CHAPTER #1

INTRODUCTION:
Background of Islamic Financial System:
Islamic financial system is as old as the religion itself with its principles primarily derived from the Quran,
which was revealed some 1400 years ago and the hadith of Prophet Muhammad (SAW). Some principles
of Islamic finance derived from prior Abrahamic traditions. While some historical Islamic finance
instruments have been adopted into modern conventional products such as letters of credit and
cheques.

The basic principles of Islamic financial system are prohibition of interest, profit and loss sharing and
Gharar. These three principals were being the basic roots of Islamic financial systems in every age and in
every time. Islamic finance products are based and developed on clear guidelines as outlined in the
Quran in which there is no element of interest and Gharar. So, the base of Islamic financial products is
the Quran and Sahi Hadith of prophet Muhammad (SAW).1

The three basic principles of Islamic financial system can be divided into the following categories;

Principle of equity: Scholars generally describe this principle as the rationale for the prohibition of
predetermined payments (Riba), with a view to protect the weaker contracting party in a financial
transaction. The term Riba, which means “hump” or “elevation” in Arabic, is an increase in wealth that is
not related to engaging in a productive activity. The principle of equity is also the basis for prohibiting
excessive uncertainty (Gharar) in financial transactions. Transacting parties have a moral duty to disclose
information before engaging in a contract, thereby reducing information asymmetry; otherwise the
presence of Gharar would nullify the contract. The principle of equity and wealth distribution is also the
basis of a 2.5 percent levy on cash or in-kind wealth (Zakat), imposed by Shari’ah on all Muslims who
meet specific minimum levels of income and wealth to assist the needy and poor people of the society.

Principle of participation: When we talk about interest free financing and prohibition of interest then it
does not mean that the capital will not be rewarded, according to key rule of Shari’ah the profit (return,
payoff) comes with risk taking. So, the return on investment should also be earned with risk taking and
not with passage of time, which is also the basis of prohibiting Riba. Thus, return on capital is legitimized
by risk-taking and is determined and based on asset performance or project productivity, thereby
ensuring a link between financing activities and real activities. The principle of participation lies at the
heart of Islamic finance, ensuring that increases in wealth accrue from productive activities.

Principle of ownership: The rulings of “do not sell what you do not own” (for example, short-selling) and
“you cannot be dispossessed of a property except on the basis of right” mandate asset ownership
before transacting. Islamic finance has, thus, come to be known as asset-based financing, creating a
strong link between finance and the real economy. (Hussain at all, (2015))

Introduction to Islamic Banking System:

Just like the Islamic financial system Islamic banking system is also too old as the religion itself. The basic
aim and principle of Islamic banking is the exclusion of interest (Riba in Arabic) from the banking system.
According to Islamic view point there is no concept of interest in banking system because interest in the
main factor which mount up the wealth in hands of few people which ultimately opens the door for
immoral and injustice activities in the society that is a big hurdle in the way of prosperity and welfare of
the society.

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of
the Shari’ah (Islamic rulings) and its practical application through the development of Islamic economic
system. These principles of Islamic banking which promotes and emphasis on moral and ethical values in
all dealings have wide universal appeal. Shari’ah prohibits the payment or acceptance of interest
charges (Riba) for the lending and accepting of money, as well as carrying out trade and other activities
that provide goods or services based on terms and conditions that opposed the principles of Islamic
banking. These principles of Islamic banking were used as the basis for a prosper economy in early
times. Islamic banking system provides alternative to Muslims for conventional banking system but
although Islamic banking is not only for Muslims it is for the whole humanity.

Islamic banking has the same purpose as conventional banking except that it operates in accordance
with the rules of Shari’ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking
activities must be practiced and consistent with the Shari’ah and its practical application through the
development of Islamic economics. Many of these principles upon which Islamic banking is based are
commonly accepted all over the world, for centuries rather than decades. These principles are not new
but as old as the religion itself.

The principle source of the Shari’ah which outlines clear guidelines, rules, regulations and many other
activities of Islamic banking is The Qur’an followed by the recorded sayings and actions (Hadith) of
Prophet Muhammad (SAW). Where solutions to problems cannot be found in these two sources, rulings
are made based on the consensus of a community leaned scholars, independent reasoning of an Islamic
scholar and custom, so long as such rulings to not deviate from the fundamental teachings in The
Qur’an.4

History of Islamic Banking System:

Islamic Banking can be said to come in existence with the advent of Islam, in the time of Prophet
Muhammad (PBUH). Prophet Muhammad (PBUH) started trading operations based on Islamic teaching
for His wife. “MUDARBAH” a term used for Islamic way of Partnerships has been the primary and most
appreciated way for Muslim business community to carry out their trading operations. However,
because the conventional banking system plays a very critical role in any country`s economy and
businesses, it can become very difficult for business people to decide which product of a conventional
bank they can or cannot use for their business or other day-to-day activities. This is exactly where
Islamic Banking and Islamic Banks play their role of providing their customers with a solution that not
only solves their financial problems but make sure that the solution adheres complete with the Islamic
teachings as well.

Very first proper Islamic Banking model came into existence in Egypt in 1963. The main philosophy of
this bank was to provide financial products to its products that are complete Interest/Riba-Free. Ahmed
Al Najjar was the founder and the real visionary of this bank. This bank offered products that were
completely according to the Islamic teachings about the trade, and was completely different from the
conventional banks as it did not charge any Interest on any transaction whatsoever.

In 1974, IDB or Islamic Development Bank was formed with the efforts of the Organization of Islamic
Countries (OIC), which was the first officially registered Islamic Bank in the history. The main idea behind
this bank was to provide its customer financial support on profit sharing basis, instead of interest.

In 1975, the first privately held commercial Islamic Bank was formed in Dubai, UAE. In the same year, an
agreement was signed to re-establish the Islamic Development Bank as an Inter-Governmental Plan
Islamic Bank. The main aim was to provide financial facility to the development projects through the
Muslim world, and make sure that the financial assistance complies completely with the Shariah Law.

In 1977, Faysal Islamic Bank was formed in Egypt, which was followed by the formation of Bahrain
Islamic & Jordan Islamic Banks in 1978.

Mid 1980s witnessed an overwhelming interest in Islamic Banking and several banks were formed just to
provide Islamic Law based financial products to their customers. The major boost in this trend was seen
in Middle East and South Asia. Also such financial institutions begin establishing their own market in
countries where Muslims are in minorities, such as: UK, USA, Denmark, India, Australia, etc. This gave
the customers an ultimate relief, as they knew; now they can avail financial services without having to
bear the Interest Rate, which is strictly forbidden in Islam.5

In Pakistan, a new attempt to create an Islamic banking system took place in 1979, gradually eliminating
interest from all banking operations by 1985. It is important to note that this forced conversion to
Islamic banking is characteristic of banks in Pakistan and financial institutions in countries like Sudan and
Iran, which is very different from more successful financial institutions like those in Malaysia. Although
Pakistan was a pioneer in Islamic banking, the idea of Profit and Loss Sharing, which is fundamental to
modern Islamic banking was not carried out, with most of the banks’ transactions being carried out in
other ways.1
Current Status of Islamic Banking System:
Over the last few decades, the demand for Islamic banking and its products has grown rapidly. In 2014,
the Islamic financial market had 392 banks with assets of $ 992.7 billion and total income of $ 24.08
billion (GFDR, 2014).6. From simple profit and loss sharing accounts Islamic banks are offering a lot of
products and services for its customers which are truly according to the Shari’ah. Islamic savings and
investment products have now more advanced than before and can be used to hedge funds, bonds and
derivatives. The introduction of Islamic banking products in more than 50 countries of the world
including USA and Europe is understandable as international banks can see a profit opportunity by
tapping into the large and growing banking needs of the Muslim population in Middle East, Asia and
elsewhere.

Islamic banks are prohibited to pay or receive any amount as interest in their lending and investing
activities. Due to this prohibition these banks face a supply side shortage of appropriate Islamic
instruments which can be used to serve the purpose of maintaining liquidity, risk management and
hedging needs of customers or the banks themselves. Traditional banks offer such instrument in the
form of derivatives (forward and features contracts) and options (put and call). All such instruments
which are offered by traditional banks are forbidden under various (though not all) interpretations of
Islamic law because all these instruments include the element of risk (Gharar) and Islam forbid all those
transactions which include the element of risk. The risk of these instruments is that at the time the
contract is executed, (which is the current period), the commodity/object being sold usually does not
exist and Islam does not allow the sale of commodity which is not owned or not come into existent
before sale. Insurance is also neglected on the ground of risk and element of Riba (interest) because the
insurance companies invest their funds in a number of activities which earn interest.

The involvement of interest in lending and investing activities is a major distinction between Islamic and
conventional banks. The involvement of no interest and no uncertainty and risk in contracts and other
activities do not imply that the implementation of Islamic financial system is inconceivable and that
markets cannot develop to provide financing and risk hedging instruments. Islam is a complete code of
life and it guides its followers in every stage of their life. Islam is for all time and all situations. In fact,
such a system has been designed and in practice along with varying degrees of success in number of
countries including Pakistan and Malaysia. It has also been proved theoretically that if a country fallow
pure Islamic banking techniques and products then I can easily cope with things like inflation and
financial crisis.

To get around the prohibition of interest, Islamic business contracts are based on equity participation
and profit distribution according to agreed ratio and loss distribution according to the ratio of
investment. Although these contracts are not easy to develop for various modern activities as they have
not to avoid interest only but also uncertainty, as well as to comply with various ethical codes enjoyed in
Islamic contract law.

Future of Islamic Banking System:

Islamic banking and financing has gained a foothold both nationally in Muslim countries and
internationally in the financial world. “Islamic Banking: Efficiency, Growth and Stability”, is an annual
report published by the Dubai Center for Islamic Banking & Finance , which is organizing the Islamic
Banking and Finance track at Innovation Arabia 8. The report’s 2014 edition identified several factors
pointing to a better growth scenario for Islamic banking in the rest of the current decade.
According to the 2013 annual report of the Jeddah-based Islamic Development Bank, the population of
OIC countries is growing at the rate of two percent per annum on average. It is certainly not
unreasonable to assume that the world’s Muslim population will also increase by (at least) two percent
per annum, which will be reflected in the growth of Islamic banks’ potential clientele.

The economic conditions of the world’s Muslim population are improving: According to the IDB annual
report, 25 member countries of the Organization of the Islamic Conference (OIC) will achieve the UN’s
Millennium Development Goal (MDG) of halving the population who live below the poverty line. Though
the growth of OIC countries slowed during the first three years of this decade, annual GDP growth in all
56 OIC countries has been around five percent per annum, which is substantially higher than the growth
in the Europe and North America. This reflects the general improvement of economic conditions of the
Muslim populations in those countries with large proportions of Muslims. This is expected to have a
positive effect on the growth of the banking sector – both Islamic and non-Islamic – in these countries.

Another factor that needs to be kept in mind when assessing the future growth of Islamic banking is the
unused Islamic banking potential in the countries with a large proportion of Muslims.

Currently, in terms of assets, Islamic banking represents only 11.5 percent of the value of total
commercial banking in the countries where it competes with other commercial banking in a dual system.
These countries offer great potential for Islamic banks to grow. If Islamic banking makes strategic moves
to enhance its current clientele base, the above-mentioned countries can witness accelerated growth in
the Islamic banking industry.

One of the most important requirements for enhanced growth would be providing a level playing field
for Islamic banking to compete with “conventional” banking. Interestingly, this type of market
environment also offers another type of value because if Islamic banks are able to compete with
conventional banks on a level playing field, it will also improve the efficiency of conventional banking.
(Tahir, (2003))

As far as the future of Islamic banking system in Pakistan is concerned, it is the fact that 96% population
of Pakistan is Muslim and aware of prohibition of interest in Islam. In addition to that people have
witness through media about debt crises and hardships the interest / debt bring about life of people of
west. So, people in Pakistan want Islamic banking system. Currently there are 14 Islamic banks operating
in Pakistan. In future this number will keep on growing as almost every bank operating in Pakistan is
now adopting Islamic banking and there will be a time when there is no conventional bank in Pakistan.

Islamic Financial Contracts:

Islamic financial instruments are based on the principles that they exclude interest (Riba), not possess
major uncertainty (Gharar) and not have gambling like features (Maysir). Due to the prohibition of
interest, Islamic banks or traditional banks with windows for Islamic products cannot have fixed interest
debt instruments. The Islamic financial system instead proposes equity participation and risk sharing on
the part of banks and debtors (investors).
This research provided a brief overview of some widely used Islamic banking contracts which are used as
a mode of financing and take the form of cost plus sales (Murabaha), credit sales (bay ‘‘bithaman ajil’’),
leasing (Ijarah), partnerships (Modaraba and Musharakah) and some forward contracts (Salam and
Istisna). In addition there are zero interest loans for poor farmers and needy students referred as Qard-
e-Hasna (benevolent loan).

In this article on Islamic banking, we will present a brief overview of some commonly used Islamic saving
and investment contracts in section 1. In section 2 we will discuss the risk associated with these
contracts and role of SBP (State Bank of Pakistan) to minimize the risk and to support risk management
practices adopted by Islamic banks. Section 3 will examines data from 5 Islamic banks operating in
Pakistan (Meezan, Al Baraka, Bank Islami, Dubai Islamic Bank and Burj Bank) and conclusion in section 4
summarizes the findings with some policy implications.

Background of the Problem:

In Pakistan, there are two types of banks (conventional and Islamic). Both types of bank have their own
way of banking backed by State Bank of Pakistan (SBP). Islamic banking system is totally different from
conventional banking system which involves the element of interest (Riba). In Islamic banking there is no
involvement of interest (Riba) because it is prohibited in Islam. Because of this prohibition the financial
contracts offered by Islamic banks and the risk associated with these contracts is different as that of
conventional banks. This research analyzed the financial contracts offered by Islamic banks in Pakistan
and the risks associated with these contracts. In this research the researcher has also analyzed the
performance of five Islamic banks operating in Pakistan.

Identification of Gap:
The previous researcher took only two Islamic banks operating in Pakistan to measure performance of
Islamic banks, this research took five Islamic banks (Meezan, Al Baraka, Bank Islami, Dubai Islamic Bank
and Burj Bank) to measure the performance of Islamic banking in Pakistan.

Problem Statement:
Because of the prohibition of interest in Islam, the contracts offered by Islamic banks are different than
those of conventional banks and their risk profile is also different, moreover the performance of Islamic
banks is fair enough as compared to conventional banks that practice mark-up pricing.

Objective of the Study:

The objective of this research is to analyze the different financial contracts offered by Islamic banks to
different customers to cater their needs and requirements, to identify risks associated with financial
contracts and to measure the performance of five purely Islamic banks operating in Pakistan.

Significance of the Study:

Over the last decade the demand for Islamic banking and finance products has grown strongly, this
research will help the reader to know that how he can be benefited from the Islamic banking products
and services and can make an investment or can finance himself or his organization in a permissible way.
This will also encourage the conventional banks that are operating in Pakistan to be converted into
Islamic banks because the Islamic banks can earn more than conventional banks in country like Pakistan.
Research Questions:
 What are different financial contracts offered by Islamic banks to cater the varying needs of
customers?
 What are the risks associated with Islamic financial contracts?
 What is the financial performance of Islamic banks operating in Pakistan?

Theoretical Framework:

Independent variables
Dependent Variable
 Financial Contracts
 Risks to financial  Performance of Islamic
contracts Banks

CHAPTER # 2
Literature Review:

FINANCIAL CONTRACTS:
This review represents a brief overview of some widely used Islamic banking contracts which are usually
used by Islamic banks and act as products for savings, investment and trade. These contracts are based
on Shari’ah compliant (i.e. based on Islamic principles). Islamic banks like traditional banks also offer
different range of financial services and products. These include financing for consumer, financing
related to trade and modes of financing related to investment. Such modes of financing offered in the
form of cost plus sales (Murabaha), credit sales (bay ‘‘bithaman ajil’’), leasing (Ijarah), partnerships
(Modaraba and Musharakah) and some forward contracts (Salam and Istisna). Along with these modes
of financing there are zero interest loans which are offered by Islamic banks to needy students and poor
formers, these loans referred as Qard-e-Hasna (benevolent loan). Siddiqui, (2008).
Murabaha: (trade with mark up or cost plus sale)
Murabaha is a special kind of sale by a bank or any other institution in which both the cost and the profit
of a product or service to be sold are expressly stated and communicated to the buyer, it has nothing to
do with financing in its original sense. (Muhammad, Yousaf & Hezlina (2011). For using Murabaha for
financing, Islamic banks purchase certain goods (required by clients) and sell these goods to the client
(buyer) at cost plus profit basis. Its cost includes all expenses incurred in the acquisition of goods such as
invoice price, transportation, insurance, storage, sales tax and other Government duties. As far as the
payment of Murabaha sale is concerned it may on the spot, in installments on in lump sum after a
predetermined period in future.
Murabaha is one of the most widely used modes of financing by the Islamic banks. This instrument is
usually used for financing of consumer goods, real estate and for purchasing raw materials, machinery
or equipment in the industry. However it is most common and popular use is in short-term trade
financing which includes the financing for letters of credit. Murabaha facility is similar to the consumer
loans, lines of credit and working capital facilities provided by conventional banks. Although the
Murabaha contract is signed between the bank and the purchaser but actually there are three parties
involved in this contract: the seller of the good to the bank (Manufacturer, trader), the buyer (bank’s
debtor, client) who could be an ordinary consumer, and the bank which acts as an intermediary ‘‘trader’’
and facilitator between the original buyer and the seller. Siddiqui,(2008).

The Murabaha sale contract signed between the bank and the purchaser (debtor) is based on the prior
promise by the debtor to purchase contract signed initially between both of them (bank and debtor).
Under the Murabaha sale contract the bank purchases the goods desired by the purchaser from the
seller and sells to the purchaser on his ‘‘promise to purchase’’ at a price which includes the cost of the
purchase plus a pre-agreed profit. Siddiqui, (2008)

Murabaha sale contract which is based on the promise by the debtor to purchase certain goods is used
by the Islamic banks which undertake the purchaser of commodities according to the specification
requested by the customer. The bank then resell them on Murabaha to the one who promised to buy
for its cost price plus a margin of profit agreed upon previously by the two parties. Under the Murabaha
mode of investment the bank agrees to purchase for a client who will then reimburse the bank in a
stated time period at an agreed upon profit margin. The mark-up price that the bank and the buyer
agree to is mainly based on the market price of the commodity. Thus the bank earns a profit without
bearing any risk if client paid the agreed price on time. Khoja and Gudah (1997)

According to the Islamic Banking Bulletin of SBP Murabaha leads the financing share mix of Islamic banks
is 36%. It means that if there is total financing of Rs. 100 then Rs. 36 are financed through Murabaha
sales. Murabaha financing contains several risks to be countered by Islamic banks, including price risk,
default risk, commodity risk and market risk. (Iqbal and Mirakhor 2007).

Bay ‘‘bi-thaman ajil’’ (credit sales)

The cost plus profit (Murabaha) contract which has been discussed above is hardly ever executed on
spot through immediate payments by the purchaser for the goods or services acquired by him thorough
bank. At spot payment of the full amount of the loan by the purchaser means that the bank loan has
been paid immediately and the bank is simply performing the role of an intermediary trader by
facilitating the delivery of goods from seller to buyer and charging a profit mark up over cost for its
middleman services. The financial intermediary role which is required by the banks is the traditional role
of banks and money lenders for centuries that can only be played by the bank if the loan payments by
the purchaser for the goods or services are through installments or in other words the bank is extending
credit to the purchaser. This type of sale by the bank is called Bay ‘‘bi-thaman ajil’’ (credit sales).
Siddiqui,(2008). This is exactly what happens in the actual practice of Islamic banking in which the more
common and usual mode of payment for goods, machinery or equipment is deferred payments through
installments. The deferred payments of the loan at higher price than the cost price which is incurred by
the bank in acquiring the goods can be interpreted to mean that Islamic mode of finance for deferred
payments is very much similar to traditional loan installments in conventional banks in which customer
pays loan amount along with interest. It looks same but actually it’s not. The Islamic bank charges
interest (profit) on the loan payment because the bank purchased the goods and sell it to the debtor on
deferred payments and in such situation charging higher cost is allowed. Islamic jurists allows for
increase in price due to deferment of payment by the debtor; see Usmani (1998) for legal explanations.

Musharaka (partnership or joint venture)

Hadiths-e-Qudsi:
“Allah Subhan-o-Tallah has declared that He will become a partner in a business
between two Mushariks until they indulge in cheating or breach of trust (Khayanah).”
(Sunan Abu Daud)
In another Hadiths-e-Qudsi, it is stated:
“Allah’s hand is with both the partners unless any one of them indulge in cheating and
when any one of them indulges in cheating than Allah takes back his hand from both the
partners.” (Sunan dar e qutni)
The literary meaning of Musharakah is "sharing". The root of the term "Musharakah" in
Arabic comes from the word ‘Shirkah’, which means 'being a partner'. It is used in the
same context as the term "Shirk" meaning "partner to Allah".
Under Islamic jurisprudence, Musharakah means "a joint enterprise formed for
conducting some business in which all partners share the profit according to a specific
ratio while the loss is shared according to the ratio of the contribution". It is an ideal
alternative for the interest based financing with far reaching effects on both the
production and distribution of wealth in the economy. The connotation of this term is
limited than the term "Shirkah", more commonly used in the Islamic jurisprudence.
Usmani, (2015).
If the debtor (purchaser) does not want 100 percent financing by bank for the product, service or for any
business he want to conduct and contributes some of his own equity capital for the acquisition of
service, product, business, then such a contract between bank and client (debtor) is called Musharakah.
Even in this partnership a cost plus sale (Murabaha) contract will be signed between the bank and the
purchaser. However, now the purchaser (debtor) will be exposed to the risk of capital loss on the capital
committed by him, in case if 100 per cent of the capital was financed by the Islamic bank then the
debtor will have no risk. The two parties are involved in a profit and loss sharing agreement in
conformity with Islamic principles of risk and reward sharing. The profits are shared in accordance with
pre-determined ratios while the losses are borne in proportion to equity participation. Musharaka
financing is used by banks for financing trade, imports and to issue letters of credit and also in
agriculture and industry. Siddiqui, (2008).
Modaraba (profit and loss sharing)
This is a kind of partnership where one partner gives money to another for investing in a
commercial enterprise. The investment comes from the first partner who is called "Rab-
ul-Maal" while the management and work is an exclusive responsibility of the other,
who is called "Mudarib" and the profits generated are shared in a predetermined ratio.
Usmani, (2015).
This is also like a partnership contract except that in this there is no equity partnership but only profit
and loss sharing. Its counterpart in conventional business structures would be limited partnership. One
can think of bank deposits as a case of a Modaraba contract between the bank and the customer. In this
contract the bank lends the entire capital to the investor/consumer (debtor) and the financial losses of
the debtor entrepreneur are borne entirely by the bank. Only in the event of mismanagement or neglect
is the customer held liable for the losses. The Modaraba contract is reflected in the balance sheet of the
bank on both the asset and the liability side. On the liability side it is an unrestricted Modaraba in which
the depositors agree that the bank is free to choose the investments that it will make with their deposit
money and agree to share the profits earned by the bank. On the asset side it is a restricted Modaraba
contract because the bank agrees to finance a particular (restricted) investment need of the customer
and to share a percentage of the project’s associated profits. Siddiqui, (2008).
2.5 Salam (sales contract)
In Salam, the seller undertakes to supply specific goods to the buyer at a future date in
exchange of an advanced price fully paid at spot. The payment is at spot but the supply
of purchased goods is deferred. This mode of financing can be used by the modern
banks and financial institutions especially to finance the agricultural sector to meet the
needs and requirements of small farmers who need financing to grow their crops and to
feed their families until the time of harvest.
When Allah's messenger declared Riba as haram, the farmers could not take usurious
loans. Therefore, the Holy Prophet allowed them to sell their agricultural products in
advance.
Salam can also be used to meet the need of traders for import and export business.
Under Salam, it is allowed to sell the goods in advance so that after receiving cash price,
the traders can easily undertake the aforesaid business. Salam is beneficial to the seller
as he receives the price in advance and it is beneficial to the buyer also as normally the
price in Salam is lower than the price in spot sale. Usmani, (2015).
Salam is a sale of a commodity whose delivery will be in a future date for a cash price, which means, it is
a financial transaction in which price is advanced in cash to the seller, who abides to deliver a
commodity of determined specification on a definite due date. The deferred is the commodity sold and
described (on liability) and the immediate is the price. In other words a Salam sale contract is a futures
contract. The practical steps in the Salam sale are as follows. The bank: pays the price in the contract to
the seller so that he can have the immediate use of funds to cover his financial needs. The seller abides
by the contract to make a delivery of the commodity on the specific due date. At the time of delivery on
the specific due date the bank has several options to choose from: the bank receives the commodity on
due date, and sells it either for cash or on credit; or it can authorize the seller to sell the commodity on
its behalf against fees (or without fees); or it can direct the seller to deliver the commodity to a third
party (the buyer) according to a previous promise of purchase, where the promise is that the buyer will
purchase from the bank. Once the delivery has been arranged by any of the above mentioned options,
the commodity is sold through a sale contract between the bank and the buyer. In this contract, the
bank agrees to sell the commodity for cash or a deferred price higher than the Salam purchase price
paid by the bank to the seller. The buyer agrees to purchase and to pay the price according to the
agreement. The Salam sale can be used to meet the capital requirements as well as cost of operations of
farmers, industrialists, contractors or traders as well as craftsmen and small producers. The bank
benefits from entering into a Salam contract with a seller because usually a Salam purchase by the bank
is cheaper than a cash purchase. Due to this reason the bank is secured against price fluctuations,
barring those extreme circumstances of a price deflation or a market crash when post Salam prices
could dip lower than currently contracted Salam sale prices. Siddiqui, (2008).
2.6 Ijarah (leasing contract)
"Ijarah" is a term of Islamic fiqh which means “to give something on rent”. In the Islamic
jurisprudence, the term “Ijarah” is used for two different situations.
 In the first place, it means “to employ the services of a person on wages given to
him as a consideration for his hired services.” The employer is called “Mustajir”
while the employee is called “Ajir”, while the wages paid to the Ajir are called
their “Ujrah”.
 The second type of Ijarah relates to the usufructs of assets and not to the services
of human beings. 'Ijarah' in this sense means “to transfer the usufruct of a
particular property to another person in exchange for a rent claimed from him.”
In this case, the term 'Ijarah' is analogous to the English term 'leasing'. Here, the
lessor is called 'Mujir', the lessee is called 'Mustajir' and the rent payable to the
lessor is called 'Ujrah'. However, there are many differences between leasing
contract of Conventional Bank and Ijarah, Meezan Bank Guide to Islamic Banking.
Usmani, (2015).
As is well known, leasing is designed for sale of vehicles, equipment or property for conducting business.
Unlike traditional banking where the bank allows the customer (buyer) to lease goods at fixed interest
rates, the Islamic leasing facility has two sub contracts. First, the bank signs a purchasing contract with
the seller for the commodity which the buyer wishes to lease. The bank pays the seller and then gets the
commodity delivered to the buyer from the seller. Second, the bank signs a lease contract with the
buyer in which commodity is leased to the customer allowing him the ownership (or simply the use) of
the asset after payment of lease installments and residual charges. The lease option is commonly used
for transactions in real estate, cars, computers, machinery and equipment. Siddiqui, (2008).
2.7 Qard-e-Hasna (benevolent loan or interest free loan)
Islamic banks provide such a facility on a limited scale to poorer sections of society such as needy
students or small rural farmers. Such loans would have negative NPVs for the banks. Traditional banks
do not have any such benevolent loan structure. Such loans are granted as charity, grant or scholarship
by Islamic banks through zero interest loan and not by non-returnable zero interest loan. There is no
literature available on this type of loan as it is unique and only practiced in pure Islamic banks.

Risks of financial contracts:

Risk is broadly defined in terms of uncertainty of expected outcome in
any event or in other word risk means a deviation from the expected
results (outcomes, return, mean). Horne, (2002). Almost every human
action carries some element of risk that may be high or low depending
upon the activity and its related tasks. Risk may happen to take place in
business, health, security, games, economy etc. In financial terms, risk is
any event that can harm the revenues or the cash flows of business in
short, medium or long time period. Risk may mean the loss of entire
investment or less than expected outcome. The distinction between
uncertainty and risk is, in case of uncertainty one is not sure of the real
outcome whereas risk is the state of uncertainty where there is a chance
that undesirable results may occur. It may also be defined as the
possibility that some undesired and adverse event will take place. For
example, if someone attempts a sky dive, he/she is taking a risk as it
may take his/her life. Similarly if someone is buying stocks, he is taking
a risk in expectation of earning profits. Generally the riskier the event is,
the higher is the return because no one likes to invest unless the expected
return from that investment is high enough to pay off the investor
against his assumed risk. Brigham & Houstan, (2003).
Risks also happen in banks. A bank either conventional or Islamic usually faces a
number of risks in its daily banking operations, these risks include credit risk,
benchmark risk, liquidity risk, operational risk, legal risk, withdrawal risk,
fiduciary risk, displaced commercial risk etc. Siddiqui, (2008).

In traditional banks (banks which do not fallow Islamic banking practices)

customers are paid a fix return on their deposits by bank, this return in first earned
by banks via investments in loans and other assets such as mutual funds or real
assets. By doing so the traditional banks may face market risk or interest rate risk
but these banks do not take any investment specific risk related to their loans other
than the risk of default by the borrower which may have been partially covered by
pre-loan collaterals. If the borrower made an investment from the borrowed money
then the risk of the investment is borne by the borrower. The debtor is liable to pay
the borrowed money along with interest to the lending bank at the end of each loan
tenure. The relationship between lender and debtor is simple: the bank is the
‘‘owner’’ of capital and the debtor pays the bank a return (interest charges) on the
borrowed money. The bank determines that interest rate or return by assessing the
current market’s conditions and practices. The investment project financed by a
bank is basically a debt – equity contract in which the exposure of the bank is on
the debt part of the investment. To protect themselves against loan losses, banks
operating under a conventional banking system will garnish the wages of the wage
earner if he is the defaulting debtor, or have the first right on the assets of the
corporation in case of loan default by a corporation.

In Islamic banking system a collateral has been maintained already at the time of
granting loan. When the Islamic bank gives a loan to a company then it becomes
the owner of the assets that the company wants to purchase with the loan and if a
default occurs then the Islamic bank confiscates those collateral assets, which it
owns anyway, for the tenor of the profit sharing loan contract. The ownership of
the assets by the lending bank continues till the principal and its associated profits
are paid by the debtor. Thus by eliminating fixed interest payments and
substituting them with profit and loss payments, Riba (interest) is avoided under
an Islamic banking framework. While Islamic banks do not pay interest they pay a
rate of return to depositors on their savings. Islamic banks periodically declare a
return on deposits, based on the profits actually earned on investments financed by
their PLS deposits. Because banks could theoretically suffer a loss, this means that
depositors’ principal as well as return are both at risk under the PLS system. In
practice, banks announce expected PLS rates in advance, so depositors have a good
estimate of their rate of return before making a deposit. Siddiqui, (2008).

Like traditional banks, Islamic banks also face credit risk. In case of profit sharing
modes of financing (Modaraba and Musharakah), the credit risk would be
nonpayment of the bank’s share by the lender entrepreneur. This situation arises
due to asymmetric information available to borrowers and lenders – in this case the
borrower would have inside information about the proposed projects and their
profitability which the bank would not have access to. Under other contracts such
as Murabaha (cost plus sales or sales with markup) the rate of return is fixed and
predetermined and such adverse selection and moral hazard problems would not
arise. However, credit risk in Murabaha contracts remains in the form of
counterparty risk due to nonperformance of the trading partner (Musharik). The
non-performance may not be the fault of the partner but could be due to external
systematic forces. Whether Islamic banks have less or more credit and liquidity
risk as compared to conventional banks depends on institutional arrangements
prevalent in a particular country for example the availability of an Islamic Money
Market and central bank regulations on capital and liquidity requirements for
Islamic banks. The evidence for Malaysia shows that banks engaging in Islamic
financing have lower credit and liquidity risks, but higher interest rate risks than
conventional banks. One reason for lower liquidity risks is that unlike other Islamic
countries Malaysian Islamic banks can use the central bank as a lender of the last
resort (How et al., 2005).

Those Islamic contracts which are based on equity participation will minimize the
adverse selection and moral hazard problems. This is so because under joint
ventures and equity participation schemes there is much more disclosure of a
company’s books and investments. However, the agency problems (principal agent
problems) will still be there due to asymmetric information and costly monitoring
(Sarker, 2000). However, one would expect that there will be some reduction in
agency problems due to representation of the equity partners on the Board of
Directors of the company.

In developing economies such as Pakistan, most businesses continue to maintain

multiple books of accounts, thus making it very difficult for banks to monitor the
true profitability of various clients. Due to this asymmetry of information the risk
of default increases and also the monitoring costs increase. Documentation of the
economy is a huge challenge for the government of Pakistan where only 1.2
million income earners pay tax out of a total population of 140 million and 60 per
cent of whom are wage earners. In traditional (non-Islamic) banks, interest rate
swaps are used as a hedging instrument against illiquidity which can arise if
payment liabilities against deposits exceed receipts against loans and other assets.
In Malaysia, 85 per cent of the Islamic banks’ assets are based on fixed rates of
return as measured through profit rates, while 90 per cent of the liabilities are on
floating profit rates. In the event that cost of funds increases the banks could find
themselves in liquidity shortages even leading to bankruptcy and a run on the bank.
The reason that so far we have not seen such a situation is that the cost of funds has
not fluctuated much. Another reason that Islamic banks are maintaining their
solvency is that a number of banks offering Islamic products have also been
operating conventional banking products and using conventional hedging
instruments (Baqar, 2005).

Traditional banks use forward contracts and futures contracts to hedge price risks.
Futures contracts were an improvement over forward contracts in that counterparty
risk (risk of default by a party) is eliminated by the futures exchange by means of
the margining process and by daily marking to market. The incentive to default is
reduced as the futures exchange requires the contracting parties to make an initial
deposit (another name for initial margins) and requiring the losing party to pay up
(adjusting the margins) as losses occur. Through this method of margining and
marking to market the counterparty risks (defaults) have been reduced to negligible
rates. Traditional banks have also used another derivative instrument, that is, of
options, to manage contingent liabilities or contingent claims. Since call and put
options allow one to purchase the right to act or not to act (non-obligation) such
non-obligation to exercise the buying or selling of the asset allows more flexibility
and allows further hedging, risk management and improving cash flows. Islamic
scholars have some reservations on options especially pertaining to the part
relating to trading of call and put options and the charging of premiums, which are
viewed as interest (Riba), and are forbidden. Kamali (1996) and Bacha (1999) give
arguments in favor of options and contend that its premiums and its trading are an
extension of the basic trading model allowed in Islam.
In order to manage risk of the banking sector as a whole central banks of Islamic
countries have stipulated various capital adequacy and reserve requirements which
are not uniform to all Islamic banks in various regions of the world (for a general
review of risk analysis, see Khan and Ahmed (2001)). Here mention must be made
that since Islamic banks do not have a large portion of their assets in fixed income
interest bearing assets, as conventional banks do, they should theoretically budget
for a larger capital adequacy ratio and a larger liquidity ratio. Based on this logic,
the Basel Committee has stipulated higher minimum capital requirements for
Islamic banks.

Performance of Islamic banking:

Organization is a structured entity that is established to achieve
specific goals. It consists of physical, human, informational and
financial resources that are combined to realize certain
objectives. Business organization is primarily formed for the
sake of profit by performing legal activities. Bank is also one of
the business organizations that offer a large number of products
and service for profit. Organization as it is goal oriented,
boundary-maintained and socially constructed systems of human
activity (Aldrich, 1979).

Every organization is trying to enhance the performance of

individuals for overall improvement of the whole organization.
Performance evaluation enables the organization to assess its
efficiency and effectiveness over a period of time by comparing
with its objectives or with market leader to overcome its
weaknesses. Researchers explored a number of indicators to
measure organizational performance (Dess & Robinson, 1984).

There are several criteria to evaluate the performance of banks

for successful survival in the era of globalization and
competition. Multiple aspects like profitability, liquidity,
management performance, leverage, market share, productivity,
innovation, quality of products, human resources and sales
volume etc. can evaluate any organization. Inception of Islamic
banks necessitated the importance of performance evaluation to
compete with conventional banks in Pakistan.

Tvorik and McGivern (1997) investigated performance by

comparing economic and organizational factors. They concluded
that organizational factors influenced the profitability more than
that of the economic factors. Successful organizations realized
the
Comparative Study of Islamic Banking 71 importance of
ongoing performance measurement practices (Weiss and Hartle,
1998).

Organization's performance could be assessed by resource-based

view as explored by a number of researchers (Wernerfelt, 1984;
Barney, 1986 a,b; Prahalad and Hamel, 1990). It may be shown
by varied combination in the literature. Organizational
performance could be linked with market orientation,
organization learning, human resource productivity, quality
improvement or any other component (Day, 1994; Banker and
Sinkula, 1999; Santos-Vijande et al., 2005).

Organizational performance reflects an organization's

understanding and knowledge regarding customer needs and
expectations (Kohli and Jaworski, 1990; Deshpande et al.,
1993; Slater and Narver, 1995). It is reported that an
organization can maximize the customer satisfaction for better
profitability, increased sales volume that ultimately improves its
performance for long term benefit (Baker and Sinkula, 1999).
Generally, organizational performance is assessed by the
application of financial measures. There are a number of studies
in the literature that used non-financial measures to evaluate the
effectiveness and performance of organization (Quinn and
Rohrbaugh, 1983; Venkatramanand, 1986). It is suggested that
four models i.e. human relations; internal process; open system
and rationale goal model could represent the organizational
performance (Quinn and Rohrbaugh, 1983).

Wheelen and Hunger (1998) argue that appropriate performance

measures depend on the organizations and their objectives i.e.
profitability, market share and cost reduction. Financial
indicator like return on investment (ROI), earning per share
(EPS) and return Comparative Study of Islamic Banking 72 on
equity (ROE) etc. are used by number of organizations to
measure their progress. Return on investment is used to reflect
the profitability while corporate performance was measured by
operating cash flows and return on investment capital (Sorenson,
2002).
Rashid et al. (2003) measured firm's financial performance
using the financial indicators such as return on assets, return on
investments and current ratios. Financial ratios reflect the
financial performance of the organization by an examination of
financial statements as indicated by profitability, liquidity,
leverage, asset utilization and growth ratios (Ho and Wu, 2006).
The relationship between organizational innovation and
performance was investigated by application of return on sales,
return on assets, return on equity and market-to-book ratio (Kuo
and Wu, 2007).
3.3.1 Performance Evaluation of Islamic
Banks
Islamic banks are competing for more customers with each other
besides stiff competition with conventional banks. There are
several measures that were adopted by the researchers to assess
the bank performance like profitability, liquidity, management
performance, market share, sales volume, innovation,
productivity, human resources, quality of goods and service etc.
There are different qualitative and quantitative tools that are
used to measure the bank performance. The measure of
performance evaluation should be meaningful. It reflects
management's clarity about organization's current situation and
its viability to achieve its goals. It should be manageable as it
can be handled easily based on simple calculations and
manipulation of data. It must be measurable as it should be
quantifiable and operationalized. It may be material, as it should
provide material results of significant improvement (Ernst &
Young, 1995).
Chapman et al. (1997) examined the influence of quality on
the performance of an organization. The study measured the
organizational performance using financial ratios such as
earnings on shareholders funds, return on total assets and labor
productivity ratio. It is found that there is a positive relationship
between strategic quality indicators and financial performance
parameters. It is reported that employees of domestic banks do
not contribute towards profitability. But employees of foreign
banks significantly contributed towards profitability (Arby,
2003).
3.3.2 Performance of Pakistani Banking
Sector
Pakistani banking sector has shown an excellent growth during
last few years. Financial performance of banking sector was
outstanding due to sufficient profitability, strong solvency,
assets management quality, better risk management practices
and continuous improvements for the provision of quality
services. Total banking assets surpassed the limit of Rs. 4 trillion
along with Rs. 100 billion pretax profits. Islamic banks also
experienced unprecedented growth by a 67% increase in total
assets of this segment. Islamic banking system has proved a
successful alternative for the conventional banking system (SBP,
2007).

In today's global, dynamic and competitive environment banks

should improve and diversify their products and services to meet
changing customers' demands to enhance their performance for
successful survival. There are a few studies available in the
literature that measured the performance of Islamic banks across
the global. Performance measurement became indispensable for
the successful survival banks due to stiff competition and
customers' awareness of service quality. It is reported that
Pakistani banking sector has shown good performance by
attracting a large number of customers due to the provision of
quality services (Arby, 2003).
Dick (2003) examined the service quality and bank performance
in the United States. Deregulation increased the branch network
of banks to attract more and more customers that resulted into
more profits with increased risks due to changing demographics.
Findings showed that improved service quality resulted in
increased service fee and risk could be reduced by geographical
diversification and hedging. It is reported that two principle
paths can improve financial performance of banks i.e. by
improving operational efficiency or improvement in customer
services (Duncan and Elliott, 2004).

Dick (2005) reported that market concentration is not affected

by its size. Dominant banks have almost similar influence on
markets of different size. The study found that service quality is
enhanced and focused by dominant banks. Performance
evaluation provides sufficient information to take better and
informed business decisions. Better decisions results more
profitability and improved performance for the institution and its
shareholders (Crider, 2007).

Proposed Hypothesis:
 Efficient management of Islamic financial contracts risks leads to high bank performance.
 Islamic financial contracts along with proper risk management improves bank performance.

Chapter # 3
Methodology:
Design of study:
Due to the Islamic prohibition of interest and in compliance with injunctions on permissible
trade contracts, the savings and investment contracts offered by Islamic banks have a different
risk profile than those of conventional banks. This gives rise to a number of regulatory issues
pertaining to capital adequacy and liquidity requirements. Operational issues also arise as
Islamic banks are limited in their choice of risk and liquidity management tools such as
derivatives, options and bonds. All these issues are theoretically examined and various
performance indicators of five Islamic banks are also examined to show their financial
performance.
Population:
Population size for this research is 19 Pakistani banks which contains 14 pure Islamic banks and 5
conventional banks.

Islamic banks:

 Dubai Islamic Bank Pakistan Ltd

 Al-Baraka Bank Pakistan Ltd

 Bank Alfalah Islamic Banking

 Meezan Bank Limited

 Standard Chartered Bank (Islamic Banking)

 Askari Bank Ltd (Islamic Banking)

 MCB Islamic Baking

 UBL Islamic Banking

 HBL Islamic Banking

 National Bank of Pakistan NBP Islamic Banking

 Bank Al Habib Islamic Banking

 Burj Bank Limited Pakistan

Conventional Banks:

 Summit Bank Limited

 Silk Bank Limited
 Allied Bank Limited
 Faysal Bank
 Soneri Bank

Sampling strategy
The previous researcher took only two Islamic banks for performance analysis, this research will take
five Pakistani Islamic banks for analysis of performance.

 Meezan bank,

 Al Baraka bank

 Bank Islami
  Dubai Islamic Bank

Burj Bank

Unit of analysis
The unit of analysis will be individual banks.

Time horizon
This research will take 1 month to complete.

Instrumentation
This research will be adapted.

Likely statistical tests being applied

No statistical test will be used as this research will have to measure performance of Islamic banks by
using Return on Assets (ROA) and Return on Equity (ROE).