Economic Substance or Legal Form: An Evaluation of

Islamic Finance Practice
Muhammad Hanif FCMA
1
Abstract
Islamic banking, based on principles of Islam, was started in last quarter of twentieth century
and got momentum in first decade of twenty first century. By the end of December 2011, Global
volume of assets, under Islamic financial system, have reached to US $ 1,289 Billion. This study
is conducted to examine legal form as well as economic substance of contracts used by Islamic
financial industry. Five most widely used contracts including Murabaha, Ijarah, Diminishing
Musharaka, Skuk and deposits, were selected to test against the theory of Islamic financial
system. It is found in the process that legally contracts are in line with theory, however economic
substance is not very different from conventional counter parts. Through application of
alternative calculation measures and proper training of human resources, Islamic financial
Institutions can shift economic substance of contracts in line with theory of Islamic finance.
I-Introduction
Islamic banking was started in last quarter of 20
th
century and got momentum in first decade of
21
st
century. Global volume of assets under Islamic financial system has reached to US$ 1,289/-
billion by the end of December 2011 (IFSL-2012) with above 300 institutions operating in more
than 50 countries. Islamic banking was emerged as a reaction to Haram (prohibited by Islamic
code of life) practices in financial sector including Riba (interest & usury), Gharar (uncalculated
risk) Myser (game of chance) and financing for Haram (prohibited) businesses
2
.
In order to address these issues especially Riba (interest & usury) a modified model of
banking was required. Riba is the foundation on which whole structure of modern conventional

1
Assistant Professor, FSM, National University of Computer & Emerging Sciences, Islamabad
2
Examples of prohibited businesses include liquor, pork, pornography, promotion of adultery etc.
banking stands. Thus existing contracts (including overdraft, credit card, export financing,
agricultural loans, short, medium and long term loans, leases and mortgages etc) of conventional
banking primarily based on Riba was not suitable in their original form for Islamic banking.
Hence, modified business contracts (between bank and customers) were introduced based on
principles of Islamic financial system. Major contracts introduced by Islamic financial system
are categorized as asset based financing (trade & rentals), profit and loss sharing (Musharaka &
Mudaraba) and capital market (equity funds, Skuk).
Analysis of these contracts suggests that nature and role of Islamic banking is different
from conventional banking. Islamic banks are not dealers in money rather dealers in goods (asset
based financing), business partners sharing risk and rewards (Musharaka & Mudaraba),
investment companies (equity funds & Skuk). In spite of difference in nature and role, Islamic
banks are also meeting the same needs of customers as conventional banks do, albeit in a
different way, hence both are competitor. Competition between Islamic and conventional
banking is major driving force in operations of Islamic banks as for provision of services and
earning of returns is concerned.
Islamic financial industry has knowingly and willfully benchmarked its operations to
conventional banking being immediate competitor. During this process through financial
engineering many products were developed within Shari’a constraints matching with the
alternative products of conventional financial industry. This led the industry to focus on legal
form and ignore economic substance of underlying transactions. This practice of being
competitive with conventional banking raised questions in the minds of common man as what is
the difference between conventional and Islamic banking. Confusion also arose to expert (in
Shari’a) level; as a result a Fatwa against current Islamic banking was issued by Jamia Banori
Town, Karachi in 2008
3
. Also market participants [finance professionals] are skeptical about
operations of local Islamic financial industry (Hanif, 2012). One of the issues in Islamic financial
industry is application of conventional banking based calculation software to determine financial
rights and obligations, which definitely bring the installments payable by customers and profit
allocated on deposits very close to conventional banking. Furthermore, these software were
designed keeping in view time value of money which is rejected by Islamic financial system
theoretically, however study is needed to comment on practice.

3
Murawajja Islami Bankari (Urdu), Maktaba Bayyanatt, Jamia Benori Town, Karachi, Pakistan.
This study is intended to identify and analyze gaps (if any) between theory and practice
of Islamic financial system to address the general confusion among the masses. Focus is to test
legal form of selected contracts on Shari’a principles and analyze economic substance to
document evidence. Findings suggest that although financial contracts take into account legal
form, however economic substance is ignored. Rest of study proceeds as follow. In section two
background (history and principles of Islamic finance) is documented, followed by purpose and
methodology in section III. Analysis is documented in section IV while section V concludes.
II-Background
IIA-Historic Development
Modern Islamic banking is a recent development in Muslim world, after getting liberation from
colonial power in second half of 20
th
century. Syed Modoodi in subcontinent was the first
scholar who criticized the existing practice of interest based banking. First ever practical
experience of interest free banking was done in a town of Egypt in 1963, which could not last
longer. Mile stone in the history of Islamic banking was conference of OIC foreign ministers in
1973, where establishment of Islamic Development Bank was decided. Dubai Islamic bank
started operation in 1975. After 1979 revolution Iran shifted whole of its economy on interest
free operations. Malaysia started program of Hajj financing (Tabong Haji), later on converted to
full fledge Islamic banking.
In Pakistan although it is recognized constitutionally that interest free banking would be
the banking of economy (Articles 2, 31, 37, 227), however first ever genuine effort was made by
Council of Islamic Ideology (CII) in 1980 in the form of first ever report on elimination of
interest from the economy and suggested transition and implementation of Islamic banking at
operational level. Pakistan started efforts initially by converting specialized financial institutions
(e.g. HBFC, ICP) and transformed total banking system on interest free system in 1985.
However this optimism failed very badly due to lack of human resource expert in Islamic
banking and operations of banking industry continued on conventional system under the
umbrella of profit and loss sharing.
This hypocrisy was not acceptable to practicing Muslims of Pakistan and they took the
matter to federal Shari’a court. Apex court issued order in 1991, declaring the existing practice
Haram (prohibited), and ordered the government to take drastic measures for implementation of
interest free banking as agreed in constitution of Pakistan. After receiving the order of court
government of Pakistan analyzed its strengths and weaknesses and once again lack of trained
human resources hindered the state from converting conventional system into Islamic.
Government of Pakistan responded through two pronged strategy. First; a commission was set up
under the able chairmanship of Raja Zafar ul Haq to analyze whether interest free system is
workable (in fact to re-invent the wheel, as same job had been done by CII in 1980). Second;
government went into appeal against the federal Shari’a court decision in Shari’a appellate bench
of supreme court of Pakistan (to get some time in implementation of decision). It is interesting to
note there was above 60 appeals, against the decision of federal Shari’a court, in Supreme Court
of Pakistan which were heard by honorable court as a single case. This shows the deep roots and
resistance level displayed by promoters of conventional financing in Pakistan. Government failed
on both fronts. Commission recommended the applicability of interest free system, and in 1999,
Supreme Court issued a detailed decision favoring application of interest free economy (Supreme
Court of Pakistan 1999).
By early 2000, state bank of Pakistan (SBP) adopted a different strategy, of promoting
Islamic banking, as parallel to conventional banking. Islamic banking department (IBD) was set
up in SBP to guide, facilitate and regulate Islamic banking stream. By the end of June 2011, 17
(5+12) banks are operating in Pakistan with a branch network of 799, assets under operation are
PKR 560 Billion, deposits PKR 452 Billions, financing and investments PKR 420 Billions.
Islamic banking is covering approximately 8% of market share (SBP-2011).
IIB-Principles of Islamic Finance
Islamic finance is based on Shari’a (Islamic law). Ulema (Clerics in Islamic law) have identified
objectives of Shari’a including safety of faith, Life, property, next generation and intellect (Hifz
ul Eemaan, Jan, Maal, Nasal and Aqal) [Siddiqi 2010]. Every design of community institution
should at least ensure conformity with objectives of Shari’a if not enhance performance on these
fronts. Based on these objectives of shari’a following principles of Islamic finance have been
documented by Clerics.
1. First is prohibition of interest and usury in financial dealings. In Qura’n four sets of
verses have been identified dealing with the charging of Riba
4
(30:39, 4:161, 3:130, & 2:275-
281). Several Hadiths (traditions of Prophet Muhammad PBUH) clearing the meanings of Riba
in various transactions have been reported (khan, 1989). Furthermore resolutions of council of
Islamic Fiqh Academy are very much qualifying the status of Ijma’a (consensus) on the issue of
Riba. Also there are several Ulema (clerics) who declared both usury and commercial interest
Haram (Unlawful) (e.g. see Usmani 1999, 2002 & Usmani 2003, Qarzawi, Maudoodi 1961,
Rehman, Siddiqi 2006, Chapra, Zaman 2010, Ayub 2007). Implication of this principle of
Islamic finance is discouraging time value of money in its conventional banking sense. Under
Islamic financial system money is mere a medium of exchange and not a factor of production.
Human labor is required in addition to money to earn a return, hence there is no fixed return for
capital, however capitalist can participate in business under profit and loss sharing with or
without participation in management of entity.
2. Second principle of Islamic finance is avoidance of Gharar (uncertainty) in a business
transaction (Ayub 2007,page 57; Mansoori 2007, page 179; Ghazi 2010, page 237). Ayub 2007
defines “Gharar refers to entering into a contract in absolute risk or uncertainty about the
ultimate result of the contract and the nature and/or quality and specifications of the subject
matter or the rights and obligations of the parties [page 75]. Mansoori 2007, documented that
Gharar contains [certain] characteristics such as risk, hazard, speculation, uncertain outcome, and
unknown future benefits.
3. Third principle of Islamic finance is avoidance of Myser (speculation) or any game of
chance (Ghazi 2010). Ayub 2007, documented that Maisir refers to easily available wealth or
acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar (similar to
Myser) means the game of chance; one gains at the cost of other(s) right [page 62]. Myser is
prohibited by Holy Qura’n [ 2: 219 and 5: 90] as well as in Hdiths (Khan 1989, page 92)
4. Fourth principle is profit and loss sharing. According to this principle capitalist
demanding profit on capital should also participate in loss as well (Khan 1989, page 71; Usmani
2002, page 87; Ghazi 2010, page 386; Khan 2007, page 307 & Shari’a standard 12). According
to this principle an investor can earn return on his investment subject to risk of loss, hence
concept of risk free return is disappeared under Islamic financial system.

4
Reported in the order of revelation. First Surah (chapter) number then Aya (verse) number.
5. Fifth principle of Islamic finance is financing for only Halal (permitted) businesses.
According to Qardawi
5
“Nothing is Haram except what is prohibited by a sound and explicit Nas
(Verse of Qura’n and an authentic Sunnah) from the law-Giver Allah SWT. Ulema has made the
list of prohibited businesses in which investment for Muslims (Islamic banks) is prohibited.
Activities such as liquor, pork, pornography, adultery, dance clubs, conventional banking,
insurance etc are unlawful, hence earning return through investment in any of these activities is
not allowed under Islamic financial system(KMI-30).
To conclude Islamic financial system ensures justice between savers and investors. By
demolishing risk free return and promotion of profit and loss sharing, justice is ensured for both
parties i.e. capital supplier as well as capital user. As a model of modern commercial banking,
initially capital is supplied by depositors and later on by bank to business community. Under
Islamic financial system bank can invest in businesses to earn variable return based on actual
results of activities and share profit earned with depositors based on agreed sharing formula.
Hence it is ensured to distribute the actual outcome and none is to bear risk alone and none is to
earn with zero risk.
III-Purpose and Methodology
This study is intended to analyze and test the financial contracts (being used in practice by
Islamic banks) against the theory of Islamic financial system. In summary following are study
objectives:-
1. A survey of calculation methods applied in (selected) financial contracts in Islamic financial industry.
2. Identification of contradiction of financial calculations with Shari’a compliant financial system
3. Suggestion of modified methods for calculation of financial rights and liabilities.
In order to achieve the above stated objectives we got access to calculation process applied by
local Islamic financing industry and obtained standard contracts as used in day to day business
dealings. After getting sufficient required information we tested calculation methods one by one
as per laid down Shari’a principles. We accepted the calculation methods which are in line with
dictates of Shari’a and rejected the method(s) contradicting with Islamic law. We present to the

5
http://www.ymsite.com/books/lpi/ch1-
pre.htm#1.%20The%20Basic%20Asl%20Refers%20to%20the%20Permissibility%20of%20Things accessed on Dec
9, 2012.
market alternative calculation methods in order to judge Shari’a compliance, economic impact
and suitability in application. We have also analyzed the calculation assumptions and bench
mark used by Islamic banking in comparison with other available options. On assets side of
balance sheet of bank, Our focus is on only four products (including Murabaha, Ijarah,
Diminishing Musharaka and Skuk) offered by Islamic financial industry. On liabilities side we
have selected deposits collection mechanism used by Islamic financial industry for examination.
Selection of contracts on asset side is based on sole criterion of relatively excessive use by
Islamic financial institutions (IFIs) and relatively higher share in earning portfolios of IFIs.
IV-Analysis
Based on Islamic finance principles following modes of financing were developed by Islamic
banking. These modes are classified objectively as Asset based financing (Murabaha, Muajjal,
Salam, Istisna’a and Ijarah), profit and loss sharing financing (Musharaka, Diminishing
Musharaka and Mudaraba) and capital market financing (equity funds and Skuk). In this study
we have selected five types of contracts including Murabaha (overdraft), Ijarah (leasing)
diminishing Musharaka (mortgages), Mudaraba (Deposit collection) and Skuk (bonds) for
analysis. Selection of these contracts for examination is based on the sole criteria of their larger
application in practice. In Pakistan share of these types of financing are very high in overall
portfolios of Islamic banking industry including Murabaha 40%, Ijarah 22% and Diminishing
Musharaka 26%, while Mudaraba for deposit collection.
A-Murabaha Financing
Murabaha is a sales contract whereby cost of goods sold is disclosed to the buyer. In its original
form as a contract of sales it has nothing to do with credit provision or financing facilitation.
However given the matching feature of Murabaha with conventional banking, its application is
largest in the financing and investment portfolios of IFIs working in Pakistan. In fact during
Sept. 2006 to Sept. 2010, share of Murabaha financing was slightly above 40% in financing and
investment portfolios of Islamic banking industry in Pakistan (Hanif, 2011). Any customer
comes for any business need, preference is given to Murabaha contract if applicable. Procedure
is very simple and makes the job of bankers easier. Whatever price of a product exists in the
market, Islamic banks are adding the KIBOR rate as profit margin based on the length of credit.
To make the concept clear following example would be helpful. A person needs a Laptop for his
son studying in a local University. Market price is Rs; 50,000/- and KIBOR rate is 10%.
Customer needs financing for 1 year. Working is presented as under. If customer pays in single
installment at completion of one year then his financial liability is amounting to Rs; 55,000/- if
he pays in two semiannual installments he is required to pay two installments of Rs; 26,890/-
with a financial obligation of Rs; 53,780/- which is less than yearly payment equal to Rs; 1,220/-
Like wise if he makes payment in four quarterly installments then amount of each installment
becomes Rs;13,291/- with financial obligation of Rs; 53,164/- which is lesser in amount under
annual and semiannual payment plan equal to Rs;1,836/- and Rs; 617/- respectively. If customer
opts for monthly installment then amount of an installment becomes Rs; 4,396/- with financial
obligation of contract amounting to Rs; 52,750/- which is less than annual, semiannual and
quarterly installment equal to Rs; 2,250/-; Rs; 1,031/- and Rs; 414/- respectively.
Shari’a risk in such a contract is indulging in time value of money. As per Murabaha sale
one can charge any profit rate as agreed with buyer including KIBOR and KIBOR plus. Likewise
one can agree to any payment plan including spot, credit, single payment, semiannual plan,
quarterly plan, monthly plan or any other. However one cannot increase or decrease amount
receivable on the basis of early or delayed payment which is being violated in practice. At ten
percent profit rate price of computer becomes Rs; 55,000 irrespective of any payment plan.
However as we saw price varies according to receivable schedule. For single payment at end it is
Rs; 55,000/- for semiannually installments it is Rs; 53,780/- for quarterly installments it is Rs;
53,164/- and finally under monthly payment plan it is Rs; 52,750/-. What is justification of four
different amounts to be recovered from customer except time value of money? Under this
principle of determination of financial rights and obligations if payment plan extends to more
than a year then price would be higher than Rs; 55,000/-
As for legal status of contract is concerned, nothing wrong in it and IFIs have the right to
negotiate any price (Ayub, 2007, p.218, Shari’a standard 8), however economic substance is
suffered. Under sales contract essence is to charge profit irrespective of length of receivables.
Islamic finance discourage time value of money, while charging different profit based on length
of period, brings back time value in the transaction resulting in matching economic substance
with conventional banking.
What is the way out? As a matter of principle time value should be given up, however
this will turn operations uncompetitive with conventional banks. Important question is the
decision making process of customers of IFIs. In depth studies are required to answer the
question. Very limited studies available so for on the subject, have concluded that customers of
IFIs are doing business with these banks assuming Shari’a compliance in their operations. Chief
motivating factor to choose an Islamic bank is the avoidance of interest and Shari’a compliance.
If this is true then leaving time value concept should not be difficult for Islamic financing
industry. IFIs should charge a single price irrespective of payment plan. E.g single price should
be negotiated with customer for one year credit and customer should be given the flexibility to
discharge obligation within one year as per his/r convenience.
B-Ijarah Financing
Ijarah is reward for a service. Ijarah (Leasing) is a rental contract whereby IFI leases an asset for
a specific rent and period to the client. Ownership risks of the asset are borne by IFI while
expenses relating to use the asset are the responsibility of client. The difference between Ijarah
and sale is that ownership in Ijarah remains with lesser while in case of sales it is transferred to
purchaser. Ending Ijarah in sale of asset is allowed by IFA through a separate contract at
completion of term of lease. Contract can be executed prior to purchase and possession of asset.
Consumables cannot be leased out. Right of lessee to use the asset is restricted to lease
agreement or/and as per normal course of business. Lessee is liable for any harm to the asset
caused by any misuse or negligence on his part. Rentals of joint property are shared according to
equity. A joint owner can rent his share only to the co partner. Inter Bank Rate can be used as a
benchmark for amount of rentals. At the completion of Ijarah term either asset is returned to IFI
or purchased by client (Shari’a standard 9).
Although in theory Ijarah is a rental contract whereby rent of the asset should be
determined on the basis of aggregate demand and supply of assets available on rent. Also
ownership risks are required to be born by lessor. At completion of lease tenure either asset may
be taken back or sold to lessee. However in practice except legal form of the contract all
calculations are deto copy of conventional leasing. Islamic banks determine rentals on the basis
of KIBOR where by principal amount as well as required return is ensured. Further more
principal amount is also recovered along with rentals (Hanif, 2011).
Suppose, on January 01, 2006, ABC Company contacted the Gujranwala branch of bank
to provide a car costing Rs; 1,500,000, on lease for five years, payable in five equal annual
installments at the beginning of the year. Bank promised to gift the asset after five years subject
to prompt payment of lease rentals. Bank wants to earn 10% per annum on this deal.
Two of the calculation methods are explained here. First is traditional method of
installment calculation by applying following formula P = R|1 −
(1+ì¡m)
-nm
ì¡m
](1 + i) Where P
is the amount spent on purchase of asset, R is the installment, I is the rate of return, n is the
number of years and m is number of compounding in a year. This formula is based on concept of
time value of money hence not recommended for use in Islamic modes of financing. As per this
formula if we calculate five equal annual installments compounded annually amount of each
installment becomes approximately Rs; 359,700 rounded to 100.
Table I- Breakup of Returns and Principal
End of years Installment Interest Principal Balance
0 359,700 - 359,700 1,140,300
1 359,700 114,030 245,670 894,630
2 359,700 89,463 270,237 624,393
3 359,700 62,439 297,261 327,132
4 359,700 32,713 326,987 146
Total 1,798,500 298,646 1,499,854 2,986,601
In present practice following observations demand attention of experts in the field of Islamic
financial system
1. First is the charging of rent based on KIBOR plus a certain percentage. KIBOR is cost of
capital and not the rent of an asset. KIBOR is determined through demand and supply of
capital, if free market is in operation, or based on return offered by government for its
borrowing. While asset rent is determined based on total demand and supply of a
particular asset on rent. Rent of assets is determined independently (e.g. rent of vehicles
is higher than KIBOR and rent of houses is lesser than KIBOR in Pakistan).
Consequently when rent is charged on the basis of KIBOR, economic substance of
transaction disappears under Islamic financial system, however matches with
conventional banking.
2. Second is recovery of price of asset through sale at the end of Ijarah term. at present asset
is sold at par value which make the transaction competitive with conventional banking.
Practically certain assets lose their value and should be sold at less than par (e.g. Cars,
Machines etc), while others appreciate in their value (e.g houses). Islamic financial
system dictates to sell asset at market value in its essence, while under present practice,
real economic substance of transaction based on risk and return is compromised.
It is interesting to note as for legal form is concerned, nothing is being violated. In both cases
listed above nothing is against Shari’a law; one can charge any rent for his asset and one can sell
at any price as agreed between the parties (Shari’a standard 9), however the difference which
Islamic financial system wants to create is absent.
Here we are suggesting an alternative calculation method under Ijarah. This method
suggests calculating rent on the basis of rentals of underlying asset prevailing in the market.
Suppose rental of this type of car is Rs; 216,000 [18,000 per month] in the market but without
transfer of ownership. It is assumed impact of any inflation on rentals shall be equally off set by
the depreciation in value of car, hence, no increase in rentals. Suppose further after five years,
estimated residual value of car is Rs; 875,000. As bank has promised to gift the car at the end
without any consideration so the capital and return must be recovered through installments. To
accelerate the payments, residual value is included in the amount of installments hence amount
of each installment becomes 391,000 [175,000+216,000]. Bank shall receive Rs; 391,000 of
investment immediately hence no return for this amount. So actually investment is Rs; 1,109,000
and bank receives extra for four years amounting to Rs; 455,000 [(391,000 X 4) – 1,109,000]
which is 41% of original investment and average annual return is 10.3%.
Table II- Breakup of Rentals and Principal
End of years Installment Rentals Principal Balance
0 391,000 216,000 175,000 1,325,000
1 391,000 216,000 175,000 1,150,000
2 391,000 216,000 175,000 975,000
3 391,000 216,000 175,000 800,000
4 391,000 216,000 175,000 625,000
Total 1,955,000 1,080,000 875,000 4,875,000
Certainly amount is higher from conventional banking; actually customer is required to
pay an additional amount of Rs; 156,500 (in present value terms 130,500) rounded to 100 during
the lease term. Is it a cost of being Muslim as some quarters claim; and following Islamic
financial system? Answer is no! a strong No! Look at the nature of contract under both systems.
First is the bearing of risk level by investor; and demanding higher return for higher risk is well
established and accepted principle of finance. IFI is bearing total risk of ownership during lease
term and mitigates through permissible mode of insurance on its own expenses, while under
conventional leasing system risks are transferred to customer. Second if asset demands certain
overhauling IFI do not receive the rentals while under conventional system installments are
required irrespective whether asset is in repair or usage phase. IFIs should promote this
philosophy among their customers that investor deserves higher return keeping in view the
bearing of more risk as compared to conventional leasing. I recommend the second method to be
used in calculation of rentals, under Ijarah, by IFIs.
C-Diminishing Musharaka
Literal meaning of Musharaka is sharing. Its root in Arabic language “Shirka” means being a
partner. Musharaka means a joint enterprise formed conducting some business in which all
partners share the profit according to pre-agreed ratio while loss is shared according to the ratio
of contribution (Meezan bank guide 2002). For a valid Musharaka fulfillment of certain
conditions required. First is there must be an agreement written (verbal) among the partners
stating clearly the terms and conditions including management, capital contributions, profit and
loss sharing among the partners. Second capital can be contributed in cash as well as in assets.
However once an asset is contributed as capital that belongs to firm and contributing partner is
relieved from the bar of risks and returns attached with ownership of that asset. Third profit is
distributed according to agreement of partnership however sleeping partner cannot claim share in
profit more than his proportionate share in equity. None of the partner can guarantee the capital
or profit share to any other partner (Shari’a standard 12).
Diminishing Musharaka is form of declining partnership between IFI and client generally
used to finance real estates. When a customer requests to IFI for financing to purchase an asset
IFI participates in the ownership of asset by contributing required finance. Certain portion
(e.g.20%) must be contributed by customer. Total equity of bank is divided into units of smaller
amounts which are purchased by client in installments. Under this mode of financing one of the
partners (client) promises to buy the equity share of the other partner (IFI) gradually until the
title to the equity is completely transferred to him. Buying and selling of equity units must be
independent of partnership contract and must not be stipulated in partnership contract. Generally
IFI rent out his share to client and earns rentals. Any profit accruing on property is distributed
among the co owners according to agreed ratio however losses must be shared in proportion of
equity (Shari’a standard 12).
Again theoretically it is purchase of house under joint ownership and later on rent of the
property is shared by partners. Practically bank rent out its share to the customer and receives
rentals proportionally. At the same time total interest in property of bank is divided in smaller
units of equal value depending upon the nature of rentals. Customers pay the installments which
constitutes a portion for rent and another portion for purchase of units. Following example would
clarify the concept. Mr ABC is went for Islamic house financing to acquire the house in
Islamabad. Cost of house is Rs; 5000,000. As per terms of contract 20% is to be paid by
customer and balance by an Islamic bank. KIBOR is 9% and bank charges to this customer
KIBOR plus 1%. Term of the contract is 5 years. Let us further assume following table III
KIBOR and property inflation rates for 5 years.
Table III- KIBOR and Inflation Rates
End of Years KIBOR Inflation
00 -0- -0-
01 09% 07%
02 10% 07%
03 10% 08%
04 11% 09%
05 10% 10%
It is further assumed that at beginning average rent of property in that area is Rs; 240,000 per
year. As per prevailing practice following table-IV analyses the five yearly payments. Rent is
charged as a percentage (return/Interest) on balance payable and shares are sold at par.
Table IV-Analytical table under prevailing Method
End of years Installments Rent Principal Balance
0 1,000,000 - 1,000,000 4,000,000
1 1,200,000 400,000 800,000 3,200,000
2 1,152,000 352,000 800,000 2,400,000
3 1,064,000 264,000 800,000 1,600,000
4 992,000 192,000 800,000 800,000
5 888,000 88,000 800,000 -
Following observations are worth mentioning and demands immediate attention of leaders in
Islamic financial system
1. Rent is charged on the basis of KIBOR plus a certain percentage and not on the basis of
rent prevailing in market. KIBOR is return on capital and not rent of property. Property
rent is determined independently based on demand and supply of houses in a region and
also it varies from region o region. In case of Pakistan property rents are much lesser than
KIBOR rate
6
.
2. Sale of units at par value is also not in line with essence of Islamic financial system. It
should be based on market value, which creates the real difference in Islamic and
conventional system. If it is Musharaka as it is claimed then no question of guaranteed
return to any of partners. Under present system return is guaranteed to banker in the form
of rent as well as purchase of equity share at par value. This practice takes away
economic substance of Islamic financial system and matches trisection with conventional
banking as for economic substance is concerned.
By looking at legal form of contract one can conclude as nothing is against Shari’a law. One can
charge rent of house as per his own calculations based on any bench mark including KIBOR rate.
Also one can sell his equity share on any price as agreed between seller and buyer (Shari’a
standard 12). However the unique thinking of Islamic financial system of variable return does
not exists in the transaction. Mentality of fixed and certain returns for banks prevails in the
transaction. With this practice Islamic financial system cannot be accepted as superior
particularly in avoiding real estate crisis as occurred in United States in 2007-08. If rent is to be

6
In Islamabad average rent of a house is about Rs. 60,000 with market value of Rs. 20 million, resulting in 3.6%
return while KIBOR is about 12%. Also rent of a same house in Islamabad is much different from Rawalpindi city.
charged on KIBOR and equity shares are to be sold at par then such crisis cannot be avoided,
however if rent is to be charged based on market rent of property and equity units are to be sold
based on market value then it is guaranteed that such crisis could not happen.
Although legal requirements are fulfilled, however substance of the transaction is not
matching with theory. Theory suggests earning rent of property and not of money, as well as no
question of selling shares at par value while market value is different from par. Following table-
V shows calculations in line with theory.
Table V-Analytical table under proposed method
End of Year Property Value Rentals Share of Bank Share in Rent Unit Price Installment
0 5,000,000 - 1,000,000 1,000,000
1 5,350,000 240,000 0.80 192,000 800,000 992,000
2 5,724,500 256,800 0.64 164,352 856,000 1,020,352
3 6,182,460 274,776 0.48 131,892 915,920 1,047,812
4 6,738,881 296,758 0.32 94,963 989,194 1,084,156
5 7,412,770 323,466 0.16 51,755 1,078,221 1,129,976
Total 36,408,611 1,391,800 - 634,962 5,639,335 6,274,296
The difference in two tables is clear. In second case units are sold on the basis of market value as
well as rent is charged on the basis of rents prevailing in the market which links financial sector
to real sector. In first table rent is charged on the basis of KIBOR which is not preferable under
Islamic financial system. Calculation in second table is in line with theory where rent of property
(and not of capital) is charged as well as units are sold on market value ( and not return of
principal). Under prevailing practices (where economic substances of Islamic housing is
matching with conventional), one cannot claim superiority of Islamic financial system in
economic crisis like 2007-08 in the housing sector of United States.
D-Skuk
Skuk is a creation of IFIs to meet their liquidity requirements. Skuk provide an opportunity to
distribute the value of an asset/enterprise/project/usufruct into smaller amount certificates of
equal value to create an opportunity for small investors to share the benefits of investment which
is otherwise impossible keeping in view the larger amounts required to acquire or build an asset
or enterprise/project. According to Shari’a standard # 17 investment Skuk are certificates of
equal value representing undivided shares in ownership of tangible assets, usufruct and services
or (in the ownership of) the assets of particular projects or special investment activity, however,
this is true after receipt of the value of the Skuk, the closing of subscription and the employment
of funds received for the purpose for which the Skuk were issued. All Skuk are tradable in
secondary market.
Skuk market has got momentum under Shari’a compliant financial system. According to
ISI Emerging Markets
7
, approximately 2000 issues of Skuk were held with Global volume of
around US $200 Billion by the end of June 2010. In addition to corporate Skuk, Sovereign Skuk
are also issued by the governments including Pakistan, Jordan, UAE, Thailand, Malaysia,
Turkey, Indonesia, Bahrain, Qatar, Cayman Islands, Singapore, Germany, Brunei, Gambia and
Kuwait. Concept of Skuk is initially developed to replace the conventional bonds having features
of fixed return, money back security/guarantee and ready market for liquidation. However under
Islamic financial system even Skuk cannot guarantee of all the features of conventional bonds
listed above. Different types of Skuk are offering varying degree of feature(s) of conventional
bonds. Objective classification of Skuk places them into either fixed return Skuk or variable
return Skuk. Variable return Skuk are very much similar to equity securities rather than
conventional bonds, however fixed return Skuk are having some of the features of conventional
bonds (Hanif, 2011).
Following observations came to our knowledge during study process of Skuk, which are being
presented for attention of experts.
1. An important observation about Skuk issued so for is redemption of certificates at issue
price. Skuk are certificate of ownership in an asset(s) or an organization and should be
redeemed at market price of asset(s) or organization. Announcement of redeemable price
at the time of issue is not appropriate. If Ijarah Skuk (somehow dominating) are issued,
under most of the cases value of assets gone down by the time of redemption, hence
redeeming at par value takes away economic substance of transaction under Islamic
financial system. While in case of Musharaka Skuk redemption value could be more as
well as less than par value depending upon the performance of underlying entity. This
practice is pushing the economic substance of transaction very near to conventional
banking, although partial risk sharing present.

7
www.123 accessed on 5
th
July, 2010.
2. Second is offering return based on KIBOR plus a certain percentage of profit. Islamic
financial system encourages sharing of actual outcome, which can be more as well as less
than KIBOR. In case of Musharaka Skuk, nothing is known with certainty, but still return
is offered based on KIBOR plus (e.g. JAZF Skuk), while in case of Ijarah Skuk rent of
the underlying asset(s) prevailing in the market is different from KIBOR plus. This
practice takes away the economic substance of transaction as should be under Islamic
financial system and bring it very near to conventional banking, although partial risk
sharing is still there.
3. Third is the independent guarantee of return by third party under Skuk agreements. Due
to this guarantee of independent third party without consideration, whole philosophy of
Islamic financial system is being compromised. For investors return is certain, then where
is the difference of conventional and Islamic financial system.
Very interesting to note that as for legal form is concerned nothing is violated.
8
One can sell his/r
equity holdings at any price (including par value) as agreed between buyer and seller (Shari’a
standard 17). As well as one can charge whatever rent s/he thinks appropriate on his assets. Also
one can decide any distribution of profit linked with any bench mark (including IBOR) and
reserve the balance or give to managing partner or company as incentive payment. Finally any
independent third party without having consideration can guarantee return to any of the partners
(Skuk holders) [Shari’a standard 17]. However economic substance of transaction (as claimed by
Islamic financial system) is compromised through fixing IBOR plus returns, redemption at par
value and also by providing guarantee.
Ideally returns on Skuk should be provided on the basis of actual returns generated from
the business. An Ijarah Skuk should provide the return to holders on the basis of actual rent of
assets and Musharaka Skuk should distribute profit on the basis of actual profit earned instead of
IBOR plus certain basis points. Likewise redemption price of Skuk should be decided on the
basis of actual market value of assets, instead of redeeming at par. If value of assets against
which Skuk were issued has been decreased (usually in case of Ijarah Skuk) or increased (usually
in case of Musharaka Skuk) then redemption at par value must be discouraged. It is very valid
view that return on Skuk should be at least at par with conventional bonds; however, the

8
Very interesting case of Enron (USA) is recommended to readers to study for understanding of “Form over
Substance”
objective can be achieved through higher rentals in case of Ijarah Skuk. In case of Musharaka
Skuk, these are equity units and should be served on the basis of actual results. Market itself will
decide the intrinsic value of securities and should be called for redemption on market price in
order to promote the real essence of Islamic finance i.e. sharing of risk and reward.
E-Deposits
Mudaraba is the chief tool of deposits collection for Islamic financial institutions. Current
deposits are accepted as loans from depositors which can be withdrawn on demand by
depositors. Some of the Islamic banks are accepting these deposits as Ammanah. If Ammanah
deposits are lost without negligence of bank, making the loss of depositors good is not
responsibility of the bank, hence, Ammanah deposits are not recommended to safeguard the
interest of both bank and customers. Under loan current deposit scheme bank has the flexibility
to use the funds and customer is protected from loss of amount in case of any miss-happening
(burglary, fire, theft etc.) in any branch of bank. Saving deposits are accepted under profit and
loss sharing schemes hence Shari’a rulings of Musharaka and Mudaraba apply as the case may
be. Generally banks are accepting deposits under Mudaraba then mix the funds of bank and
create a joint pool for investment. Out of this pool after meeting the statutory reserve
requirements investment portfolio is created and managed by IFIs. Any profit generated on
investment portfolio is shared by bank and depositors. As deposits are not fixed hence depositors
are free to deposit and withdraw which had created problem in profit distribution. IFIs came up
with solution of profit distribution on daily product basis. Third category of deposits is time
deposits under profit and loss sharing system. Under the scheme deposits are accepted for a fixed
period which provides opportunity to IFI to invest in more profitable long term projects hence
depositors of this scheme are getting higher profit in comparison of second scheme discussed
above. Longer the period, higher the rate of return is earned. Higher return to longer period
deposits is justified because it provide an opportunity to IFI to invest the funds in long term
projects, generally giving higher return, without the fear of returning to depositors on demand.
As for legal matters are concerned, every scheme is duly certified by Shari’a experts. In
every Islamic bank, Shari’a advisor as well as supervisory board exists. However following
observations demand due care from experts in the field. It is practice (knowingly & willfully) of
Islamic financial industry to serve the depositors at least equal to conventional banking in order
to retain deposits. As for investment of funds by Islamic banks is concerned, resulting return may
or may not be sufficient to service depositors at par.
1. In case of actual return to depositor is more than conventional banking, Islamic banks are
happy, however if actual return to depositors is less than return offered by conventional
banks, usually IFIs sacrifice their share in profit to compensate the deficit of depositors.
At legal front there is no issue and any of partner can sacrifice his share in favor of other
partner, however this practice take away economic substance of transaction under Islamic
financial system and match with conventional banking.
2. Another issue is sharing of gross profit with depositors; hence in certain instances
(especially in initial years of a IFI) even if banks suffer net loss, depositors are gaining
return on their savings. In addition to compromising on economic substance under this
sheme, doubts in the minds of masses are also created as where is the difference between
conventional and Islamic banking.
As for legal form of contract is concerned, there is nothing against Shari’a, and one can negotiate
a contract of Mudaraba to share gross profit instead of net profit. Also there is no bar in
sacrificing share of profit by one partner(s) in favor of others without prior agreement, at the
time of profit distribution, however in the presence of such practices economic substance of
transaction shifts from Islamic financial system to conventional banking, leading to doubts in the
minds of masses, consequently jeopardizing future of Islamic financial industry.
In the following paragraph we are presenting our analysis as why this is happening?
There are two different classes of human resources participating in the operations of Islamic
financial system including Shari’a experts (mainly got education in Islamic schools with
negligible banking. Finance and accounting education) and bankers (educated in banking,
finance, accounting and business with very negligible knowledge of Islamic financial matters).
At the time of design of a product input is received as well as approval of final shape is sought
from Shari’a experts, hence legal contracts are designed which ensure formalities, however lacks
economic substance. In fact product development departments of Islamic financial institutions
have focused so for on existing products of conventional banking and offered their Islamic
versions with minor changes to ensure Shari’a compliance. Ideally every Islamic banker should
have knowledge of Shari’a as well as finance to develop new products in line with Shari’a
dictates and also viability in the financial market.
Second is lack of training to existing staff of Islamic financial institutions to think beyond
current practices of conventional banking and understand philosophy of this relatively new
stream of banking, hence IFIs should focus on investing in training of their staff. Also training in
conventional finance and banking is required for Shari’a advisors and Shari’a supervisory board.
Guidelines for a specific course/module should be in practice by regulator (SBP) for bankers in
Shari’a and for Shari’a experts in conventional finance.
Third is external pressure of competitiveness with conventional financial industry, which
can overcome through expansion and growth of Islamic financial industry. Once market share of
Islamic financial industry dominates then bench marks will be settled in collaboration of Islamic
banks.
Also there is need of general awareness among the masses about philosophy and working
of Islamic financial system, so that people accept the concept of profit and loss sharing. At
present depositors expect positive return which makes sense, however perhaps they are not
willing to accept loss (at least it is perceived by Islamic banks). Also there is need to educate the
customers requesting for financing to be willing to share actual outcome of project instead of
comparing cost of Islamic finance with conventional finance.
V-Conclusion
In this study we have tested the calculation process used by IFIs in practice against the theory of
Islamic financial system. It is found that contracts of IFIs are in line with theory as far legal
position is concerned; however, economic substance is not different from conventional banking.
Following major observations are worth mentioning. First is calculations are based on
time value of money resulting in charging of rent based on IBOR plus a certain percentage in
cases of Ijarah, Diminshing Musharaka and Ijarah Skuk. Also time value of money dictates to
share profit under Musharaka Skuk in line with IBOR plus certain percentage and fixing of
prices under Murabaha sale based on length of receiveables. Second is sale and purchase of
equity units on par value ignoring market value. This is also result of bringing time value of
money in transactions. Third is use of guarantee by an independent third party in Skuk
transactions and sacrifice of profit share by IFIs in favour of depositors to compensate them if
actual result is less than conventional counterparts.
Islamic financial system is unique (as is claimed by leaders in the industry), however this
uniqueness is not being displayed in financial contracts which determines financial rights and
liabilities. We selected five types of contracts (including Murabaha, Ijara, Diminishing
Musharaka, Skuk and Deposits) based on excessive use of these contracts by IFIs working in
Pakistan. It is found during the study that although IFIs have linked financing with assets (which
is really appreciable), however profit percentage is decided on the basis of prevailing interest rate
in the market (determined on the basis of demand and supply of capital) and not on the basis of
risk and return of underlying project. After examining the calculation process, alternate methods
suggested which are in line with theory. It is worthy to note that IFIs have to work for education
of customers to inculcate the uniqueness of system. It is required to project, present and practice
true Islamic financial system in order to make a meaningful difference in the global society. We
recommend following measures to experts, policy makers and regulators.
1. New product development mainly based on profit and loss sharing system, ignoring time
value of money.
2. Shari’a education courses/modules for bankers and conventional finance courses for
Shari’a experts.
3. Full fledge qualification on Islamic financial system consisting of relevant Shari’a and
Banking modules should be offered by Business schools keeping in view the potential
growth of industry worldwide.
4. Programs of general awareness among the masses through television programs,
conferences, workshops and provision of relevant literature.
References
1. Ayub, Muhammad (2007). Understanding Islamic Finance. John Wiley & Sons limited, John
Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England.
2. CII-1980. Report on Elimination of Interest, Council of Islamic Ideology, Islamabad, Pakistan.
3. Constitution of Pakistan; Government of Pakistan.
4. Federal Shari’a Court of Pakistan (1991), Decision on Banking Interest (written by Justice Tanzil
ur Rehman).
5. Ghazi, M.A., (2010). Mahazrat e Maeshat o Tijarat. Alfaisal Publishers, Ghazni street, Unrdu
Bazar, Lahore, Pakistan.
6. Hanif, Muhammad, (2011). Islamic Banking: Theory & Practice. Createspace limited liability
company (a subsidiary of Amazon.com).
7. Hanif, Muhammad, (2012). Inside-out: perception of key finance professionals about theory and
practice of Islamic banking. International Journal of Humanities & Social Sciences 2:4, pages
198-208.
8. IFSL-2012, International Financial Services London, Report on Islamic Banking.
9. Khan, M.A., (1989). Economic Teachings of Prophet Muhammad. International Institute of
Islamic Economics, International Islamic University, Islamabad.
10. KMI-30. KSE Meezan Index. Available at www.kse.com, accessed on 14/10/2010.
11. Mansoori, M.T., (2007). Shari’a Maxims on Financial Matters. International Institute of Islamic
Economics, International Islamic University, Islamabad.
12. Modoodi, S.A.A (1962). “Sood” in Urdu, Islamic Publications, Lahore, Pakistan.
13. Murawajja Islami Bankari (Urdu), Maktaba Bayyanatt, Jamia Benori Town, Karachi, Pakistan.
14. Qura’n: The Holy book of religion Islam. Available everywhere.
15. SBP-2011. Islamic Banking Bulliten, State Bank of Pakistan. WWW.sbp.gov.pk.
16. Shari’a Standards-2004. AAOIFI, P.O. Box 1176, Manama, Bahrain.
17. Siddiqi, Nijatullah, (2010). Maqasad e Shari’a (Objectives of Sari’a). Institute of Islamic
Research, International Islamic University, Islamabad.
18. Supreme Court of Pakistan (1999), Decision on Riba, (written by Justice Taqi Usmani).
19. Usmani, M.I.A., (2002). Meezan Bank Guide to Islamic Banking. Dar ul Ishaat, Karachi,
Pakistan.