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THE EMERGENCE OF ISLAMIC BANKING IN TANZANIA: A CRITICAL ANALYSIS OF ITS IMPACTS TO THE SUBSISTING REGULATORY AND SUPERVISORY REGIMES;

THE CASE OF THE BOT

By Kisilwa, Zaharani1

A Dissertation Submitted to the Faculty of Law in Partial Fulfillment of the Requirements for the Award of the Degree of Master of Laws (LL.M (CL) of Mzumbe University, 2012

The author of this work is an Assistant Lecturer at the Institute of Accountancy Arusha (IAA), Advocate of the High Court of Tanzania and courts subordinate thereto, with the exception of the primary courts, and a founder of Legademic Company Ltd and a founding partner at the Laws Empire Tanzania (Letan Advocates) both based in Arusha Tanzania. He has a master of commercial law and lectures on Commercial, Business, procurement and Banking laws. 1

CERTIFICATION We, the undersigned, do hereby certify that we have read and hereby recommend for acceptance by the Mzumbe University, a dissertation entitled: The Emergence of Islamic Banking In Tanzania: A Critical Analysis of Its Impacts to the Subsisting Regulatory and Supervisory Regime, the case of the B.O.T, in partial fulfilment of the requirements for award of the degree of Master of Laws in Commercial Law (LL.M (CL)) of Mzumbe University.

Signature

___________________________ Major Supervisor

Signature

___________________________ Internal Examiner

Accepted for the Board of

Signature _______________________ DEAN FACULTY OF LAW

DECLARATION AND COPYRIGHT I, Zaharani Kisilwa, do hereby declare that this dissertation is my own original work. That to the best of my knowledge and understanding it does not contain any material previously published or written by another academician except only to the extent where due references are shown herein, as such all sources used or referred to have been recognized; and lastlty that it has not been previously submitted in full or in partial fulfillment of the requirements for an equivalent or higher qualification at any other recognized education institution.

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Date:

This dissertation is a copyright material protected under the Berne Convention, the Copyright Act 1999 and other international and national enactments, in that behalf, on intellectual property. It may not be reproduced by any means in full or in part, except for short extracts in fair dealings, for research or private study, critical scholarly review or discourse with an acknowledgement, without the written permission of Mzumbe University, on behalf of the author.

ACKNOWLEDGEMENTS To the completion of this dissertation, many individuals played a role to ensure its success. Honour and gratitude is conferred to them by the author through this acknowledgement in consideration of their support, help and encouragement. Specifically the following are acknowledged;

First and foremost, special recognition is directed towards God Almighty for keeping the researcher consistently healthy during the time of undertaking this research. Special gratitude is directed to Dr. OPIYO, Modesta, Dean Faculty of Law Mzumbe University, Lecturer and Research Supervisor to the researcher whose guidance, perseverance where researcher went wrong and encouragement during the course of his research efforts charted a worthwhile directional course along which this study was undertaken.

The researcher next, extends appreciation to his employer, IAA first for granting him a paid leave to pursue his LLM (C.L) and second by granting a financial support that helped him to conduct this study. The significance of this assistance cannot be overemphasized.

Researcher acknowledges those who unconditionally offered to him due assistance relating to the collection of data from their offices: Mr. Goodhope Mkaro and Mr. Goodluck Herman, Bank Examiners in the Directorate of Bank Supervision at the B.O.T. Dar es salaam. Mr. Mlekwa Kulwa,

Financial Analyst in the Directorate of Financial Markets at the B.O.T Dar es salaam. Veronica Mmanda, Head Islamic Banking section at the Arusha Branch who introduced him to Mr. Yassir Massoud, Head Islamic Banking Department at the N.B.C headquarters in Dar es salaam and. Further, Mr. Babu Joseph of K.C.B Bank, Arusha branch who connected him to Mr. Omar Shareef, islamic banking scholar and lastly, Mr. Abdul Rahmaan, who established islamic banking at the Stanbic Bank Arusha branch from whom

the researcher received an invaluable assistance on the general idea on how islamic banks operate.

Further, he wishes to express his gratitude to everyone who in one way or another has had a share in the general set up and organisation of this work from being nothing to what it is now. As it is not possible to give special appreciation to all of them individually, their honest contribution is truly appreciated.

While all the persons mentioned herein to whom the author cordially bestows appreciation have significantly served as indispensable thrusts, constant accelerators and reliable reference points to the setting, organisation and compilation of this work, the author fully retains responsibility for all errors, slip-ups, omissions and any anomaly relating thereto that might have impaired its quality. It is not because their contribution did not suffice but because the author is a human being and human beings are always prone to imperfections.

DEDICATION

To my beloved kids Meddy and Maryam for their invaluable patience during my absence in pursuit of my LL.M studies (course work) and in undertaking this research

ABSTRACT This study is about the impacts of Islamic Banking in Tanzania to the subsisting regulatory and supervisory framework. As Tanzania adopts Islamic banking many issues arise. Banking laws are not favourable to it. The researcher undertook this study to find out the inherent risks and challenges that islamic banking practice brings forth against the Tanzanian regulatory and supervisory framework with the aim of suggesting what should be done to properly accomodate this type of banking.

The study is a qualitative study. The researcher used interview guide as a tool to collect information from respondents at the BoT and NBC, KCB and Stanbic Bank. The study finds out that as islamic banking is new not many are aware of how it functions, including many of the muslims themselves. In this spirit out of a sample of 21 respondents chosen purposevely, which included BoT officials, commercial banks officials, Muslim scholars and banking lawyers, 12 comfortably responded to interview questions. 3 of these from B.o.T, 2 from NBC, 1 from Stanbic Bank, 1 Muslim scholar knowledgable on islamic banking and 5 banking lawyers. The study further found out that islamic banking has many risks unique to itself. The most significant being credit risks, which affect PLS transactions and market risks which affect sales based transactions. The study revealed also that there are numerous challenges that islamic banking poses to the countrys banking regulation and supervision systems. Banking regulation instils protection to the depositors funds and averts banking systemic failures, ultimately stabilising the economy. Thus, its significance to islamic banking, cannot be overemphasized.The author, therefore, suggests that since islamic Banking operates under philosophical bases different from conventional banking, new regulatory and supervisory laws should be enacted. As amendments of

existing laws would be so impractical and their dual application would rather complicate the systems.

LIST OF STATUTES Banking and Financial Institutions Act No. 5 of 2006 Bank of Tanzania Act No. 4 of 2006 Companies Act No. 12 of 2002 Cooperative Societies Act, 2003 Judicature and Application of Laws Act no. Cap 358 [R.E. 2002] Law of Contract Act, Cap 345 [R.E. 2002] Probate and Administration of Estates Act, Cap 352 [R.E. 2002] Sale of Goods Act, Cap 214 [R.E. 2002] Stamp duty Act, Cap 189 [R.E. 2002] United Republic of Tanzania Constitution of 1977. as am. From time to time

LIST OF ABREVIATIONS AND ACRONYMS AAOIFI Accounting and Auditing Organisation for Islamic Financial Institutions ADB As am BFIA B.O.T BoTA African Development Bank as amended Banking and Financial Institution Act Bank of Tanzania Bank of Tanzania Act

CAMEL An acronym for Capital Adequacy, Asset quality, Management, Earnings capability and Liability management DIB IDT IAA IFCB I.M.F JALA K.C.B N.B.C NY P.L.S S.G.A UK Deposit Insurance Board Innovation Diffussion Theory Institute of Accountancy Arusha Islamic Financial Services Board International Monetary Fund Judicature and Application of Laws Act Kenya Commercial Bank National Bank of Commerce New York Profit and Loss Sharing Sale of Goods Act United Kingdom

TABLE OF CONTENTS
CERTIFICATION ............................................................................................................... 2 DECLARATION AND COPYRIGHT ................................................................................ 3 ACKNOWLEDGEMENTS ................................................................................................. 4 DEDICATION .................................................................................................................... 6 ABSTRACT........................................................................................................................ 7 LIST OF STATUTES .......................................................................................................... 8 LIST OF ABREVIATIONS AND ACRONYMS ................................................................. 9 CHAPTER ONE ............................................................................................................... 13 INTRODUCTION ............................................................................................................. 13 1.1 Background to the problem............................................................................. 13 1.2 Statement of the Problem ...................................................................................... 15 1.3 Research objectives ............................................................................................... 17 1.4 Research Questions. .............................................................................................. 18 1.5 Significance of the Study ...................................................................................... 18 1.6 Scope of the study ................................................................................................. 19 1.7 Literature Review ................................................................................................. 19 1.8 Research Methodology.......................................................................................... 25 1.8.1 Research Design ............................................................................................. 25 1.8.2 Area of Study ................................................................................................. 26 1.8.3 Target Population ........................................................................................... 26 1.8.4 Sample Size ................................................................................................... 26 1.8.5 Sampling Procedure ....................................................................................... 26 1.8.6 Types of Data and Data Collection Methods ................................................... 27 1.8.6.1 Primary Data ...................................................................................................... 27 1.8.6.2 Secondary data ................................................................................................... 27 1.8.7 Data collection Methods. ................................................................................ 27 1.8.8 Data Analysis Techniques ..................................................................................... 28 1.8.9 Limitations of the Study ........................................................................................ 28 CHAPTER TWO .............................................................................................................. 30 CONCEPTUAL FRAMEWORK....................................................................................... 30 2.1 Introduction ................................................................................................................. 30 2.2 The concept of islamic banking .................................................................................... 30 2.3 The rationale behind the Islamic Prohibition of interest (Riba) ..................................... 33 2.4 Distinctions between Islamic Banking and Conventional Banking ................................ 36 CHAPTER THREE ........................................................................................................... 41 ORIGINS AND DEVELOPMENT OF ISLAMIC BANKING........................................... 41 3.1 Early Development ...................................................................................................... 41 3.2 Islamic Banking Beyond Islamic Communities ............................................................ 43 3.3 The Practicability of Islamic Banking without interest (Riba) ....................................... 44 3.3.1 Source of Funds .................................................................................................... 45 3.3.2 Islamic Banking Financing Modes ........................................................................ 45 3.3.2.1 Partnership based Modes ........................................................................................ 46 3.3.2.2 Trade- Based Financing Modes .............................................................................. 47 3.4 Development of Islamic Banking in Tanzania ....................................................... 52 3.5 Status of the Tanzanias Islamic Banking Practice ........................................................ 53 CHAPTER FOUR ............................................................................................................. 56 BANKING REGULATORY AND SUPERVISORY FRAMEWORKS IN TANZANIA ... 56 4.1 Introduction ................................................................................................................. 56 4.2 Regulation and Supervision of Banks in Tanzania ........................................................ 56
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4.2.1 On-site inspection ................................................................................................. 56 4.2.2 Off-site inspection ................................................................................................. 58 4.3 Principles and Subsidiary Legislations over Banks Regulation and Supervision............ 58 4.3.1 Principle Legislations ............................................................................................ 59 4.3.1.1 The BoT Act, No. 4 of 2006 ................................................................................... 59 4.3.1.2 The BFIA Act, No. 5 of 2006 ................................................................................. 60 4.3.1.3 The Foreign Exchange Act, No. 1 of 1992 .............................................................. 60 4.3.1.4 The Companies Act, No. 12 of 2002 and the Law of Contract Act, Cap 345 of 2002 (RE 2002),......................................................................................................................... 61 4.3.2 Subsidiary Legislations. ........................................................................................ 61 4.3.2.1 Banking Regulations .............................................................................................. 61 4.3.2.2 Banking Circulars .................................................................................................. 64 4.4 The Rationale of Banking Regulation and Supervision .......................................... 66 4.5 Role of Supervision and Regulation ............................................................................. 67 4.5.1. Protection of Depositors Funds ........................................................................... 67 4.5.2 Maintaining Stability of Monetary and Financial System, ...................................... 68 4.5.3 Promoting an Efficient and Competitive Banking System. ..................................... 68 4.5.4 Protecting Consumer and General Public Rights. ................................................... 69 CHAPTER FIVE............................................................................................................... 70 THE RESEARCH FINDINGS .......................................................................................... 70 5.1 Introduction ................................................................................................................. 70 5.2 Response from respondents as regards the question on what are the inherent risks in Islamic banking practices? .............................................................................................. 70 5.2.1 Islamic Banking Credit Risks ......................................................................... 71 5.2.2 Islamic Banking Market Risks ........................................................................ 72 5.3 Response from respondents as regards the question on what are the challenges Islamic banking practices engender to the regulatory and supervisory regime? ........................... 74 5.3.1 Regulatory and Supervisory Challenges ................................................................ 74 5.3.2. Supervisory challenges ......................................................................................... 84 5.3.3 Judicial challenge.................................................................................................. 85 5.4 Response from respondents as regards the question on does the existing regulatory and supervisory system call for any fine tuning as regards Islamic banking established in Tanzania? ....................................................................................................................... 86 5.4.1 Islamic Banking Regulatory and Supervisory Regime needs change to accommodate Islamic Banking ...................................................................................... 87 CHAPTER SIX ................................................................................................................. 90 CONCLUSIONS AND RECOMMENDATIONS .............................................................. 90 6.1 Introduction .......................................................................................................... 90 6.2 Conclusions .......................................................................................................... 90 6.3 Recommendations ....................................................................................................... 91 6.3.1 Ammendment of the regulatory and supervisory systems ....................................... 91 6.3.2 Alignment of Regulatory and Supervisory Rules to International Best Practices .... 92 6.3.3 Intensive training to employees ............................................................................. 92 6.3.4 Amendment or enactment of certain banking laws ................................................. 93 6.3.5 Improve Corporate Governance............................................................................. 93 BIBLIOGRAPHY ............................................................................................................. 96 BOOKS............................................................................................................................. 96 PEER REVIEWED JOURNAL ARTICLES ...................................................................... 96 RESEARCH AND WORKING PAPERS .......................................................................... 99 INTERNET ARTICLES .................................................................................................. 100 WEB PAGES .................................................................................................................. 101
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ANNEXTURES .............................................................................................................. 102 ANNEXTURE I .............................................................................................................. 102 INTERVIEW GUIDE FOR BoT OFFICIALS AND LEGAL PRACTITIONERS ............ 102 ANNEXTURE II ............................................................................................................. 103 INTERVIEW GUIDE TO THE OFFICIALS OF NBC, KCB AND STANBIC BANK .... 103

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CHAPTER ONE INTRODUCTION 1.1 Background to the problem Banking forms an important part of any prudently functioning financial system. At the centre of banking business there is the activity of money lending upon taking interest. From the time when early forms of banking began to the present time, interest taking has been important for development of banking. This characterised old banking practices in Babylon, Genoa, Venice, Catalonia, and Barcelona as it characterised modern banking in its origin and development in England. For a long time until fairly recently and without any significant respite, the taking of interest by bankers has thus been viewed as being part and parcel of banking business. There is historical evidence to the effect that where interest was forbidden banking business succumbed to an impasse. In line with this fact it is reported in english history of banking that King Henry VIII, at the end of his reign in 1546, once repealed the usury laws which he viewed as constraints to development of banking in his country. Prior to this the Church to which England was allied had disallowed the lending of money with interest. It was this law that the King repealed. From this time onwards money was to be lent only upon interest according to the King's Majesty's Statute at 10 percent.2 It was after this that real modern progress in banking could be felt. To date, the taking of interest by bankers is a legacy that features banking as it is practiced by a majority of banks world wide.

Recently, however, there has evolved a form of banking which is charecterised as being interest free. This kind of banking is Islamic banking or alternatively known as shariah banking. Islamic banking is increasingly and unrestrictively, becoming significant all over the world. It has been reported that islamic banking has been developing at an explosive pace due to internatilisation of worlds financial markets and growth in significance of islamic economics.3 In 2001 it was reported that about forty-eight developing and emerging market countries that represent almost one2

For more information see British Banking History Society (BBHS). (2011, August 23). A History of English Clearing Banks Retrieved from http://www.banking-history.co.uk/history.html 3 See Andilile, J. (2009). Viability and Challenges of Establishing Islamic Banking in Tanzania. The Accountant Journal, 24 (2), p.15. 13

third of all the International Monetary Fund (IMF) member countries, are increasingly involved with varying intensity in islamic banking. 4 This involvement is shared by both Muslim and non-Muslim countries.5 Recent studies report that Islamic banking is steadily moving into an increasing number of conventional financial systems and that it is expanding not only in nations with majority Muslim populations, but also in other countries where Muslims are a minority, such as the United Kingdom and Japan. It is estimated that there are currently more than 300 Islamic financial institutions spread over 51 countries, plus well over 250 mutual funds that comply with Islamic principles. Over the last decade, this industry has experienced growth rates of 10-15 percent per annum, a trend that is expected to continue.6 In the countries where islamic banking is practised, banks have either established islamic windows within the traditional banking regimes7 or licences have been granted for establishment of full-fledged and independent islamic banks.

In East Africa islamic banking has had the doors opened first in Kenya by the year 2007 which marks Kenya the first country in East and Central Africa to allow the operation of Islamic Banking when the Central Bank of Kenya approved First Community Bank (FCB) on May 29, 2007, to operate as a full-fledged Shariahcompliant commercial bank. Later on another bank: Gulf African Bank (GAB), was granted approval by the Commercial Bank of Kenya to become the second fullfledged Shariah compliant bank in Kenya. In Rwanda already there is an islamic bank known as the Al Halaal Islamic Bank.8 In Uganda, the Central Bank pays consistent attention to the significance of introducing islamic banks in the financial

See Errico, L. & Farahbaksh, M. (2008). Islamic Banking: Issues in Prudential Regulations and Supervision (Working Paper No. WP/98/30). International Monetary Fund. P.6. Retrieved from https://www.imf.org/external/pubs/ft/wp/wp9830.pdf 5 See Andilile, J. (2009). Viability and Challenges of Establishing Islamic Banking in Tanzania. The Accountant Journal, 24 (2), p.14 6 Sol, J. (2007). Introducing Islamic Banks into Conventional Banking Systems (Working Paper No. WP/07/175). International Monetary Fund. p. 3. Retrieved from www.imf.org/external/pubs /ft/wp/2007/wp07175.pdf 7 These are like Malaysia, Iran, Bangladesh, Jordan and Egypt. 8 It is a legally agreed Microfinance-Bank,open for all (Muslims and non-muslims). 14

system of that country and it has proposed necessary amendments to the financial institutions laws to close the gap occassioned by the laws as they exist today. 9

In Tanzania Amana Bank is the first full-fledged islamic bank to have acquired a commercial bank licence from the Bank of Tanzania (BoT)10. Many other banks have established islamic windows and these are such as the National Bank of Commerce, Stanbic Bank, Kenya Commercial Bank, Bank of Baroda etc. These operate within the established conventional system. Furthermore, there are many applications routed to the BoT for licences either to operate islamic windows or fullfledged islamic banks.11 In Tanzania, logically, islamic banking can only be adequately accomodated if countrys policies and laws are aligned to reflect the nature of islamic banking. This can be done if the principles of islamic banking and the existing principles of conventional banking are harmonised. These facts serve as a premise upon which the researcher builds the motive to conduct this study with the aim of finding out the challenges islamic banking poses to the existing legal and regulatory regime that would weigh down smooth operation of the banking sector.

1.2 Statement of the Problem Islamic banking is gaining popularity and an ever increasing significance in the Tanzanias financial circles. However, it has proved to be an area that is largely unfamiliar to legal practitioners, policy makers and financial markets regulators (emphasis added).12 Most of its implications still constitute a jungle less explored and known in the Tanzanias legal context.13 This has been true with the rest of the

For more information read Bank of Uganda. (n.d.). Islamic Banking in Uganda. Retrieved October 24, 2010, from http://bou.spsvrtplsite.bou.or.ug /bou/media/from_the_bank/archived_messages /islamic_banking 10 See Koyesiga, F. (2011, August 3). A New Dawn Breaks for Tanzania The Islamic Globe. Retrieved from http://www.theislamicglobe.com/index.php?option=com_content&view=article&id =664:a-new-dawn-breaks-for-tanzania&catid=8:artcile&Itemid=40 11 See Reli, J.H. (2009, July). The oversight of islamic finance in Tanzania. Paper presented at the High level Seminar. Dar es salaam, Tanzania. Retrieved from http://www.eastafritac.org /images/uploads/documents_storage/Juma_Reli_Speech_Islamic_Banking.pdf. The presenter is the Deputy Governor of the Bank of Tanzania. 12 Ibid. 13 See Reli, J.H. (2009, July). The oversight of islamic finance in Tanzania. Paper presented at the High level Seminar. Dar es salaam, Tanzania. Retrieved from http://www.eastafritac.org 15

world where islamic banking has been established.14 In Tanzania islamic banking is a foreign creature and with respect to its inherent features it is apparently inconsistent with the existing laws of banking currently applicable in the country. Tanzanias regulatory and supervisory system on banking is based on a conventional banking infrastructure a large part of it imposed by the common law and core principles of banking supervision15 based on the model engeneered by the Basel committee16. Islamic banking, though may be established to operate within the same regulatory infrastructure,17 commands an application of a system of principles that are quite different from those that apply to conventional banking. This set of principles is collectively known as the islamic shariah/law which stems from the general body of islamic religious principles grounded in the Quran, the Muslims sacred book.18 This, among others, makes islamic banking distinct and unique in its own right. Tanzania being a secular state, has a set of its own laws and does not follow islamic law. Despite this significance islamic banking has a set of its own laws which Tanzania does not use. Further more the existing laws and the legal and supervisory framework are designed for conventional banking and not islamic banking, logically it is incapable to handle the peculiarities of islamic banking. Yet,
/images/uploads/documents_storage/Juma_Reli_Speech_Islamic_Banking.pdf. The presenter is the Deputy Governor of the Bank of Tanzania. 14 See Timberg, T.A.. (n.d). Risk Management : Islamic Financial Policies Islamic Banking and Its potential Impact, Paving the Way Forward for Rural Finance. Paper presented at the International Conference on Best Practices case study. Indonesia. Retrieved from http://www.ruralfinance.org /fileadmin/templates/rflc/documents/Islamic__Banking_pdf.pdf. For the same information see also Sol, J. (2007). Introducing Islamic Banks into Conventional Banking Systems (Working Paper No. WP/07/175). International Monetary Fund. p. 3. Retrieved from www.imf.org/external/pubs /ft/wp/2007/wp07175.pdf 15 See, for more information, Basel Committee on Banking Supervision. (1997, April). Core Principles for Effective Banking Supervision. (Consultative paper). Basle, Switserland. Retrieved from http://www.bis.org/publ /bcbs30.pdf. 16 The Basel Committee on Banking Supervision is an international body that provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. At times the committee develops guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision. Visit http://www.bis.org/. 17 See Muneeza, A. (2010). The Paradox Struggle Between the Islamic and Conventional Banking Systems. Journal of Asia Pacific Studies 1 (2). 188-224. Retrieved from www.japss.org/upload/5.% 20Muneezaetal.pdf 18 See Ahmad, Rehman & Safwan. (2011, March). Islamic Banking and Prohibition of Riba/Interest African Journal of Business Management. 5(5). 1763-1767. Retrieved from http://www.academic journals.org/AJBM 16

both of these are supposed to work within the same economic and regulatory framework which is likely to cause legal difficulties. Intrinsically, there is neither any law specifically enacted to cater for islamic banking nor at least any relevant legal recognition of Islamic Shariah in the present legal system. The only official recognition of islamic law is by way of Judicature and Application of Laws Act (JALA).19 This legislation allows application of islamic principles in Tanzania only in matters that relate to marriage, divorce, guardianship, inheritance, wakf and similar matters. This application, however, is exclusively in relation to members of a community which follows that law.20 This practically shuts out of its realm of applicability the islamic shariah on banking which occassions a grievous legal vacuum to operations of islamic banking. Essentially, being interest free, islamic banking practices greatly differ from conventional banking practices which are rooted in interest. Conventional laws can thus not apply to islamic banking environment.

The fact that Islamic banking is inevitable and that it is a new and forciful development unknown in the present legal system brings about critical issues that dictate the need for a thourough research in the area. This study will analyse the regulatory and supervisory implications of islamic banking adoptability in the Tanzanias banking industry with reference to the laws relating to banking as supervised by the Bank of Tanzania (BoT).

1.3

Research objectives

The overall objective of the study is to make a critical analysis of the impacts of the emergence of Islamic banking in Tanzania to the subsisting regulatory and supervisory regimes. This will entail examining how it fits in the supervisory and regulatory roles of the BoT under the existing laws relating to banking and financial institutions. Specifically the study aimed;

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Cap 358, [RE: 2002] See particularly section 11 (1) (c) (ii) of the Act. 17

(a) To find out inherent risks in islamic banking and asses the relation between the current system of banking regulation and supervision in the country and islamic banking.

(b) To examine the challenges brought about by establishment of islamic banking to the Tanzanias banking regulatory and supervisory structures, both legal and institutional.

(c) To suggest the legal and institutional measures essential for effective regulation and supervision of islamic banking.

1.4

Research Questions.

This study was expected to answer the following research questions (a) What are the common types of risks that are experienced in islamic banking system?

(b) What are challenges that islamic banking engender to the Tanzanias banking regulatory and supervisory regime? And

(c) Lastly, does the existing regulatory and supervisory system call for any fine tuning as regards islamic banking established in country?

1.5

Significance of the Study

This study is of vital significance in Banking industry as it is expected to uncover all the challenges that islamic banking engenders to the existing regulatory framework. It is also intended to find solution to these challenges and to enlighten financial sector regulators, policy makers and the legislature on how best can these challenges be contained and come up with the best way of practice as regards both islamic banking and conventional banking.

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Moreover, this study is expected to be a worthwhile contribution to the existing knowledge in this area which for the case of Tanzania it does not have such a wide archival base given the novelty of islamic banking. The underlying significance of the study is that, it is expected to serve the researcher a realisation of his academic accomplishment in the field of a master degree in commercial Law.

1.6

Scope of the study

This study is confined to a critical analysis of impacts of Islamic banking system to the regulatory and supervisory system in Tanzania on the one hand. On the other hand the study exclusively covers the collection of data in Arusha and Dar es salaam.

1.7

Literature Review

Review of the literature reveals that most studies carried out on the subject, do not directly relate particularly to the situation in Tanzania. There is no study done particularly on the present topic that is, a critical analysis of the impacts of the emergence of Islamic banking in Tanzania to the subsisting regulatory and supervisory regime. There is however, one study conducted in Tanzania which dealt with viability and challenges of establishing Islamic banking in Tanzania and this as the topic suggests was conducted before Islamic banking was actually established. Specifically, the following are what the literature reveals.

Khan and Mirakhor (1990) point out that a central tenet of an economic system based on Islamic principles is the absolute prohibition on the payment and receipt of interest. It is this prohibition that makes Islamic banks and financial institutions differ in a fundamental sense from their Western counterparts. As the use of the interest rate in financial transactions is precluded, Islamic banks are expected to conduct operations only on the basis of profit-sharing arrangements or other modes of financing permissible under Islamic law.
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This explains the conception that

Khan, M.S. & Mirakhor, A. (1990). Islamic Banking: Experiences in the Islamic Republic of Iran. Pakistan Economic Development and Cultural Change, 38(2). 353-375. Retrieved from http://www.jstor.org/stable/1154031. 19

islamic banking operations are more related to financing facilities which are only permissible under islamic law and logically which might differ from those that currently are employed in Tanzanias legal context.

Errico and Farahbakash (2001) appreciate that Islamic banking differs from conventional banking in several important ways. These include the prohibition of transactions based on fixed or predetermined rate of interest on the one hand and the requirement that banks operations be carried out according to certain procedures through the use of certain financial instruments. They also point out that though in a majority of countries where Islamic banks operate the same regulatory framework applies to both conventional and Islamic banks, these standards however are not always applicable in an Islamic banking framework in the same way as they are in other banking systems.22 This means the difficulties ensued by Islamic banking differ from one banking system to another depending on the law applicable.

The authors further argue, thus, Islamic finance, banking being a component part, (emphasis added) should be encouraged by regulation and supervision that accommodate its forms while ensuring that their unfamiliarity is not exploited to defraud clients. During supervision, Banks performance is rated by their Capital adequacy (C), Assets quality (A), Management (M), Earnings capability (E), and Liability management (L), thus CAMEL. The authors specifically conclude that the CAMEL23 rating system of banking supervision does not automatically apply to Islamic banking. Significance of this literature is that, when it comes to supervision Islamic banking and conventional banking are quite distinct and thus the traditional approach to banking regulation and supervision can not necessarily be applicable to Islamic banking.

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Errico, L. & Farahbakash, M. (2001). Islamic Banking: Issues in Prudential Regulation and Supervision. Review of Islamic Economics, 10. p.6. Retrieved from http://iaie.net/Common/Controls /DImage/DImage.aspx?imagePath=UploadFolder1%5CJournal%5C10/10-Luca_01.pdf 23 Is an accronym for Capital Adequacy (C), Asset quality (A), Management (M), Earnings Capability (E), and Liability Management (L). 20

Sole (2007) in the same line of argument points out that, in any country where islamic finance is introduced and keeps expanding, the supervisory authorities will have to ensure that these new institutions become fully integrated with the rest of the financial system and that the integration process will not only entail allowing Islamic institutions to operate, but also providing a comprehensive regulatory framework, as well as developing a supportive financial infrastructure.24 This means islamic banking must be harmonised to the financial system and work together with the conventioanl banking towards a common goal of intermidiating finances to the deficit units in the countrys economy.

Ahamad (2007) argue that Islamic banking is facing challenges and problems but they are of the view that the cause of these challenges and problems is the fact that it is on the infant stage. 25

Reli (2009) notes that though Islamic finance is becoming increasingly integrated into the international financial system many supervisory authorities and other

policy makers in emerging markets remain unfamiliar with the key principles that are involved in Islamic finance and banking. He further notes that though both islamic and conventional banking are the same on the basis that their ultimate focus being to provide liquidity to the deficit unit or investors in the economy and that they have many differences than this similarity, the Supervisors objective of ensuring safety, stability and soundness of the banking system as a whole, as well as the proper prudent conduct of individual institutions in the financial system remain as key. The regulators and supervisors are expected to undertake similar supervisory and regulatory functions regarding Islamic institutions as those performed on conventional banking institutions. In line with this however, if regulations are not well thought, they may affect the degree of success within which Islamic banking is introduced into a conventional system. In this regard,
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Sol, J. (2007). Introducing Islamic Banks into Conventional Banking Systems (Working Paper No. WP/07/175). International Monetary Fund. p. 3. Retrieved from www.imf.org/external/pubs /ft/wp/2007/wp07175.pdf 25 Ahamad, H. (2007). Regulation and Performance of Islamic banking in Bangladesh. Thunderbird International Business Review,49 (2), pp. 251-277. 21

policy makers cannot ignore the role of developing an environment where Islamic banking can offer a suitable response to customers demands for Islamic products.
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Eldin and Abdullah (2007) report that Islamic banking has a smooth way of going successful but in order to be so there is a need to bring changes by policy makers, on the one hand, and in order to strengthen Islamic banking transactions there is a need to develop a strong legal framework, on the other. They further argue that Islamic banking is faced with a lack of a unified regulatory system for its products and transactions. 27

Maurer (2005) observes that like Islam itself, Islamic banking is fastly growing in public prominence.He further provides a metaphor, that Islamic banking is a new world that is poorly understood by Westerners, finance professionals, and even by some of the Muslims themselves. This literature is significant in that the advent of islamic banking comes as a new thing which brings forth challenges unknown to the key banking functionaries experiences thus to be able to manage islamic banking familiarisation with and effective knowledge of all the policy, regulatory and supervisory concerns becomes important so as to prepare a financial system that reflects its demands. 28

Horowitz (1994) concluding in his study on associations of legal systems and laws of different countries articulates that many legal systems, including those of the United States, the European Union, Eastern Europe, and the former Soviet Union, as well as those of the Islamic world, are in a period of rapid legal change, that is, the boundaries between legal systems are by no means watertight. Change in a legal system is rarely comprehensible by reference to dynamics internal to that system
26 27

The author is the Deputy Governor Bank of Tanzania. Eldin, S.I.T and Abdullah, N.I. (2007). Issues of implementing Hire purchase in dual banking systems: Malaysian experience. Thunderbird International Business Review, 49 (2). 225-249. Retrieved from http://www.kantakji.com/fiqh/Files/Banks/c1014.pdf 28 Maurer, B. (2005). Mutual Life, Limited: Islamic Banking, Alternative Currencies, Lateral Reason. In Harrington, B. (Ed.). (2006, March) Brown University. American Journal of Sociology 111 (5). pp 1606-1608. Retrieved from http://www.jstor.org/stable/10.1086/504662. 22

alone. In the process of innovation, legal systems are brought into contact with each other and due to this change in one system can ultimately induce change in others.
29

The significance of this work sheds light on the fact that islamic banking and the

legal principles within which they operate being innovations from other countries outside the Tanzanias legal system are likely to impose challenges and thus influence change to the Tanzanias legal system as long as this form of banking operates in Tanzania.

Muneeza, Wisham & Hassan (2010) studying the functioning of the conventional and islamic banking systems in Malaysia conclude that systems which function on two different paradoxical statements but operating in the same pluralistic system are inevitably bound to open quarrels with each other in terms of its basis, operation and mind-set. They further observe that emergence of two systems within the same organism would predictably give rise to certain clashes and a need arises where these clashes and challenges are addressed if the effort to bridge the gap is to be effected at a useful level. The authors identify these clashes as they include those based on legislative grounds and those faced in the process of judicial adjudication in dispute as well as those which are relevant to alternative means of dispute resolution (ADR). These clashes can not be avoided anywhere conventioanl banking operates,Tanzania inclusive, and where islamic banking is introduced since the two function from two paradoxical grounds. 30

Balz (2004) observes that Islamic financing transactions today often are implemented in a non-Islamic legal environment, i.e., a jurisdiction that is not effectively bound by and does not give effect to the principles of the Islamic Shari'a. He further notes that by far most of the Islamic finance business is transacted in jurisdictions where the relevant Shari'a principles, in particular the
29

Horowitz, D.L. (1994, Spring). The Qur'an and the Common Law: Islamic Law Reform and the Theory of Legal Change. The American Journal of Comparative Law, 42(2). pp. 233-293. Retrieved http://www.jstor.org/stable/840748. 30 Muneeza, A., Wisham I.& Hassan, R. (2010). The Paradox Struggle Between the Islamic and Conventional Banking Systems. Journal of Asia Pacific Studies ( 2010) 1(2). 188-224. Retrieved from www.japss.org/upload/5.%20Muneezaetal.pdf

23

prohibition of riba, are no longer enforced and may never have been enforced as the law of the land. In these jurisdictions which include London and Geneva, the business model of Islamic financial institutions is based on reference to Islamic legal norms that are not enforced as the (official) law of the state, that is, transactions guided by the principles of the Islamic Shariah are carried out in a nonIslamic legal environment. He notes issues this practice raises such as the questions of how Islamic legal principles that are the basis of Islamic financial transactions relate to the laws of the jurisdiction in which they are implemented and how traditional Islamic contractual structures are transformed when adjudicated in a court that does not necessarily share the parties' commitment to Shariah-rules. 31

Andilile (2009) appreciates the benefits of islamic banking as it provides alternative banking products to customers, he however notes that it is not without challenges. He notes that these challenges stem from the fact that we live in the world economy where interest rate is a central balancing mechanism for demand and supply of financial resources. In the world financial market, he further notes, the newness of islamic banking also poses several challenges to both regulators and practitioners. The biggest legal challenge islamic banking introduces to Tanzania, he highlights, is a constitutional one. He is of the view that Tanzania being a secular state, any attempt to foster faith-based institutions by the government or its agencies is likely to be perceived by the public to be a violation of article 19 of the Constitution of the United Republic of Tanzania of 197732 which gives freedom of religion to all citizens but shuts out the state from participating in the affairs and management of religious bodies. 33

The reviewed literature suffers from two shortcomings,firstly, it does not directly and sufficiently relate to the Tanzanias context particularly. That is non of this
31

See Balz, K. (2004). A Murbaa Transaction in an English Court: The London High Court of 13th February 2002 in Islamic Investment Company of the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & OrsAuthor(s). Islamic Law and Society, 11 (1). pp. 117-134. Retrieved from http://www.jstor .org/stable/3399382. 32 As amended from time to time. 33 See Andilile, J. (2009). Viability and Challenges of Establishing Islamic Banking in Tanzania. The Accountant Journal, 24 (2), p.22. 24

literature has attempted a comprehensive study particularly on the impact of islamic banking on the regulatory and supervisory framework subsisting in Tanzania. Further there is only one study carried out in Tanzania34 fairly on subject but again this study suffers from being incomprehensive as it was intended to only study viability of establishing islamic banking in Tanzania at a time before the same was established. This study intends to investigate on the impacts islamic banking brings forth onto the regulatory and supervisory framework of banking industry in Tanzania and at a time after its establishment.

1.8

Research Methodology

This section sheds an insight on the methodological issues in research. It focuses primarily on providing help with the tools and techniques used in the research process. The researcher employed interview guide as the tool for collecting information from the BoT and from some financial institutions which offer some form of islamic banking such as the NBC, Stanbic Bank and KCB.

1.8.1 Research Design Research design is the conceptual structure within which research is conducted; it constitutes the blueprint for the collection, measurement and analysis of data. As such the design includes an outline of what the researcher will do from writing the research questions and its operational implications to the final analysis of data.35 Since this study is a qualitative study the researcher used a case study design with which he collected information regarding the impacts of Islamic banking to the Tanzanias regulatory and supervisory regime. Creswell (1994) points out that in a case study, a single person, program, event, process, institution, organization, social group or phenomenon is investigated within a specified time frame, using a combination of appropriate data collection devices.36 This study is one that concerns narration of facts about a situation which is brought to the fore by the
34 35

The one by Andilile, ibid. See Kothari, C.R. (2010). Research Methodology (2nd Edn). New Delhi: New Age International, Publisher. P 31 36 See Creswell, J. W. (1994). Research Designs: Qualitative and quantitative approaches. Thousand Oaks, CA: Sage. p. 12 25

advent of islamic banking as it impacts upon the existing regulatory and supervisory regime in Tanzania.

1.8.2 Area of Study The study was conducted mainly at the BoT in Arusha but from its Headquarters in Dar es salaam. Data was collected also from commercial banks offering islamic banking services in Arusha but from their Headqurters in Dar es salaam. These banks included National Bank of Commerce (NBC), Stanbic bank, and Kenya Commercial Bank (KCB).

1.8.3 Target Population The targeted population of this study involved banks officials from the BoTs Directorate of Bank Supervision, selected commercial banks and banking lawyers who specifically deal with supervision, management and daily operations relating to Islamic banking, on the one hand. On the other hand, the researcher targeted also the persons who have knowledge of the functioning of Islamic banking.

1.8.4 Sample Size A sample of 21 respondents was drawn from the target population. The researcher collected data from 12 respondents who included 3 BoT officials in the Bank Supervision Directorate, 4 members of staff in commercial banks engaging in issues of islamic banking and 5 banking lawyers appropriately knowledgable on the functioing of islamic banking.

1.8.5 Sampling Procedure Researcher of this study used purposive sampling. It is a kind of sampling in which a researcher has an opportunity to select, on the bases of his own judgment in each unit, the most useful representatives to be observed.37 The researcher employed this kind of sampling because he wished to ensure that respondents selected were particularly informative and that data required was feasibly attained in a limited
37

Adam, J., Kamuzora, F. (2008). Research Methods for Business and Social Studies. Mzumbe Book Project Morogoro-Tanzania. 26

period of time. As such respondents were selected basing on the researchers perception of their knowledge on the matter under investigation regard being had to the nature of the study itself. Hence it was the one that was more appropriate in this study.

1.8.6 Types of Data and Data Collection Methods The researcher intends to collect the following types of data;

1.8.6.1

Primary Data

As for collection of primary data researcher used interview guides administered to selected officials identified in the sample of respondents depending on their availability. Simplicity and flexibility in the form of the questions was adopted by the researcher for allowing easy of self expression for the respondents. In formulating the questions regard was had on their ability to give explanatory details as per objectives of this study.

1.8.6.2

Secondary data

Here documentary sources were used. In this, various documents relating to the topic were thoroughly consulted. Due regard was given to various domestic legislation and subsidiary legislation that relate to banking, relevant books, journals, academic and scholarly articles, policies, International Instruments, declarations and other documents. These were important in highlighting the theoretical base relating to Islamic banking and regulatory and supervisory principles used by the BoT.

1.8.7 Data collection Methods. In data collection the major data collection instrument employed by the researcher was interview. Interview guides were distributed to respondents before hand and later telephone interview was conducted. The instrument designed to extract information from respondents was well formulated and tested. As this study mainly required qualitative data, interview guides were drawn to comprise of open ended

27

questions with the view to acquiring opinions and critical presentation of the ideas of the respondents on the subject. Generally the data collection exercise involved mainly telephone interview. The questions asked in this interview were structured. The exercise also involved collection of secondary data, from which various useful materials were provided. In interview, a total of 3 officials of the BoT were interviewed: 2 being Bank examiners under the BoTs Directorate of Banking Supervision, and 1 being Financial Markets Analyst from the BoTs Directorate of Financial Markets. Also 4 officials from commercial banks that practice Islamic banking were interviewed: 2 from NBC (1 from Arusha Branch and the other from NBC Head quarters, Dar es Salaam), 1 from KCB and another 1 from Stanbic Bank. The researcher also interviewed 5 other persons from the legal fraternity who were conversant with Islamic banking. This makes a total of 12 respondents. Previously, the researcher had distributed interview guides to all respondents sampled i.e. 21 but the mentioned 12 only were interviewed and they responded positively, by answering the questions asked both orally and by supplying various documents relevant to the study.

1.8.8 Data Analysis Techniques The researcher used qualitative data analysis technique. The researcher first

gathered all the information obtained from the respondents. Then items of data (e.g. statements) were arranged into various groups in a preliminary way, then all items which were of relevance to certain groups, were there in included. Then the researcher set up a number of categories basing on the information obtained from the previous steps. The major concern of the researcher in setting up the categories was on their variety of meanings, attitudes, and interpretations found within each category. interpretation of the data was then done basing on information obtaining from categories set up.

1.8.9 Limitations of the Study Limitations that the researcher faced include difficulties in obtaining data within the area of study as islamic banking practiced by banks within Arusha is centrally

28

managed from their headquarter offices all located in Dar es salaam. Heads of Islamic banking operations are all located in Dar es salaam. This is true for all the commercial banks as well as the BoT, Arusha branch which could not provide data because all the issues of regulation and supervision are done and controlled from the Directorate of Bank Supervison in Dar es salaam.

Another limitation that the researcher encountered arose from the novelty of Islamic banking discipline in the country. This brought forth a considerable drawback to the researcher in relation to collection of data since only a few specified officials in these institutions were appropriately conversant with Islamic banking. This explains why out of the total population of 21 individuals, information was collected from 12 respondents, which is 57.14% of all the respondents. Further, permission to collect data depended upon respondents availability in their offices and or their convenience to respond to questions.

Moreover, the researcher encountered strict issues of confidentiality when he asked banks under study to disclose profiles of their customers, consumers of Islamic Banking. As it was difficult to identify Islamic banking customers because they used same tellers as conventional banking customers, with the help of these profiles the researcher would identify and establish rapport with them prior to collecting information from them.

29

CHAPTER TWO CONCEPTUAL FRAMEWORK 2.1 Introduction In this chapter the researcher introduces Islamic banking and explains the key concepts that underlie it.

2.2 The concept of islamic banking Islamic banks are defined as banks whose operations are considered to be integral parts of complete islamic system based on codification of prohibitions outlined in the Quran and the traditions of the Prophet Muhammad (P.B.U.H) that is shariah. The principle elements of islamic economic system include individual rights, property rights, contracts, relation between labour and wealth and the role of the state.38 Islamic banks practices are characterised first, by the restriction against payment and receipt of a fixed and predetermined rate of interest (Riba). Interest is replaced by profit and loss Sharing arrangements where the rate of return on financial assets held in banks is not predetrmined until the transaction is done.39 Secondly, by the requiremnt to operate by way of financing modes. These are mainly devided into PLS modes and sales modes. Lastly, by two types of deposits of funds, namely investment deposit and demand deposits. Investment deposits are not guaranteed in capital value and do not yield any fixed or guaranteed rate of return. Customers only enjoy an agreed ratio of profit distribution. If, however, a bank sustains loss customers may lose all or part of their investment deposits.40 Demand deposits are guaranteed in capital value but no returns are paid on them. Islamic banks in this aspect are regarded as bailees of the customers money and as such the money is entrusted to them for safe keeping. The deposits must be returned as they belong to customers whether there is sustenance of profit or loss.41

38

See Errico, L., & Farahbaksh, M. (2001). Islamic Banking: Issues in Prudential Regulations and Supervision. Review of Islamic Economics, 10. 7-8. Retrieved from http://iaie.net/Common /Controls/DImage/DImage.aspx?imagePath=UploadFolder1%5CJournal%5C10/10Luca_01.pdf 39 Ibid. 40 Ibid. 41 Ibid. 30

Central to all these is the injunction against riba. A central tenet of an economic system based on Islamic principles is the absolute prohibition on the payment and receipt of interest (riba). The word 'riba' means 'increase' which corresponds to the word 'interest' as defined by Webster's New World Dictionary. 42 Islamic Banking principles posit that interest is strictly unacceptable.43 Muslims are prohibited by their religion from taking, giving or witnessing interest (riba) on loans regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged.44 Thus Riba and interest are one and the same thing. For the sake of this research the word riba shall be used throughout.

Muslims have two levels of authorities which guide their actions: the Muslims Holy book, the Quran and the Hadeeth.45 These authorities form the basis for prohibition of riba. Beginning with the Quran; in one verse a stern instruction to all Muslims is ensued that they should stay away from taking riba.46 It is declared in another verse47 that disregarding the prohibition of riba is equal to wedging a war with God himself and His Prophet48 together. In another verse49 the act of taking riba is equalled to confiscation of other persons property. Yet in another verse, the Quran stipulates that taking interest deprives wealth of Gods blessings.50 Coming to the Hadeeth, there is a string of hadeeths that prohibit riba. In one ahadeeth the prophet Muhammad (P.B.U.H) is quoted enjoining upon muslims to refrain from riba, which he charecterised as being amongst most deadly things. 51 In another ahadeeth,52 the prophet is reported to have cursed three groups of people: the receiver of interest and the payer thereof, the one who records it and the two witnesses thereof. Further these
42

Noorzoy, M.S. (1982). Islamic Laws on Riba (interest) and their Economic Implications. Int. J. Middle East Stud. 14(1). 3-17. 43 Ariff, M. (1988). Islamic Banking in South-East Asia. Institute of Southeast Asian Studies. Singapore. 44 Abdulgafoor, A.L.M, (1995, February) Interest- Free Banking Commercial Banking. Groningen, Aptec Publications. Retrieved from http://users.bart.nl/abdul. 45 Words of the prophet of the Muslims; Prophet Muhammad (SAW). 46 Quran 3: 130 47 Quran 2: 275-281 48 The Word prophet here refers to prophet Muhammad (P.B.U.H) referred to in note 43 above. 49 Quran 4:161 50 Quran 30:39 51 This ahadeeth is reported by Bukhari, Muslim, Abu Dawud and Nasai. 52 This ahadeeth is related by Jabir B. Abdullah and reported by Muslim, Tirmidhi and Ahmad 31

people are all alike in guilt. Riba has also been said to have more than seventy grades of evil, the least serious of them is equalled to committing adultery with ones own mother.53

Islam's prohibition of interest is not new to itself. The prohibitions receive credit even from the early Jewish and Christian traditions. The renowned Greek philosopher, Aristotle, is quoted to have issued a condemnation on acquiring of wealth by the practice of charging interest on money when he said:

The most hated sort, and with the greatest reason, is usury, which makes a gain out of money itself, and not from the natural object of it. For money was intended to be used in exchange, but not to increase at interest. And this term interest, which means the birth of money from money, is applied to the breeding of money because the offspring resembles the parent. Wherefore of an modes of getting wealth this is the most unnatural.54 In judeo-christian philosophy interest is also abhorred:55 The fundamental ruling on usury for both Judaism and medieval Christianity is a Biblical statement found in the Book of Deuteronomy, which reads: You must not lend on interest (Neshekh) to your brother, whether the loan be of money or food or anything else that may earn interest. 56

This passage is supported by another from Exodus: If you lend money to any of my (i.e. Yahwehs) people, to any poor man among you, you must not play the usurer with him: you must not demand interest (neshekh) from him.57

53 54

Reported by Ibn Majah Aristotle (350, B.C.E). Politics: Book One Part X. ( B. Jowett, Trans). Retrieved from http://classics.mit.edu/Aristotle/politics.1.one.html. 55 For adeeper discussion under this part see Cornel, V. J. (2008). In the Shadows of Deuteronomy: Approaches to Interest and Usury in Judasm and Christianity. The American Muslim (TAM) 1989. Retrieved from http://theamericanmuslim.org/tam.php/features /articles/ in_the_shadows_of_deutero nomy_approaches_to_interest_and_usury_in_judaism_a 56 See Deuteronomy. 23:19-20 57 See Exodus 22:24-25 32

The same can be seen as well in Leviticus as follows: If your brother who is living with you falls on evil days and is unable to support himself with you, you must support him as you would a stranger or a guest, and he must continue to live with you. Do not make him work for you, do not take interest (tarbit) from him; fear your God, and let your brother live with you. You are not to lend him money at interest (neshekh) or give him food to make a profit out of it.58

It appears from this that interest, riba or usury which is at the root of traditional banking is rather a creature of capitalism and it is only entertained in the economic set up of capitalist ideology.

2.3 The rationale behind the Islamic Prohibition of interest (Riba) Outside the islamic world interest is central to loans acquisitions in banking practice. Loans acquisition can not be divorced from either micro or macro, government or private economic development project planning. The purpose why loans are taken may fall in two categories: first, for consumption and, second, for investment in a business venture. Lenders usually lend on interest (Riba). In islam Riba is unlawful on both of these types of loans, as discussed above. The simple bases of the prohibition against riba on consumption loans is that those who borrow are assumed to be in need of such loans for purposes of maintaining some minimum standard of living. To make a loan to another without riba, then, is an act of charity. Thus, those with higher incomes and, therefore, higher savings (surplus funds) are asked to make loans to those with lower incomes who are in need without having to extract riba from them. Achieving equity among different levels of income and wealth is a fundamental aspect of the Islamic value system. Islamic taxation in the form of zakat is directed toward this end. The prohibition of riba on consumption loans is clearly so aimed at the redistribution of purchasing power from the rich to the poor. 59

58 59

See Leviticus 25:35-3 7. Noorzoy, M.S. (1982, Feb). Islamic Laws on Riba (interest) and their Economic Implications. Int. J. Middle East Stud. 14(1). 6. Retrieved from http://www.jstor.org/stable/163331. 33

In the case of loans for business investment it is generally argued that the basic reason for the prohibition of interest is that it generates income without "labor" (work) on the part of the lender. It seems that this prohibition is directed at those who would, in essence, be clipping coupons from fixed interest earning assets. But this reasoning also has the implication that money has no productivity per se. The argument is aimed at encouraging capitalists to invest directly, through proprietorships or active partnerships, or indirectly through silent partnerships (mudaraba) and purchases of shares in corporations rather than hold idle cash balances. Thus, capital formation should proceed through the expenditures by any of these types of business on new buildings, machines, equipment, or inventories from their available capital funds. Along these lines physical capital is clearly considered to be a factor of production in the conventional sense. 60

In line with this, Islam does not view money as a commodity which can be bought and sold at a profit. By denying money the role of a commodity, Islamic finance ensures the only way a financier can generate a profit is by purchasing an equity share in a business venture in exchange for his capital. This one difference strikes at the heart of the evils of interest based banking by ensuring money is better able to flow to those projects which are viable and away from those projects which offer the greatest collateral. This in turn enables economic growth rates to increase and the wealth generated to be shared more equally by society. 61 Islamic financing only permits the government to issue currency which must be backed by an underlying asset. This in turn, removes from private banks, control and power over the issuing of artificial paper money.62

Generally, money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. Interest can lead to injustice and exploitation in society; The Quran
60 61

Ibid, p. 7. Glaeser, E L., Scheinkman J. (1998, April). Neither a Borrower nor a Lender Be: An Economic Analysis of Interest Restrictions and Usury Laws. Journal of Law and Economics 41. 1-36. 62 First Ethical. (2005). Guide to Why Islam Has Prohibited Interest and Islamic alternatives for Financing. Retrieved from msmsoton.files.wordpress.com/2008/02/guide-to-interest.pdf 34

(2:279) characterises it as unfair, oppressive and exploitative. Islamic banking is an instrument for the development of an Islamic economic order. investment. In principle, these problems are avoided under Islamic markup contracts.

While the above mentioned rationales for banning interest in Islam are unambiguously rooted in isalmic theology, exponents of Islamic banking also do have economic arguments to support a ban on riba. Many of these arguments are similar to those put forth in medieval Christianity to restrict usury. Some of the economic rationales for the superiority of profit-and-loss sharing over the use of interest are: If interest is replaced by profit sharing, some imbalances are expected to be reduced.

i. First, the return on capital will depend on productivity. Allocation of investable funds will be guided by the soundness of the project. This will in effect improve the efficiency of capital allocation.

ii. Second, the creation of money by expanding credit will be created only when there is a strong likelihood of a corresponding increase in the supply of goods and services. In case the enterprise loses, repayment of capital to the bank is diminished by the amount of loss. Thus in the profit-sharings ystem, the supply of money is not allowed to overstep the supply of goods and services. This will eventually curb inflationary pressures in the economy. iii. Third, the shift to profit sharing may increase the volume of investments that translates into job creation. This is because the interest mechanism makes feasible only those projects whose expected profits are sufficiently high to cover the interest rate plus added income. This filters out projects which otherwise would be accepted in the profit-sharings ystem.

iv. Fourth, the new system will also ensure more equitable distribution of wealth. Wealth would bring more wealth to its owners only when its use has actually

35

resulted in the creation of additional wealth. This would in time reduce the unjust distribution of wealth which continued for decades during the interest regime.

v. Fifth, the abolition of interest, together with the restriction of forward transaction, as prescribed by Shariah, will curtail speculations measurably. But still, there will be a secondary market trading common stocks and investment certificates based on profit-sharing principles. This will bring sanity back to the market and allow raising of funds for enterprises and liquidity to equity holders. 63

The above discussion has presented the dogmatic foundations of islamic principles as they apply to islamic banking. These form the principle constructs for differences between islamic banking and conventional banking. The differences are discussed below.

2.4 Distinctions between Islamic Banking and Conventional Banking In discussing how islamic banking differs from conventional banking, it is worthwhile noting before hand that Islamic Financial Institutions are operating in the same environment as do the conventional banks. They also perform all those functions which are expected from a financial institution. Islamic banks assist the business world by providing all the services required to run the economy smoothly, that is, they do the role of intermediation of funds. However, the philosophy and operations of islamic banks are different. 64

Any financial system is expected to assist in running the economy by providing the following services grouped into two headings. First; Savings mobilization from savers to entrepreneurs and Second; Provision of general utility services including transfer of funds, facilitation in international trades, consultancy services, safekeeping of valuables, and any other service for a fee. There is no restriction on
63

Aggarwal, R.K.. Yousef, T. (2000, Feb). Islamic Banks and Investment Financing. Journal of Money, Credit and Banking, 32 (1). pp. 93-120. Retrieved from http://www.jstor.org/stable/2601094 64 Hanif, M. (2011, Feb). Differences and Similarities in Islamic and Conventional Banking. International Journal of Business and Social Science, 2(2). p. 169. Retrieved from http://www.ijbssnet.com/journals/Vol._2_No._2%3B_February_2011/20.pdf. 36

provision of such services by Islamic banks since provision of such services is not against the shariah. However, there exist differences in mechanism of funds mobilization from savers to entrepreneurs as described below.65

Islamic and conventional banks are distinguished on the basis of their functions and operating modes. While the functions and operating modes of conventional banks are based on fully manmade principles the functions and operating modes of Islamic banks are based on the principles of Islamic Shariah. The shariah is contained in the Quran and in the hadeeth. The manmade principles are contained in laws of a particular country relating to banking. The two are also distinguished on the aspect of paying and receiving interest (riba). While in conventional banking the investor is guaranteed on a predetermined rate of interest, islamic banking promotes risk sharing between the provider of capital (investor) which is usually an islamic bank and the user of funds (entrepreneur) who is usually the customer. Further, while conventional banks are not concerned with payment of a mandatory contribution charged on ones income on a yearly basis commonly known as zakat in the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks: to be a Zakat Collection Centre.

Farther distinctions relate to the fact that Lending money and getting it back with compounding interest is the fundamental function of the conventional banks. Participation in partnership business is the fundamental function of the Islamic banks. In another aspect convetional banks can charge additional money (penalty and compounded interest) in case of defaulters. This is prohibited in islamic banks. They have noprovision to charge any extra money from the defaulters. They charge insted only small amount of compensation the proceeds of which must be given to charity and rebates (discounts) are given for early settlement at the bank's discretion. It is also argued that it is relatively easier for interest-based commercial banks to borrow from the money market. Borrowing in islamic banks must be based on a Shariah approved underlying transaction. This may be fatal to islamic banks urgent
65

Ibid. 37

needs of money. Moreover, in advancing loans conventional banks give greater emphasis on credit-worthiness of its clients. Credit-worthiness of a customer is of no concequence to islamic banks, which give greater emphasis on the viability of the projects they agree to share profits and losses. It necessarily implies that islamic banking is a form of trading.

Islamic banks and conventional banks are distinguished on their status in relation to their customers. The status of a conventional bank, in relation to its clients, is that of creditor and debtors the customer being the former while the bank being the latter. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller. Another aspect of distinction is the aspect of customers deposits guarantee. A conventional bank has to guarantee all its deposits, islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is an investment account, customers have to share profit and loss and may lose all or part of their money as there is no guarantee.

Conclusively, in financial intermediation, a function which is shared by both types of banks, islamic banks cannot provide finance for projects that are prohibited by Shariah regardless of how profitable they may be. Islamic banks deal with assets instead of cash as such they do not receive interest but rather finance the borrower by supplying to him an asset he requires by an agreement to share profit and loss.

With the mentioned differences, Islamic banking is completely a new creature in Tanzania. Being new, its adoptability needs to be preceded by enough preparation of the banking system as a whole. Islamic banking results in many issues such as policy issues, legal issues, operational issues and systemic issues. The researcher is concerned about the mechanics of its adoptability. Adopting any thing with new feature previously unknown by a system always proves to be problematic. A theory propounded by Rogers66 reinforces this fact. The theory is known as the Innovation
66

Rogers, E.M. (2003). Diffusion of Innovations (5th Edn). The Free Press, New York. 38

Diffusion Theory (IDT). Innovation refers to anything new that was not known before. It can be technology, idea, machinery, practices and so forth. In this regard Islamic banking is an innovation. The IDT theory states that the process of diffusion and adoption are very closely related processes. Diffusion is a mega process that relates with familiarizing and accepting an innovation and adoption is a mini process that comprises of various stages that a system goes through prior to accepting or rejecting that innovation. In this process adopters pass from awareness to a full acceptance of an innovation. 67 This implies that adoption of an innovation has to be done in two levels: acquiring it and adopting it either by individuals or organisations. Generally, the key theoretical constructs concerned with IDT focus on adoption of an innovation. 68

However, getting a new idea adopted either by individuals or organisation, despite the obvious advantages it may have, can be utterly difficult and considerably not without challenges. Many innovations require a lengthy period of many years, from the time when they become available, to the time when they are widely adopted. Furthermore, the same innovation may be desirable for one situation but undesirable for another potential adopter, whose situation differs.69 Innovations are said to come with such characteristics as relative advantage, compatibility, complexity, observability and trialability.70 IDT is an apotheosis to be applied to the present study which seeks to research on the challenges brought about by adoption of Islamic banking in Tanzania.

For this purpose Islamic banking is an innovation which rapidly diffuses into Tanzania. In studying this, the study mainly deals with the diffusion of Islamic banking as innovation in view of one of the mentioned characteristics, which is compatibility as above mentioned, as it comes with innovation. The study finds out how Islamic banking practices are compatible with the currently existing regulatory
67 68

Ibid. Ibid. 69 Gerard, P., Cunningham, J.B. (1997). Islamic Banking: A study in Singapore. International Journal of Bank Marketing, 15(6), p. 204-16 70 Rogers, Op cit. 39

and supervisory framework. It determines how far application of Islamic banking principles is compatible with the conventional banking practices.

Compatibility denotes the degree to which an innovation is perceived as being consistent with existing values, past experiences and the needs of potential adopters.71 Generally, the Tanzanian banking institutions have some long banking experiences from the conventional banking practices. Comparably since Islamic banking is banking, its banking functions and purpose are nearest to the functions and purpose of conventional banking. However, the question is does the shariah law within which the functioning of Islamic banking is governed have any compatible dictations with the current regulatory and supervisory framework within which the conventional banking functions? Thus two variables; one dependent which is adoption of Islamic banking72 and another independent, which is compatibility of Islamic banking with the Tanzanian regulatory and supervisory regime prove to be of vital significance in fixing the focus of this study. From that influence, the following research questions guided the researcher throughout this study:

(a) What are the common types of risks that are experienced in islamic banking system? (b) What are the challenges that islamic banking engenders to the Tanzanias banking regulatory and supervisory regime? and (c) Lastly, does the existing regulatory and supervisory system call for any fine tuning as regards islamic banking established in Tanzania?

Therefore, this study examines compatibility concerning adoption of Islamic Banking in the context of how it fits or does not fit in our current regulatory framework, if or not it brings about any challenges which necessitate tuning up our regulatory framework.
71 72

Rogers, E.M. (2003). Diffusion of Innovations (5th Edn). The Free Press, New York. This means acceptance and continued use of Islamic Banking. 40

CHAPTER THREE ORIGINS AND DEVELOPMENT OF ISLAMIC BANKING 3.1 Early Development The concept of Islamic Banking is as old as islam itself. The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships73 dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions.74 Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.75

The first most practical of modern forms of islamic banking grew its first roots in Egypt at the area known as Mit-Ghamr in 1963. Many savings banks were established during this time. These banks invested mostly in trade both singly and in partnership with others with whom they also shared profits. Interest was not charged. 76 The Nasser Social Bank (NSB) by a special statute, known as Law 66 of 1971 was the first to be established which became the first Islamic bank in the urban and is still existent todate. 77

In spearheading advancement of Islamic banking one may not help not to mention Malaysia. The first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings Corporation established in l963 with the view of helping people make savings for performing hajj.78 In l969, this body evolved into the Pilgrims
73 74

In modern Islamic banking these are known as Mudarabah. Ibid. 75 Ibid. 76 Mayer, A. E. (1985, Nov). Islamic Banking and Credit Policies in the Sadat Era: The Social Origins of Islamic Banking in Egypt. Arab Law Quarterly, 1(1). pp. 32-50. 77 ibid 78 Pilgrimage to Mecca and Medinah, the Muslims holy cities in Saudi Arabia. 41

Management and Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has been acting as a finance company that invests the savings of wouldbe pilgrims in accordance with Shariah, but its role is rather limited, as it is a nonbank financial institution. The success of the Tabung Haji, however, provided the main impetus for establishing Bank Islam Malaysia Berhad (BIMB), which represents a full fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed a substantial contribution to the initial capital directed toward establishment of of the BIMB.79 In 1970s many islamic banks flourished.80 These include the Dubai Islamic Bank (first Islamic private commercial bank, 1975, the Faisal Islamic bank of Sudan (1977) and the Bahrain Islamic Bank (1979). Others from the Asia Pacific region include the Philippine Amanah Bank (PAB), formulated under presidential decree. Pakistan also had an established Islamic banking system at the time which unfortunately didnt survive.81 During this time, however, The first bank explicitly based on Shariah principles was established by the Organization of Islamic countries (OIC) in 1974, called Islamic Development Bank (IDB). This bank was primarily engaged in intergovernmental activities mainly for provision of funds for economic development of projects in member countries. Its business model involved fees for financial services and profit sharing financial assistance for projects.82

All these banks were a result of efforts by private institutions endevours, no government had played a significant role in establishing most of these banks up to this time until 1985 when the first concrete government endevour was taken by the Iranian government, when it prohibited all banks from giving or taking interest.

79

Zakariya, M. (1988). Islamic Banking: The Malaysian Experience. In Ariff, M. (Ed.), Monetary and Fiscal Economics of Islam. International Centre for Research in Islamic Economics, Jeddah 1982. 80 Ariff, M, (1982). Monetary Policy in an Interest-free Islamic Economy - Nature and Scope. In Ariff, M. (Ed.), Monetary and Fiscal Economics of Islam. International Centre for Research in Islamic Economics, Jeddah 1982. 81 Shariah Fortune. (n.d). History and Evolution of Islamic Banking. Retrieved June 20th, 2012, from http://shariah-fortune.com/history-of-islamic-banking 82 ibid 42

Interests was replaced with service charges of 4-8% and guaranteed minimum profits.83

3.2 Islamic Banking Beyond Islamic Communities There is a good record of establishment of Islamic banks outside the countries with islamic influence just about the time when the countries with islamic influence were developing the concept of Islamic Banking. The first islamic bank in Europe, forinstance, is said to have been established by the year 1978 in Luxembourg. Currently, all over Europe Islamic banks are establishing branches. These banks are offering shariah-compliant financial services, and European governments are in a league to outcompete each other in licencing these banks. Islamic Finance has ceased to be viewed as only being the orbit of the specialist practitioner with strong links to the islamic world. As of recent islamic financial institutions within nonMuslim communities practically are mushrooming exponentially. Islamic finance has immensely found its way into the mainstream retail sector in the United Kingdom and in other European countries. 84 In these countries islamic banking is accepted, amid, the general financial crisis facing the developed world. It is viewed by europeans now as being founded on more ethical principles comperatively. A Vatican Newspaper comments that, the ethical principles on which islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service85

In the United Kingdom where particulary the government is making a concerted effort to turn London into a global hub for the islamic banking industry, Islamic finance grows faster than in other european countries. Financial institutions now present in the UK mainly manifest themselves in the form of either retail banking

83 84

ibid Mac Farlane, B. (2006). Introduction to The Principles of Islamic Finance, Mondaq. Retrieved December 23, 2012, from http://www.mondaq.com/article.asp?articleid=21512 85 See Giovanni, M.V. (2009). Dalla Finanza Islamica Proposte e Ide per lOccidente in Crisi. Losservatore Romano. In Thomas L. (2009, March). Shariah Banking Conquers Europe. The Brussels Journal. Retrieved from www.brusselsjournal.com/node/3837 43

and or investment banks.86 The Financial services Authority (FSA) in the UK has only authorised one Islamic retail Bank known as The Islamic Bank of Britain (IBB) and about five islamic investment banks the most common of which being the European Islamic Investment Bank (EIIB) and the Gatehouse Bank. 87 In 2003, HSBC was the first conventional bank to offer mortgages in the UK that comply with Islamic financial principles using the ijara structure, this was followed by United National Bank Limited ("UNB") offering its first Islamic product in the UK based on the ijara model. This has come to be known as the UNB Islamic mortgage.

3.3 The Practicability of Islamic Banking without interest (Riba) As islamic banking advances and as nations issue more licences to banks and financial institutions, islamic banking is becoming ubiquitous and with a pertinent question money; how does it function without riba? As already put clear, the principal restriction under which the Islamic financial system must work is the prohibition against interest (riba). However, it is important to note that what is forbidden by Islamic law is the fixed or predetermined return on financial transactions, and not an uncertain rate of return represented by profits. On account of this, alternative interest-free financing techniques have been developed by Islamic banks and monetary authorities in several countries. The instruments of commercial financing have been based on two principles: the profit-and-loss sharing (PLS) principle and the markup principle.88 Mainly, however, the modern concept of islamic banking has been developed on the basis of profit sharing.89 In the last few decades a variety of models of islamic banking have been proposed, but in general the operations of a typical system would have the features discussed below.

86

Islam, N. (2008). Islamic Banking : A Golden Opportunity for European Banks. The DinarStandard. Retrieved from http://dinarstandard.com/finance/islamic-banking-%E2%80%93-agolden-opportunity-for-european-banks 87 Mac Farlane, B. (2006). Introduction to the Principles of Islamic Finance, Mondaq. Retrieved December 23, 2012, from http://www.mondaq.com/article.asp?articleid=21512 88 Aggarwal, R.K.. Yousef, T. (2000, Feb). Islamic Banks and Investment Financing. Journal of Money, Credit and Banking, 32 (1). pp. 93-120. Retrieved from http://www.jstor.org/stable/2601094 89 Mohsin, S. K. and Mirakhor, A.. (1990, Jan). Islamic Banking: Experiences in the Islamic Republic of Iran. Pakistan Economic Development and Cultural Change, 38 (2). p. 354. Retrived from http://www.jstor.org/stable/1154031 44

3.3.1 Source of Funds Besides its own capital and equity, the main sources of funds for an Islamic bank would be two forms of deposits, namely transactions deposits and investment deposits. Transactions deposits are directly related to payments and can be regarded as equivalent to demand deposits in a conventional banking system. Although a bank would guarantee the nominal value of the deposit, it would pay no return on this type of liability. Investment deposits constitute the principal source of funds for banks, and they resemble more closely shares in a firm rather than time and saving deposits of the customary sort. The bank offering investment deposits would provide no guarantee on their nominal value and would not pay a fixed rate of return. Depositors, instead, would be treated as if they were shareholders and therefore entitled to a share of the profit, or losses, made by the bank. The only contractual agreement between the depositor and the bank is the proportion in which profits and losses are to be distributed. The share, or distribution, parameter has to be agreed on in advance of the transaction between the bank and the depositor and cannot be altered during the life of the contract, except by mutual consent.90 To make this possible the bank must acquire assets out of which profits are shared. The following part shows modes of how assets are acquired.

3.3.2 Islamic Banking Financing Modes Declaring interest as riba intensified the search for interest-free modes to conduct banking business. This pursuit has so far led to discovery of many operational modes to perform all types of banking transactions on an interest-free basis. These modes comprise: mudarabah, musharakah, musharakah mutnaqisah, ijarah, ijarah waiktina, murabaha, bai salam, bai mu'ajjal (bai bithaman ajil), bai istisna, bai eenah, muzara'a, musaqah, qardhul-hasan, wakala, service charge, sale on instalments, development charges, equity participation, sale and purchase of shares, purchase of trade bills, and financing through auqaf.91 All these fall in three most

90 91

ibid Anwar, M. (2003). Islamicity of Banking and Modes of Islamic Banking. Arab Law Quarterly, 18(1). 62-80. Retrieved from http://www.jstor.org/ stable/3382068 45

common groups which are identified as partnership based modes, trade based modes and rental based modes.

3.3.2.1 Partnership based Modes Partnership based modes include mudarabah and musharaka. Mudarabah is a contract between two parties: a capital owner known as rabb-al-maal and an investment manager known as the mudaarib. Surplus funds are made available to the entrepreneur to be invested in a productive enterprise in return for a predetermined share of the profits actually earned. Financial losses are borne exclusively by the lender. The loss to the borrower being the opportunity cost of his own labour which failed to generate for him any profit.The borrower, as such, loses only the time and effort invested in the venture. This arrangement, therefore, effectively places human capital at par with financial capital. While the islamic bank provides capital, the borrower provides skills, time, effort and all that which is needed to make investment for return of profit.92 A presigned contract in this mode is important as profit, if any, would be distributed according to what has been agreed in this contract. The Islamic bank in this arrangement may not have any right to interfere with how the borrower manages his investment. Traditionally, Mudarabah has been employed in investment projects with short gestation periods and in trade and commerce.93

Musharakah (Partnership) is a mode of islamic financing whereby there are more than a single contributor of funds. The islamic bank and the borrower invest in a business project in varying proportions pursuant to an agreemnt as to such investment. The profits and losses are shared strictly in relation to their respective capital contribution. This financing method corresponds to a capital market in which shares can be acquired by the public, banks, and even the central bank and the government. Musharakah is used in long-term investment projects.

92 93

ibid ibid 46

3.3.2.2 Trade- Based Financing Modes Trade-Based Financing modes include Murabaha (cost plus sale contract), musawamah and bai Salam a (sale contract). Murabaha is a cost-plus sale contract whereby disclosure of cost to the buyer is necessary. Under Murabaha arrangement customer requests the Islamic bank to purchase an asset for him (customer) and sell to him on deferred payment. An essential feature of Murabaha is that IFI must purchase the required commodity from supplier first and then sell to customer. Thus, the transaction consists of an order accompanied by a promise to purchase and two sales contracts. The first contract is concluded between the Islamic bank and the supplier of the commodity. The second is concluded between the bank and the client who placed the order, after the bank has possessed the commodity, but at a deferred price, that includes a markup. The deferred price may be paid as a lump sum or in installments.

Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Bai-Salam (forward sale) is a combination of two Arabic words Bai and Salam. Bai means to sell94 while Salam means advance. Payment of Bai-Salam transaction is made in advance. It is a form of sale on delayed terms in which the money may be paid first and the goods delivered at a later date. In Shariah, the salam is a forward sale for immediate payment."95 It is the selling of a specified commodity for

exchange of a price paid in advance. It is thus a contract of sale whereby advance


94

Visit Wikipedia, the Free Encyclopedia. (n.d). Bay'ah. Retrieved June 4, 2011, from http://en.wikipedia.org/wiki /Bay'ah 95 Naga, S.E.A.A. (1997) The Salam Sale Contract in Jurisprudence and Practice, The Fatwa and Research Department. Tadamon Islamic Bank. Retrieved from http://tadamonbanksd.com/prints/publi/4.pdf 47

payment is made for goods to be delivered later on. Salam is an exception to three general rules of sale under islamic law which are: firstly that the purchased commodity must be existing, secondly that the seller should have acquired the ownership of that commodity and thirdly that the commodity must be in the physical or constructive possession of the seller. 96

In this contract, the seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.97

There are three foundations or pillars of salam which are that, first, there must be a proposal and acceptance, second, that there must be parties to the contract who are buyers and sellers and lastly that there must be the contracted item, which includes the capital paid by the buyer, and the commodity, which the seller undertakes to supply.98 It is logical that these pillars only prove that there ia a salam contract between parties but do not prove validity of the same. Validity is proved if certain conditions are satisfied. It validity is assessed against some conditions which are firstly that, the transaction is considered salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under shariah. The idea of salam is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible. 99 Secondly that, salam cannot be effected on a particular commodity or on a product of a particular field or farm. For
96 97

Ibid. Visit Wikipedia, the Free Encyclopedia. (n.d). Islamic Banking Principles. Retrieved May 25, 2012, from http://en.wikipedia.org/wiki/Islamic_banking#Principles 98 Naga, op cit. 99 Ibid. 48

example, if the seller undertakes to supply wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. 100 Thirdly that it is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. 101 Fourthly that it is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa.102 Fifthly that, the exact date and place of delivery must be specified in the contract. And lastly that, salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange for silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.103

The salam contract is said to have the following purposes: To meet the needs of small farmers who need money to grow their crops and to feed their family up to the time of harvest in which case they can enter into agreement to sell even before they have harvested. Another purpose is to help people meet the needs of working capital, also to help people meet the needs of liquidity problem and lastly to meet the need of traders for import and export business.104 Salam is beneficial to both the seller, as he receives the price in advance, and to the buyer also, as the price in

100 101

Ibid. Ibid. 102 Ibid. 103 Ibid. 104 Khan, M.N. (n.d). Salam. Paper presented at AlHuda CIBE Workshop. Pakistan: Habib Metropolatin Bank. Retrieved from www.kantakji.com/fiqh/Files/Finance/N261.ppt 49

salam is relatively lower than the price paid for the same item in spot sales.105 Conclusively except for a few differences, salam seems to be similar to a contract of sale under the Tanzanian Sale of Goods Act, Cap 215 (RE 2002).

Istisna like salam istisna is an exception to general conditions of sale in islam which require that the goods, subject matter of sale, must exist before a contract of sale is entered into. Istisna is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. A manufacturer or builder agrees to produce or build a well-described good or building at a given price on a given date in the future. Price can be paid in installments, step by step as agreed between the parties. Istisnaa can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, and building of bridges, roads and highways.106

3.3.2.3 Rental - Based Financing Modes Rental based modes include Ijara (Leasing) and diminishing Musharaka

(diminishing partnership). Ijara is an arabic word which is equivalent to leasing. It means a contract which enables possession of a particular intended usufruct of the leased asset for a consideration. 107The lessor retains the ownership of the asset with all the rights as well as the responsibilities that go with ownership. As a form of financing used by Islamic banks, the contract takes the form of an order by a client to the bank, requesting the bank to purchase a piece of equipment, promising, at the same time, to lease it from the bank after it has been purchased. Thus, this mode of financing includes a purchase order, a promise to lease, and a leasing contract.

The evidence from reasoning is that, ijarah is a means of facilitating life by helping people to get the usufructs of assets which they do not own, and the need for

105 106

Ibid. Hanif, M. (2011, Feb). Differences and Similarities in Islamic and Conventional Banking. The International Journal of Business and Social Science, 2(2). 107 See Abu Ghuddah, A. (n.d). Ijara (Lease). A research paper. Al-Baraka Banking Group (ABG), Department of Research & Development. Retrieved from http://www.albaraka.com/media/pdf /Research-Studies/RSIJ-200706201-EN.pdf 50

usufructs is similar to the need for assets themselvesi.e. the poor needs the wealth of the rich while the rich needs the poor's labor, and consideration of the people's need is a basic principle in contract legislation where contracts are legislated to fulfill such needs and requirements in conformity with shariah which is considered the rationale behind such legislation.

Ijara may end in the purchase of the leased asset. In this case the ijarah contract is that which is intended to transfer ownership of the leased asset to the lessee at the end of the lease agreement.This transfer of ownership is made through a new contract, in which the leased asset is either given to the lessee as a gift or is sold to him at a nominal price at the end of the lease agreement. The totality of rent paid is over and above the cost incurred to acquire the asset.

Diminishing Musharakah (Diminishing Partnership) is a contract between an islamic bank and a beneficiary in which the two agree to enter into a partnership to own an asset, as described above, but on the condition that the financier will gradually sell his share to the beneficiary at an agreed price and in accordance with an agreed schedule. This works in that, the beneficiary before purchasing the asset say a house will contribute some money towards buying that house and the bank pays the rest. Both become co-owners. After buying the beneficiary stays in the house or uses the asset upon paying rent comensurate with the shares that are held by the bank but at the same time paying regular scheduled purchases of the banks share in the house or asset. As the banks ownership diminishes, the rental fee deiminishes accordingly until the asset or home buyer owns the asset or home outright.

From this, Islamic banking, it is obvious, does not only envisage financing activities as do conventional banks, but goes further to include equity financing and trade financing. 108

108

Ariff, M. (1988, Sep). Research Report on Islamic Banking. Asian Pacific Economic Literature, 2

(2) 51

3.4

Development of Islamic Banking in Tanzania

Islamic banking has three faces namely, islamic window, islamic investment bank and a full-fledged islamic bank. Islamic banking may be introduced by adopting any of these faces. An Islamic window is simply a window within a conventional bank which is intended for customers to conduct business utilizing only Shariah compatible instruments. In an islamic window, a bank while engaging in conventional banking products, introduces shariah complient products such as maintaining shariah accounts for deposits keeping which are reflected as a liabilities to the bank and Islamic trade-financing products at a small scale which are reflected as assets to the bank.
109

Islamic window is usually taken as a take-off stage for any

non muslim country undertaking to establish islamic banking. Reliance on Islamic windows, as a take-off platform for moving into the Islamic financial industry, has been a more common practice in Western countries than in the Middle East, where the tendency has been to establish stand-alone Islamic banks.110

In an Islamic Investment Bank a conventional bank offers products specifically designed to attract shariah-compliant investors.111 The most significant product of investment is the sukuk. Islamic Development Bank defines sukuk as being an Islamic equivalent of bonds. However, as opposed to conventional bonds, which merely confer ownership of a debt, sukuk grants the investor a share of an asset, along with the commensurate cash flows and risk. As such, sukuk securities adhere to Shariah principles as to charging or payment of interest. Through these products, lenders desire to avail themselves of investment opportunities while complying with Islamic jurisprudence.112

In a full-fledged Islamic Bank Once a conventional bank has operated an Islamic window for some time and has gathered a sizeable customer base for its Islamic
109

Andilile, J. (2009). Viability and Challenges of Establishing Islamic Banking in Tanzania. The Accountant Journal, 24 (2), p.17. See also Sol, J. (2005, May). Introducing Islamic Banks into Conventional Banking Systems. Journal of Islamic Economics Banking and Finance, 4(2). p. 16. 110 Sol, J. (2005, May). Introducing Islamic Banks into Conventional Banking Systems. Journal of Islamic Economics Banking and Finance, 4(2). p. 16. 111 Ibid. 112 Ibid. p. 17. 52

activities, it may decide to establish an Islamic subsidiary, or even fully convert into a full-fledged Islamic bank. By following either of these two routes, the bank may benefit from economies of scope and concentration of knowledge and expertise. The bank will be able to offer, under one roof, a wider range of shariah-compliant banking products than through the islamic window alone. For example, it may be better equipped to fully engage in Islamic investment banking activities, such as underwriting sukuk issuances or managing Shariah-compliant investment and hedge funds, or to manage its own treasury and money market operations.113

Conclusively banks in non muslim countries would hardly begin with a full-fledged islamic window as do some of the banks in islamic countries. for the former countries it has been ideal to begin with islamic windows and with accelerating experience they gather to embark onto full-fledged islamic banks.

3.5 Status of the Tanzanias Islamic Banking Practice In Tanzania most banks have been licensed to operate islamic windows except for Amana Bank which has been licensed as a full-fledged Islamic bank. Though all these banks follow the basic principles rooted in shariah they differ in their adoption of which face of Islamic banking and the differences are influenced by varying objectives of these banks, individual banks circumstances and experiences, and the need to interact with conventional banks which are based on interest. 114 The salient features common to all banks, however, are the similarity of the services they offer. These banks offer current, savings and investment accounts.Current or demand deposit accounts are virtually the same as those offered in all conventional banks. In these accounts deposit is guaranteed. As for savings deposit accounts there is comparably rather different ways of operation. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank.115 Banks adopt several methods of inducing their clients to
113 114

Ibid. These are common features for all islamic banks in all countries in which islamic banking is at nascent stage. See Abdul Gafoor A.L.M. (1995). Interest free Commercial Banking. Retrieved from http://www.islamicbanking.nl/chap4.html#_Toc3149103 115 True of shariah and transact plus accounts of Stanbic Bank 53

deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.116 These accounts are 100% Shariah compliant and provide the same convenient features of conventional accounts, including internet banking, Visa electron or Maestro debit card, and prepaid airtime services. 117

Islamic Banks and windows in Tanzania currently offer mainly deposit and financing products. They, however, do not offer the full range of all the modes of financing available in Islamic banking practices. Thus funds for these banks are collected from such deposit products. Stanbic Bank Tanzania Limited has plans to launch mortgage loans, vehicle loans and home loans through its Shariah Banking product.118 Kenya Commercial Bank (KBC) has gone further as to offer more products than National Bank of Commerce, which currently offers two products under Islamic Banking, namely the Corporate and Business Accounts.119 KCBs products include deposit products which are Amana Savings Account, Amana Current Account, Amana Cub Account and Amana Community Account. It also offers islamic financing products120 which are Short term trade Financing, Asset Based Financing, Construction Materials Financing, Cash Cover Letters of Credit etc. These are offered through Mudarabha where the bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by
116

At stanbic if the account stays cashless for a period of over six months it is cancelled. This was observed from the Branch Manager, Stanbic Bank, Arusha. 117 Standard Bank Launches Sharia Banking In Tanzania. (2012, May 04). The New Business Ethiopia. Retrieved from http://www.newbusinessethiopia.com/index.php?option=com_ content&view=article&id= 125 :standard-bank-start-shariah-banking- in-tanzania& catid=43:regional &Itemid=41 118 Mr. Mohammed Issa, the stanbic bank's board supervisor Shariah banking, talking at a seminar to educate Imams on the essence of Shariah banking, lending and governance and its adherence to Muslims sometimes in 2011. http://allafrica.com/stories/201105170005.html. visit also http://thecitizen.co.tz/business/-/10963-bank-to-offer-loans-under-islamic-law 119 Visit the banks website http://www.nbctz.com/news/news-66. 120 Visit http://www.kcbbankgroup.com/tz/index.php?option=com_content&task=view&id=396& Itemid=242 54

both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank.

Conclusively, Islamic banking in Tanzania is at its nascent stage. Except for one case of Amana Bank, it largely functions within the conventional banks as islamic windows mainly offering deposit products than profit and loss sharing modes of financing. Amana Bank has a Partnership Current Account which is a special product based on Shariah compliant contract of Qardh (Loan).121 Amana bank is the only full-fledged islamic bank in Tanzania offering products which are fully shariah-compliant.

121

For more information on this visit the banks website at http://amanabank.co.tz/partnershipcurrent-account/ 55

CHAPTER FOUR BANKING REGULATORY AND SUPERVISORY FRAMEWORKS IN TANZANIA 4.1 Introduction Throughout the historical development of banking, regulation of banks has been done mainly through law. When law governs banking practice it is known as regulation122 and when the institution vested with the power of regulation (usually central banks) uses the law to regulate the banks, that act is known as supervision.123 Regulation and supervision are important elements in establishing a sound banking and financial system. This part presents the mechanisms of regulation and supervision partaining in Tanzania.

4.2 Regulation and Supervision of Banks in Tanzania Regulation of banks in Tanzania is through a number of various pieces of banking legislations and subsidiary regulations that have been passed to date. The principle Regulatory and supervisory organ in Tanzania is the Bank of Tanzania (BoT). The BoT has the power to supervise and regulate the functioning of all other banks as well as all other financial institutions.124 This means no other institution apart from the BoT is legally allowed to partake of this duty with the BoT. 125 BoT employes a methodology of regulation and supervision which is known as inspection.

Insepection is done in respect of all commercial banks. There are two ways in which such inspection is effected by On-site inspection126 and by Off-site inspection.

4.2.1 On-site inspection In an On-site inspection the BoT inspects banks with respect to their Capital Adequacy, Asset quality, Managemnet quality, Earnings capability and Liquidity. These aspects are usually reduced into an accrony CAMEL and it is generally
122 123

Banking regulation refers to the framework of laws and rules under which banks operate. Supervision refers to the Banking Agencies monitoring of financial conditions at banks under their jurisdiction and to the enforcement of banking regulation and policies. 124 See section 4(1) of The Banking and Financial Institutions Act, 2006 and 5(1), 6(1)(a)(b) and 7(1)(2) of The Bank Of Tanzania Act, 2006. 125 See generally s. 44(1) of the BOT Act, 2006 for the BOTs power of control over other banks. 126 See s. 47(1) of the BOT, Act 2006 56

referred to as the CAMEL rating system. By using this system, the BoT, analyses institutions financial conditions and their operational soundness. Under CAMELS analysis, all institutions are evaluated in a comprehensive and uniform manner, and that supervisory attention is appropriately focused on the institutions exhibiting financial and operational weaknesses or adverse trends. The CAMELS analysis also serves as useful vehicle for identifying problem or deteriorating institutions, as well as for categorizing institutions with deficiencies in particular component areas. Further, the rating system assists in following up safety and soundness trends and in assessing the aggregate strengths and soundness of the banking industry. 127

As regards capital adequacy, there are two forms of capital that all banks are required to maintain: core capital and total capital. A bank is required to commence banking business with core capital of not less than 15, 000,000,000 or higher.128 A bank should also maintain not less than 10% of its total risk-weighted assets and off balance sheet exposure.129 Matters of adequacy of capital by all banks are one of the the things that the BoT has power of oversight and all banks have to comply. The BoT has a mandate to order a bank that has insufficient capital necessary to cushion it against risks to increase its capital above the requirements of s. 17.130 The requirement of Capital Adequacy being important for all banks to observe may cause any bank which fails to so observe it to be required by the BoT to apply for a license to operate as a financial institution instead of a bank.131

Adequate capital is not enough to inculcate sound banking system, the assets must have a requisite quality as prescribed by the BoT. All banks and financial institutions thus are supposed to maintain liquid assets132 at levels prescribed by the

127

Bank of Tanzania. (2010). Risk Based Supervision Framework. Directorate of Banking Supervision. 128 , s.17 (1) (a) of the BFIA, 2006 and as reviewed recently. 129 S. 17 (b) of the BFIA, 2006 130 See s. 17 (3) of BFIA Act, 2006 131 See s. 18(4) of BFIA 132 s. 21 (5) (a) of BFIA defines this to mean, a banks cash in hand, its balances with the BOT, unencumbered (unfettered/not tied) short term securities issued or guaranteed by the Government of Tanzania. 57

BoT from time to time.133 In finance, liquid assets are considered to be of a superior quality than illiquid assets. The question of who should take part in the management and Boards of banks and financial Institutions is also controlled since the success of a bank would depend upon its management. 134 Compliance to requirements of corporate governance and international principles of best practices are also matters that the BoT inspects.

With respect to the earnings capability and liquidity of banks, the BoT has power to inspect and get reports of all accounting matters of respective banks and Financial Institutions. Auditors of such banks have to be approved by BoT and these auditors are accountable to BoT directly.135 In this regard the BoT inspects also banks and financial institutions in respect of their liquidity.136 The BoT does this inspection for every financial institution at least once a year and during this activity the supervisors verify these institutions compliance with laws and regulations and and assess the effectiveness of the institutions' internal control system.

4.2.2 Off-site inspection In the off-site inspection the BoT undertakes to make a thorough assessment of financial soundness of the financial institutions. This assessment is done through: firstly, analyzing statistical returns and other returns covering key areas of the operations of the institutions. From this analysis Warning Reports are produced. Secondly, putting a requirement to banks and financial institutions that the statistical returns be submitted every week, month, quarter, semi-annual and annual periods and if the circumstances so demand at any time of the year.

4.3 Principles and Subsidiary Legislations over Banks Regulation and Supervision BoTs power to regulate and supervise is obtained from certain countrys legislations and subsidiary legislations.The BoT in its duty of regulation and
133 134

See s. 21 (1) of BFIA, 2006 See s.12(1) of the BFIA, 2006 135 See s. 22(1)-(11) of BFIA, Act, 2006 136 See Part IX of the BFIA, 2006. 58

supervision of banks and financial institutions is guided by various Acts of Parliament of the United Republic of Tanzania that have been purposely enacted to cater for the banking and financial operations in the country as well as by a number of subsidiary legislations. 137

4.3.1 Principle Legislations 4.3.1.1 The BoT Act, No. 4 of 2006 This is the first important legislation in banking regulation. This legislation had a long history of amendments and repeals in resonance with economic needs from time to time. The present legislation began as the BoT Act of 1965. The BoT was established then by this law. This law was amended later in 1978 through BoT Act No.17 of 1978. In 1995 the 1978 Act was repealed and replaced by the BoT Act No. 1 of 1995 which was ultimately repealed by the BoT Act No. 4 of 2006. The latter Act is applicable to date. The BoT Act of 2006 was enacted to provide for more responsive regulatory role of the Bank of Tanzania with respect to the formulation and implementation of monetary policy on the one hand, and to provide for the supervision of banks and financial institutions on th other.138 Main provisions relate to establishment of the bank itself,139 issuance of currency,140 and other operations of the Bank under which fall its regulatory and supervisory functions.141 Thus, this law apart from establishing the Bank, it provides for how the same should be managed and it specifies expressely the functions of the Bank as the regulator and supervisor of banks and financial institutions.

137

S.70 (3) of the BOT Act 2006 the BOT through its board of directors is legally allowed to pass various by-laws, rules, directions, orders, and circulars intended to reach the objective of the Act. S.71 of the Banking and Financial Institutions Act, 2006 legally empowers the governor of the BOT to make regulations and issue directives and circulars intended to give effect to the provisions of the BFIA. And the minister of Finance also has a discretionary power granted him by s. 70 (1) of BOT Act, 2006 to make various regulations to help the attainment of the primary objective of the Act. 138 See Preamble to the Act. 139 See part II of the Act. 140 See part III of the Act. 141 See part IV particularly sections 44-48 of the Act. 59

4.3.1.2 The BFIA Act, No. 5 of 2006 This law began as the Banking and Financial Institutions Act, No. 12 of 1991. It was replaced by the Banking and Financial Institutions Act No. 5 of 2006 which applies to date. The repeal was necessitated by the need to restructure the banking sector due to a shift in the needs of the country with an impetus from the IMF and the World Bank. This is visible in the preambles to these two laws. That of 1991 consolidated the law relating to business of banking, intended to harmonize the operations of all financial institutions in Tanzania, to foster sound banking activities, to regulate credit operations and provide for other matters incidental to or connected with those purposes. The 2006 Act is geared, among others, to provide for comprehensive regulation of banks and Financial Institutions.142 These are the main laws relating to banking.

4.3.1.3 The Foreign Exchange Act, No. 1 of 1992 This Act was Foreign Exchange Act, 1992 was passed by the Parliament for the purpose of making better provisions for the more efficient administration and management of dealings and other acts in relation to gold, foreign currency, securities, payments, debts, import, export, transfer or settlement of property and for the purposes incidental to and connected to those. There is a close relationship between the banking activity of intermediation of funds and foreign exchange. The BoT licenses and regulates bureaux de change in respect of their activity of foreign exchange.143 Money obtained from them may be deposited by any person into specific accounts maintained in the commercial banks. 144 This means failure in foreign exchange market may restrict cash in the banks to a certain extent and this would in turn affect flow of the same into the economy.

142 143

See preamble to this Act. See section 4 of the Act. See also section 5 (a) of the same Act. 144 See section 5 (d) of the Foreign Exchange Act, 1992 60

4.3.1.4 The Companies Act, No. 12 of 2002 and the Law of Contract Act, Cap 345 of 2002 (RE 2002), The companies Act provides for more comprehensive provisions for regulation and control of companies, associations and related matters. This law will control every bank which is a corporate entity145 while other forms like agency and partnerships are mainly governed by the Law of Contract Act, Cap 345 (RE: 2002). These laws are important also in the management aspects of the banks in such forms on the one hand and other aspects such as protection of relations between themselves and their customers. Though management of a partnership is done with reference to contracts establishing such partnerships and thus directly falling under this law, its propriety is regulated by the BoT with reference to CAMEL rating system of banks herein above discussed. Now these are the main laws directly and indirectly involved in regulation and supervision of banks. These are backed up by various subsidiary legislations discussed below.

4.3.2 Subsidiary Legislations. As discussed above three authorities are empowered by law to make various rules, by-laws, regulations directives and circulars useful to make the banking and financial system operate smoothly within the realm of the objectives of the Bank of Tanzania. These authorities are the Board of Directors of BoT, the Governor of BoT, and the Minister of Finance of the United Republic of Tanzania.

4.3.2.1 Banking Regulations The number of regulations that have so far been made due to the granting of these powers above are as they appear hereunder;

(i) Banking and Financial Institutions (Licensing) Regulations 2008 It enumerates conditions governing entrance into or exit, of banks and Financial Institutions, from the banking industry in Tanzania, In short it deals with all matters

145

See forinstance s. 169 (2) (3) and s. 171 (4) (a) (i) of the Companies Act, Cap 212. 61

relating to licensing of new entrants in the banking system on the first hand and on the other it sets conditions necessary for their safe and sound operations.

(ii) The Banking and Financial Institutions (Management of Risk Assets) Regulations, 2008 These regulations replaced those of 2001 which had repealed "The Guidelines on Management of Risk Assets, Classification of Loans and Other Risk Assets, Provisioning for Losses and Accrual of Interest" issued on 18th October, 1991. The objectives of these Regulations are generally to provide a prudential (cautious) guidance on management of risk assets and bases for providing for losses on loans and other risk assets.

(iii) The Banking and Financial Institutions (Capital Adequacy) Regulations, 2008 These Regulations came into effect in 2008 and replaced the Capital Adequacy Regulations of 2001 which had repealed "Guidelines for Measuring Capital Adequacy" issued on 1st October, 1993 and the Addendum (addition) to Circular No. 3 on Capital Adequacy issued on 27th March, 1996.The principal objective of these Regulations is to provide the depositing public with reasonable protection by enhancing the capability of banks and financial institutions to absorb unexpected losses and thus minimize the incidence of bank failure.

(iv) The Banking and Financial Institutions (Liquidity Management) Regulations, 2008: These Regulations replaced those 2000. The focal intent of the Regulations is to provide guidance on measuring and monitoring liquidity of banks and Financial Institutions and the maximum ratio of loans to deposits.

(v) The Banking and Financial Institutions (Publication of Financial Statements) Regulations, 2008:

62

The Regulations replaced The Publication of Financial Statements Regulations, 2000. The main objective of the Regulations is to keep the general public informed on the condition and performance of banks and financial institutions. Under this duty the banks and Financial Institutions are required to publish Quarterly unaudited balance sheet, income statement and cash flow statement and the audited financial statements are to be published once annually.

(vi) The Banking and Financial Institutions (Independent Auditors) Regulations, 2008 These Regulations replaced those of 2000. The main objective of these Regulations is to give guidance to banks and financial institutions to appoint independent auditors that are recognized and registered by the National Board of Accountants and Auditors as well as by the Bank of Tanzania. Bank auditing requires more than commercial enterprise auditing and as such only audit firms that meet registration requirements by the Bank of Tanzania may be appointed to audit banks and financial institutions.

(vii) The Banking and Financial Institutions (Credit Concentration and Other Exposure Limits) Regulations, 2008 These regulations replaced those of 2001 which had repealed "The Guidelines on Concentration of Credit and Other Exposure limits" issued on 22nd December, 1992. The objectives of these Regulations are to encourage risk diversification and curtail excessive concentration of risk exposure of any bank or financial institution to one customer or group of customers, industry economic sector or activity, thereby stability of the financial system, to promote arms length relationship in dealing between a bank or financial institution and its directors, officers, staff, shareholders and their related interest, to make credit available to a broader group of borrowers, to regulate equity investments of banks and financial institutions and to avoid undue concentration of economic power and to regulate the amount of investments in fixed assets and prevent the use of depositors' money in acquiring such assets.

63

(viii)

The Banking and Financial Institutions (Physical Security

Measures) Regulations, 2008: These Regulations became effective in December, 2008 . The principal objective of these Regulations is to prescribe minimum security measures to be instituted by all banks and financial institutions for the purpose of: - preventing acts of robbery and burglary, assisting in identifying and apprehending persons who commit acts of robbery or burglary, preventing injury and loss of life to staff and customers, preventing damage or loss of assets, which could result into major losses to individual institutions, the banking sector and the national income, and creating security awareness among management and staff in all banks and financial institutions thereby promoting a security conscious working environment.

(ix) The Banking and Financial Institutions (Prompt Corrective Action) Regulations, 2008: These Regulations became effective in December, 2008. The main objectives of these Regulations are to ensure timely and effective actions to deal with a weakening bank or financial institution, enhance transparency by establishing the minimum actions the Bank shall take in addressing identified weaknesses in banks and financial institutions, and maintain confidence in the Tanzanian banking sector.

4.3.2.2 Banking Circulars Most regulations discussed above began as circulars. The existing circulars so far made by the Bank of Tanzania include the following:

(i) Circular No.1: Reserves against Deposits and Borrowings This circular requires maintenance, by banks, of statutory minimum reserves on

their total deposits, including foreign currency deposits, received and funds borrowed from the general public. The requirements contained in this circular do not cover Non-bank financial institutions. Circular no. 2 which was named Foreign

64

Exchange Cover against Foreign Currency Deposits, Borrowing and Off-Balance Sheet Commitments was repealed on 02/01/1995 and replaced with Circular No. 5 discussed below. Secular no. 3 which was known as Measuring Capital Adequacy was converted into the Capital Adequacy Regulations, 2001 and later into Banking and Financial Institutions (Capital adequacy) Regulations of 2008. Also Circular No.4 the liquid assets circular which required banks and financial institutions to maintain adequate liquid assets for meeting normal operations and demands of depositors and creditors was turned into The Liquid Assets Ratio Regulations, 2000 above discussed.

(ii) Circular No.5: Foreign Exchange Exposure and Placements, Purchases, Sales and Balances This sets limits on placements with the correspondent banks by the banks and

financial institutions, and requires the institutions to maintain a net open position not exceeding 20% of the core capital.

(iii) Circular No.6: the Publication of Financial Statements Regulations, 2001). It requires banks and financial institutions to publish Quarterly and Annual Financial Statements in newspapers of General Circulation in Tanzania.

(iv) Circular No.7: Instructions for Filing Returns under the Banking and Financial Institutions Act, 1991. It became effective on 30th June; 2000.This circular provides guidance to banks and financial institutions on how to file returns submitted to the Bank of Tanzania formally as required by the Banking and Financial Institutions Act, 1991and later in accordance with the Banking and Financial Institutions Act, 1991. The aim is to capture accurately and uniformly compiled information.

It is mandatory that these regulations and circulars are well complied with otherwise there is a penalty for non compliance. S. 67(1) of the BFIA, 2006 grants the BoT

65

power to describe and impose civil penalties on any bank and Financial Institution which violates provisions of the BFIA, 2006 or any regulation issued under this Act. The penalty may be imposed also in cases where a bank or Financial Institution violates directives or circulars issued by the BoT under this Act. However by s. 68 of the BFIA, 2006 the governor of the BoT has due power to waive compliance with the provisions of this Act, regulations, directions or circulars made or issued under this Act. These regulations and circulars have legal force as long as they do not occasion inconsistencies with the Act as well as except when they are revoked or cancelled. 146

4.4 The Rationale of Banking Regulation and Supervision Regulation and supervison is done for many reasons. Generally, to protect the economy due to the fact that the broad range of activities banks undertake directly extend to and affect various areas of the economy. Specifically the justifications 147 why the law is important in regulation of the banking business are as follows;

Firstly, through customer deposits-taking, customers deposit-lending and other related activities banks, have a unique and central role in financial markets across the world. The power that the bank has in accepting deposits has made bankers to become the principle agents or middlemen in a number of financial transactions as well as in any countries payment system. Due to this most payments in Tanzania, especially at this era when foreign capital is heavily encouraged, involve a bank at some point. This payments system plays a vital role in enabling goods and services to be exchanged throughout the economy.

Secondly, when the bank does the first function above it has to deal with a vast range and types of borrowers on the one hand, and with the flexibility with which banking institutions can handle them. Banks are key lenders to business sector as well as to individuals; therefore, they determine how an available large portion of
146 147

See s. 72 (2) of the BFIA Act Spong, K.. (2000). Banking Regulation: Its Purposes, Implementation, and Effects (5th ed), Division of Supervision and Risk Management: Federal Reserve Bank of Kansas City. 66

credit is to be allocated across the country. Regulation and supervision provides dos and donts that make it done fairly.

A combination of these activities makes it apparent how much the banking system can affect the comprehensive supply of money and credit in a country. Due to this, banks are made very decisive links in the monetary mechanism and in influencing the overall condition of the economy. Considering this importance of banks to the economy and the level of trust customers place in them, it is in no way a surprise to find that governmental regulation and oversight have to extend to many aspects of banking. Banking is an industry having strong public policy implications. Thus, the general public, bankers and the government have all played roles in developing the present system of banking laws and supervision. Owing to that regulatory system has been responsive to many different needs of the public. 148

4.5 Role of Supervision and Regulation The primary objectives of the Supervision and Regulation function include protecting depositors' funds, maintaining stability of monetary and financial system, promoting an efficient and competitive banking system and protecting consumer rights related to banking relationships and transactions. hereunder in detail.
149

These are discussed

4.5.1. Protection of Depositors Funds Depositor protection is the most basic reason of the law/ regulation and supervision. This is true in three aspects: that the public makes a substantial amount of financial transactions through banks, that many business men, firms as well as individuals do hold a very significant portion of their funds in these banks and lastly that banking activities pose a good number of peculiar dangers to customers funds deposited with a bank. These dangers arise out of the following facts, one that, in most cases customers basically make use of banks when they draw and cash cheque and when they carry out other financial transactions which necessarily require them to
148 149

Ibid. Ibid. 67

maintain a deposit account. As a result of maintenance of these deposit accounts, customers become banks creditors and become tied to the fate of their bank. Should the bank fail, the customer fails also. In other businesses a customer never becomes a creditor of the firm; he simply pays for goods and services there at. Two, that, individual bank depositors have a significant difficulty protecting their interests than customers of other types of businesses. When they decide to open an account with any bank, they usually make a more general judgment about the condition of the banks, which is sporadically prone to error. It is rather difficult to make a thorough and precise assessment of a banks financial soundness from the view of these banks expensive buildings or from the lengthy period of time the same has been in business. On this account banking laws contain many provisions which are calculated to protect the funds of the depositors.150

4.5.2 Maintaining Stability of Monetary and Financial System, Banking systems are integral parts of stable frameworks for payment systems in which they operate. There are numerous and vast volumes of transactions conducted every day both by individuals, business men and even the governments. Significance of these transactions necessitate that certain rules should be used to make viable safer and acceptable means of payment which is vital to the state of a particular countrys economy. Excessive problems of banking system may gravely interrupt the flow of the transactions across the economy and can threaten the general public confidence in the system.151

4.5.3 Promoting an Efficient and Competitive Banking System. A good banking system is the one whose focus is on making sure that its customers are well provided with quality service and at competitive costs. The role of the regulation and supervision in this aspect is to create a regulatory frame work that encourages efficiency and competition and to ensure an adequate level of banking services throughout the entire economy. Efficiency and competition are related
150

Read the following sections of the BFIA, 2006: ss.32(1), 11(1)(b), 11(3)(f), 22(1)(4)(5), 23(1)(2)(3)(4), 25(1)(2)(3)(4), 36(2), 39(2)(a)(b)(c), 43(1), 52(1), 53(1), 55(1), 59(1). 151 The following sections from the BFIA, 2006 directly and indirectly relate to maintaining stability of the monetary and financial system; ss. 6(1), 7(2), 17(3), 18(1), 56(1) & (2) of the Act. 68

terms, as far as banks are concerned, a competitive banking system must be made by banks which operate efficiently. Without competition some banks might attempt to gain higher prices by restricting supply of their services. This can work well in an economy like ours where some banks have a monopoly in some areas or even in those areas where many banks do operate, this restriction of services for higher prices may be done by a group of banks by way of collusion (common agreement).152

4.5.4 Protecting Consumer and General Public Rights. Under consumer protection the law or regulation of banks becomes important so that the banks effect an equal and nondiscriminatory treatment of all the consumers of its services though he is not a depositor especially during this time when there are mounting complexities of financial instruments that come with the uniqueness of individual customers. 153 Many parties apart from consumers may also be concerned with a bank in its corporate social performance. A bank does not function only for the benefits of those who own it. The public has a general interest in the returns the bank brings to the economy. Some people deal in business with the bank whether or not they are this banks customers. A key factor in a party's decision to participate in or engage with a bank is his confidence that the corporation will deliver the party's expected outcomes. When categories of parties (stakeholders) do not have sufficient confidence that a corporation is being controlled and directed in a manner consistent with their desired outcomes, they are less likely to engage with the corporation. When this becomes a system feature, the loss of confidence and participation in markets may affect many other stakeholders, and increases the likelihood of political action.

Conclusively, practitioners of banking regulation and supervision must well design it in such a way that they extend cover to all areas that require immediate concern of

152

Relevant sections as regards this role are s.33(2), s.34(1)(2), s.12(1)(a)(b)(c), s.12(2), s.13(1), s.28(1)(a)(b)(c)(d) of the BFIA,2006 153 Read sections, 26(1), 48(1) (3) (a) (b) (c), 48(4) (a) (b) (c), of the BFIA, 2006. 69

public policy as failure of a banking system is always catastrophic and in serious cases results into economic depressions affecting all people indiscriminately.154 CHAPTER FIVE THE RESEARCH FINDINGS 5.1 Introduction This chapter presents the finding and makes an analysis of the data in relation to the research questions and objectives behind the study that motivated the doing of this research as stated in chapter one. The findings in this study, therefore, mirror the three research questions that this study dealt with. The researcher presents data collected from the Bank of Tanzania (BoT), the Kenya Commercial bank (KCB), Stanbic Bank and the National bank of Commerce (NBC). Data are also presented from secondary data mainly from an analysis done on various pieces of legislations relating to banking and subsidiary legislations which include regulations and circulars that are used in banking regulation and supervision.

5.2 Response from respondents as regards the question on what are the inherent risks in Islamic banking practices? All twelve respondents were interviewed as per the interview guide herein annexed as regards this question. Most of them although they were knowledgable of presence of risks in banking generally, they had no idea what would be the risks in islamic banking. Out of twelve respondents in the sample only six responded to this

question positively, one being a bank examiner from Directorate of Bank Supervision of BoT Dar es salaam, who supplied documents which contained answers, a muslim scholar relatively conversant with islamic banking from Arusha who responded orally and by supplying documents and four legal practioners who were much aware of presence of risks in banking generally but not particularly in islamic banking. These constitute 50% of all respondents who responded tothis

154

See generally Honohan, P. (1997). Banking System Failures in Developing and Transition Countries: Diagnosis And Prediction. Bank For International Settlements, Monetary and Economic Department: CH-4002 Basle, Switzerland. Retrieved from http://www.bis.org. Read also Gilbert, B. A. (1975). Bank Failures And Public Policy. Federal Reserve Bank of St. Louis: USA. Retrieved from http://research.stlouisfed.org/publications/review/75/11/ Failures_Nov1975.pdf 70

question. Thus what is presented here is a mix of information from their own best knowledge and information obtained from the documents they supplied.

From the analysis of the obtained information, researcher found out that Islamic banking has many inherent risks. First risk was defined as an uncertainty or possibility of unfavourable outcome from an undertaking.155 Since Islamic banking is banking just like conventional banking, operating in the same environment and having the same purpose of financing the economy in which it operates, it is not devoid of risks. By its very nature, Islamic banking is just as risky business as conventional banking. Although risk is a key element that is equally shared between both systems, the fact remains that each system is distinct and has its own distinguishing featuresvarying the nature and degree of risk to each one of them.156 Since islamic banking functions on risk sharing arrangements, which is the very basis of all islamic financial transactions, risk itself can not be divorced from it: these financing transaction are risky in themselves. The are generally the following types of risks in islamic banking namely credit risks which mostly militate against the PLS contracts, market risks and liquidity risks. These are discussed hereunder.

5.2.1 Islamic Banking Credit Risks Credit risks mainly affect the PLS financing modes. In Murabaha transactions forinstance, risks are partinent especially where the bank makes prompt delivery of assets but client fails to make timely payment. The bank is in no position to take immediate effective measures to cover its dues nor can it charge interest or impose penalty on the outstanding balance. The bank stands to lose not only its funds but also funds of its depositors. Thus both the bank and the customer may sustain the risk of loss.157 In mudarabah transaction the islamic bank is an inactive partner. Being so it has no means to monitor the investment or to participate in the

155

Rasem, N.K.., Kassim, M.M. (2009, December). Unique Risks of Islamic Modes of Finance: Systemic, Credit and Market Risks. Journal of Journal Islamic Economics Banking and Finance, 5(3), p. 11. 156 Ibid, p. 22. 157 Ibid, p. 23 71

management of the project to which it put its funds. The bank is exposed to total loss of its investment if the entrepreneur fails to manage the business.158

Apart from those customers who participate in PLS financing modes demand depositors are also exposed to islamic banking risk. These are indirectly exposed to risk of failing banking business. Customers are exposed indirectly if the losses suffered by banks on their PLS advances by using funds of demand depositors are substantial and the capital and reserves plus investment deposits are not sufficient to cover them.159 The PLS and sales-based modes of financing are prone to certain degrees of risk. Islamic banks have, on the liabilities side, both demand as well as investment deposits from customers. While demand deposits do not participate in the risks of banking business and are thus guaranteed, investment deposits do participate in the risks of the business of banking and are not, therefore, guaranteed.

Conclusively, the Profit and Loss Sharing (PLS) modes are relatively more risky because the rate of return on them may be either positive or negative, depending on the ultimate outcome of the business financed. When the business is not sucessiful it affects both the bank and the customers who deposit their funds with the bank. This is when there is erosion in the principal amount of investment deposits in cases of loss. As the bank will chip on customers deposits to maintain capital. Thus the loss to the bank may also extend to the customers. This is not the case in the conventional banking system as all demand as well as time and fixed deposits are guaranteed.

5.2.2 Islamic Banking Market Risks Market risksmainly arise from within arrangements under the Sales-based Modes. Such risks are like mark-up Risk within Murabaha (cost plus sale). Islamic shariah requires that the mark-up rate under murabaha and other trade-financing instruments be fixed at the time of contracting. This means if the rate agreed say 20% of the cost
158 159

Ibid. Ibid, p. 13 72

of the asset is pre-fixed at the time of making the contract for the entire length of the contract. The Islamic bank is exposed to the risk of upward movement of the mark up rate without being able to benefit from such an increase. Another risk islamic banks may face is price risk arising from bai salam. In bai salam the Islamic bank has the risk of having to deal with an uncertain environment where the price of goods can vary significantly between the time of delivery and the time of actual sale of the goods in question at the current market price.160

Inflation risks are said to be the most important market risk facing Islamic banks especially when the currency used to finance is weak or weakens against the US dollar. A good example is the tanzanian shilling. The risk is the Tshs may be strong when the bank pays for the asset but may be weak when some or all installments from the customer are due.

Liquidity risk means the inability of an economic agent to exchange its existing wealth for goods and services or for other assets.161 An official from NBC bank notes that Islamic banks are mainly affected by liquidity risks that arise from general lack of liquidity as the vast majority of their assets are maintained in the form of illiquid assets. Illiquid assets are distinguished from liquid assets such as money and financial securities. Islamic banks deal with assets which are the primary feature of their transactions, and not money.

One respondent noted that causes of liquidity risk in islamic banks are firstly, the limited availability of Shariah compliant money markets, secondly the absence of true inter-bank money market, thirdly undeveloped secondary markets and lastly the money these banks holds in current accounts is largely maintained in the form of idle cash which can not be used to invest in a broad range of activities as conventional banks do since there are no illiquid short-term instruments (as liquid instruments are not allowed in islamic shariah).
160 161

Ibid, p. 23 Nikolaou, K.. (2009). Liquidity Risk: Concept, Definitions and Interactions (Working Paper Series No. 1008). European Central Bank Eurosystems. Retrieved from http://www.ecb.int/pub /pdf/scpwps/ecbwp1008.pdf 73

Conclusively risk in islamic banking is said to be the distinctive feature of islamic finance. Risk is chiefly considered to be a dividing line between shariah acceptable profit and interest (riba). Risk is present in all Islamic financial transactions including saving and deposit accounts. Of significant is that risk as it is applicable in islamic banking has unparallelled attributes and distinctive characteristics.

5.3 Response from respondents as regards the question on what are the challenges Islamic banking practices engender to the regulatory and supervisory regime? In relation to this question the researcher targeted most respondents from BoT. Questions, however, were administered as per interview guide to all 12 respondents sampled. However only 9 responded positively. This constitutes 75% of all

respondents in the sample and the remaining 3 respondents, which is 25% were nogt appropriately clear about any challenges. Those who responded expressed their views generally that the biggest challenge is that the existing regulatory and supervisory documents are not applicable to islamic banking and that the BoT is undertaking the making of new compatible regulations. The researcher, however, obtained enough information on how the BoT supervises banks and financial institutions. The researcher, apart from this information, also did an in-depth analysis of the existing principle and subsidiary legislations that relate to the aspect of regulation and supervision of banks.

From the analysis of the obtained information, researcher found out that Islamic banking occasions many challenges which are regulatory, supervisory, and judicial challenges.

5.3.1 Regulatory and Supervisory Challenges Regulatory challenges caused by adoption of Islamic banking are those that relate to various laws in the Tanzanias legal system. Most laws are not favourable to the

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functioning of the Islamic banking as their enactment preceded the introduction of this type of banking. This means Islamic banking is alien to our laws. These laws and the challenges wedged against them are as follows:

(i) Challenges against the United Republic of Tanzania Constitution of 1977 as am. from time to time. The first challenge is wedged against the supreme law of the country which is the Constitution. The constitution establishes the state of Tanzania as a secular state. Being seccular it is not aligned to any religions available in Tanzania. It however recognises peoples individual faiths. This supreme law limits the government to only the recognition of such faiths but strictly forbids it to engage itself with the management of the affairs of any religious body. Article 19 (2) - (3) of the United Republic of Tanzania Constitution of 1977162 is relevant here. It should be noted that the official version of this constitution is the Kiswahili version163 thus I reproduce here the relevant articles in their official version as the English translation distorts the real meaning and thus if employed would confer a different meaning.164 This article reads in Swahili;

Uhuru wa mtu kuamini dini atakayo Sheria (2) Bila ya kuathiri sheria zinazohusika za Jamhuri ya Muungano, kazi ya kutangaza dini, kufanya ibada na kueneza dini itakuwa ni huru na jambo la hiari la mtu binafsi; na shughuli na uendeshaji wa jumuiya za dini zitakuwa nje ya shughuli za mamlaka ya nchi.165 (3) Kila palipotajwa neno "dini" katika ibara hii ifahamike kwamba maana yake ni pamoja na madhehebu ya dini, na maneno mengineyo

162 163

As amended from time to time. The Kiswahili version of 2005 is the official constitution. The last ammendments were in February 2005 which were not captured in the 2000 constitution. The English version of 1998 was flawed and was actually withdrawn from circulation. 164 The English version does not necessarily correctly represent the stipulations of the Kiswahili version. 165 This highlighted part is not found in the English version. 75

yanayofanana au kuambatana na neno hilo nayo yatatafsiriwa kwa maana hiyo.

The Article literally transalated means: (2) Protection of rights referred to in this Article shall be in accordance with the provisions prescribed by the laws which are of importance to a democratic society for security and peace in the society, integrity of the society and the national coercion.166 (3) in this Article reference to the term religion shall be construed as including reference to religious denominations, and cognate expressions shall be construed accordingly.

The researcher was interested in the words na shughuli na uendeshaji wa jumuia za dini zitakuwa nje ya shughuli za uendeshaji wa mamlaka ya nchi which in English the words would loosely mean and the state shall not engage in the affairs and management of religious organisations. Under article 19 (3) the word religion is defined to include religious denominations and expressions relating to it.

Islamic banking as the expressions suggest is based on Islamic religion and is founded in Islamic shariah principles. It has and it is increasingly becoming part of the Tanzania financial system. As it is part of this system it is likely to affect the countrys economy if its affairs and management are not supervised by the state authorities as article 19 (3) suggests. This article shuts Islamic banking outside the regulatory and supervisory functions of the Bank of Tanzania as the oversight body of all banks and financial institutions in the country.167

The BoT is the organ of the state and as such its governor is appointed only by the president.168 Being an organ of the state it cannot engage in regulating and
166 167

The highlighted part in Swahili version is missing. S.4 (1) of The Banking and Financial Institutions Act, 2006, provides that the power relating to the licensing regulation and supervision of all banks and financial Institutions in the united republic are hereby vested in the Bank. 168 See s. 8 (1) of the Bank of Tanzania Act, 2006. 76

supervising islamic banks activities since if it does, it would mean the state itself is managing the affairs and activities of Islamic religion.169 This, the Tanzanian constitution forbids since the state is a secular state.170 Conclusively, the concept of central banking is not alien to an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system.171 While Islamic banking accepts regulatory and supervisory functions of a central bank, the BoT legally does not recognise it. Thus islamic banking brings forth a very significant challenge to Article 19 (2)and (3) of the Constitution.172

(ii) The Judicature and Application of Laws Act, Cap 358 (RE: 2002) Another challenge is brought by islamic banking against the provisions of the Judicature and Application of Laws Act, Cap 358 (RE 2002). This is the principle law that declared the laws applicable to our state, then Tanganyika and it specifically states these laws to be the substance of the common law, the doctrines of equity and the statutes of general application in force in England on the 22 nd July, 1920, and the procedure and practice observed in courts of justice in England at that date.173 Part Three of the Act recognizes application of certain laws including certain Acts of England,174 customary laws, (ii) which reads:
175

some Indian Acts176 and Islamic law under s. 11 (c)

Nothing in this subsection shall preclude any court from applying the rules of Islamic law in matters of marriage, divorce, guardianship, inheritance,

169

The BOT does its regulatory and supervisory activities as an agent of the state. The famous latin maxim Qui facit per alium facit per se, which means "he who acts through another does the act himself." applies here. The state has a legal personality as well as the BOT under s. 4 (2) of the BOT Act, 2006. Having legal personalities it is justified that the BOT acts for the state. 170 See Article 3 (1) of the Tanzania Constitution of 1977, as amended from time to time. 171 Chapra, M.U., Khan, T. (2000). Regulation and Supervision of Islamic Banks. Islamic Development Bank and Islamic Research And Training Institute: Jeddah - Saudi Arabia. 172 See here in cited. 173 See s 2 (3) of the Act. 174 See s. 9 of the Act. 175 Section 11 (a)(b)(c)of the Act 176 See ss. 14-21 of the Act. 77

wakf and similar matters in relation to members of a community which follows that law.

This application of Islamic law does not warrant application of Islamic shariah as it is the jurisprudential basis of Islamic banking. The reasons are that: one, Islamic law is only applicable with respect to matters of marriage, divorce, guardianship, inheritance and wakf as Islamic banking is not mentioned it is excluded.177 Two, that all the matters stipulated by the Act to which Islamic law is applicable are relevant only if there are members of a community which follows that law, that is, Islamic law. Islamic banking is not necessarily used by people who have professed Islam; it is used even by non-Muslims who do not follow Islamic law.

This law too faces a serious challenge from establishment of Islamic banking both in its text and in its purpose as it is the only principle law that provides for the sources of law in our country. If this Act does not state that a particular law applies, logically it strictly does not apply. 178 This is a grave challenge to the regulatory and supervisory regime as Islamic banking cannot be properly supervised if it is not legally accommodated.

(iii) Act, 2006

The Banking and Financial Institutions Act, 2006 and the BoT

The researcher found out that this Act whose objectives among others are to provide for comprehensive regulation of banks and financial institutions with the view to maintaining the stability, safety and soundness of the financial system aimed at reduction of risk of loss to depositors.179 Convincing as this objective would appear, it does not by necessary implication apply to Islamic banks. These were found to be in the following aspects:

177

See the rule of statutory interpretation Expressio unius est exclusio alterius ("the express mention of one thing excludes all others") that is, tems not on the list are assumed not to be covered by the statute 178 See note 167. 179 See the preamble to this Act. 78

(a) Eligibility to acquire licence Sections 3 and S. 7 (1) of the BFIA, 2006 impare islamic banks chances to be eligible to acquire license to operate as a bank in other forms than as a company or as a cooperative society. An entity in Tanzania may not operate as a bank without acquiring license from BoT. This is the essence of section 7(1) of the Act which reads: The Bank may, upon application made in pursuance of the provisions of this Act, grant a licence to undertake the banking business to an entity formally established in accordance with the Companies Act, Companies Decree, Cooperative Societies Act, 1986 or the Cooperative Societies Act, 2003.

The incumbent condition in this section is that to be granted a license by the BoT the entity must either be a company or a cooperative society. This section has the effect of restricting the scope of application of section (S.3) of the same Act which defines an entity as to include other forms of business associations such as partnership, trust, association etc. Section 7 (1) excludes these other forms of business entities under section 3.

Ultimately from this observation a non Islamic bank must either be a company or a cooperative society. It seems, however, that the only option for an Islamic bank is a cooperative society since the concept of a company is not acceptable180 in Islamic shariah.181 The most common form used by islamic banks is thus partnership and this is the basis of the Profit and Loss Sharing Schemes (PLS). The main reason why there is no corporation in Islam is that, it is natural persons who have connection and thus are answerable to God for their deeds. While modern corporate law theory posits that a company has an artificial personality responsible for its own deeds, this theoretical construct on responsibility of a company is not recognised in Islamic philosophy as the company has no faculty of mind as an individual person.
180 181

This is a challenge to the Companies Act, Cap 212 (RE: 2002) Kuran, T. (2005, Fall). The Absence of the Corporation in Islamic Law: Origins and Persistence. The American Journal of Comparative Law, 53 (4). pp. 785-834. Retrieved from http://www.jstor.org/stable/30038724. Issues sorrounding absence of the corporation in islamic law is, however, stiffly debatable. 79

(b)

Maintenance of liquid assets ratios

Sections 21 (1) of BFIA reads: ...every bank or financial institution shall maintain liquid assets at levels prescribed by the Banks from time to time. S. 45 of the BoT Act is in resonance with this section positing the same dictates. The two Acts do not define liquid assets. Elsewhere liquid assets are defined as financial resources which can be readily turned into cash or are already cash.182 This section makes it mandatory that all banks including Islamic banks should maintain liquid assets at levels which the BoT prescribes indiscriminately. This section can not apply to Islamic banking given the intrinsic features it has that differentiates it from conventional banking: Islamic shariah prohibits dealing in most of liquid assets as such a vast majority of Islamic banks assets are maintained in the form of illiquid assets.183 The most liquid of liquid assests is money and islamic banks do not deal with money but deal with assets which is the foundation of islamic banking financing.

Islamic banks thus can not maintain any higher levels of liquid assets than the illiquid assets. The BoT cannot prescribe levels which can apply equally to both islamic and conventional banks since while the former would like to have more illiquid assets the latter would like to have more liquid assets, the core of their businesses lie on these varying interests. Thus this is an important challenge to this law as well as to the regulatory framework generally.

(c) Restriction to trade by banks Section 24 (4) of the BFIA reads: With approval of the Bank, a bank or financial institution may engage in trade or other commercial operations that are temporarily
182

Liquid assets are those assets that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally regarded in the same light as cash because their prices are relatively stable when they are sold on the open market. Liquid assets include most stocks, money market instruments and government bonds. The foreign exchange market is deemed to be the most liquid market in the world because trillions of dollars exchange hands each day, making it impossible for any one individual to influence the exchange rate. Read more: http://www.investopedia.com /terms/l/liquidasset.asp#ixzz1z3rupXlz. Visit also http://whatareassets.net/definition-and-examplesof-liquid-assets 183 Illiquid assets include all types of assets including houses, cars, antiques, private company interests, and some types of debt instruments. 80

necessary in the conduct of its business or in the course of the satisfaction of debts due to it.

This section is also a challenge to the regulatory structure. The philosophical tenets of islamic Shariah prohibit riba but in its place allow trade, which is the underpin of all the financing modes available in islamic banking. Islamic banking is not possible without trading. In essence trade is the continuous activity of these banks. The fact that the section allows the BoT to approve trading by banks only for temporary purposes is a big challenge to the smooth operation of islamic banks and to the successiful operations of BoTs supervision endevours.

(d)

Deposit Insurance Fund

Section 36 (1) establishes the Deposit Insurance Fund which is managed by the Deposit Insurance Board (DIB). The section specifically reads: There shall continue184 to exist the Deposit Insurance Fund to be managed and controlled by the Deposit Insurance Board in its acronym DIB, into which shall be paid all contributions and other payments required by this Part to be paid into the Fund and out of which shall be made the payments required to be made out of the Fund.

Monies paid into the Deposit Insurance Fund are contributed by banks in order to secure their customers in case those banks suffer failures. When this happens the fund pays back to the bank an amount which is greater than that which had been earlier on contributed by the banks.185 S. 36 (4) provides that the moneys constituting the Fund shall be placed in an account with the Bank to be invested in obligations of, or obligations guaranteed by, the United Republic and other

184

The word is used since the Fund had been established by the Banking and Financial Institutions Act of 2001. 185 Read Deposit Insurance from the Shariah Perspective Discussion Paper prepared by the Islamic Deposit Insurance Group of the International Association of Deposit Insurers located in Basel Switzerland. Retrieved from www.IADI.org 81

obligations as determined by the DIB to be suitable investments taking into account the purposes of the Fund.

Implications of these sections are that since deposit insurance involves the exchange of money for money and the exchange occurs with different values with a contributing bank receiving more than it gives.This would be viewed by shariah scholars as an interest-based transaction and therefore non-permissible. The interest element could also exist in deposit insurance when the deposit insurence fund is invested in interest-based transactions or projects not approved by islamic shariah. The profit would be viewed as not permissible and thus doubtiful to be applied in paying an islamic bank when it has failed.

(iv)

The Legal Concept of goods

A greater part of islamic banking financing modes are either contracts and or sales. While findings under this part reveal that islamic banking brings in new experience as regards contracts and sales as they are known in conventional banking practice, observations reveal that the only laws that are greatly useful in islamic banking are the sale of Goods Act, Cap 214 (RE: 2002) and the Law of contract Act, Cap 345 (RE: 2002) . A few challenges, however, against these laws are:

S. 2 of the Sale of Goods Act defines goods as all chattels personal excluding things in action and money, emblements, industrial growing crops, and things attached to or forming part of the land, which are agreed to be severed before sale or under the contract of sale and by this a contract of sale involving the things excluded is not acceptable. In Islamic banking, the bai salam mode of financing is mainly used for sales of goods such as crops which have not been planted or severed from the farm the same things which are not recognised as goods that can be sold under the the Sale of Goods Act, Cap 214.

Under bai salam the fact that one can sell crops even before he has planted the same is not accepted in the law relating to contract. Under s. 29 of the Law of Contract

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Act, Cap 345 agreement on this kind of transaction is void for uncertainty and under s. 31 of the same law is referred to as a contingent contract. Contingent contracts under s. 32 of the same law are nenforceable. A contingent contract is a contract to do or not to do something, if some event, collateral to such contract, does or does not happen. In islamic law a farmer may receive funds from islamic bank to cultivate in return for crops he will harvest. The crops may or may not be obtained, this fact makes the contract contingent upon availability of such crops. Despite these challenges the general freedom of contract under the islamic banking is quite impressive.

(v)

Double taxation with respect to sales modes transactions

Islamic banking brings forth issues relating to stamp duty fee. The fee often relates to the value of real property or a financial agreement and is usually charged as a standard part of conventional commercial banking and in business practice. Section 5 of the stamp duty Act, Cap 189 (Re 2002) provides:

(1) Every instrument specified in the Schedule to this Act and which (a) (b) is executed in Tanzania; or if executed outside Tanzania, relates to any property in

Tanzania or to any matter or thing to be performed or done in Tanzania, shall be chargeable with duty of the amount specified or calculated in the manner specified in that Schedule in relation to such instrument.

The challenge is as regards the purchase and resale agreements associated with some islamic financing. Usually stamp duty is paid when the ownership in the asset is transferred. So the buyer must pay this over and above the purchase price paid to the seller. With Islamic sales, however, the bank buys the property instead and then resells it to the client with an appropriate markup. The taxation problem is; these two transactions would normally incur two separate stamp duty payments. Here there is only one financing arrangement but that two transactions are needed to achieve the desired outcome.

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Thus while the interest a conventional bank receives is regarded as a passive income, profit received by Islamic bank is regarded as an earned income which is treated differently for purposes of tax. In addition, in trade financing there are title transfers twice, once from seller to bank and then from bank to buyer and therefore both these transactions are twice taxed. This decreases the profitability of the venture.

5.3.2. Supervisory challenges Supervision mainly relates to liquidity requirements and adequacy of capital in banks. The two depend on an assessment of the value of assets of the banks supervised. The key words here are liquidity, capital adequacy and assets of the bank. The general findings here are that all regulations that are currently used by the BoT in supervising banks are not applicable to Islamic banking since Islamic banking has new commands as opposed to conventional banks. As such a task force has been appointed to design new Regulations which will take on board Islamic banks needs.

Specifically, however, the challenges against regulation relate to relevant only against the following regulations:

(i)

Risk Assets Management

Mangement of risk assets is governed by the Banking and Financial Institutions (Management of Risk Assets) Regulations, 2008: The objectives of these Regulations are generally to provide prudential guidance on management of risk assets and bases for providing for losses on loans and other risk assets. These regulations in view of its objectives require banks to do thorough analysis of creditworthiness of a client as regards his character and financial capacity. This requirement does not capture the primary expectation of Islamic banking in the loan client. Since Islamic bank does business in a partnership with a client, it is not much

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interested in the latters character but rather whether he has skills to engage himself in a profitable venture.

(ii)

Banks Liquidity Measuring and Monitoring

Measuring and monitoring Liquidity of banks is governed by the Banking and Financial Institutions (Liquidity Management) Regulations, 2008. The main objectives of the Regulations are to provide guidance on measuring and monitoring liquidity of banks and financial institutions. i.e. to ensure that banks and financial institutions have in place liquidity management policies adequate to enable them meet all known obligations and commitments and plan for unforeseen development, to ensure that banks and financial institutions implement liquidity management standards that conform to international norms and maintain public by ensuring that banks and financial institutions have sufficient liquidity all the times.

Islamic banks cannot be as liquid as conventional banking as they mainly deal with assets instead of cash. Assets are less liquid compared to cash. The effect of this regulation is like the effect of Sections 21 (1) of the BFIA, 2006 and s. S. 45 of the BoTA, 2006 aboe discussed.

(iii)

Limitation to invest on equity and assets

Directives on this aspect are obtained from the Banking and Financial Institutions (Credit Concentration and Other Exposure Limits) Regulations, 2008. The main objective of these Regulations, among others, is to prescribe limits for investment in equity and fixed assets. Investment and trade in assets and equities in Islamic banking cannot be divorced. It is the only products which underlie the foundations of any Islamic banking business. Money in Islamic banking is inferior to property. These are challenges to these regulations and the giant oversight organ that made them.

5.3.3 Judicial challenge

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Respondents in Islamic banks operations were worried about how a disagreement arising out of shariah principles would be solved. Though Islamic banks and conventional banks operate on different philosophical foundations, the dispute settlement machinery is favourable only to the former. There is a big challenge on the question on which law to apply as Islamic law is not recognised when a dispute ensues within the confines of Islamic banking practices. Disputes in a commercial and specifically in the banking area are strictly unavoidable. Justice Kalegeya186 notes the trend of cases filed by or against the banks in the Commercial division of the High court since its inception in 1999 as being 85.5% of all cases filed in the court. The issue is not whether they will or they will not happen but the issue is how they will be resolved. Islamic banking being a new discipline, research findings reveal that many practitioners in the legal field are not trained on its facets. Neither Justices, judges, magistrates on the one side nor advocates and legal practitioners on the other side are knowledgeable on how Islamic banking works. This is a serious challenge to the regulatory system. The first case 187 that was settled in an English court raised many of these issues and there was a considerable difficulty deciding the questions above. If a country where Islamic banking came earlier the problem was that significant, how would it be for a recent adopter like Tanzania? This in itself is an area for further research.

5.4 Response from respondents as regards the question on does the existing regulatory and supervisory system call for any fine tuning as regards Islamic banking established in Tanzania? In relation to this question all 12 respondents were interviewed. Respondents who responded to questions relating to this research question as per interview guide did not have any issues on how the BoT regulates commercial banks but had issues on
186

Kalegeya, L.B. (2005, March). The Role Of Courts In Facilitating Loan Recovery: Tanzania Experience. Paper presented at the Tanzania Bankers Association Conference. Golden Tulip, Dar es salaam, p. 3. 187 See Balz, K. (2004). A Murba a Transaction in an English Court: The London High Court of 13th February 2002 in Islamic Investment Company of the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & OrsAuthor(s). Islamic Law and Society, 11 (1). pp. 117-134. Retrieved from http://www.jstor .org/stable/3399382. 86

how would islamic banking be regulated. Best response, however, on whether the regulatory and supervisory systems be fine tuned came from respondents at the Bank Supervision Directorate of BoT and legal practitioners and one islamic banking scholar. From the analysis of the obtained information, the researcher found out that the sytem requires fine tuning to allow for accomodation of islamic banks.

5.4.1 Islamic Banking Regulatory and Supervisory Regime needs change to accommodate Islamic Banking Respondents from BoT stated their knowledge that Islamic banking does not fit in the BoTs regulatory framework. Apart from pointing to the fact that new

regulations are underway that will accommodate forms of Islamic banking regulation and supervision they did not point out what would be the difference between the existing regulations and the new regulations. Generally, respondents pointed out those specific areas that require fine tuning include;

i.

Capital ratios requirements

Islamic banks are more prone to risk of loss to depositors funds given the nature of their activities, that is mostly trading on PLS schemes. When trade goes wrong the bank may opt to erode on the capital and even depositors funds. Thus, the capital requirements set by the BoT for all banks can not suffice for islamic banks. They necessarily need to have a relatively stronger capital base in order to provide an adequate safety net but also to adopt some effective strategy that would help prevent the risks of investment deposits from being transferred to demand deposits. The risk to which depositors may be exposed creates a greater need in the Islamic banking system for providing a psychological reassurance to the depositors about the health of the financial system. The current regulations are restrictive on capital ratios of banks that need to be amended.

ii.

Trading restrictions

Trade is central to islamic banking. The current regulatory and supervisory framework restricts trading for banks and does not permit banks to engage directly

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in business enterprises using depositors funds. There is need for further auxiliary legislation in order to fully realise the goals of Islamic banking by either enacting new law or modifying the existing statutes and the BoT regulations.

iii.

Maintenance of liquid assets ratios

The existing regulatory and supervisory principles require that banks maintain liquid assets ratios. Islamic banks mainly maintain illiquid assets. It is in these that lies their core function, trading. Islamic banks have no use for money except in so far as trading is concerned. The existing rules on liquid assets ratio maintenance must be fine tuned to reflect ratios that are as minimal as possible to accomodate islamic banks. This also another area of reform.

iv.

Management of risk assets

In this the BoT is concerned with management of risk assets and provision for losses for loan and other risk assets. The bank stresses upon creditworthiness of customers judged alongside their character and financial capabilities. For islamic banking these are not significance. Since their core activity is trading, of much importance is the customers skills to engage in a profitable investment with a bank. The existing regulation need changes in this area.

v.

Deposit Insurance Fund (DIF)

Since the bases of islamic banking is islamic sharia principles, the deposit insurance Fund to which all banks pool resources in order to help them out during the times they are likey to collapse does not suit and ideal islamic bank. Islam does not accept pay-little-receive-more schemes as any excess in return is regarded as interest (Riba). Islamic insurance may be useful as its functions are also within sharia principles. This is also an area of reform which is not addressed by the existing regulations.

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vi.

Registration and licencing requirements

The regulatory requirements for acquiring licence as a bank are not favourable to islamic banking. It restricts islamic banks to operate only as cooperative societies as discussed herein above. Other forms such as partnership which may be more appropriate are not availed to islamic banks. Fine tuning need to take stock of this issue also.

vii.

Policy and Laws of the country to address needs of Islamc Banking

Any sound banking system results from prudential regulation and effective supervision, with special stress on capital adequacy, proper risk assessment and management, effective internal controls and external audit, and greater transparency. It is also necessary to improve and streamline corporate governance so that the funds received by firms from banks are more effectively utilised for the ultimate benefit of both the financier and the user. These are possible if Policy and law support the same. These currently address conventional banking only. So it is important that they should aslo reflect islamic law.

Conclusively, this change in the law or enactment of new set of laws is necessary in order to put in place a proper regulation and supervision of this new type of banking. The significance of this cannot be overemphasized as banking without regulation always attracts failures. As Islamic banks do not operate in vacuum but in the same financial and economic system as conventional banks, failure of Islamic banks would be contagious to the whole system and this would in turn tarnish trust in them by depositors bringing about sweeping consequences.

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CHAPTER SIX CONCLUSIONS AND RECOMMENDATIONS 6.1 Introduction

The study dealt with a critical analysis of the impacts of adopting Islamic banking in Tanzania to the subsisting regulatory and supervisory regime. Presented in this chapter are conclusions on the findings and recommendations thereto.

6.2

Conclusions

The first objective was to assess the current system of banking regulation and supervision in Tanzania as it relates to islamic banking. The study concludes that the current regulatory framework comprises of various statutes relating to banking such as the Banking and Financial Institutions Act, the BoT Act both of 2006 and various Regulations and circulars made by the governor of BoT are not geared towards accomodating Islamic banking smooth operation.

Study also revealed that regulation of banks is done in order to save depositors from the risk of loss by these banks. Islamic banking, like any other banking system, has risks too which are identified as credit risks within the Profit and loss Sharing schemes, risks on possibility of islamic banks eroding on depositors funds when PLS schemes fail, market risks that relate to sales based modes, price risks, inflation risks, liquidity risks etc. Risks are prevalent in all Islamic financial transactions including saving and deposit accounts. Of significance is that risk as it is applicable in islamic banking has unparallelled attributes and distinctive characteristics as such regulation and supervison of the same is as mandatory as is of conventional banking. Islamic Banking, thus, requires stronger regulations which is currently lacking in the regulatory framework. The study, therefore, concludes that the current regulatory and supervisory environment is not, without changes applicable to Islamic banking.

Furthermore, the study generally reveals that Islamic banking in Tanzania brings forthwith many regulatory and supervisory challenges given its nature which necessitates a customised regulatory and supervisory mechanism in order to properly

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adopt Islamic banking. The regulatory challenges are wedged against Article 19 (2) and (3) of the Constitution of the United Republic of Tanzania, the Judicature and Application of Laws Act and the Banking and Financial Institutions Act, 2006. Also the BoT Act, 2006, the Sale of Goods Act, Cap 214, the Law of Contract Act, Cap 345 and Tax Laws. In relation to that the study found that all regulations that are currently used by the BoT in supervising banks are not applicable to Islamic banking since Islamic banking has new commands as opposed to conventional banks.

The study found out that the nature of Islamic Banking requires a reinforcement of prudential regulation and effective supervision, with special stress on capital adequacy, proper risk assessment and management, effective internal controls and external audit, and greater transparency.

6.3 Recommendations The researcher came up with the following recomendations;

6.3.1 Ammendment of the regulatory and supervisory systems The BoT as the body vested with regulation and supervision of banks needs to have in place a regulatory mechanism which takes on board both the traditional prudential supervision aspect and a developmental role that is equally important to Islamic banking. Further that the system must take into certain considerations as they arise from the risk-sharing nature of investment deposits, in which depositors provide the funds that the bank invests in the activities it deems profitable. It must also take into consideration the aspect of safeguarding the interests of demand depositors and such systemic considerations in view of the fact that, the failure of an islamic bank can significantly result in the publics loss of confidence in the stability of the banking system as a whole, thus triggering a generalized bank run. 188

188

Massive deposits withdrawals by a banks customers. 91

6.3.2 Alignment of Regulatory and Supervisory Rules to International Best Practices As the question of central banking is not alien to an Islamic framework the basic functions of a modern central bank are relevant also for an Islamic monetary system. This stems from the imperative of ensuring the viability, strength, and continued expansion of these institutions and enhancing their contribution to financial stability and economic development. The regulatory and supervisory instruments of the BoT need something with regard to islamic banking in view of the relatively different risk perspective of these institutions. Tanzania banking sector is part of a larger global economy. It does not work in a vacuum. The BoT and other banking practitioners must effect a liason with international bodies for Islamic banking best practices. A number of Multilateral institutions have been established to provide assitance to governments and supervisory agencies on islamic banking generally, and specifically on best practice guidelines. These institutions include IMF, IFSB, which is the international board for islamic banks standards setting, the AAOIFI which is an international standards setter for accounting and auditing best practises for islamic banks, and ADB. These bodies have greater experiences regarding islamic banking, they could as such share this experience to help the local situation.

6.3.3 Intensive training to employees Practitioners within the BoT especially those in the Directorate of Bank Supervision must be well trained to enhance the supervison exercise. They need to know how islamic banks work in order to effect a worthwhile supervision to the benefits of islamic banking and the general financial syatem. It is dangerous in a central bank to have staff engaged in supervison of islamic banks while they have not had enough exposure to islamic banking activities. There is a need to put in place requisite islamic banking proffessionalism in the BoT supervision practice. This is necessary as most staff are more conversant as they were trained in conventional economics. Without this they may lack while on duty the requisite vision and conviction on the efficiency or otherwise of islamic banking. The BoT must also put it mandatory to practitioners in the islamic banking industry that they are well conversant with the

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principles under which their banks functions. This will assist the Bank in it supervisory missions.

6.3.4 Amendment or enactment of certain banking laws Law makers must review the existing laws so that they accommodate Islamic banking. Laws on banking were enacted without the view of sharia principles. As stated above Islamic banking has unique needs that include mainatenence of illiquid rather than liquid assets and the requirement of trading. These are not currently addressed in these laws. Only after this is done that regulation and supervision of islamic banking can effectively be done to the benefits of the banking and the economic system as whole. The laws may either take an all-in-one feature, that is, the same laws may provide for both Islamic banking and conventional banking. This is so since it is not all of Islamic sharia that applies to Islamic banking but only a few principles and that is only those that relate to Islamic finance. This is a very limited area, a larger area being that which relates to other Islamic aspects such as, tawheed,189 fiqhi,190 marriage, inheritance, wakf191 et cetera. This implies that only a small portion of Islamic sharia that needs being considered. As such the necessary principles may be included in the banking statutes and the statutes may have a selective application depending on which bank they apply. Alternatively, new laws may be enacted that specifically regulate Islamic banking leaving the old laws to regulate conventional banking.

6.3.5 Improve Corporate Governance It is also recommended that there is a necessity of improving and streamlining corporate governance so that the funds received by firms from banks are more effectively utilized for the ultimate benefit of both the financier and the user. To

189 190

Faith in one Muslims God, Allah Islamic jurisprudence 191 Section 140 of the Probate and Administration of Estates Act, Cap 352 (RE: 2002) defines wakf as an endowment or dedication in accordance with Islamic law of any property within Tanzania for religious, charitable or benevolent purposes or for the maintenance and support of any member of the family of the person endowing or dedicating such property; 93

effect this either new laws and regulations are needed or a massive accommodative amendment of the existing documents should be effected

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Muneeza, A., Wisham I. & Hassan, R. (2010). The Paradox Struggle Between the Islamic and Conventional Banking Systems. Journal of Asia Pacific Studies (2010) 1(2). 188-224. Retrieved from www.japss.org/upload/5.% 20Muneezaetal.pdf

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ANNEXTURES ANNEXTURE I INTERVIEW GUIDE FOR BoT OFFICIALS AND LEGAL PRACTITIONERS This research is about the regulatory and supervisory challenges of establishing Islamic banking in Tanzania. The researcher seeks to investigate and collect in depth information on the effectiveness of the regulatory and supervisory framework in accommodating Islamic banking. It is hoped that you will provide maximum cooperation in answering the questions. 1. What does the word risk stand for in banking operations? 2. Do the banks that operate as Islamic banks have any risks as do those operating conventional banking? 3. What are the common types of risks do Islamic banks face? 4. How does the BoT regulate and supervise banks? 5. Given their nature, are Islamic banks regulated and supervised any how different from conventional banks? 6. Is the present system of regulation and supervision of banks in Tanzania capable of regulating Islamic banking without any problems? 7. If there are any problems, can you identify them? 8. What amendments do you think should be done to the existing regulatory and supervisory framework?

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ANNEXTURE II INTERVIEW GUIDE TO THE OFFICIALS OF NBC, KCB AND STANBIC BANK 1. What is Islamic banking? 2. Since when has your bank offered Islamic banking products? 3. How many Islamic banking products does your bank offer? 4. What are you required to do by the BoT with respect of Islamic banking products you offer?

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