ISLAMIC ECONOMICS

Islamic banking is based on the principles of Islamic economics — an

economic framework in accordance with Islamic law (Sharia'h).

There are two types of Islamic economics:

 Caliphate , the Islamic form of government representing the

political unity and leadership of the Muslim world (Islamic
political framework)
 Assuming the political framework is non-Islamic, therefore,
seeking to integrate some prominent Islamic tenets into a secular
economic framework

Caliphate is the absolute Islamic rule, thus the economy focuses on

distribution of resources in order to meet the basic and luxurious needs
of individuals in society, and the state has a clear role in policing,
taxation, managing public assets, and ensuring the circulation of wealth.
Such a political framework in its true form does not exist in today's
world.

Assuming non-Islamic political framework simply proposes two main

tenets: no interest can be earned on loans and socially responsible
investing. This is the way conventional banking is Islamized—the first
step towards an Islamic economic framework.

Modern day Islamic scholars and academics have developed various

modes of Sharia'h complaint financing that are designed to work within
the prevailing capitalist economic framework. In order to achieve this
balance numerous concessions have been afforded to financial
institutions that would not apply if a viable interest free economic
system existed. The intention behind making these concessions is to
encourage the evolution of this type of alternative system.
ISLAMIC BANKING

Islamic banking refers to a system of banking or banking activity that is

consistent with Islamic law (Sharia’h) principles and guided by Islamic
economics. In particular, Islamic law prohibits usury, the collection and
payment of interest, also commonly called riba. Generally, Islamic law
also prohibits trading in financial risk (which is seen as a form of
gambling). In addition, Islamic law prohibits investing in businesses that
are considered unlawful, or haraam.

Islamic finance has been gaining momentum on a global scale for the
last 30 years.

Many Islamic Banks have sprung up over the last few years. These
changes are occurring both in Muslim and in western countries, and are
driven by a global trend amongst Muslims to become more observant of
their faith. It might have been the reason why Islamic Banking emerged,
however, today Islamic Banking is sought by Muslims and non-Muslims
due to the benefits it offers.

Industry size is currently estimated at more than $400 billion, with

projected growth of 15% per annum.

Financial institutions around the globe are trying to keep pace with the
growing demand for Sharia’h compliant products and services.

Islamic Banking Global Scenario

Over the last three decades Islamic banking and finance has developed
into a full-fledged system and discipline reportedly growing at the rate
of 15percent per annum. Today, Islamic financial institutions, in one
form or the other, are working in about 75 countries of the world.
Besides individual financial institutions operating in many countries,
efforts have been underway to implement Islamic banking on a country
wide and comprehensive basis in a number of countries. The instruments
used by them, both on assets and liabilities sides, have developed
significantly and therefore, they are also participating in the money and
capital market transactions. In Malaysia, Bahrain and a few other
countries of the Gulf, Islamic banks and financial institutions are
working parallel with the conventional system.

Bahrain with the largest concentration of Islamic financial institutions in

the Middle East region, is hosting 26 Islamic financial institutions
dealing in diversified activities including commercial banking,
investment banking, offshore banking and funds management. It pursues
a dual banking system, where Islamic banks operate in the environment
in which Bahrain Monetary Agency (BMA) affords equal opportunities
and treatment for Islamic banks as for conventional banks. Bahrain also
hosts the newly created Liquidity Management Centre (LMC) and the
International Islamic Financial Market (IIFM) to coordinate the
operations of Islamic banks in the world. To provide appropriate
regulatory set up, the BMA has introduced a comprehensive prudential
and reporting framework that is industry-specific to the concept of
Islamic banking and finance. Further, the BMA has pioneered a range of
innovations designed to broaden the depth of Islamic financial markets
and to provide Islamic institutions with wider opportunities to manage
their liquidity.

Another country that has a visible existence of Islamic banking at

comprehensive level is Malaysia where both conventional and Islamic
banking systems are working in a competitive environment. The share of
Islamic banking operations in Malaysia has grown from a nil in 1983 to
above 8 percent of total financial system in 2003. They have a plan to
enhance this share to 20 percent by the year 2010. However, there are
some conceptual differences in interpretation and Shariah position of
various contracts like sale and purchase of debt instruments and grant of
gifts on savings and financial papers.
In Sudan, a system of Islamic banking and finance is in operation at
national level. Like other Islamic banks around the world the banks in
Sudan have been relying in the past on Murabaha financing. However,
the share of Musharaka and Mudaraba operations is on increase and
presently constitutes about 40 percent of total bank financing. Although
the Islamic financial system has taken a good start in Sudan, significant
problems still remain to be addressed.

Like Sudan, Iran also switched over to Usury Free Banking at national
level in March 1984. However, there are some conceptual differences
between Islamic banking in Iran and the mainstream movement of
Islamic banking and finance.

Owing to the growing amount of capital availability with Islamic banks,

the refining of Islamic financing techniques and the huge requirement of
infrastructure development in Muslim countries there has been a large
number of project finance deals particularly in the Middle East region.
Islamic banks now participate in a wide financing domain stretching
from simple Shariah-compliant retail products to highly complex
structured finance and large-scale project lending. These projects, inter
alia, include power stations, water plants, roads, bridges and other
infrastructure projects. Bahrain is the leading centre for Islamic finance
in the Middle East region. The establishment of the Prudential
Information and Regulatory Framework for Islamic Banks (PIRI) by the
BMA in conjunction with AAOIFI has gone a long way towards
establishing a legal and regulatory framework to meet the specific risks
inherent in Islamic financing structures.

The BMA has quite recently signed MoU with the London Metal
Exchange (LME) to pool assets to develop and promote Shariah
compliant tradable instruments for Islamic banking industry. The
arrangement is seen as a major boost for industry’s integration in the
global financial system and should set the pace for commodity-trading
environment in Bahrain. BMA has also finalized draft guidelines for
issuance of Islamic bonds and securities from Bahrain. In May 03, the
Liquidity Management Centre (LMC) launched its debut US$ 250
million Sukuk on behalf of the Government of Bahrain.

National Commercial Bank (NCB) of Saudi Arabia has introduced an

Advance Card that has all the benefits of a regular credit card. The card
does not have a credit line and instead has a prepaid line. As such, it
does not incur any interest. Added benefits are purchase protection,
travel accident insurance, etc and no interest, no extra fees with no
conditions, the card is fully Shariah compliant. It is more secure than
cash, easy to load up and has worldwide acceptance. This prepaid card
facility is especially attractive to women, youth, self employed and small
establishment employees who sometimes do not meet the strict
requirements of a regular credit card facility. Saudi Government has also
endorsed an Islamic-based law to regulate the kingdom's lucrative
Takaful sector and opened it for foreign investors.

Islamic banks have also built a strong presence in Malaysia, where

Standard & Poor's assigned a BBB+ rating to the $600 million Sharia-
compliant trust certificates (called sukuk) issued by Malaysia Global
Sukuk Inc. Bank Negara Malaysia (BNM) has announced to issue new
Islamic Bank licences to foreign players. The Financial Sector Master
plan maps out the liberalisation of Malaysia's banking and insurance
industry in three phases during the next decade. It lists incentives to
develop the Islamic financial sector and enlarge its market share to 20
percent, from under 10 percent now. A dedicated high court has been set
up to handle Islamic banking and finance cases.

In United Kingdom, the Financial Services Authority is in final stages of

issuing its first ever Islamic banking license to the proposed Islamic
Bank of Britain, which has been sponsored by Gulf and UK investors.
The United States of America has appointed Dr. Mahmoud El Gamal, an
eminent economist/expert on Islamic banking to advise the US Treasury
and Government departments on Islamic finance in June 2004.
 History of Islamic banking

Classical Islamic banking

During the Islamic Golden Age, early forms of proto-capitalism and free
markets were present in the Caliphate, where an early market economy
and an early form of mercantilism were developed between the 8th-12th
centuries, which some refer to as "Islamic capitalism". A vigorous
monetary economy was created on the basis of the expanding levels of
circulation of a stable high-value currency (the dinar) and the integration
of monetary areas that were previously independent.

A number of innovative concepts and techniques were introduced in

early Islamic banking, including bills of exchange, the first forms of
partnership (mufawada) such as limited partnerships (mudaraba), and the
earliest forms of capital (al-mal), capital accumulation (nama al-mal),
cheques, promissory notes, trusts, startup companies, transactional
accounts, loaning, ledgers and assignments. Organizational enterprises
similar to corporations’ independent from the state also existed in the
medieval Islamic world, while the agency institution was also
introduced. Many of these early capitalist concepts were adopted and
further advanced in medieval Europe from the 13th century onwards.

Riba

The definition of riba in classical Islamic jurisprudence was "surplus

value without counterpart." or "to ensure equivalency in real value" and
that "numerical value was immaterial." During this period, gold and
silver currencies were the benchmark metals that defined the value of all
other materials being traded. Applying interest to the benchmark itself
made no logical sense as its value remained constant relative to all other
materials: these metals could be added to but not created.
Applying interest was acceptable under some circumstances. Currencies
that were based on guarantees by a government to honor the stated value
[“fiat money”] or based on other materials such as paper or base metals
were allowed to have interest applied to them. When base metal
currencies were first introduced in the Islamic world, no jurist ever
thought that "paying a debt in a higher number of units of this fiat
money was riba" as they were concerned with the real value of money
(determined by weight only) rather than the numerical value. For
example, it was acceptable for a loan of 1000 gold dinars to be paid back
as 1050 dinars of equal aggregate weight (i.e., the value in terms of
weight had to be same because all makes of coins did not carry exactly
similar weight).

Modern Islamic banking

The first modern experiment with Islamic banking was undertaken in

Egypt under cover without projecting an Islamic image—for fear of
being seen as a manifestation of Islamic fundamentalism that was
anathema to the political regime. The pioneering effort, led by Ahmad
Elnaggar, took the form of a savings bank based on profit-sharing in the
Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967,
by which time there were nine such banks in the country.

In 1972, the Mit Ghamr Savings project became part of Nasr Social
Bank which, till date, is still in business in Egypt. In 1975, the Islamic
Development Bank was set-up with the mission to provide funding to
projects in the member countries. The first modern commercial Islamic
bank, Dubai Islamic Bank, opened its doors in 1975. In the early years,
the products offered were basic and strongly founded on conventional
banking products, but in the last few years the industry is starting to see
strong development in new products and services.
MODES OF ISLAMIC FINANCE

MURABAHA

Literally it means a sale on mutually agreed profit. Technically, it is a

contract of sale in which the seller declares his cost and profit. Islamic
banks have adopted this as a mode of financing. As a financing
technique, it involves a request by the client to the bank to purchase
certain goods for him. The bank does that for a definite profit over the
cost, which is stipulated in advance.

Ijarah
Ijarah means lease, rent or wage. Generally, Ijarah concept means selling
benefit or use or service for a fixed price or wage. Under this concept,
the Bank makes available to the customer the use of service of assets /
equipments such as plant, office automation, motor vehicle for a fixed
period and price.

Advantages of Ijarah

Ijarah provides the following advantages to the Lessee:

 Ijarah conserves the Lessee' capital since it allows up to 100%

financing.

 Ijarah gives the Lessee the right to access the equipment on

payment of the first installment. This is important as it is the access
and use (and not ownership) of equipment that generates income.

 Ijarah arrangements aid corporate planning and budgeting by

allowing the negotiation of flexible terms
  Ijarah is not considered Debt Financing so it does not appear on the
Lessee' Balance Sheet as a Liability. This method of "off-balance-
sheet" financing means that it is not included in the Debt Ratios
used by bankers to determine financing limits. This allows the
Lessee to enter into other lease financing arrangements without
impacting his overall debt rating.

 All payments towards Ijarah contracts are treated as operating

expenses and are therefore fully tax-deductible. Leasing thus offers
tax-advantages to for-profit operations.

 Many types of equipment (i.e computers) become obsolete before

the end of their actual economic life. Ijarah contracts allow the
transfer of risk from the Lesse to the Lessor in exchange for a
higher lease rate. This higher rate can be viewed as insurance
against obsolescence.

 If the equipment is used for a relatively short period of time, it may

be more profitable to lease than to buy.

 If the equipment is used for a short period but has a very poor
resale value, leasing avoids having to account for and depreciate
the equipment under normal accounting principles.

Ijarah Thumma Al Bai' (Hire Purchase)

Parties enter into contracts that come into effect serially, to form a
complete lease/ buyback transaction. The first contract is an Ijarah that
outlines the terms for leasing or renting over a fixed period, and the
second contract is a Bai that triggers a sale or purchase once the term of
the Ijarah is complete. For example, in a car financing facility, a
customer enters into the first contract and leases the car from the owner
(bank) at an agreed amount over a specific period. When the lease period
expires, the second contract comes into effect, which enables the
customer to purchase the car at an agreed to price.

The bank generates a profit by determining in advance the cost of the

item, its residual value at the end of the term and the time value or profit
margin for the money being invested in purchasing the product to be
leased for the intended term. The combining of these three figures
becomes the basis for the contract between the Bank and the client for
the initial lease contract.

This type of transaction is similar to the contractum trinius, a legal

maneuver used by European bankers and merchants during the Middle
Ages to sidestep the Church's prohibition on interest bearing loans. In a
contractum, two parties would enter into three concurrent and
interrelated legal contracts, the net effect being the paying of a fee for
the use of money for the term of the loan. The use of concurrent
interrelated contracts is also prohibited under Shariah Law.

Ijarah-Wal-Iqtina

A contract under which an Islamic bank provides equipment, building,

or other assets to the client against an agreed rental together with a
unilateral undertaking by the bank or the client that at the end of the
lease period, the ownership in the asset would be transferred to the
lessee. The undertaking or the promise does not become an integral part
of the lease contract to make it conditional. The rentals as well as the
purchase price are fixed in such manner that the bank gets back its
principal sum along with profit over the period of lease.
MUSHARAKAH

Musharakah means a relationship established under a contract by the

mutual consent of the parties for sharing of profits and losses in the joint
business. It is an agreement under which the Islamic bank provides
funds, which are mixed with the funds of the business enterprise and
others. All providers of capital are entitled to participate in management,
but not necessarily required to do so. The profit is distributed among the
partners in pre-agreed ratios, while the loss is borne by each partner
strictly in proportion to respective capital contributions.

MUSAWAMAH

Musawamah is a general and regular kind of sale in which price of the

commodity to be traded is bargained between seller and the buyer
without any reference to the price paid or cost incurred by the former.
Thus, it is different from Murabaha in respect of pricing formula. Unlike
Murabaha, seller in Musawamah is not obliged to reveal his cost. Both
the parties negotiate on the price. All other conditions relevant to
Murabaha are valid for Musawamah as well. Musawamah can be used
where the seller is not in a position to ascertain precisely the costs of
commodities that he is offering to sell.

ISTISNA'A

It is a contractual agreement for manufacturing goods and commodities,

allowing cash payment in advance and future delivery or a future
payment and future delivery. Istisna'a can be used for providing the
facility of financing the manufacture or construction of houses, plants,
projects and building of bridges, roads and highways.
BAI MUAJJAL

Literally it means a credit sale. Technically, it is a financing technique

adopted by Islamic banks that takes the form of Murabaha Muajjal. It is
a contract in which the bank earns a profit margin on his purchase price
and allows the buyer to pay the price of the commodity at a future date
in a lump sum or in installments. It has to expressly mention cost of the
commodity and the margin of profit is mutually agreed. The price fixed
for the commodity in such a transaction can be the same as the spot price
or higher or lower than the spot price.

MUDARABAH

A form of partnership where one party provides the funds while the
other provides expertise and management. The latter is referred to as the
Mudarib. Any profits accrued are shared between the two parties on a
pre-agreed basis, while loss is borne only by the provider of the capital.

BAI SALAM

Salam means a contract in which advance payment is made for goods to

be delivered later on. The seller undertakes to supply some specific
goods to the buyer at a future date in exchange of an advance price fully
paid at the time of contract. It is necessary that the quality of the
commodity intended to be purchased is fully specified leaving no
ambiguity leading to dispute. The objects of this sale are goods and
cannot be gold, silver or currencies. Barring this, Bai Salam covers
almost everything, which is capable of being definitely described as to
quantity, quality and workmanship

Basic features and conditions of salam

The transaction is considered Salam if the buyer has paid the purchase
price to the seller in full at the time of sale. This is necessary so that the
buyer can show that they are not entering into debt with a second party
in order to eliminate the debt with the first party, an act prohibited under
Sharia. The idea of Salam is to provide a mechanism that ensures that
the seller has the liquidity they expected from entering into the
transaction in the first place. If the price were not paid in full, the basic
purpose of the transaction would have been defeated. Muslim jurists are
unanimous in their opinion that full payment of the purchase price is key
for Salam to exist. Imam Malik is also of the opinion that the seller may
defer accepting the funds from the buyer for two or three days, but this
delay should not form part of the agreement.

Salam can be affected in those commodities only the quality and

quantity of which can be specified exactly. The things whose quality or
quantity is not determined by specification cannot be sold through the
contract of salam. For example, precious stones cannot be sold on the
basis of salam, because every piece of precious stones is normally
different from the other either in its quality or in its size or weight and
their exact specification is not generally possible.

Salam cannot be affected on a particular commodity or on a product of a

particular field or farm. For example, if the seller undertakes to supply
the wheat of a particular field, or the fruit of a particular tree, the salam
will not be valid, because there is a possibility that the crop of that
particular field or the fruit of that tree is destroyed before delivery, and,
given such possibility, the delivery remains uncertain. The same rule is
applicable to every commodity the supply of which is not certain.

It is necessary that the quality of the commodity (intended to be

purchased through salam) is fully specified leaving no ambiguity which
may lead to a dispute. All the possible details in this respect must be
expressly mentioned.
It is also necessary that the quantity of the commodity is agreed upon in
unequivocal terms. If the commodity is quantified in weights according
to the usage of its traders, its weight must be determined, and if it is
quantified through measures, its exact measure should be known. What
is normally weighed cannot be quantified in measures and vice versa.

The exact date and place of delivery must be specified in the contract.

Salam cannot be affected in respect of things which must be delivered at

spot. For example, if gold is purchased in exchange of silver, it is
necessary, according to Shari'ah, that the delivery of both be
simultaneous. Here, salam cannot work. Similarly, if wheat is bartered
for barley, the simultaneous delivery of both is necessary for the validity
of sale. Therefore the contract of salam in this case is not allowed.

Hibah (Gift)

This is a token given voluntarily by a creditor to a debtor in return for a

loan. Hibah usually arises in practice when Islamic banks involuntarily
pay their customers interest on savings account balances.

Islamic Banking Issues

HUMAN RESOURCE FOR SHARIA'H COMPLIANCE

Users of Islamic financial services assign primary importance to Sharia'h

compliance of the services they use. It is understandable that Sharia'h
noncompliance entails a serious operational risk and can result in
withdrawal of funds from and instability of an Islamic bank, irrespective
of its initial financial soundness. Sharia'h compliance is hence a serious
matter for an Islamic bank, in addition to its compliance with other
regulatory requirements.

UNRESOLVED FIQH ISSUES

Lack of standard financial contracts and products can be a cause of

ambiguity and a source of dispute and cost. In addition, without a
common understanding of certain basic foundations, further
development of banking products is hindered.

LEGAL FRAMEWORK

An appropriate legal, institutional and tax framework is a basic

requirement for establishing sound financial institutions and markets.
Islamic jurisprudence offers its own framework for the implementation
of commercial and financial contracts and transactions.

Nevertheless, commercial, banking and company laws appropriate for

the enforcement of Islamic banking and financial contracts do not exist
in many countries.

EXCESS LIQUIDITY

Islamic banks have over 60 % excess liquid funds which cannot be

properly utilized due to non-availability of Sharia'h Compliant products
and instruments.

The competitiveness and soundness of financial institutions depend on

the availability of efficient financial products. Islamic banks urgently
need Sharia'h compliant products to meet a number of pressing needs.
Conventional Banking

Conventional banking is based on the principle that the more you have,
the more you can get. In other words, if you have little or nothing, you
get nothing. As a result, more than half the population of the world is
deprived of the financial services of the conventional banks.
Conventional banking is based on collateral. Conventional banks look at
what has already been acquired by a personConventional banks go into
‘punishment’ mode when a borrower is taking more time in repaying the
loan than it was agreed upon. They call these borrowers “defaulters”.
When a client gets into difficulty, conventional banks get worried about
their money, and make all efforts to recover the money, including taking
over the collateral. In conventional banks charging interest does not stop
unless specific exception is made to a particular defaulted loan. Interest
charged on a loan can be multiple of the principal, depending on the
length of the loan period.

Islamic Banking Vs Conventional Banking

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The main difference between Islamic and conventional banking is that
Islamic teaching says that money itself has no intrinsic value, and
forbids people from profiting by lending it, without accepting a level of
risk – in other words, interest (known as "riba") cannot be charged.

To make money from money is prohibited – wealth can only be

generated through legitimate trade and investment. Any gain relating to
this trading are shared between the person providing the capital and the
person providing the expertise.

At Islamic Bank of Britain, we generate all our profit through sharia’a

compliant trading and investment activities. We then share the profits
with our customers at a pre-agreed ratio. In order to share profits you
must hold one of our savings or investment accounts

There are two major difference between Islamic Banking and

Conventional Banking:
1. Conventional banking practices are concerned with "elimination of
risk" where as Islamic banks "bear the risk" when involve in any
transaction.
2. When Conventional banks involve in transaction with consumer they
do not take the liability only get the benefit from consumer in form of
interest whereas Islamic banks bear all the liability when involve in
transaction with consumer. Getting out any benefit without bearing its
liability is declared Haram in Islam.

While the basics of what the business is are the same, the term refers to
operating the business within Islamic law. The main thing that effects
this business under that law is that Islam prohibits the charging of
interest. Certainly a problem in modern banking!

However, what is considered to be interest has different definitions by

different Islamic scholars...some say it can only be considered on gold
and silver...but paying back the same weight as you borrowed (the same
weight of paper money for example), is not interest. Like in all religious
things, there would seem to be some conflict and differences between
followers that may seem strange to outsiders.

So basically, modern Islamic banking may take many forms, each of

which strives to adhere to it's understanding of Islamic law.
Islamic banks playing role in Economic Development of the Country
Islamic banking is unique, but by no means anomalous. It is neither at
odds with nor incomparable to conventional banking. Is it possible to
contrast the two models?
 
I-They are both financial intermediations. A financial intermediary is
the institution that acts as a middleman between cash surplus units
(savers) and deficit spending units (users of fund). It is quite obvious
that the main function of conventional banks is financial
intermediation. However, there are those who would like to think that
there is no such thing in the Islamic economic system as financial
intermediation and that an Islamic bank can only be “sufficiently”
Islamic if it can operate like a trader, one who buys and sells goods
and commodities.
 
The financial intermediary in conventional banking is a “borrower-
lender” institution. Since such institution will not survive unless it at
least covers expenses, then an income must be generated from such
arrangement. This is where interest appears. An Islamic bank, on the
other hand, is based on a multi-tier Mudarabah. A Mudarabah is a
partnership in profit where capital and management may joint together
to create value. The income accruing to the Islamic financial
intermediary is coming out of profit not from interest. The root of
such a conception is the fact that Shari'ah doesn’t distinguish between
a seller being a trader or a final intermediary, unlike positive law
where civil law is different from commercial law. In Shari'ah all
people stand against one legal code.
 
II-A case in mind is Murabaha. There are those who say if an Islamic
bank does Murabaha any other form but the traders way of doing
things it will not be permissible from Shari'ah point of view, and an
Islamic bank would be in their view a “dubious” conventional bank.
They say: since it is never the intention of the bank, to own there
assets and hold on to them then, such bank is not sufficiently Islamic.
 
According to this viewpoint, an Islamic bank must have huge
warehouses and elegant stores full of goodies for sale. This is not
valid and those who think so miss two important points:
 
           Intention is of no consequence on the permissibility or
otherwise of any exchange contract in Shari'ah. In an authentic
Hadith, the Prophet (PBUH) showed one companion how to substitute
a usurious transaction by another non usurious to reach the same
purpose, He (PBUH) didn’t object to the intention nor that he nullified
the contract on the basis of intention. Rather he corrected the form of
contract.
 
If the anatomy of the contract is in line with Shari'ah requirements,
then the transaction is acceptable. Hence, if bank actually buys and
then sells, with ownership passing from seller to buyer and that the
subject of contract is a good or commodity then the transaction is
correct. In conventional banking the subject of contract is money
hence any increase is usurious.
 
III-The way conventional banks render financial intermediation is
very simple. They borrow money and lend money. Both assets and
liabilities are one form of lending. Islamic banking function in a rather
“elaborate” (not perplexing) way. They have to continuously innovate
to satisfy the needs of their clients. It is because of this we see
Murabaha, Musharakah, Mudarabah, Istisna’a, Salam to name just a
few Islamic modes of finance. This makes the job of an Islamic
banker “not all roses”, but certainly a more interesting one.
 
IV-A conventional banker is a risk manger. He is concerned with all
kind of credit, market, interest rate, legal and other risk factors. An
Islamic banker should be just as concerned. However, there is one
added risk for the Islamic banker, this is what we may call “Shari'ah
disobservance risk”. Risk analysis refer to the forces that may cause
the outcome of investment to be sub optimal. Certainly an Islamic
investor earning   non-permissible income is an outcome that is most
undesireous, and it may cause the value of his investment to be
reduced.
 
V-Contrary to popular opinion, being concerned about time value of
money is a similarity not a difference between Islamic and
conventional banking. There is no basis for the current thinking that
Shari'ah doesn’t allow the attachment of monetary value to time in the
contracts exchange. The contract of Salam and differed-payment sales
fly in the face of this argument. It is only in loans that Shari'ah
requires that no time value of money is considered (but replaced by
great rewards in the hereafter).
 
VI-A major difference, however, remains in the handling of
delinquency and default. When a borrower delays payment of debt,
interest will accrue on his delayed portion. Unless, such borrower
defaults and become incapable of paying back his debt, such interest
will compensate the conventional bank for lost business. This can’t be
done in Islamic banking as this is considered usurious.
 
Clearly, this is a disadvantage from two aspects: Firstly, an Islamic
bank will not have the opportunity in a Murabaha transaction for
example, to be compensated for lost profit. But more importantly, it
increases significantly, the Murabaha risks. Since bank clients are
rational people who will seize an opportunity when they see one, they
will always delay payment. One major Ijtihad of contemporary
Shari'ah scholars, is to allow the Islamic bank to impose penalties.
Rather than accrue such penalties as income, and hence become
usurious, they are disposed off to charity. This way the pressure will
mount on the debtor to pay in time, without falling into Shari'ah
impressibility.
Operational Challenges and Prospects
Both the theory of Islamic banking and the rapid expansion of Islamic
banks recent years have demonstrated the viability and feasibility of
non-interest-based operations. This must be surprising to those who
believed that banks and financial systems could not operate in a modern
economy without reliance on an interest rate mechanism. Indeed,
experience has shown that Islamic banks are powerful means of
mobilizing resources. Operationally, however, both the Islamic financial
systems in the three countries that have adopted it as well as individual
Islamic banks face challenges that need to be addressed.
The most important among these challenges is the fact that, while it has
been relatively easy to create a system in which deposits do not pay
interest, the asset portfolios of Islamic banks do not contain sufficiently
strong components that are based on profit-sharing. The main reasons
for this are: (a) lack of a legal and institutional framework to facilitate
appropriate contracts as well as mechanisms to enforce them; and/or (b)
lack of appropriate menus containing a broad range and a variety of
maturity structures of financial instruments. Consequently, a relatively
strong risk perception has become associated with profit-sharing
methods in particular and Islamic banking in general. This, in turn, has
led to concentration d asset portfolios of the Islamic banks in short-term
and trade-related assets with inimical effects on investment and
economic development. The problem is exacerbated by the fact that
Muslim countries, as is the case in much of the developing world, suffer
from a lack of deep and efficient capital and money markets that can
provide the needed liquidity and safety for existing assets. The absence
of suitable long-term instruments to support capital formation is
mirrored in the lack of very short-term financial instruments to provide
liquidity.
a. The challenges facing individual Islamic banks
Impressive as the growth record of individual Islamic banks may be, the
fact is that at present, those banks have mostly served as intermediaries
between the financial resources of Muslims and major commercial banks
in the West. In this context, this has been a one-way relationship, so far.
There is still no major Islamic bank that has been able to develop ways
and means of intermediating between Western financial resources and
the demand for them in Muslim countries.
It also appears that individual Islamic banks face difficulties in fund
placement because they have had a major bias towards short-term,
secured, low-return but liquid investments. The challenge for these
institutions stems from motivational and technical factors.
Motivationally, their basic aim appears to have been that of
demonstrating the viability of Islamic banking without taking too many
risks. Admittedly, this is a noble and a very important objective,
however, although they have succeeded in this effort and have managed
to create a market niche for Islamic banking, they do not seem to have
achieved the market depth that could ensure long-term profitability and
survival. This stems from the fact that they appear to be far behind in
technical innovations and financial market developments that in recent
years have revolutionized finance and capital markets. There is no
evidence that these banks have made any large investment in research
and product development, nor is there any evidence that new financial
products developed in recent years, particularly in equity derivatives,
have been utilized to any significant degree by the major Islamic banks.
This is unfortunate because the market opportunities that these banks
have been able to develop, to allow funds from Islamic communities to
be placed in Islamically permissible portfolios, can and will be exploited
by more efficient and innovative Western financial institutions that
already have or will discover this market niche.
While there is considerable room for competition and expansion in this
field, the long-term survivability of individual Islamic banks will depend
on how rapidly, aggressively, and effectively they can develop
techniques and instruments that would allow them to carry on a two-way
intermediation function. They need to find ways and means of
developing marketable Shari‘ah-based instruments by which asset
portfolios generated in Muslim countries can be marketed in the West as
well as marketing Shari’ah-based Western portfolios in Muslim
communities.
b. The challenge of adopting an Islamic financial system
The most important challenge for Islamic banking is in its system-wide
implementation. At present, many Islamic countries suffer from
financial disequilibria that frustrate attempts at wholesale adoption of
Islamic banking. Financial imbalances in the fiscal, monetary and
external sector of these economies cannot provide fertile ground for
efficient operation of Islamic banking. Major structural adjustments
particularly in fiscal and monetary areas are needed to provide Islamic
banking with a level playing field. Additionally, adoption of a legal
framework of property ownership and Contracts that would clearly
specify the domain of private and public property rights as well as
stipulation of legally enforceable rights of parties to contract that fully
reflect the requirements of the Shari’ah, are necessary to allow an
operational framework conducive to efficient operation of Islamic
banking.
An Islamic financial system can be said to operate efficiently if, as a
result of its adoption, rates of return in the financial sector correspond to
those in the real sector. In many Islamic countries fiscal deficits are
financed through the banking system. To lower the costs of this
financing, the financial system is repressed by artificially maintaining
limits on bank rates. Thus, financial repression is a form of taxation that
provides governments with substantial revenues. To remove this burden,
government expenditures have to be lowered and/or revenues raised.
Massive involvement of governments in the economy makes it difficult
for them to reduce their expenditures. Raising taxes is politically
difficult. Thus, imposing controls on domestic financial markets
becomes a relatively easy form of raising revenues. Under the above
circumstances, it is understandable why governments would have to
impose severe constraints on private financial operations that can
provide higher returns to their shareholders and/or depositors. This
makes it very difficult for Islamic banks and other financial institutions
to realize fully their potential. For example, Mudarabah companies that
can provide higher returns than the banking system would end up in
direct competition with the banking system for deposits that are used for
bank financing of fiscal deficits.
While Muslim countries may, for legitimate reasons, opt for an Islamic
financial system, for the economy as a whole to benefit fully from the
operations of such a system, it is necessary that (a) government
expenditures are fully rationalized, (b) revenues from taxation, and those
derived from property legitimately placed within the government
domain by the Shari’ah, are raised to meet the expenditure needs the
government, (c) the financial sector is liberalized so that returns to this
sector reflect returns to the real economy, (d) equity markets are
developed to allow financing of investment projects outside banking
institutions, and, finally, (e) the structure of the banking system should
be such as to allow strong banking supervision and prudential regulation
commensurate with the risks involved in various transactions.* To
accomplish the last objective, the banking structure can be tiered in
accordance with principal Islamic financial transactions. It is reasonable
to assume that risks involved in Musharakah or Mudarabah financing,
are different from those involved in trade-type financing. It follows,
therefore, that prudential regulations of these transactions should be
different.

Motivating Factors for Islamic Banking

Motivation and renewed interest in Islamic finance industry stems from

its strong economic, financial and social considerations, backed by its
unique features.
Most significant is its appeal to add to financial diversity and innovation
being skewed towards:
 (i) Asset backed and equity based transactions, which
promote entrepreneur friendliness and consideration of
project viability

(ii) Equitable distribution of risks and rewards among the

stakeholders;

(iii) inculcating market discipline and higher ethical

standards given its emphasis on non-exploitation and
social welfare.

In the wake of high Asian domestic savings rates and build up of the
region’s foreign exchange reserves as well as oil surpluses of Middle
East in the last few years, Islamic finance is now also emerging as a way
to wealth management, both of richer nations and high
net worth individuals.