This action might not be possible to undo. Are you sure you want to continue?
It was the beginning of 2006’s and I was in BBA (Honors) in Institute of Management Sciences Peshawar. In 6th semester we were offered an introduction of Islamic banking course and were taught to us by Sir Attaullah Shah the faculty member of Institute of Management Sciences. When I took ten to twelve classes I was so much impressed from the system of Islamic banking because it is so much fair and balanced system so it enforced me to start research on Islamic banking. Actually there are lots of people who are not aware of their Islamic banking system, while some people are aware but they have different doubts and misgivings in their minds. At that time I contracted myself that I will clarify what ever misgivings are their in people minds. For that I started study and took me quite some time to study the relevant literature of Islamic banking. I am indebted to Sir Attaullah Shah for providing me the data of Islamic banking and providing some guidance in the study of relevant and pertinent literature. After that I felt that now I am able to clarify the misgivings and myths faced by the Islamic banking. I fell short of words to express my gratitude to the learned pioneers of interest free banking, particularly Dr. Muhammad Uzair, Muhammad Taqi Usmani, Dr. Muhammad Imran Ashraf Usmani and Dr. Ziauddin Ahmad the then Deputy Governor, State Bank of Pakistan. I studied their books and derived immense benefit from their intellectual writings, without them firming up my views thereon would not have been possible. Nevertheless, what ever shortcomings, visible or latent, are to be found, they reflect none but me. My special thanks are also to my friends for providing me support and encouragement during the writing of this research. By Muhammad Abbas Khan March 17, 2007
Chapter 1 Introduction to Islamic Banking: Islamic banking is a new phenomenon that has taken many observers by surprise. Islamic banking (also called non-interest based, Riba or interest free banking) is an alternate to interest based banking. Its inspirations and guidance is derived from the directives of Shariah and has to be conducted rigorously in accordance with these directions. The key feature of Islamic banking is the prohibition of Riba. Islamic banking is a system of banking, which is based on Shariah rules and principles. It is different from current banking system, which is based on Riba. Islamic baking is based on profit and loss sharing.
What is an Islamic Bank? Islamic bank is a financial and social institution, which sets its objectives and principles on the basis of principles of Shariah, as lay down by Qur’an and authentic Sunnah, and carries out its banking practices and operations strictly in accordance with these doctrines. Islamic bank operates on the principal of actual profit and loss. They take deposit and lend money at a pre-determined ratio of profit and loss that they share with their depositor or debtors on actual profit and loss.
Objectives of Islamic Banking: The main feature of Islamic banking is prohibition on interest. However the objective of an Islamic bank is not merely refraining from interest based transaction but an Islamic bank has to make positive contribution towards the fulfillment of socio-economic objective of a society and to ensure an exploitation free society as imagined in Islam. An Islamic bank has to contribute positively in all spheres of society and the economy including trade, industry, agriculture, science and technology etc, with special focus on human factor. Evolution The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors (Siddiqi l988). Thus, they functioned essentially as saving- investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).
The Organization of Islamic Countries (OIC) established the IDB in l974, but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to member countries. The IDB operations are free of interest and are explicitly based on Shariah principle.
In the seventies, changes took place in the political climate of many Muslim countries so that there was no longer any strong need to establish Islamic financial institutions under cover. A number of Islamic banks, both in letter and spirit, came into existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic Bank (l979), to mention a few. The Asia-Pacific region was not oblivious to the winds of change. The Philippine Amanah Bank (PAB) was established in l973 by Presidential Decree as a specialized banking institution without reference to its Islamic character in the bank's charter. The establishment of the PAB was a response by the Philippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. However, the primary task of the PAB was to assist rehabilitation and reconstruction in Mindanao, Sulu and Palawan in the south (Mastura l988). The PAB has eight branches located in the major cities of the southern Muslim provinces, including one in Makati (Metro Manila), in addition to the head office located at Zamboanga City in Mindanao. The PAB, however, is not strictly an Islamic bank, since interest-based operations continue to coexist with the Islamic modes of financing. It is indeed fascinating to observe that the PAB operates two 'windows' for deposit transactions, i.e.,
conventional and Islamic. Nevertheless, efforts are underway to convert the PAB into a full-fledged Islamic bank (Mastura l988). Islamic banking made its first appearance in Malaysia in l983, but not without past history. The first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings Corporation set up in l963 to help people save for performing hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the Pilgrims 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 would-be pilgrims in accordance with Shariah, but its role is rather limited, as it is a non-bank financial institution. The success of the Tabung Haji, however, provided the main momentum for establishing Bank Islam Malaysia Berhad (BIMB) which represents a full- fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per cent of BIMB's initial capital of M$80 million. BIMB has a complement of fourteen branches in several parts of the country. Plans are afoot to open six new branches a year so that by l990 the branch network of BIMB will total thirty-three (Man l988). Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. There was a proliferation of interest-free savings and loan societies in India during the seventies (Siddiqi l988). The Islamic Banking System (now called Islamic Finance House), established in Luxembourg in l978, represents the first attempt at Islamic banking in the Western world. There is also an Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment Company has been set up in Melbourne, Australia.
Islamic banking growing in popularity
The future prospects of Shariah complaint banking products largely depend upon how efficiently and prudently the existing Islamic
banking institutions perform in terms of profitability and growth in their asset and deposit base. Moreover, committed are the sponsors of the institutions to convince entrepreneurs and depositors to route all their financial transactions through Islamic banks. Keeping in close touch with market requirements and responding to them promptly could enhance the potential growth of the Islamic banking industry. Introduction of innovative Shariah complaint products is crucial aspect of such growth. It is estimated that there are 267 Islamic banks in over 75 countries, which manage approximately $202 billion in deposits, $400 billion in investments and over $262 billion in other assets. Islamic windows of international banks manage another $200 billion to $300 billion. The average annual rate of growth of Islamic banking is considered to be over 10 percent per annum since it first emerged in 1960s. Throughout Asia, the Middle East and Europe, more and more banks and their customers are turning to Islamic finance. A growing number of the decisions to do so are increasingly made on commercial rather than religious grounds. The rising global interest in Islamic finance has led to major expansions in the number of institutions offering Islamic financial services. Global financial institutions, led by HSBC, Citigroup, ABN AMRO, Deutsche Bank and BNP Paribas, have now set up either Islamic divisions or Islamic subsidiaries. The future of Islamic Banking in Pakistan looks very promising. SBP targets 10 percent of the industry under Islamic banking by 2020. At 98 percent correlation with GDP growing at 5 percent, the
deposit size of Islamic banking is expected to reach Rs 480.6 billion in 2020 with a growth rate of 18.88 percent. It is conservative estimate as in Malaysia the industry grew to 10 percent in 15 percent with a Muslim population at around 60 percent at a growth of 37 percent. In addition a renowned consultancy firm in Pakistan Ferguson Associates professes a similar conclusion. They projected that the deposit with Islamic banks in Pakistan would reach Rs. 780 billion by 2014 with an average growth of 140 percent.
GENERAL INFORMATION OF ISLAMIC BANKING DEPARTMENT IN PAKISTAN
Islamic Banking Department was established on 15th September, 2003 and has been entrusted with the huge task of promoting & developing the Shariah Compliant Islamic Banking as a parallel and compatible banking system in the country. Islamic Banking is one of the emerging field in global financial market, having tremendous potential and growing at a very fast pace all around the world. Al-Hamdulillah, the progress of Islamic Banking in Pakistan has also been commendable during the last two years. Currently there are three licensed Full fledged Islamic Banks and nine conventional banks with stand alone Islamic Banking Branches with the total branch network of 62 branches operating in thirteen cities of all the four provinces in the country as of 30-06-2005 and applications for few more players are under consideration. The importance of Islamic Banking is also evident from the fact that the internal and external stakeholders have given high priority to Islamic Banking during the last Strategic Management Conference at SBP. One of the biggest challenges being faced by this growing industry is the dearth of professional Islamic Bankers and capacity
building in this regard is one of the top most priorities for the promotion of Islamic Banking. In order to play our regulatory and supervisory role more efficiently we are working on the areas like Risk Management, Corporate Governance, Prudential Regulations, Accounting and Shariah Standards etc. regarding Islamic Banking Currently the Islamic Banking Department (IBD) consists of following three divisions: 1. Policy Division 2. Shariah Compliance Division 3. Business Support Division The conventional banks in Pakistan have 31 dedicated Islamic banking branches and there is increasing interest from these entities to open branches. With the new applications for full-fledged Islamic banks show the promising growth. The State Bank of Pakistan expects the number of total dedicated Islamic branches to grow substantially by end December 2006. According to an analyst with the regular entrance of new Islamic Banks, the market stands to benefit and grow. The injection of new ideas, the investment in training and infrastructure, and the healthy results that free competition engenders all coming together within a properly regulated and risk management environment. "Though the Pakistani market presents its own unique set of challenges amidst a dynamic and competitive arena, it truly presents the fitting crucible for the evolution of Islamic banking in its most cogent form". Meezan Bank, the country's premier Islamic bank said in its recently released report that soon the "smart branch", though not new concept would be launched. The concept of self-service branch, using state of the art technologies, the branch would be equipped with a system through which the customer would immediately be able to deposit and
withdraw cash or make electronic bank transfers. Moreover, SMS banking is another value added service that would be providing aimed to give comfort for mobile customers to do banking the way they want to.
2003 Total assets *Rs in billion 12.9
Islamic Banking has proven its competence and can grow to become a powerful force in years to come in Islamic countries and beyond. For an industry that is still considered something of a newcomer, in the past three decades, it has done a very impressive progress. It is projected that total assets of the industry would growth in the range of 8 to 15 percent over the next five years, according to Opportunities and Trends in Islamic Finance, February 2005. According to an analyst a big challenge for SBP is to develop Shariah-complaint products to enable the monetary management of Islamic Banking Institutions. Similarly, accounting standards for all modes of Islamic financing need to be developed, as in the case of Murabaha and Ijara. Increase in the size and volume of Islamic capital markets also depends on the existence of a secondary market for trading in Sukuk, which is still to be developed even on an international level. Another challenge for the industry is the establishment investment banks and liquidity management institutions exclusively for Islamic banking, following the models of Bahrain and Malaysia.
The State Bank of Pakistan in report earlier said that the unique distributive and facilitating nature of Islamic banking products can contribute extensively not only in the development of the economy but also to the reduction in poverty, unemployment and income inequalities. Products based on profit and loss sharing with emphasis on financing production and not consumption, can have a favorable impact on savings and investments. If operated efficiently and transparently. In this respect, Musharaka can especially be used in short, medium and long term project financing, import and pre-shipment export financing and working capital requirements. Islamic financial services in Pakistan, a relatively recent occurrence, have recorded a noteworthy progress during the last three years, constituting an asset base of Rs 57.1 billion and deposits of over Rs. 37.6 billion as of September 2005. Given its nascent stage of development, the share of the Islamic Banking industry in the total assets of the banking sector grew from 0.5 percent in 1996 to 1.7 percent as of September 2005. However, given the rapid growth of this industry, it is expected that this share would grow considerably in the years to come.
The essential feature of Islamic banking is that it is interestfree. Although it is often claimed that there is more to Islamic banking, such as contributions towards a more equitable distribution of income and
wealth, and increased equity participation in the economy (Chapra l982), it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order. Islam prohibits Muslims from taking or giving interest (Riba) regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production. It has also been argued that Riba refers to usury practiced by petty money-lenders and not to interest charged by modern banks and that no Riba is involved when interest is imposed on productive loans, but these arguments have not won acceptance. Apart from a few dissenting opinions, his general consensus among Muslim scholars clearly is that there is no difference between Riba and interest. In what follows, these two terms are used interchangeably. The prohibition of Riba is mentioned in four different revelations in the Qur'an. The first revelation emphasizes that interest deprives wealth of God's blessings. The second revelation condemns it, placing interest in juxtaposition with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay. It is further declared in the Qur'an that those who disregard the prohibition of interest are at war with God and His Prophet. The prohibition of interest is also cited in no uncertain terms in the Hadith (sayings of the Prophet). The Prophet condemned not only those who take interest but also those who give interest and those who record or witness the transaction, saying that they are all alike in guilt. It may be mentioned in passing that similar prohibitions are to be found in the pre-Qur'anic scriptures, although the 'People of the Book', as the Qur'an refers to them, had chosen to rationalize them. It is amazing
that Islam has successfully warded off various subsequent rationalization attempts aimed at legitimizing the institution of interest. Some scholars have put forward economic reasons to explain why interest is banned in Islam. It has been argued, for instance, that interest, being a pre- determined cost of production, tends to prevent full employment (Khan 1968; Ahmad n.d.; Mannan l970). In the same vein, it has been contended that international monetary crises are largely due to the institution of interest (Khan, n.d), and that trade cycles are in no small measure attributable to the phenomenon of interest (Ahmad l952; Su'ud n.d.). None of these studies, however, has really succeeded in establishing a causal link between interest, on the one hand, and employment and trade cycles, on the other. Others, anxious to vindicate the Islamic position on interest, have argued that interest is not very effective as a monetary policy instrument even in capitalist economies and have questioned the efficacy of the rate of interest as a determinant of saving and investment (Ariff l982). A common thread running through all these discussions is the exploitative character of the institution of interest, although some have pointed out that profit (which is lawful in Islam) can also be exploitative. One response to this is that one must distinguish between profit and profiteering, and Islam has prohibited the latter as well. Some writings have alluded to the 'unearned income' aspect of interest payments as a possible explanation for the Islamic doctrine. The objection that rent on property is considered halal (lawful) is then answered by rejecting the analogy between rent on property and interest on loans, since the benefit to the tenant is certain, while the productivity of the borrowed capital is uncertain. Besides, property rented out is subject to physical wear and tear, while money lent out is not. The question of erosion in the value of money and hence the need for indexation is an interesting one. But the Islamic jurists have ruled out compensation for erosion in the value of money, or, according to Hadith, a fungible good
must be returned by its like (mithl): 'gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for equal, and hand to hand ...'.3 The bottom line is that Muslims need no 'proofs' before they reject the institution of interest: no human explanation for a divine injunction is necessary for them to accept a dictum, as they recognize the limits to human reasoning. No human mind can comprehend a divine order; therefore it is a matter of faith (iman). The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative (Kahf l982a and l982b). In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit- sharing permissible in Islam, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined. It has been argued that profit-sharing can help allocate resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors which offer the highest profit- sharing ratio to the investor, other things being equal. One dissenting view is that the substitution of profit-sharing for interest as a resource allocating mechanism is crude and imperfect and that the institution of interest should therefore be retained as a necessary evil (Naqvi l982). However, mainstream Islamic thinking on this subject clearly points to the need to replace interest with something else, although there is no clear consensus on what form the alternative to the interest rate mechanism should take. The issue is not resolved and the search for an
alternative continues, but it has not detracted from efforts to experiment with Islamic banking without interest.
Abolition of Riba is really a very challenging task. For the first time in the modern world Muslim countries have undertaken to abolish Riba. Since there exists no experience in Islamic banking in the modern financial system there would surely arise some myths and misgivings about its viability and practicality. A research of these myths and misgivings can really contribute constructively to the solution of the problems with which we face in the elimination of Riba. I have taken these myths and misgivings in the spirit in which they have been expressed and try to make whether I can make some clarification about these myths and misgivings which might really take us towards our objective. Now with that I would start with the myths and misgivings which have been expressed in various ways.
1. The first myth and misgiving which has been
expressed is whether interest paid by banks on deposits or charged on advances does not tantamount to Riba and hence permissible. It is also argued that the Arabic word Riba means usury and not bank interest.
For the clarification of this misgiving it is proposed to discuss the true nature and meaning of Riba, usury and interest, so that we can understand and ascertain whether interest comes within the purview of Riba as stipulated in Shariah.
Even prior to the dawn of Islam, over 1400 years ago, the majority of ancient philosophers and almost all the religions of the world had prohibited money lending as a business; Riba, interest or usury. If one goes back into history, as far as one can, it would be found that lending and borrowing as a transaction between members of a society was started as a commercial operation after the switching over from the barter system to the money system. Money lending with the earning motive became a common phenomenon in most of the societies of the world, but people engaged in this business were generally not regarded respectable during any period of history. The doctrine of famous Greek philosopher Aristotle was, that a piece of money cannot beget another piece, as the sole natural object of the use of money was to facilitate exchange and that money cannot be used as a source of accumulating money at interest. Aristotle, therefore, rejected interest on the basis that ‘money is sterile’ and accordingly compared money to ‘a barren hen, which lays no eggs’. Plato too condemned interest. In the early years, the Roman Empire had also prohibited earnings on money lending. In Biblical times, all payments for the use of money were forbidden. Earlier in 340 B.C., Lex Genucia prohibited interest in the Republic of Rome. When the Roman Empire was Christianized in the Fourth Century, the Church forbade the clergy from taking interest. In the early middle ages, Popes and Councils continued to oppose all forms of payments for the use of money lent, as the money was mainly for the purpose of exchange and its principal use was its consumption, whereby it was sunk in exchange. In those days, governments introduced laws to prohibit charges for use of money. In AD 1311, Pope Clement V made the prohibition of usury absolute and declared all legislations in favor of usury as null and void. The teachings of Jesus on the subject are very clear ––––
“Love your enemies and do good, Lend, expect nothing in return”. The charging of interest has also been prohibited in Judaism. It says, “If you lend money to any of my people who is poor, you shall be to him creditor, and you shall not extract interest from him”. It is interesting to note that in AD 605; just before the dawn of Islam, on a tempestuous day, a spark of fire caught the curtains of Ka’ba (House of God in Makkah) resulting in serious damages to the building. For the repair and reconstruction of the building, contributions were asked from the general public living in the locality. It was, however, solemnly announced that for the Holy Building, only pure, clean and honestly earned money should be donated; prostitutes and usurious people were specifically debarred from contributing anything. It is, therefore, obvious that even among the pagans of Arabia, in the dark days of civilization usury and interest was considered to be the money earned by unethical means. The end of thirteenth century saw the decline of the influence of Orthodox Church and the rise of secular powers. As a consequence, the charging of interest, which was forbidden by the Church gradually, started being tolerated. In the Mercantile Era (1500 – 1700) money began to be used on a large scale for commercial transactions and assumed the role of a factor of production like land and interest on capital was equated to t he payment for renting of money, similar to the rent of land. In 1740, the city of Verona, issued a bond at 4% interest, which led to a lot of controversies. The Benadict XIV wrote to the Bishop of Italy, firmly emphasizing that it was a sin to take profit beyond the principal amount given as loan. He specifically condemned various pleas such as profit on loan was moderate or that the loan was given to rich person or that it was to be used for production purposes. In this connection, it is significant to note that after the establishment of political supremacy of Islam over a greater part of the world, the prohibition of usury or interest, which was also considered as undesirable among non-Muslims, was enforced more strictly. The
prohibition of Riba, usury or interest, by Islam is, therefore, nothing new. Islam allows profits through trade but prohibits interest because of the negative effects of the fixed interest-being loans. As the times passed by, Muslims gradually began to lose political supremacy in places, which were being ruled by them, and accordingly the political ascendancy passed on to Europe. Although in England during the Middle Ages, charging of interest was opposed by the Church and prohibited by the state but with the decline in the influence of the Church and religion, the practice of usury and interest reappeared notwithstanding the fact that the charging of usury and interest was still condemned by Christianity. During this period, the doctrine that ‘sale transaction is similar to interest deal’ was revived and the governments enacted legislation to legalize interest with new dimensions. Formerly, interest income was restricted to those individuals who were engaged in the business of money lending. The western socio-economic structure was then organized in such a manner that any person who had little savings could be assured of interest income without investing in any business directly. With the advancement of this system and growth in economic activity, it has now become almost impossible to participate in any economic activity without either charging or paying interest. The Holy Prophet of Islam, Peace Be Upon Him, had predicted this over 1400 years ago. In the above paragraph, it has been mentioned that laws were framed for legalizing interest transactions as a consequence of decline in the influence of the Church. It was during this period that a step was taken to Christening of interest (which may originally have been a Hebrew or Greek word) resulting in the complete transformation of its sense. The two terms, interest and usury, thus developed were given different treatment, as interest was declared lawful and usury was prohibited. The word “interest” indicated a reasonable and moderate rate as against usury, which was symbolized as an excessive rate of return. Laws were framed for legalizing the charging and paying of interest on money lending
transactions. The rates of interest were, however, controlled. During the reign of King Henry VIII in 1745, national laws were changed to permit interest but a maximum rate of interest of 10% per annum was fixed. The economists of those periods argued that the law must fix lower rates of interest to facilitate growth of business. To conclude, it seems interesting to give a brief review of the article on usury in the Encyclopedia of Religion and Ethics. It says that usury and interest were considered one and the same thing. Usury was not used in its modern sense of excessive interest and it meant interest generally. Judaism, however, later allowed that God could recover interest from non-Jews only as a privilege granted to faithful Israelite. The Christians had similar views about usury and interest. The early Fathers totally disapproved usury. The decision of Canonist Conscious was that money lending did not justify a charge. Augustine placed usury in the category of crime and denounced the usurers as breed of vipers that gnaw the womb that bears them. A canon of the third Lateran Council directed that, manifest usurers shall not be admitted to Communion, nor, if they die in their sin, shall receive Christian burial. It was, however, not until 1830 that Holy Office allowed that interest could lawfully be taken for money lent to merchants who were in profitable trade.
Nature and Meaning
Riba is an Arabic word which means “increase”, “addition”, “expansion” or “growth” and refers to the additional amount, which a lender recovers from the borrower according to a fixed rate over and above the principal amount. In the New Encyclopedia Britannica, usury is explained as compensation for the use of money regardless of the amount, according to earlier English law. The Concise Oxford Dictionary, however, defines usury ass “Practice of lending money at exorbitant interest, especially at higher interest than is legal”. According to Hughes, Riba is a term in Muslim Law as:
“An excess according to legal standard of measurement or weight, in one or two homogeneous articles opposed to each other in a contract of exchange and in which such excess is stipulated as an obligatory condition on one of the parties without any return. The word Riba appears to have the same meaning as the Hebrew “neshec” which included gain, whether from the loan of money or goods or property of any kind. In Mosaic Law, conditions of gain for the loan of money or goods were rigorously prohibited”. In Oxford Advanced Learner Dictionary, Riba refers to “excess, addition and surplus” while the associated verb implies “to increase, to multiply, to exceed, to exact more than was due, to practice usury”. Lane’s, Lexicon presents a synthesis, which transcends and covers most of the earlier authentic definitions of Riba. It says that the common meanings that emerge are: ‘to increase”, “to augment”, “swelling”, “forbidden”, “addition”, “to make more than what is given”, “the practicing or taking of usury or the like”, “an excess” or “an addition”, “an addition over and above the principal sum” [that is lent or expended]. It will thus be seen that originally the word usury meant the fact or practice or lending money at interest. It came to mean, in later use, the practice of charging, taking or contracting to receive excessive or illegal rates of interest for money given as loan. Usury before reformation amounted to taking of any amount of interest than what is authorized by law. It is, therefore, clear that interest charged on a loan is nothing but usury in the original sense of the word. Subsequently, laws were enacted specifying the limits within which usury could be tolerated. These limits prescribed by law came to be known as interest. Encyclopedia Americana – International Edition says: “Interest is a charge for the use of money… Interest has not always been considered a legitimate or even moral payment. Until the end of middle Ages, any charge for a loan was generally considered to be usury. The teachings of Christians, Judaic and Islamic religion, all condemned in varying degrees, the taking of interest. In more recent times,
however, usury has come to be regarded as only the charging of illegal rates of interest.” Encyclopedia Americana explains usury as: “previously interest meant payment to compensate for a loss suffered by the lender, whereas usury signified a charge for the use of money”. New Encyclopedia Britannica defines interest as: “the price paid for the use of credit or money. It maybe expressed either in money terms or as a rate of payment”, it defines usury as “In the middle ages, practice of charging excessive interest for the loan of money. Originally all interest was termed usurious, but with the expansion of trade in the 13th century, the demand for credit increased, necessitating a modification in the definition of usury”. According to Stiengass, the word interest by and large has now been accepted and understood as Riba. It is now proposed to discuss the prohibition of Riba, as ordained by Islam. 2. The second misgiving which has been often
expressed is that interest is the key player of the modern banking system. How can one run a banking system without interest? Clarification:
But here the basic question arises that why interest is regarded as the kingpin of the modern banking system. According to my perspective there are two basic reasons behind this phenomenon. i. It is considered that the payment of interest is necessary to
call for the supply of savings and deposits, and for the mobilization of deposits by the banking system and ii. Interest performs an important allocative function in the allocating the scarce resources among competing uses.
Now as far as this misgiving is concerned, I think western economic thought itself is not unequivocal in respect of these propositions. I think we all are aware of the famous economist Keynes who completely denied the relationship which was postulated by the earlier economists between saving and the rate of interest. Classical economists thought that saving is a function of that rate of interest rate. Symbolically S = f (I) But Keynes completely denied this relationship; he said saving is not the only function of the rate of the interest. Symbolically S ≠ f (I) He further says that saving is a function of income rather than the rate of interest. There are some other researches and contributions which have made empirical research on the determinants of savings in various countries by using both time series data and cross sectional data and none of these studies really have conclusively demonstrated that savings are highly correlated with interest. In fact, some of the studies found that the relationship is very tenuous and some of the other empirical researches have found that there are other determinants of savings which are more important than the rate of interest, even though that rate of interest might play some part .but the level of national income, the level of per capita income, and the pattern of income distribution, these things have vital influence on the growth of savings in the economy. As far as investment is concerned, there have been a number of empirical studies which throw doubt on the proposition that interest is the most important determinant of the investment decisions. In fact anticipated factors play a very important role in investment decisions. However, my major observation on this misgiving is that for justifying the eradication of interest it is not even necessary for Muslim scholars to reject that interest plays a part in mobilization of resources. As
already mentioned, some of the empirical studies do show that while the rate of interest is not the main determinant of savings. We can admit that the rate of interest has a positive influence on savings. Secondly we can also admit that interest does perform some sort of alloactive function, particularly in market based economy. But my proposition is that even though interest might be a factor both in the savings decisions and the investment decisions, existence of interest is not by itself an unavoidable necessity for the performance of these two functions. These two functions, that is, the function of mobilization of savings and the function of allocation of resources can be performed equally well, and perhaps even better, under the Islamic banking without interest. When we talk about the abolition of interest, the idea is not merely to abolish interest but to replace interest by an alternative system. Now it depends what kind of alternative system will take but I think it is generally agreed that it will not be a zero interest banking in the sense that there will be no return on savings and that person who secure financial assistance from the banks will not have to give anything to the banks. The banking so far shows that almost every one who has studied this problem has come to the conclusion that in the alternative system there will have to be a system whereby people who put their deposits in the banking system will get some return but this return will not be interest because it will not have the attributes which are there in interest i.e. fixed return and return irrespective of risk of gain and loss. It will be a variable return and the depositor will share both in gains and losses. So for those who believe that savings is a function of the rate interest, or the rate of interest is important. For it helps to mobilize deposits and savings , my answer is that in the alternate system there will be a return on savings and there will be a return on bank deposits so the savings decisions, if they are influenced by the rate of interest , will continue to get incentives for savings . Similarly, as far as the allocative role of interest is concerned in the alternate system we have to formulate ways in which these alloctive functions will be performed and if you have a system of profit sharing in
the banks, one can easily see that by prescribing different profit sharing ratios, you can influence the allocation of resources. Suppose if we take the example of two sectors. In one sector the banks decide that they will give financial assistance only if the parties are prepared to share 80% of their profits with them, while in another sector they are prepared to participate if the party gives them only 20%. One can easily see that this will have an allocative effect. It will discourage the securing of assistance from commercial banks in those cases where the banks are participating to the extent of 80%and people educed to put in more of their own resources or they will go in for those lines of activity where banks are taking a comparatively smaller part of the share of the profit. 3. The third myth about Islamic banking is that this
system based on profit-sharing will result in a diminution of banks profit, and also in diminution of bank deposits as the system cannot give as much return to the account holders as the fixed interest system. Clarification:
To clarify this myth about Islamic baking, first of all my question to this kind of myth is: Does the fixed interest system really give fair return to the depositors? Most often in inflationary situation under the present system depositors get a negative real rate of interest. If the rate of interest on deposits is, say 8%, and if the rate of inflation is 12%, the depositors get a negative rate of interest of 4%. Mathematically Rate of interest = 8% Inflation rate = 12% 12% - 8% = 4%
As compared to this a system which is based on profit and loss sharing will be able to capture a part of inflationary profits and hence, if properly worked, is capable of giving better return to the depositors. Suppose depositor deposit 100,000 rupees in bank under profit loss sharing system and the depositor and bank agreed on 30%:70%, so after declaring of profits suppose six months later the depositor will get 30% profit while the ban k will get 70% profit which can cover all their administrative and daily expenses. 4. The fourth myth about Islamic banking is related
to the third misgiving, is that it is all right in theory that a system of banking which is based on profit-loss sharing may be able to give a better return because you will be participating in the profits of so many trades which are characterized by high margins of profit, like the distributive trade, might be construction industry. So you should be able to give a better return. Clarification:
Of course it is all right in theory, they say. But will it actually happen in practice? When you start interest free banking will it really be possible for banks to get more by way of return, so that they can give better returns to depositors as compared to the present day interest based system? And this connection they point out that, as we know there is widespread concealment of profits and the accounts are not the true accounts of the various concerns. Well I think these kind of malpractices and stealing are there in the conventional system and these evils do exists and it is a real problem and this the problem which has to be faced when Islamic banking is introduced. But I do not regard it as an insurmountable problem. The problem should not exist at all if, along with the introduction
of institutional reforms by way of abolition of interest and introduction of zakah, efforts are also made for bringing about those values in our society which Islam really advocates. If our society is really permeated by Islamic values and ethos, there should be no problem of this kind that people will try to conceal their profits from the banks but even in the interim, because nobody perhaps can wait till the whole society is purified and everybody begins to work according to the ideals and standards of Islam. Ways can be found through which this problem can be surmounted. And here I would refer only to three steps that can be taken when interest free banking is introduced which will minimize the problem which arise from the concealment of profit. One is a basic reform in income tax system. The effort should be to so reform the present income tax system that factors responsible for the concealment of profits are eliminated or at least minimized. The second thing that can be done is to bring about some important changes in accounting and auditing systems. For example, when the profit-sharing system introduced, it can be stipulated that auditors of a firm’s accountants will be appointed with the mutual agreement of the bank and the firm. Some reforms in the auditing system itself may be needed. And finally, the banks will also be overseeing the operations of the concerns to which they made financial assistance available. They can, in the case of big companies, establish their presence in the management. I might also add that even in the present social environment, institutions like the NIT and ICP are making profits and declaring dividends. And when the scope of the interest-free operations is expanded to cover also the distributive trade, construction industry etc., there is no reason why banks should not be able to make more profits than NIT and give a positive return on the savings that are deposited with the banking system.
5. The fifth myth about Islamic banking is:
How the profit –sharing system could work when so many firms and individual business either do not maintain accounts or cannot maintain accounts due to the high level of illiteracy. Clarification:
This is the most important myth regarding Islamic banking to be clarified. Here the thing I have to say is that interest-free banking does not necessarily mean that no other device can be employed except profit sharing. Obviously the ideal is profit and loss sharing. When our society gets fully literate and Islam places very great importance on the abolition of illiteracy this problem will not exist. But in the meantime when you have this problem of illiteracy and the problem of so many people who cannot maintain accounts or proper accounts, it is possible that under the Islamic system of banking, banks deal with these parties on the basis of certain other modes which have been permitted by Islam and in this respect Shariah allows different modes of financing which are below. Islamic banks around the world have introduced various financial products based on the profit and risk sharing principle of Islamic banking. The areas in which Islamic banks are more active are trade and commodity, finance property and leasing and providing short-term capital to the business. Some of the basic financial modes of Islamic banking are as follows. Before going to explain the Islamic modes of financing, I want to clarify some basic rules of sales which are necessary for a valid sale in Islamic Shariah. Some Basic Rules of Sale: Sale is defined in Shariah as the exchange of thing of value by another thing of value with mutual consent.
Basic rules are: 1. The subject of sale must exist at the time of sale. 2. 3. 4. 5. 6. 7. 8. The subject of sale must be in the ownership of seller at The subject of sale must be in physical or constructive The sale must be instant and absolute. The subject of sale must be a property of value. The subject of sale should not be a thing, which is not used The subject of sale must be specifically known and The delivery of the sold commodity should be certain and the time of sale. position of the seller when he sells it to another person
except for a haram purpose like pork, wine etc. identified to the buyer. should not depend on the contingency or chance
Islamic modes of financing
I. Murabaha: Murabaha is one of the most commonly used modes of financing by Islamic banks in financial institutions. Definition: Murabaha is a particular kind of sale where the seller expressly mentions the cost of the sold commodity He has incurred, and sells it to another person by adding some profit there on. Thus, Murabaha is not alone given on interest; it is a sale of a commodity for cash /deferred price. The Bai Murabaha involves purchase of a commodity by bank on behalf of a client and its resale to latter on cost-plus-profit basis. Under
this arrangement the bank discloses its cost in profit margin to the client. In other words rather than advancing money to a barrower, which is how the system would work in a conventional banking agreement, the bank will buy the goods from a third party and sale those goods to the customer for a pre agreed price. Murabaha is a mode of financing as old as Musharaka. Today in Islamic banks world over 66% of all investment transaction are through Murabaha.
DIFFERENCE BETWEEN MURABHA AND SALE:
A simple sale in Arabic is called Musawamah- a bargaining sale without disclosing or referring to what the cost price is. How ever when the cost price is disclosed to the client it is called Murabaha. A simple Murabaha is one where there is cash payment and Murabaha Muajjal is one on deferred payment basis.
ARGUMENTS AGAINST MURABIHA:
An argument that arises in Murabaha is that profit or interest both are the same and Murabaha financing is the same as conventional banking. Islamic scholars how ever argue that in several respects a Murabaha financing structure is quite different to an overdraft organized along conventional lines and the former offers several benefits to the bank and its customers. Depositors are made to share in profits of the bank as a result of this financing. The basic difference is however the Aqd or the contract which covers the Islamic conditions. If the contract has interest element then it will be void.
BASIC RULES OF MURABAHA:
Following are the rules governing a Murabaha transaction
1) The subject of sale must exists at the time of sale. Thus any thing that may not exist at the time of sale cannot be sold and its non existence makes the contract void. 2) The subject matter should be in the ownership of the seller at the time of sale. If he sells something that he has not acquired himself then the sale becomes void. 3) The subject of sale must be in physical or constructive possession of the seller when he sells it to another person. Constructive possession means a situation where the possessor has not taken physical delivery of the commodity, yet it has come into his control and all rights and liabilities of the commodity are passed onto him including the risk of its destruction. 4) The sale must be instant and absolute. Thus a sale attributed to a future date or a sale contingent on a future event is void. 5) The subject matter should be a property having value. Thus a good having no value cannot be sold or purchased. 6) The subject of sale should not be a thing used for an unIslamic purpose. 7) The subject of sale must be specifically known and identified to the buyer. 8) The delivery of the sold commodity to the buyer must be certain and should not depend on a contingency or chance .
9) The certainty of price is a necessary condition for the validity of the sale. If the price is uncertain, the sale is void. 10) The sale must unconditional. A conditional sale is invalid unless the condition is recognized as a part of the transaction according to the uses of the trade. STEP BY STEP MURABAHA FINANCING: 1) The client and the institution sign an over all agreement where by the institution promises to sale and the client promises to buy the commodity from time to time on an agreed ratio of profit added to the cost. This agreement may specify the limit up to which the facility may be availed. 2) An agency agreement is signed by both parties in which the institution appoints the client as his agent for purchasing the commodity on its behalf. 3) The client purchases the commodity on behalf of the institution and takes possession as the agent of the institution. 4) The client informs the institution that it has purchased the commodity and simultaneously makes an offer to purchase it from the institution. 5) The institution accepts the offer and the sale is concluded where by owner ship as well as risk is transferred to the client. All the above conditions are necessary to affect a valid Murabaha. If the institution purchases the commodity directly from the supplier, it does not need any agency agreement.
The most essential element of the transaction is that the commodity must remain in the risk of institution during the period between the third and the fifth stage. The above is the only way by which this transaction is distinguished from an ordinary interest base transaction.
ISSUES IN MURABAHA:
Following are some of the issues in Murabaha financing: 1) securities against Murabaha Payments coming from the sale are receivables and for this, the client may be asked to furnish a security. It can in the form of a mortgage or hypothecation or some kind of lien or charge. 2) Guaranteeing the Murabaha The seller can ask the client to furnish a third party guarantee. In case of default on payment the seller may have recourse to the guarantor who will be liable to pay the amount guaranteed to him. There are two issues relating to this: a) The guarantor can’t charge a fee from the original client. The reason being that a person charging of fee for advancing a loan comes under the definition of Riba. b) However the guarantor can charge for any documentation expenses. 3) penalty of default Another issue with Murabaha is that if the client defaults in payments of the price of the due date, the price can’t be changed nor can penalty fees be charged. In order to deal with dishonest clients who default in payment deliberately, they should be made liable to pay compensation to the
Islamic bank for the loss suffered on account of default. However these should be made subject to the following conditions: a) The defaulter may be given a grace period of at-least one month. b) If it is proven beyond doubt that the client is defaulting without valid excuse then compensation can be demanded. 4) Rollover in Murabaha Murabaha transaction cannot be rollover for a further period as the old contract ends. It should be understood that Murabaha is not a loan rather the sale of commodity, which is differed to a specific date. Once this commodity is sold, its ownership transfers from the bank to the client and it is therefore no more a property of the seller. Now what the seller can claim is the only the agreed price and therefore there is no question of effecting another sale on the same commodity between the same parties. 5) Rebate on Earlier Payments Sometimes the debtors want to pay early to get discounts. However in Islam, majority Muslim scholars including the major schools of thoughts consider this to be un- Islamic. However if the Islamic bank or financial institutions give somebody a rebate on its own, it is not objectionable especially if the client is needy. 6) Calculations of cost in Murabaha The Murabaha can only be effected when the seller and ascertain the exact cost he has incurred in acquiring the commodity he wants to sell. If the exact cost can’t be ascertained then Murabaha can’t take place in this case the sale will take place as Musawamah i.e. sale without reference to cost. 7) subject matter of the sale
All commodities can’t be the subject matter in Murabaha because certain requirements need to be fulfilled. The share of lawful company can be sold or purchased on Murabaha basis because according to the principles of Islam the shares represent ownerships and the assets of the company provided all others basic conditions of the transaction are fulfilled. A buy back arrangement or selling without taking their possession is not allowed at all. Murabaha is not possible on things that can’t become the subject of sale. For example, Murabaha is not possible in exchange of currencies. Basic mistakes in Murabaha Financing Some basic mistakes that can be made in practical implications of the concept are as follows: 1) The most common mistake is to assume that Murabaha can be used for all types of transaction and financing. This mode can only be used when a commodity is to be purchased by the customer. If funds are required for some other purpose Murabaha can’t be used. 2) The document is signed for obtaining funds for a specific commodity and therefore it is important to study the subject matter of the Murabaha. 3) In some cases, the sale of commodity to the client is affected before commodity is acquired from the suppliers. This occurs when the various stages of the Murabaha are skipped and the documents are signed all together. It is to be remembered that Murabaha is a package of different contracts and they come into claim one after another at their respective stages.
4) It is observed in some financial institutions that Murabaha is applied on already purchased commodities, which is not allowed in Shariah and can be affected on not yet purchased commodities. Uses of Murabaha Murabaha can be used in following conditions: Short / Medium / Long term finance for: • Raw material • Inventory • Equipment • Asset financing • Import financing • Export financing • Consumers good financing • House financing • Vehicle financing • Land financing • Shop financing • PC financing • Tour package financing • Education package financing • All other services that can be soled in the form of package(i.e. services like education, medical etc as a package ) • Securitization of Murabaha agreement (certificate) is allowed at par value only otherwise certain rules of Islamic financing must be met.
2. Bai’ Muajjal
Bai Muajjal is the Arabic acronym for “sale on deferred payment basis”. The deferred payment becomes a loan payable by the buyer in a lump sum or installment (as agreed between the two parties). In Bai Muajjal all those items can be sold on deferred payment basis which come under the definition of capital where quality does not make a difference but the intrinsic value does. Those assets do not come under definition of capital where quality can be compensated for by the price and Shariah scholars have an ijmah (consensus) that demanding a high price in differed payment in such a case is permissible. Conditions for Bai’ Muajjal 1) The price to be paid must be agreed in fixed at the time of the deal. It may include any amount of profit without qualms about Riba. 2) Complete/ total possession of the object and question must be given to the buyer, while the deferred price is to be treated as debt against him. 3) Once the price is fixed, it cannot be decreased in case of earlier payments nor can it be increased in case of default. 4) In order to secure the payment of price , the seller may ask the buyer to furnish a security either in the form of mortgage or in the form of an item. 5) If the commodity is soled on installments, the seller may put a condition on the buyer that if he fails to pay any installment on its due date, the remaining installments will become due immediately.
This mode of financing can be used by the modern banks and financial institutions especially to finance the agricultural sector. In Salam the seller undertakes to supply specific goods to the buyer at a future date in exchange an advanced price fully paid spot. The price is in cash but the supply of purchase goods is deferred
Purpose of use:
• To meet he need of small farmers who need money to grow their crops and to feed their family up to the time of harvest. When Allah declared Riba haram, the farmers could not take usurious loans. Therefore Holy Prophet (PBUH) allowed them to sell their agricultural products in advance. • To meet the need of traders for import and export business.
Under Salam, it is allowed for them that they sell the goods in advance so that after receiving their cash price, they can easily undertake the aforesaid business. Salam is beneficial to the sellers because he received the price in advance and it was beneficial to the buyer also because normally the price in Salam is lower than the price in spot sales. The permissibility of Salam is and exception to the general rule that prohibits forward sale and therefore it is subject to strict conditions, which are as follows:
CONDITIONS OF SALAM:
1. It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of affecting the sale. In the absence of full payment, it will be tantamount to sale of a debt against a debt which is expressly prohibited by the Holy Prophet (PBUH). Moreover, the basic wisdom for allowing Salam is to fulfill the “instant need” of the seller. If it’s not paid on full, the basic purpose will not be achieved. 2. Only those goods can be sold through a Salam contract in which the quantity and quality can be exactly specified for example precious stones can’t be sold on the basis of Salam because each stone differed in quality, size, weight and their exact specification is not possible.
3. Salam can’t be effected on a particular commodity or on a product of a particular field or farm e.g. Supply of wheat of a particular field or the fruit of a particular tree since their is a possibility that the crop is destroyed before delivering and given such possibility, the delivery remains uncertain. 4. All details in respect to quality of good soled must be expressly specified leaving no ambiguity, which may lead to a dispute. 5. It is necessary that the quantity of the commodity is agreed upon in absolute terms. It should be measured or weighed in its usual measure only, meaning what is normally weighed cant be quantified and vice versa. 6. The exact date ion place of delivering must be specified in the contract. 7. Salam can’t be affected in respect of things, which must be delivered at spot. 8. The commodity for Salam contract should remain in the market right from the day of contract up to the date of delivery or at least till the date of delivery. 9. The time of delivery should be at least 15 days or one month from the date agreement. Price in Salam is generally lower than the price in spot sale. The period should be long enough to affect prices. But Hanafi Fiqh didnt specify any minimum period for the validity of Salam. It is all right to have an earlier date of delivery if the seller consents to it. 10. Since price in Salam is generally lower than the price in spot sale; The difference in the two prices may be a valid profit for the bank. 11. A security in the form of guarantee, mortgage or hypothecation may be required for a Salam in order to ensure that the seller delivers. 12. The seller at the time of delivery delivers commodities and not money to the buyer who would have to establish a special cell for dealing in commodities.
There are two ways of benefiting from the contract of Salam: 1) After purchasing a commodity by way of Salam, the financial institutions can sell it through a parallel contract of Salam for the same date of delivery. The period of Salam in the second parallel contract is shorter and the price is higher than the first contract. The difference
between the two prices shall be the profit earned by the institution. The shorter the period of Salam, the higher the price and the greater the profit. In this way institutions can manage their short term financing portfolios. 2) The institutions can obtain a promise to purchase from a third party. This promise should be unilateral from the expected buyer. The buyer does not have to pay the price in advance. When the institutions receive the commodity, it can sell at a pre-determined price to a third party according to the terms of the promise.
1) In an arrangement of parallel Salam there must be two difference and independent contract; one where the bank is a buyer and the other in which it is a seller. The two contracts can’t be tied up and performance of one should not be contingent on the other. For example, if ‘A’ has purchased from ‘B’ 1000 bags of wheat by way of Salam to be delivered on 31st December, ‘A’ can contract a parallel Salam with ‘C’ to deliver to him 1000 bags of wheat on 31 December. But while contracting parallel Salam with ‘C’, the delivery of wheat to ‘C’ cant is conditioned with taking delivery form ‘B’. Therefore even if ‘B’ didn’t delivered wheat on 31 December, A is duty bound to deliver 1000 bags of wheat to C. He can seek whatever recourse he has against B, but he can’t rid himself from his liability to deliver wheat to C. similarly, if B has delivered defective goods, which don’t conformed to the agreed specifications, A is still obligated to deliver the goods to C according to the specifications agreed with him. 2) A Salam arrangement can’t be used as a buy back facility where the seller in the first contract is also the purchaser in the second. Even if the purchaser in the second contract is a separate legal entity, but owned by the seller in the first contract; it would not tantamount to a valid parallel Salam agreement. For example A has purchased 1000 bags of wheat by way of Salam from B- a joined stock company. B has a subsidiary C, which is a separate legal entity but is fully owned by B. A
cant contract the parallel Salam with C. However, if C is not wholly owned by B, A cannot parallel Salam with it, even if some share holders are common between B and C.
Istisna is a sale transaction where a commodity is transacted before it comes into existence. It is an order to a manufacturer to manufacture a specific commodity for the purchaser. The manufacturer uses its own material to manufacture the required goods. In Istisna, price must be fixed with consent of all parties involved. All other necessary specifications of the commodity must also be fully settled.
CANCELLATION OF CONTRACT:
After giving prior notice, either party can cancel the contract before manufacturing party has begun its work. Once the work starts, the contract can’t be cancelled unilaterally.
TIME OF DELIVERY:
As pointed out earlier, it is not necessary in Istisna that the time of delivery is fixed. However, the purchaser may fix a maximum time for delivery which means that if the manufacturer delays the delivery after the appointed time, he will not be bound to accept the goods and to pay the price. In order to ensure that the goods will be delivered within the specified period, some modern agreements of this nature contain a penal clause to the effect that in case the manufacturer delays the delivery after the appointed time, he shall be liable to a penalty which shall be calculated on daily basis. Can such a penal clause be inserted in a contract of Istisna according to Shariah? Although the classical jurists seem to be silent about this question while they discuss the contract of Istisna, yet they have
allowed a similar condition in the case of Ijarah. They say that if a person hires the services of a person to tailor his clothes, the fee may be variable according to the time of delivery. The hirer may say that he will pay Rs.100 in case the tailor prepares the clothes one day and Rs.80 in case he prepares them after two days. On the same analogy, the price in Istisna may tied up with the time of delivery, and it will be permissible if it is agreed between the parties that in the case of delay in delivery the price shall be reduced by a specified amount per day.
ISTISNA AS A MODE OF FINANCING:
Istisna may be used to provide financing for house financing. If the client owns a land and seeks financing for the construction of a house, the financer may undertake to construct the house on the basis of an Istisna. If the client doesn’t owns the land and wants to purchase that too, the financer can provide with a constructed house on a specified piece of land. The financer doesn’t have to construct the house himself. He can either enter into a parallel Istisna with a third party or hire the services of a contractor (other than the client). He must calculate his cost and fixed the price of Istisna with his client that allows him to make a reasonable profit over his cost. The payment of installments by the client, may start right from the when the contract of Istisna is signed by the parties. In order to secure the payment of installment, the title deeds of the house or land, or any other property of the client may be kept by the financer as a security until the last installment is paid by the client. The financer will be responsible to strictly conform to the specifications in the agreement for the construction of the house. The cost of correcting any discrepancy would have to be borne by him.
Istisna may also be used for similar projects like installation of an air conditioner plant in the client’s factory, building a bridge or a high way. The modern BOT (Buy, operate and transfer) agreement may be formalized through an Istisna agreement as well. So, if the government wants to build a high way, it may enter into an Istisna contract with the builder. The price of Istisna may be the right of the builder to operate the high way and collect tolls for a specific period.
USES OF ISTSNA:
• • • • • House financing Financing of plant/ factory/ Factory building BOT arrangements Construction of buildings and plants
5. IJARAH (LEASING)
BASIC RULES Transferring of usufruct not ownership In leasing an owner transfers its usufruct to another person for an agreed period, at an agreed consideration.
Subject of lessee
Should be valuable, identified and quantified All consumable things can’t be leased out The corpus of the leased property remains in the ownership of the seller, and only its usufruct is transferred to the lessee. Thus, anything, which can’t be used without consuming, can’t be leased out. For example money, wheat etc All liabilities of ownership is born by lessor As the corpus of the leased property remains in the ownership of the lesser, all the liabilities emerging from the ownership shall be born by lessor.
Period of lease
• • The period of leas must be determined in clear terms It is necessary for a valid lease that the leased asset is fully
identified by the parties.
Lease for specific purpose
The lessee can’t use the leased asset for any purpose other than the purpose specified in the leased agreement. However, if no such purpose is specified in the agreement, the lessee can use it for what ever purpose it is used in the normal course.
Lessee as Ameen
• • The lessee is liable t compensate the lessor for every harm The leased asset shall remain in the risk of the lessor to the leased asset caused by any misuse or negligence. throughout the least period in the sense that any harm or loss caused by the factors beyond the control of the lessee shall be born by the lesser.
Lease of jointly owned property
• A property jointly owned by two or more persons can be leased out, and the rental shall be distributed between all joint owners according to the proportion of their respective shares in the property. • A joint owner of a property can lease his proportionate share only to his co sharer, and not to any other person.
Determination of Rental
• of lease. • It is permissible that different amounts of rent are fixed for different phases during the least period, provided that the amount of rent for each phase is specifically agreed upon at the time of affecting lease. If the rent for a subsequent phase of the lease period has not been determined or has been left at the option of the lesser, the lease is not valid. • The determination of rental on the basis of the aggregate cost incurred in the purchase of the asset bye lessor, as normally done in financial leases, is not against the rule of Shariah, if both parties agreed to it, provided that all other conditions of a valid lease prescribed by the Shariah are fully adhere to. • effect is void. • The rent or any part thereof may be payable in advance before the delivering of he asset to lessee, but the amount show collected by the lesser shall remain with him as on account payment and shall be adjusted towards the rent after its been due. • The lease period shall commence from the date on which the lease asset has been delivered to the lessee. The lesser can’t increase the rent unilaterally, in any agreement to this The rental must be determined at the time of contract for the whole period
If he leased asset has totally loss the function for which it we leased, the The rentals can be used on or benchmarked with some index as well. In
contract will stain terminated. this case the ceiling in floor rentals can be identified for validity of lease.
Lease as a mode of Financing:
Lease is not originally a mode of financing. It is simply a transaction mean to transfer the usofruct of a property from one person to another for an agreed period against an agreed consideration. However, certain financial institutions have a adopted leasing as a mode of financing instead of long term landing on the basis of interest. This transaction of financial lease may be used for Islamic financing, subject to certain conditions. It is not sufficient for this purpose to substitute the name of interest by the name of rent and replace the name of mortgage by the name of leased asset. There must be a substantial difference between leasing and an interest bearing loan. That will be possible only by following all the Islamic rules of leasing, some of which have been mentioned earlier. To be more specific, Shariah are indicated below.. some differences between the
contemporary financial leasing and the actual leasing allowed by the
The commencement of lease
Unlike the contract of sale, the agreement of Ijarah can be effected for a future date. Hence, it is different from Murabaha.
In most cases of the financial lease the lesser i.e. the financial institutions purchases the assets through the lessee himself. The lessee purchases the asset on behalf of the lesseer who pays its price to the suppliers, either directly or through the lessee. In some lease agreements, the lease commences on the very day on which the price is paid by the lesser, irrespective of whether the lessee has effected payment to the supplier and taken delivery of the asset or not. It may mean that lessees liability for the rent starts before the lessee takes delivery of the assets. This is not allowed in Shariah, because it amounts to charging rent on the money given to the customer, which is nothing but interest, pure and simple. Rent should be charged after the delivery of the leased asset. The correct way, according to Shariah, is that the rent will be charged after the lessee has taken delivery of the asset, and not from the day the price has been paid. If the supplier has delayed the delivery after receiving the full price, the lessee should not be liable for the rent of the period of delay.
Different relation of the parties:
It should be clearly understood that when the lessee himself has been entrusted with the purchase of the asset intended to be leased, there are two separate relation between the institutions and the client, which come into operation one after the other. In the first instance, the client is an agent of the institution to purchase the asset on latter behalf. At this stage the relation between the parties is nothing more than the relation of a principal and his agent. The relation of lesser and lessee has not yet come into operation. The second stage begins from the date when the client takes delivery from the supplier. At this stage, the relation of lesser and lessee comes to play its role . these two capacities of the parties should not be mixed up or confused with each other. During the first stage, the client
can’t be held liable for the obligations of a lessee. In this period, he is responsible to carry out the functions of an agent only. But when the asset is delivered to him, he is liable to discharge his obligations as a lessee.
Expenses consequent to ownership:
• As the lesser is the owner of the asset and he has purchased it from the supplier through his agent, he is liable to pay all the expenses incurred in the process of its purchased and its import to the country of lesser for example expenses of freight and customs duty etc. • He can, of course, include all these expenses in his cost and can take them into consideration while fixing the rentals, but as a matter of principle, he is liable to bear all these expenses as the owner of the asset. An agreement to the contrary, as is found in the traditional financial lease, is not in conformity with Shariah. Lessee as Ameen/ liabilities of the parties in case of loss to the asset; As mentioned in the basic principles of leasing, the lessee is responsible for any loss caused to the asset by his miss use or negligence. He can also be made liable to the wear and tear, which normally occurs during its use. But he cant be made liable to a loss caused by the factors beyond his control. The agreements of the traditional financial lease generally don’t differentiate between the two situations. In a leased based on Islamic principles, both the situations should be dealt with separately.
Penalty for late payment of rent:
In some agreements of financial leases, a penalty is imposed on the lessee in case he delays the payment of rent after the due date. This penalty it means to add to the income of the lesser is not warranted by the Shariah. The reason is that the end after it becomes due, is a debt payable by the lessee, and is subject to all the rules prescribed for a debt. A
monetary charged from a debtor for his late payment is exactly the Riba prohibited by the Holy Qur’an. Therefore, the lesser cant charge an additional amount in case the lessee delays payment of the rent. Penalty of late payment is given to charity. In order to avoid the adverse consequences, an alternative may be restored to. The lessee may be asked undertake that, if he fails to pay rent on its due date, he will pay certain amount to a charity. For this purpose the financer/lesser may maintain a charity where such amounts may be credited and disburse for charitable purposes, including advancing interest free loans to the needy person. The amount payable for cheatable purposes by the lessee may vary according to the period of default and may be calculated at percent, per annum basis. The agreement of the lease may contain the following clause for this purpose; “the lessee hereby undertakes that, if he fails to pay rent at its due date, he shall pay an amount calculated at ....% per annum to the charity fund maintained by the lesser which will be used by the lesser exclusively for charitable purposes approved by the Shariah and shall in no case form part of the income of the lesser.” This arrangement, though doesn’t compensate the lesser for his opportunities cost of the period of the default, yet it may serve as a strong deterrent for the lessee to pay the rent from promptly
Terminations of the lease:
If the lessee contravenes any term of the agreement, the lesser has a right to terminate the lease contract unilaterally .however, if there is no contravention on the part of the lessee the lease cant be terminated without mutual consent. In some agreements of the financial lease it has been noticed that the lesser has been given an unrestricted power to terminate the lease unilaterally when ever he wishes, according to his sole judgment. This is again contrary to the principles of Shariah.
In some agreements of the financial lease a condition has been found to the effect that in case of the termination of lease, even at the option of the lesser, the lessee shall pay the rent of the remaining least period. This condition is obviously against Shariah and the principles of equity and justice. The basic reason for inserting such conditions in the agreement of lease is that the main concept behind the agreement is to give an interest bearing loan under the ostensible cover of lease. That is why every effort is made to avoid the logical consequences of the least contract. Naturally, such a condition can’t be acceptable to Shariah. The logical consequence of the termination of lease is that the lesser should take the asset back. The lessee should be asked to pay the rent as due up to the date of termination. If the termination has been effected due to the miss use or negligence on the part of lessee, he can also be asked to compensate the lesser for the loss caused by such misuse or negligence. But he can’t be compelled to pay the rent of the remaining period.
Insurance of the assets
If the leased property is insured under the Islamic mode of Takaful, it should be at the expense f the lesser and not at the expense of the lessee, as is generally provided in the agreements of the current financial lease.
The Residual Value of Leased Asset
Another important feature of the modern financial lease is that after the expiry of the lease period, the corpus of the leas asset is normally transferred to the lessee. As the lesser already recovers his cost along with an additional profit their on, which is normally equal to the amount of interest which could have been earned on a loan of that amount advance
for that period, the lesser has no further interest in the leased asset. On the other hand, the lessee wants to retain the asset after the expiry of the leased period. For these reasons, the leased asset is generally transferred to the lessee at the end of the lease, either free of any charge or at a nominal token price. In order to ensure that the asset will be transferred to the lessee, sometimes the leased contract has an expressed clause to this effect. Sometimes this condition is not mentioned in the contract expressly; however, it is understood between the parties that title of the asset will be passed on to the lessee at the end of the leased term. This condition, whether it is expressed or implied, is not in accordance with the principles of Shariah. It is a well-settled rule of Islamic jurisprudence that one transaction can’t be tied up with another transaction so as to make the former a pre-condition for the other. Here the transfer of the asset at the end has been made a necessary condition for the transaction of lease that is not allowed in Shariah. The original position in Shariah is that the asset shall be the sole property of the lesser, and after the expiry of the leased period, the lesser shall be at liberty to take the asset back, or to renew the lease or to leased it out to another party, or sell it to the lessee or to any other person. The lessee can’t force him to sell it to him at a nominal price, nor can such a condition be imposed on the lesser in the leased agreement. But after the leased period expires, and the lessor wants to give the asset to the lessee is a gift or to sell it to him, he can do so by his free well. However, some contemporary scholars, keeping in view the needs of Islamic financial institutions have come up with an alternative. They say that agreement of Ijarah itself should not contain a condition of gift or sell at the end of the leased period. However, the lessor may enter into a unilateral promise to sell the leased asset to the lessee at the end of
the leased period. This promise will be binding on the lessor only. The principle, according to them, is that a unilateral promise to enter into a contract at a future date is allowed whereby the promiser is bound to fulfill the promise, but the promise is not bound to enter into that contract. It means that he has an option to purchase, which he may or may not exercise. However, if he wants to exercise his options to purchase, the promiser cant refuse it because he is bound by his promise. Therefore, these scholars suggests that the lessor, after entering into the leased agreement, can sign a separate unilateral promise whereby he undertakes that if the lessee has paid all the amounts of rentals and wants to purchase the asset at a specified mutually acceptable price, he will sell the leased asset to him for that price. Once the lessor signs this promise, he is bound to fulfill it and the lessee may exercise his option to purchase at the end of the period, if he has fully paid the amounts of rent according to the agreement of lease.
6. IJARAH WA IQTINA
(LEASING AND PROMISE TO GIFT)
In Islamic Shariah, It is allowed that instead of sale, the lessor signs a separate promise to gift the leased asset to lessee at the end of the leased period, subject to his payment of all amounts of rent. This arrangement is called Ijarah WA Iqtina. It has been allowed by a large number of contemporary scholars and is widely acted upon the Islamic banks and financial institutions. The validity of this arrangement is subject to two basic conditions: a) The agreement of Ijarah itself should not be subjected to signing this promise of sale or gift but the promise should be recorded in a separate document. b) The promise should be unilateral and binding on the promiser only. It should not be a bilateral promise binding on both parties
because in this case it will be a full contract effected to a future date, which is not allowed in the =case of sale or gift.
If the leased asset is used differently by different users, the lessee can’t sub-lease the leased asset except with the expressed permission of the lessor. If the lessor permits the lessee for sub-leasing, he may sub-lease it. If the rent claimed from the lessee is equal to or less than the rent payable to the owner/ original lessor, all the recognized schools of Islamic jurisprudence are unanimous on the permissibility of the sub-lease. However, the options are different in case the rent charge from the sublessee is higher than the rent payable to the owner. Imam Shafi and some other scholars allow it and hold that the sub-lessor may enjoy the surplus received from the sub-lessee. This is preferred view in the Hanbali School as well. On the other hand, Imam Abu Hanifah is of the view that the surplus received from the sub-lessee in this case is not permissible for the sub-lessor to keep and he will have to give that surplus in charity. However, if the sub lessor has developed the least property by adding something to it or has rented it in a currency different forms the currency in which he himself pays rent to the owner/ the original lessor, he can claim a higher rent from his sub-lessee and can enjoy the surplus. Although the view of Imam Abu Hanifah is more precautious which should be acted upon to the best possible extent, in cases of need the view of Shafi and Hanbli schools may be followed because there is no expressed prohibition in the Holy Qur’an or in the Sunnah against the Surplus claimed from the lessee. Ibne Qudamah has argued for the permissibility of surplus on forceful grounds.
Assigning of the lease
The lessor can sell the leased property to a third party whereby the relation of the lessor and lessee shall be established between the new owner and the lessee. However, a signing of the lease itself( without assigning the ownership in the leased asset) for a monetary consideration is not permissible. The difference between the two situations is that in latter case the ownership of the asset is not transferred to the assignee, but he becomes entitled to receive the rent of the asset only. This kind of assignment is allowed in Shariah only where no monetary consideration is charged from the assignee for this assignment. For example, a lessor can assign his right to claim rent from the lessee to his son, or to his friend in the form of a gift. Similarly, he can assign this right to any one of his creditors to set off his debt out of the rentals received by him. But if the lessor wants to sell this right for a fixed price, it is not permissible, because in this case the money (the amount of rentals) is sold for money, which is a transaction subject to the principle of quality. Otherwise it will be tantamount to a Riba transaction, hence prohibited.
7. Muqarada: Under this technique Islamic bank floats the Islamic bonds to finance a specific project. The investor who purchase muqarada bonds not only get a share in the profit of the project being finance but also share the risks of low profit or even loses. Bondholders have no say in the management of the project but act as non-voting shareholder. These above are the Islamic modes of financing through which an Islamic bank can finance the companies as well as individuals. Even a system based on the concept of a normal rate of return can be applied in cases where the accounts are not kept. The central bank of the country or
any other suitable agency can determined what is the normal rate of profit in particular sectors and the banks can contract on that basis. If the party pays out that profit no questions are asked, but if it is claimed that less profit has been made or a loss has been incurred the bank should be entitled to ask the party to prove his claim and the varsity of this claim could be judged by an independent agency and on the basis a settlement could be arrived at. So this is not an insurmountable problem. 6. The sixth misgiving very serious one regarding
Islamic banking is that a system based on profit and loss sharing may lead to the fall down of the banking system as banks will have to share in losses also.
According to my opinion and thinking such a fear and doubt has no solid basis. It is true that under the profit loss sharing system some of the concerns to which banks gives financial assistance may make losses but the important thing to bear in mind is that the banks will be working on a system of pooling the risk. They will be giving financial assistance to a large number of concerns in the country. While some may make losses, other are expected to make profits and substantial profits. On the basis of principles of averaging even if some losses might be incurred there is a probability, and a strong probability that a situation will not arise in which their will be no profit at all in the banking system. It is also been said by some economists that if you abolish interest and adopt a system based on profit sharing you will make the banking system crisis-prone. By saying that the system would become crisis-prone they mean that the business
cycle will affect the banking system itself and will create an additional element of instability. Well, i have to say two things in this respect. We no longer have business cycles of a type in which there may be virtual collapse of the whole economic system. The whole post world War-II period demonstrates that there have being periods of inflation and recession but no period like the depression of the thirties. In fact, what we are now facing are the problems stagflation, in which inflation co-exists with recession, and in this situation there are some concerns which make losses but there are others which make profits and a diversified basis. It is not possible that all the concerns which the banks finance incure losses. A part from that, even if it is approved that the profit-based system will be more directly affected by the business cycles, one may ask the question whether, weighing the relative prose and cons, the interest system is better suited in a period of business recession or the profit based system ? we all know what happens in a business recession. The system of interest really intensifies the business recession. As soon as the banks finds that the companies will begin to incur loss they reduce a assistance and call back their loans, as a result of which some firms have to close down, unemployment increase, purchasing power and the economy goes down, there is further reduction and demands, other firms get into trouble and the infection spreads. The fixed interest system thus intensifies the business recession. At the same time, the interest system believes in putting the dead weighed of interest even in times of losses on the shoulders of the companies which are least able to bear it so that if the company goes into loss for, say, five years for genuine reasons, then there is such a heavy dead weighed of interest that accumulate over time and it is very difficult for it to recover even after the reasons leading to the loss cease to exists. As against this, the system of profit sharing and the period of business cycle recession will be to the advantage of the country when banks will not claim their pound of flesh in a period when some concerns incur genuine losses. This will lighten their burdens and will enable these concerns to recover much more quickly than is possible under the fixed
interest system. Thus the problem of sick industries will not be there in an acute form. Moreover if in a period of transition it’s desired to insulate the banks against even sporadic losses, some cushions can devised within the system of Islamic banking. It can be arranged, for example, that all the banks will be contributing a small amount of premium to some insurance organization in respect of assistance that they provide to various firms which itself becomes a pool from which in time of difficulty the banks can draw the resources. At the same time, in a system which will be based on profit sharing it is very natural that the banks themselves may like to build up higher levels of capital and reserves to cushions the effects of any losses that they might incur in some periods.
7. The seventh myth and misgiving regarding Islamic banking is that profit loss sharing system will lead to large scale defaults and thereby it will affect the stability of the banking system. Clarification:
But my query to such kind of myth is why should it be so? There are three kinds of factors which are relevant to the possibilities of defaults. 1st, to whom finance is provided 2nd, for what purpose the finance is provided 3rd, what type of supervision is exercised by the financial institutions on the end use of the resources. Now these elements are essentially the same whether it is an interest based banking system or it is a system which is based on profit sharing under Shariah principles. If sufficient care is not exercised in respect of these three elements defaults are sure to arise and as we know they do arise in the modern systems even though it is based on interest. In
fact, i feel that a system which is not based on interest will be superior and the chances of default should be minimized if properly worked. This is because as compared to the fixed interest system, the banks will be more closely associated with the end-use of funds. In the fixed interest system tendency is that the banks are satisfied if they get enough security for the advances and if they feel that the company has profits enough to cover re payment of its capital and the amount of interest, they are not concerned even if the profitability is nil after paying interest to banks. But when they begin to share in the profit they will be more concerned about the efficient working of the enterprises and, therefore, from that point of view under the new system, the defaults should be less rather than more.
8. The eighth misgiving which has been expressed that profit loss sharing system will make the banking system less liquid and hence there will be a great risk of bank failures due to the inability of the banks to meet the demands for the withdrawal of funds. Clarification:
Well, this is an argument similar to one which says that since the banks have short terms liabilities they should not lend on long term basis because this can create a problem of liquidity. This use to be a fashionable argument a few decades back but very little really is heard about that now. For one reason we know that in a number of countries the liabilities of the banking systems are not pre dominantly sight liabilities. In fact, in our country Pakistan, we find that about fifty percent of the liabilities are other than demands liabilities. A part from that, with the growth of central banking and the concept of what we call shift ability of assets, the liquidity can be ensured by the central bank which is under no constraint as it can create any amount of credit in times of need. So it can come to the assistance of the banking systems in time stress.
So i think one should not exaggerate the difficulties about liquidity. Moreover, not all the finance that will b provided by the banks under the Islamic banking systems will be for long terms because when the whole banking systems switches over to a system which is not based on interest, banks will be expected to provide both short term finance and long term finance and therefore, by proper management they should be able to arrange a cash flow which will be quite adequate to take care of the demands that may be made on the banking systems for withdrawal of the deposits. I might also add that if you study the history of grow of banking in the western countries you will find that before central banks came on the same and before the system of deposits insurance came into fashion, there were cases of bank failures in a number of countries. 9. The ninth misgiving, which has been expressed by
some businessmen, is that a system based on profit sharing would involve too much interference in the affairs of the concerns to whom the assistance is provided by the banks and this will militate against the proper functioning of the various business concerns. Clarification:
According to my perspective regarding this query, i am not in the favor of undue interference by banks under the profit sharing system in the affairs and daily conduct of the business concerns. It should be possible to have enough safeguards against too much interference, but some say of the financial institutions and the running of the business concerns should not be unhealthy. In fact i think it will have a healthy effect. Even in the present interest based system a trend has been in evidence that banks and other financial institutions set a number of conditions while providing finance. And it is not only about Pakistan but a number of countries in the rest. The trend is that while making finance available, the banks do make it a condition that the borrowing concern will
not incur additional long term debt obligations without the permission of the bank from which they have borrowed in the first instance. In some countries banks do establish their presence on the management of the concerns to whom they provide financial resources. In some countries the declaration of dividend by a concern is also made conditional on the banks first formatting the concerns to make that amount of dividend declaration.
Finally the tenth misgiving regarding Islamic banking, it has been pointed out that interest free banking amounts to capital being provided free while capital has a scarcity value. Clarification:
My perspective regarding this query, it is quite true that under the profit sharing system there is no stipulation for payment of a fixed return on the funds provided. In other words, there is no binding commitment beforehand that the business concerns will make available to the banks a certain amount of return irrespective of what profit it earns and irrespective of the fact that it may incur a loss. But once a concern makes a profit the system that we envisage will entitle the banks to receive and agreed share of the profit of that concern. It can thus be seen that capital is not been provided free to the business concerns. In fact, in the case of highly profitable undertakings banks may well earn much more under the profit sharing system than under the fixed interest systems. So it is not correct to say that capital is been provided free. However, when the whole system gets going, one can visualize that while mainly work on the system of profit and loss sharing there can be some institutional mechanisms whereby some sectors can be provided finance without any return whatsoever that is without claiming any part of the profit even if profits are made. But this will have to be a conscious decision and it will have to be taken in context of socio economic objectives of a particular country. For example, if the objective of
economic policy is to bring about a certain transfer of resources from one section of society to another it is perfectly legitimate to have a system whereby resources of the bank will be provided completely free without share in the profit of a particular sector or a particular sub sector, while banks appropriate large parts of profits that might be made in other sectors, thereby setting up a mechanism of transfer of resources from certain sectors of high income generation to sectors of low income generations. I hope my this Research paper will help in clarifying some of the issues that have been raised on this very sensitive subject of interest free banking and that they will provide food fore the further thought.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.