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Macroeconomics Term Report

Islamic Banking & Finance
Submitted to: Submitted by: Mr. Khalid Mustafa Syed Asad Mehmood MBA Evening MEN-2200475

Macroeconomic Term Report on Islamic Banking and Finance


Table of Contents
Islamic Banking and Finance 1.The Prohibition of Riba in the light of Quran & Hadith …. 2.Brief History of Islamic Banking and Finance 3.Brief Introduction of Islamic Banking and Finance …. ……. 1 2 3 3 4 5 5 5 5 6 6 6 6 7 7 7 8 8 9 10 12 12 13 14 16 ……………… 18

a. Advantages of Islamic Banking System over conventional Banking System ………………. b. Conventional and Islamic Banking, the main difference. c. Islamic Modes of Financing i.Musharakah ii.Mudarabah iii.Diminishing Musharakah iv.Murabaha v.Ijarah (Leasing) vi.Ijarah Wa Iqtina vii.Istisna' viii.Bai Muajjal (Credit Sale) i.Investment in Stock ii.Investment in Mutual Funds ……………. ………………. ………………. ………………. ………………. ………………. ………………. ………………. ………………. ………………. ……………….

d.Permissible Investment Vehicles in Islamic Finance

iii.Investment in Day-to-day Trading………………. e.Problems facing by Islamic Banking and Finance 4.Islamic Banking and Finance, The Global Scenario 5.Islamic Banking and Finance in Pakistan a.Brief History of Islamic Banking and Finance Development in Pakistan ………………. b.The Prominent Icons of Islamic Finance in Pakistan c.Current Status of Islamic Banking in Pakistan …. d.Role of Islamic Banking and Finance in Pakistan Development e.State Bank’s Role in Development of Islamic Finance in Pakistan f.Future Prospectus of Islamic Finance . …….

Macroeconomic Term Report on Islamic Banking and Finance



Most probably, the reader is familiar with the verses of prohibition of Riba in the Quran. Unfortunately, negligent interpretations of the meaning of those verses has led many individuals to assume that the prohibition only relates to situations where the creditor is likely to charge exploitatively high rates of interest. One of the most popular translations of the meaning of the Quran, Yusuf ‘Ali (1991), translates the meaning of verses [2:278-279] thus: 278. 279.

O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are Indeed believers. If ye do not, take notice of war from Allah and His Messenger: but if ye turn back, ye shall have your capital sums; Deal not unjustly, and ye shall not be dealt with unjustly.

The (sole) objective served by the prohibition of Riba is the avoidance of injustice (in the sense of exploitation of the poor debtor by the rich creditor). However, the meaning of the ending of the verse – as explained by ’Abu Jafar Ibn Abbas, and others (c.f. Al-Imam Al-Tabarı (1992, vol.3, pp.109-110)) – is much closer to: “if you turn back, then you should collect your principal, without inflicting or receiving injustice”. The exegetes (ibid.) then explain “without inflicting or receiving injustice” as “without increase or diminution”, where both an increase or a decrease of the amount returned relative to the amount lent would be considered injustice. Muslim narrated on the authority of ’Abu Saıd Al-Khudriy; The Messenger of Allah (pbuh) said:

“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is Riba.”
Muslim narrated on the authority of ’Abu Saıd Al-Khudriy:

Bilal visited the Messenger of Allah (pbuh) with some high quality dates, and the Prophet (pbuh) inquired about their source. Bilal explained that he traded two volumes of lower quality dates for one volume of higher quality. The Messenger of Allah (pbuh) said: “this is precisely the forbidden Riba! Do not do this. Instead, sell the first type of dates, and use the proceeds to buy the other.”
The first Hadıth enumerates six goods, which are eligible for Riba. Since barter trading (e.g. dates for dates, as in the second Hadıth) is rarely of concern today, we shall mainly be concerned with Riba as it pertains to gold and silver, the monies (Roman and Persian, respectively) used during the Prophet’s (pbuh) time. With the exception of juristic schools which denied the use of reasoning by legal analogy (qiyas) as a source of legislation (e.g. the Z.ahirıs), and a few contemporary detractors, most Islamic schools of jurisprudence accepted gold and silver in the first Hadıth to signify money in general, including contemporary monies.
Macroeconomic Term Report on Islamic Banking and Finance



In Muslim communities, limited banking activity, such as acceptance of deposits, goes back to the time when the Prophet Muhammad (PBUH) was still alive. At that time, people deposited money with the Prophet or with Abu Bakr Sedique (RWU), the First Khalif of Islam. The first modern Islamic bank, established in Egypt in 197, was called Nasser's Social Bank. Islamic accounting, an essential tool for the success of Islamic banks, is said to have been developed contemporaneously at the University of Cairo (Crane, p. 80). The desirability of abolishing fixed interest rates and the Islamization of financial systems were discussed at the first meeting of the Islamic Organization Conference (IOC) in Jeddah in 1973. Subsequently, many Islamic banks were founded under the profit-and-Loss sharing system (PLS), which will be discussed below. Modern Islamic banking has undergone three phases of development: Emergence-1972 through 1975: This period was marked by a surge in oil revenues and great liquidity .Parallel events included a resurgence of fundamentalist Muslim movements, reemphasis on the Wahabi School of Brotherhood and Pan-Islamism, and establishment of IOC. Expansion-1976 to the early 1980s: Islamic banking spread from the Arabian Gulf eastward to Malaysia, and westward to England. More than Accounting Needs of Islamic Banking 20 Islamic banks were established, including international and intercontinental institutions. Islamic banking associations or consultancy. bodies broadened their operations. Maturity--1983 to the present: The Arab world was confronted by economic setbacks, including slowdowns in oil revenues, the collapse of Kuwait's Souk alManakh, the relative strength of the U.S. dollar, higher interest rates in the United States, and capital outflows from OPEC nations. At the same time, Arab banks opened branches in the United States and Islamic banking practices were implemented in both Pakistan and Iran. Islamic banking operations are not limited to Arab soil, or Islamic countries, but are spreading throughout the world. One reason is the "growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity that could have a significant impact on the pattern of world trade. Since Muslims are inclined to follow Islamic traditions, there is a tendency to establish an Islamic economic system in every Islamic nation and to restore Shariah Law as the basic source for legislation" (Abdel-Magid, p. 81).

Macroeconomic Term Report on Islamic Banking and Finance



Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15 per cent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have developed significantly Ad therefore; they are also participating in the money and capital market transactions. In this report we have taken the advantages provided by the Internet and collect and analyze all available resources. The road ahead for Islamic banking and finance is long and will be full of challenges. More so, in the current global financial environment characterized by volatile and unpredictable market dynamics, rapid advancements in technology and financial innovation, which have all culminated in increasingly more complex and heightened financial risks. With the continued cooperation and active participation of the central banks and the financial community.


CONVENTIONAL AND ISLAMIC BANKING, MAIN DIFFERENCE The main difference between the two banking systems is that Islamic banks are supposed to work without charging and giving interest. Rather than charging a predetermined fixed rate of interest to those who want to use banks' funds for trade, commerce and production, Islamic banks are ideally required to have a profit and loss sharing arrangement with them. On the other side, the depositors have two choices. First, they can keep all or part of their money in an Islamic bank in a no-risk account. The bank will keep this money as safe deposit and guarantee the principal amount (it could be suggested that Islamic banks should not use these deposits for investment ie, a 100% reserve requirement for such accounts). Alternatively, depositors can choose to put all or part of their money in investment accounts. Islamic banks will use the proceedings of these accounts to make investments in trade and production. The profits made by Islamic banks are then shared with depositors. To avoid gharar, the details of profit and loss sharing arrangements are completely and clearly known to all parties in advance. The Islamic sense of social justice requires that all parties directly or indirectly financing in a business should share the risk of the business. The banks should combine shareholders' equity funds with those of their depositors and provide these funds to the ultimate users: traders and producers. All parties of this business arrangement should share the benefits as well as the risks of these investments. Conventional banks have to guarantee the principal and accrued interest by law, whereas Islamic banks will violate their

Macroeconomic Term Report on Islamic Banking and Finance


very basic principles if they give such guarantee (to their investment deposit holders). In principle, Islamic banks are not supposed to ask for collateral. In order to avoid risk, the integrity, capability/competence of the potential user of banks' funds (or the entrepreneurs) and the viability of the trade or business proposal are given much more importance in comparison to conventional banks. Banks being equity provider of a business would be given the right to inspect all financial accounts of the business. This is normally not the case when conventional banks provide loans on interest. A number of conventional commercial banks all over the world go bankrupt every year due to bad loans or bad economic condition or both. To be competitive, Islamic banks have to be prudent and efficient. However, even when banks are working prudently, they could still face insolvency due to an overall downturn in the economy. The sharing principles of Islamic banking would channel negative consequences of a genuine downturn to all parties involved: depositors, banks and traders/producers. The depositors may get a lower than normal return in some years. In extreme cases, a negative return is also a possibility. However, one should also keep in mind that when most businesses would realize better returns, both shareholders of Islamic banks and their depositors should also receive higher than normal returns.


A number of theoretical works examined the implications of preferred Islamic modes of finance in the contemporary world. In their theoretical work, Siddiqui and Zaman (1989a & 1989b) have shown how the application of Mudarabah and Musharakah techniques of finance has the potential to enhance investment and could also generate a more equitable desirable income distribution pattern. Their models confirm the intuitive point that compared to a debt arrangement, both under deterministic and probabilistic framework, Mudarabah and Musharakah finance could lead to higher level of investment as new (marginal) projects would be under taken as long as they are expected to give a positive rate of return, however small those rates might be. It also shows that under these Islamic techniques of finance, compared to a debt system, a greater portion of profits is allocated to the providers of funds if the economy is doing well. On the other hand, in bad conditions, the providers of fund receive a lower return and in extreme cases they may get a negative return. This has a stabilising effect on the economy.

Macroeconomic Term Report on Islamic Banking and Finance


Siddiqui (1994) further discuss how an economy based on the institution of interest is inherently unstable (a proposition so elegantly presented and championed by prominent post-Keynesian economist, Hyman Minsky) and how the Islamic techniques of finance based on profit and loss sharing have the potential to provide financial stability. It emphasises the point that Mudarabah finance is particularly capable of attracting those potential capable entrepreneurs who are unable to provide any collateral. This possible increase in the supply of entrepreneurs would decrease the power of existing entrepreneurs and can lead to a desirable distribution of income by discouraging concentration of wealth in fewer hands. Siddiqui (1994) also addresses the problems one would face under Islamic techniques of finance and argues that those problems are not insurmountable. He points out that any serious attempt to implement profit sharing financing would require, at the initial stages, commitment and often supervision and intervention by the government.


i) MUSHARAKAH (PARTNERSHIP) The literal meaning of Musharakah is sharing. The root of the word "Musharakah" in Arabic is Shirkah, which means being a partner. It is used in the same context as the term "shirk" meaning partner to Allah. Under Islamic jurisprudence, Musharakah means a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution. It is an ideal alternative for the interest based financing with far reaching effects on both production and distribution. The connotation of this term is little limited than the term "Shirkah" more commonly used in the Islamic jurisprudence. For the purpose of clarity in the basic concepts, it will be pertinent at the outset to explain the meaning of each term, as distinguished from the other. "Shirkah" means "Sharing" and in the terminology of Islamic Fiqh, it has been divided into two kinds: MUDARIBAH This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise. The investment comes from the first partner who is called "Rab-ul-Maal" while the management and work is an exclusive responsibility of the other, who is called "Mudarib" and the profits generated are shared in a predetermined ratio. DIMINISHING MUSHARAKAH Another form of Musharakah, developed in the near past, is 'Diminishing Musharakah'. According to this concept, a financier and his client participate either in the joint ownership of a property or an



Macroeconomic Term Report on Islamic Banking and Finance


equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of the financier one by one periodically, thus increasing his own share until all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be. iv) MURABAHAH Murabahah is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit thereon. Thus, Murabahah is not a loan given on interest; it is a sale of a commodity for cash/deferred price. The Bai' Murabahah involves purchase of a commodity by a bank on behalf of a client and its resale to the latter on cost-plus-profit basis. Under this arrangement the bank discloses its cost and profit margin to the client. In other words rather than advancing money to a borrower, which is how the system would work in a conventional banking agreement, the bank will buy the goods from a third party and sell those goods on to the customer for a pre-agreed price. Murabahah is a mode of financing as old as Musharakah. Today in Islamic banks world-over 66% of all investment transactions are through Murabahah. IJARAH (LEASING) Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons. IJARAH-WAL-IQTINA (HIRE PURCHASE) A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum alongwith with profit over the period of lease. MUSAWAMAH Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well.




Macroeconomic Term Report on Islamic Banking and Finance


Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell. viii) ISTISNAA (ISLAMIC FORWARDS) It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna’a can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways. BAI MUAJJAL (CREDIT SALE) Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.



i) Investing in equities Common shares in a listed company are – as the name suggests – “shares” in the assets of the company. Thus, if the company’s business is legitimate, and its conduct complies with the rules of Shar¯ı‘a, Muslims are allowed to own such common shares (stock). Other common means of investing in claims on companies’ capital are not allowed: bonds are explicitly a claim on a portion of the company’s interest-bearing debt, and preferred stock is a hybrid stock/bond. Since common stocks of Islamically appropriate companies may thus be bought and sold, it is also possible to create mutual funds in such stocks. Muslims before going to park equity investment considers following set of filters: The first set of filters is straightforward: exclude all companies whose primary business involves forbidden products (e.g. alcohol, pork, tobacco, financial services, weapon production, and “entertainment”). The second set of filters, based on “financial ratios”, is significantly more dubious. The rules recently adopted by the DJII board are virtually identical with those adopted in earlier years by other fund management company Sh¯ar¯ı‘a boards in Islamic countries. Those rules relate to the above mentioned compromises on three prohibitions due to the inherent Rib¯a and other impurities: 1. Carrying interest-bearing debt. 2. Receiving interest or other impure income.

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3. Trading in debts at a price other than their face values. The Shar¯ı‘a boards of most Islamic fund managers and equity indices have reached very similar compromises. The following is the list of rules/compromises (ibid, p.10) used by DJII: 1. Exclude companies with a debt to total asset ratio of 33% or more. 2. Exclude companies with “impure plus non-operating interest income” to revenue ratio of 5% or more. 3. Exclude companies with accounts receivable to total assets ratio of 45% or more. ii) Investment in Mutual Funds Recall that an Islamic financial institution engaged in a number of lease contracts continues to own the assets throughout the life of the leases. While some jurists restricted the lessor’s ability to sell the leased asset or parts thereof during the lease period, most others permitted such a sale as long as the lease continues. Therefore, the Islamic financial institution can treat its portfolio of leased assets as a company or fund, shares of which may be sold to investors. The investors then earn a fixed income according to their shares in the fund. Like the forbidden conventional fixed income investments (e.g. money market funds, bonds, etc.), the fixed income from a lease fund will move up with inflation, and the risks borne are minimal (default in the conventional contract vs. default and repairs or losses of assets in the lease fund). iii) Investment in Day-to-day Trading Following a “buy low and sell high” strategy is at the heart of all profitable trading, including the caravan trades in which the Prophet (pbuh) participated. If a profitable opportunity presents itself sooner than anticipated, a good merchant or investor would be criticized for foregoing such profits. Whether or not speculation amounts to gambling depends on the intentions of the trader, and the nature of the traded goods. The issue of whether “day trading”, where the investor intends to liquidate all positions at the end of each day, is particularly close to gambling as compared to other investment strategies. There is no reason to believe that the term of the trading activities influences whether or not it is considered gambling. Tradition has it that ‘Abdul-Rah.m¯an ibn ‘Awf (mAbpwh) reached Mad¯ınah without any wealth (having left it all in Makkah), went to the market with an axe, and returned at the end of the day with a small fortune. His abilities to amass wealth were legendary, but that did not reduce his religious status, as he was one of the sh¯¯ura group tonominate the Kh¯al¯ıfah, and he was one of the ten companions of the Prophet (pbuh) to receive glad tidings of admission into paradise.

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Current Problems of Islamic Banking and Finance may be summarized as follows: i) Shortage of experts in Islamic banking: The supply of trained or experienced bankers has lagged behind expansion of Islamic banking. The training needs affect not only Arab domestic banks. both Islamic and non-lslamic. but foreign banks. Academic institutions. international organizations, and transnational firms must respond to the need by organizing training materials, lectures. and workshops; although ml and IAIB have made successful efforts. much remains to be accomplished. Mr. AI-Yasin, the chairman of KFH. has proposed "an Islamic banking institute which will provide professional Islamic bankers and expand. the resent training activities of IAIB" (Arabia. February 1984. p. 52). Absence of accounting (and auditing) standards pertinent to Islamic banks: Uncertainty in accounting principles involves revenue realization, disclosures of accounting information, accounting bases. valuation, revenue and expense matching. etc. Thus. the results of Islamic banking schemes may not be adequately defined. particularly profit and loss shares attributed to depositors. Lack of uniform standards of credit analysis: Islamic banks have no appropriate standard of credit analysis, especially for PLS schemes. Similarly, there is a widespread training need involving related aspects such as financial feasibility studies, monitoring of ventures, and portfolio evaluation. Potential conflicts with central banks: Islamic banks have been established as separate legal entities; therefore, their relationships with central banks and/or other commercial banks are uncertain. Problems may be complicated when an Islamic bank is established in a non-muslim nation, and is subject to that nation's rules and requirements. Potential conflict between domestic banks. foreign banks, and Islamic banks : It appears that domestic banks and foreign banks will experience continuing difficulty in adopting Islamic banking practices, including the PLS scheme, until they can become more confident of the results of investing ventures. Difficulties in cash management: For example, KFH suffered from excessive cash in late 1983 and 1984, i.e..lack of promising investments. The situation is believed to have contributed to KFH's 1984 action, whereby it paid no dividend and transferred its entire annual surplus to reserves.






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Lack of a deposit insurance system: The lack of such a system becomes more grave, because Islamic banks generally do riot have standard measures of reserve requirements or liquidity ratios.


Over the last three decades Islamic banking and finance has developed into a fullfledged system and discipline reportedly growing at the rate of 15percent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have developed significantly and therefore, they are also participating in the money and capital market transactions. In Malaysia, Bahrain and a few other countries of the Gulf, Islamic banks and financial institutions are working parallel with the conventional system. Bahrain with the largest concentration of Islamic financial institutions in the Middle East region, is hosting 26 Islamic financial institutions dealing in diversified activities including commercial banking, investment banking, offshore banking and funds management. It pursues a dual banking system, where Islamic banks operate in the environment in which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for Islamic banks as for conventional banks. Bahrain also hosts the newly created Liquidity Management Centre (LMC) and the International Islamic Financial Market (IIFM) to coordinate the operations of Islamic banks in the world. To provide appropriate regulatory set up, the BMA has introduced a comprehensive prudential and reporting framework that is industry-specific to the concept of Islamic banking and finance. Further, the BMA has pioneered a range of innovations designed to broaden the depth of Islamic financial markets and to provide Islamic institutions with wider opportunities to manage their liquidity. Another country that has a visible existence of Islamic banking at comprehensive level is Malaysia where both conventional and Islamic banking systems are working in a competitive environment. The share of Islamic banking operations in Malaysia has grown from a nil in 1983 to above 8 percent of total financial system in 2003. They have a plan to enhance this share to 20 percent by the year 2010. However, there are some conceptual differences in interpretation and Shariah position of various contracts like sale and purchase of debt instruments and grant of gifts on savings and financial papers. In Sudan, a system of Islamic banking and finance is in operation at national level. Like other Islamic banks around the world the banks in Sudan have been relying in the past on Murabaha financing. However, the share of Musharaka and Mudaraba operations is on increase and presently constitutes about 40 percent of total bank financing. Although the Islamic financial system has taken a good start in Sudan, significant problems still remain to be addressed. Like Sudan, Iran also switched over to Usury Free Banking at national level in March 1984. However, there are some conceptual differences between Islamic banking in Iran and the mainstream movement of Islamic banking and finance.

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Owing to the growing amount of capital availability with Islamic banks, the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals particularly in the Middle East region. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. These projects, inter alia, include power stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the leading centre for Islamic finance in the Middle East region. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures. The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool assets to develop and promote Shariah compliant tradable instruments for Islamic banking industry. The arrangement is seen as a major boost for industry’s integration in the global financial system and should set the pace for commoditytrading environment in Bahrain. BMA has also finalized draft guidelines for issuance of Islamic bonds and securities from Bahrain. In May 03, the Liquidity Management Centre (LMC) launched its debut US$ 250 million Sukuk on behalf of the Government of Bahrain. National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that has all the benefits of a regular credit card. The card does not have a credit line and instead has a prepaid line. As such, it does not incur any interest. Added benefits are purchase protection, travel accident insurance, etc and no interest, no extra fees with no conditions, the card is fully Shariah compliant. It is more secure than cash, easy to load up and has worldwide acceptance. This prepaid card facility is especially attractive to women, youth, self employed and small establishment employees who sometimes do not meet the strict requirements of a regular credit card facility. Saudi Government has also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector and opened it for foreign investors. Islamic banks have also built a strong presence in Malaysia, where Standard & Poor's assigned a BBB+ rating to the $600 million Sharia-compliant trust certificates (called sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank licences to foreign players. The Financial Sector Master plan maps out the liberalisation of Malaysia's banking and insurance industry in three phases during the next decade. It lists incentives to develop the Islamic financial sector and enlarge its market share to 20 percent, from under 10 percent now. A dedicated high court has been set up to handle Islamic banking and finance cases. In United Kingdom, the Financial Services Authority is in final stages of issuing its first ever Islamic banking license to the proposed Islamic Bank of Britain, which has been sponsored by Gulf and UK investors. The United States of America has appointed Dr. Mahmoud El Gamal, an eminent economist/expert on Islamic banking to advise the US Treasury and Government departments on Islamic finance in June 2004.

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a) HISTORY OF ISLAMIC FINANCE IN PAKISTAN 1949 The Objectives Resolution was adopted by the first constituent Assembly based on the ideology of a sovereign Islamic state. This was the first step in the conception towards Pakistan’s Constitution. The first constitution defined Islam as the State Religion and all laws to be according to the injunctions of the Qur’an and Sunnah. The establishment of the Council of Islamic Ideology (CII) was followed by the conception of second constitution of Pakistan. The third constitution of Pakistan was passed allowing comprehensive legislation on Islamic principles and establishment of a Federal Shariat Court (FSC) CII presents its report on the elimination of interest, genuinely considered to be the first major work in the world undertaken on Islamic Banking and Finance. Procedures adopted by banks, was declared un-Islamic by the FSC. The government and some banks/DFIs made appeals to the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan Al-Meezan Investment Bank is established as the first Islamic Bank of Pakistan. Dr. Muhammed Imran Usmani appointed as resident Shariah Advisor. The Shariat Appellate Bench of the Supreme Court of Pakistan rejects the appeals and directs all laws on interest banking to cease. The Government sets a high level commission, task forces and committees to institute and promote Islamic Banking on parallel basis with the conventional system. The Shariah Supervisory Board is established at Al-Meezan Investment Bank, led by Justice (Retd.) Muhammad Taqi Usmani as Chairman. The SBP sets criteria for the establishment of Islamic Commercial Banks in the private sector and subsidiaries and standalone branches by existing commercial banks, to conduct Islamic Banking in the country. The first Islamic Banking license is issued to Meezan Bank by the State Bank of Pakistan. Societe Generals’s, (a French Commercial Bank) operating in Pakistan were amalgamated with Meezan Bank. President Gen. Pervez Musharraf inaugurates the first commercial bank branch of Meezan Bank at the FTC Building, Karachi. A Musharakah based Export Refinance Scheme is designed by the SBP in coordination with Meezan bank, in order to provide export

1956 1962 1973








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finance to eligible exporters on the basis of Islamic mode of financing. Efforts are underway to develop Islamic money market instruments like Ijarah Sukuk to facilitate Banks in term of liquidity and SLR management. Pakistan’s first Shariah compliant Mortgage facility is launched by Meezan Bank. Approved by the Shariah Supervisory Board, the product enables home purchase, home construction, renovation, as well as replacement of any existing mortgage. 2004 The SBP establishes a dedicated Islamic Banking Department (IBD) by merging the Islamic Economics Division of the Research Department with the Islamic Banking Division of the Banking Policy Department. A Shariah Board has been appointed to regulate and approve guidelines for the emerging Islamic Banking industry. The Government of Pakistan awards the mandate for its debut international Sukuk (Bond) offering for US$ 600 million. The offering is a success and establishes a benchmark for Pakistan. Meezan Bank acts as the Shariah Structuring Advisor for this historic transaction. Meezan Bank’s assets management arm, AL-Meezan Investment Management Limited (AMIML), launches the Meezan Balanced Fund (MBF). The offering was oversubscribes 1.25 times. 2005 The State Bank of Pakistan granted license to Al Baraka Islamic Bank BSC EC, and Bank Islami Pakistan Ltd., Emirates Global Islamic Bank Ltd., and Dubai Islamic Bank Ltd. State Bank of Pakistan granted license to First Dawood Islamic Bank Ltd, the country's sixth Islamic bank. First Dawood Bank is coowned by local partners and a consortium comprising Bank Islam Malaysia Berhad, Unicorn Investment Bank of Bahrain and a wing of the Islamic Development Bank.



PROMINENT ICONS OF ISLAMIC FINANCE IN PAKISTAN 1. Justice (Retd.) Muhammad Taqi Usmani Renowned figure in the field of Shariah, particularly Islamic Finance. He holds the position of Deputy Chairman at the Islamic Fiqah Academy, Jeddah. He is also member of Shariah Advisory boards of a number of financial institutions practicing Islamic Banking and Finance including Saudi American Bank, Saudi Arabia; HSBC Plc, Global Islamic Finance, London; Citi Islamic Investment Bank, Bahrain and Dow Jones Islamic Market Index. Justice Usmani has also serving as the Vice Prsident of Darul-Uloom, Korangi, Karachi. Born in Pakistan, Justice Usmani holds an LLB from Karachi University. He graduated from Punjab University in 1970. Prior to

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the he completed Takassus course i.e. the specialization cource of Islamic Fiqah and Fatwa from Jamia Darul-Uloom, Karachi. 2. Dr. Muhammad Imran Usmani Is an LLB, M.Phil, and Ph. D. in Islamic Finance and graduated as a scholar from Jamia Darul-Uloom, Karachi where he also completed a specialization course in Islamic Jurisprudence. He is the Shariah Advisor for the Al Meezan Bank where he is involved in conducting training sessions for the staff in Islamic Finance and Shariah Issue. Dr. Usmani has been teaching several branches of Islamic learning since 1990 at Jamia Darul-Uloom, Karachi he is also visiting faculty member of the Institute of Business Administration (IBA) Karachi. Dr. Usmani serve as an Advisor/Member of Shariah Board of the following institutions. • • • • • • 3. State Bank of Pakistan HSBC Amana Finance Guidance Financial Group, USA Lloyds TSB Bank, UK Credit Suisse, Switzerland Future Growth Equity, South Africa

Mr. Irfan Siddiqui The founding CEO of Meezan Bank (Pakistan first premier Islamic Bank) has held senior management positions with various financial institutions in Pakistan and abroad, including Pakistan Kuwait Investment Authority, Abu Dhabi Investment Company, Abu Dhabi Investment Authority and Coopers & Lybrand, London.


Mr. Pervez Said He is the Director of Islamic Banking Department of State Bank of Pakistan (SBP). He is also advisor to the Governor SBP on Islamic Banking. He also handles issues relating to the central bank and sharia board. He has worked as Head of Marketing and Business Development at Pakistan’s first Islamic Bank (Meezan Bank) Most probably he is the first Pakistani banker who has got the experience of developing sharia-compliant products and actually marketing those at the initial stages of process of islamization of banking system in Pakistan.


CURRENT STATUS OF ISLAMIC BANKING AND FINANCE IN PAKISTAN Islamic Financial services in Pakistan, a relatively recent occurrence, have recorded a noteworthy progress during the last three years, constituting an

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asset base of Rs: 57.10 billion and deposits of over Rs: 37.6 billion as of September’2005. GROWTH OF ISLAMIC BANKING 2003 Total Assets 12.90 (Rupees in Billion) 2004 44.00 2005 60.00

Given its nascent stage of Development, the share of the Islamic Banking industry in the total assets of the banking sector grew from 0.5 % in 1996 to 1.7 % as of September’2005. However, given the rapid growth of this industry, it is expected that this share would grow considerably in the years to come. LIST OF ISLAMIC BANKS OPERATING IN PAKISTAN Fully functional Islamic Banks Meezan Bank Ltd. Albaraka Islamic Bank BankIslami Pakistan Ltd. Emirates Global Islamic Bank Ltd. Dubai Islamic Bank Ltd. First Dawood Islamic Bank Ltd. Status Operating Operating Operating In The Pipeline In The Pipeline In The Pipeline

Standalone Islamic Bank Branches of Conventional Banks Askari Commercial Bank Ltd. Soneri Commercial Bank Ltd. Faysal Bank Bank Alfalah Ltd. Muslim Commercial Bank Ltd. The Bank of Khyber Standard Chartered Commercial Bank Ltd. Prime Commercial Bank Ltd. Bank of Punjab Ltd. Habib Bank AG Zurich Total No. of Islamic Branch Banking (IBB) (As on March’05) 54

Modarabas can be rightly termed as the pioneer of long drawn process of Islamization of financial system in Pakistan. According to data compiled by Modaraba Association of Pakistan (MAP) the number of management companies has come down from32 in 2001 to 27 as on 30 th June’2005 and number of Modarabas declined from 35 to 28. However, this should not be considered a sign of weakness, during the period aggregate paid-up capital of the sector grew from Rs: 6.648 Million to Rs: 7,406 Million, growth of total assets, growing from Rs: 15,216 Million to Rs: 21,131 Million and net profit going up from Rs: 97 Million to Rs: 794 Million – also touching the highest level of Rs: 1,072 in year 2003.

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Top 10 MODARABAS Standard Chartered Modaraba First Habib Modaraba Al-Zamin Leasing Modaraba B.R.R. International Modaraba Fayzan Manufacturing Modaraba First Punjab Modaraba Guardian Modaraba First Habib Bank Modaraba First National Bank Modaraba First Equity Modaraba Source : MAP Year Book 2006 Islamic Banking in Pakistan Breakup of Financings March’05 Murabaha Ijarah Musharaka Diminishing Musharaka Salam Others Breakup of Deposits March’05 Savings Current non-remunerative Others Fixed 47% 24% 1% 28% 53% 28% 1% 8% 1% 9% Rs: Rs: Rs: Rs: Rs: Rs: Rs: Rs: Rs: Rs: 2,725 Million 2,657 Million 2,276 Million 2,030 Million 1,357 Million 1,325 Million 1,288 Million 1,215 Million 1,206 Million 742 Million


Islamic banks, while functioning within the framework of Shariah, can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharaka and Mudaraba) and non-PLS (trading & leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. Sharing modes can be used for short, medium and long-term project financing, import financing, pre-shipment export financing, working capital financing and financing of all single transactions. In order to ensure maximum role of Islamic finance in development of the economy it would be necessary to create an environment that could induce financiers to earmark more funds for Musharakah/Mudarabah based financing of productive units, particularly of small enterprises. The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the
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society. Trade-based techniques like Murabaha with lesser risk and better liquidity options have several advantages vis-à-vis other techniques but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques. Ijarah related financing that would require Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shariah rules, require the banks to engage in activities beyond financial intermediation and can be very much conducive to the formation of fixed assets and medium and long-term investments. On the basis of the above it can be said that supply and demand of capital would continue in an interest-free scenario with additional benefit of greater supply of risk-based capital alongwith more efficient allocation of resources and active role of banks and financial institutions as required in asset based Islamic theory of finance. Islamic banks can not only survive without interest but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of risk capital in the economy, facilitating capital formation, and growth of fixed assets and real sector business activities. Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides incentive to enhance production as the seller would spare no effort in producing, at least the quantity needed for settlement of the loan taken by him as advance price of the goods. Salam can also lead to creating a stable commodities market especially the seasonal commodities and therefore to stability of their prices. It would enable savers to direct their savings to investment outlets without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption. Banks might engage in fund and portfolio management through a number of asset management and leasing & trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis, and use the funds so collected on Murabaha, leasing or equity participation basis. Subsidiaries can be created for specific sectors/operations, which would enter into genuine trade and leasing transactions. Lowrisk Funds based on short-term Murabaha and leasing operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford possible losses, in PLS based investments. Under equity based Funds, banks can offer a type of equity exposure through specified investment accounts where they may identify possible investment opportunities from existing or new business clients and invite account-holder to subscribe. Instead of sharing in the bank’s profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work. Banks can also offer open-ended Multiple Equity Funds to be invested in stocks.
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Small and medium enterprises (SME) sector has a great potential for expanding production capacity and self-employment opportunities in the country. Enhancing the role of financial sector in development of SME subsector could mitigate the serious problems of unemployment and low level of exports. The banks may introduce ‘SME Financing Funds’ with various geographical locations. The corporate sector and the commercial banks may set up a network of such Funds under the aegis of SECP by establishing institutions under syndicate arrangements or otherwise. e) ROLE OF STATE BANK IN THE DEVELOPMENT OF ISLAMIC BANKING AND FINANCE IN PAKISTAN Former Governor SBP Dr. Ishrat Hussain and his team at SBP have worked very sincerely to promote Islamic Banking in the country. In Junuary’2003, SBP announced critical measures to promote Islamic Banking in the country. It has established separate Islamic Banking Department to facilitate Islamic Banking. Another major step was the introduction of an Islamic Export Refinance Scheme, that enabled Islamic Banks to provide Export Refinance at confessional rates under Shariah compliant instruments. In order to promote Islamic Banking in Pakistan, State Bank is following a three pronged strategy as under: I) Establishment of full-fledged Islamic bank(s) in the private sector; II) Setting up of subsidiaries for Islamic Banking by existing commercial banks; and III) Allowing Stand-alone branches for Islamic banking in the existing commercial banks. In line with Part-I of this strategy, on 1st December, 2001, State Bank of Pakistan had issued detailed criteria for setting up of Scheduled Islamic Commercial banks based on Shariah Principles in the Private Sector in the form of a Press Release, As regards Part-II of this strategy, in terms of Banking Companies (Amendment) Ordinance, 2002 notified in the Gazette of Pakistan dated November 4, 2002, inter alia, a new clause (aa) has now been inserted in subsection (1) of section 23 of the Banking Companies Ordinance as follows: “(aa) the carrying on of banking business strictly in conformity with the Injunctions of Islam as laid down in the Holy Quran and Sunnah”. Therefore, the scheduled commercial banks are henceforth allowed to open subsidiaries for Islamic Banking operations. Accordingly, a Detailed Criteria for setting up of Islamic Banking Subsidiaries by existing Commercial Banks has been prepared. For Part-III of this strategy, Guidelines for opening of Stand-alone branches for Islamic banking by existing commercial banks, enlisting Eligibility Criteria, Licensing Requirements and other operational guidelines on the subject have been prepared. f) FUTURE PROSPECTUS OF ISLAMIC FINANCE IN PAKISTAN The rapidly increasing focus on Islamic Banking in this market is a clear indication of its viability as a profitable alternative to traditional finance, and
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one that cannot be ignored. The entry of credible new players in the nascent Islamic Banking industry are welcomed by the peoples and it will result in significant growth in the market. Today there is a great demand for Islamic banking among the Muslims. It is an alternate system for non-Islamic interest-bearing system. In Pakistan, our clerics as well as people are very keen to adopt Shariah-based banking. Every day commercial banks, whether local or foreign, are entering this field. The resultant effects of increased competition and the benefits to the consumer in terms of product variation and pricing will Inshallah support the overall cause of Islamic Banking in Pakistan, which is now almost 1.7% of total Financial Sector. Finally, it is worth re-emphasizing that Islamic finance is a veritable reality. The depth and scoop of this industry, both locally and internationally, evidenced by the sheer size of investment being made, the mushrooming client bases, the quality of portfolios, the wide experience and talent of its stakeholders and executors, are all clearly indicative that its time to stand up and take notice. In fact in Pakistan alone the growth rate is currently over 70% per annum with estimates of the total assets of Islamic Banks reaching close to Rs: 600 Billion in the next few years.

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The Negative Aspect: The advocates of Islamic banking assert that the Islamic banking is based on the laws of contract as laid down in Islamic Fiqah, and all transactions and products offered by them are in accordance with Shariah. Most of the commercial banks have divisions of Islamic banking and these divisions are transacting business according to the tenets of Shariah. But the question arises, from where are these divisions of Islamic banking getting the funds? They are getting funds from their parent organizations, which are functioning on interest-bearing business. Since these funds are generated on interest, whether depositors' money or borrowers' loans, the element of interest, howsoever negligible it may be, remains in their funds. Thus, the products sold by the divisions of Islamic banking have the element of interest, which is as per Shariah is not Halal. Now the transactions of Islamic banks, such as Meezan Bank etc, are analysed. These Islamic banks also canvas for deposits because without the support of deposits no bank, whether Islamic or un-Islamic, can function. Do these Islamic banks, while accepting depositors' money, examine the intrinsic value is whether the money that they are accepting is pure (earned by halal means) or impure means (Najis)? We do not think so because every bank is after deposits, and very rarely they scrutinise the credentials of these prospective clients. Unfortunately, our society is such that now-a-days it is very difficult to find an honest and truthful trader, industrialist, bureaucrat, or moneyed person because everywhere the devil of corruption reigns. Upright people are few and far between. Can these Islamic banks, which accept deposits from depositors of our society, vouch for pure and halal money? The Positive Aspect: Islamic Banking does not believe in demolition of existing systems unnecessarily. Basic requirement of Shariah is that we need to undertake asset-based transactions (Without Speculation & Gambling). Most of the commercial based loans are obtained for the purpose of financing assets, therefore, for converting them into Shariah acceptable mode we only need to change the processes. It is like McDonald’s Burger in Karachi and New York would look like, taste alike and feel alike, but it is the processing that makes one Halal and the other one Haram. The Islamic bank has emerged as a unique socioeconomic, yet religiously motivated, institution. Islamic banks have been confronted by a not unexpected "learning curve" in handling complicated banking schemes, ever-increasing competition, liquidity traps, credit crunches, and a need for accounting standards based on the national ethos of the nations involved. It is less surprising that difficulties have occurred, than that the difficulties have not been more serious. To resolve existing and future problems, the authors present the following suggestions: credit analysis: Standards should be established for credit evaluation; state of the art analytical techniques should be emphasized.

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Modern technology: Although some Islamic banks have instituted modem systems management, and have acquired centralized as well as microcomputer facilities, considerable work is needed in other cases, especially in basic systems analysis. Freer market facilities: Special efforts should be made to increase the productive use of available short-term liquid funds. (The authors believe that Shariah principles may allow at least some alternatives.) Improved coordination among banks would also be especially helpful in the utilization of excessive deposits. Recommendations Bearing on Legal and Regulatory Matters Institutionalize Shariah boards: Although some Islamic banks have an oversight (Shariah) board, there would seem to be a need for a coordinated and unified authority to interpret Islamic law in cases not comprehended by the Quran, Shariah, or Ijma. Although it is evidently, clear that any new system competing against a wellestablished structure that has prevailed for centuries will naturally require strong efforts in the beginning, and Islamic Finance in his very beginning, lets hope and prey for the full fledge commencement of true Islamic Financial Systems. (Concluded)



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A Basic Guide to Contemporary Islamic Banking and Finance by Mahmoud Amin El-Gamal1 Rice University Growing propensity for Islamic banking Interview with Hamish Khan (CEO Bank of Punjab) by Monem Farooqi The Nation - Monday, October 17, 2005 Islamic Mode of Financing (Al-Meezan Bank) by Dr. Imran Usmani Sharia Advisor Al-Meezan Bank Islamic Financing Glossary Courtesy: State Bank of Pakistan Annual Reports 2004 Meezan Bank Can We Avoid Interest M.A. Chishti May 31’2006 (Article Published in Daily Business Recorder) Pakistan & Gulf Economist August 15-21, 2005 Issue No. 33 Pakistan & Gulf Economist March 27- April 2, 2006 Issue No. 13 Can Islamic financial instruments be meaningfully introduced?-II Courtesy: General of Management Sciences June 4'2006 (Article Published in Daily Business Recorder)



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Macroeconomic Term Report on Islamic Banking and Finance