What is Islamic Banking?

What is Islamic Banking?

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasise moral and ethical values in all dealings have wide universal appeal. Shari'ah prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.

Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari’ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shari’ah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. These principles are not new but arguably, their original state has been altered over the centuries.

The principle source of the Shari’ah is The Qur’an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) – the Hadith. Where solutions to problems cannot be found in these two sources, rulings are made based on the consensus of a community leaned scholars, independent reasoning of an Islamic scholar and custom, so long as such rulings to not deviate from the fundamental teachings in The Qur’an.

It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and principles of Islam.

Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.

Origin

The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions.

Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.

Commercial Banks in Muslim Lands

Western commercial banks date from about two and a quarter centuries ago, when the western world was dispensing with moral and ethical considerations in economics. When the Muslim world came into contact with the west, Muslims had two choices:

a) To accept commercial banking, arguing that the interest charged by them did not contain the element of riba prohibited in the Qur'an; or,

b) To accept that interest charged was riba and try to develop an alternative system of banking.

But ancient Muslim institutions, such as the Shari'ah courts, had been made ineffective by the colonial powers. Muslims had no alternative but to work with the colonial institutions, including commercial banking.

Nevertheless, during the 19th century, several religious scholars argued that the term riba referred to loans for consumption, which people found it difficult to repay, and not to commercial banking loans, where the debtor can repay from the profits.

But the Qur'an makes no distinction between loans for consumption and loans for productive purposes. So their views were rejected. As a consequence, modern commercial banking did not make much headway in Muslim countries and to this day the presents of the conventional framework still dominates the national financial system.

Early Western PLS Proposals

Equity-participation systems had been proposed at various times of economic crises in the United States and Latin America. The most ardent proponent of these was American Economist, Henry Simons (1899 – 1946), who, in the 1930s, argued that the traditional fractional reserve banking system was inherently unstable and should be replaced by two separate financial institutions:

1. Deposit banks, which would maintain 100% reserves. They could not fail the depositors and could not create or destroy effective money. They would simply accept deposits.
2. Investment trusts, which would perform the lending functions of existing banks. Such companies would obtain funds for lending by selling their own stock.

Simons' call for a distinction between the payments and portfolio functions of banks, and for 100% reserve requirement in the former, was rejected at the time, but interest in Simons' ideas has remained.

Many reasons have been advanced for the possible instability of the traditional banking system. Simons suggested that the basic flaw was that as a crisis develops and earnings fall, banks make loans to increase reserves. However, each bank can do so only at the expense of other banks and thus some banks become insolvent.

The bank failures in the U.S. during the 1980s revived interest in equity-based proposals and the separation of the payment of deposits from the portfolio activities of banks. The proposals made were strikingly similar to the Islamic systems now being implemented, at least on the deposit side. But the Islamic system goes further, requiring that loans made by banks should also be equity-based.

Islamic Banks in the 20th Century

When, in the1960s, Muslim thinkers began to explore ways and means of organising commercial banking on an interest-free basis, economists dismissed their work as wishful thinking.

But, in 1963, in Mit Ghamr, in Egypt, the first Islamic interest-free bank came into being. Mt Ghamr was a rural area and the people were religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam. In these circumstances, the task was not only to respect Islamic values concerning interest, but also to educate the people about the use of banking.

The following types of accounts were accepted:

a) Savings accounts
b) Investment accounts
c) Zakat accounts

No interest was paid on savings accounts, but withdrawals could be made on demand. Small, short-term, interest-free loans for productive purposes could be made. Funds in investment accounts were subject to restricted withdrawals and invested on the basis of profit- sharing. The zakat account attracted the official amount of zakat.

The Mit Ghamr project was successful, as deposits increased from 1963 to 1966. The bank was cautious, rejecting about 60% of loan applications and the default ratio was zero in economically good times. But project was eventually abandoned for political reasons. Nevertheless, it had shown that commercial banking could be organised on a non-interest basis.

slamic Banking Principles

The Shari’ah prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars covers any excess in financial dealings, usury or interest) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.

"While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.

"The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens - ranging from the equitable distribution of wealth through to man's fundamental right to work - is clearly present in modern Islamic society.

"Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997)

Theoretical Basis for Islamic Banking

A popular belief persists that Islamic banking is simply an interest-free financial structure. But, in fact, Islamic economics is a complete system of social and economic justice. It deals with property rights, the incentive system, the allocation of resources, economic freedom and decision-making and the proper role of government.

Western bankers have said that savings and investments would soon dry up if interest were not paid. But this is due to identifying "rate of interest" and "rate of return". The Qur'an says: "God has permitted trade, but forbidden riba (interest)” (2:275). Therefore it is only the fixed, or predetermined, return on savings or transactions that is forbidden, not an uncertain rate of return, such as the making of profit.

Modern Justifications for Interest

Modern economists have developed many arguments to justify interest.

One argument is that interest is the reward for saving; a compensation that the creditor pays the debtor for the latter's temporary loss of the use of capital.

Another is that interest is the payment for the loss in value of money due to inflation. The goods the saver wants will cost more in the future, so he is justified in charging a rent for the use of his loan.

John Maynard Keynes (1883-1946) argued that money is the most liquid of assets, that is to say, it is the asset most readily exchangeable for other forms of assets and that interest is the price paid for loss of liquidity.

The theory that interest protects savings from inflation neither explains why the rate of interest is, nevertheless, always above the rate of inflation, nor does it question the proposition that inflation is the cause of interest. Nor do these theories answer the question as to why interest should be the market regulator for the supply and demand of money. Why should interest be paid for one's postponement of enjoyment of present goods, or paid for abstaining from diminishing one's present capital, which would otherwise be diminished by the ravages of time and consumption?

Basis of Islamic Banking

In order to be Islamic, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law.

Another Islamic principle is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks.

Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways:

1. Debt-financing (the western loan system). The businessman borrows the capital from the capital-owner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction.
2. Mudarabah (the Islamic way, or PLS). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit.

The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah.

There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship:

(i)  Both parties agree on the ratio in which profits will be shared between them.

(ii) The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort.

(iii) Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work.

Mudarabah is the basis of modern Islamic banking on a two-tier basis.

1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds.

2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager.

Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views true profit as a return for entrepreneurial effort and objects to money being placed on a pedestal above labour, the other factor in production. As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely nominal share based on the prevailing interest rate.

Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit.

The records of banks that have been involved in PLS show that they have usually provided higher returns to their depositors than those who have used such transitory instruments as cost-plus and leasing. PLS is thus the real goal of Islamic banking.

Rules of Permissibility

Muslims believe that all things have been provided by God, and the benefits derived from them, are essentially for man’s use, and so are permissible except what is expressly prohibited in The Qur’an or Hadith. When guidance is not clearly given in he Qur’an there are several other sources of law. For example, guidance can be sought from Fiqh, which means ‘understanding’ and is the science of jurisprudence: the science of human intelligence, debate and discussion

Prohitbition of Interest

Riba best translated today as the charging of any interest, meaning money earned on the lending out of money itself. The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.

Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. Interest can leads to injustice and exploitation in society; The Qur’an (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice)

There is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn a profit-share or purely fee-based remuneration. In order for an Islamic bank to earn a return on money lent, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset. This requires the lender to also participate in the sharing of risk.

Individuals and the world as a whole probably know too well the burden of interest and misery and suffering that irresponsible lenders have inflicted on individuals and societies. It has become so completely institutionalised and accepted in modern economies that it is almost impossible to conceive that there are some who completely oppose it and refuse to enter into any transactions that involve interest.
Islam's prohibition of interest and usury was not unprecedented. The early Jewish and Christian traditions also forbade riba. Even the renowned Greek philosopher, Aristotle, condemned acquiring of wealth by the practice of charging interest on money.

“Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways of getting wealth, this is the most contrary to nature." Aristotle, The Politics, tr. Sinclair, pg. 46, Penguin

“Do not charge your brother interest, whether on money or food or anything else that may earn interest.” (Deuteronomy 23:19)

“If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest.” The Holy Bible (American Standard Bible)

[Jesus said], “If you have money, do not lend it at interest, but give [it] to one from whom you will not get it back.” Gospel St Thomas, V95

Other Key Prohibitions

Islam not only prohibits dealing in interest and investment in unlawful activities that Islam deems harmful to society, but also transactions involving excessive uncertainty (gharar) and all forms of gambling (maysir).

Islamic Economics Order

Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:

While permitting the individual the right to seek economic well-being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden or unlawful) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious. While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it. While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat (a tax on wealth that is distributed to the needy). While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance. Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.

Wealth and Islam

Islam has a unique dispensation on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins wealth creation not for its own sake.

The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. The true nature of wealth in Islam requires social preferences and market exchange mechanisms that are ethicised by human consciousness of the Moral Law. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. They point out how individual preferences on wealth formation ought to be utilised within the social meaning.

According to Shaikh Yusuf Talal DeLorenzo, well-known and respected Shari’ah advisor and Islamic scholar as well as also author of the three volume “Compendium of Legal Opinions on the Operations of Islamic Banks” the first English reference on the fatwa (religious ruling) issued and published by the Institute, business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari’ah on proper transacting is that Islam accords great importance to the economic welfare of society.

Profit-and-Loss Sharing

While Islam employs various practices that do not involve charging or paying interest, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and- loss-sharing basis. Such participatory modes used by Islamic banks are known as Musharakah and Mudarabah. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.

The concept of profit-and-loss sharing in an enterprise, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management. The Islamic sukuk system is similar to bonds of capitalist system, but in sukuk, money is invested concrete projects and profit share is distributed to clients instead of interest earned.

Financing Modes of Islamic Banks

Islamic financing in its first stages used only the partnership modes of musharakah and mudarabah. Later it was realised that, to avoid moral hazards, yet compete successfully with conventional banks, it was necessary to use all permissible Islamic modes and so trade-based and leasing techniques were developed.

The general rule is that all financial arrangements that the contracting parties agree to use are lawful, as long as they do not include an element of interest. Equity-holding and commodity and asset-trading are an integral part of Islamic financing.

The two basic categories of financing are: 1) profit-and-loss-sharing (PLS), also called participatory modes, i.e., musharakah and mudarabah and 2) purchase and hire of goods or assets and services on a fixed-return basis, i.e., murabaha, istisna'a, salam and leasing.

Legitimate modes include financing trade, industry or budget deficits through domestic or foreign sources. Islamic banks may design diversified investment portfolios and instruments that generate profit with the required liquidity. To maximise its profits, a bank needs to look for investments that yield the highest return, minimize risks and provide adequate liquidity. At the same time, it is necessary for the bank's liabilities and assets to be matched.

A pyramid of financial assets can be built based on liquidity and profitability, which are the criteria of prudent banking. At the top would be high-risk and less-liquid assets, such as long-term investments out of its own equity or from deposits of its risk-accepting account-holders. At the bottom of the pyramid would be the least risky and most highly liquid assets, based on murabaha (leasing) or short-term (even overnight) Mudarabah Certificates (PLS).

Musharakah and mudarabah can be used for short, medium and long-term project-financing, import-financing, export financing, working capital financing and financing of single transactions. Diminishing musharakah can be used for large fixed assets such as houses, transport, machinery, etc. Murabaha can be used for purchases of goods needed by the bank's clients. Salam is useful for financing farmers, trading commodities for the public and private sectors and other purchases of measurable and countable things. But it must be kept in mind that buyback and rollover modes may not be used, because they are seen as a back door to interest.

With Islamic financing, the need to assess clients' acceptability is more important than it is for conventional banks. The bank needs to be vigilant and prudent by concentrating on the client's integrity as well as his status regarding property and particularly his willingness to comply with Shari'ah-compliant contracts.

Islamic banks, while functioning within the Shari'ah, can perform the crucial task of resource mobilization and efficient allocation on the basis of both PLS and non-PLS modes. Sharing modes can be used for short, medium and long-term financing, import financing, pre-shipment export financing, working capital financing and financing of single transactions. To ensure the maximum use of Islamic finance in the development of the economy, it is necessary to create an environment that can induce financiers to earmark more funds for musharakah- or mudarabah-based financing of productive units, particularly those of small enterprises.

The non-PLS modes acceptable to the Shari'ah not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society. Trade-based modes, such as murabaha, having less risk and better liquidity options, have several advantages over other techniques, but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques are.

Ijarah-based financing, that requires Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shari'ah rules, requires the banks to engage in activities beyond financial intermediation and are very much conducive to the formation of fixed assets and medium- and long-term investments.

On the basis of the above, it can be said that supply and demand of capital in an interest-free environment have the additional benefit of providing a greater supply of risk-based capital. There is also a more efficient allocation of resources and an active role for banks and financial institutions to play, as required in the asset-based Islamic theory of finance.

Islamic banks can not only survive without interest, but are also helpful in achieving the objective of distributive justice by increasing the supply of risk capital in the economy and facilitating capital formation and the growth of fixed assets and real-sector business activities.

Salam (forward purchase with prepayment of price) has a vast potential to finance productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides an incentive to enhance production, as the seller will spare no effort to produce at least the quantity needed for settlement of the loan taken by him as the advance price of the goods.

Salam can also lead to creating a stable commodities market, especially of seasonal commodities, and therefore to stability of their prices. It enables savers to direct their savings to investment outlets, without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption.

Banks might engage in fund and portfolio management through a number of asset-managing and leasing and trading companies. Such companies can exist on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on a mudarabah basis, and to some extent on an agency basis, and use the funds so collected on a murabaha, leasing or equity-participation basis. Subsidiaries can be created for specific sectors or operations and would enter into genuine trade and leasing transactions. Low-risk funds based on short-term murabaha and leasing operations of the banks, in both local and foreign currencies, would be best suited to risk-averse savers who cannot afford the possible losses of PLS-based investments.

Under equity-based funds, banks can offer a type of equity exposure through specified investment accounts where they identify possible investment opportunities from existing or new business clients and invite account-holders to subscribe. Instead of sharing in the bank's profits, the investors share in the profit of the enterprise in which the funds are placed and the bank takes a management fee for its work. Banks can also offer open-ended multiple-equity funds to be invested in stocks.

The small and medium enterprises (SME) sector has a great potential for expanding production capacity and self-employment opportunities in developing countries. Islamic banks may introduce SME-financing funds for various places. Enhancing the role of the financial sector in the development of the SME sub-sector can mitigate the serious problems of unemployment and the low level of exports of such countries.

Islam's Approach to Ethical Investment

Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered. These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.

The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

• Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation
• Investments are made in permissible activities
• Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity

"The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service," the Vatican's official newspaper Osservatore Romano said in an article its latest March 2009 issue.

Islamic Banking: True Modes of Financing
By Dr. Shahid Hasan Siddiqui, Eminent Pakistani Banker & Economist.

Introduction

Prohibition of interest is ordained in Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous. The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! fear Allah and give up what remains of your demand for riba, if ye are indeed believers." and verse 2: 279 says "If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly."

It therefore, follows that interest is prohibited as it leads to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system, which aims at securing extensive socio-economic justice. The Islamic law of prohibition of riba, which includes interest, was originally not based on economic theory but on Divine Authority which considers the charging of interest as an act of injustice.

There could be no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most under the system and practices enforced by banks and financial institutions operating world-wide under the banner of Islamic banking.

Islamic banking made its debut over a quarter a century ago. At present 200 Islamic banks and financial institutions, operating in 27 Muslim and 16 non-Muslim countries, are managing a portfolio of about $200 billion. It is now the time to pose the following questions:

i) Whether banks operating under the banner of Islamic banking have succeeded in the elimination of injustices of the interest-based system as ordained by Holy Qur'an (2:279)?

ii) Whether banks operating under the banner of Islamic banking have contributed to the attainment of socio-economic justice in line with the objectives of Islamic economic system?

iii) Whether banks operating under the banner of Islamic banking are, for all practical purposes, not following the bench marks of interest-based system under Murabaha, Bai-Mu'ajjal or the like modes of financing?

iv) Whether the net result in modes referred to at (iii) above really differs much from the interest-based loaning?

v) Whether by adopting the modes referred to at (iii) above, banks assume any responsibility for the operational losses of the party availing finances from them?

vi) Whether sharing in the operational losses are not the essence of Islamic system of banking?

vi) Whether large scale financing on a perpetual basis, on modes approved for "Sale transactions", can continue to be made for an indefinite period by Islamic banks which are not trading houses but are financial institutions?

While attempting to firm up views in respect of above questions, it must be kept in view that Islamisation of banking system is a part of overall Islamic value system and is not merely refraining from interest-based transactions. The objective of Islamic banking system is to make a positive contribution to the fulfilment of socio-economic objectives of the society in all spheres, including trade, industry & agriculture etc.

True Modes of Financing

An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except interest-free loans which are termed as Qard Hasanah (Benevolent Loans) while loans on service charge, not exceeding the actual administrative cost of such loans, have also been permitted by Muslim Scholars.

To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis. Qard Hasanah are for the benefit of the individuals and the society at large. To safe-guard the interest of depositors/investors, these type of loans, as a matter of policy, do not constitute a significant source of financing by Islamic banks. However, if in any country, the Islamic System of Zakat is established and the Islamic State treasury starts functioning, the requirements of Qard Hasanah would primarily be met by the treasury.

The bulk of financing by Islamic banks has to be equity oriented. In this mode of financing, the losses are shared by the financier along with the entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. The rates of returns are thus replaced by ratios.

While designing an alternate to interest-based system, it was realised that large scale resorting to PLS system of Islamic banking could pose serious risks and hazards to Islamic banks due to wide-spread tendency to adopt un-ethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons.

It was therefore, considered necessary to devise various other modes of financing in addition to Mudaraba & Musharka based on PLS system and of course, Qard-Hasan. These modes being the second line fixed return techniques include the following:

i) Murabaha (Cost-plus sale).

ii) Bay Mu'ajjal (Deferred payment sale).

iii) Bay' Salam (Purchase with deferred delivery).

iv) Bay' Istis'na (Made to order).

v) Ijara (Leasing).

vi) Ju'ala (Loans with a service charge).

It may be mentioned that the above mentioned six modes cannot be expected either to remove the injustices of the interest-based system or to contribute to the achievement of socio-economic objectives which Islam seeks to achieve. The fact however, remains that these modes bear pre-determined fixed rates wherein neither the operational losses are shared by the banks nor the returns charged are dependent on the operational result of the entrepreneur.

It is important to note that Islam wants that in case the entrepreneurs earn profit from the finances provided to them by banks, these must be shared with the banks. The banks, on the other hand, must share their profit with their depositors / investors. A large number of depositors would thus hopefully be able to get significantly higher rates of return from the banks leading to over-all prosperity. It will be only then that justice would be ensured between the parties and the banks would start moving towards the path of making a positive contribution towards the achievement of socio-economic objectives.

Islamic banking is now over 25 years old. It is however, observed that, despite all the good intentions, Islamic banks world-wide have generally sheltered themselves in comfort zone by persisting with the second line fixed return techniques for bulk of their financing operations and that too within the bench-marks of interest-based system.

As the single largest mode of financing adopted by Islamic banks is on the basis of Murahaba, it is now proposed to briefly examine this mode.

Murabaha

Murabaha in ancient Islamic connotations referred to a particular kind of simple sale and had no relevance whatsoever with a transaction of financing. In view of the difficulties and risks visualised in adopting PLS system of Islamic banking on a large scale, in recent times, the Murabaha, for all practical purposes was transformed from the sale transaction to a mode of financing.

In this mode, the bank, at the request of its client, purchases the specified goods from a third party against payment. Immediately on the transfer of ownership of the goods as also obtaining its physical or, in most cases, the constructive possession, the bank sells these goods to the client at cost plus an agreed fixed profit margin. The client then takes physical possession of the goods and undertakes to pay the price to the bank either in instalments or in lump sum, at an agreed later date.

The instances are not lacking where customers of the bank and the seller of the goods are sister concerns. In yet many other cases, the customers of the bank purchase the commodities themselves as agents of the bank and then they repurchase the same commodity from the bank for a cost plus profit to be paid at a mutually agreed later date. In many cases of Murabaha, there is therefore, only a change of name.

It is however, felt that there would be no objection if an Islamic bank, in addition to its normal banking business, separately establishes a Merchant Banking Division wherein various types of goods are purchased and then offered for sale to other prospective buyers at a profit. There are however, serious reservations to the wide spread use of murabaha technique as a mode of finance where the bank purchases the commodity only after the customer has agreed in principle to purchase it from the bank at a profit - mark-up. It must therefore, be appreciated that under Murabaha, a trading transaction is being transformed into a mode of finance just to meet the Shariah requirements.

While referring to alternate modes of financing based on Murabaha and Ijara (Leasing) etc., Justice Taqi Usmani observes that if designed to fulfill the Shariah requirements, these modes can be adopted as transitory measure. He however, cautions that " .... there should be a gap between purchasing the commodity and selling it to the customer and the risk of owning the commodity during the period should be borne with all its basic components and all its essential consequences."

In actual practice, practically there is no gap as in many cases, the bank makes the payment almost simultaneously or even after the goods are delivered at the premises of the client. The bank thus does not in fact assume any risk including even the risk of the goods, during the short period, the bank is supposed to own and possess these goods. The bank however, gets a return at a pre-determined fixed rate, which is not dependent on the operational results of the entrepreneur. This in any case, does not appear to be in conformity with the requirements of Shariah.

Taqi rightly observes: -

a) Islamic banks are using the instrument of Murabaha and Ijarah within the framework of the conventional benchmarks like Libor etc. where the net result does not differ much from interest-based transactions.

b) By not even gradually enhancing the financing on PLS basis, the basic philosophy of Islamic banking seems to be totally neglected by the Islamic banks.

c) The Shariah Scholars have allowed the use of fixed return financing techniques i.e. Murabaha & leasing etc only in those spheres where Musharaka can not work.

d) When the common people realise that the net result in the transaction of the Islamic banks is the same as was in the transactions of conventional banks, they become sceptical towards the function of Islamic banks. It therefore, becomes very difficult to argue for the case of Islamic banking before the common people, especially before the non- Muslims who feel that it is nothing but a matter of twisting documents only.

Nijatullah Siddiqui says: -

"The payment obligations of the firms operating with murabaha - financed goods and services are independent of the profitability of the enterprise, unlike Profit - Sharing, thus exposing it to the charge of being inequitable, as in the case of debt financing".

While commenting on "Mark-up" system he opines: -

"I would prefer that Bai' Mu'ajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form, we have the overriding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai'Mu'ajjal in order to save interest-free banking from being sabotaged from within."

At this point it is important to mention that Maududi observes: -

"Islam says in clear terms that the lender is not justified in earning a fixed rate of profit, irrespective of the operational results of the business."
It therefore, appears that, in most cases, the fixed returns charged by banks on transactions which are financial in nature are not permissible simply by providing them a cover of Murabaha or the like modes which are in fact transactions of sale.
It was over two decades ago that The Council of Islamic Ideology, Pakistan observed: -
" ... ideally the real alternatives to interest under an Islamic economic system are profit / loss-sharing and Qard-Hasan."

While referring to other modes of financing such as Bai-Mu'ajjal, Hire Purchase & Leasing etc. the Council observed: -

"It is, therefore, imperative that the use of these methods should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed."

The Council in this report cautioned:

"It would not be advisable to use it widely or indiscriminately in view of the danger attached to it of opening a back door for dealing on the basis of interest."

"The basis of this technique, though not prohibited according to Hanafi and Hanabali Schools of Fiqh and that too in exceptional circumstances, its wide spread use is not permissible as mark-up does not differ in essence from the interest system."

The Council however, observed: "It is unfortunate that this warning was disregarded and the mark up system was made the pivot of the new arrangements."

The Federal Shariat Court, Pakistan in its Judgement dated November 14, 1991 also referred to the following observations of the Council: -

" The fact of the matter is that "mark-up" is a crude trading practice which has been permitted by certain religious scholars under specified conditions. Its permissibility is questioned by other scholars. In any case, it is a device, which is relevant in the contract of transactions between a seller and buyer of goods. Banks are not trading organizations. They are essentially financial institutions which mobilise funds from the general public and make them available to productive undertakings."

Hasanuzzaman says:

" ..... the ghost of interest is haunting banks to calculate a fixed rate percent per annum in many modes of financing including Murahaba (Bai-Mu'ajjal , Mark-up) etc. The spirit behind all these contracts seems to make a sure earning comparable with prevalent rate of interest and as far as possible, avoid losses which otherwise could occur."

He adds that "they (Second line techniques), have failed to do away with undesirable aspects of interest thereby they have retained what an Islamic bank should eliminate."

The Supreme Court of Pakistan (2000) in its' historic judgement delivered on December 23 1999 i.e. after about sixteen years of the observations, of The Council of Islamic Ideology, referred to above, inter-alia gave the following verdict: -

a) "The major condition for the permissibility of a mark-up transaction is that it should not be charged on lending or advancing money. It must be based on the genuine sale of a commodity with all its substantive consequences."

b) " ...... murabaha or Bia Mu'ajjal is a transaction of sale effected on the basis of deferred payment."

c) "We are conscious of the fact that the transaction of a sale of murabaha based on mark-up, even after fulfilling its necessary conditions is not an ideal mode for the extensive use of Islamic banks, Still, the banks will have to resort to this transaction in certain cases, especially in the initial phase of transformation."

Looking at the Murabaha from yet another angle, it is important to note that Almighty Allah has condemned riba in harshest possible terms perhaps only second to "Shirk". It does not appeal to the mind that by simply assuming some risks by banks in financing through murabaha and the like during "shifting of stocks" from the godown of the seller to the entrepreneur (party availing finance from the bank) which can also be practically avoided and ensuring a fixed return on financing while not sharing in the operational losses of the entrepreneur, which is the essence of Islamic banking, the objectives of the Shariah are met.

It is obvious that the wide spread and persistent use of the second line techniques has neither contributed in removing the injustices of the interest-based system as ordained by Holy Qur'an (2:279) nor in securing the socio-economic justice in the society. If Islamic banks persist with these modes for bulk of their operations, the cause of Islamic banking would never be fulfilled.

It was only in the initial stages of transformation of the conventional banking system into Islamic banking system that the second line fixed return techniques could have been adopted by Islamic banks with a proviso that gradual shift to PLS system will take place. With the passage of time, the second line techniques should have been adopted only where PLS is not possible or feasible including say leasing of machinery or vehicle etc. which are not trading items of the enterprise availing funds from the banks. Unfortunately these modes have been allowed to be perpetuated by Islamic banks. This is injurious to the cause of Islamic banking.

During the last few years, a number of Western bankers, economists and journalists have posed to this writer a rather cynical question about what the real difference between the interest-based system and it's Islamic counterpart, as being practised by Islamic banks actually is. However, even they concede that the PLS system of Islamic banking, if practised in earnest, could ensure socio-economic justice across the globe.

It is therefore, seriously apprehended that if the present sad state of affairs is allowed to continue, even many innocent Muslims may develop doubts about the feasibility, practicability and usefulness of the "Islamic system of banking" notwithstanding that the fault lies with us and not with the system.

The large scale financing by banks on second line techniques is some times advocated on the ground that the size of Islamic banks is too small. The combined assets of 200 Islamic banks and financial institutions are almost 1/3 of the quantum of individual assets of some of the largest conventional banks. Since Islamic banks have to compete with these banks, they generally tend to avoid indulging in risky financing based on PLS. To make the situation worse, some of the Islamic banks find it more feasible to divert part of their funds received from Muslims to multinationals and large corporations of the West.

The Arab world including GCC countries and rich citizens of many others Muslim countries are reported to be maintaining huge deposits with conventional banks operating in the West. The quantum of these deposits is estimated to be more than the total external debt of Muslim countries.

The placement of these funds by Muslims is enabling the imperialistic powers to exploit the Islamic world by simply providing them loans and credits out of these deposits. The placement of funds in this manner by Muslims is clearly not in conformity with the directives of Qur'an and Sunnah.

The Ummah must keep in mind that according to the injunctions of Islam, surplus wealth of Muslims can no be utilised for strengthening the Capitalistic System or for the benefit of non-believers or enemies of Islam. This wealth should therefore, be profitability invested for the common benefit of Ummah, initially in their own country / region. The need of the hour is that a 'Fatwa' is issued on the subject immediately.

If only a portion of these funds is brought back to the respective Islamic countries, the size of many Islamic banks would become large enough to enable them to diversify their financing portfolio including more and more financing on PLS basis with greater sense of confidence.

Financing on PLS Basis

The real alternate to interest on loans in an Islamic framework is financing on PLS basis- a shift from debt based transaction to investment based funding. It is believed that the financing on PLS system of Islamic banking in a conducive environment would not only ensure a healthier financing portfolio and of course higher rates of return to depositors but would also lead to optimum allocation of resources for over-all economic growth and welfare of the society, individually and collectively.

It is however, accepted that the banks allowing financing on PLS basis are exposed to risk of losses as even a profitable company may sustain genuine loss due to various factors even beyond their control. The assuming of this risk is the essence of PLS mode of financing as all business transactions have an inseparable risk factor. It should not therefore, deter banks from making funds available on PLS basis to sound entities in feasible projects in the normal course of business.

In actual practice however, we find that traders and industrialists etc. generally earn substantial profit with the funds of a large number of depositors but they do not share these profits with the banks for onward passing on the share to the depositors. This injustice can be avoided if banks accept deposit on PLS basis according to its true spirit and also allow bulk of financing on the same basis. This will bring prosperity in the society, as a large number of depositors will be receiving higher rates of return on their deposits.

In the Islamic banking system, the concept is that of ratios in which profits and losses are shared instead of fixed, pre-determined interest and mark-up / profit rates. The issue of possible injustice due to inflation and recession, in money lending transactions, was settled by Islam over 1400 years ago, as PLS system absorbs the impact of inflation as regards the sharing of operational results are concerned. A glaring example is that of partnership where there is no dispute between partners due to high inflation or other-wise.

A comparison of the salient features of the financing on PLS Basis and the second line fixed return techniques is given below:-

Financing: PLS Vs Second Line Fixed Return Techniques

S. NO. Financing On PLS Basis Financing On Second Line Techniques

1. Unanimously held as an ideal mode of financing in an Islamic framework. A sale transaction which has ecently been transformed as a second line mode of financing and that too for transitory period. Reservations are expressed by many scholars about these mode.

2. Inequitable distribution of income and wealth will be significantly removed. Inequitable distribution of income and wealth continues like interest-based system.

3. Depositors are likely to get higher returns leading to prosperity. Returns are practically based on the bench marks of the interest based system. Depositors continue to be exploited.

4. Justice between the parties is ensured as the return to the bank on finance is dependent on the operational results of the entrepreneur. Injustice of interest-based system continues as bank is guaranteed a fixed return irrespective of the loss sustained by the entrepreneur. The return to bank is positive and pre-determined in the shape of agreed price.

5. Inflation is likely to be controlled to some extent. Same as under the interest-based system.

6. Progress towards Self-reliance will hopefully be made through enhanced
rate of savings. Same as under the interest-based system.

7. May lead to more efficient and optimum allocation of resources as compared to interest-based system. Same as under the interest-based system.

It is now about the time that the performance of Islamic banks worldwide should be judged from the contribution it is making in achieving the objectives of Shariah in the real sense and not merely by the number of Islamic banks or the quantum of their deposits portfolio.

MODEL ISLAMIC BANK

It is important to appreciate that the requisites for total implementation and success of Islamic banking in a country, include re-shaping the society, re-structuring of the economic system and re-framing of the laws according to the dictates of Islam. The most important and difficult task however, is the reformation of society which has to be undertaken as an on-going process.

We therefore, need to change our priorities and at least as much emphasis should be laid on improving the ethics, honesty and values of the society as is being done for expansion of " riba-free banking". This will then create a conducive environment for more and more financing under profit and loss sharing system of Islamic banking.

Mirakhor observes, "Perhaps the most challenging issue facing the implementation of an Islamic financial system is the development of risk-bearing instruments that can provide the investors with a sufficient degree of liquidity, security and profitability to encourage their holding". Islamic banks also face a challenge of developing innovative services and products for utilising these funds effectively and efficiently for financing under PLS system.

In view of the position explained here-in-above and considering the real difficulties in presently adopting the PLS system of Islamic banking for bulk of the financing for trade, industry and agriculture, it is felt that the need of the hour is to establish Model Islamic banks in all GCC countries as also in other Islamic countries where a large number of interest-free banks have been operating for a number of years.

The Proposed Model Bank would be a commercial bank. While the objective of the Bank would be to earn profit, it would identify itself with the Shariah as regards objectives, principles, practices and operations. The Proposed Bank would undertake all normal banking business as is done by interest-based banks but the Provisions of Shariah would be kept in view at all times.

The proposed Model Bank would accept deposits/investments on PLS basis (other than demand deposits) and would also allow financing only on this basis. The operations of the Bank will be supervised from Shariah point of view by a board of religious scholars.

The proposed Bank would develop risk-bearing but competitive products for deposits / investments wherein depositors / investors are given reasonable assurance of higher returns as also of safety of their funds. This Bank would also develop innovative but competitive products for financing which are not only compatible with Shariah but also cater to the needs of traders and industrialists etc., in the modern complex world which is ever - changing.

The sponsor directors of the Proposed Model Bank should be Muslim Scholars, Jurists, chartered accountants, economists, bankers and investors. All these persons should be men of integrity and of highest reputation. They should also have unshakeable faith and commitment in the Islamic banking system and should have good knowledge of it's principles, products and procedures.

These persons would take up the challenging assignment for the pleasure of Allah and for proving that Islamic banking in its totality is not only workable but would In sha Allah also pay rich dividends in material terms to all those who deal with or work for the Bank.

It is sincerely believed that the proposal of Model Islamic Bank is not only feasible but is the need of the hour. The successful operational results of this Bank would also motivate the existing Islamic banks to enhance their share of financing on PLS basis.

Conclusion

The first full-fledged Islamic Bank was established in Dubai in 1975. In 1995, GCC countries accounted for 15 percent of the paid up capital, 27 percent of the assets, 34 percent of the deposits and 28.8 percent of the net profit of the Islamic banks world-wide. The Islamic banks in GCC countries are therefore, in an ideal position to take a lead to shift the bulk of financing operations to PLS system of Islamic banking.

It is now time that Islamic banks and financial institutions resolve to gradually enhance their share of financing on PLS basis and reduce the share of financing on the basis of Murabaha, Bai Mu'ajjal and the like modes of financing.

If Islamic banks succeed in demonstrating a practical example of socio-economic justice by gradually enhancing their financing on PLS basis and also achieve further satisfactory operational results, there is no reason why more cooperation would not be extended to them by the European, American and other interest-based banks. Some of these conventional banks may even be tempted to adopt PLS system of financing in their subsidiaries & affiliates operating under the banner of Islamic banking.

The dawn of an era of justice can, therefore, be visualised where the fruits of the Islamic system would be available to a large number of people leading to over-all social and economic prosperity.