----------------------- Page 1-----------------------

IslamicFinancing ANALTERNATEFINANCINGTECHNIQUE SAHEEBASABAKKA ----------------------- Page 2----------------------ISLAMIC FINANCING AN ALTERNATE FINANCING TECHNIQUE A PROJECT REPORT Under the guidance Of Mrs. Neena P. G Submitted By SAHEEBA SABAKKA Roll No. 510915516 In partial fulfillment of the requirement For the award of the degree Of MBA in FINANCE DEC 2010 2 ----------------------- Page 3----------------------ACKNOWLEDGEMENT I lor Mrs. Roshini P. K, for her invaluable guidance and blessings. I am very grateful to our Principal and Head of Department Mr. Vinod C. T for providing with an environment to complete this project successfully. I especially thank Project Coordinator Ms. Neena for all express our deepest gratitude to our Advisor and Counse

the support she had extended to complete the project. I neral Secretary ICIF, for his constant encouragement and support throughout the course of the project. I am immensely grateful to Mr. Abdussalam K. M Trustee entire ICIF, for his unwavering support throughout the express our sincere thanks to Mr. H. Abdul Raqeeb Je

course of the project. I would also like to thank all the staff at ICIF who have co-operated with me for the completion of this project. I aff at Mercy Institute of Technology who have extended their help and support throughout the project. Finally, I take this opportunity to extend our deep appreciation to our family and friends, for all that they meant to us during the crucial times of the completion of our project. 3 ----------------------- Page 4----------------------would also like to thank Ms. Gopika and all other st

BONAFIDE CERTIFICATE Certified that this project report titled ISLAMIC FINANCE is the

bonafide work of SAHEEBA SABAKKA who carried out the project work under my supervision. SIGNATURE Vinod C. T HEAD OF THE DEPARTMENT MBA Mercy Institute of Technology Punnathoor Rd. Puthanpally (P. O) SIGNATURE Neena P. G FACULTY IN CHARGE MBA Mercy Institute of Technology Punnathoor Rd. Puthanpally (P. O)

Guruvayur Thrissur

Guruvayur - Thrissur 4

----------------------- Page 5----------------------EXECUTIVE SUMMARY Uncontrolled capitalism has caused the global economy into a plunge into an unprecedented crisis. Adding to the distress, economists worldwide are expecting he near the global economy to experience a double dip in t

future. This calls in for a need for eradicating huge bubbles of fiat money and able assets brought in by capitalism and build up a real and st

economy. In an alternate mode of financing as a remedy. In the wake of crisis, world has slowly started to shifting to this alternate financing model which offers a wide a, range of complexly engineered tools viz., Mudaraba, Murabah this project, we try to study Islamic banking and financing as

Musharaka, Istisna, Musaqat, Ijara and a lot more as has been discussed in the upcoming een studied. Though bal Islamic financing has been creating waves in the glo chapters. Salient features of each have also b

economy, it is yet to unveil in our much potential Indian economy, owing to ng its non-consonance with the prevailing provisions of Banki

Regulations Act. Even though remedies are available as has been studied in the project, our Central Bank is yet to sanction this model of financing which promises a new era of bright future for Indian economy. 5 ----------------------- Page 6-----------------------

TABLE OF CONTENTS 1. INTRODUCTION 1. 1 An Introduction to financial system 1.1.1 Importance of financial system 2.1 Islamic financial system 2.1.1 Need for Islamic banking 2. ISLAMIC FINANCE 2.1 Basic Tenets of Islamic Banking and Finance 2.1.1 Riba 2.1.2 Gharar 2.1.3 Zakaat 2.1.4 Haram 2.2 Principles of Islamic Banking 2.2.1 Prohibition against the payment and receipt of a fixed or pre- determined rate of interest 2.2.2 Sharing risks and rewards 2.2.3 Permissible forms of businesses 6

----------------------- Page 7----------------------2.2.4 Making money from money is not acceptable 2.3 Islamic Financial Institutions 2.3.1 Islamic Banking 2.3.2 Islamic Insurance (Takaful Institutions) 2.3.3 Investment Banking and Mutual Funds 2.4 Tools and Techniques of Islamic Financing 2.4.1 Murabaha (Cost plus Finance) 2.4.1.1 Steps in Murabaha 2.4.1. 2 Subject of Murabaha

2.4.1.3 Specification of price 2.4.2 Mudaraba (Trustee Finance Contract) 2.4.1 Participatory Financing 2.4.2 Preconditions of Mudaraba Contract 2.4.3 Restricted and Unrestricted Mudaraba 2.4.4 Two tier Mudaraba 2.4.5 Termination of Mudaraba 2.4.3 Musharaka (Joint Venture) 2.4.3.1 Different types of Musharaka 2.4.3.2 Diminishing Musharaka 2.4.3.3 Management of Musharaka 2.4.3.4 Termination of Musharaka 7 ----------------------- Page 8----------------------2.4.4 Muzaraat and Musaqat (Agricultural Partnership) 2.4.4.1 Contracting Musaqat 2.4.4.2 Conditions of Musaqat 2.4.4.3 Termination of Musaqat 2.4.5 Ijara (Islamic Lease) 2.4.5.1 Basic Rules governing leasing 2.4.5.2 Types of Ijara 2.4.6 Qard Hassan (Benevolent Loan) 2.4.6.1 Objectives of Qard Hassan 2.4.6.2 Conditions of Qard Hassan Transaction 2.4.6.3 Application of Qard Hassan 2.4.7 Salam or Bai Salam (Forward Contracts) 2.4.7.1 Conditions of Salam 2.4.8 Takaful (Islamic Insurance) 2.4.8.1 Principles of Takaful

2.4.8.2 Modules under Takaful 2.4.8.3 Tabarru to eliminate Uncertainity 2.4.8.4 Issues in conventional Insurance 2.4.8.5 Distinguishing features of Takaful 2.4.9 Istisna 8 ----------------------- Page 9----------------------2.4.9.1 Ways of effecting Istisna Sale Contract 2.4.9.2 Termination of Istisna 2.4.9.3 Istisna as a Deferred Payment Scheme 2.4.9.4 Application of Istisna 2.4.10 Sukuk (Islamic Bonds) 2.4.10.1 Difference between Sukuk and Conventional Bonds 2.4.10.1 Features of Sukuk 2.4.10.2 Uses of Sukuk Funds 2.4.10.3 Types of Sukuk 2.5 Functioning of Islamic Banks 2.5.1 Current Accounts 2.5.2 Savings Accounts 2.5.3 Investment Accounts 2.5.3.1 Equity Fund 2.5.3.2 Ijara Fund 2.5.3.3 Commodity Fund 2.5.3.4 Murabaha Fund 2.5.3.5 Mixed Fund 2.6 Rise and Scope of Islamic Banking 2.6.1 History of Islamic Banking 2.6.2 Growth of Islamic Banking

2.6.3 Reasons for popularity of Islamic Banking 2.7 Viability of Islamic Finance in India 9 ----------------------- Page 10----------------------2.7.1 Hurdles on the way of introducing Islamic Banking in India 2.7.2 Risks inherent in Islamic Banking 3. CONCLUSION 10 ----------------------- Page 11----------------------LIST OF TABLES Table 1 : Financing Options for Capital Holders Table 2 : Financing Options for Entrepreneurs Table 3 : An Example of Payment Schedule under Musharaka 11 ----------------------- Page 12----------------------LIST OF FIGURES Figure 1 : Working of Mudaraba Figure 2 : Bar Diagram showing Banking reach in India 12 ----------------------- Page 13----------------------LIST OF ABBREVIATIONS AND NOMENCLATURE SYMBOLS 1. Rs. 2. & 3. % 4. @ Rupees And Percent at the rate

5. $ 6. i.e 7. viz ABBREVIATIONS 8. SRI 9. SSB 10.QIB 11.LIBOR 12.P/L 13. ROSCA 14.UK 15.PLS 16.IDB 17.GCC 18.OPEC 3

Dollar that is namely/ that is to say

Socially Responsible Investments Sharia Supervisory Board Qualified Institutional Buyers London Inter Bank Offer Rate Profit and/or Loss Rotating Savings and Credit Association United Kingdom Profit Loss Sharing Islamic Development Bank Gulf Cooperation Council Organization of Petroleum Exporting Countries 1

----------------------- Page 14----------------------19.USA 20.BRA 21.RBI 22. IPO NOMENCLATURE 1. Sharia (shariah/sharia) 2. Riba 3. Gharaar 4. Zakat 5. Haram 6. bai bithaman ajil 7. nisab Islamic Rules and Regulations Interest Uncertainity Islamic tax Prohibitted/ Unethical Sales wih advance Payment basic amount excepted out of tax or zakat United States of America Banking Regulation Act Reserve Bank of India Initial Public Offering

8. halal 9. israf wa traf 10. Maisir 11. Murabaha 12. Mudaraba 13. Rabb ul Mal 14. Mudarib 15. Mudaraba Al-Mutlaqa 16. Al-Muqayyada 17. Musharaka 18. Shirkat-ul-milk 19. Shirkat-ul-aqd relationship

permitted/ encouraged luxurious activity gambling Cost-plus Financing Trustee Finance Contract Owner of the capital Fund Manager Restricted Mudararaba Restricted Joint Venture Partnership based on joint ownership Partnership based on contractual

20. Shirkat-ul-Mufawadah full authority and obligation partnership 14 ----------------------- Page 15----------------------21. Shirkat-ul-Inan partnership 22. Shirkat-ul-Wujuh 23. Shirkat-ul-Abdan 24. Mazara at and musaqat 25. Baligh 26. Ijara goodwill/ credit worthiness partnership labor, skill and management partnership Agricultural partnership Major/ Mature Islamic lease restricted authority and obligation

27. Ijara Thumma Al- Baai Hire Purchase 28. Ijara Wa Iqtina 29. Qard Hassan 30. Aqil 31. Rashid 32. Ijab A form of Islamic lease Benevolent Loan person with sound mind person capable of sound judgment offer

33. Qabul 34. Sanduq 35. Amana/Wadia 36. Salam 37. Bai Salam 38. Takaful 39. Ras ul Mal 40. Retakaful 41. Wakala 42. Tabarru 43. Istisna 44. Sukuk 15

acceptance Box Pure Deposit Forward Contract Forward Contract Islamic Insurace Islamic Insurance Contributions Reinsurance Islamic Agency Insurance Contract in writing in Takaful Manufacture Financing Islamic Bonds

----------------------- Page 16----------------------AN INTRODUCTION TO FINANCIAL SYSTEM A financial between and system is a system that allows transfer of a set instruments, of money of clo sav

savers sely

borrowers. financial

It normally

comprises

interconnected ers,

institutions, markets,

practices, transactions etc. Financial which household ive system savings in the modern are distributed day serve as a channel through

to corporate

sector

for product

utilization for the ultimate good, consequently, of the economy at large. It allocates ral investment funds among firms, and allows inter tempo

smoothing consumption by household and expenditure by firms. In effect, an efficient financial system is a tool of running the economy smoothly, ensuring stability and growth.

Importance of financial system Provides framework for carrying out economic transactions and

monetary policies Helps efficiently channel savings to investments Sound growth. 16 ----------------------- Page 17----------------------Sound of a prospering ss of financial economy. system can be considered one could as the reduce back bone financial system is essential for promoting economic

A defective

effectivene

monetary policy and deepen or prolong economic downturn. It creates a capital flight ( or large fiscal costs related to rescuing troubled institution) on a large scale. rld scenario, weakness of borders one To add can to it, in spill the modern over liberal wo

country

rapidly

across

national

and result in a global economic slump as weve seen in the recent past. That is to say, a sound financial system is essential for the domestic as well as the countries those that have trade or financial linkages with the country concerned. Thinkers of forms of the recent and ancient past have devised several

financial system to keep large economies on its heels. The most popular of them are capitalistic and communist system of finance, both of which in the present scenario have proven to fail on account the unprecedented economic crisis that the planet plunged into. This situation calls system for a out for a need for alternative financial

healthy and sustainable global economy.

17 ----------------------- Page 18----------------------ISLAMIC FINANCIAL SYSTEM Islamic finance is based on principles of shariah, or Islamic law. Major principles tainty, adherence ethical investments tional of shariah are a ban and on interest, profit sharing, and asset a ban on uncer of interna

to risk- sharing that enhance

promotion The

society,

backing.

market for Islamic finance has grown between 10% to 15% annually in recent years. in the Persian Gulf im and non-Muslim for Islamic mestic regulatory ons in Islamic tutions, Islamic countries, finance but is India. been historically has expanded huge and has been to market concentrated both Musl

globally growing

countries. finance bodies, finance

There in the

potential and do

Through

international

there has across

effort to standardize countries and financial

regulati insti

different

although challenges remain. Islamic banking is essentially banking in consonance with the ethos and value system of Islam and governed in addition to the conventional good governance wn by and risk management rules, by principles laid do

Islamic law, Shariah. It is, however, not confined to interest free banking, which is interesta narrow concept. In addition to non-acceptance of

based transactions, the fundamental tenet is that of fairness. It envisages ethical practices, tion of income and wealth contributions and active towards a more in equitable achieving distribu the go

participation

als

and

objectives of an Islamic economy. 18 ----------------------- Page 19----------------------The history of tion is of non-interest banking in its present day incarna

recent origin. In the second half of the 20th century, efforts were made to adopt Islamic finance in Egypt. It slowly spread to Middle East and then to other parts of the world. Today approximately 700 registered Islamic finance institutions The annual are said to exist covering 51 countries.

growth rate of Shariah compliant assets is more than 15% on year-to-year basis. At this rate, it is the worlds fastest growing financial sector and is becoming an increasingly important component of the international

financial system. Need for Islamic Banking The collapse of major Wall Street institutions, notably Lehman Brothers, and Islamic the subsequent banking global financial crisis and economic recession, as a

is seriously being considered and has emerged

possible alternative to the conventional banking because of the following reasons: It is based on Ethical and Socially Responsible Investments (SRI) It aims at Equity and Justice and leads to poverty alleviation It acts to new imension to assets andactual projects aiming to

support real economic growth instead of financial engineering It provides services to under banked populations ignored by

conventional banks

19 ----------------------- Page 20-----------------------

BASIC TENETS OF ISLAMIC BANKING AND FINANCE The basic down as under; 1. Prohibition of interest-based (riba) transactions; 2. Ban on speculation and excessive 3. Islamic tax system (zakat); 4. Discouragement ich contradict the value pattern of Islam (haram) Riba Perhaps the most far reaching of these is the prohibition of interest (riba). The of payment and acceptance of riba, which are the fundamentals banki means. Technic of a of the production of goods and services wh risk taking (gharar); tenets of Islamic banking and finance can be put

conventional banking system is explicitly prohibited in Islamic ng and thus ally, riba refers loan investors must be compensated by other

to the addition in the amount

of the principal

according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, mic there now appears to be consensus of opinion among Isla

scholars that the term extends to all forms of interest. In banning riba, Islam seeks to establish a society based upon fairness and justice. A loan provides the lender with a fixed return irrespective of the outcome of the borrower s venture. It is much fairer to share the profits and losses. Fairness supplier of capital possesses

in a right

this

context

has

two

dimensions: reward

the should

to reward,

but this

be 20 ----------------------- Page 21----------------------commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied. Hence, what d return. The sharing ovided the is of forbidden profit is in Islamic legitimate precepts and that is a predetermine has pr

practice

foundation for Islamic banking. Gharar Another feature condemned by Islamic banking is economic transactions involving elements of speculation, gharar. Buying goods or shares at low price and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to avoid a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large. Under this free from prohibition any transaction entered into should be

uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit.

interpretation, does not even allow an undertaking from the customer to repay ccount the borrowed principal plus an amount to take into a

inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic ecause and so are forward foreign exchange transactions b

rates are determined by interest differentials.

This is based on a strict

the principle

of

uncertain

gains

which,

on

A number of inciple of gharar: sales ract to 21

transactions with advanced

are

treated

as

exceptions bithaman

to

the

pr

----------------------- Page 22----------------------manufacture (lstisna); and hire contract (jIara). However, there are legal requirements for ized in a the conclusion of these contracts to be organ

way, which minimizes risk. Zakat A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic meaning tax, Zakat (a term derived from the Arabic zaka,

"pure") is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim s annual income in cash or kind from all forms of assessed wealth exceeding nisab. Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and Islamic Banking. Haram on the profits as described in the Handbook of

for Islamic banks to finance activities or items forbidden in Islam, haram, such as should only ven trade of alcoholic beverage and pork meat. Investments or e

support

practices

or products

A strict code of

ethical investment is prescribed and hence it is forbidden

that are not forbidden

payment (bai

ajil); cont

discouraged by Islam. Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community, 22 ----------------------- Page 23----------------------while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint. In order to ensure that the practices and activities of Islamic banks do not contradict cted to establish the Islamic ethical standards, Islamic banks of Muslim are expe

a Sharia

Supervisory

Board, consisting

jurisprudence, who act as advisers to the banks.

23 ----------------------- Page 24-----------------------

PRINCIPLES OF ISLAMIC BANKING Islamic banking has its own unique principles that clearly distinguish it from the rest of the financial system. Principles of Islamic banking and finance are escribed by the sharia and largely law. value based principles and form as per the the guidelines pr

These

basis for

the tools

techniques of Islamic financing. Prohibition preagainst the payment and receipt of a fixed or

determined rate of interest The est essential feature free. Islam of Islamic banking is that it is inter

prohibits Muslims from taking or giving interest regardless of the purpose for which which such loans are made and regardless of the rates at

interest is charged. However, the Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production, but does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. Islam allows the owners is uncertain. of capital a share in the surplus, which

Profit sharing permissible in Islam, while interest is not, as in the case of the former, it is only the profit sharing ratio, not the rate of return itself that is pre-determined. Profit- making is acceptable in Islamic society as long as these profits are

not unrestricted or driven by the activities of a monopoly or cartel. Islam deems profit, rather than interest, to be closer to its sense of morality and equity and rewards. ustice because Profit earning making profits inherently addresses involves ideals sharing risks

the Islamic

of social j

because both the entrepreneur and the lender bear the risk of investment. 24 ----------------------- Page 25----------------------Thus the angements, interest of is replaced return on by profit and assets loss held sharing in arr

where the rate is not known

financial

banks

and not fixed prior to the undertaking of the transaction. The actual rate of return can actual profits accrued through from be determined only ex-post, that on are the made basis of

real sector

activities

possible

productive use of financial assets. Sharing risks and rewards The prohibition of a risk free return and permission of trading makes the financial activities in an Islamic set-up real asset-backed with ability to cause value addition . Islamic banking system is based oh risk sharing, owning and cess of trading, modes of finance. As such, rpose of Islamic banks deal with asset management for the pu handling and

leasing

income generation. They will have to prudently handle the unique risks involved in management ctices of corporate governance. Once of assets by adherence have to best stable stream pra

of

physical

goods, contracts

involvement using

in. various

the

pro

construction

Islamic

the banks

of Halal income, depositors will also receive stable and Halal income. Permissible forms of businesses The forms joint of businesses on sharing allowed of under risks 8 Islamic profits banking and include provision o

ventures based f services

through trading, both cash and credit, and leasing activities. Though the sale and apparent similarity between trade profit in credit

Riba in loaning is not denied in literature, trade has been permitted and Riba is prohibited. Profit has been recognised as reward for (use of) 25 ----------------------- Page 26----------------------capital s for and Islam permits gainful deployment of surplus resource

enhancement of their value. However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be s. Financial made to bear the burden of the risk of los

transactions, in order to be permissible, should be associated with goods, services or benefits. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership. Making money from money is not acceptable 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 nd risk

else. The

human

effort, initiative, a

involved in a productive venture are more important than the money used to finance it. Muslim jurists capital, consider money as potential capital rather than

meaning that money becomes capital only when it is invested in business. Accordingly, ded as a money advanced to a business as a loan is regar

debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims eping are encouraged so that, to for purchase instance, and are discouraged money is from regarded ke

money idle as being

hoarding

26 ----------------------- Page 27----------------------unacceptable. In Islam, money represents purchasing power which is considered ng power (money) to be the only proper use of money. This purchasi

cannot be used to make more purchasing power (money)

without undergoing the intermediate step of conversion into kind; i.e. by acquisition of goods and services.

27 ----------------------- Page 28-----------------------

ISLAMIC FINANCIAL INSTITUTIONS While the Islamic financial institutions started almost fifty years back, the growth was slow which is still in the early stages and it is a system,

young, evolving and expanding in terms of innovation and

geographical

location. It is estimated that as of now there are more than three hundred Islamic nonIslamic al financial institutions countries. Some spread across major both of the Islamic and

of the

forms

Islamic

financi

institutions are; a) Islamic Banking

Islamic banking is the most popular form of financial institution and it is estimated to e different be into several hundred billion dollars. There ar

models of Islamic banking; wherein the Islamic banking is a private institution with a traditional conventional economy a nationalized Islamic banking and third is the existence of both the Islamic and conventional banking system running parallel Many , commercial banks have innovated and engineered new products

which have led to their impressive growth. In traditional system, stress is on efficiency financial and productivity, code of the basic with thrust of an Islamic idea of

system is equitable

ethical

conduct

an underlying

and just distribution of resources to achieve an equitable society. The concept of efficiency and productivity of resource comes later in this 28 ----------------------- Page 29----------------------system. The islamic banking is currently undertake through two channels; Islamic banks and ; Islamic windows. Islamic l their operations ervices banks are in are purely conformity based with on Islamic Islamic principle windows and are al s

sharia.

provided by the traditional commercial banks to Muslim customers who engage in Islamic banking through exclusive window. b) Islamic Insurance (Takaful Institutions) Risk sharing and management is an important constituent of any financial system. find place in There an are Islamic scholars who believe system as that insurance can a Muslim should never be

financial

dependent upon God and getting insured amounts to challenging the will of Allah. But there a Muslim is another school of thought, which believes that

should take all precautions to mitigate the risk and then not worry about the outcome and leave it to the wilt of Allah. The traditional Maisir concept of insurance is considered to be

(gambling) and a contract, which has lot of gharar (uncertainty), Islamic insurance is based on takaful wherein every person participating gives a donation or tabarru, all these donations together constitute the fund from which any participant that suffers a loss or damage gets reimbursement. The balance to the participants. c) Investment Banking and Mutual Funds The conventional for a investment banking deals with raising capital amount, if any, left in the fund is returned back

business either through sale of shares to the public or allotting the shares to certain also Qualified institutional Buyers (QIB). Investment banks

29 ----------------------- Page 30----------------------create venture for the capital funds wherein they provide seed capital

start-up business growth stages of the business. An investment other banker raises money through equity, debt and

investments like derivatives. An islamic investment banker cannot deal in debt instruments and derivatives. In case of equity and preference shares, the majority of islamic scholars permit it on the ground that it involves pro rata ownership of assets of the company. But the investment bankers must deal with only those companies, which are engaged in sharia

compliant business. Venture fully appraising rtainty capital and financing evaluating by the investment venture, bankers which should will be after unce form

eliminate the

(gharaar) and therefore permissible. Investment in of

venture capital without analyzing the business proposition is outside the preview ertainty of an Islamic investment banker as it has lot of unc

involved in it. Dealings purely speculative Islamic in the secondary are market by fund The managers, which are for

in nature,

un-Islamic.

pre-condition

mutual funds is that there can be no assured profits and the profits and losses from the investment of the pooled funds will have to shared on a pro rata basis. Though this type of fund resembles a but the funds have to be invested in acompany certain conditions prescribed in the sharia laws. One of these business 30 ----------------------- Page 31----------------------must be halal that is, it should not be dealing in business like pork selling, liquor, gambling. Secondly, the company should not be using debt, in other words having no borrowed ld not be money on which it is paying interest and it shou conditions for the company is that its principal traditional only if mutual it fund fulfills

keeping its money in a bank, which pays interest on these deposits. These two conditions, especially the second one about intere

st

on

deposits and borrowings make it almost impossible for the followers of Islam to invest their money in stock markets through pooled funds. However, of the certain scholars have advocated that if the business

company is halaal and it is a zero debt company and it receives a small amount from receives its deposits with banks, then if an investor who

dividends, gives away that part of the dividend which is attributable to the interest on deposits, then such income will be considered ha1al. Thirdly, the company shares of company can be purchased only if the

holds a combination of liquid and illiquid assets. If all the assets are in money then the shares will have to be purchased at par. There has been a huge growth in Islamic equity funds and there are islamic indexes, one of the popular ones is the Dow Jones islamic index. Even though a fund may be tracking an Islamic index, this by itself does not make the profits fully sharia compliant. 31 ----------------------- Page 32----------------------TOOLS AND TECHNIQES OF ISLAMIC FINANCING In order to cater to the needs of the modern world, Islamic financing puts forwards a wider range of tools and techniques of financing. These while ensuring s care to to meet the needs of the financial world, also take

adhere to rules of sharia, which is primarily staying off interest system. As per the amount which rules of sharia, any addition to the principal

adds up without creation of real wealth amounts to riba. That is to say, the amount n effect amount to riba. earned without sharing of risks or losses would i

Engineers of Islamic financing tools have been careful enough to meet up the requirements of its tenets and basic principles. In effect, what they put forward to us is a wide range of new techniques of financing which are complex in its very own nature and application. At the same time, theres ease and simplicity at the side of the customer of the banker. Islamic financial tools function basically on; 1. Profit sharing (mudaraba) 2. Buy and sell back (murabaha) 3. Venture Capital (musharaka) Many tools as they might resemble the conventional tools of financing

might look, but might differ in it simply because it dont cater to riba. A wide range of tools and techniques of Islamic financing has been listed in the upcoming chapters.

32 ----------------------- Page 33-----------------------

MURABAHA (Cost Plus Finance)

Murabaha is a form of cost plus or mark up financing where an asset id acquired by the bank and sold to the customer. No money is loaned to the client. Rather, the financing party purchases the goods himself, based on the requirement of the client. This ensured that financing is always assetbased. In effect, this type of financing creates real assets and inventories. It is understood that most of the financing operations in Islamic banking are based on Murabaha. Steps in Murabaha 1. The client indicates an interest in purchasing a particular asset from

the bank for a certain price (a combination of cost price plus profit) at a certain time (the utilization date). 2. The client identifies the vendor, selects the goods and advises its ce to

bank in writing. Often the bank will appoint the client as its wakil (agent) to acquire the asset on the bank s behalf. 3. The bank acquires the asset and offers to sell it to the client. The vendor will typically make delivery of the asset to the client (as the bank s agent). Delivery need not be physical; it can also be

constructive (i.e. evidenced by delivery of documents of title). 4. The agency contract comes to an end. The client accepts the offer and the through a 33 ----------------------- Page 34----------------------e in valid the future. Fig 1: Working of Murabaha Subject of Murabaha The assets (mal), which the following requirements: The subject of sale must exist and be in the ownership (physical or er constructive) words, the of the bank at the time of sale. In oth are the subject of the sale, must fulfill sale contract, with payment due on the agreed dat bank immediately sells the asset to the client

second contract must "follow" the first contract. This risk- bearing by the bank - even if for a short or fleeting time period - legitimizes banks profits under Shari ah as distinct from prohibited riba. They must be something of value that is classified as property in

particulars, the

including

the

vendor s

name

and

its

cost

pri

fiqh den

(Islamic

jurisprudence)

and

must

not

be

forbid

commodities, such as alcohol, pork etc. 34 ----------------------- Page 35----------------------Specification of price The sale price and payment terms must be known. The price is fixed at the time of requency and quantum contracting, as is the mode of payment, e.g. f

of installment payments. This is to avoid any gharar or

uncertainty. Where the sale price includes a known profit or mark-up, the profit rate can be determined or expressed in relation to the market interest rate such as LIBOR. The price may not always be specified in the main murabaha documentation but can often be the subject of side

letters/agreements between the parties.

35 ----------------------- Page 36----------------------MUDARABA (Trustee Finance Contract) Mudaraba an entrepreneur e is essentially an agreement between a financier and side th

the principals. It is a contract whereby one

investor or Rabb ul Mal contributes money and the other side work, being the the manager or Mudarib. The Rabb ul Mal bears all losses, and

Mudarib earns a profit share. Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar

to the function of an asset manager or employed manager of a company. Participatory Financing The central idea in the concept of mudaraba is that two parties, one with capital and the other with know- how, get together to carry out a project. The financier provides the capital and plays no further part in the project; specifically, he does not interfere in its execution, which is the exclusive province of the entrepreneur. If the project ends ed in profit they share the profit in a pre-arrang

proportion. If it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the or investment. However, in cases of proven negligence

mismanagement by the entrepreneurs, they may be held responsible for the financial loss incurred. 36 ----------------------- Page 37----------------------Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is concerned, it is in fact profit-sharing-and-loss-absorbing. Preconditions of Mudaraba contract the 1. The financial banker, risk is entirely and exclusively born by

and as such theres no scope for reducing credit risk by requesting collateral security. 2. The rate of profit should be determined strictly as a percentage and not as a lumpsum. 3. The entrepreneur has absolute freedom to manage the business. Restricted and Unrestricted Mudaraba Where the capital is provided as being unrestricted for any purpose the manager deems fitting is called Unrestricted Mudaraba or al-mudaraba

al-mutlaqah. The banker may also grant it upon conditions what has to be made with it which a would then constitute what is called Restricted Mudarab

(Mudaraba al Muqayyadah), e.g. all investment funds. Two -Tier Mudaraba The structure of Mudaraba transactions is such that the banker is involved in two different mudaraba ier mudaraba. The ent with first Mudaraba transactions, and is between the hence bank the name and the two-t cli

surplus capital (depositors) and the second one is between the bank and the clients who require financing. 37 ----------------------- Page 38----------------------The first those tier Mudaraba between depositors and the Islamic has

depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The depositors place their funds with the bank with no guarantee of principal and a de by return the based behalf. on As the profitability of with other the investments the depositors ma

bank on their bear any

Mudaraba,

losses and share profits with the Islamic bank according to a pre-agreed ratio. The second tier Mudaraba between the Islamic bank and those receiving financing has the bank acting as Rabb ul Mal and the customers acting as Mudarib. the Mudarib and re-agreed ratio. Table No. 1 The bank share bears all losses except in cases of fraud by profits with the customer according to a p

Investment options of capital- holders Type of Investment Active investment Mode of Investment In own enterprise Shares in a Company Passive Bonds/ investment securities Bank deposit 38 ----------------------- Page 39----------------------Table No. 2 Financing options for entrepreneurs Type of financing Active Own funds finance Share Capital company Passive finance Bonds/ securities Bank loans (riba) Termination of Mudaraba The contract of Mudaraba can be terminated at any time by either of the parties. The only condition is to give a notice to the other party. If at the time of termination, form, the mudarib assets of the mudaraba are not in cash Fixed positive return Prohibitted (riba) Fixed positive return Prohibitted enterprise Dividend (P/L) from the Allowed Mode of financing Type of return on Rule Capital Profit or Loss from the Allowed Fixed positive return (riba) Prohibitted Fixed positive return (riba) Prohibitted Type of return on Rule Capital Profit or Loss from the Allowed enterprise Dividend (P/L) from the Allowed company

shall be given an opportunity to liquidate them so as to

determine the as per the agreed ratio.

amount

of

profit,

which

shall

then

be

divided

39 ----------------------- Page 40-----------------------

MUSHARAKA (Joint Venture) Musharaka to combine ng of their a is a contract whereby financial resources the bank for the and a customer establishment or agree runni

business or project, or for undertaking any type of business activities. The two parties agree to manage the project in accordance with the terms of the contract. The profit or loss will be apportioned between the parties, according to a mutually tio of agreed proportion, which need not coincide with the ra

amount of capital invested. Losses are shared by all parties in proportion to te their investment. in the Banks have a legal authority to participa

management of Directors.

of the project, including representation

on the Board

Different types of Musharka There are two basic types of Musharaka; 1. Shirkat-ul-milk a voluntary Musharaka, which come into existence at the option of (Partnership based on joint ownership) This

the participants. 2. Shirkat-ul-aqd (Partnership based on contractual relationship)

This partnership is based on contractual relationship. They are further divided into 5; 40 ----------------------- Page 41----------------------1. Shirkat-ul-Mufawadah (full authority and obligation) This is a limited partnership with equal capital contributions, responsibility, ility full for authority on behalf of others, along with responsib

liabilities incurred through the normal course of business. 2. Shirkat-ul-Inan (restricted authority and obligation) This too is a capital contributions. d this reflects their share of profits. 3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) This is a kind of partnership ns of one of both parties, typically small scale business. 4. Shirkat-ul-Abdan (labour, skill and management) Partnership entered into with companies based on reputatio They do not share equal responsibility, an limited form of partnership, but with unequal

with a company based on the contribution of human efforts with no capital scale business. 5. Shirkat-ul-Mudaraba ba contract. Diminishing Musharakah This is a derived form of Musharakah and was developed in the near past. According to this concept, the financier-and the client participate either in This is a partnership for a Mudara contributions. These are again typically small

the joint ownership a joint commercial of the enterprise,

of a property on a diminishing

or

an equipment, share basis. The

or

in share

financier would be divided into a number of units and the contract is on a condition that the client purchases the units of the share of the banker one by one periodically, thus increasing his own share till all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be. At the same 41 ----------------------- Page 42----------------------time, the share of ownership of the financier in the property keeps

diminishing and hence the name Diminishing Musharaka. Table No. 3 An example of Payment Schedule under Musharaka Extra Month Rent (Rs.) Payment (Rs.) opening 1 2 . 176 177 178 179 180 Management of the Musharaka Every partner has a right to take part in the management and to work for it. However, the partners may agree upon a condition that the 800 789 .. 37 30 22 15 7 347 349 .. 1110 1117 1125 1132 1065 1147 1147 1147 1147 1147 1147 1147 1072 Total Fixed Payments (Rs.) Banks ownership (Rs) 120000 119653 119304 4439 3322 2197 1065 0

management shall be carried out by one of the and not by other partners. In that case, the sleeping partner should be entitled to the profit only to the extent of his investment, and the ratio of the profit allocated to him should not exceed the ratio of his investment. 42 ----------------------- Page 43----------------------Termination of Musharaka Every partner ime after giving his araka with has partner a a right notice to to terminate this the effect, Musharaka whereby at the anyt Mush

come to an end. Termination of one partner need not terminate the whole agreement and and others may purchase the terminating partners share

continue the business.

43 ----------------------- Page 44----------------------MAZARA AT AND MUSAQAT (Agricultural Partnership) Mazara at and musaqat are two types of partnership. They are similar to mudarabah, capital

in

that The

they

and labour. rading

difference

whereas muzara at is for farming. If a person leaves his trees with someone for a specified period of time, so at that he cares, person will tends and waters them, and in return, th

take an agreed quantity of fruits, this transaction is called Musaqat. In bah partnerships between capital and labour, whether mardara

agreements or mazara at or musaqat, any kind of harm or loss the capital is subject to is nvestor. And, as

born

such, there is also no certainty of making a profit on the capital. The only profit that is returned to the owner of the capital is in accordance to the profit made by the partnerships and to his specified proportion of those profits. Here it is that the financer, just like the worker, might make no profit, and it al and even become bankrupt. Contracting Musaqat is even possible that he may lose his capit

are

both

types

of

partnerships is relevant

between to t

is that mudarabah

by

the

owner

of

the

capital,

the

While concluding a transaction of Musaqat, the prescribed formula can be recited in any language, or without reciting the formula, if the owner of trees hands over them, with the intention of Musaqat, to the person who 44 ----------------------- Page 45----------------------has agreed to take care of them, and he also receives them with the same intention, the transaction will be in order. (Of course, the necessary talks about the place earlier). The following points need to be considered; 1. If a clear agreement, in respect of melon, cucumber vines etc., in which the number of times of picking and the share of each one are specified, is made. 2. Trees that need not be irrigated and benefit from rainwater or the moisture of the earth, but need other work to be done for them, like turning up with a spade, fertilizing and spraying which will make their fruits or their quality to be increased, it will be in order. 3. The work should be to be done by each of the parties involved duration and the conditions, etc. should have taken

specified in advance, like, repairing the subterranean canals, or the water spray rule equipments, in this etc., and if there is a local practice and well engine, also the supply of the manure,

respect, that will suffice. 4. It is possible that the other party in Musaqat be more than one, that is, the owner of the trees may leave them in the hands of several people, and conclude the contract of Musaqat with them. Conditions for Musaqat 1. The owner of the trees and the person who undertakes to tend and

care for them, should be Baligh and sane. 2. No one should have compelled them to do so. 3. They over should not have been banned from having discretion

45 ----------------------- Page 46----------------------their own property. 4. The period of Musaqat should be specified, and if the beginning of it is specified, and its end is fixed to be the time when fruits for tha t year become available, the contract is in order. 5. It is necessary that the share of each one of them be fixed as 1/2 or 1/3 etc. of the crop. 6. It is necessary that the contract of Musaqat be concluded before the appearance er the appearance of the fruits and before they are ripe, the contract will be in order, provided that some work like, watering and spraying which are required for increasing the crop and protecting the trees, be still done, remain is to be done. And if the work required to of the crop. And if the contract is made aft

merely plucking the fruits and looking after them, the contract is in order but it is not Musaqat. Termination of Musaqat The parties involved can cancel the transaction of Musaqat with mutual consent, and also if, when concluding the contract, they had agreed that one or both of them would have the right to cancel it, then, he can do so according to the agreement. And if in the contract of Musaqat, they had laid a condition and that condition is not fulfilled, and if the person who benefits from the condition is not able to compel the other party to fulfill it, then, he can cancel the transaction.

The Musaqat transaction will not terminate with the death of the owner of the orchard, and his heirs will act on his behalf. However, if the person who has undertaken ey had agreed 46 ----------------------- Page 47----------------------that he himself would do the job, the contract will become cancelled, but if they have not laid such a condition, his heirs will take his place. 47 ----------------------- Page 48----------------------IJARA (ISLAMIC LEASE) Ijara is an agreement wherein the Bank leases movable and immovable assets to its customers, with the option that the customer may or may not own the leased the agreement ent or wage. Basic rules governing Leasing 1. Contract ed consideration; determined at the time of contract. 2. The consideration should in monetary form. 3. The object being leased must have a valuable use; and it should not be perishable. 4. The leased asset should remain in the ownership of the lesser; only its usage is transferred to the lessee 5. All the liabilities arising out of the ownership shall be borne by the lesser, but the liabilities arising from the use of the property shall should be for an agreed period, at an agre singed asset at the end of the term of the lease as per between the two parties. Ijara means lease, r to look after the trees, dies and if th

be borne by the lessee. 6. The lessee cannot use the leased asset for any other purpose than specified in the agreement. 7. Damages to the asset owing to misuse or negligence shall be borne by the lessee asset caused by any misuse or negligence on the part of of the lessee 48 ----------------------- Page 49----------------------shall be borne by the lesser. 8. A property under joint ownership can be leased out and the lease amount to their distributed between the owners In proportion lessee; whereas that which is beyond the control

shares in the property. 9. The leased asset should be fully identified by all the parties. 10. If variable rentals are fixed different phases, the particulars should be agreed upon at the time of the lease; else the agreement would not be valid. 11. The lease period commences on the delivery of the asset. 12. If the leased asset loses the function for it was leased, provided it cant be repaired and it didnt occur due to negligence on part of the lessee, the lease is terminated. Types of Ijara Ijara Thumma Al- Baai (Hire Purchase) These are variations on a theme of purchase and lease back transactions. There are two contract, an contracts involved in this concept. The first

Ijarah contract (leasing/renting), and the second contract, a Bai contract (purchase) n a car are undertaken one after the other. For example, i

financing facility, a customer enters into the first contract and leases the

car fic

from the period. lease

owner period

(bank)

at

an the

agreed second the

rental contract car at

over

speci into agreed

When the effect,

expires, to

comes an

which enables price. In

the customer

purchase

effect, the bank sells the product to the debtor, at an above market-price profit margin, in return for agreeing to receive the payment over a period of time; the profit margin on the lease is equivalent to interest earned at a fixed rate of return. 49 ----------------------- Page 50----------------------Ijara- 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.

50 ----------------------- Page 51-----------------------

QARD HASSAN (Benevolent Loan) Islam allows loan as a form of social service among the rich to help the poor and those who are in need of financial assistance. Loan in Islam may be obtained in two ways: (i) Loan with condition of repayment, and (ii) gratuitous does loan without any compensation or gift. However, Islam

not recognize any loan with interest for the benefit of the debtor. It only recognizes gratuitous loan or better known as al-qard al-hasan. M. Umer Chapra has given the definition of qard al hasan as: "Qard alhasan is a loan which is returned at the end of the agreed period without any interest or share in the profit or loss of the business." Therefore, qard al- hasan is a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of qard al-hasan is only required to repay the original amount of the loan. Objectives of Qard Hassan 1. To help the needy fellow people. 2. To establish better relationship among poor and the rich. 3. The mobilization of wealth among all people in the society. 4. To strengthen the national economy. 5. To facilitate the poor to create new jobs market and business

ventures by using their merits, skills and expertise.

6. To establish a caring society. 51 ----------------------- Page 52----------------------m 7. It can the society. 8. To eradicate unemployment problem from the society. Conditions of Qard Hassan Transaction 1. Both parties should be legally (shari ah) capable to enter into the qard contract It is unanimously agreed by the four schools of law that to enter into a remove social and economical discrimination fro

judgment). The age of majority, o any and

age

of

marriage a major

and

thereby

person

transaction validly. A person, who has not attained the age of puberty , may not be a responsible party for al-qard al- hasan transaction. 2. Ijab (offer) and qabul (acceptance) of the qard must be clearly made before entering into the loan contract Ijab and qabul should be clearly indicated in the contract, otherwise, the loan contract may create dispute in future. In the loan agreement, there should have ijab and clear expression, collation and conjunction of the

qabul between the parties. 3. The date of payment must be specified The date of t. If no payment the should be mentioned may in lead the to loan ambiguity agreemen and

date is specified, dispute in

transaction

future between the lender and the borrower.

contract, th sound

parties

should

be

baligh,

aqil the

and sound

rashid judgment

(major is

wi the int

is capable

to enter

52 ----------------------- Page 53----------------------4. The loan contract should be written down In order to avoid essary that the chances of any future dispute, it is nec

contract be made in writing. However, some opine that it is not obligatory but strongly recommended. The reason given by them is that if both parties agree not to write, then it is no longer an obligation upon them to write down. The reason behind the writing down is to avoid future dispute. On the contrary, a minority of the scholars the parties are to of the opinion that it is obligatory upon

write down the contract. 5. Getting two witnesses There must be two male witnesses to make any contract valid. Witnesses are of great importance in sharia compliant contracts. If two men are not available, then one man and two women will suffice. This will help avoid any chance lity of Qard Hassan. 6. Administrative fee / Service charge To obtain some compensation for offering al-qard al-hasan facilities, the banks demand some charges and fees. These expenses incurred by banks on providing al-qard al- hasan are collected from the borrowers, and the basis the bank. If any bank or other institutions give al-qard al-hasan, they may require service charge pe for an 53 or administrative fee. However, there is no sco for the central calculation of these expenses is laid down by of future disputes which disrupt the whole functiona

----------------------- Page 54----------------------individual lender to demand this charge unless any amount incurred due to procedural er s fee, stamp duty etc. 7. Extra Payment It is very clear that in the loan agreement, there will be no condition for extra payment, otherwise, it will be riba . It is however, permissible for the debtor gn of to give some sort of gift to the creditor as a si requirements of the loan agreement, such as lawy

appreciation of his voluntary deed. It is exclusively up to the borrower whether to pay extra or not, regardless the loan ender cannot er on was demand for consumption or commercial purpose and the l

repayment and not a right of the lender. Added, there should not be any stipulation for extra benefit in the loan agreement. 8. Early demand to pay back Loan is a voluntary act by the creditor. However, it is not encouraged for early demand to pay back the loan from the debtor. The creditor should not demand ment the loan amount from the debtor before the agree

matures or lapses. 9. Guarantors: In the The case of the al-qard the borrower may al-hasan, be any there can person or be guarantors. the property

guarantors of of the

borrower that is collateral security, such as, mortgage, charge etc. In case of the borrower s failure to pay back the loan after the expiration of the 54

it, as it is only a virtue on part of the borrow

----------------------- Page 55----------------------time specified, his guarantor has to pay or the collateral security is to be valued for the repayment of the loan. But, Muslims should remember that a true believer should not delay to pay back his obligations. Application of Qard Hassan 1. Friends and Families

The application for interest free loans is relevant especially among larger families, among which may put in place a private box called Sanduq

them where needy family members could draw out an interest free credit. Wealthy loss member may draw out a finance facility against profit/

sharing explained later on. 2. Qard Hassan for Deposit Taking Islamic ard banks to provide finance do not use the instrument of Q

Hassan widely, rather it is used to accept deposits. Such a deposit loan is permissible and could be used to be invested in other projects of the bank, while a pure deposit (Amanah / Wadiah) is cannot be used in the same way. 3. ROSCA - Rotating Credit and Saving Associations Another the potential model. application The loan for the Qard depositor Hassan receives technique instead of is in A

savings/lending terest, saving fter

points for the size and duration

of the funds

provided.

achieving a sufficient number of those points, he should able to take out a 55 ----------------------- Page 56----------------------loan himself. The administration of such a model could be subject to fees which are not bound by time and size of the credit.

Another positive factor ss test for the

to

be

seen

is

the

effect

of

stre

borrower having savings over a period time is a good way to know the own repayment capacity. Further a credit history is no longer an absolute must. It is a called in the conventional sector a rotating savings and credit association (ROSCA ), and reported to be practiced in the informal sector even in UK and Australia but not on a professional basis.

56 ----------------------- Page 57-----------------------

SALAM or BAI SALAM (Forward Contracts)

undertakes to supply some specific goods to the buyer at a future date in exchange for a to a forward price fully paid in advance. It is similar

contract with the buyer paying the seller, the negotiated price of a product that the seller promises and quantity of the must be products to deliver at a future date. The involved in this type of quality

capable of being specified at the time of the contract. Condition of Salam The buyer should pay the price in full to the seller at the time of sale effecting of debt against basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated. Salam lity and precious quantity can be specified exactly. For example, the can be effected in those commodities only whose qua the debt, sale. which Else, is it will be tantamount to a the

stones cannot be sold on the basis of Salam, because every piece of precious their specifications need to drawn differently. 57 ----------------------- Page 58---------------------- on a Salam cannot be effected on a particular commodity or stones is normally different from the other and

Salam the

or Bai Salaam as seller

it

is

also

called,

is

sale

whereby

transaction

expressly

prohibited.

Moreover,

product of possible that ence field is of this

particular before

field

or

farm.

Because and in

it the

is pres

destroyed

the delivery,

possibility the delivery remains uncertain. ply is It is necessary that the quality of the The same rule is applicable to every commodity whose sup

not certain. commodity be

fully specified leaving no ambiguity that may lead to dispute. It is a necessary that the quantity of the commodity be agreed upon in unequivocal terms. The exact date of delivery must be specified in the contract. ased Salam cannot be affected in respect of those commodities that must be in delivered at the spot. For example, if gold is purch

exchange for silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, Salam cannot work. Salam ecause sale is not permissible on existing commodities b

damage and deterioration cannot be assured before delivery on the due date. ality Salam is permissible on a commodity of a specific locality, if it is assured that and it it is almost always available in that loc

rarely becomes unavailable. The if the place of delivery must be stated in the contract,

commodity needs loading or transportation expenses. 58 ----------------------- Page 59---------------------- It is not permissible for the buyer of a Salam commodity to sell it before receiving it because that is similar to the prohibited sale of

debts before holding. Salam ations, sale is suitable for the finance of agriculture oper

where the bank can transact with farmers who are expected to have the commodity in plenty during harvest either from their own crops or case crops their of others, which they can buy and deliver in

crops fail. Salam sale is also used to finance commercial and industrial

activities, especially phases prior to production and export of commodities and that is by purchasing them on Salam and

marketing them for lucrative prices.

59 ----------------------- Page 60-----------------------

TAKAFUL (Islamic Insurance)

Takaful or joint or Islamic or

is

an

Arabic

word

which

means

guaranteeing

each

other

guarantee Insurance

as against guarantee is basically based

or mutual

security. Takaful of mutual

on the concept

cooperative insurance and it takes care of all the Shariah related concerns including instruments. The concept of Takaful as such is not new in Islamic Commercial Law. Islam nt accepts the The principle system of of reciprocal Takaful compensation tends to and joi ensuring investment to be made in Shariah compliant

responsibility. self-

insurance

achieve

reliance through a self-sustaining insurance system based on community pooling, solidarity and joint guarantee for the well being of community and individuals in need, the entire system and operation being based on Islamic principle. Principles of Takaful Policyholders cooperate among themselves for their common good. Every need policyholder pays his subscription to help those that

assistance. Losses are divided and liabilities spread according to the

community pooling system. Uncertainty compensation. It does not derive advantage at the cost of others. 60 ----------------------- Page 61----------------------Modules under Takaful is eliminated in respect of subscription and

1. Mudaraba arib (takaful stallments or from investors ipants) acting profit (surplus) takaful iple operator of alMudharabah, capital

- By operator)

this principle, the entrepreneur will accept payment of the

or al-Mudh takaful in

or providers as Sahib-ul-Mal. from is to between the be

of capital The

or fund

(takaful how by the

contract of in takaful

specifies managed with

operations shared, the

accordance as the

participants

providers

and the takaful operator as the entrepreneur. 2. Wakala for the - Here the Takaful provider act as an agent

participants and manages the Takaful/Retakaful (Reinsurance) fund for a fee. This model is generally used in middle-east region. 3. A combination of both Mudaraba and Wakala Tabarru to eliminate uncertainity Takaful companies normally divide the contributions into two parts, he 1. Donations fellow for meeting mortality liability or losses of t

policyholders. 2. Investment fund to be invested in halaal business on a non-interest basis. Accordingly, the clause of Tabarru is incorporated in the contract. How much of the contribution is meant for mortality liability and how much for investment account is based on a sound technical basis of mortality tables and invested other actuarial requirements. Both the accounts are

61

takaful contributions

(premium)

termed

as Ra s-ul-Mal partic the the princ of

----------------------- Page 62----------------------and returns the thereof and distributed on Mudarabah The principle between

participants to the

the Takaful

operators.

profit attributable

participants is credited into the two accounts separately. Issues in Conventional Insurance n 1. Riba be (interest) Conventional life insurance schemes ca

considered to contain riba in that the claim is much higher than the premium d is invested in instruments that are interest based. 2. Maisir (gambling) There can be cases where theres no claim and im, the its policy holder loses all money, and where theres cla amount paid. As about general insurance, the fun

much higher than the amount contributed and hence gambling. Life insurance as such is a contract of wager on the death of the policy holder. 3. Gharaar dent upon ertain. Conventional insurance in itself is a game of uncertainty. Distinguishing features of Takaful 1. The Retakaful fund 2. The contribution so received are not aimed at making profit per se but are more in the nature of pooling the risk and risk management rather than risk taking. 3. The Takaful t merely its custodian. operator is not the owner of the fund bu policyholders are the participants to the Takaful / the outcome of a future event, which is unc (uncertainty) The benefits on insurance are depen

62 ----------------------- Page 63----------------------4. The surplus generated belongs to the contributor (i.e. and to both i.e.

policyholders) solely under wakala model

policyholder and Takaful Company under mudarba model. This is a unique feature of Takaful insurance 5. Since rtion to the surplus goes back to the participants in propo

their contribution, there is an inbuilt check on over-pricing. 6. Funds are invested in Shariah compliant instruments / avenues. 7. Incidentally, Reliance Life has come out with a plan called RSIP where the investment is made in non-banking sector excluding

liquor, cigarette, tobacco, entertainment, gambling, etc.

63 ----------------------- Page 64----------------------ISTISNA Istisna is an Islamic form of financing used to finance construction and

industrial projects, such as the construction of buildings and so on. The unique feature of Istisna a is that it allows the selling of an asset, which does not exist at time of the contract. The payment can be in immediate cash or may be in the form of deferred payments. Ways of effecting Istisna sale contract 1. It is permissible sna contract then sell it after receipt for cash or deferred payment. 2. It is also permissible for the bank to enter into a lstisna contract in the of a act the commodity agreed upon in the first contract. Each transaction is deemed a separate contract with payment being made in cash either immediately or on a deferred basis. Any disagreements that may arise the are settled under each contract separately according to particular in the commodity and then draw another a parallel istisna contr party to manufacture capacity of seller to those who demand a purchase for the bank to buy a commodity on Isti

capacity

of a buyer with

provisions therein. Istisna is, thus, an exceptional mode of sale, at an agreed price, whereby the buyer places an order to manufacture, assemble or construct, or cause so to do anything to be delivered at a future date. It means to place an order with a manufacturer to manufacture a specific commodity for the 64 ----------------------- Page 65----------------------purchaser. If the e goods for him, t it is manufacturer undertakes to manufacture into existence. th Bu

the transaction

necessary for the validity of Istisna that the price is fixed with the consent

of Istisna comes

of the parties and that necessary specification of the commodity (intended to be manufactured) is fully settled between them. Termination of Istisna The contract of Istisna creates a moral obligation on the manufacturer to manufacture the e of the goods, but before he starts the work, any on

parties may cancel the contract after giving notice to the other. But after the manufacturer cancelled unilaterally. However, , if the the party placing the order has the right to retract has started the work, the contract cannot be

commodity does not conform to the specifications demanded.. Istisna as a Deferred Payment Scheme Since it is not necessary in Istisna that the price is paid in advance, nor is it necessary rather, it that it may be is paid at the time of the delivery,

deferred to any time according to the agreement of the parties, therefore, the sh. time The of payment may be fixed in whatever manner they wi

payment may also be in installments. Application of Istisna Istisna contracts are applied in high technology intensive industries such as the aircraft industry, ries. In locomotive and ship building indust

addition, this type of business transaction is also used in the production of large machinery and equipment manufactured in factories and workshops. Finally, the istisna contract n industry 65 ----------------------- Page 66----------------------such as apartment buildings, hospitals, schools, and universities to is also applied in the constructio

whatever that makes the network for modern life. The Istisna contract is

best used in those transactions in which the product being purchased can easily be measured in terms of the specified criteria of the contract.

66 ----------------------- Page 67-----------------------

SUKUK (Islamic Bonds) Sukuk in general may be understood as a shariah compliant Bond. In its simplest form sukuk represents ownership of an asset or its usufruct. The claim embodied but an in sukuk is not simply a claim to cash flow

ownership claim. This also differentiates sukuk from conventional bonds as the latter sukuk are proceed over interest bearing securities, whereas

basically investment certificates consisting of ownership claims in a pool of assets. Sukuk (plural in the of word sak) were extensively used by Muslims

Middle Ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of sukuk are different kin to the from the sukuk originally used and are a

conventional concept of securitization, a process in which ownership of the underlying assets is transferred to a large number of investors through certificates representing proportionate value of the relevant assets. Distinction between Sukuk and conventional Bond s contractually pecified obliged to pay to bondholders, on certain s A bond is a contractual debt obligation whereby the issuer i

dates, interest and principal, whereas, the sukuk holders claims an undivided ts. Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk assets as well as being entitled to share in 67 ----------------------- Page 68----------------------the proceeds of the realization of the sukuk assets. beneficial ownership in the underlying asse

 A distinguishing feature of a sukuk is that in instances where the certificate represents a debt to the holder, the certificate will not be tradable on the secondary market and instead is held until maturity or sold at par. Features of Sukuk g medium Assessed to long-term fixed or variable rates of return. Tradable shariah-compliant capital market product providin

and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a sukuk issue. od with ital appreciation of the sukuk. Liquid instruments, tradable in secondary market. Uses of Sukuk Funds The most common uses of sukuk can be named as project specific, assetspecific, and balance sheet specific. 1. Project-specific Sukuk Under this category money is raised through sukuk for specific project. 2. Assets-specific Sukuk Under the this arrangement, the resources are mobilized by selling easy and efficient settlement and a possibility of cap Regular periodic income streams during the investment peri

beneficiary right of the assets to the investors. 68 ----------------------- Page 69----------------------3. Balance Sheet-specific Sukuk This is s by an arrangement wherein the Islamic bank mobilizes fund

issuing sukuk and these funds are used to finance various projects of the

member countries. Types of Sukuk: Sukuk ine takes several innovative Shariah compliant forms that comb

various particles of Islamic forms of finance together. 1. Ijarah Sukuk Ijarah Sukuk are related to leased properties and assets, they carry equal values, and are issued by the owner of the leased property or his agent. The aim of the transaction at the end is to sell the leased property through issuing Sukuk, accordingly, the holders of the certificates or Ijarah Sukuk own the asset and its charges during the rental period, each in proportion to the certificates of Sukuk held in the leased asset. 2. Usufructs of Existing Assets: Usufructs of existing assets Sukuk certificates carry equal values and are issued by the owner for an existing asset or by sublease at the consent of the owner or by both. The certificates represent the rights on the service or usufruct of an asset that could either be directly or indirectly hired to a second or a third party. A house could either be rented by its owner or agent to a second party or sub rented by the second party to a third party. In both cases the lessee owns the right to enjoy the service of the asset during the lease period while not owning the asset itself. 69 ----------------------- Page 70----------------------3. Usufructs of Future Assets: The usufruct could also be futuristic for a specified period of time for a specified asset which would not be ready at the time of issuing the Sukuk certificates d for but, it could be under construction or contracte

construction and delivery at a future time. This is analogous to the Salam contract.

4. Contractor s Sukuk:

supplier xisting

of

a good

or

a service. The

commodities or those, which would be offered during a contracted time in future. nanter to These sukuk carries equal values issued by a cove

provide or sell services described in the security, such services are to be sold in a form of sukuk, so that the holders of the same shall to be the owners of such services and shall gain the proceeds from selling the same in the markets. 5. Potential Services Sukuk: These Sukuk carries equal values issued by a contractor (or a supplier) or an agent having h holders a saleable services to Sukuk holders and suc

shall have the right to sell the same in the stock market. 6. Salam Sukuk Sukuk or g the certificates of Salam carry equal values for mobilizin

capital necessary to produce some specified commodities contracted for deliverance at specified periods of time in future while their value prices are fully paid could be in advance. A separate parallel Salam contract

signed by the Salam item buyer with a third party, without linking it to the first contract. Ethically, the contractors should be committed towards 70 ----------------------- Page 71----------------------their contract parties, and should not transfer their own responsibilities in a contract to their parties in another one. 7. Istisna Sukuk Sukuk or certificates of Istisna carry equal values for mobilizing capital

A contractor s ntactor or a

or

supplier s

Sukuk

can

be Sukuk

issued could

by be

co

for e

necessary

to

produce with

some

specified advance

commodities. payments

Such

commodities to

could be sold Istisna

partial

according

contracts in order to be delivered at a specified period of time in future. Istisna is applicable on building and establishing ships, airplanes, bridges, roads, power alike according t and according ible to to a generation stations, water supply stipulated date and stations and the

specific specifications delivery

in the contrac It is poss

to a pre-stated

value.

synthesize another formula with the same to respond to the requisites of the process and finance. This type is amongst the most active instruments in world of Sukuk. A separate parallel Istisna item Istisna contract could be signed by the

buyer, with a third party, without linking it to the first contract, as it is th e case with the parallel Salam contracts. Wherein the supplier enters into a contract with an entity to manufacture a specified merchandise for them, then the supplier enters into a contract with a third party to manufacture the product to deliver the same for the demanding party on the stipulated time. 8. Murabaha Sukuk These or Sukuk his carry equal to values the and are issued a by the merchant then to

agent in order sell the

finance

purchasing

commodity

same at a known Murabaha as for equipments required within an Istisnaa contract weher the equipments shall be purchased on a known Murabaha 71 ----------------------- Page 72----------------------and the holders of Sukuk will be the owners of such equipments and of

the sales income from the same. 9. Musharakah Sukuk These plier Sukuk carry equal values and are issued by the sup a proje

(entrepreneur ct or

or a covenanter

)or his agent,

to finance

projects where the holders of Sukuk will be the owners of such projects, this is far similar to partnership companies although they might differ if the Sukuk issuer is authorized to select the projects which are transferred and constructed. 10.Mudarabah Sukuk This type of Sukuk, carry equal values issued by the contractor to provide the entrepreneurship and to manage the proposed project, for the purpose of financing such project or a combination of projects which are specified or those in which ukuk he is authorized to act upon. Thereby, the S

holders shall be the owners of the capital of the project and the project shall remain a partnership between them and between the entrepreneur at an agreed portion losses in of the profits and shall bear the expected

capital. 11.Muzaraa Sukuk: These Sukuk carry equal values issued by the owner of the agricultural land in order a Muzaraa contract roduced where to the finance holders the of agricultural Sukuk become costs according in the to p

partners

crops as per the terms stipulated in the contract. 12.Musaqat Sukuk: These Sukuk carry plants, the 72 equal values, issued by the owner of the

----------------------- Page 73----------------------subject of the contract, in order to finance the processes of irrigation and cultivation, where the holders of Sukuk become partners in the produced crops as per the terms stipulated in the Musaqat contract. 13.Musharakah Sukuk in Investment Agency: These Sukuk carry equal values and are issued by an investment agent. They represent projects and activities, where the investment agent shall be appointed as a mediator who manages the investment on behalf of the Sukuk holders in consideration of a percentage out of the profits. 14.Mugharasah Sukuk (Planting): These Sukuk carry equal values and are issued by the owner of the land subject under Mugharasa re the of the contract The for holders financing of the the costs Sukuk shall of plantation jointly sha

contract.

ownership of the trees planted together with the ownership of the land on which such trees were planted according to the contract. 15.Sukuk of Reducing Ownership: These Sukuk innovated carry equal values issued by the owner of the

idea, the subject of the contract, in order to finance a project pursuant to the establishment of the assets unding specified hall be partners in l or both or services after a period the contract to the ending owners The either by of transferring the idea the or ownership to the idea by fo s

of time. project

owners by

of the innovated employment (work),

capita

together. i.e, the partner shall be an employee who entitles a wage against his work, or a partner by business who shall start paying for the value of the the project to the profit in a holders of Sukuk out of his share in

manner reducing the number of Sukuk holders making him a partner with

an increasing share, the more he is able to pay out of his share. Thus the 73 ----------------------- Page 74----------------------shares of working Sukuk holders diminishes, while the shares of the

partners increases ending to stage where the ownership of the assets and its associated services, the asset alone or the services alone in favor of the partners. This formula combines the limited period lease Sukuk for assets and services. The for above could be summarized that could as, funds would be partially owned be mobilized by the ho

establishing lders of

companies

the Sukuk certificates. Gradually, the Sukuk holders can buy the capital share of their own the partners in the company so that they entirely

company, as per the agreed contractual conditions. The ing market for sukuk is now maturing and there is an increas

momentum in the wake of interest from issuers and investors. sukuk have confirmed their viability as an alternative means to mobilise medium to long-term savings and investments from a huge investor base. Different sukuk structures have been emerging over the years but most of the sukuk issuance to date have been ijara sukuk, since they are based on the it undivided is pro-rata ownership of the underlying leased asset,

freely tradable at par, premium or discount. Tradability of the sukuk in the secondary less common ing market makes them more attractive. Although of sukuk are also play

than Ijara sukuk,

other types

significant role in emerging markets to help issuers and investors alike to participate in major projects, including airports, bridges, power plants etc.

74 ----------------------- Page 75-----------------------

FUNCTIONING OF ISLAMIC BANKS It can be seen that in any banking business, there exist two aspects - at the one end lending is or the deposit aspect and at the other end is the

investment aspect. At the deposit end of the scale, Islamic banks normally operate three broad categories of accounts, namely, current, savings, and investment accounts. 1. Current accounts Current y the accounts are based on the principle of al-wadiah, whereb

depositors are guaranteed repayment of their funds. At the same time, the depositor does not receive remuneration for depositing funds in a current account, because the guaranteed funds will not be used for PLS ventures. Rather, the used to funds accumulating in these accounts. can only be

balance the liquidity needs of the bank and for short term transactions on the bank s responsibility. 2. Savings accounts Savings accounts also operate under the al-wadiah principle. Savings from current deposits in that they earn the

accounts differ depositors

income: depending upon financial results, the Islamic bank may decide to pay a premium, riba, at its discretion, to the holders of savings accounts. 3. Investment accounts An investment account operates under the 75 mudaraba-al-mutlaqa

----------------------- Page 76----------------------principle, absolute in which the mudarib (active partner) must have

freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: a) a higher fixed minimum amount, b) a longer duration of deposits, and c) funds in the the depositor may lose some of or all his

event of the bank making losses; ie, the principal or the rate of return on the deposits is not guaranteed. The only contractual agreement between investment which depositors and banks is the proportion according to

profits or losses are to be distributed between the parties of the deposit contract. The amounts so pooled are invested in a business acceptable to Shariah. The investment funds so created may be invested in varied forms: a. Equity Fund es of In an joint equity fund the amounts are invested in the shar

stock companies. The profits are mainly derived through the capital gains and dividends earned on the equity shares. can be acceptable under Shariah, subject to the following conditions: Dealing in shares or acquisition of shares of companies

If the utomobiles, an textile, interest

main etc.

business but they

of

the deposit

companies their

is surplus

ha/al, amounts

bearing account or borrow money on interest, the shareholder must express his disapproval against such dealings, preferably by raising his voice meeting of against such activities in the annual general

The main business of the company is not violative of Shari ah. like in a

the company. in the income in the 76 ----------------------- Page 77----------------------dividend paid to the shareholder must be given in charity, and must not be retained by him. The shares of a company are negotiable only if the company owns some illiquid assets. of the company, the proportion of such income If some income from interest-bearing accounts is included

interest. All the subscription amounts will form a joint pool and will be invested in purchasing the shares of different companies. The profits can accrue either through dividend distributed by the relevant companies or through the appreciation in the prices of the shares. In the first case i.e. where the profits are earned through dividends, a certain proportion of the dividend, which by the company, nds must be corresponds given in to the charity. proportion The of interest earned Fu

contemporary

have termed this process as purification . The management of the fund may be carried out in two alternative ways. The managers of the Fund may act as mudaribs for the subscribers. In this case a certain percentage of the annual profit accrued to the fund may be determined as the reward of the management. The second option for the management is to his case, the act as an agent for the subscribers. In t

management may be given a pre-agreed fee for its services. This fee may be fixed in a lump tion. According to the sum or as a monthly Shari ah or annual the fee remunera can a

contemporary

scholars,

The subscribers rtners

to the fund

will

be treated

in Shari ah

as pa

Islamic

lso

be

based on a percentage of the net asset value of the fund. b. Ijarah Fund In this fund the subscription amounts are used to purchase assets like real estate, motor leasing vehicles or other equipments for the purpose of

them out to their ultimate users. The ownership of these assets remains 77 ----------------------- Page 78----------------------with the Fund and the rentals are charged from the users. These rentals are the source of income for the fund which is distributed pro rata to the subscribers. his Each subscriber is given a certificate to evidence

proportionate ownership in the leased assets and to ensure his entitlement to the pro erably be rata share in income. These certificates may pref

Since these sukuk represent the pro rata ownership of their holders in the tangible assets of the fund, and not the liquid amounts or debts, they are fully negotiable and can be sold and purchased in the secondary market. Anyone who pro rata purchases these sukuk replaces the sellers in the

ownership of the relevant assets and all the rights and obligations of the original subscriber are passed on to him. The price of these sukuk will be determined on the basis of market forces, and are normally based on their profitability. c. Commodity Fund Another possible type of Islamic Funds may be a commodity fund. In the fund asing of this type the subscription amounts are used in purch

different commodities for the purpose of their resale. d. Murabaha Fund

called

sukuk -a term recognized in the traditional Islamic jurisprudence.

If a fund is created to undertake Murabaha, it should be a closed-end fund and its units cannot be negotiable in a secondary market. The reason is that in the case of murabaha, ancial as undertaken by the present fin

institutions, the commodities are sold tothe clients immediately after their purchase from deferred the original supplier, while the price being on

payment basis becomes a debt payment payable by the client. Therefore, the portfolio of murabaha does not own any tangible assets. It comprises either fund cash or the receivable debts, therefore, the units of the

78 ----------------------- Page 79----------------------represent either otiable. If the money or the received debts are not neg

they are exchanged for money, it must be at par value. e. Mixed Fund Another type of Islamic Fund may be of a nature where the

subscription amounts are employed in different types of investments, like equities, leasing, commodities, etc. This may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more than 51% while the liquidity and debts are less than 50%, the, units of the fund may be negotiable. However, if the proportion of liquid assets and debts exceeds 50%, its units cannot be traded according to the majority of the contemporary scholars. In this case the Fund must be a closed-end fund.

79 ----------------------- Page 80-----------------------

RISE AND SCOPE OF ISLAMIC BANKING Since the early 1980s, Islamic banking has developed into a multi-billion dollar business. its own The Western world is realizing that, even in

cities, it is no longer a fringe business. History of Islamic Banking The creation of the Islamic Development Bank (IDB) in Jeddah in 1975 was a landmark for Islamic banking. The IDB was the first development institution untries. dedicated to the financial requirements of Muslim co

The bank s articles of association stipulate that all its business should be

subscribed r

capital of the IDB to $5.7bn, making it the largest inte

government agency in the Muslim world. Commercial Islamic banking took off in the 1970s when a number of new institutions Islamic were established in the Gulf, including the Dubai

measured

by the Saudi government s

decision in 1992 to double the

conducted can be

in

accordance

with

Islamic

Shari a

law.

Its

success

Bank (1975), the Kuwait Finance House (1977) and the Bahrain Islamic Bank (1979). However, the most significant developments took place in Saudi Arabia, aided by its huge economic infrastructure. One of the prime movers of such to developments create a was network Prince of Mohammad Islamic Al-Faisal, banks across whose the

ambition was Muslim

world - a process which saw the founding of the Faisal Islamic Bank in 80 ----------------------- Page 81----------------------Egypt in 1977 and the Faisal Islamic Bank in Sudan in 1978. But it was Prince Al Faisal s Geneva-based Dar Al Mal Al Islami, founded in 1981 that brought bankers

who, previously, had little or no knowledge of Islam or Middle Eastern countries. of a The Geneva office of Dar Al Mal is now the centre

network of 43 branches in 20 countries with assets under management in excess of $3bn. The ose assets from of Islamic to banks in incorporated 1994, in the Middle total East r con

$4.4bn in 1985 trolled by

Islamic financial institutions, including assets under management and the activities of banks based outside the Middle East, are estimated to be in the order of $80-$100bn. Compared with conventional banking this is a relatively small sum, but the overall demand for Islamic banking products is probably much greater than banks have so far been able to tap. Growth of Islamic Banking In recent ncreased times, Islamic banking and financing services have i

phenomenally around the world. There now exist 150 such banks spread

Islamic

banking

to

the

attention

of

those

Western

$15.7bn

although

assets

over most countries of the world. Yet, the same trend in financing with a concentration ify. around murabaha (trade financing) is found to intens

Equity participation and profit sharing have remained distant minimum in the total allocation s in of resources. Secondary financial instrument

accordance with Shariah could not be developed so as to give rise to a viable Islamic capital market. Islamic financial instruments are therefore traded the in conventional stock markets. As a result, neither

developmental aspects of Islamic banking in favor of realizing an Islamic 81 ----------------------- Page 82----------------------economy nor the distributive goals for the poor and marginal enterprises could be attained. Reasons for the popularity of Islamic Banking Some possible reasons of the popularity and acceptability of the Islamic Banking are as under: 1. Evils of interest based system Interest caused based economic and financial system of the world has

havoc and that Islamic system has the ability to prevent the recurrence of the global financial crisis and resolve all related issues. But the world is not ready to do away with the system it is following. The truth is that the Islamic system presented has not been fully and effectively introduced,

and popularized in the world to merit any worthwhile attention towards it. 2. Attractive performance of Islamic banking Islamic the banking as has a not yet been fully implemented to the anywhere in in has

world, except terestbased system.

system

complementary where this

conventional system

However,

alternative

been implemented odern financial larized successfully system. Such has proven the unthinkable has in to the m effect popu

attractive

performance

Islamic banking, so much that they accommodate 3. Extended reach of Banking activity The reach of banking activity in many of the non-Muslim countries like that in the y of Muslim countries is very poor and a vast majorit

population is not bankable. For example it is estimated that not more than 82 ----------------------- Page 83----------------------15 per cent of Indians have any bank account. In other words the

overwhelming majority of Indians, say 85 per cent, are outside the net of banking activities they are not bankable. This is a precarious situation for any e he country because normally when a person becomes bankabl

also brings his savings in the main stream of economy. As Islamic Banking is ving in non-Muslim ntry and genuinely countries it expected will to attract the savings of Muslims in a li cou

increase

bankability

will have direct positive effect on the economy of the countries. 4. Invites Petrodollar It is said that introduction of Islamic Banking in any country will serve as the drain through which petrodollar will flow through. As the economy of the members of Gulf Cooperation Council (GCC) countries in particular and other members of Organisation of Petrol Exporting Countries

(OPEC) in general is rentier based the fund saved in these countries are mostly invested outside their own respective countries. Till 9/11 a major portion of those savings were being invested in the USA and other

Western

countries. But now the situation has changed and the Arab

investors have started looking around for other possible opportunities. If Islamic banks are opened in non-Muslim countries, including India, such funds will be attracted and this will ultimately give a boost to economy and a fillip to the overall welfare of the states.

83 ----------------------- Page 84-----------------------

VIABILITY OF ISLAMIC FINANCE IN INDIA Like is how the clear emerging Islamic finance world has shown us, it

that banking without interest can take care of any kind of financing which the conventional banks are indulged in. This may also save thousands of needy people to come forward to borrow from the banks and can free the banks from the clutch of Non-Performing Assets to a large extend;

ultimately resulting in complacency amongst the customers of the bank as well as for the banks themselves. It is reported that in India, thousands of crores earned in interest is kept

in suspended accounts, as believers do not claim it. The assets controlled

In Kerala alone, it is reported that this money could be above Rs. 40,000 crore. Research reveals that a handsome bulk of money in. India owned by the believers is lying idle, which if invested in profit sharing basis -

by Muslims are estimated to be $1.5 trillion and growing at 15% a year.

and utilized properly, can have a major impact on the Indian economy. 84 ----------------------- Page 85----------------------SouthernRegion WesternRegion CentralRegion usion Rateofinancialexlu sion EasternRegion NorthEasternRegion NorthernRegion 0% 20% 40% 60% 80% 100% RateofinancialIncl

Fig : Bar diagram showing extend of banking reach in India Data Source: www.rbi.org There are t of Islamic onomic several and moral its and religious in arguments India. on the concep However, the ec

Banking

introduction

argument, which has been welcomed across the globe, has also set its foot in India. Hurdles on the way of introducing Islamic Banking in India 1. Islamic Banking does not adhere to BRA, 1949 Many a critical in india since the concept h the issues emerge in Banking introducing islamic Banking wit

of Islamic

is not in consonance

provisions of the Banking Regulation Act, 1949, which is the prevailing Act over the banks in the country. 2. Role of RBI as the Central Bank Issues also emerge India as the 85 as to the role of the Reserve Bank of

----------------------- Page 86----------------------Central e basic Banker the context of Islamic Banking. Though th

functions of a modern Central Bank may be relevant also for an Islamic monetary system, the mechanisms may have to be different. For instance, in k rate terms of Central banking functions the ban

Instrument cannot be used as it entails interest.

that adjustments in profit-sharing ratios can be substituted for bank rate manipulations by the Central Bank. 3. Issue of Credit According share accruing is also proposed take in to Scholars, credit can and Bank be tightened eased should by by reducing the

to the that the

businessmen Central

acquire

commercial banking by holding, say, 25 per cent of the capital stock of the commercial to a permanent source er of last resort could. 4. Inability to maintain interest-based Reserves Another aintain issue cash is that the Islamic banks if set up cannot m banks of which income would so give-the that Central Bank act access as lend

it effectively

reserve and SLR since these involve interest. 5. Inability to maintain capital adequacy The other constraints may be their inability to maintain capital adequacy and would money be unable to interact with interest based banks and

market in India.

In this regard the Scholars in the field of Islamic Banking

has suggested

increasing an

it. It equity s

86 ----------------------- Page 87----------------------The problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the Central Bank. However, Scholars have suggested a solution in such cases i.e.

arrangement for reciprocal accommodation among banks without interest payments and creation of a common fund at the Central Bank into which surpluses would flow and from which shortages could be met without any interest charges.

87 ----------------------- Page 88----------------------RISKS INHERENT IN ISLAMIC BANKING There are some unique risks in Islamic banking in additional to the risks faced by conventional banks: 1. Credit risk While the profit loss sharing modes of financing may shift the direct

credit risk of -may also increase the sheet. This significantly ates an incentive without

these overall increases

banks risk on

to

their the

investment side of

depositors, the

they

asset

balance and cre

the potential and

for moral

hazard

for risk taking

operating

financial

institution

adequate capital. This risk arises when the bank is under pressure to pay a rate that exceeds financed by their investment ct for the return The that has of been the earned on assets contra

depositors.

breach

investment

management of investor s funds may also lead to fiduciary risk. 2. Market risk

interest rate risk affects Islamic banks only indirectly through the markup price of isk arises from exposures assets deferred sale and lease-based transactions. underlying This r

to the price volatility of the

inherent in some financing modes, which are in the form of trading and real investment. Similarly, the bank has to share any increase in earnings with rice investment its depositors, but cannot, at the same time, bank, re-p is th

receivables erefore,

on the

exposed to mark-up price risk due to this pricing mismatch. 88 ----------------------- Page 89----------------------These banks are directly exposed to commodity price risk because, unlike conventional banks, they typically carry, inventory items on their books. They are exposed to equity to a greater extent than conventional banks

Owing to the uments,

Sharia s

prohibition

against

interest-based

instr

"real"

asset side at higher

rates. The

price risk as the very nature of Islamic banking is equity financing through the PLS modes. 3. Operational risk The unique activities that these banks perform like administration of

profit loss sharing modes of financing which includes determination of profit and loss sharing ratios in investment projects in various sectors of the economy, as well as on-going auditing of financed projects to ensure proper governance and appropriate valuation, is more complex and these activities that are not normally performed by conventional banks. This is compounded by the non-standard nature of some Islamic financial

products and lack of an efficient and reliable Sharia litigation system to enforce financial contracts. 4. Shariah compliance risk This risk arises from non-compliance the Islamic banking with Shariah principles in which may lead to rep

conducting utation

business,

risk. The interpretation of Shariah also differs across countries.

89 ----------------------- Page 90-----------------------

CONCLUSION Global finance today dominates the world economy. Western economies are characterized for the economy. Stock with Markets, financial sectors which generate billions

multinationals, companies

raising billions,

initial public offerings (IPO) and success of Capitalism.

so on, all symbolize the apparent

Over a period of 300 hundred years the emergence of fiat currencies (i.e. currency without erest and the development an intrinsic value), the role of compound int

of limited liability company structures have shaped

western finance. Such developments t has have also been the sole reason why the Wes

come to be characterized with regular financial crises. This is because the financial sector moved away from raising finance to fund business startups and projects to speculating on company share prices and the

movement of currencies. In this way trading in the financial sector ceased to be about purchasing currency or buying shares in the hope of receiving a dividend to purchasing financial commodities in the hope they could be sold for a higher price.

sophisticated that an

various

products

investment in a paper with no real asset represented. 90 ----------------------- Page 91----------------------The problems that the world economy faced caused hues and cries about an alternative financial system for smoother and healthier economy. The answer to this human quest was Islamic Banking and Finance. With its peculiar ationally features of being interest-free primarily, r

ensures real economic activities. Its various unique forms of trade, once unfolded to of more stable araka, the world All under of crisis it opened viz., a brand new way Mush

economy.

tools

The

financial economy

that doesn t produce anything have been

has become which

so allow

created

Mudaraba,

Murabaha,

Ijara etc. all form the discussion of world economies. Its basis laid down centuries ago, and practiced for once at the time it was opened to the money and sheer selfish entities world, ends. it Now was soon forgotten for the verge the greed of

that on

of crisis, some

practically reminded the world of this wonderful system of finance, lets hope that the t apparently does now. However, introduction of this complex, yet rational system of financing and banking, is Even after still at and the scope, on doorstep our to of own nor to our Indian economy. conservati little roo world will receive it a warm welcome, like i

proving its viability sm is allowing us to neither m for this new system.

financial leave

shift

For better health and stability of our economy, we do need an alternative, and lets hope that the Indian government soon resolves the current issues and receive Islamic banking into our economy. 91 ----------------------- Page 92----------------------REFERENCES/ BIBLIOGRAPHY 1. Bernard Lietar 2. Bindu Vasu Future of Money Islamic Banking- Banking for a Change

(RBI Legal News and Reviews- Jounal Section) 3. Mufti Barkatulla Ethical Fusion, Islamic Banking and

Finance Vol.7 Issue 3 No.23 4. Niladri Bhattacharya Islamic funds likely to invest $1 bn, Business Standard (2008. 10th Jan) 5. Rodney Wilson Islamic Finance and Ethical Investment

6. Syed Zahid Ahmed, Economics of Islamic Banking in India, RGE Monitor (2008, 11th Sept) 7. Report of the Working Group to examine financial instruments used in Islamic Banking, RBI 8. Report on the Committee on Financial Sector Reforms, Planning Commision, Govt. of India, A hundred Small Steps 9. www.icif.in 10.www.rbi.org 11.http://www. newhorizon-islamicbanking.com/index.cfm 12.www.islamic-finance.com 13.en.wikipedia.org/wiki/Islamic_banking 14.www.islamicfinance.de 15.www.islamicfinancenews.com

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