Economic Substence or Legal Form: An Evaluation of Islamic Finance Practice

Presented at Global Forum on Islamic Finance 2013, PC Hotel, Lahore

I-Introduction

Islamic banking was started in last quarter of 20^th century and got momentum in first decade of 21^st 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 law) practices in financial sector including Riba (interest & usury),Gharar (excessive risk) Myser & Qimar (game of chance) and financing for Haram(prohibited) businesses [Examples of prohibited businesses include liquor, pork, pornography, promotion of adultery etc ]. 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 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 are 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 2008[1]. 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 softwares 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.
This study is intended to identify and analyze gaps (if any) between theory and practice of Islamic financial system to address the general confusion among the masses. Focus is to test legal form of selected contracts on Shari’a principles and analyze economic substance to document evidence. Findings suggest that although financial contracts take into account legal form, however economic substance is ignored. Rest of the study proceeds as follow. In section two background (history and principles of Islamic finance) is documented, followed by purpose and methodology in section III. Analysis is documented in section IV while section V concludes.

II-Background

IIA-Historic Development

Modern Islamic banking is a recent development in Muslim world, after getting liberation from colonial power in second half of 20^th century. Modoodi, (2000), was the first scholar in subcontinent who criticized the existing practice of interest based banking in 1936-37 [page 228]. First ever practical experience of interest free banking was done in a town of Egypt in 1963, which could not last longer. Mile stone in the history of Islamic banking was conference of OIC foreign ministers in 1973, where establishment of Islamic Development Bank was decided. Dubai Islamic bank started operation in 1975. After 1979 revolution Iran shifted whole of its economy on interest free operations. Malaysia started program of Hajj financing (Tabong Haji), later on converted to full fledge Islamic banking.
In Pakistan although it is recognized constitutionally that interest free banking would be the banking of economy (Articles 2, 31, 37, 227), however first ever genuine effort was made by Council of Islamic Ideology (CII) in 1980 in the form of first ever report on elimination of interest from the economy and suggested transition and implementation of Islamic banking at operational level. Pakistan started efforts initially by converting specialized financial institutions (e.g. HBFC, ICP) and transformed total banking system on interest free system in 1985. However this optimism failed very badly due to lack of human resource expert in Islamic banking and operations of banking industry continued on conventional system under the umbrella of profit and loss sharing.

This hypocrisy was not acceptable to practicing Muslims of Pakistan and they took the matter to federal Shari’a court. Apex court issued order in 1991, declaring the existing practice 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, for promotion of 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 September 2012, 18 (5+13) banks are operating in Pakistan with a branch network of 977, assets under operation are PKR 741 Billion, deposits PKR 627 Billions, financing and investments PKR 571 Billions. During last Nine years (2004-12) Islamic banking has depicted an unprecedented average annual growth of 65% (Y-o-Y). Islamic banking is covering approximately 8% of market share (SBP-2012).

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.

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 (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, Jeddah, 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 Supreme Court, 1999; Usmani, 2002; Qaradawi, 1960;  Modoodi, 2000; Rehman, Siddiqi, 2010; 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 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.

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.

5.         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.

III-Purpose and Methodology

This study is intended to analyze and test the financial contracts (being used in practice by Islamic 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 essence of Islamic financial system. We present to the 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. There are four deposit collection [including Mudaraba, Musharaka, Ammanah and loan] and ten investment and financing modes [including Murabaha, Masawama, Salam, Istsna’a, Ijarah, Musharaka, Diminshing Musharaka, Mudaraba, Skuk and equity investments] suggested for Islamic banking. In order to conclude on objectives of study five most widely used contracts (modes) including Murabaha, Ijarah, Diminishing Musharaka, Skuk and Mudaraba (deposits), were selected to test against the theory of Islamic financial system. 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[Mudaraba] used by Islamic financial industry for examination. Selection of contracts for analysis 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% (Hanif, 2011), 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 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 total 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 total 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 total 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 payment plan. Islamic finance discourages time value of money, while charging different profit based on payment plan and length of period, brings back time value in the transaction resulting in matching economic substance with conventional banking.
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. [Bley, et. al. 2004; Haque, et.al. 2009; Hanif, et. al. 2012]. 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 IFIs lease 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 Islamic Fiq Academy (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 [of that class]. Also ownership risks are required to be borne by lesser. 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. Furthermore principal amount is also recovered along with rentals (Hanif, 2011).
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: 

Where P is the amount spent on purchase of asset, R is the installment, I is the rate of return, nis 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	32,568	327,132	0
Total	1,798,500	298,500	1,500,000

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 class on rent. Rent of assets is determined independently (e.g. rent of vehicles is 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.

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 makes 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 calculation of 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%. Instead of receiving residual value in installments, through a changed contract asset can be sold for this price at the end of lease term.

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

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. Finally monthly rental of 18,000 can be reduced to 15,400 to be competitive with conventional banking. 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 to be shared according to the ratio of contribution (Usmani, 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 and also loss is to be shared according to equity stake. None of the partners 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 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 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.

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	-
Total	6,296,000	1,296,000	5,000,000

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 the 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 rate[2].

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 form of rent as well as purchase of equity share at par value. This practice takes away economic substance of Islamic financial system and matches transaction 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 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. 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 over conventional mortgages.

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

Overall difference in total charge is just Rs. 21,704/- in five years. It could be more or less depending upon market conditions; however there is a major difference in rental as well as selling price of equity shares by bank to customer. In fact there is a difference of Rs. 661,038/- in rentals and of Rs. 639,335/- in selling price of equity units. These differences of calculation clearly changes economic substance of transaction under both systems. Under conventional mortgage return is fixed while under Islamic return is variable depending upon market conditions, hence second method, in the opinion of author is more in line with essence of Islamic financial system.

D-Skuk

Skuk is a financial engineering under Islamic financial system to meet 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 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 Markets[3], 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 is present.

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. JAFZA 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.[4]One 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 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. Ammanah deposits cannot be utilized by bank in its operations. 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 this 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 is present. 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 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 the partners 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 an IFI) even if banks suffer net loss, depositors are gaining return on their savings. In addition to compromising on economic substance under this scheme, 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.
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-Conclusion

In 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 profit based on IBOR plus a certain percentage in cases of Ijarah, Diminishing Musharaka, Ijarah and 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 receivables. Second is sale and purchase of equity units on par 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 favor of depositors to compensate them if actual result is less than conventional counterparts.
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 staff and 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.

References

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2.      Bley, J. and Kuehn, K. (2004). Conventional verses Islamic finance: Students knowledge and perception in the United Arab Emirates. International Journal of Islamic Financial Services 5:4.

3.      CII-1980. Report on Elimination of Interest, Council of Islamic Ideology, Islamabad, Pakistan.

4.      Constitution of Pakistan; Government of Pakistan.

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[1] Murawajja Islami Bankari (Urdu), Maktaba Bayyanatt, Jamia Benori Town, Karachi, Pakistan.

[2] In 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.

[3]  www.123 accessed on 5^th July, 2010.

[4] An interesting case of Enron (USA) is recommended to readers to study for understanding of “Form over Substance”