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1.

Introduction
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Shariah) and its practical application through the development of Islamic economics. Shariah prohibits the payment or acceptance of interest fees for loans of money (Riba, usury), for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community. During the Islamic Golden Age, early forms of proto-capitalism and free markets were present in the Caliphate, where an early market economy and an early form of mercantilism were developed between the 8th-12th centuries, which some refer to as "Islamic capitalism". A vigorous monetary economy was created on the basis of the expanding levels of circulation of a stable, high-value currency (the dinar) and the integration of monetary areas that were previously independent. A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, the first forms of partnership (mufawada) such as limited partnerships (mudaraba), and the earliest forms of capital (almal), capital accumulation (nama al-mal), cheques, promissory notes, trusts (see Waqf) , transactional accounts, loaning, ledgers and assignments. Organizational enterprises independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.

2. Riba
The word "Riba" means excess, increase or addition, which according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial." During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself (ex natura sua) made no logical sense as its value remained constant relative to all other materials: these metals could be added to but not created (from nothing). Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, the question of "paying a debt in a higher number of units of this fiat money being riba" was not relevant as the jurists only needed to be concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).

3. History of Islamic Banking
Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses.
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Another set of works emerged in the late sixties and early seventies. as time went on it became difficult to engage in trade and other activities without making use of commercial banks.The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. the First International Conference on Islamic Economics in Mecca in 1976. 1969). Works specifically devoted to this subject began to appear in this period. In the next two decades interest-free banking attracted more attention. partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. 1957 and 1962 should be included in this category. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970. The first such work is that of Muhammad Uzair (1955). Nejatullah Siddiqi (1961. Abdullah al-Araby (1967). and the International Economic Conference in London in 1977 were the Page | 3 . 1955. The earliest references to the reorganization of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946). The local trading community avoided the ´foreignµ banks both for nationalistic as well as religious reasons. 1974) were the main contributors. Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties." have proposed a banking system based on the concept of Mudarabha . alNajjar (1971) and Baqir al-Sadr (1961. The early 1970s saw institutional involvement. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion Interest-free banking seems to be of very recent origin. However. the Egyptian study in 1972. The writings of Muhammad Hamidullah 1944. Even then many confined their involvement to transaction activities such as current accounts and money transfers.profit and loss sharing. They have all recognized the need for commercial banks and their perceived "necessary evil. followed by a more elaborate exposition by Mawdudi in 1950.

The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. In 1972.result of such involvement. the Islamic Development Bank was set-up with the mission to provide funding to projects in the member countries. The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image³for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The first modern commercial Islamic bank. In 1975. The Islamic Development Bank. Islamic banks have more than 300 institutions spread over 51 countries. Islamic finance is the fastest- Page | 4 . but in the last few years the industry is starting to see strong development in new products and services. Dubai Islamic Bank.5% of total world estimated assets as of 2005. In the early years. The pioneering effort. currently. Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. the products offered were basic and strongly founded on conventional banking products. took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. It is estimated that over US$822 billion worldwide Shariah-compliant assets are managed according to The Economist. was born of this process. an intergovernmental bank established in 1975. According to CIMB Group Holdings. This experiment lasted until 1967 (Ready 1981). led by Ahmad Elnaggar. opened its doors in 1975. the Mit Ghamr Savings project became part of Nasr Social Bank which. as well as an additional 250 mutual funds that comply with Islamic principles. by which time there were nine such banks in country. including the United States through companies such as the Michigan-based University Bank. This represents approximately 0. is still in business in Egypt.

However. The goods or land is registered to the name of the buyer from the start of the transaction. and leasing (Ijarah). held annually in Bahrain since 1994. The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). known as Fiqh al-Muamalat (Islamic rules on transactions). The Vatican has put forward the idea that "the principles of Islamic finance may represent a possible cure for ailing markets. while allowing the buyer to pay the bank in installments. This arrangement is called Murabaha. In an Islamic mortgage transaction. instead of loaning the buyer money to purchase the item. Another approach is EIjara wa EIqtina. and re-sell it to the buyer at a profit. safekeeping (Wadiah). Difference between Islamic and Conventional Banking Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah. The World Islamic Banking Conference. cost plus (Murabahah). Page | 5 . In order to protect itself against default. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid). the bank asks for strict collateral. Common terms used in Islamic banking include profit sharing (Mudharabah). which is similar to real estate leasing. the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment.growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010. joint venture (Musharakah). a bank might buy the item itself from the seller. is internationally recognized as the largest and most significant gathering of Islamic banking and finance leaders in the world.

the profit-sharing arrangement is concluded. resulting in a balanced distribution of income and not allowing lender to monopolize the economy. especially in a dual-banking system like in Malaysia. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure. both providing capital at an agreed percentage to purchase the property. If default occurs. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. There are several other approaches used in business transactions. allows for a floating rate in the form of rental.An innovative approach applied by some banks for home loans. The bank and borrower form a partnership entity. Further. At the same time. Once the principal amount of the loan is repaid. Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. Islamic banks lend their money to companies by issuing floating rate interest loans. This practice is called Musharaka. called Musharaka al-Mutanaqisa. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. The floating rate of interest is pegged to the company's individual rate of return. the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. Page | 6 . The partnership entity then rents out the property to the borrower and charges rent. This method allows for floating rates according to the current market rate such as the BLR (base lending rate).

notably Grameen Bank. Shariah Advisory Council (SAC) Islamic banks and banking institutions that offer Islamic banking products and services are required to establish a Shariah Supervisory Board (SSB) to advise them and to ensure that the operations and activities of the banking institutions comply with Shariah principles. In theory. and moral purchasing. especially Bangladesh. pork. Page | 7 . etc. in practice. which exclude those involving alcohol. Micro-lending institutions founded by Muslims. the National Shariah Advisory Council. Islamic banking is an example of full-reserve banking. use conventional lending practices and are popular in some Muslim nations. However. the founder of Grameen Bank and microfinance banking. In Malaysia. but some do not consider them true Islamic banking. with banks achieving a 100% reserve ratio.Islamic banking is restricted to islamically acceptable transactions. and no examples of 100 per cent reserve banking are observed. gambling. and other supporters of microfinance. In Indonesia the Ulama Council serves a similar purpose. Muhammad Yunus. there are also those who believe that no form of banking that involves interest payments can ever comply with the Shariah. this is not the case. However. On the other hand. Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. which has been set up at Bank Negara Malaysia (BNM). advises BNM on the Shariah aspects of the operations of these institutions and on their products and services. argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba). The aim of this is to engage in only ethical investing.

a number of Islamic banks were created to cater to this particular banking market. Fundamentals of Islamic finance The term ´Islamic bankingµ refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In the late 20th century.A number of Shariah advisory firms have now emerged to offer Shariah advisory services to the institutions offering Islamic financial services. The World Database for Islamic Banking and Finance (WDIBF) has been developed to provide information about all the websites related to this type of banking. The original word used for usury in this text was Riba. the prohibition of interest was a well-established working principle integrated into the Islamic economic system. according to Islamic economists Choudhury and Malik (1992). or businesses that produce media such as gossip columns or pornography. which literally means ´excess or additionµ. Usury in Islam The criticism of usury in Islam was well established during the Prophet Mohammed's life and reinforced by several of verses in the Holy Qur·an dating back to around 600 AD. Islamic law prohibits usury. also commonly called riba in Islamic discourse. In particular. Issue of independence. which are contrary to Islamic values). Islamic law prohibits investing in businesses that are considered unlawful. Page | 8 . the collection and payment of interest. impartiality and conflicts of interest have also been recently voiced. or haraam (such as businesses that sell alcohol or pork. This was accepted to refer directly to interest on loans so that. by the time of Caliph Umar. In addition.

issued by the body handling this investment or the body acting on its behalf. Pakistan and Saudi Arabia. Indeed. and interest which they say refers to lending for commercial investment (Ahmed. there does seem to be evidence in modern times for what Choudhury and Malik describe as ´a gradual evolution of the institutions of interest-free financial enterprises across the worldµ (1992: 104). still argues for an interpretative differentiation between usury. which it is claimed refers to consumptional lending. They cite. Subsequently the asset is sold to the customer on a deferred-payment basis and the price is payable in instalments.It is not true that this interpretation of usury has been universally accepted or applied in the Islamic world. the current existence of financial institutions in Iran. a school of Islamic thought which emerged in the 19th Century. 1958). Islamic Financial Instruments A financial instrument is a certificate representing a common share in a fund for investing and making a profit. led by Sir Sayyed. the Dar-al-Mal-al-Islami in Geneva and Islamic trust companies in North America. The financier buys an asset from the customer on spot basis. Page | 9 . Nevertheless. The price paid by the financier constitutes the disbursement under the facility. The second sale serves to create the obligation on the part of the customer under the facility. Following are the main modes of Islamic banking and finance: Bai' al 'inah (Sale and Buy-back agreement) Bai' al inah is a financing facility with the underlying buy and sell transactions between the financier and the customer. for instance. which provides for its negotiation and conversion into liquid money when required.

Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan. Like Bai' al 'inah. whereby each partner provides funds to be used in a venture. The common perception is that this is simply straightforward charging of interest disguised as a sale Bai' Muajjal (Credit sale) Literally bai' muajjal means a credit sale.There are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah. Bai' muajjal is also called a deferred-payment sale. Technically. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. The problem here is that this includes linking two transactions in one which is forbidden in islam. it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal. Profits made are shared between the partners according to the invested capital. this concept is also used under an Islamic financing facility. one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. Page | 10 . which includes a profit margin agreed to by both parties. Musharakah Musharakah (joint venture) is an agreement between two or more partners. However. however this is practised in Malaysia and the like jurisdictions. Bai' Bithaman Ajil (Deferred payment sale) This concept refers to the sale of goods on a deferred payment basis at a price.

that justifies the bank's claim to part of the profit. Profits generated are shared between the parties according to a pre-agreed ratio. provides no capital. and the profit margin must be clearly stated at the time of the sale agreement. Note that Musharaka and Madharaba commonly overlap. The bank is compensated for the time value of its money in the form of the profit margin. a financial institution provides all the capital and the other partner. The investment comes from the first partner who is called "rabb-ul-mal". the entrepreneur. Mudarabah (Profit-sharing) "Mudarabah" is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. If the Bank provides capital. according to the Shariah. A working partner gets a greater profit share compared to a sleeping (non-working) partner. one partner. the same conditions apply.In case of loss. Each partner may or may not participate in carrying out the business. which includes a profit margin agreed to by both parties. Compared to Musharaka. The difference between Musharaka and Madharaba is that. each partner loses capital in the same ratio. in a Mudaraba only the lender of the money has to take losses.g. The Mudarabah (Profit Sharing) is a contract. e. Murabahah (Cost + Profit) This concept refers to the sale of goods at a price. each partner contributes some capital. other costs. Page | 11 . It is this financial risk. whereas in Madharaba. in Musharaka. The purchase and selling price. while the management and work is an exclusive responsibility of the other. who is called "mudarib" or agent.

quality. however. Barring this. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores. and workmanship. While the seller may or may not have full knowledge of the cost of the item being negotiated. Bai Salam Bai salam means a contract in which advance payment is made for goods to be delivered later on. Musawamah Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price.. Page | 12 . they are under no obligation to reveal these costs as part of the negotiation process. with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i. This difference in obligation by the seller is the key distinction between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. silver.e. Musawamah is the most common type of trading negotiation seen in Islamic commerce.This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle). The objects of this sale are goods and cannot be gold. Bai Salam covers almost everything that is capable of being definitely described as to quantity. or currencies based on these metals. the bank cannot charge additional profit on late payments). the asset remains as a mortgage with the bank until the default is settled.

Imam Malik is also of the opinion that the seller may defer accepting the funds from the buyer for two or three days. Page | 13 .Basic features and conditions of Salam The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. Muslim jurists are unanimous in their opinion that full payment of the purchase price is key for Salam to exist. if the seller undertakes to supply the wheat of a particular field. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. precious stones cannot be sold on the basis of salam. because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible. Salam can be affected in those commodities only the quality and quantity of which can be specified exactly. For example. Salam cannot be affected on a particular commodity or on a product of a particular field or farm. or the fruit of a particular tree. given such possibility. an act prohibited under Sharia. the basic purpose of the transaction would have been defeated. The same rule is applicable to every commodity the supply of which is not certain. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. but this delay should not form part of the agreement. the delivery remains uncertain. because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery. If the price were not paid in full. the salam will not be valid. and. For example. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party.

Similarly. and may. representing a portion of the profit made by using those savings account balances in other activities. if the ventures are profitable. it is necessary. Salam cannot be affected in respect of things which must be delivered at spot. that the delivery of both be simultaneous. in effect. Therefore the contract of Salam in this case is not allowed. and cannot be 'guaranteed.It is necessary that the quality of the commodity (intended to be purchased through Salam) is fully specified leaving no ambiguity which may lead to a dispute. then some of those profits may be gifted back to its customers as Hibah. Hibah is a voluntary payment made (or not made) at the bank's discretion. It is important to note that while it appears similar to interest. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. have the same outcome. and if it is quantified through measures. The exact date and place of delivery must be specified in the contract. If the commodity is quantified in weights according to the usage of its traders. if wheat is bartered for barley. Here. the simultaneous delivery of both is necessary for the validity of sale. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances. Salam cannot work. Hibah (gift) This is a taken-given voluntarily by a debtor to a creditor in return for a loan. What is normally weighed cannot be quantified in measures and vice versa.' However. For example. the opportunity of receiving high Hibah will draw in customers' savings. if gold is purchased in exchange of silver. according to Shari'ah. Page | 14 . providing the bank with capital necessary to create its profits. its weight must be determined. its exact measure should be known. All the possible details in this respect must be expressly mentioned.

Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This higher rate can be viewed as insurance against obsolescence. office automation. This method of "offbalance-sheet" financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. If the equipment is used for a relatively short period of time. Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange for a higher lease rate. Ijarah is not considered Debt Financing so it does not appear on the Lessee' Balance Sheet as a Liability. Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible terms. the Bank makes available to the customer the use of service of assets / equipments such as plant. Page | 15 . motor vehicle for a fixed period and price. rent or wage. All payments towards Ijarah contracts are treated as operating expenses and are therefore fully tax-deductible. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating. Leasing thus offers tax-advantages to forprofit operations. it may be more profitable to lease than to buy.Ijarah Ijarah means lease. Many types of equipment (i.e computers) become obsolete before the end of their actual economic life. This is important as it is the access and use (and not ownership) of equipment that generates income. Generally. Under this concept. Ijarah concept means selling the benefit of use or service for a fixed price or wage. Advantages of Ijarah Ijarah provides the following advantages to the Lessee: Ijarah conserves the Lessee' capital since it allows up to 100% financing.

the net effect being the paying of a fee for the use of money for the term of the loan. For example. two parties would enter into three concurrent and interrelated legal contracts. Page | 16 . The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period. to form a complete lease/ buyback transaction. leasing avoids having to account for and depreciate the equipment under normal accounting principles. in a car financing facility. Ijarah Thumma Al-Bai' (Hire purchase) Parties enter into contracts that come into effect serially. a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The bank generates a profit by determining in advance the cost of the item. the second contract comes into effect. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. The use of concurrent interrelated contracts is also prohibited under Shariah Law. In a contractum.If the equipment is used for a long period but has a very poor resale value. a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans. This type of transaction is similar to the contractum trinius. When the lease period expires. and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. which enables the customer to purchase the car at an agreed to price.

the debtor may. However. since it is the one type of loan that truly does not compensate the creditor for the time value of money. Page | 17 . the ownership in the asset would be transferred to the lessee. 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. Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles. However. Hence. 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 undertaking or the promise does not become an integral part of the lease contract to make it conditional. is the Arabic name for financial certificates that are the Islamic equivalent of bonds. building.Ijarah-wal-iqtina A contract under which an Islamic bank provides equipment. and the debtor is only required to repay the amount borrowed. In the case that the debtor does not pay an extra amount to the creditor. which prohibit the charging or paying of interest. pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. this transaction is a true interest-free loan. interest-bearing bonds are not permissible in Islam. Sukuk (Islamic bonds) Sukuk. plural of Sakk. fixed-income. Qardul Hassan (Good loan/Benevolent loan) This is a loan extended on a goodwill basis. at his or her discretion. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba.

Despite these successes. Wadiah (Safekeeping) In Wadiah. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products. there are approximately 100 Islamic equity funds worldwide. when the depositor demands it. may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank. Page | 18 . A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit. With the continuous interest in the Islamic financial system. The depositor. Over the last few years. quite a number of funds have closed down.Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. a bank is deemed as a keeper and trustee of funds. at the bank's discretion. there are positive signs that more funds will be launched. The total assets managed through these funds currently exceed US$5 billion and is growing by 12²15% per annum. Currently. Wakalah (power of attorney) This occurs when a person appoints a representative to undertake transactions on his/her behalf. this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. similar to a power of attorney. or any part of the outstanding amount. Islamic equity funds Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system.

also prohibits bayu algharar (trading in risk.. The hadith. The Web site failaka.com monitors the performance of Islamic equity funds and provides a comprehensive list of the Islamic funds worldwide. Malaysia and Gulf-based investment funds. in addition to prohibiting gambling (games of chance). some cater for their local markets. Islamic derivatives With help of Bahrain-based International Islamic Financial Market and New York-based International Swaps and Derivatives Association.g." Page | 19 . The Hanafi school of thought in Islam defines Gharar as "that whose consequences are hidden. with minimum investments ranging from US$50. Others clearly target the Middle East and Gulf regions. neglecting local markets and have been accused of failing to serve Muslim communities. where the Arabic word gharar is taken to mean "risk" or excessive uncertainty). e. Since the launch of Islamic equity funds in the early 1990s.Most of the funds tend to target high net worth individuals and corporate institutions. The ´Hedging Master Agreementµ provides a structure under which institutions can trade derivatives such as profit-rate and currency swaps. global standards for Islamic derivatives were set in 2010. there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series. Target markets for Islamic funds vary. Islamic laws on trading The Qur'an prohibits gambling (games of chance involving money) and insuring ones' health or property (also considered a game of chance).000 to as high as US$1 million.

" The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable.). such as Dr. an unborn calf in its mother's womb etc." The modern scholar of Islam. Sami al-Suwailem. This was mainly due to the complication of having to decide what is and is not a minor risk. have used Game Theory to try and reach a more measured definition of Gharar. Microfinance is ideologically compatible with Islamic finance. a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu alghasar) is deemed to be haram. whether it exists or not. There are a number of hadith that forbid trading in gharar. often giving specific examples of gharhar transactions (e. with the less desirable one being more likely.g. Some Islamic banks do provide brokerage services for stock trading. wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain. or the seller does not know what he sold.. Professor Mustafa Al-Zarqa. and possesses a sizeable potential market. What gharar is. selling the birds in the sky or the fish in the water. exactly. Jurists have sought many complete definitions of the term. defining it as "a zero-sum game with unequal payoffs". was never fully decided upon by the Muslim jurists. They also came up with the concept of yasir (minor risk). due to the risky nature that makes the trade similar to gambling.The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities." Ibn Hazm of the Zahiri school wrote "Gharar is where the buyer does not know what he bought. Microfinance in Islamic Microfinance is a key concern for Muslims states and recently Islamic banks also. Derivatives instruments (such as stock options) have only become common relatively recently. capable of Shariah-compliancy." Other modern scholars. Page | 20 . the catch of the diver.

etc. musharaka. Deposit is guaranteed. In the following paragraphs. individual banks differ in their application. we will describe the salient features common to all banks. individual bank·s circumstances and experiences. Current practices of Islamic Banking Generally speaking. Current accounts Current or demand deposit accounts are virtually the same as in all conventional banks. several microfinance institutions (MFIs) such as FINCA Afghanistan have introduced Islamiccompliant financial instruments that accommodate Shariah criteria. Already. Deposit accounts All the Islamic banks have three kinds of deposit accounts: current. the need to interact with other interest-based banks. In some banks. objectives of the different banks. the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Page | 21 . These differences are due to several reasons including the laws of the country.Islamic microfinance tools can enhance security of tenure and contribute to transformation of lives of the poor. However. The use of interest found in conventional microfinance products and services can easily be avoided by creating microfinance hybrids delivered on the basis of the Islamic contracts of mudaraba. all interest-free banks agree on the basic principles. Savings accounts Savings deposit accounts operate in different ways. savings and investment. and murabaha.

In others. The venture is an independent legal entity and the bank may withdraw gradually after an initial period.Banks adopt several methods of inducing their clients to deposit with them. Modes of financing Banks adopt several modes of acquiring assets or financing projects. Profit and loss are shared in a pre-arranged fashion. But they can be broadly categorised into three areas: investment. management and labour. b) Mudarabha where the bank contributes the finance and the client provides the expertise. both parties participating in the various aspects of the project in varying degrees. but when a loss occurs the total loss is borne by the bank. This is not very different from the joint venture concept. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment financing This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture. Profits are shared by both the partners in a pre-arranged proportion. savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Investment account Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed. but no profit is promised. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. trade and lending. Page | 22 . c) Financing on the basis of an estimated rate of return.

Trade financing This is also done in several ways. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period. This charge may be subject to a maximum set by the authorities. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. If the profit is less than the estimate the bank will accept the lower rate. entrepreneurs.Under this scheme. (Perhaps this rate is negotiable. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. on the basis of sharing the profit from the sale of this item or on a mark-up basis. and at the end of that period the client automatically becomes the owner of the item. b) Nocost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers.) If the project ends up in a profit more than the estimated rate the excess goes to the client. In case a loss is suffered the bank will take a share in it. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. Lending Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. Page | 23 .

in one form or the other. etc. Besides individual financial institutions operating in many countries. are working in about 75 countries of the world. both on assets and liabilities sides. trade in foreign currencies at spot rate etc. free of charge. efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them. where the bank·s own money is not involved are provided on a commission or charges basis. offshore banking and funds management. have developed significantly and therefore. It pursues a dual banking system. Services Other banking services such as money transfers. they are also participating in the money and capital market transactions. where Islamic banks operate in the environment in which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for Islamic banks as for conventional banks. Page | 24 . Bahrain and a few other countries of the Gulf. bill collections. investment banking. is hosting 26 Islamic financial institutions dealing in diversified activities including commercial banking. Global Scenario of Islamic Banking Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15percent per annum. Today. Islamic financial institutions.producers. c) Overdrafts also are to be provided. In Malaysia. subject to a certain maximum. Islamic banks and financial institutions are working parallel with the conventional system. and to needy consumers. Bahrain with the largest concentration of Islamic financial institutions in the Middle East region.

Like other Islamic banks around the world the banks in Sudan have been relying in the past on Murabaha financing. the share of Musharaka and Mudaraba operations is on increase and presently constitutes about 40 percent of total bank financing. Although the Islamic financial system has taken a good start in Sudan. Like Sudan. there are some conceptual differences in interpretation and Shariah position of various contracts like sale and purchase of debt instruments and grant of gifts on savings and financial papers. The share of Islamic banking operations in Malaysia has grown from a nil in 1983 to above 8 percent of total financial system in 2003. significant problems still remain to be addressed. Further.Bahrain also hosts the newly created Liquidity Management Centre (LMC) and the International Islamic Financial Market (IIFM) to coordinate the operations of Islamic banks in the world. a system of Islamic banking and finance is in operation at national level. However. the BMA has pioneered a range of innovations designed to broaden the depth of Islamic financial markets and to provide Islamic institutions with wider opportunities to manage their liquidity. However. the BMA has introduced a comprehensive prudential and reporting framework that is industry-specific to the concept of Islamic banking and finance. Another country that has a visible existence of Islamic banking at comprehensive level is Malaysia where both conventional and Islamic banking systems are working in a competitive environment. They have a plan to enhance this share to 20 percent by the year 2010. In Sudan. there are some conceptual differences between Islamic banking in Iran and the mainstream movement of Islamic banking and finance. However. Iran also switched over to Usury Free Banking at national level in March 1984. Page | 25 . To provide appropriate regulatory set up.

Owing to the growing amount of capital availability with Islamic banks. water plants. In May 03. The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool assets to develop and promote Shariah compliant tradable instruments for Islamic banking industry. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures. As such. Added benefits are purchase protection. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. easy to load up and has worldwide acceptance. The card does not have a credit line and instead has a prepaid line. etc and no interest. it does not incur any interest. travel accident insurance. These projects. no extra fees with no conditions. Bahrain is the leading centre for Islamic finance in the Middle East region. include power stations. the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals particularly in the Middle East region. the Liquidity Management Centre (LMC) launched its debut US$ 250 million Sukuk on behalf of the Government of Bahrain. inter alia. The arrangement is seen as a major boost for industry·s integration in the global financial system and should set the pace for commodity-trading environment in Bahrain. Page | 26 . It is more secure than cash. bridges and other infrastructure projects. roads. BMA has also finalized draft guidelines for issuance of Islamic bonds and securities from Bahrain. National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that has all the benefits of a regular credit card. the card is fully Shariah compliant.

Scholars. self employed and small establishment employees who sometimes do not meet the strict requirements of a regular credit card facility. Mahmoud El Gamal. Conclusion Considering the important role of Islamic Bankings in the mobilisation of financial resources. Saudi Government has also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector and opened it for foreign investors. A dedicated high court has been set up to handle Islamic banking and finance cases. Islamic banks mainly deal with the area of an assets rather than liability. Ulemu' and Bankers with vision. which has been sponsored by Gulf and UK investors. absolute conviction and commitment to the cause of Islam. where Standard & Poor's assigned a BBB+rating to the $600 million Shariahcompliant trust certificates (called sukuk) issued by Malaysia Global Sukuk Inc. an eminent economist/expert on Islamic banking to advise the US Treasury and Government departments on Islamic finance in June 2004. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank licenses to foreign players. Furthermore. courage. It lists incentives to develop the Islamic financial sector and enlarge its market share to 20 percent. The Financial Sector Master plan maps out the liberalization of Malaysia's banking and insurance industry in three phases during the next decade. Furthermore. will have to work in tandem to examine the future prospects and possibilities of diversifying and widening the scope. Page | 27 . from under 10 percent now. imagination and above all.This prepaid card facility is especially attractive to women. which make their operations more diversify and complex. Islamic banks have also built a strong presence in Malaysia. The United States of America has appointed Dr. youth. In United Kingdom. the Financial Services Authority is in final stages of issuing its first ever Islamic banking license to the proposed Islamic Bank of Britain. volume and size of Islamic Banking of different maturities.

5.M Fazlul Hoque and R. Jeddah. edited by Dr Ausaf Ahmad. Saudi Arabia. (2005). Abu Musa. International Islamic University Malaysia. 4. Saiful Azhar Rosly. 2004. Page | 28 . etc.A. Md. In writings on Islamic banking. A Comparative Study of Islamic Banking Practices. Kuala Lumpur. Functions of an Islamic bank. A. Sudin Haron. 5-7 January. Kuala Lumpur. Research centre. Islamic banks should try to create a means to embark in profit and loss sharing techniques. Islamic Banking and Finance Law.K. Critical Issues on Islamic Banking and Financial Markets. LEE and Ivan Jeron DETTA. IRTI 3. Malaysia.Z (2006). Islamic Banking: It¶s Operating Mechanisms. Therefore. (2007). References 1. (2006). (2004). Kuala Lumpur. International Islamic University Malaysia 2. Edited by Ataul Huq Pramanik. as it is true concept of Islamic banks. Islamic banking and Finance. such as venture capital and private equity. Pearson Longman. Mannan.& Efazuddin Mallick. 6. Kuala Lumpur. Mei Pheng. School of Management. It is also observed that Islamic banks tend to be favour the murabahah technique rather than profit/loss sharing. effort should be made to harmonize the funds standard in Islamic banks in Muslim Countries. Selecte papers from Conference in Brunei. edited by Ataul Huq Pramanik. Dinamas Publishing 7. University Utara. M. Contemporary Practices of Islamic financing Techniques.edited by Salman Syed Ali and Ausaf Ahmad.It is also evident that there has no exhaustive funds standard in Islamic banks. Research center. In writings on Islamic banking . organized by Islamic Research and Training Institute and University Brunei Dar Salam. Sadeque. Therefore.