Friday, 18 October 2013

Islamic Banking: An Update

1. Introduction

Societies are building on the basis of certain ideologies and formation of Muslim society is based on Islamic ideology. In order to understand the institution building in any society understanding the ideology and philosophy of life (and death) is prerequisite. Muslims believe in oneness of Allah (God) the sole creator of this universe, prophet-hood (Messengers of Allah came to the world to reform the society), and Day of Judgment (everyone has to answerable for his deeds before Allah). According to religion of Islam life of every believer is regulated through the revelations (Qura’n & Sunnah). In order to extract legal order from Qura’n & Sunnah religious clerics conduct research and come up with a solution of existing problem keeping in view the objectives of Shari’a (Islamic law). Objectives of Shari’a include safety of faith (Hifz e Eimaan), life (Hifz e Jaan), wealth (Hifz e Maal), Conscious (Hifz e Aqal) and next generation (Hifz e Nasal) [Siddiqi, 2000]. While it is settled opinion of Muslim jurists that any sphere of life either directly regulated through revelations or juristic opinion by experts in Shari’a (if direct order is not found in revelations), hence, financial matters have no exception.
Capitalism is dominant economic system prevailing (complete or partial) in almost every society of the world including Muslim countries. According to capitalism factors of production include land, labor, capital and organization. Rewards for three of the production factors (i.e. land, labor and capital) are fixed while reward of entrepreneur is variable depending upon the outcome of the underlying project. Reward for three factors of production is risk free and cannot be negative however entrepreneur’s reward can be zero or even negative. Although underlying project is completed by participation of all factors of production however in case of reward, share of three of them (land, labor and capital) is fixed irrespective of outcome. If a huge profit is earned it belongs to entrepreneur (after servicing other factors of production) and if a heavy loss is suffered that also borne by entrepreneur.

According to Shari’a reward for entrepreneur is not fixed hence it is similarity in capitalism and Islamic financial system however difference lies in fixation of reward for capital. According to Islamic financial system reward for capital is also variable and not predetermined. For Muslims practicing of true capitalism in its original form does not suit well because it contradicts with faith. An ordinary Muslim is very much confused about his economic matters because business world is dominated by capitalism especially interest based banking. On one side is the cherish dream of development and better life while on the other hand is faith in Allah which demands abide by the Shari’a. Sources of law in Islam have categorized (into four) keeping in view the changing needs of society.
Two are the prime sources (Qura’n & Sunnah) while two are derivations/ inferences i.e. Ijma’a (consensus opinion of clerics) and Qias (individual opinion of a cleric). Qura’n (the revealed book of Islam) is at the top in order and if guidance in a matter is not discussed in Qura’n then Sunnah (includes actions and sayings of Prophet Muhammad PBUH) is consulted. If no guidance  found in Sunnah relating to underlying matter then Ijma’a (consensus opinion of experts in Shari’a) is consulted and finally if nothing exists in Ijma’a relating to the underlying issue then Qias (individual opinion of an expert in Shari’a) is allowed.Room of difference in opinion for an individual exists in two sources of law i.e. Sunnah and Qias. In case of Sunnah reporting authority of a Hadith (tradition) can be questioned and Ulema (clerics) of Islam have done a very good job by categorizing Hadiths as weak and strong on the basis of reporting evidence. However in case of Qias one can have difference of opinion based on solid arguments not violating any principle of Shari’a and specifically matching with the objectives of Shari’a.
Prohibition of Riba (usury and interest) has proven in three sources of law repeatedly (Qura’n, Hadith and Ijma’a) hence no question of having difference of opinion according to Shari’a. First in Qura’n four sets of verses have been identified dealing with the charging of Riba[1] (30:39, 4:161, 3:130, & 2:275-281). Second several Hadiths clearing the meanings of Riba in various transactions have been reported (khan, 1989). Third resolutions of council of Islamic Fiqh Academy are very much qualifying the status of Ijma’a on the issue of Riba. Fourth there are several Ulema who declared both usury and commercial interest Haram (Unlawful) (e.g. see Usmani 1999, 2002 & Usmani 2003, Qarzawi, Maudoodi 1961, Rehman, Siddiqi 2006,  Chapra, Zaman 2010, Ayub 2007). As discussed earlier one can have difference of opinion in two sources of law i.e. Sunnah and Qias and not in Qura’n and Ijma’a hence it is very much clear now that commercial interest is Haram (Prohibited) undoubtedly because we found the evidence in Qura’n, Sunnah and Ijma’a.
Interest is the foundation on which the organization of modern commercial as well as central banking is running and prospering. Important role of these institutions in running the modern economies cannot be undermined. Keeping in view the prohibition of interest and importance of banking in the economy,  Muslims (clerics & professionals) decided to search for an alternative and after due consideration they came up with the idea of Islamic banking. Islamic banking is not the dealing in money like conventional banking. It is dealing in goods and services. The milestone in formation and implementation of Islamic financial system was the conference of Foreign Ministers of Organization of Islamic Conference (OIC) 1973, in Jeddah, whereby decision to establish Islamic Development Bank (IDB) was taken place. During last quarter of 20th century serious efforts were made for promotion of Islamic financial system in Muslim societies as well as throughout the world in general. This journey has been continuing in the 21st century as well.
By the end of 2011, estimated global volume of assets of Islamic finance has reached to US$ 1,289 Billion (IFSL, 2012) with operations in more than 50 countries consisting of above 300 institutions. Islamic finance had shown tremendous growth in 2007 & 08; an era of economic downturn in developed countries including United States and Europe.   Assets of Islamic finance had grown at the rate of 38% and 25% in 2007 and 2008 respectively, an era of economic recession in developed economies. Persian gulf area is the centre of Islamic financial system with a share of 80% followed by Fareast & south Asia region 15% and balance from rest of the world is contributed in Shari’a compliant assets (IFSL, 2012). Table-1 depicts the country wise and Figure-1 presents region wise share in assets under Islamic financial system.

Table.1 Country wise share in Assets under Islamic financing (US $ Billions)

No. of firms
S. Arabia
Total Middle East
Total NA
Total Far East
Total South Asia
United Kingdom
Total Europe

(Source: The Banker as quoted by IFSL, 2012)

Islamic banking and conventional banking are different in their philosophy as well as operations. Islamic banks are not dealer of money hence no provision of financing in hard currency is available while conventional banks are providing hard cash as loan by charging interest. Likewise Islamic banks cannot promise of risk free return to depositors while conventional banks are providing predetermined return (risk free) to depositors. Islamic banks are traders of goods and services and not the loan houses as for financing is concerned while conventional banks are lenders of cash. This difference is being reflected at operational level as well (e.g. Islamic banks are not issuing credit card while conventional banks do). Islamic banks use financing tools being used in trade including Murabaha (cost plus profit), Ijarah (rental arrangement), Bai Salam (spot payment with deferred delivery of goods), Bai Muajjal (deferred sale), Istisna’a (order to manufacture) and diminishing Musharaka (house financing). On the other hand if financing is required in cash form then Islamic banks are using profit and loss sharing modes including Musharaka (partnership in capital) and Mudaraba (partnership in capital and skill).
Use of profit and loss sharing tools as financing modes changes the philosophy of doing business of banking. Under conventional financial system financier is earning risk free return in the form of interest while under Islamic financial system opportunity of risk free return does not exist hence increasing the risk exposure of Islamic Financial Institutions (IFIs). Doing business according to principles of profit and loss sharing is difficult given the dominance of interest based banking and non conduciveness of existing business environment. Under profit and loss sharing system result of underlying project is shared by IFIs, depicted through financial reports. It is well documented in the financial literature that earnings are managed (manipulated) by opportunistic managers in order to gain some preset objectives. Hanif, 2010, documented that Literature on earnings management has identified various motives behind earnings manipulation including e.g. a particular reference point to be achieved (Burgstahler, 1997, and Guan, et. al., 2008); avoiding technical default on debt covenants  (Sweeney, 1994, Gaun, et. al., 2008,); reduction in transactions costs (Burgstahler, 1997); tax considerations (Baralexis, 2004); attracting better price at public offerings  ( Teoh, et. al., 1998,  and Iqbal, et. al., 2009); better management compensation (Wang, et. al., 2008,  Dechow and Sloan, 1991);  beating financial analysts’ forecast (Kasznik, et. al., 2002 as quoted by Wang, 2008 and Burgstahler, 1997);  and hiding poor performance of management (Beneish, 2001).

2. Riba (Interest and Usury)
In this section I will explore the meaning of term Riba as used in Arabic language and literature about its prohibition. 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. 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. Following are some further citations (definitions) extracted from literature to clarify the meanings of word Riba used in Holy Qura’n.
1. In the words of Imam Abubakr Al-Jassas (D.380 AH)[2] "The riba of Jahiliyya [period of ignorance] is a loan given for stipulated period with a stipulated increase on the principal payable by the loanee [debtor]."  
2. Extract from the decision of Supreme Court of Pakistan “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). While deciding the issue of banking interest as permitted or prohibited in Islam, 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).
The consensus view of Muslims about the meaning of Riba is presented here under.
3. Islamic Fiqh Academy India[3] explains “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 [debtor] and thus increases his wealth manifold without participating in the business process of profit and loss”.

4. 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.
5. 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 prohibited by Allah (SWT). Iqbal, & Molyneux, documented "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” (p. 9; IFC/2000)[4].

Charging of predetermined additional amount (usury, interest) on loans had never got support in ethics/religions. Interest charging is forbidden by at least all known revealed religions including Judaism, Christianity and Islam.  Following are six verses cited by Usmani, (1999), from Old Testament of The Bible.
1. "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]
2."Lord, who shall abide in thy tabernacle? Who shall dwell in thy holy hill? He that walketh uprightly, and worketh righteousness and speaketh the truth in his heart. He that putteth not out of his money to usury, nor taketh reward against the innocent." [Psalms 15:1, 2, 5]
3. "He that by usury and unjust gain increaseth his substance, he shall gather it for him that will pity the poor." [Proverbs 28:8]
4. "Then I consulted with myself, and I rebuked the nobles, and rules and said unto them, Ye exact usury, every one of his brother. And I set a great assembly against them." [Nehemiah 5:7]
5. "He that hath not given forth upon usury, neither hath taken any increase, that hath withdrawn his hand from iniguity, hath executed true judgment between man and man, hath walked in my statues, and hath kept my judgments, to deal truly; he is just. He shall surely live, said the Lord God." [Ezekiel 18:8.9]
6. "In thee have they taken gifts to shed blood; thou hast taken usury and increase, and though hast greedily gained of thy neighbors by extortion, and hast forgotten me, said the Lord God." [Ezekiel 22:12]
According to Usmani, 1999, “The word riba used in the Holy Qur'an carries the same meaning [as word Usury] because the verse of Surah An-Nisaa explicitly mentions that riba was prohibited for the Jews also”.

In The Holy Qura’n four sets of verses are about Riba (interest) revealed on different occasions. Translation of the verses[5] is presented here in the order of revelation.
1. The first verse is in Surah Al-Rum 30:39 whereby displeasure of Allah is disclosed for interest based practices. "And whatever riba you give so that it may increase in the wealth of the people, it does not increase with Allah."
2. The second verse is in Surah An-Nisaa 4:161 where interest charging was disclosed as sinful act of Jews.  "And because of their charging riba while they were prohibited from it."
3. 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."
4. The last set of verses revealed is reported in Surah Al-Baqarah 2:275-281 whereby severe punishment is declared for those dealing in interest and also persuaded for charity, deferment of loans from miser persons and even write-off as alms.
"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” [2:275]
“Allah destroys riba and nourishes charities. And Allah does not like any sinful disbeliever” [2:276]
“Surely those who believe and do good deeds, establish Salah and pay Zakah, have their reward with their Lord, and there is no fear for them, nor shall they grieve”[2:277]

“O those who believe, fear Allah and give up what still remains of the riba if you are believers” [2:278]
“But if you do not, then listen to the declaration of war from Allah and His Messenger. And if you repent, yours is your principal. Neither you wrong, nor be wronged” [2:279] “And if there be one in misery, then deferment till ease. And that you leave it as alms is far better for you, if you really know” [2:280]

“And be fearful of a day when you shall be returned to Allah, then everybody shall be paid, in full, what he has earned. And they shall not be wronged." [2:281]
 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.
Following conclusions are drawn from above citations; First Interest is prohibited by all revealed religions and charging of interest is Haram (unlawful) for at least 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 dealings in interest based transactions are Haram (unlawful) including conventional banking; important role of commercial banks cannot be rejected in the modern economy; so change in the philosophy and design of commercial banking was required to meet the religious obligation.  Referring to the above citation it is further 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) invested (2:275). 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.

Although practice of charging interest by conventional banking was major factor which led to the development of Islamic banking, however, it is not only the avoidance of interest which can make a conventional bank as Islamic. When we talk about Islamic banking us means following of Islam in all spheres of business including e.g. but not limited to:-

1. The principal activity of customer of Islamic financial institutions (IFIs) must not be prohibited by Islamic Shari’a. To mention few Islamic banks cannot receive deposit or extend financing for business of liquor, pornography and pig forming.
2. Under partnership business (Musharaka & Mudaraba) IFIs cannot limit their share in profit only to safeguard the capital. IFIs are required by Islamic law to share loss as well. Furthermore loss in partnership must be shared according to equity stake; however, profit can be shared in any ratio subject to the limit for sleeping partner whose share cannot be more than proportionate equity stake.
3. Islamic banks have to follow the principles of sales and purchase as given by Shari’a including five khiyars[6] (stipulations).
4. Islamic bank cannot claim additional amount from customer in case of default because it falls in circle of riba. However to penalize the defaulters, Ulema (clerics) have allowed IFIs to charge a penalty; but same cannot form part of income of IFIs rather it goes into charity.
5. Islamic banks cannot service depositors like conventional banking with a predetermine return. Deposits are taken as interest free loans (current accounts) and refunded on demand and/or on the principle of profit and loss sharing. If any IFI accepts deposits in current account as Ammanah then principles of Ammanah shall prevail including no guarantee of refund and no right to invest. Through creation of specialized deposits (restricted Mudaraba) for sectorial investments including real estates, agricultural products, oil sector, civil work projects etc. IFIs can even provide superior return to their depositors.

6. Islamic banks cannot avoid Shari’a compliance in their operations on the excuse of non conduciveness of existing legal & business framework. E.g. Islamic banks cannot demand interest on interbank deposits and statutory cash reserves maintained with central bank. Certainly this makes the job of practitioners of Islamic financial system challenging.
7. Islamic banks cannot enter into transactions of futures and forwards, gambling, and any other mode of doing business which contradict with injunctions of Shari’a.
8. For IFIs avenues are very limited to create required liquidity at the same time to earn some revenue by investing in short term and liquid securities. IFIs cannot invest in government securities, short term loans, bonds and money at call and short notices because of interest based transactions. Mandatory reserve with central bank is maintained by IFIs but they are not rewarded like conventional banks.
9. 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 safely that a very negligible number of firms meet both conditions. Islamic banks are not free to invest in equity of any company rather have to check the Shari’a compliance of the company prior to investment. Meeting of following tests is required to declare a security as Shari’a compliant (KMI-2008).
1. The core business of the company should be Halal (not prohibited by Islamic Law such as liquor, pork and pornography etc).
2. Illiquid assets should be at least 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.

3. Ratio of all interest based debts including preferred stock should be less than 40% of total assets of the company.
4. Ratio of non Shari’a compliant investments to total assets of the company should be less than 33%.
5. 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.
6. Market price per share should be greater than the net liquid assets per share.
10. 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 Skukholders. While it is known the rentals of the asset under Ijarah so the return on investment is predetermined and known with certainty to the investors. 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 Skukholders.

11. Musharaka and Mudaraba are the sources of financing available to Islamic banking which can play role of catalyst in uplifting living standard of unserved/underserved large population in underdeveloped countries including Muslim countries by providing opportunities of self employment. Mudaraba financing can replace the venture financing and could be used successfully in promotion of new ideas generated by skilful graduates, lacking finances.

4. Objections/Perceptions
It is pertinent to address certain objections/issues raised by experts in conventional finance and (may be) by common man.
1. First is by the time of revelation paper currency was not in circulation hence injunctions about coins cannot be implemented on paper currency. The most important issue is the devaluation of paper currency due to inflation. Certainly one loses his wealth due to inflation if kept in currency. Equally; wealth is lost if given as Qarz e Hasna (charity loan) giving zero return rather negative return if currency devalued due to inflation.  This is very valid argument and I analyses in two parts. First is Excessive inflation which we face in less developed countries including some Muslim societies is not the direct consequence of paper currency rather it is financial indiscipline of the governments of these countries. After all why such a massive figure of inflation is not hitting developed world. Discipline is required in government spending, borrowings and issue of currency. Second as for mild inflation is concerned that requires a debate and settlement. The case for indexation of loans as per actual inflation in the economy is being debated at various forums among the Shari’a scholars and we expect an early outcome.[7]
2. Second issue is of lack of trust which is vital between IFI and customer to put sharing modes into practice. Musharaka and Mudaraba can only work if customer discloses his earnings honestly in a transparent way. This argument is also very valid and carries some empirical support as well. By looking at portfolios of IFIs it is evident that sharing modes are not as much practiced as others. We must accept this fact that trust deficit really exists among customers and IFIs. However we cannot conclude impracticability of sharing modes of financing due to (1) deposits are accepted by IFIs under sharing modes and succeeded in building trust in the eyes of depositors (2) corporate world is working under sharing modes. An investor who purchases the shares of a company becomes the limited partner of that company; hence, sharing modes of doing business are not totally foreign to business world.
3. Third is the similarity in products and even charges of IFIs with conventional banking. Undoubtedly IFIs are trying knowingly and willfully to match in products, services, costs and returns with conventional banks. This phenomenon exists due to (1) IFIs are lacking severely skilled human resources having the ability and understanding of philosophy of Islamic financial system (2) dominance of conventional banking with major market share even in Muslim societies (3) conventional banks are immediate competitors of IFIs hence an element of fear of losing customers is always there.
4. Fourth is linkage of profit percentage charged by IFIs on their products with interbank offered rate (KIBOR, LIBOR etc.). certainly this is not appreciable that an institution claiming itself Shari’a compliant in its operations use the bench mark of interest for charging profit however using KIBOR as bench mark does not translate the transaction itself Haram [unlawful] (Usmani, 2003). Why IFIs are using KIBOR as bench mark? The possible reasons include (1) IFIs are competing with conventional banks hence trying to be competitive in the market (2) lack of any other bench mark based on Shari’a compliant tools. One can hope with the increase in market share, IFIs would be able to develop their own bench mark for profit.

Pakistan has remained chief proponent of Islamic banking because it is the only Muslim state which created on the basis of Islamic ideology. Islam is the state religion of Pakistan and any law repugnant to the injunctions of Islam is void as per constitution of Pakistan. In early eighties council of Islamic ideology presented blue print of interest free banking in its report and country wide efforts started to switch the economy towards interest free system. However due to number of reasons including dependence on foreign aids (concessional loans), incapacity of trained human resources required to run the economy on interest free basis, financial indiscipline, corruption, political instability etc. system could not run in its true spirit. Although all commercial banks started operation on profit and loss sharing but the practice was not in line with theory. Certain quarters took the case in federal Shari’a court and order passed in 1991; declared interest based banking haram (unlawful). Government of Pakistan was obliged to abide by the order of higher judiciary. By looking at the overall situation government decided to respond through two pronged strategy. On one hand a commission was set up for recommendations to Islamize the economy while on the other hand cases were pleaded in Supreme Court. Commission finalized its recommendations and Supreme Court given its decision in 1999 declaring the interest based banking haram(prohibited) with instruction to government to implement interest free system in the economy. By early 2000 onward a new strategy put into practice to Islamize the economy by state bank of Pakistan. Instead of moving abruptly towards interest free system (because the move made in eighties was failed badly) it was decided to promote the Islamic banking in parallel to conventional banking. Islamic banking department (IBD) was established in central bank to regulate the Islamic financial industry. IBD has done a great job so for in promotion and implementation of Islamic banking, although thrust is there for further promotion.
Islamic banking has shown tremendous growth in Pakistan in last eight years period (12/03-12/11).  By the end of December 2011, five full-fledged Islamic banks and 12-conventional banks with Independent Islamic Banking Branches are operating in Pakistan. Figure-2 depicts the growth in assets, deposits, and financial disbursements of IFIs working in Pakistan (SBP, 2011). Number of branches has been increased from 17 in 2003 to 886 within eight years an average annual increase of 72%. Assets increased at average annual rate of 71% while deposits increased at average annual rate of 79% and financial disbursements and investments increased at average annual rate of 68% during the period (12/03 - 12/11). Overall an average growth of 73% per annum in the last eight years (12/03-12/11) was achieved by Islamic banking in Pakistan. In Pakistan, Islamic banks accept deposits either as interest free loans or on profit and loss sharing basis and succeeded in getting the trust in the eyes of depositors. Average annual increase of 79% in deposits of IFIs working in Pakistan for last eight years is something cherishable. On the financing and investment side, modes of financing used by IFIs are categorized objectively as Shari’a based and Shari’a compliant (Hanif & Iqbal, 2010)[8]. It is pertinent to describe briefly modes of financing used by IFIs.
Figure-2 depicts growth in Islamic Banking in Pakistan Rs. Billions

A-Shari’a Compliant Financing
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.

A-1. Murabaha Financing
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.

 A-2. Ijarah Financing
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.

A-3. Diminishing Musharaka Financing

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.

 A-4. Salam Financing

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 (Sh. St. 10).

A-5. Muajjal Financing

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.

A-6. Istisna’a Financing

Murabaha is a cost-plus sale contract whereby disclosure of cost to the buyer is necessary.
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).

B-Shari’a Based Financing

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.

B-1. Musharaka Financing
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

Mudaraba is a type of partnership whereby skill and money brought together to conduct business.
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.

B-2. Mudaraba Financing

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).
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. By looking at portfolios of IFIs working in Pakistan (figure 1.3) it is depicted that for last seventeen quarters, share of Shari’a compliant modes of financing is dominant with a negligible portion (less than 5%) invested in Shari’a based modes. This is an issue which demands serious attention of industry leaders as well as policy makers.

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.
Practitioners of IFIs have focused so for on Murabaha, Ijarah and diminishing Musharaka, all are very much similar to conventional banking. Of course, difference lies in nature of contracts including bearing of ownership risk by IFIs, no extra charges for late payment, no interest charging, linkage of financial and real sector etc. however returns of IFIs are certain and pre-calculated. One of the major reasons of lesser popularity of Profit and loss sharing (PLS) system is lack of human resources equipped with updated knowledge of Islamic financial system. Most of the officers working in Islamic financial industry are trained in conventional banking and lacking severely the philosophy and knowledge of Islamic banking.

Figure-3. Share of each mode of financing in portfolios of IFIs working in Pakistan from 09/06 to 09/10.

Hanif, & Iqbal, 2010, concluded that the major hurdle in the popularity of Musharaka financing is the dominance of conventional banking and this hurdle can be removed only through the expansion and growth of IFIs. Other factors discouraging Shari’a based financing, identified in their study, include the higher risk level in Musharaka, profit manipulation behavior of businesses, lack of trust and confidence in the ability of Musharaka partner, manipulations of accounts by firms under conventional accounting framework, relatively higher taxes, weaker auditing and lack of awareness among masses about the philosophy and operations of IFIs. Through increased awareness, grants of tax incentives, capacity building of IFIs, strengthening audit institution, fostering by central bank and new products development with focus on small and medium enterprises under Musharaka principles, Shari’a based financing can be promoted.

[1] Reported in the order of revelation. First Surah (chapter) number then Aya (verse) number.
[2] As cited by Usmani, (1999)
[3] accessed on 20th March, 2010.
[5] Translation adopted from Usmani, 1999.
[6] According to Usmani, 2002a, Five khiyars include, Khiyar e Shart (option to rescind contract within specific period), Khiyar e Roiyyat (option to inspect), Khiyar e Aib (option to return defective goods), Khiyar e Wasf (option to return low quality goods), Khiyar e Ghaban (option to return goods when charged price higher than market).
[7] For details on the topic of indexation please see “Indexation of loans by Mohay ud Din Hashmi” chapter in book “ Institutions of collective Juristic opinions, Concept, Evolution and Practical ways” [Ijtamai Ijtehad kay idarey; tasawer , Irtaqa aor amaly tareekay; in Urdu language], Institute of Islamic Research, International Islamic University, Islamabad, Pakistan.
[8] Originally this classification was spoken by Prof. Khurshid on launching ceremony of RCIB.

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