In the Name of Allah, Most Beneficent Most

Merciful.

ISLAMIC BANKING:

GENERAL OVERVIEW

BY:MUDASIR GULZAR

MBA & PGPBM IIBS BANGALORE

MAIL ID:makbatool@yahoo.com
Oh believers, take not doubled and redoubled interest, and fear God so that you
may prosper. Al-Qur'an

This era where trends flourish around increasing aspirations to

identify with social conscious initiatives, it comes as no surprise that
Islamic Banking is booming. The concept of interest is fundamental to
the business of banking. With this background it is very interesting
that sharia banking is working without profits and is still flourishing.
They are not only profitable but are also growing at an astonishing rate
in sense of capital, assets and consumers. From Jakarta to Jeddah to
Jordan, 280 Islamic banks operate in over 50 countries, with assets
estimated between $ 250 million and $ 300 billion. Management
Consultants Mckinsey and Co. say in their world Islamic
Competitiveness Report, 2007 that the value of assets managed by
Islamic Banks will grow by 33 % by 2010.
INTRODUCTION

Islamic banking refers to a system of banking, which is consistent with

Islamic Shari’ah (Law), and guided by Islamic economics. Islamic law
prohibits the payment and collection of riba (interest or usury).The
main argument against interest is that money is not used as a
commodity with which to make a profit but that it should be earned on
goods and services only, not on control of money itself. Features of
Islamic Banking are based on ethical principles. Islamic Shari’ah allows
all economic activities in the framework of protecting public interest
and safeguarding it. Man may make profit from doing business.
However, when this runs against Islamic ethics and morality, it is
outlawed. In addition, for an investment to be legitimate, one of the
most important requirements is that its outcome must fulfil the reality
of investment transactions and that it enables the Islamic Financial
Institution (IFI) to state what it expects to make in profits. However,
this cannot be determined as a certainty or can one commit one’s self
to it, or bear any loss sustained.

Main conditions governing Islamic investment include: Money does not

generate or beget money in itself, but it becomes productive if it is
involving an activity or work; Investment is subject to the rule of
profit and loss sharing; Investment in business activities is lawful, but
prohibitions should be avoided. ; Contracts must be free of gharar
(uncertainty, ignorance and the conditions which lead to disputes).
Historical Development
During the Islamic Golden Age, early forms of proto-capitalism and free markets
were present in the Caliphate, where an early market economy and an early form of
mercantilism were developed between the 8th-12th centuries, which some refer to
as "Islamic capitalism". A vigorous monetary economy was created on the basis of
the expanding levels of circulation of a stable high-value currency (the dinar) and
the integration of monetary areas that were previously independent.

A number of innovative concepts and techniques were introduced in early Islamic

banking, including bills of exchange, the first forms of partnership (mufawada)
such as limited partnerships (mudaraba), and the earliest forms of capital (al-mal),
capital accumulation (nama al-mal), cheques, promissory notes, trusts (see Waqf),
startup companies, transactional accounts, loaning, ledgers and assignments.
Organizational enterprises similar to corporations independent from the state also
existed in the medieval Islamic world, while the agency institution was also
introduced during that time. Many of these early capitalist concepts were adopted
and further advanced in medieval Europe from the 13th century onwards.

It seems that the history of Islamic banking could be divided into two parts. The
earliest references to the organization of banking on the basis of profit sharing
rather than interest (Fiqh al-Muamalat-the fundamental principal of Islamic
Banking) can be traced to the late forties. However In the next two decades it
attracted more attention, partly because of the political interest that it created in
Pakistan and partly because of the migration of muslims to the western countries.
The Islamic Development Bank, an inter-governmental bank established in 1975,
was born of this process, being the first bank incorporating the principles of sharia
banking. The first private interest-free bank, the Dubai Islamic Bank, was also set
up in 1975 by a group of Muslim businessmen from several countries. Two more
private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt
and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance
House. In the ten years since the establishment of the first private commercial
bank in Dubai, more than 50 interest-free banks have come into being. Though
quite a few of them are in Muslim countries, there are now spreading in other
countries as well like in Denmark, Luxembourg, Switzerland and the UK.

In most countries the establishment of interest-free banking has been by private

initiative (mostly by migrant muslims). In Iran and Pakistan, however, it was by
government initiative and covered all banks in the country.

Modern Islamic banking

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 Elnaggar, took the form of a savings bank
based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This
experiment lasted until 1967 (Ready 1981), by which time there were nine such
banks in the country.

In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which,
till date, is still in business in Egypt. In 1975, the Islamic Development Bank was
set-up with the mission to provide funding to projects in the member countries.
The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in
1975. In the early years, the products offered were basic and strongly founded on
conventional banking products, but in the last few years the industry is starting to
see strong development in new products and services.

Islamic Banking is growing at a rate of 10-15% per year and with signs of
consistent future growth[11]. Islamic banks have more than 300 institutions spread
over 51 countries, including the United States through companies such as the
Michigan-based University Bank, as well as an additional 250 mutual funds that
comply with Islamic principles. It is estimated that over US$822 billion worldwide
sharia-compliant assets are managed according to The Economist. This represents
approximately 0.5% of total world estimated assets as of 2005.

The World Islamic Banking Conference, held annually in Bahrain since 1994, is
internationally recognized as the largest and most significant gathering of Islamic
banking and finance leaders in the world.
The Vatican has put forward the idea that "the principles of Islamic finance may
represent a possible cure for ailing markets."

Principles
Islamic banking has the same purpose as conventional banking except that it
operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat
(Islamic rules on transactions). The basic principle of Islamic banking is the sharing
of profit and loss and the prohibition of riba (usury). Common terms used in Islamic
banking include profit sharing (Mudharabah), safekeeping (Wadiah), joint venture
(Musharakah), cost plus (Murabahah), and leasing (Ijarah).

In an Islamic mortgage transaction, instead of loaning the buyer money to purchase

the item, a bank might buy the item itself from the seller, and re-sell it to the
buyer at a profit, while allowing the buyer to pay the bank in installments. However,
the bank's profit cannot be made explicit and therefore there are no additional
penalties for late payment. In order to protect itself against default, the bank
asks for strict collateral. The goods or land is registered to the name of the buyer
from the start of the transaction. This arrangement is called Murabaha. Another
approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks
handle loans for vehicles in a similar way (selling the vehicle at a higher-than-
market price to the debtor and then retaining ownership of the vehicle until the
loan is paid).

An innovative approach applied by some banks for home loans, called Musharaka al-
Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower
form a partnership entity, both providing capital at an agreed percentage to
purchase the property. The partnership entity then rents out the property to the
borrower and charges rent. The bank and the borrower will then share the
proceeds from this rent based on the current equity share of the partnership. At
the same time, the borrower in the partnership entity also buys the bank's share
of the property at agreed installments until the full equity is transferred to the
borrower and the partnership is ended. If default occurs, both the bank and the
borrower receive a proportion of the proceeds from the sale of the property
based on each party's current equity. This method allows for floating rates
according to the current market rate such as the BLR (base lending rate),
especially in a dual-banking system like in Malaysia.

There are several other approaches used in business transactions. Islamic banks
lend their money to companies by issuing floating rate interest loans. The floating
rate of interest is pegged to the company's individual rate of return. Thus the
bank's profit on the loan is equal to a certain percentage of the company's profits.
Once the principal amount of the loan is repaid, the profit-sharing arrangement is
concluded. This practice is called Musharaka. Further, Mudaraba is venture capital
funding of an entrepreneur who provides labor while financing is provided by the
bank so that both profit and risk are shared. Such participatory arrangements
between capital and labor reflect the Islamic view that the borrower must not
bear all the risk/cost of a failure, resulting in a balanced distribution of income
and not allowing lender to monopolize the economy.

Islamic banking is restricted to Islamically acceptable transactions, which exclude

those involving alcohol, pork, gambling, etc. The aim of this is to engage in only
ethical investing, and moral purchasing.

In theory, Islamic banking is an example of full-reserve banking, with banks

achieving a 100% reserve ratio.However, in practice, this is not the case, and no
examples of 100 per cent reserve banking are observed.

Islamic banks have grown recently in the Muslim world but are a very small share
of the global banking system. Micro-lending institutions founded by Muslims,
notably Grameen Bank, use conventional lending practices and are popular in some
Muslim nations, especially Bangladesh, but some do not consider them true Islamic
banking. However, Muhammad Yunus, the founder of Grameen Bank and
microfinance banking, and other supporters of microfinance, argue that the lack of
collateral and lack of excessive interest in micro-lending is consistent with the
Islamic prohibition of usury (riba).
HOW BIG IS THE INDUSTRY?

* There are more than 300 Islamic banks and investment firms globally, according
to the Bahrain-based General Council for Islamic Banks and Financial Institutions.
The figure does not include traditional banks with Islamic operations.

* Islamic financial institutions, including non-bank operations such as insurance

firms, manage more than $800 billion, according to data cited by the Islamic
Development Bank in its 2005-2006 annual report.

* Islamic banks will hold 40 percent-to-50 percent of the savings of the world's
1.2 billion Muslims in eight-to-10 years, according to the International Islamic
Finance Forum.

* The total value of sukuk issued in the last six years is about $21 billion, according
to data from by the Bahrain-based Liquidity Management Center (LMC). In 2006,
$7 billion worth of sukuk was issued, an 87 percent increase on 2005. Sukuk worth
$20 billion are still outstanding, LMC data showed.

SOME OBSTACLES
* Differing interpretations of Islamic law are hindering the growth of the Islamic
banking industry by making it difficult to standardize products across markets.
Some scholars take the opposite view, fearing too much standardization will hinder
innovation.

* Some Gulf investors believe the Malaysian interpretation of Islamic law is too
flexible, stifling cooperation between the two regions. The Malaysian policy of
allowing debt to be traded in some Islamic transactions is a key bone of contention.

* Malaysian Islamic finance deals are typically valued in ringgit, making them less
attractive to Gulf investors, who prefer U.S. dollars. Malaysia's capital markets
are deep and liquid enough to easily sell products in the local currency, unlike the
Gulf, where dollars are used to widen appeal.
RIBA (USUARY / INTEREST)
The Islamic Economic System revolves upon the prohibition of Riba
(interest).

What is Riba?

What does the Qur’an tell us about Riba?

What does the Hadith tell us about Riba?

What is the difference between interest and Riba?

Why are Muslims forbid from taking/accepting Riba?

Is Riba-free banking a reality?

What is Haram/Halal in business transactions?

Is Islamic banking possible in a non-Muslim society?

Is Islamic banking open to non-Muslims?

What is the difference between Islamic and Conventional banking?

What is the way forward in Kenya?

What can we learn from the experience of others?

The two main types of usury to be avoided are as follows:

Riba al-Nasiah

Riba al Nasiyah defined as: “any excess compensation over and above
the principal which is without due consideration.”

The Prophet (SAW) said:

“Every loan that draws interest is Riba”

»Ali ibn Talib).

Riba al-Nasiah, or deferred usury, is related to extension of the

repayment period for additional payment of money. It is also called
Riba Jahiliyyah which was a pre-Islam form of usury and the worst of
its kind.

Riba al-Fadl

Riba al-Fadl means the excess which is taken in exchange of specific

homogenous commodities, such as selling gold with another gold,
whereby one has more “weight” than the other.

“Oh believers, take not doubled and redoubled interest, and fear God
so that you may prosper.”

Qur’an

The Prophet banned all interest based transactions as well as cancelling

all interest due to and from the people of Taif condition of the Taif
Treaty.

PROHIBITION OF RIBA IN ISLAM

The Islamic Economic System revolves upon the prohibition of Riba.

Riba in the Qur’an

First Revelation:

“That which you give as interest to increase the peoples wealth

increases not with God; but that which you give in charity, seeking the
goodwill of God, multiplies manifold”(30:39)
Surah Al Rum, verse 39

Riba from Surah Al Baqarah

“Those who benefit from interest shall be raised like those who have
been driven to madness by the touch of the devil; this is because they
say: “trade is like interest” while God has permitted trade and
forbidden interest.”

Qur'an, 275.

God deprives interest of all blessing but blesses charity

Qur'an, 276.

“O believers fear Allah and give up what is still due to you from
interest (usury), if you are true believers.”

Qur'an, 278.

“If you do not do so, then take notice of war from Allah and His
Messenger. But, if you repent, you can have your principal. Neither
should you commit injustice nor should you be subjected to it”. 279 “O
Believers, take not doubled and redoubled interest and fear God so
that you may prosper”

Surah Al Imran, 130-1.

Riba in the Hadith

The Prophet (SAW) said:

“Cursed is the receiver and the payer of interest, the one who records
it and the two witnesses to the transaction. They are all alike in guilt.”

»Jabirbin Abdalla(Muslim/Tirmidhi)
Prophet’s Last Pilgrimage

Jabir bin Abdalla(RAW) giving a report on the Prophet’s (SAW)

farewell pilgrimage said:

“The Prophet (SAW) addressed the people and said “All the Riba of
Jahiliyyah is annulled. The first Riba that I annul is our Riba, that
accruing to Abbasibnal Muttalib (Prophets uncle); it is cancelled
completely”

»Muslim –Kitabal Hajj, Babb Hajjatial Nabi.

The Prophet's Vision During Miraj

The Prophet (SAW) said:

“On the night of Ascension, I came upon people whose stomachs were
like houses with snakes visible from the outside. I asked Gibril who
they were. He replied that they were people who had received
interest.”

»(IbnMajah, MusnadAhmed)

PRINCIPLES OF ISLAMIC BANKING

Islamic Banking is based on the principles of trade, partnership,

sharing of gains and losses, and prohibition of reckless risk. It
prohibits:

Interest-based banking

Gharar –unclear contracts

Maysir–speculation

Financing of haram transactions -– alcohol, gambling, pork, etc.

Lending in Islamic Banking

Islamic Financing involves a buy-sale deal or a rent to sale deal. There

is always an underlying asset behind the deal. Allah reminds us: “We
have permitted trade and forbidden riba”. In Islamic banking, the
lender must share the risk with the borrower.

Types of Lending contracts

Murabaha – sale contract

Mudaraba – Part financing

Musharika – Partnership

Ijara – rental/lease

Tawarruq – overdraft facilities.

Istisna’a

Salam

Murabaha

The term Murabaha comes from the Arabic word “rabh” which means
profit (Short term trade financing). Client identifies goods which we
wishes to buy for KShs. x and requests a bank to finance the
transaction. The Bank buys the said goods and resells them to the
client for KShs. x+ margin (e.g. 10% agree profit).The Client then
repays within agreed timeframe.

Musharika

This is a joint enterprise formed for business where all the partners
(Bank and customer) contribute capital and share the profit according
to a specific ratio while any possible loss is in turn shared according to
the capital contribution by the two parties. Both the bank and the
client contribute capital, client brings know how. Profits/losses are
thus shared on agreed ratios.

Musharika vs Interest Banking

The characteristics of Interest Based banking are:

Fixed Rate of Return percentage

Bank does not take any share of loss/risk

Banks not invoved in owning and selling of goods.

Mudaraba

This is a partnership where the bank contributes 100% of the capital

and the client contributes know how. Profit is in turn shared on an
agreed ratio. If there are any losses, the bank absorbs it fully. This is
the equivalent to 100% financing by the bank.

Uses of Musharika/Mudhariba

Short/medium/long term financing

Project financing

SME set up

Import financing

LC’s

Export (Pre-shipment Financing

Working Capital Financing.

Diminishing Musharika

This is where a client wants the bank to finance and remain a partner.
The Diminishing Musharika/Murabaha is where the client buys out the
shares of the bank over time. The classic examples is for example, the
purchase of houses, equipment etc.

Ijara

Ijara is the same as leasing. The bank purchases the asset/house.

There is Joint ownership between the bank and the client. The client
rents it from the bank. Client enters into an agreement to buy the
shares from the bank over an agreed timeframe. He then buys out
small amounts of shares from the bank time to time ending up with a
hundred per cent (100%) ownership. Repayment is in the form of rental
costs which changes as the percentage owned by the client increases.
The value of the asset can also increase thus the bank has the right to
charge a higher price for the sale of its shares.

Istisna’a

Istisna’a is a sales transaction where a commodity is sold before it

comes into existence. For example this mode of financing may be used
for home financing where the client owns land and seeks financing for
the construction of a house, the financier can provide him with a
constructed house on a specified piece of land. The price must be fixed
with the consent of all parties involved. All other necessary
specifications of the commodity must also be fully settled. The
payment of an Istisna’a may be made in advance or instalments or in a
lump sum at the end of the period.
Salam

Salam is a sales transaction where a commodity, usually horticultural or

agricultural goods, is sold before it comes into existence. The price of
the commodity must be paid in advance to make the transaction valid.

Deposits in Islamic Banking

Clients deposits fall under the category of qard(Loan) to the bank and
the bank is obliged to pay back. These loans fall under the category of
Musharika. The bank is obliged to share in the profits of the bank with
its depositors. Bank must protect these assets on behalf of its clients
as well as get them the highest halal returns. Since banks do not pay
interest, clients must therefore become a partners or Mushariks to
share in the profits. The only way to become a partner is to open an
investment account (Time or Saving Deposit) which allows the bank to
invest one’s money. Profit sharing is then calculated and distributed.
Profits will be very close to prevailing deposit rates.

Types of Accounts in an Islamic Financial Institution (IFI)

In Islamic banking each customer is a partner with the Islamic

Financial Institution (IFI). This relationship is classified as a Mudarib
Partnership. Profits resulting from the account are divided between
the parties. An IFI receives a certain percentage of the net profits, as
a return for the amounts deposited in different investment accounts
as its share, being a Mudarib, as agreed between the customer, who is
the investment account holder, and the IFI.
Current Accounts

Current accounts are an interest-free loan by the account holder to

the Islamic bank, which maintains these funds and pays them to the
customer on demand. These accounts are similar to a loan in guarantee
and the payment of the same amount. An IFI has the right to invest
the funds it is holding in current accounts without the customer
bearing any loss. For this reason, the customer does not get any profit
on this type of account, but he also does not bear any loss.

Investment Savings Accounts

Many Islamic banks offer savings accounts to their customers. This

account allows the account holder to place funds in a safe environment
till such time when they may wish to withdraw them. Profits and losses
under investment savings accounts accrue on the minimum monthly
balance. Profits are paid, or losses are deducted, after the expiry of
the financial year and the net profits are determined.

The balances under investment savings accounts are invested on the

basis of unrestricted Mudharaba. An Islamic bank has the right to do
everything necessary to realize common interest.

An account holder authorizes the Islamic bank to invest the profits

made from the moment they are registered in his own account with the
Islamic bank.

DIFFERENCES BETWEEN ISLAMIC AND CONVENTIONAL

BANKING

There are a number of key differences between the products and

services offered by a conventional bank in comparison to an Islamic
Financial Institution (IFI). Islamic transactions are created in view of
the juristic rules of Islamic Shari’ah and the differences can be
highlighted as follows:

Qur’anic rule: “if the debtor is in a difficulty, grant him time till it is
easy for him to repay.” However, if he is procrastinating, the bank
applies Shari’ah compliant rules to guarantee its right, but without
resorting to interest.

Funds must be invested in lawful areas that achieve social and economic
development. Areas outlawed by Shari’ah must be avoided. The capital
is invested on a partnership basis between the bank or entrepreneur
and the capital provider.

SHAR’AH ADVISORY BOARDS/COMMITTEES

All Islamic Financial Institutions are required to have a Shari'ah

Supervisory Board/Committee. This Board should consist of
trustworthy scholars who are highly qualified to issue fatawa (religious
rulings) on financial transactions. In addition, Shari'ah board members
ought to have considerable experience in modern business/financial
dealings and transactions.

The world renown Shari'ah expert, Sheikh Nizam Yaquby points out:

"The Articles of Association, prospectuses, or statutes (depending on

the type of activity) should provide for the existence of a Shari’ah
advisory board, whose fatawa and resolutions should be binding upon
the financial institution's board of directors and management. The
advisory board is required to be independent and free to give opinions
on proposed contracts and transactions. The role of the Shari’ah
supervisory board should be concurrent with that of the financial
institution itself in the sense that it should be formed from the
moment the financial institution is incorporated, and that it should
provide continued supervision and permanent checking of contracts,
transactions, and procedures. This should be expressly provided for in
the Articles of Association or the prospectus."

Feasibility of Islamic banking in India

Current status of Islamic Banking in India

Islamic banks in India do not function under banking regulations. They

are licensed under Non Banking Finance Companies Reserve Bank
Directives 1997 RBI (Amendment) Act 1997, and operate on profit and
loss based on Islamic principles. All the Islamic banks have to be
compulsorily registered with RBI.

Reasons for non implementation of Islamic Banking in India

In the straitjacket world of Indian banking, something as fascinating

as Islamic banking is a distant dream. Nonetheless, countless advocates
of Islamic banking have been trying their best over the years to
propagate the concept. In furtherance of this propagation the Reserve
Bank of India (RBI) constituted a committee in 2007 to examine the
issue but viewed that Islamic banking cannot be offered by banks in
India as well as the overseas branches of local banks under the present
legal framework. Except a basic offering like current account, almost
no other banking product in India can be modified to meet the
conditions of Islamic banking. As a genre of financial services, Islamic
banking shuns the very idea of interest rates, and rests on profit-
sharing principles. Based on the Shar'h law, it abhors the business of
making money out of money, upholding the belief that wealth is
generated through actual trade and investment.The RBI has not put
the report in the public domain.

While the final form of the report is not known, from the newspaper
reports it can be collected that the members had pointed out how
Indian banking laws come in the way of various Islamic banking
principles. These are as follows:

1. n Al Wadiah (for saving bank account): Section 21 of the Banking

Regulation Act (BR Act) requires payment of interest on such deposits;
thus, interest-free deposit and a simple charging of premium or Hiba is
not permissible.

2. Mudarabah (for term deposit or investment): Here again, Section

21 of the BR Act disallows such products where the bank can invest the
money in equity funds (in India, equity exposure is determined by a
separate set of rules), and the client has complete freedom in the
management.

3. Mudarabah, Musharakah (for project finance and SME credit):

Sections 5, 6 of the BR Act indicate the forms of business a banking
company can undertake, and does not allow any kind of profit-sharing
and partnership contract the basis of Islamic banking.

4. Ijarah (for home finance) : As against Islamic banking where the

banks owns the asset and hold the title, Section 9 of the BR Act
prevents the bank from any sort of immovable property other than
private use.

5. Istisna (leasing, buyback): Besides the usual curbs on acquiring

immovable property, offering Islamic banking products many not are
bankable due to stamp duty, central sales tax and state tax laws that
will apply depending on the nature of the transfer.

The BR Act even disallows an Indian bank from floating a subsidiary

abroad to launch such products, or offering these through a special
window. Thus, the upshot of the findings is that such banking
experiment is impossible without a new law or multiple amendments to
the BR Act.

Another important consideration is the tax procedures. While interest

is a passive income, profit is defiantly an earned income which is
treated differently. If principles of Islamic banking are incorporated
then how does it comply with the tax procedure is the moot question.
Furthermore RBI cannot act as the lender to such banks because such
accommodation by the monetary authority is also interest based.
Islamic banks cannot interact with conventional banks based on
principles of interest.

Conclusion

Though it can be concluded that as of now RBI has stopped all the
possibility of Islamic banking in India (other than NBFCs), there are
certain questions which remain unanswered. The RBI report has not
been made available on the public domain like other reports is
definitely one question waiting to be answered. If the international
banks[10] have established Islamic merged it with their object of
profit making why can the same be done in India also is not answered.
Keeping in mind the flourishment of Islamic Banking all over the world
and the muslim population in India these are the questions which have
to be answered immediately and with certainty.
 THANKING YOU

MUDASIR GULZAR

MBA & PGPBM IIBS BANGALORE

CONTACT AT: 9886168812

EMAINL ID: makbatool@yahoo.com