. Under

Islamic financial system bank can invest in businesses to earn variable return based on actual

results of activities and share profit earned with depositors based on agreed sharing formula.

Hence it is ensured to distribute the actual outcome and none is to bear risk alone and none is to

earn with zero risk.

III-Purpose and Methodology

This study is intended to analyze and test the financial contracts (being used in practice byIslamic banks) against the theory of Islamic financial system. In summary following are study

objectives:-

1. A survey of calculation methods applied in (selected) financial contracts in Islamic financial industry.

2. Identification of contradiction of financial calculations with Shari’a compliant financial system

3. Suggestion of modified methods for calculation of financial rights and liabilities.

In order to achieve the above stated objectives we got access to calculation process applied by

local Islamic financing industry and obtained standard contracts as used in day to day business

dealings. After getting sufficient required information we tested calculation methods one by one

as per laid down Shari’a principles. We accepted the calculation methods which are in line with

dictates of Shari’a and rejected the method(s) contradicting with Islamic law. We present to the

5 http://www.ymsite.com/books/lpi/ch1- pre.htm#1.%20The%20Basic%20Asl%20Refers%20to%20the%20Permissibility%20of%20Things accessed on Dec9, 2012.

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market alternative calculation methods in order to judge Shari’a compliance, economic impact

and suitability in application. We have also analyzed the calculation assumptions and bench

mark used by Islamic banking in comparison with other available options. On assets side of

balance sheet of bank, Our focus is on only four products (including Murabaha, Ijarah,

Diminishing Musharaka and Skuk) offered by Islamic financial industry. On liabilities side we

have selected deposits collection mechanism used by Islamic financial industry for examination.

Selection of contracts on asset side is based on sole criterion of relatively excessive use by

Islamic financial institutions (IFIs) and relatively higher share in earning portfolios of IFIs.

IV-Analysis

Based on Islamic finance principles following modes of financing were developed by Islamic

banking. These modes are classified objectively as Asset based financing (Murabaha, Muajjal,

Salam, Istisna’a and Ijarah), profit and loss sharing financing (Musharaka, Diminishing

Musharaka and Mudaraba) and capital market financing (equity funds and Skuk). In this study

we have selected five types of contracts including Murabaha (overdraft), Ijarah (leasing)

diminishing Musharaka (mortgages), Mudaraba (Deposit collection) and Skuk (bonds) for

analysis. Selection of these contracts for examination is based on the sole criteria of their larger

application in practice. In Pakistan share of these types of financing are very high in overall portfolios of Islamic banking industry including Murabaha 40%, Ijarah 22% and Diminishing

Musharaka 26%, while Mudaraba for deposit collection.

A-Murabaha Financing

Murabaha is a sales contract whereby cost of goods sold is disclosed to the buyer. In its original

form as a contract of sales it has nothing to do with credit provision or financing facilitation.

However given the matching feature of Murabaha with conventional banking, its application is

largest in the financing and investment portfolios of IFIs working in Pakistan. In fact during

Sept. 2006 to Sept. 2010, share of Murabaha financing was slightly above 40% in financing and

investment portfolios of Islamic banking industry in Pakistan (Hanif, 2011). Any customer

comes for any business need, preference is given to Murabaha contract if applicable. Procedure

is very simple and makes the job of bankers easier. Whatever price of a product exists in the

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market, Islamic banks are adding the KIBOR rate as profit margin based on the length of credit.

To make the concept clear following example would be helpful. A person needs a Laptop for his

son studying in a local University. Market price is Rs; 50,000/- and KIBOR rate is 10%.

Customer needs financing for 1 year. Working is presented as under. If customer pays in single

installment at completion of one year then his financial liability is amounting to Rs; 55,000/- if

he pays in two semiannual installments he is required to pay two installments of Rs; 26,890/-

with a financial obligation of Rs; 53,780/- which is less than yearly payment equal to Rs; 1,220/-

Like wise if he makes payment in four quarterly installments then amount of each installment

becomes Rs;13,291/- with financial obligation of Rs; 53,164/- which is lesser in amount under

annual and semiannual payment plan equal to Rs;1,836/- and Rs; 617/- respectively. If customer

opts for monthly installment then amount of an installment becomes Rs; 4,396/- with financial

obligation of contract amounting to Rs; 52,750/- which is less than annual, semiannual and

quarterly installment equal to Rs; 2,250/-; Rs; 1,031/- and Rs; 414/- respectively.

Shari’a risk in such a contract is indulging in time value of money. As per Murabaha sale

one can charge any profit rate as agreed with buyer including KIBOR and KIBOR plus. Likewise

one can agree to any payment plan including spot, credit, single payment, semiannual plan,

quarterly plan, monthly plan or any other. However one cannot increase or decrease amount

receivable on the basis of early or delayed payment which is being violated in practice. At ten

percent profit rate price of computer becomes Rs; 55,000 irrespective of any payment plan.

However as we saw price varies according to receivable schedule. For single payment at end it is

Rs; 55,000/- for semiannually installments it is Rs; 53,780/- for quarterly installments it is Rs;

53,164/- and finally under monthly payment plan it is Rs; 52,750/-. What is justification of four

different amounts to be recovered from customer except time value of money? Under this

principle of determination of financial rights and obligations if payment plan extends to more

than a year then price would be higher than Rs; 55,000/-

As for legal status of contract is concerned, nothing wrong in it and IFIs have the right to

negotiate any price (Ayub, 2007, p.218, Shari’a standard 8), however economic substance is

suffered. Under sales contract essence is to charge profit irrespective of length of receivables.

Islamic finance discourage time value of money, while charging different profit based on length

of period, brings back time value in the transaction resulting in matching economic substance

with conventional banking.

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What is the way out? As a matter of principle time value should be given up, however

this will turn operations uncompetitive with conventional banks. Important question is the

decision making process of customers of IFIs. In depth studies are required to answer the

question. Very limited studies available so for on the subject, have concluded that customers of

IFIs are doing business with these banks assuming Shari’a compliance in their operations. Chief

motivating factor to choose an Islamic bank is the avoidance of interest and Shari’a compliance.

If this is true then leaving time value concept should not be difficult for Islamic financing

industry. IFIs should charge a single price irrespective of payment plan. E.g single price should

be negotiated with customer for one year credit and customer should be given the flexibility to

discharge obligation within one year as per his/r convenience.

B-Ijarah Financing

Ijarah is reward for a service. Ijarah (Leasing) is a rental contract whereby IFI leases an asset for

a specific rent and period to the client. Ownership risks of the asset are borne by IFI while

expenses relating to use the asset are the responsibility of client. The difference between Ijarah

and sale is that ownership in Ijarah remains with lesser while in case of sales it is transferred to

purchaser. Ending Ijarah in sale of asset is allowed by IFA through a separate contract at

completion of term of lease. Contract can be executed prior to purchase and possession of asset.

Consumables cannot be leased out. Right of lessee to use the asset is restricted to lease

agreement or/and as per normal course of business. Lessee is liable for any harm to the asset

caused by any misuse or negligence on his part. Rentals of joint property are shared according to

equity. A joint owner can rent his share only to the co partner. Inter Bank Rate can be used as a

benchmark for amount of rentals. At the completion of Ijarah term either asset is returned to IFI

or purchased by client (Shari’a standard 9).

Although in theory Ijarah is a rental contract whereby rent of the asset should be

determined on the basis of aggregate demand and supply of assets available on rent. Also

ownership risks are required to be born by lessor. At completion of lease tenure either asset may

be taken back or sold to lessee. However in practice except legal form of the contract all

calculations are deto copy of conventional leasing. Islamic banks determine rentals on the basis

of KIBOR where by principal amount as well as required return is ensured. Further more

principal amount is also recovered along with rentals (Hanif, 2011).

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Suppose, on January 01, 2006, ABC Company contacted the Gujranwala branch of bank

to provide a car costing Rs; 1,500,000, on lease for five years, payable in five equal annual

installments at the beginning of the year. Bank promised to gift the asset after five years subject

to prompt payment of lease rentals. Bank wants to earn 10% per annum on this deal.

Two of the calculation methods are explained here. First is traditional method of

installment calculation by applying following formula = [1 −(/)

/](1 + i) Where P

is the amount spent on purchase of asset, R is the installment, I is the rate of return, n is the

number of years and m is number of compounding in a year. This formula is based on concept of

time value of money hence not recommended for use in Islamic modes of financing. As per this

formula if we calculate five equal annual installments compounded annually amount of each

installment becomes approximately Rs; 359,700 rounded to 100.

Table I- Breakup of Returns and Principal

End of years Installment Interest Principal Balance

0 359,700 - 359,700 1,140,300

1 359,700 114,030 245,670 894,630

2 359,700 89,463 270,237 624,393

3 359,700 62,439 297,261 327,132

4 359,700 32,713 326,987 146

Total 1,798,500 298,646 1,499,854 2,986,601

In present practice following observations demand attention of experts in the field of Islamic

financial system

1. First is the charging of rent based on KIBOR plus a certain percentage. KIBOR is cost of

capital and not the rent of an asset. KIBOR is determined through demand and supply of

capital, if free market is in operation, or based on return offered by government for its

borrowing. While asset rent is determined based on total demand and supply of a

particular asset on rent. Rent of assets is determined independently (e.g. rent of vehiclesis higher than KIBOR and rent of houses is lesser than KIBOR in Pakistan).

Consequently when rent is charged on the basis of KIBOR, economic substance of

transaction disappears under Islamic financial system, however matches with

conventional banking.

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2. Second is recovery of price of asset through sale at the end of Ijarah term. at present asset

is sold at par value which make the transaction competitive with conventional banking.

Practically certain assets lose their value and should be sold at less than par (e.g. Cars,

Machines etc), while others appreciate in their value (e.g houses). Islamic financial

system dictates to sell asset at market value in its essence, while under present practice,

real economic substance of transaction based on risk and return is compromised.

It is interesting to note as for legal form is concerned, nothing is being violated. In both cases

listed above nothing is against Shari’a law; one can charge any rent for his asset and one can sell

at any price as agreed between the parties (Shari’a standard 9), however the difference which

Islamic financial system wants to create is absent.

Here we are suggesting an alternative calculation method under Ijarah. This method

suggests calculating rent on the basis of rentals of underlying asset prevailing in the market.

Suppose rental of this type of car is Rs; 216,000 [18,000 per month] in the market but without

transfer of ownership. It is assumed impact of any inflation on rentals shall be equally off set by

the depreciation in value of car, hence, no increase in rentals. Suppose further after five years,

estimated residual value of car is Rs; 875,000. As bank has promised to gift the car at the end

without any consideration so the capital and return must be recovered through installments. To

accelerate the payments, residual value is included in the amount of installments hence amount

of each installment becomes 391,000 [175,000+216,000]. Bank shall receive Rs; 391,000 of

investment immediately hence no return for this amount. So actually investment is Rs; 1,109,000

and bank receives extra for four years amounting to Rs; 455,000 [(391,000 X 4) – 1,109,000]

which is 41% of original investment and average annual return is 10.3%.

Table II- Breakup of Rentals and Principal

End of years Installment Rentals Principal Balance

0 391,000 216,000 175,000 1,325,000

1 391,000 216,000 175,000 1,150,000

2 391,000 216,000 175,000 975,000

3 391,000 216,000 175,000 800,000

4 391,000 216,000 175,000 625,000

Total 1,955,000 1,080,000 875,000 4,875,000

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Certainly amount is higher from conventional banking; actually customer is required to

pay an additional amount of Rs; 156,500 (in present value terms 130,500) rounded to 100 during

the lease term. Is it a cost of being Muslim as some quarters claim; and following Islamic

financial system? Answer is no! a strong No! Look at the nature of contract under both systems.

First is the bearing of risk level by investor; and demanding higher return for higher risk is well

established and accepted principle of finance. IFI is bearing total risk of ownership during lease

term and mitigates through permissible mode of insurance on its own expenses, while under

conventional leasing system risks are transferred to customer. Second if asset demands certain

overhauling IFI do not receive the rentals while under conventional system installments are

required irrespective whether asset is in repair or usage phase. IFIs should promote this

philosophy among their customers that investor deserves higher return keeping in view the

bearing of more risk as compared to conventional leasing. I recommend the second method to be

used in calculation of rentals, under Ijarah, by IFIs.

C-Diminishing Musharaka

Literal meaning of Musharaka is sharing. Its root in Arabic language “Shirka” means being a

partner. Musharaka means a joint enterprise formed conducting some business in which all

partners share the profit according to pre-agreed ratio while loss is shared according to the ratio

of contribution (Meezan bank guide 2002). For a valid Musharaka fulfillment of certain

conditions required. First is there must be an agreement written (verbal) among the partners

stating clearly the terms and conditions including management, capital contributions, profit and

loss sharing among the partners. Second capital can be contributed in cash as well as in assets.

However once an asset is contributed as capital that belongs to firm and contributing partner is

relieved from the bar of risks and returns attached with ownership of that asset. Third profit is

distributed according to agreement of partnership however sleeping partner cannot claim share in

profit more than his proportionate share in equity. None of the partner can guarantee the capital

or profit share to any other partner (Shari’a standard 12).

Diminishing Musharaka is form of declining partnership between IFI and client generally

used to finance real estates. When a customer requests to IFI for financing to purchase an asset

IFI participates in the ownership of asset by contributing required finance. Certain portion

(e.g.20%) must be contributed by customer. Total equity of bank is divided into units of smaller

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amounts which are purchased by client in installments. Under this mode of financing one of the

partners (client) promises to buy the equity share of the other partner (IFI) gradually until the

title to the equity is completely transferred to him. Buying and selling of equity units must be

independent of partnership contract and must not be stipulated in partnership contract. Generally

IFI rent out his share to client and earns rentals. Any profit accruing on property is distributed

among the co owners according to agreed ratio however losses must be shared in proportion of

equity (Shari’a standard 12).

Again theoretically it is purchase of house under joint ownership and later on rent of the

property is shared by partners. Practically bank rent out its share to the customer and receives

rentals proportionally. At the same time total interest in property of bank is divided in smaller

units of equal value depending upon the nature of rentals. Customers pay the installments which

constitutes a portion for rent and another portion for purchase of units. Following example would

clarify the concept. Mr ABC is went for Islamic house financing to acquire the house in

Islamabad. Cost of house is Rs; 5000,000. As per terms of contract 20% is to be paid by

customer and balance by an Islamic bank. KIBOR is 9% and bank charges to this customer

KIBOR plus 1%. Term of the contract is 5 years. Let us further assume following table III

KIBOR and property inflation rates for 5 years.

Table III- KIBOR and Inflation Rates

End of Years KIBOR Inflation

00 -0- -0-

01 09% 07%

02 10% 07%

03 10% 08%

04 11% 09%

05 10% 10%

It is further assumed that at beginning average rent of property in that area is Rs; 240,000 per

year. As per prevailing practice following table-IV analyses the five yearly payments. Rent is

charged as a percentage (return/Interest) on balance payable and shares are sold at par.

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Table IV-Analytical table under prevailing Method

End of years Installments Rent Principal Balance

0 1,000,000 - 1,000,000 4,000,000

1 1,200,000 400,000 800,000 3,200,000

2 1,152,000 352,000 800,000 2,400,000

3 1,064,000 264,000 800,000 1,600,000

4 992,000 192,000 800,000 800,000

5 888,000 88,000 800,000 -

Following observations are worth mentioning and demands immediate attention of leaders in

Islamic financial system

1. Rent is charged on the basis of KIBOR plus a certain percentage and not on the basis of

rent prevailing in market. KIBOR is return on capital and not rent of property. Property

rent is determined independently based on demand and supply of houses in a region and

also it varies from region o region. In case of Pakistan property rents are much lesser than

KIBOR rate6.

2. Sale of units at par value is also not in line with essence of Islamic financial system. It

should be based on market value, which creates the real difference in Islamic and

conventional system. If it is Musharaka as it is claimed then no question of guaranteed

return to any of partners. Under present system return is guaranteed to banker in the formof rent as well as purchase of equity share at par value. This practice takes away

economic substance of Islamic financial system and matches trisection with conventional

banking as for economic substance is concerned.

By looking at legal form of contract one can conclude as nothing is against Shari’a law. One can

charge rent of house as per his own calculations based on any bench mark including KIBOR rate.

Also one can sell his equity share on any price as agreed between seller and buyer (Shari’a

standard 12). However the unique thinking of Islamic financial system of variable return does

not exists in the transaction. Mentality of fixed and certain returns for banks prevails in the

transaction. With this practice Islamic financial system cannot be accepted as superior

particularly in avoiding real estate crisis as occurred in United States in 2007-08. If rent is to be

6In Islamabad average rent of a house is about Rs. 60,000 with market value of Rs. 20 million, resulting in 3.6%

return while KIBOR is about 12%. Also rent of a same house in Islamabad is much different from Rawalpindi city.

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charged on KIBOR and equity shares are to be sold at par then such crisis cannot be avoided,

however if rent is to be charged based on market rent of property and equity units are to be sold

based on market value then it is guaranteed that such crisis could not happen.

Although legal requirements are fulfilled, however substance of the transaction is not

matching with theory. Theory suggests earning rent of property and not of money, as well as no

question of selling shares at par value while market value is different from par. Following table-

V shows calculations in line with theory.

Table V-Analytical table under proposed method

End of Year Property Value Rentals Share of Bank Share in Rent Unit Price Installment

0 5,000,000 - 1,000,000 1,000,000

1 5,350,000 240,000 0.80 192,000 800,000 992,000

2 5,724,500 256,800 0.64 164,352 856,000 1,020,352

3 6,182,460 274,776 0.48 131,892 915,920 1,047,812

4 6,738,881 296,758 0.32 94,963 989,194 1,084,156

5 7,412,770 323,466 0.16 51,755 1,078,221 1,129,976

Total 36,408,611 1,391,800 - 634,962 5,639,335 6,274,296

The difference in two tables is clear. In second case units are sold on the basis of market value as

well as rent is charged on the basis of rents prevailing in the market which links financial sector

to real sector. In first table rent is charged on the basis of KIBOR which is not preferable under

Islamic financial system. Calculation in second table is in line with theory where rent of property

(and not of capital) is charged as well as units are sold on market value ( and not return of

principal). Under prevailing practices (where economic substances of Islamic housing is

matching with conventional), one cannot claim superiority of Islamic financial system in

economic crisis like 2007-08 in the housing sector of United States.

D-Skuk

Skuk is a creation of IFIs to meet their liquidity requirements. Skuk provide an opportunity to

distribute the value of an asset/enterprise/project/usufruct into smaller amount certificates of

equal value to create an opportunity for small investors to share the benefits of investment which

is otherwise impossible keeping in view the larger amounts required to acquire or build an asset

or enterprise/project. According to Shari’a standard # 17 investment Skuk are certificates of

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equal value representing undivided shares in ownership of tangible assets, usufruct and services

or (in the ownership of) the assets of particular projects or special investment activity, however,

this is true after receipt of the value of the Skuk, the closing of subscription and the employment

of funds received for the purpose for which the Skuk were issued. All Skuk are tradable in

secondary market.

Skuk market has got momentum under Shari’a compliant financial system. According to

ISI Emerging Markets7, approximately 2000 issues of Skuk were held with Global volume of

around US $200 Billion by the end of June 2010. In addition to corporate Skuk, Sovereign Skuk

are also issued by the governments including Pakistan, Jordan, UAE, Thailand, Malaysia,

Turkey, Indonesia, Bahrain, Qatar, Cayman Islands, Singapore, Germany, Brunei, Gambia and

Kuwait. Concept of Skuk is initially developed to replace the conventional bonds having features

of fixed return, money back security/guarantee and ready market for liquidation. However under

Islamic financial system even Skuk cannot guarantee of all the features of conventional bonds

listed above. Different types of Skuk are offering varying degree of feature(s) of conventional

bonds. Objective classification of Skuk places them into either fixed return Skuk or variable

return Skuk. Variable return Skuk are very much similar to equity securities rather than

conventional bonds, however fixed return Skuk are having some of the features of conventional

bonds (Hanif, 2011).

Following observations came to our knowledge during study process of Skuk, which are being

presented for attention of experts.

1. An important observation about Skuk issued so for is redemption of certificates at issue

price. Skuk are certificate of ownership in an asset(s) or an organization and should be

redeemed at market price of asset(s) or organization. Announcement of redeemable price

at the time of issue is not appropriate. If Ijarah Skuk (somehow dominating) are issued,

under most of the cases value of assets gone down by the time of redemption, hence

redeeming at par value takes away economic substance of transaction under Islamic

financial system. While in case of Musharaka Skuk redemption value could be more as

well as less than par value depending upon the performance of underlying entity. This

practice is pushing the economic substance of transaction very near to conventional

banking, although partial risk sharing present.

7 www.123 accessed on 5

thJuly, 2010.

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2. Second is offering return based on KIBOR plus a certain percentage of profit. Islamic

financial system encourages sharing of actual outcome, which can be more as well as less

than KIBOR. In case of Musharaka Skuk, nothing is known with certainty, but still return

is offered based on KIBOR plus (e.g. JAZF Skuk), while in case of Ijarah Skuk rent of

the underlying asset(s) prevailing in the market is different from KIBOR plus. This

practice takes away the economic substance of transaction as should be under Islamic

financial system and bring it very near to conventional banking, although partial risk

sharing is still there.

3. Third is the independent guarantee of return by third party under Skuk agreements. Due

to this guarantee of independent third party without consideration, whole philosophy of

Islamic financial system is being compromised. For investors return is certain, then where

is the difference of conventional and Islamic financial system.

Very interesting to note that as for legal form is concerned nothing is violated.8One can sell his/r

equity holdings at any price (including par value) as agreed between buyer and seller (Shari’a

standard 17). As well as one can charge whatever rent s/he thinks appropriate on his assets. Also

one can decide any distribution of profit linked with any bench mark (including IBOR) and

reserve the balance or give to managing partner or company as incentive payment. Finally any

independent third party without having consideration can guarantee return to any of the partners

(Skuk holders) [Shari’a standard 17]. However economic substance of transaction (as claimed by

Islamic financial system) is compromised through fixing IBOR plus returns, redemption at par

value and also by providing guarantee.

Ideally returns on Skuk should be provided on the basis of actual returns generated from

the business. An Ijarah Skuk should provide the return to holders on the basis of actual rent of

assets and Musharaka Skuk should distribute profit on the basis of actual profit earned instead of

IBOR plus certain basis points. Likewise redemption price of Skuk should be decided on the

basis of actual market value of assets, instead of redeeming at par. If value of assets against

which Skuk were issued has been decreased (usually in case of Ijarah Skuk) or increased (usually

in case of Musharaka Skuk) then redemption at par value must be discouraged. It is very valid

view that return on Skuk should be at least at par with conventional bonds; however, the

8Very interesting case of Enron (USA) is recommended to readers to study for understanding of “Form over

Substance”

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objective can be achieved through higher rentals in case of Ijarah Skuk. In case of Musharaka

Skuk, these are equity units and should be served on the basis of actual results. Market itself will

decide the intrinsic value of securities and should be called for redemption on market price in

order to promote the real essence of Islamic finance i.e. sharing of risk and reward.

E-Deposits

Mudaraba is the chief tool of deposits collection for Islamic financial institutions. Current

deposits are accepted as loans from depositors which can be withdrawn on demand by

depositors. Some of the Islamic banks are accepting these deposits as Ammanah. If Ammanah

deposits are lost without negligence of bank, making the loss of depositors good is not

responsibility of the bank, hence, Ammanah deposits are not recommended to safeguard the

interest of both bank and customers. Under loan current deposit scheme bank has the flexibility

to use the funds and customer is protected from loss of amount in case of any miss-happening

(burglary, fire, theft etc.) in any branch of bank. Saving deposits are accepted under profit and

loss sharing schemes hence Shari’a rulings of Musharaka and Mudaraba apply as the case may

be. Generally banks are accepting deposits under Mudaraba then mix the funds of bank and

create a joint pool for investment. Out of this pool after meeting the statutory reserve

requirements investment portfolio is created and managed by IFIs. Any profit generated on

investment portfolio is shared by bank and depositors. As deposits are not fixed hence depositors

are free to deposit and withdraw which had created problem in profit distribution. IFIs came up

with solution of profit distribution on daily product basis. Third category of deposits is time

deposits under profit and loss sharing system. Under the scheme deposits are accepted for a fixed

period which provides opportunity to IFI to invest in more profitable long term projects hence

depositors of this scheme are getting higher profit in comparison of second scheme discussed

above. Longer the period, higher the rate of return is earned. Higher return to longer period

deposits is justified because it provide an opportunity to IFI to invest the funds in long term

projects, generally giving higher return, without the fear of returning to depositors on demand.

As for legal matters are concerned, every scheme is duly certified by Shari’a experts. In

every Islamic bank, Shari’a advisor as well as supervisory board exists. However following

observations demand due care from experts in the field. It is practice (knowingly & willfully) of

Islamic financial industry to serve the depositors at least equal to conventional banking in order

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to retain deposits. As for investment of funds by Islamic banks is concerned, resulting return may

or may not be sufficient to service depositors at par.

1. In case of actual return to depositor is more than conventional banking, Islamic banks are

happy, however if actual return to depositors is less than return offered by conventional

banks, usually IFIs sacrifice their share in profit to compensate the deficit of depositors.

At legal front there is no issue and any of partner can sacrifice his share in favor of other

partner, however this practice take away economic substance of transaction under Islamic

financial system and match with conventional banking.

2. Another issue is sharing of gross profit with depositors; hence in certain instances

(especially in initial years of a IFI) even if banks suffer net loss, depositors are gaining

return on their savings. In addition to compromising on economic substance under this

sheme, doubts in the minds of masses are also created as where is the difference between

conventional and Islamic banking.

As for legal form of contract is concerned, there is nothing against Shari’a, and one can negotiate

a contract of Mudaraba to share gross profit instead of net profit. Also there is no bar in

sacrificing share of profit by one partner(s) in favor of others without prior agreement, at the

time of profit distribution, however in the presence of such practices economic substance of

transaction shifts from Islamic financial system to conventional banking, leading to doubts in the

minds of masses, consequently jeopardizing future of Islamic financial industry.

In the following paragraph we are presenting our analysis as why this is happening?

There are two different classes of human resources participating in the operations of Islamic

financial system including Shari’a experts (mainly got education in Islamic schools with

negligible banking. Finance and accounting education) and bankers (educated in banking,

finance, accounting and business with very negligible knowledge of Islamic financial matters).

At the time of design of a product input is received as well as approval of final shape is sought

from Shari’a experts, hence legal contracts are designed which ensure formalities, however lacks

economic substance. In fact product development departments of Islamic financial institutions

have focused so for on existing products of conventional banking and offered their Islamic

versions with minor changes to ensure Shari’a compliance. Ideally every Islamic banker should

have knowledge of Shari’a as well as finance to develop new products in line with Shari’a

dictates and also viability in the financial market.

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Second is lack of training to existing staff of Islamic financial institutions to think beyond

current practices of conventional banking and understand philosophy of this relatively new

stream of banking, hence IFIs should focus on investing in training of their staff. Also training in

conventional finance and banking is required for Shari’a advisors and Shari’a supervisory board.

Guidelines for a specific course/module should be in practice by regulator (SBP) for bankers in

Shari’a and for Shari’a experts in conventional finance.

Third is external pressure of competitiveness with conventional financial industry, which

can overcome through expansion and growth of Islamic financial industry. Once market share of

Islamic financial industry dominates then bench marks will be settled in collaboration of Islamic

banks.

Also there is need of general awareness among the masses about philosophy and working

of Islamic financial system, so that people accept the concept of profit and loss sharing. At

present depositors expect positive return which makes sense, however perhaps they are not

willing to accept loss (at least it is perceived by Islamic banks). Also there is need to educate the

customers requesting for financing to be willing to share actual outcome of project instead of

comparing cost of Islamic finance with conventional finance.

V-ConclusionIn this study we have tested the calculation process used by IFIs in practice against the theory of

Islamic financial system. It is found that contracts of IFIs are in line with theory as far legal

position is concerned; however, economic substance is not different from conventional banking.

Following major observations are worth mentioning. First is calculations are based on

time value of money resulting in charging of rent based on IBOR plus a certain percentage in

cases of Ijarah, Diminshing Musharaka and Ijarah Skuk. Also time value of money dictates to

share profit under Musharaka Skuk in line with IBOR plus certain percentage and fixing of

prices under Murabaha sale based on length of receiveables. Second is sale and purchase of

equity units on par value ignoring market value. This is also result of bringing time value of

money in transactions. Third is use of guarantee by an independent third party in Skuk

transactions and sacrifice of profit share by IFIs in favour of depositors to compensate them if

actual result is less than conventional counterparts.

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Islamic financial system is unique (as is claimed by leaders in the industry), however this

uniqueness is not being displayed in financial contracts which determines financial rights and

liabilities. We selected five types of contracts (including Murabaha, Ijara, Diminishing

Musharaka, Skuk and Deposits) based on excessive use of these contracts by IFIs working in

Pakistan. It is found during the study that although IFIs have linked financing with assets (which

is really appreciable), however profit percentage is decided on the basis of prevailing interest rate

in the market (determined on the basis of demand and supply of capital) and not on the basis of

risk and return of underlying project. After examining the calculation process, alternate methods

suggested which are in line with theory. It is worthy to note that IFIs have to work for education

of customers to inculcate the uniqueness of system. It is required to project, present and practice

true Islamic financial system in order to make a meaningful difference in the global society. We

recommend following measures to experts, policy makers and regulators.

1. New product development mainly based on profit and loss sharing system, ignoring time

value of money.

2. Shari’a education courses/modules for bankers and conventional finance courses for

Shari’a experts.

3. Full fledge qualification on Islamic financial system consisting of relevant Shari’a and

Banking modules should be offered by Business schools keeping in view the potential

growth of industry worldwide.

4. Programs of general awareness among the masses through television programs,

conferences, workshops and provision of relevant literature.

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