Earlier Version published in International Journal of Business and Social Sciences, USA
In the second half of 20th century liberation of Muslim
world from colonial powers almost completed and widespread renaissance of Islamic
ideology took its path in Muslim societies whereby the masses started looking
at the existing social systems through Islamic lenses and proposed
modifications and developments. The Muslim thinkers and philosophers challenged
the world’s ruling economic and social systems and uncovered their weaknesses.
Capitalism was examined and criticized in detail due to its magnitude and
general acceptability in majority of leading societies of the world.[i]
Out of the four factors of production (as
described in Capitalism) reward of three is fixed and all risk is born by the
entrepreneur alone. In capitalism, capital is a factor of production, hence,
deserves the fixed reward in the form of interest --- a risk free reward. As
the bank is dealer of money; and reward for using money is interest according
to capitalist system; so the prime source of revenue and cost of funds to conventional
banks is charging interest through lending and accepting deposits for interest
respectively. Interest is the major driver of operations of conventional banks
although other valuable services including guarantees, funds transfers, safety
of wealth, facilitation in international trade etc. are also provided for
reward and form substantial part of income of modern conventional banks.
As the conventional banks are established under
the principles of capitalism and transect business by
charging interest, which is unacceptable (forbidden) in Islamic law, so Muslims left with no choice except to establish their own financial institutions under Islamic principles. The mile stone, in growth and popularity of Islamic Financial Institutions (IFIs), was the Conference of Foreign Ministers of Muslim countries (1973) under Organization of Islamic Conference (OIC), where decision to establish Islamic Development Bank (IDB) was taken place.
charging interest, which is unacceptable (forbidden) in Islamic law, so Muslims left with no choice except to establish their own financial institutions under Islamic principles. The mile stone, in growth and popularity of Islamic Financial Institutions (IFIs), was the Conference of Foreign Ministers of Muslim countries (1973) under Organization of Islamic Conference (OIC), where decision to establish Islamic Development Bank (IDB) was taken place.
Islamic finance has shown tremendous growth in
last two decades. By the end of December 2011, in more than 50 countries
approximately above 300 institutions are operating with an asset base of US$ 1,289
billion. Persian Gulf Area is the centre of Islamic finance with a share of 80%
followed by South Asia and Fareast region 15% and balance from all over the
world (IFSL-2012). So for (09/2012) five full-fledged Islamic banks and 13-conventional
banks with Independent Islamic Branches are operating in Pakistan. Growth in Islamic
banking industry in last nine years (01/04 - 09/12) is marvelous in Pakistan.
Figure 1 displays growth in Islamic banking in Pakistan (appendix A). Number of
branches has increased from 17 in 2003 to 977 within period under review an
average annual increase of 65%. Assets increased at average annual rate of 65%
while deposits increased at average annual rate of 73% and financial
disbursements and investments increased at average annual rate of 63% during
the period under review. Overall an average growth of 66% per annum in the last
nine years was achieved by Islamic banking in Pakistan.
This study is an attempt to understand the
mechanism of Islamic financial system and document the similarities and
differences in comparison with conventional financial system. Study has
documented the products (modes) used by Islamic Financial Institutions (IFIs)
in their operations including deposit collection, servicing and provision of
financing facilities, investments etc. and their applicability in competing
with conventional modes of financing and deposit collections. Study has also
uncovered the difficulties and hindrances being faced by Islamic financial
system at operational level given the non conducive and fully dominated
environment by interest based financing.
Rest of the study is in following order. Section
II discusses briefly background of the study focusing upon prohibition of
interest and interest free modes of financing used by IFIs followed by
differences and similarities in section III. Section VI concludes and offers
recommendations.
II. Background
Modern commercial banking is based on interest which is against the Shari’a
(Islamic law) hence for all the believers in Allah SWT (God) dealings with
these institutions do not suit well. Over the time role assumed by the banking
sector has become vital for the growth and development of economies and
societies (a jointly shared goal of humanity). A common man who is believer of
any revealed religion including Judaism, Christianity and Islam is very much in
a state of confusion. On one hand is the very cherishing dream of development
while on the other hand is faith. Furthermore
there is a reasonable number of experts who think and propagate that prohibited
riba means Usury (additional amount
charged on consumption loans) and not interest
(additional amount charged on production loans) being charged by modern
commercial banks. In this section I will analyze the term Riba (interest) and
finally present the modes of financing free of interest being used by IFIs to
service the needs of customers.
In Arabic term Riba is a synonym
for the term interest used in conventional banking operations. Riba means
charging predetermined additional amount on a loan extended based on length of
credit period. In the words of Imam Abubakr Al-Jassas (D.380 AH)[ii]
"The riba of Jahiliyya is a loan given for stipulated period
with a stipulated increase on the principal payable by the loanee."
Charging of interest on loans had never got support in ethics. Interest charging is forbidden by
all revealed religions including Islam. According to Old Testament of The Bible[iii] "Thou shalt not lend upon usury to thy brother;
usury of money, usury of victuals, usury of anything that is lent upon
usury." [Deuteronomy 23:19]
In
the wholly Qura’n four verses are about Riba (interest) revealed on different
occasions. The first verse is in Surah Al-Rum 30:39[iv]
whereby displeasure of Allah is disclosed for interest based practices. The
second verse is in Surah An-Nisaa 4:161 where interest charging was disclosed as sinful act of Jews. The third verse is part of Surah Al-i-'Imran 3:130 whereby
prohibition of Riba (interest) was declared "O those who believe do not eat up riba doubled and
redoubled." The last verse revealed is reported in
Surah Al-Baqarah 2:275 whereby severe punishment is
declared for those dealing in interest "Those who take interest will not stand but as
stands whom the demon has driven crazy by his touch. That is because they have
said: 'Trading is but like riba'.
And Allah has permitted trading and prohibited riba. So, whoever receives an advice from his Lord and stops, he
is allowed what has passed, and his matter is up to Allah. And the ones who
revert back, those are the people of Fire. There they remain forever” (translation from Usmani, 1999).
Instructions
are clear. No ambiguity is left. If a person believes in revelations then s/he
should avoid charging interest and seek the pleasure of Allah (SWT). It is the
responsibility of all true believers in God (Jews, Christians and Muslims) to
give up interest based transactions from their personal lives immediately and
input their energies collectively to design promote and implement a financial
system free of interest. Certain
quarters are of the view that Riba which is prohibited by revelations is the
Usury (interest charged on consumption loans) and banking interest (interest
charged on productive loans) is not covered by the term. This point was debated
in detail during the Supreme Court (Pakistan) hearing and concluded that there
was no difference between usury and interest as for prohibition is concerned.
Extract from the decision follows “It is
thus clear that the permissibility of interest can neither be based on the
financial position of the debtor, nor on the purpose for which money is
borrowed, and therefore the distinction between consumption loans and productive loans in
this respect is contrary to the well-established principles” (Usmani, 1999
Para 72).
The
consensus view of Muslims about the meaning of Riba is presented here under. Islamic
Fiqh Academy India[v] defines “Riba (interest) is a very important term in the Islamic
terminology showing disapproval and it refers to the instrument by which a
loaner charges some amount lump sum or in installments over and above his
principal amount from the loanee and thus increases his wealth manifold without
participating in the business process of profit and loss”. Siddiqi, (2004) concluded that
unanimous view of Muslims throughout history remained is--- any excess charge
in a contract of loan is riba ---- and bank interest has no exception. Islamic
Fiqh Academy (IFA) Jeddah of OIC representing the collective wisdom of Shari’a
experts is of the view that any increase stipulated in a contract of loan
irrespective whether consumption loan or productive loan is Riba and prohibited
by Allah (SWT). "The equivalence of riba to interest has always been unanimously recognized in Muslim history by all schools of
thought. In conformity with this consensus the Islamic Fiqh Academy of the
Organization of the Islamic Conference (OIC) has recently issued a verdict in
its Resolution No. 10(10/2) upholding the historical consensus on the
prohibition of interest”. [Iqbal and Molyneux, p. 9; IFC/2000][vi].
While deciding the issue of banking interest as permitted or prohibited
in ISalam, Supreme Court (Pakistan) declared that “Any additional amount over the principal in a contract of loan or debt
is the riba prohibited by the Holy Qur'an in several verses” (Usmani, 1999 Para 242).
Following
conclusions are drawn from above citations; First Interest is prohibited by all
revealed religions and charging of interest is Haram (unlawful) for Jews,
Christians and Muslims. Second; as for prohibition of interest is concerned,
there is no difference in commercial loans and consumption loans at all and
bank interest is haram (unlawful). While it is clear from the above citations
that dealing in interest is Haram (unlawful);
and design of conventional banks is based on interest; important role of
commercial banks cannot be rejected in the modern economy; so change in the
philosophy and design of commercial banking is required to make it suitable for
believers and meet the religious obligation.
Referring to the above citation it is concluded that what is prohibited through
revelations is the pre determined charge on capital (risk free return) and not
the profit on capital (involving risk). Muslim Jurists are of the view
that reward for capital should be linked with the outcome of the underlying
project if financing facility is being extended and/or reward should be
obtained through trade involving sale and purchase. Based on objectives of
Shari’a following principles of Islamic finance have been documented by
Clerics.
First
is prohibition of interest and usury in financial dealings. 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 independently. 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.
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.
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)
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.
Fifth
principle of Islamic finance is financing for only Halal (permitted) businesses. According to Qaradawi, (1960)
“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
(Clerics) have 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. Hanif & Iqbal,
(2010), categorized Islamic modes of financing objectively in two heads; Shari’a
compliant and Shari’a based. Table 1 displays Islamic modes of financing
(appendix A). A brief introduction of
the terms used for modes of financing is provided here.[1]
Shari’a
compliant products mean the modes of financing where return of financier is
predetermined and fixed but within Shari’a constraints. The tools which are
relatively harmonizing the operations of Islamic financial system with
conventional banking includes Murabaha (cost plus profit sale), Ijarah (a
rental arrangement), Bai Salam (spot payment for future delivery), Bai Muajjal
(sale on deferred payment), Istisna’a (order to manufacture) and Diminishing
Musharaka (house financing) are all Shari’a compliant products. Shari’a based
transactions means the financing modes adopted by IFIs on profit and loss
sharing basis including Musharaka (partnership in capital) and Mudaraba
(partnership of capital and skill). Under Shari’a based modes of financing
returns of financier are not fixed in advance rather it depends upon the
outcome of the project. However loss is to be shared according to capital
contribution. Following the rule of substance over form one can conclude that
the major difference between conventional and Islamic financing is Shari’a
based modes of financing.
III. Similarities and Differences
Islamic Financial Institutions (IFIs) operate in the same society
where conventional banks do and perform all those functions which are expected
from a financial institution. IFIs assist business world by providing all the
services required to run the economy smoothly, however, the philosophy and
operations are different. In this section I will analyze the operations and
products of IFIs in comparison with traditional conventional banks. Any
financial system is expected to assist in running the economy by providing the
following services grouped in two headings. First; Savings mobilization from
savers to entrepreneurs and Second; Provision of general utility services
including transfer of funds, facilitation in international trades, consultancy
services, safekeeping of valuables, and any other service for a fee. There is
no restriction on provision of such services by IFIs except the service is
against Shari’a. However there exists difference in mechanism of funds
mobilization from savers to entrepreneurs as described following. Savings mobilization
consists of two phases’ i.e. accepting deposits and extending financing and
investments.
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Deposits are collected from savers under both types of institutions
for reward irrespective a bank is operating under conventional system or Islamic
system. The difference lies in agreement of reward. Under conventional system
reward is fixed and predetermined while under Islamic deposits are accepted
through Musharaka and Mudaraba (appendix B) where reward is variable. Under
conventional banking return is higher on long-term deposits and lower for
short-term deposits. Same is the practice in Islamic banking to share profit
with depositors. Higher weight for profit sharing is assigned to long-term
deposits being available to bank for investing in longer term projects yielding
superior returns and lower weight for short-term deposits which cannot be
invested in long term projects. The only difference in conventional and Islamic
system lies in sharing of risk and reward. Under conventional system total risk
is born by the bank and total reward belongs to it after servicing the
depositors at fixed rate while under Islamic system risk and reward both are
shared with depositors. Reward of depositors is linked with outcomes of
investments made by IFIs. Under Islamic financial system only those IFIs will
be able to collect deposits who can establish trust in the eyes of masses hence
leading to optimal performance by financial industry. So for IFIs working in
Pakistan have succeeded in establishing their credibility in the eyes of savers
as depicted in figure 1 (appendix A) an increasing trend in deposits collection.
3.2. Financing and Investments
The second phase in savings mobilization process is extension of
credit facility to business and industry for return. Both types of institutions
(Islamic and Conventional) are providing financing to productive channels for
reward. The difference lies in financing agreements. Conventional banks offer
loan for a fixed reward while IFIs cannot do that because they cannot charge
interest. IFIs can charge profit on investments but not interest on loans. In
conventional banking three types of loans are issued to clients including short
term loans, overdrafts and long-term loans. Islamic banks cannot issue loans
except interest free loans (Qarz e Hasna) for any requirement however they can
do business by providing the required asset to client and/or participating in
outcome of the underlying project. In following paragraphs I present the
comparative working of different products (financing scheme) of both systems.
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Conventional banks offer the facility of overdrawing from account of
the customer on interest. One of its form is use of credit card whereby limit
of overdrawing for customer is set by the bank. Credit card provides dual
facility to customers including financing as well as facility of plastic money
whereby customer can meet his requirement without carrying cash. As for
facility of financing is concerned that is not offered by Islamic banks except
in the form of Murabaha (which means IFI shall deliver the desired commodity
and not the cash) however facility to shop/meet requirement is provided through
debit card whereby a customer can use his card if his account carries credit
balance. Under conventional banking a customer is charged with interest once
the facility availed however under Murabaha only profit is due when the
commodity is delivered to the customer. Furthermore in case of default customer
is charged with further interest for the extra period under conventional system
however extra charging is not allowed under Murabaha. Third; under conventional
system customer can avail the opportunity of rescheduling by entering into a
new agreement to pay interest for extended period which is not the case under
Murabaha. IFIs can claim only the original receivable amount agreed in initial
contract. Another practical issue under Murabaha is how to deal with
intentional defaulters. Different options are lying with IFIs including to
blacklist the defaulter for any further financing facility, to stipulate in the
contract that in case of default all installments will be due at once, to
stipulate in the contract a penalty shall be imposed but the same shall not
form income of IFIs rather it will go in charity (Usmani, 2002). 
Short and medium term loans are provided to customers to meet working
capital requirements of firms by conventional banks. Working capital is
required by firms to invest in inventories and accounts receivables and meet
the expenses. As for inventory investment is concerned that is provided by Islamic
banks through Murabaha. As for meeting of day to day expenses of business is
concerned financing is provided through participation term certificates where
by profit of a certain period (e.g. quarter, six month, one year) is shared by
IFIs on prorata basis. However financing through participation term certificates
is not as easy as a short term loan from conventional bank due to risk involved
for IFIs in the transaction. Firm seeking short-term facility from IFIs has to
prove the viability of the project/business to the satisfaction of investor.
For meeting the working capital requirements of
nonprofit organizations to date there is no arrangement under Islamic financial
system. Personal consumption loans are also not issued by IFIs however any
individual of sound financial position can acquire anything for his personal
use under Murabaha financing whereby a certain percentage of profit is added on
cost by IFIs. Murabaha financing is very useful for short to medium term
financial requirements of business/nonprofit organizations and individuals. Murabaha
financing is asset based financing and anyone can request to an IFI for
provision of an asset generally used for Halal (lawful) purposes. By default
under Islamic financial system IFIs cannot lend cash for interest (only
exception is Qarz e Hasna—Charity loan).
One of the features of Murabaha is the case of
delay in payment by customer. IFI cannot ask for extra amount as time value of
money like conventional banks. However penalty is imposed on defaulter if
stipulated in original contract of Murabaha duly signed by the customer but
same cannot be included in the income of IFI. This penalty must be spent for
charitable purposes. Under Murabaha scheme of financing facility is linked with
assets which leads to economic stability and creates linkage between real and
financial sector. It is not zero sum game because utility is created through
services and products and not by mere building the blocks of wealth through
dealing in paper money.
Although Murabaha is being used by IFIs
successfully and have succeeded in meeting short to medium term requirements of
firms by providing a successful replacement of conventional loans yet certain
differences exist in both types of financing. First is one cannot get cash
under Murabaha. Second asset is purchased by IFI initially then transferred to
customer hence IFI participate in risk. Third refinancing facility is not
available under Murabaha. Fourth in case of default price of the commodity
cannot be enhanced however penalty may be imposed if stipulated in original
contract of Murabaha however same cannot be included in income of IFI. Fifth
only those assets can be supplied by IFIs under Murabaha whose general and/or
intended use is not against the injunctions of Shari’a (e.g. supply of a
machine to produce liquor)
Medium to long-term loans are provided for purchase or building of
fixed assets by firms to expand or replace the existing assets. Under Islamic
financial system requirement of firms and individuals are fulfilled through
Murabaha, Bai Muajjal and Istisna’a (discussed in appendix B). Another
financing option for long-term financing is profit & loss sharing under
Musharaka and Mudaraba (discussed in appendix B). Although financing under
Murabaha, Bai Muajjal and Istisna’a is very much look like conventional loans
with the only difference of provision of asset and not cash to client however differences
exist in the contracts which alter the nature of risks and returns. Financing under
Musharaka and Mudaraba is challenging for IFIs and firms as well. Under Shari’a
based financing schemes firms have to prove the viability/profitability of the
project/business to the satisfaction of IFIs to get the finance because risk of
losing the amount is involved.
3.2.4. Leasing
Leasing is relatively recent source of financing whereby usufruct of
an asset is transferred to lessee for agreed amounts of rentals. Under leasing
ownership may or may not be transferred. Same facility is provided by IFIs
under agreement of Ijarah. Under Ijarah asset is provided to customer for use
with out transfer of ownership for a specific period of time in exchange for
agreed rentals. Ownership of asset can be transferred to customer through
mutual agreement at the completion of lease term. All ownership risks are born
by IFIs during Ijarah tenure. Certain differences exist in the transaction
under both systems. First is rental under Ijarah are not due until asset is
delivered to the lessee for use. Second additional rent cannot be demanded in
case of default except a penalty (if stipulated in original contract of lease)
which is not the income of IFI. Third during period of major repair rent cannot
be demanded by IFI. Fourth if asset is lost or destroyed, IFI cannot claim
further installments hence all risks of ownership are born by IFI.
Agricultural loans include both types of loans short-term as well as
long-term. Short-term loans are required by farmers for seeds and fertilizers
and long-term loans are required to develop additional lands and purchase of
equipments. Normally farmers return these loans after selling the finished
crops. Conventional banks provide credit facility by charging interest. Same facility
is provided by IFIs to the farmers under Bai Salam, Bai Murabaha Musharaka and
Mudaraba (discussed in appendix B). Bai Salam is a form of sale contract where
by IFIs purchase goods for spot payment with deferred delivery. Practically it
is used in financing of agricultural needs of farmers. Farmers sell their crops
prior to harvesting to IFIs in order to get money to purchase seeds and
fertilizers. For purchase of equipments Murabaha facility is used and for
development of additional land Musharaka and Mudaraba is used by IFIs. To get
finance for land development farmers have to convince the IFIs about
profitability of the venture due to risk involved in the transaction.
Housing finance/Mortgages is the more secured form of financing for
both conventional banks as well as IFIs. Under conventional system loan is
provided for interest while under Islamic financial system facility is provided
through diminishing Musharaka. Under diminishing Musharaka house is purchased
jointly by IFI and customer. IFI rents out its share in property to customer
for an agreed amount of rent. Share of financier is divided in units of small
denomination. Customer pays the installments to IFI consist of rentals plus
purchase price of a unit. Stake of customer in property is increasing while of
IFI is decreasing with payment of every installment. Finally with the payment
of last installment stake of IFI reaches to zero and property is transferred in
the name of customer. Diminishing Musharaka model can help out in avoiding the
real estate crisis (like of 2008) because when market value of property
decreases both IFI and customer suffers according to their share in property
and whole burden is not shifted on customer alone. Hijazi, & Hanif (2010)
have raised certain questions about the existing practice of IFIs working in
Pakistan and needs to be addressed by policymakers, Shari’a boards and
management of IFIs.
3.2.7. Investments
In order to maintain liquidity conventional banks have many avenues
including government securities, short term loans and money at call and short
notices, leasing companies’ bonds, investment in shares etc. Interestingly
mandatory reserve maintenance by conventional banks (a portion with central
banks and another portion invested in government securities) is also rewarded
in the form of interest. Conventional banks can also create liquidity by
issuing the bonds against their receivables. Conventional banks are also
protected by central banks by providing liquidity in rainy days for interest.
Interbank deposits are also rewarded in the form of interest by commercial
banks.
For IFIs avenues are very limited to create
required liquidity at the same time to earn some revenue by investing in short
term and liquid securities. IFIs cannot invest in government securities, short
term loans, bonds and money at call and short notices because of interest based
transactions. Mandatory reserve with central banks is maintained by IFIs but
they are not rewarded like conventional banks. Looking towards central banks in
rainy days to maintain liquidity is also not as straightforward due to interest
demand of central bank. IFIs cannot demand interest on interbank deposits. As for investment in market able securities
are concerned again IFIs are not free to invest in any equity security due to
two reasons. First Halal business of the underlying firm is required. Second
financial operations of underlying firm should be interest free. Keeping in
view the dominance of conventional banking and existing business practices one
can conclude very safely that a very negligible number of firms meet both
conditions. The much appreciable job has
been done through creation of Islamic Indexes worldwide. Almeezan investment
management limited (AIML) a subsidiary of leading Islamic bank in Pakistan
(Meezan bank) in this regard took step in 2008 and created KSE-Meezan Index
(KMI-30). A list of Shari’a compliant securities is being maintained and
updated every six monthly out of which 30 companies are selected for KMI-30. Although
differences exist in different indexes’ in Shari’a compliance filters which
needs attention of experts.
IFIs can
invest only in those securities which are declared Shari’a compliant securities
through filtering of Shari’a compliance criteria. Listing here the major
conditions to qualify a security as Shari’a compliant is worth mentioning as
follow. Meeting of following tests is required to declare a security as Shari’a
compliant (KMI-2008). First the core business of the company should be Halal
(not prohibited by Islamic Law such as liquor, pork and pornography etc).
Second illiquid assets should be equal to 20% of total assets of the company. Shares
of a company merely dealing in liquid assets are not Shari’a compliant hence
IFIs cannot invest. Third ratio of all interest based debts including preferred
stock should be less than 40% of total assets of the company. Fourth ratio of
non Shari’a compliant investments to total assets of the company should be less
than 33%. Fifth revenue from non compliant investments should be less than 5%
of total revenue of the company and even then IFIs are required to purify their
earnings by spending this non compliant revenue as charity. Finally market
price per share should be greater than the net liquid assets per share.
Recently
IFIs have created an avenue to meet their liquidity requirement in the form of Skuk
(Islamic Bonds) whereby servicing is fixed like conventional bonds however such
types of Skuk can be issued against Ijarah receivables. Under Ijarah Skuk
initially asset is given on rent to the customer for an agreed period and
rentals while ownership remains with IFI. To meet liquidity requirements IFI
issues Skuk (bonds) to the investors equal to the value of asset, hence
ownership of the asset is transferred to Skuk-holders. While it is known the
rentals of the asset so the return on investment is predetermined and known
with certainty to the investors, however risk is born by investor. Skuk of
Murabaha cannot be sold except at par being sale of loans. Other types of Skuk
(Musharaka etc) are not carrying fixed return although tradable in secondary
security market. Underlying principle in issue of Skuk is that illiquid assets
should dominate in the portfolio against which Skuk are issued. Under Islamic
financial system Skuk are ownership certificates and not mere debt securities
hence all risks and rewards are shared by Skuk-holders.
IV. Conclusion
Islamic financing is working within the Shari’a frame work following
certain restrictions including following. First IFIs cannot provide finance for
an activity which is prohibited by Shari’a (Islamic law) irrespective of its
profitability and economic viability e.g. business of liquor, pork and pornography.
Second IFIs cannot lend any amount in cash for interest however need is
fulfilled either through supply of required asset or through profit and loss
sharing. Consequently certain financial needs of some sections of the society
are ignored in financing including personal loans and working capital
requirements of not for profit organizations. Third under Islamic financial
system when financing is provided under profit and loss sharing although profit
can be shared as per agreement between the parties involved however loss must
be shared according to capital contribution/ownership.
Islamic banking is not as foreign to business
world as it is perceived by certain quarters. It is a business very much like
conventional banking within certain restrictions imposed by Islamic law. All
business needs are being fulfilled by IFIs in efficient ways through Murabaha, Ijarah,
Bai Muajjal, Bai Salam, Istisna’a, Musharaka and Mudaraba. Two features of Islamic
financial system are worth mentioning. First is linkage between financial and
real sector as IFIs cannot extend credit facility without having support from
real sector. Financing is either made through sharing risk and reward or must
be asset backed. Second a unique feature of Islamic financial system is in the
form of Mudaraba which can play role of catalyst for transforming society into
prosperity by extending capital facility to skilful persons lacking
capital. Under Mudaraba mode of
financing partnership between capital and skill is formed hence it can be used
to provide self employment to jobless skilful citizens.
Islamic banking is not a mere copy of
conventional banks as perceived by certain Muslims. It has its own way of doing
business and all operations are duly certified by Shari’a experts ranging from Shari’a
advisor to Shari’a boards and finally Islamic Fiqh Academy (IFA). Portfolios of
IFIs are dominated by Shari’a compliant modes of financing and negligible
investments are being made under Musharaka and Mudaraba. Shari’a based modes of
financing which can create a real difference in the society are not getting
momentum in the operations of IFIs. Hanif, & Iqbal, (2010) have identified
the hindrances (e.g. profit manipulation, riskiness of financing under Musharaka,
lack of awareness, widespread conventional banking, lack of skilled human
resources etc.) in the way of popularity of Shari’a based financing and
concluded that existing accounting and business frame work is not conducive for
application of Musharaka and Mudaraba.
Islamic banks are doing business in a
nonconductive environment which makes operations challenging. IFIs cannot claim
interest on their balances with other banks, on mandatory cash reserve
maintained with central bank, cannot invest in government securities, interest
based bonds, cannot claim time value of money from defaulters, bear risks in
sale and lease transactions, can only invest in Shari’a compliant securities
and not in all available equities and finally have to compete with conventional
banks in deposit servicing as well as in financing. In spite of these
difficulties growth of Islamic financial system world over in general and
marvelous growth of 66% (average annual) in Pakistan in last nine years
suggests a bright and promising future of this financing system. Two issues at
hand demands attention of policy makers immediately including a separate law of
Islamic banking to regulate the industry and implementation of accounting
standards issued by Auditing & Accounting Organization of Islamic Financial
Institutions (AAOIFI) for preparation of annual reports of IFIs.
References
1. AAOIFI.
(2003). Accounting and Auditing Standards
for Islamic Financial Institutions,
International Institute of Islamic Economics, Islamabad, Pakistan.
2. AAOIFI. (2004). Shari’a Standards. P.O. Box 1176, Bahrain.
3.
Ayub, Muhammad (2007). Understanding Islamic Finance.
John Wiley & Sons limited, John Wiley & Sons Ltd, The Atrium, Southern
Gate, Chichester, West Sussex PO19 8SQ, England.
4.
Ghazi, M.A., (2010). Mahazrat e Maeshat o Tijarat. Alfaisal
Publishers, Ghazni street, Unrdu Bazar, Lahore, Pakistan.
5. Hanif,
M., & Iqbal, A., (2010). Islamic Financing and Business Framework: A
Survey. European Journal of Social
Sciences 15:4 pages 475-489.
6. Hijazi,
T.S., & Hanif, M., (2010). Islamic Housing Finance: A Critical Analysis and
Comparison with Conventional Mortgages. Middle
Eastern Finance & Economics Issue 6 pages 99-107.
7. IFSL-2012,
International Financial Services London, Report on Islamic Banking. http://www.ifsl.org.uk/output/ReportItem.aspx?NewsID=32
accessed on March 30, 2012.
8. Khan,
M.A., (1989). Economic Teachings of
Prophet Muhammad: A Select Anthology of Hadith Literature on Economics,
chapter 6:2, page 72. International Institute of Islamic Economics, P.O. Box
1647, Islamabad, Pakistan.
9. KMI-Broacher
(2008). Available at KSE.com accessed on 14/10/2010.
10. Mansoori,
M.T., (2007). Shari’a Maxims on Financial Matters. International Institute of
Islamic Economics, International Islamic University, Islamabad.
11. Meezan
Bank (2002). Guide on Islamic Banking. Darul Ishaat Karchi, Pakistan.
12. Qaradawi,
Y., (1960). The Lawful and Prohibited in Islam. Available at http://www.ymsite.com/books/lpi/index.htm,
accessed on 16th February, 2012.
13. Qura’n:
The Holy book of religion Islam. Available everywhere.
14. SBP-2012.
Islamic Banking Bulliten, State Bank of Pakistan. WWW.sbp.gov.pk.
15. Siddiqi,
M.N., (2004). Riba, Bank interest and the
rationale of its prohibition. Islamic Research & Training Institute
Jeddah.
16. Siddiqi,
Nijatullah, (2010). Maqasad e Shari’a (Objectives of Sari’a). Institute of
Islamic Research, International Islamic University, Islamabad.
17. Usmani,
T.S., (1999).SAB-SCP (Shari’a Appellant Bench. Supreme court of Pakistan).
www.albalagh.net/Islamic_economics/riba_judgement html, accessed on February
18, 2009.
18. Usmani,
T.S., (2002). An Introduction to Islamic
Finance. Maktaba Ma’arif Al Quran, Karachi, Pakistan.
19. Zaman,
A., (2010). On Islamic Economic. Published in The Express Tribune, June 10th.
Appendix A. Figures and Tables
Figure 1: depicts growth in Islamic Banking in
Pakistan Rs. Billions
Data
Source: SBP-2012
Table
1 displaying Islamic modes of financing categorized objectively.
Shari’a Based
|
Shari’a Compliance
|
Musharaka
|
Murabaha
|
Mudaraba
|
Ijarah
|
Diminishing Musharaka
|
|
Bai Salam
|
|
Bai Muajjal
|
|
Istisna’a
|
Appendix B. Islamic Modes of Financing[vii]
Shari’a Compliant
1. Murabaha
Murabaha is a cost-plus sale contract whereby disclosure of cost
to the buyer is necessary. Under Murabaha arrangement customer requests to the Islamic
Financial Institution (IFI) to purchase an asset for him (customer) and sell on
deferred payment. An essential feature of Murabaha is that IFI must purchase
the required commodity from supplier first and then sell to customer. Bank
charges a certain profit usually linked with Inter Bank Offered Rate. Recovery
could be agreed in installments or Balloon payment. Amount of installment or
price of the asset cannot be (stipulated) increased or decreased in case of
default or early payment (Shari’a standard 8). In order to create pressure on
client for prompt payment a penalty is imposed upon customer as agreed in
Murabaha contract. Amount of penalty for default in prompt payment recovered
cannot be included in income of IFI in any case and must be spent for charity
(Usmani, 2002). Murabaha has successfully replaced the overdraft and short term
loans facility under conventional banking.
2. Ijarah
Ijarah is a rental contract whereby IFI leases an asset for a specific
rent and period to the client. Ownership risks of the asset are born 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). Ijarah has
replaced successfully the facility of leasing under conventional financial
system.
3. Diminishing Musharaka
Diminishing Musharaka
is a 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 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). Diminishing Musharaka is used for
house financing by IFIs and has replaced successfully conventional mortgages.
4. Bai Salam
Bai e Salam is a form of sale contract where by IFIs purchase goods for
spot payment with deferred delivery. Practically it is used in financing of
agricultural needs of farmers. Farmers sell their crops prior to harvesting to
IFIs in order to get money to purchase seeds and fertilizers. Generally spot
price agreed is lesser than future the actual date of delivery, hence IFIs are
making profit. As a matter of practice IFIs are entering into a parallel Salam
contract with third party to sell the proceeds once taken over however
execution of second contract is not conditional to the fulfillment of first (Shari’a
standard 10).
5. Bai Muajjal
Literal meaning is
deferred / credit sales. Islamic financial Institutions (IFIs) are using this
mode to finance the customers’ needs by supply of desired commodities. The
difference between Murabaha and Bai Muajjal lies in disclosure of cost. Under
Bai Muajjal cost may or may not be disclosed. All other features are same as
discussed in Murabaha.
6. Istisna’a
This mode of financing is designed to transect business through an
order to manufacture and/or supply. It is a sales contract with the exception
of existence of subject matter. This tool of financing is useful for
infrastructure projects. Parallel Istisna’a contract is allowed however
performance of second Istisna’a contract must not be conditional on the
fulfillment of first contract (Shari’a standard 11).
Shari’a Based
1. Musharaka
According to Hadith
Qudasi (revelation reported by Prophet Muhammad PBUH) “Indeed, Allah the Exalted says: I am the third of the two partners so
long as the one does not cheat the other, and when he cheats, I withdraw
myself” (Khan, 1989). 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. 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). Under Musharaka IFIs are
receiving deposits and finances business requirements for profit and loss
sharing.
2. Mudaraba
Mudaraba is a type of
partnership whereby skill and money brought together to conduct business.
Profit is shared according to agreement while loss is born by capital provider
only. Under this scheme of financing IFIs provide capital to financially weak but
skilful people to do the business and share outcome with IFIs. This scheme is
also used in deposit collection. Mudaraba contract can be restricted or
unrestricted. No one can claim a lump sum amount of profit it must be based on
actual outcome (Shari’a standard 13).
Notes
[i] For
example Writings of Syed A.A. Maudoodi,
Umer Chapra, Prof. Khurshid Ahmed, Justice ® Taqi Usmani, Justice ® Tanzeel ur
Rehman, Dr. Shah Ul Hameed, reports of Council of Islamic Ideology (Pak),
decisions on Riba by Federal Shari’a Court 1991 and Supreme Court Shari’a
Appellant Bench 1999, Nijatullah Sidiqi and Dr. Asad Zaman.
[ii] As cited by Usmani, (1999)
[iii] This
verse along five others relating to interest / usury from The Bible are
reported by Usmani, (1999) in paragraph 37.
[iv] Sura
Number then Verse Number.
[v] http://ifa-india.org/english/arabic_Words.html
accessed on 20th March, 2010.
[vi] http://www.globalwebpost.com/farooqm/writings/islamic/r-i-consensus.html
accessed on March 20th 2010.
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