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Islam is the latest religion and a complete code of life. Islam helps us in every
walk of life including the financial dealing in the society. If we follow Quran and
Sunnah, we shall get a clear picture of banking system. Interest is the heart of
conventional economy, but in Islam interest is declared Haram (forbidden).

Allah has strictly forbidden Riba in Holly Quran (2:275)

“Those who devour usury (riba) will not stand except as stands
one whom the Evil One by his touch hath driven to madness.
That is because they say, trade is like usury, but Allah hath
permitted trade and forbidden usury”.

Islamic banking system is based on Islamic Sharia laws. Sharia prohibits

interest fees for the lending or accepting money. Islam encourages sharing the risk
and profit or loss of the venture. This is the fundamental difference between Islamic
banking and conventional banking.

In the early years of Islam, the products offered were basic and founded on
conventional banking products, but in the last few years the Islamic banking started
development of new products and services.

Keeping in mind the great demand of Islamic banking in not only in Muslim
countries but also in Western countries many conventional banks are
showing interest in entering the market of Islamic financial
products. Unfortunately, what I observed is that Islamic banking products are
unknown to most of the people in the world even in Muslim countries, and poorly
understood by many banking staff. In this report I tried to shed some light on different
products offered by Islamic banking system I mean Shariah, as substitute for those
offered by conventional banks. I will try to describe that how these products differ
from conventional banking products. This report will guide banking staff and
common people about Islamic banking products.

Sicknesses of the Conventional Banking

Following two are the basic sicknesses of the conventional banking,

• Interest rates
• Income inequality

Difference between Conventional and Islamic Banking

Conventional banking Islamic banking

a) Lending money and getting it back a) Participation in partnership business is
with interest is the fundamental function the fundamental function of the Islamic
of the conventional banks. banking system & interest is forbidden.

b) The functions and operating modes of b) The functions and operating modes of
conventional banks are based on Islamic banks are based on the principles
principles made by man. of Islamic Shariah.

c) The investor is assured of a c) It promotes risk sharing between

predetermined rate of interest. investor and entrepreneur.

d) It can charge additional money d) No provision to charge any extra

(compound rate of interest) in case of money from the defaulters.

e) Conventional bank has to guarantee all e) Islamic bank can never guarantee all its
its deposits. deposits.

For day to day banking activities, a number of financial instruments have been
developed that satisfy the Islamic doctrine and provide acceptable financial returns for
investors. One of the best ways to understand Islamic banking is to understand the
products that are considered acceptable in Islam. Islamic banking products are an
acceptable stepping stone towards an ideal solution to deal with the conventional
banking system. Most of these are covered below.


A Substitute Product of Venture Capital

Mudarabah is an Islamic financing technique. The word Mudarabah is derived

from an Arabic word darbun meaning journey seeking for trade or work. The
Mudaraba contract is very close to Musharaka contract, where one partner named
Rab-ul-mal invests in any enterprise managed by other partner called Mudarib.

Mudarbah financing can be defined in economics term as a venture capital

arrangement in which the owner of a business provides the knowledge and expertise
to operate the business while the financer (Bank) provides the necessary capital. If the
venture operates at a loss, the Rab ul Mal receives no return on investment or even
may experience a loss. In the event the business good growth, he gets profits as
agreed at the time of signing contract. So in Mudarbah it is required that the investor
shares in both the risks and the profits from an investment, resulting the relationship
between the supplier of capital and the operator of a business in a partnership.

While in Conventional banking system, venture capital is a private equity that

involves the interest of return only. Such investments are made in cash in exchange
for interest (Riba) in the business only, which is not acceptable in Islam.

In Islamic Banking, the financers should not only evaluate the financial merits
of investment opportunities, but also structure the investment to remain with in the
boundaries of Islamic Sharia. Sharia law prohibits lending money at interest for
businesses as investment. Because of Sharia restriction, the Rab ul Mal becomes a
shareholder in the organization. Sharia laws impose an obligation on the individual or
organization making the investment to ensure the money will be used only for moral
purposes. But in conventional banking there is no restriction like this. The
requirement, however, does preclude investing in firms involved with alcohol
production, defence, the production of pork products, gambling, or pornography as
defined under Sharia interpretations.

Example of Mudarabah

An Islamic bank lends money to a client to finance a factory, for example, in

return for which the bank will get a specified percentage of the net profit every year
for a designated period. This share of profit provides for repayment of the principle
and a profit for the bank to pass on to depositors, its depositors and borrower will
jointly absorb the losses of the factory. Thus sharia law that provider and user of
capital should share risk and rewards is fulfilled.

A Substitute Product of Joint Ventures

In Arabic, the word Musharakah means sharing. There are a number of rules
in Sharıa regarding partnership contracts, the rights and obligations of parties, and
rules for sharing profits and losses. In terms of business we can classify Musharakah
contract as joint ventures in which the business operator and the capital provider
jointly supply capital, in which profits is shared on an agreed ratio and losses are
divided according to the capital contributions. This concept is different from fixed
income investing, and it is an ideal alternative for the interest based financing with far
reaching effects on production and supply. Capital provider can subsequently sell the
equity ownership for a profit or can even hold the equity stake in the firm and receive
a portion of the profits.

In conventional banking interest predetermines a fixed rate of return on a loan

in advance irrespective of the loss suffered by the debtor, but Musharakah does not
ensure a fixed rate of return. The return in Musharakah is based on real profit earned
by the joint venture. The financer in conventional banking can not suffer losses, while
in Musharakah financer can suffer loss if the joint venture fails. Islam has forbidden
interest as it results in injustice either to the creditor or debtor.

In Surah Al Imran, Allah says,

“O believers, take not doubled and redoubled riba,

and fear God so that you may prosper. Fear the fire
which has been prepared for those who reject faith,
and obey God and the Prophet so that you may
receive mercy”. (Surah Al 'Imran, verses 130-2)

There is no doubt that the Musharaka contract is one of the most popular
financial tools in Islamic finance industry. It avoids the above mentioned sicknesses
of the conventional economy.
MURABAHA H (Cost Plus)

A Substitute Product of Mortgage

Murabahah is not a loan on interest. It is a sale of a commodity for a deferred

price which includes an agreed profit added to the cost. Simply one can define
Murabahah as a cost plus contract, where the seller reveals the costs of the good & a
mark-up to the buyer. A customer identifies a house, which the bank purchases at a
certain price, for example. The bank will then sell the house to the customer at the
price they purchased the house plus a certain amount of mark-up, which can be paid
back in instalments.

Murabahah can not be used as a mode of financing except where the client
needs funds to actually purchase some commodities. For example cotton as a raw
material for ginning factory, import of goods or house. The financer must have owned
this commodity before he sells it to his client. This means bank can also use
Murabahah as a financing technique.

In Murabahah there is a meaningful connection between the credit service and

unique transfer of goods from a third party to customer, where the time value of
money is recognized, conventional banks, by way of contrast, need not have any
connection with any economic or legal event between financer and buyer undertaking
to pay.

Similarly, mortgage by the conventional banks is a security interest in real

property held by a lender as a security for a debt, usually a loan of money. Islamic
bank can not get any additional charge on late payments, and the asset remains in the
ownership of bank until the loan is fully paid, but in conventional banking they charge
in case of late payments

The following criteria are used when calculating the price that the client has to
pay and monthly instalments that are be required to make throughout the mortgage

• Length of the Murabaha mortgage term.

• Balance due to the property after the down payment (usually at least 20%) has
been paid.
• Expected return on investment over the Murabaha term.


A Substitute Product of Insurance

Being a Muslim it is our believe that everything that happens is by the will of
Allah swt. Similarly any accident or misfortune that befalls us (resulting in losses) is
by the will of Allah. Insurance means to reduce the risk of loss due to misfortunes or
accidents. In this modern world the way to reduce the losses is through insurance.
Thus, Conventional insurance involves the elements of uncertainty, gambling and
Riba that is why conventional insurance is Haram as agreed by most Islamic scholars.
It is generally accepted by Muslim Jurists that the operation of conventional insurance
does not conform to the rules of Shariah.

Islam focuses on to reduce the risk first, for example, during the Hijrah,
Prophet (PBUH) went to hide the caves first instead of going straight to Madina. He
asked the companions to migrate to Madina by batches instead of one big group. This
was to reduce the risk of theft. Similarly when Prophet (PBUH) went to war, he put
on his armour instead of wearing light cloths. This means Islam teaches to reduce the
risk not gambling or uncertainty.

Takaful is an Arabic word which means guaranteeing each other or joint

guarantee. Tabarru (donation, gift or contribution) is the main core of the takaful
system making it free from uncertainty and gambling.

Takaful is considered as cooperative insurance where members contribute a

certain sum of money to a common pool. Participants who need protection must be
there with the sincere intention to donate to other participants who are facing
difficulties. Therefore, Islamic insurance exists where each participant contributes
into a fund that is used to support other, with each participant contributing sufficient
amounts to cover expected claims.
The objective of takaful is not profit but to pay a loss by using a defined fund
under the principle,

“Bear one another’s burden”

Takaful teaches brotherhood, unity and mutual corporation. The principles of

Takaful are following,

• Policyholders cooperate with each other for their common good.

• Every policyholder donates to help those who need assistance.
• Losses are divided and liabilities spread according to the community pooling
• Uncertainty is eliminated in respect of donation and compensation.
• No one derives advantage at the cost of others.
IJARAH (Islamic Leasing/ Sale)

A Substitute Product of Lease

Ijarah means to give something on rent. So Ijarah is based on the concept of

asset rental. Under this concept, the Banks make available to the customer the
use of service of assets or equipments such as plant, machinery, property,
ships, aircrafts, computers, motor vehicles, heavy machinery, and other
fixed assets for a fixed period of time and at fixed price. Any payment based
on interest (Riba), late fees or interim rent are not allowed in Ijarah. Ijarah
gives rights to the lessee to access the equipment on payment of the first
installment. This is important as it is the access and use but not ownership of
equipment that generates income.

In conventional leasing leaser will receive rent even if the lessee could not
obtain any benefit from the leased item. Since the lesser, in an Islamic lease
(ijarah) bears all ownership responsibilities, in the event of loses without the
lessee’s fault or his negligence, the leaser helps the lessee in the form of rent
discontinues. In conventional leasing the leaser is a passive financer who
transfers all responsibilities of maintenance etc to the lessee, but in Ijarah
leaser retains the responsibility of major maintenance.

Ijarah is validated by the Quran and Sunnah. Several verses are found in the
Quran (Alkahf, 77; Alqasas, 26; Altalaq, 65-6) on the worker’s entitlement to a wage.
Prophet (PBUH) advised to the employer,

“Pay the employee his wages before his sweat dries up”

Ijarah Wa Iqtina

A type of leasing similar to the Ijarah, in which business owner is committed

to buy the equipments at the end of the lease period. Fees previously paid constitute
the purchase price. This type of lease is commonly used for home financing.
Shariah Rules for Ijarah

• Make sure that Ijarah asset is fully identified by the parties.

• The subject of Ijarah should have a valuable use. Things having no usufruct at
all can not be given on Ijarah.
• In Ijarah contract it is necessary that property remains in the ownership of the
seller. So Ijarah contract can not be used in respect of money, eatables and fuel
etc. because their use is not possible unless they are consumed.
• The period of Ijarah must be determined at the time of contract in clear terms.
• Lessee can not use the asset leased through Ijarah for any purpose other than
the purpose specified in the Ijarah agreement.
• The lessee is liable to compensate the leaser for any harm to the Ijarah asset
caused by any misuse or negligence.
• Leaser should compensate lessee in case of natural damages or losses (It does
not happens in conventional leasing).
• A property owned by two or more persons can be given on Ijarah contract, and
the rent shall be distributed between all owners according to the proportion of
their respective shares in the property.
SUKUK (Islamic Bonds)
AAOIFI (Accounting and Auditing Organization for Islamic Financial
Institutions) defined sukuk as,

“Certificates of equal value representing after closing

subscription, receipt of the value of the certificate and putting
it to use as planned, common title to shares and rights in
tangible assets, usufructs and services or equity of a given
project or equity of special investment activity”.

Sukuk is the Arabic name for a financial certificate, but commonly refers to
the Islamic equivalent of bond. Evidences show sukuk bonds were used in early days
of Islam for transferring financial obligations in trade and other commercial
businesses. Sukuk securities are structured to comply with the Islamic law and its
investment principles, which prohibit the charging, or paying of interest. A
conventional bond on the other hand involves Riba so it is not permitted. Sukuk has
the advantage of competitive pricing over the conventional bonds, as a risk mitigation

Conventional bond is a contractual debt obligation where the issuer is

contractually obliged to pay to the bond holder on certain specified dates, interest and
principal. Conventional bonds guarantee the return of principal when redeemed at
maturity, regardless weather the enterprise was in profit or loss. Without any
ownership, regular interest payments are made to the bond holder, which is unjust.

Sukuk represents the ownership of an asset or its usufruct, the claim involved
in sukuk is not simply the claim of cash flow but an ownership claim as well.
Conventional bonds are just interest bearing securities. But sukuk holders claim an
undivided beneficial ownership in underlying asset, as well as they are entitled to
share in the revenues generated by the sukuk assets.

Sukuk may be issued on existing as well as specific assets that may become
available in the future. Sukuk can be structured alongside different techniques. While
a conventional bond is a promise to repay a loan, Sukuk constitutes partial ownership
in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna),
business (Sukuk Al Musharaka), or investment (Sukuk Al Istithmar). The most
acceptable structure which is tradable, is the Sukuk Al Ijara.

Benefits of Sukuk

• Best way of financing large enterprises that are beyond the ability of single
party to finance.
• Ideal means for the investors seeking to deploy streams of capital and who
require at the same time, the ability to liquidate their position with ease
whenever they need should arise.
• Excellent way of managing liquidity for banks and Islamic financial
institutions. When they are in need of disposing of excess liquidity they may
purchase sukuk, and voice versa.
• Means for the equitable distribution of wealth, as sukuks allow all the
investors to benefit from the true profit resulting from the enterprise in equal

A substitute product for Forward Contract

Holly Prophet (PBUH) has permitted a trade, where the price of a well defined
object is paid in full at the time of agreement, and which is delivered after a specified
period of time. This advance payment of the price allows the farmers to buy seeds,
spend for their own sustenance, etc. Salam contracts are considered to be one of the
most important means provided by the Islamic financial system as an alternative to
loaning or financing.

The word Salam means, to hand over or deliver. In my own opinion, the term
Salam can be defined as,

“A contract for the guaranteed delivery of items purchased at an

agreed price with full payment at the time of the contracts signing. It
is necessary that the quality of the commodity intended to be
purchased is fully specified leaving no ambiguity to avoid any dispute
in future”.

Partial payment is not allowed as it would mean the use of credit which is
prohibited in this context. Full payment eliminates in a way the element of Gharar on
the side of the buyer. The objects of this sale are goods and cannot be gold, silver, or
currencies based on these metals. Salam covers almost everything that is capable of
being definitely described as to quantity, quality, time and place the goods are to be

In counterpart of salam named forward contract, the riba is the core part. Party
(buyer) who pays in advance gets a specified percentage of interest regardless of the
economic position of the other party, and it is not acceptable in Islam. Salam is the
future delivery of the commodity at lower cost. Salam addresses the necessity of the
liquidity and protection of the rights of the buyer, and it removes the liquidity
Shariah rules for Salam

• The asset must exist

• The sale of salam can be effected only in respect of those things which can
be determined by specification. Things which differ in quality from piece to
piece cannot be sold on salam basis.
• The payment of the purchase price should be made at the time signing salam
contact and should be in cash.
• Specifications of items should be agreed, for example quality, quantity etc.
• Both parties should agree for time and place of delivery.
• The commodity sold must be available in the market place throughout the
period of salam.
• Delivery period should not be less than one month.
• The buyer cannot sell the commodity to another person unless he takes
delivery from the seller.

QARD HASSAN (Good or Benevolent Loan)

A substitute product for loans

It can be defined as

"A loan which is returned at the end of the agreed period without
any interest or share in the profit or loss of the business."

Qard is derived from Arabic word qirad which means to deduct. In financial
terms it means to cut a certain part of the money by giving loan to the borrower.
Hasan is also derived from an Arabic word ihsan which means kindness to others.
Thus the term qard hasan means beneficial or benevolent loan, interest free loan or
good loan etc.

So, Qard Hasan is a kind of good loan given to the needy people for a fixed
period of time without interest or share in profit. The receiver of this is only required
to repay the original amount of the loan. On the other hand conventional loans are
given at a specified annual percentage ratio (APR), which the borrower has to pay
even if his purpose of borrowing is failed.


Islamic finance is fundamentally different from the conventional banking in its

prohibition of usury as a basic principle. Islam encourages all parties in a financial
transaction to share the risk and profit or loss of the businesses. Practitioners need to
understand Islamic banking products in order to be able to provide the services
demanded by consumers.
Sharia promotes justice and fairness in financial transactions as well as equity
and care for others are the basic of the finance system. Financial intermediation is
possible with out interest; Islamic finance offers a number of ways (Mudarabah,
Musharakah and Murbahah) in which funds accepted by the intermediary on the basis
of profit sharing can be profitably invested. Interest free loans (Qard Hasan) and
concept of takaful insurance can result in a just system, brotherhood and mutual
coopration in the society.
Understanding Islamic banking products is essential from a financial stability
perspective, as Islamic banks may become systemically relevant as they grow and
increasingly interact with important conventional banks.

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