Islamic Finance & Its Needs

Chapter 1 Introduction to Islamic banking

History Of Islamic Banking / Finance & Its Origin 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 economic concepts and techniques were applied 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) transactional accounts, loaning, ledgers and assignments. Organizational enterprises 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. The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions. Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each

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Islamic Finance & Its Needs shared in a pre-determined share of the profits. If there was a loss, the capitalprovider lost his money and the manager lost his time and labour. What is Islamic Banking / Finance? Islamic finance or banking refers to a system of banking or banking activity or financing activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasise 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 considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims. 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 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 arguably, their original state has been altered over the centuries. The principle source of the Shari¶ah is The Qur¶an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) ± the Hadith. 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. It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

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Islamic Finance & Its Needs The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and principles of Islam. Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations. Riba The word "Riba" means excess, increase or addition, which according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial." During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself (ex natura sua) made no logical sense as its value remained constant relative to all other materials: these metals could be added to but not created (from nothing). Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, the question of "paying a debt in a higher number of units of this fiat money being riba" was not relevant as the jurists only needed to be concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight). Rules Of Permissibility Muslims believe that all things have been provided by God, and the benefits derived from them, are essentially for man¶s use, and so are permissible except what is expressly prohibited in The Qur¶an or Hadith. When guidance is not clearly
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Islamic Finance & Its Needs given in he Qur¶an there are several other sources of law. For example, guidance can be sought from Fiqh, which means µunderstanding¶ and is the science of jurisprudence: the science of human intelligence, debate and discussion. Prohibition Of Interest Riba best translated today as the charging of any interest, meaning money earned on the lending out of money itself. The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. Interest can leads to injustice and exploitation in society; The Qur¶an (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice) There is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn a profit-share or purely fee-based remuneration. In order for an Islamic bank to earn a return on money lent, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset. This requires the lender to also participate in the sharing of risk. Individuals and the world as a whole probably know too well the burden of interest and misery and suffering that irresponsible lenders have inflicted on individuals and societies. It has become so completely institutionalized and accepted in modern economies that it is almost impossible to conceive that there are some who completely oppose it and refuse to enter into any transactions that involve interest. Islam's prohibition of interest and usury was not unprecedented. The early Jewish and Christian traditions also forbade riba. Even the renowned Greek philosopher, Aristotle, condemned acquiring of wealth by the practice of charging interest on money. ³Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange;
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Islamic Finance & Its Needs interest represents an increase in the money itself. Hence of all ways of getting wealth, this is the most contrary to nature." Aristotle, The Politics, tr. Sinclair, pg. 46, Penguin ³Do not charge your brother interest, whether on money or food or anything else that may earn interest.´ (Deuteronomy 23:19) ³If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest.´ The Holy Bible (American Standard Bible) [Jesus said], ³If you have money, do not lend it at interest, but give [it] to one from whom you will not get it back.´ Gospel St Thomas, V95.

Prohibition Of Interest Different Religions Prohibition In Islam: The word ³Riba´ is used in the Holy Quran 8 times. In 30:39,4:161,3:130, 2:276,2:278 and 3 times in 2:275. The Quran says ³Those who devour usury will not stand except as stand 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. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (The offence) are companions of the Fire: They will abide therein (for ever).´ (Quran 2:275) ³O ye who believe! Devour not usury, doubled and multiplied; but fear Allah. that ye may (really) prosper.´ (Quran 3:130) ³O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not, Take notice of war from Allah and

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Islamic Finance & Its Needs His Messenger. But if ye turn back, ye shall have your capital sums: Deal not unjustly, and ye shall not be dealt with unjustly.´ (Quran 2:278-279) If you are dealing in interest. Please do not expect angels to come down with swords to wage a war against you. It is talking about the severity of the sin. For other sins like alcohol, gambling etc. the Quran says ³O ye who believe! Intoxicants and gambling, (dedication of) stones, and (divination by) arrows, are an abomination,- of Satan's handwork: eschew such (abomination), that ye may prosper.´ (Quran 5:90) Prohibition In The Bible: ³Do not charge your brother interest, whether on money or food or anything else that may earn interest.´ (Deuteronomy 23:19) ³Do not take interest of any kind from him, but fear your God, so that your countryman may continue to live among you.´ (Leviticus 25:36) ³If you lend money to one of my people among you who is needy, do not be like a moneylender; charge him no interest´ (Exodus 22:25) Righteous servant of God doesn¶t take interest "Suppose there is a righteous man who does what is just and right. He does not eat at the mountain shrines or look to the idols of the house of Israel. He does not defile his neighbor's wife or lie with a woman during her period. He does not oppress anyone, but returns what he took in pledge for a loan. He does not commit robbery but gives his food to the hungry and provides clothing for the naked. He does not lend at usury or take excessive interest. He withholds his hand from doing wrong and judges fairly between man and man. He follows my decrees and faithfully keeps my laws. That man is righteous; he will surely live, declares the Sovereign LORD. (Ezekiel 18:5-9) But the violent one will take it

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Islamic Finance & Its Needs "Suppose he has a violent son, who sheds blood or does any of these other things (though the father has done none of them): "He eats at the mountain shrines. He defiles his neighbor's wife. He oppresses the poor and needy. He commits robbery. He does not return what he took in pledge. He looks to the idols. He does detestable things. He lends at usury and takes excessive interest. Will such a man live? He will not! Because he has done all these detestable things, he will surely be put to death and his blood will be on his own head´ (Ezekiel 18:10-13) Jesus Christ (pbuh) came to fulfill the Law. He said: Think not that I am come to destroy the law, or the prophets: I am not come to destroy, but to fulfil. For verily I say unto you, Till heaven and earth pass, one jot or one tittle shall in no wise pass from the law, till all be fulfilled. Whosoever therefore shall break one of these least commandments, and shall teach men so, he shall be called the least in the kingdom of heaven: but whosoever shall do and teach them, the same shall be called great in the kingdom of heaven. For I say unto you, That except your righteousness shall exceed the righteousness of the scribes and Pharisees, ye shall in no case enter into the kingdom of heaven.´ (Mathew 5:17-20) The Hebrew word used for interest/usury in all these verses is neh'-shek: which means: From H5391; interest on a debt: - usury. Hence, islam in not the only religion which prohibits interest taking & lending but it is Christianity also which supports and prohibits interest & its use in any part of life. Wealth And Islam Islam has a unique dispensation on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins wealth creation not for its own sake. The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. The true nature of wealth in Islam requires social preferences and
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Islamic Finance & Its Needs market exchange mechanisms that are ethicised by human consciousness of the Moral Law. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. They point out how individual preferences on wealth formation ought to be utilised within the social meaning. According to Shaikh Yusuf Talal DeLorenzo, well-known and respected Shari¶ah advisor and Islamic scholar as well as also author of the three volume ³Compendium of Legal Opinions on the Operations of Islamic Banks´ the first English reference on the fatwa (religious ruling) issued and published by the Institute, business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari¶ah on proper transacting is that Islam accords great importance to the economic welfare of society. Modern Justifications For Interest Modern economists have developed many arguments to justify interest. One argument is that interest is the reward for saving; a compensation that the creditor pays the debtor for the latter's temporary loss of the use of capital. Another is that interest is the payment for the loss in value of money due to inflation. The goods the saver wants will cost more in the future, so he is justified in charging a rent for the use of his loan. John Maynard Keynes (1883-1946) argued that money is the most liquid of assets, that is to say, it is the asset most readily exchangeable for other forms of assets and that interest is the price paid for loss of liquidity.

The theory that interest protects savings from inflation neither explains why the rate of interest is, nevertheless, always above the rate of inflation, nor does it question the proposition that inflation is the cause of interest. Nor do these theories answer the question as to why interest should be the market regulator for the supply and demand of money. Why should interest be paid for one's postponement of enjoyment of present goods, or paid for abstaining from diminishing one's
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Islamic Finance & Its Needs present capital, which would otherwise be diminished by the ravages of time and consumption?

Chapter 2 Islamic Financial Transaction Terminologies

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Islamic Finance & Its Needs Bai' Al 'Inah (Sale And Buy-Back Agreement) Bai' al inah is a financing facility with the underlying buy and sell transactions between the financier and the customer. The financier buys an asset from the customer on spot basis. The price paid by the financier constitutes the disbursement under the facility. Subsequently the asset is sold to the customer on a deferred-payment basis and the price is payable in instalments. The second sale serves to create the obligation on the part of the customer under the facility. There are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah, however this is practised in Malaysia and the like jurisdictions. Bai' Bithaman Ajil (Deferred Payment Sale) This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. Like Bai' al 'inah, this concept is also used under an Islamic financing facility. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan. The problem here is that this includes linking two transactions in one which is forbidden in islam. The common perception is that this is simply straightforward charging of interest disguised as a sale. Bai' Muajjal (Credit Sale) Literally bai' muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Bai' muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed.

Musharakah Musharakah (joint venture) is an agreement between two or more partners, whereby each partner provides funds to be used in a venture. Profits made are shared between the partners according to the invested capital. In case of loss, each
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Islamic Finance & Its Needs partner loses capital in the same ratio. If the Bank provides capital, the same conditions apply. It is this financial risk, according to the Shariah, that justifies the bank's claim to part of the profit. Each partner may or may not participate in carrying out the business. A working partner gets a greater profit share compared to a sleeping (non-working) partner. The difference between Musharaka and Madharaba is that, in Musharaka, each partner contributes some capital, whereas in Madharaba, one partner, e.g. a financial institution, provides all the capital and the other partner, the entrepreneur, provides no capital. Note that Musharaka and Madharaba commonly overlap. Mudarabah "Mudarabah" is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called "rabb-ul-mal", while the management and work is an exclusive responsibility of the other, who is called "mudarib". The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. Compared to Musharaka, in a Mudaraba only the lender of the money has to take losses. Murabahah This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores.

Musawamah
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Islamic Finance & Its Needs Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce. Bai Salam Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship. Basic Features And Conditions Of Salam 1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. If the price were not paid in full, the basic purpose of the transaction would have been defeated. Muslim jurists are unanimous in their opinion that full payment of the purchase price is key for Salam to exist. Imam Malik is also of the opinion that the seller may defer accepting the funds from the buyer for two or three days, but this delay should not form part of the agreement. 2. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. For example, precious stones cannot be sold on the basis of salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible. 3. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the

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

4.

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6. 7.

Hibah (Gift) This is a token given voluntarily by a debtor to a creditor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities. It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion, and cannot be 'guaranteed.' However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.

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Islamic Finance & Its Needs

Ijarah Ijarah means lease, rent or wage. Generally, Ijarah concept means selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price. Advantages Of Ijarah Ijarah provides the following advantages to the Lessee: Ijarah conserves the Lessee' capital since it allows up to 100% financing. Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This is important as it is the access and use (and not ownership) of equipment that generates income. Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible terms Ijarah is not considered Debt Financing so it does not appear on the Lessee' Balance Sheet as a Liability. This method of "off-balance-sheet" financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating. All payments towards Ijarah contracts are treated as operating expenses and are therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations. Many types of equipment (i.e computers) become obsolete before the end of their actual economic life. Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange for a higher lease rate. This higher rate can be viewed as insurance against obsolescence. If the equipment is used for a relatively short period of time, it may be more profitable to lease than to buy.

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Islamic Finance & Its Needs If the equipment is used for a long period but has a very poor resale value, leasing avoids having to account for and depreciate the equipment under normal accounting principles.

Ijarah Thumma Al Bai' (Hire Purchase) Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price. The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law. Ijarah-Wal-Iqtina A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease. Qard Hassan/ Qardul Hassan (Good Loan/Benevolent Loan)
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Islamic Finance & Its Needs This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money. Takaful (Islamic Insurance) Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

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Islamic Finance & Its Needs

Chapter 3 Basis of Islamic Banking

Islamic Banking Principles The Shari¶ah prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars covers any excess in financial dealings, usury or interest) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community. "While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam. "The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New
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Islamic Finance & Its Needs Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens - ranging from the equitable distribution of wealth through to man's fundamental right to work - is clearly present in modern Islamic society. "Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997) After discussing the different principles of Islamic banking, this is an attempt to explore the feasibility of Sharia banking in India. The rise of ³interest´ as a blood sapping social evil is alarming. To get rid of this menace and save the nation from the clutches of interest, suitable amendments should be made in the Banking Act. Indira Gandhi¶s slogan, ³Garibi Hatao´ and ³Roti,Kapda Aur Makaan´ as enunciated by Zulfikar Ali Bhutto are still relevant today as it was in the early seventies. Yet even today, horrendous disparities exist between different segments of the Indian society. The majority of the unorganized sector; workers, semi-skilled persons, small farmers are all non-bankable. .Access to finance by the poor and the vulnerable groups is a prerequisite for poverty reduction and social cohesion. Such ³financial apartheid" is one of the main causes of exclusion of the majority of the population in terms of growth. Government must provide the disadvantaged classes with the tools they need to improve their condition.The Indian banking sector has opened up considerably in the past decade or so and openness to interest-free banks is a logical next step. Islamic banking is one way to ameliorate the disadvantaged classes. The potential benefits of allowing Islamic banking include; decreased economic disparity between the haves and the have nots, better integration, and consequently accelerated economic growth. Government of India can leap a step closer towards the fulfillment of Indira Gandhi¶s much cherished dream of ³Garibi Hatao´ by reforming its banking sector and allowing the establishment of Islamic Banks. Theoretical Basis For Islamic Banking

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Islamic Finance & Its Needs A popular belief persists that Islamic banking is simply an interest-free financial structure. But, in fact, Islamic economics is a complete system of social and economic justice. It deals with property rights, the incentive system, the allocation of resources, economic freedom and decision-making and the proper role of government. Western bankers have said that savings and investments would soon dry up if interest were not paid. But this is due to identifying "rate of interest" and "rate of return". The Qur'an says: "God has permitted trade, but forbidden riba (interest)´ (2:275). Therefore it is only the fixed, or predetermined, return on savings or transactions that is forbidden, not an uncertain rate of return, such as the making of profit. Basis Of Islamic Banking In order to be Islamic, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law. Another Islamic principle is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks. Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways: 1. Debt-financing (the western loan system). The businessman borrows the capital from the capital-owner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction.

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Islamic Finance & Its Needs 2. Mudarabah (the Islamic way, or PLS). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capitalowner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a preagreed share of the profit. The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah. There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship: (i)Both parties agree on the ratio in which profits will be shared between them. (ii) The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort. (iii) Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work. Mudarabah is the basis of modern Islamic banking on a two-tier basis.

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Islamic Finance & Its Needs 1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds. 2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager. Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views true profit as a return for entrepreneurial effort and objects to money being placed on a pedestal above labour, the other factor in production. As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely nominal share based on the prevailing interest rate. Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit. The records of banks that have been involved in PLS show that they have usually provided higher returns to their depositors than those who have used such transitory instruments as cost-plus and leasing. PLS is thus the real goal of Islamic banking.

Chapter 4 Swot Analysis

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Islamic Finance & Its Needs To get a clear picture, let us analyze the position of Islamic banking in India on SWOT (Strength, Weakness, Opportunity and Threat) Scale. SWOT analysis will help us to logically examine the chances if this concept would flourish or flounder in India. Strength Islamic Banking will unequivocally ameliorate the deplorable condition of the poor and marginalized segments of society. Banking products which comply with Islamic law are becoming increasingly popular, not only in the Gulf countries and far eastern states like Malaysia, but also in other developed markets such as the United Kingdom. Reputed banks like Standard Chartered, Citibank, HBSC are operating interest free windows in several West Asian countries, Europe and USA. There is a huge potential market in India for Islamic banking products. We have seen the fall of giants in the world of financial sector like Lehman Brothers in the aftermath of the US sub-prime mortgage crisis. Therefore, it is of paramount importance to be strict about credit rating system, to circumvent any chance of further bankruptcy. Since Islamic banking adheres to strict credit rating system and prohibits indebted economic agents to avail more debt finance, it could save our financial and economic enterprises from bankruptcy. Interest is strictly proscribed in Islamic banking. Principles of equity finance abhor financing the indebted enterprises thereby arresting the chances of bankruptcy to great extends. Under Islamic banking, equity finance needs cost yield and pre-rating analysis of projects. It thus considerably subdues the mindless competition in financial sector to get more credit shares and tends to provide stability in the financial market. Islamic banks are unaffected by the subprime mortgage crisis. In fact, now many non-Muslim countries are turning up to Islamic banking as they are immune against such crisis due to inherent business ethics within Islamic banking. Moreover, Islamic banking helps the weaker and hapless section of the society through various financial products. Islamic banking finances (through its Joint ventures,partnerships and leasing)are provided by investors or banks to the borrowers with a condition that financial risk is to be borne by the investors, and other risks to be borne by the borrower. This helps even the indigent and vulnerable to get finance at a no risk and cost basis, but definitely requires other credits like strong business proposal, rational planning, skilled hands and specialized art to attract the financier. Better business proposals succeed in fetching funds as opposed to the projects with comparatively poor propositions. Such inclusive growth will aggrandize the Indian economy.

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Islamic Finance & Its Needs A bank in India cannot raise deposits without promising a specified rate of return to depositors, but under Sharia, returns can only be determined post-facto depending on profit. Also banks have to maintain a Statutory Liquidity Ratio (SLR), which involves locking up a substantial portion of funds either as cash, gold or in government securities. Such cash will not get any return, keeping it in gold is risky as it could depreciate and government securities come with interest.Moreover, Islamic banking can eliminate unaccountable economic activities, as every economic activity has to be financed through legal contract and physical verification of real assets under contract. There is no room for diversion of funds. Therefore, investment in consonance with Islamic banking principles will surely boost the engine of economic growth in our country. The high powered Raghuram Rajan Committee draft Report as released on 7th April 2008, strongly suggested interest-free banking as a part of recommendations made for financial sector reforms. The Committee postulates that interest free banking is another area that falls broadly in the ambit of financial infrastructure.Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region. While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.

Weakness Indian banking laws do not explicitly prohibit Islamic banking but there are provisions that make Islamic banking almost an unviable option. The financial institutions in India comprises of Banks and Non Banking Financial Institutions.
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Islamic Finance & Its Needs Banks in India are governed through Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiable Instruments Act 1881, and Co-operative Societies Act 1961. Certain provisions regarding this are mentioned below
y

y

y

y

Section 5 (b) and 5 (c) of the Banking Regulation Act, 1949 prohibit the banks to invest on Profit Loss Sharing basis -the very basis of Islamic banking. Section 8 of the Banking Regulations Act (BR Act, 1949) reads, ³No banking company shall directly or indirectly deal in buying or selling or bartering of goods«´ Section 9 of the Banking Regulations Act prohibits bank to use any sort of immovable property apart from private use ±this is against Ijarah for home finance Section 21 of the Banking Regulations Act requires payment of Interest which is against Sharia.

As regards to partnership by Islamic banks in a firm, the bank has to make sure that the manager does not avoid his responsibilities or obtain other non-pecuniary benefits at the expense of non-participating partners and ensure the veracity of the profit statements. Monitoring of data about firms in which Islamic bank invests would involve exorbitant cost. However, Islamic banks need to set up monitoring cell to keep them informed of the internal function of their joint venture. The implication is that banks and entrepreneur have to function very closely. Islamic banking needs to introduce corporate governance with transparent accounting standards. It needs to perform detailed evaluation before embarking Profit Loss Sharing Scheme, which demand a pool of highly trained professionals. The imparting of professional training is costly. Detailed principles are still to be laid down and techniques and procedures evolved to carry them out. It is only after the satisfactory achievement of these that proper training can begin. It is observed that inability to evaluate a projects¶ profitability has tended to act against investment financing. Some borrowers frustrate the banks appraisal efforts as they are reluctant to provide full disclosures of their business. These exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank. Yet, widely acceptable and reliable techniques are yet to be devised.Moreover, the borrowers do not observe business ethics which make it difficult to establish close bank-clientele relationship - a condition for

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Islamic Finance & Its Needs successful Islamic banking. Adverse selection has been one of the major impediments in the world of Islamic banking. Among the other disincentives from the borrower¶s point of view are the need to disclose his accounts to the bank if he were to borrow on the Profit Loss Sharing basis. However, many small-time businessmen do not keep any accounts, leave alone proper accounts. And large conglomerates do not like to disclose their real accounts to anybody. The widespread lack of business ethics among certain business community will be another major hurdle in the path of Islamic banking in India. The practices in use by the Islamic banks have evoked questions of morality. Some critics view Sukuk(Islamic Bond) as unIslamic in nature. Others criticize that financing through the purchase of client¶s property with a buy-back agreement and sale of goods to clients on a mark-up, involved the least risk and are closest to the old interest-based operations. Bai¶ mu¶ajjal (sale with deferred payment) and Murabaha (cost-plus financing) are permitted in the Sharia under certain conditions.What is being done in many countries are fictitious deals which ensure a predetermined profit to the bank without actually dealing in goods or sharing any real risk. This is against the letter and spirit of Sharia. Opportunity India with a 15% Muslim population, the highest in a non-Islamic country and second highest in the world offers huge opportunities to exploit . The size of the market will be very large as the Indian population is above 100 crore and Muslim population itself is about 15 crore and majority of them, in the name of religious faith, are looking for interest free banking and finance. It is pertinent to mention here that Islamic banking is not meant for Muslims only but non Muslims may also avail the benefit of it. And it is feasible to have a parallel banking system based on Sharia along with a conventional one. After 9/11, most of these countries started pulling out their investments from the US and Europe because of the fear of freezing of assets. Another reason could be the slowdown in the economies of western countries. A growing Indian economy has created a huge enthusiasm among Islamic nations as it sees the unlimited opportunities it can avail. In fact, five Indian companies, Reliance Industries, Infosys Technologies, Wipro, Tata Motors and Satyam Computer Services figure in the Standard & Poor¶s BRIC Sharia Index.

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Islamic Finance & Its Needs Eleventh Five Year Plan envisages inclusive growth with development in all sectors of economy. Islamic banking is an effective mechanism to subjugate the liquidity and inflation problems along with allowing inclusive growth. For real inclusive growth, we have to ensure increase in income and employment status of workers in all segments. If Islamic banking is introduced, the inadequate labor capital ratio, for informal sector workers associated with agriculture and manufacturing industries could be resolved through equity finance, which might be a revolution in our agriculture and unorganized sector. With improved labor capital ratio, our vulnerable workers associated with agriculture and unorganized sector might be able to compete effectively with the formal sector workers. Thus Islamic Banking may financially empower majority of Indian workers. Islamic banking may induce our political leaders to substitute grants and subsidies with equity finance schemes through specialized financial institutions because equity finance allows access to credit without debts of borrowers. Equity Finance helps achieve self-reliability which never comes through grant and subsidies. Islamic banking should not be a religion based banking business, but could be profitably used to resolve our issues pertaining to economy. Moreover with introduction of Islamic banking, Indian government will certainly gain diplomatic advantages to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from the gulf countries. This is more important after the fall of the titans like Lehman Brothers because it reflects the economic downturn in the west and the need of alternative sources of FDI for the Indian economy. India needs to provide a congenial economic environment to attract the financial inducement from the Gulf region. Islamic scholars have defined market instruments in length and they have permitted with some conditions to have investments in stock market .Certain broad criteria are:
y

y

The company¶s activities should not include liquor, pork, hotel, casino, gambling, cinema, music, interest bearing financial institutions, conventional insurance companies, etc. The total interest bearing debt of the company at any point in time should remain below one third of its average market capitalization during the last twelve months.

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Islamic Finance & Its Needs
y y

Its aggregate of account receivables should remain below 45% of total assets. If company has any interest bearing income it should not be more than 10% in any condition.

While Sharia compliant investment avenues are now becoming available in most countries, India has not seen large-scale development. To estimate the scope of Islamic investment opportunities in the Indian stock market, it is imperative to examine stocks that conform to Islamic Shariah principles "Out of 6,000 BSE listed companies, approximately 4,200 are Sharia compliant. The market capitalization of these stocks accounts for approximately 61% of the total market capitalization of companies listed on BSE. This figure is higher even when compared with a number of predominantly Islamic countries such as Malaysia, Pakistan and Bahrain. In fact, the growth in the market capitalization of these stocks was more impressive than that of the non-Sharia compliant stocks. The software, drugs and pharmaceuticals and automobile ancillaries sector were the largest sectors among the Sharia compliant stocks. They constitute about 36% of the total Sharia compliant stocks on NSE. Further on examining the BSE 500 the market capitalization of the 321 Sharia compliant companies hovered between 48% and 50% of the total BSE 500 market capitalization.´(Source: www.islamicequity.co.in) Another opportunity is mutual fund which is based on 100% equity. These funds are invested in different sectors like IT, automobile telecommunication, cement. In fact, Tata Mutual Fund made a pioneering attempt when, at the instance of the Barkat and some other Islamic financial group, it launched Tata Core Sector Equity Fund in 1996 . This scheme was specially tailored keeping in view the Muslims¶ inhibition of dealing with interest bearing and haram investments. This scheme surprised many by being able to raise Rs. 230 million from the public. Moreover, large number of Muslims who are considered unworthy of credit by commercial banks would welcome Islamic banking. People prefer to put their money in gold or jewellery, which is the worst kind of investment from the economic point of view. Some Islamic societies in India accept deposits and lend money, but can't make a business out of it because of the Sharia's prohibition of interest. And they are not able to convert themselves into banks because the government will not permit any form of banking without interest. Some of them have collected crores in interest-free deposits, but they do not have any avenue to invest that money.

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Islamic Finance & Its Needs Threats Islamic banking could be a huge political issue. Certain parties might abhor the use of the word ³Islamic´ and could term it as anti-Indian. They might argue that the very concept of Sharia banking would go against the secular fabric of our country. We are already facing problems pertaining to Muslim Personnel Law and trying to implement Uniform Civil Code. Therefore, at this juncture, if we introduce Islamic banking in India, it will create more problems than solving the issue. Moreover, it may bring financial segregation in the economy. The compartmentalization of Sharia compliant and Non Sharia Compliant banking might be used by certain vested interest to communalize the finance sector in India. Such questionably sane but unquestionably dangerous trend must be prevented with full might.

Chapter 5 Traditional & modern islamic banking

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Islamic Finance & Its Needs Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at a low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the ³foreign´ banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion. With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. Local banks were established on the same lines as the interest-based foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. As countries became independent the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it. This state of affairs drew the attention and concern of Muslim intellectuals. The story of interest-free or Islamic banking begins here. In the following paragraphs we will trace this story to date and examine how far and how successfully their concerns have been addressed.

Development Of Islamic Banking It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality -- by private initiative in some countries and by law in others. We will discuss the two periods separately. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems

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Islamic Finance & Its Needs encountered by the existing banks. Interest-Free Banking As An Idea Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961). Muhammad Hamidullah¶s 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha - profit and loss sharing. In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

The Coming Into Being Of Interest-Free Banks 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

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Islamic Finance & Its Needs Finance House. However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the mid-forties4 and another in Pakistan in the late-fifties. Neither survived. In 1962 the Malaysian government set up the ³Pilgrim¶s Management Fund´ to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial. 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 nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg , Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years. In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent µprofit¶ rate depending on the type of economic activity. Interest on deposits was also converted into a µguaranteed minimum profit.¶ In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.

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Islamic Finance & Its Needs The Last Decade The subject matter of writings and conferences in the eighties have changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking: Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference µInto the 1990¶s with Islamic Banking¶ held in London in 1988 belong to this category. The most recent one is the Workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992. Several articles, books and PhD theses have been written on Islamic Banking during this period. Special mention must be made of the work by M. Akram Khan in preparing annotated bibliographies of all published (and some unpublished) works on Islamic Economics (including Islamic Banking) from 1940 and before. It is very useful to students of Islamic Economics and Banking, especially since both English and Urdu works are included (1983, 1991, 1992). M.N. Siddiqi¶s bibliographies include early works in Arabic, English and Urdu (1980, 1988). Turkish literature is found in Sabahuddin Zaim (1980). Current Practices Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank¶s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks. Deposit Accounts All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

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Islamic Finance & Its Needs

Current accounts Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed. Savings accounts Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment account Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed. Modes Of Financing Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorised into three areas: investment, trade and lending. Investment financing This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial

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Islamic Finance & Its Needs period. b) Mudarabha where the bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it. Trade financing This is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis. Lending Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge. Services Other banking services such as money transfers, bill collections, trade in foreign
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Islamic Finance & Its Needs currencies at spot rate etc. where the bank¶s own money is not involved are provided on a commission or charges basis. Shortcomings In Current Practices In the previous section we listed the current practices under three categories: deposits, modes of financing (or acquiring assets) and services. There seems to be no problems as far as banking services are concerned. Islamic banks are able to provide nearly all the services that are available in the conventional banks. The only exception seems to be in the case of letters of credit where there is a possibility for interest involvement. However some solutions have been found for this problem -- mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of deposits both in the countries where both systems are available and in countries where law prohibits any dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem. Customers still seem to deposit their money with interest-free banks. The main problem, both for the banks and for the customers, seem to be in the area of financing. Bank lending is still practised but that is limited to either nocost loans (mainly consumer loans) including overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks¶ main income is to come from and this is also from where the investment account holders are expected to derive their profits from. And the latter is supposed to be the incentive for people to deposit their money with the Islamic banks. And it is precisely in this PLS scheme that the main problems of the Islamic banks lie. Therefore we will look at this system more carefully in the following section. Problems In Implementing The PLS Scheme Several writers have attempted to show, with varying degrees of success, that Islamic Banking based on the concept of profit and loss sharing (PLS) is theoretically superior to conventional banking from different angles. See, for example, Khan and Mirakhor (1987). However from the practical point of view things do not seem that rosy. Our concern here is this latter aspect. In the over half-a-decade of full-scale experience in implementing the PLS scheme the problems have begun to show up. If one goes by the experience of Pakistan as

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Islamic Finance & Its Needs portrayed in the papers presented at the conference held in Islamabad in 1992, the situation is very serious and no satisfactory remedy seems to emerge.13 In the following paragraphs we will try to set down some of the major difficulties. Financing There are four main areas where the Islamic banks find it difficult to finance under the PLS scheme: a) participating in long-term low-yield projects, b) financing the small businessman, c) granting non-participating loans to running businesses, and d) financing government borrowing. Let us examine them in turn. Long-term projects Table 1 shows the term structure of investment by 20 Islamic Banks in 1988. It is clear that less than 10 percent of the total assets goes into medium- and long-term investment. Admittedly, the banks are unable or unwilling to participate in longterm projects. This is a very unsatisfactory situation. Table 1 Term Structure of Investment by 20 Islamic Banks, 1988 Type of Investment Amount* % of Total 4,909.8 68.4 Short-term 64.2 0.9 Social lending 1,498.2 20.9 Real-estate investment 9.8 Medium- and long-term investment 707.7 1. Source: Aggregate balance sheets prepared by the 2. International Association of Islamic Banks, Bahrain, 1988. 3. Quoted in: Ausaf Ahmed (1994). * Unit of currency not given. The main reason of course is the need to participate in the enterprise on a PLS basis which involves time consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have developed the latter and they seem to be averse to the former. There are no commonly accepted criteria for project evaluation based on PLS partnerships. Each single case has to be treated separately with utmost care and each has to be assessed and negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very long periods, unlike in conventional banking where the capital is recovered in regular instalments almost right from the
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Islamic Finance & Its Needs beginning, and the uncertainty and risk are that much higher, b) the longer the maturity of the project the longer it takes to realise the returns and the banks therefore cannot pay a return to their depositors as quick as the conventional banks can. Thus it is no wonder that the banks are averse to such investments. Small businesses Small scale businesses form a major part of a country¶s productive sector. Besides, they form a greater number of the bank¶s clientele. Yet it seems difficult to provide them with the necessary financing under the PLS scheme, even though there is excess liquidity in the banks. The observations of Iqbal and Mirakhor14 is revealing: Given the comprehensive criteria to be followed in granting loans and monitoring their use by banks, small-scale enterprises have, in general encountered greater difficulties in obtaining financing than their large-scale counterparts in the Islamic Republic of Iran. This has been particularly relevant for the construction and service sectors, which have large share in the gross domestic product (GDP). The service sector is made up of many small producers for whom the banking sector has not been able to provide sufficient financing. Many of these small producers, who traditionally were able to obtain interest-based credit facilities on the basis of collateral, are now finding it difficult to raise funds for their operations. Running businesses Running businesses frequently need short-term capital as well as working capital and ready cash for miscellaneous on-the-spot purchases and sundry expenses. This is the daily reality in the business world. Very little thought seems to have been given to this important aspect of the business world¶s requirement. The PLS scheme is not geared to cater to this need. Even if there is complete trust and exchange of information between the bank and the business it is nearly impossible or prohibitively costly to estimate the contribution of such short-term financing on the return of a given business. Neither is the much used mark-up system suitable in this case. It looks unlikely to be able to arrive at general rules to cover all the different situations. Added to this is the delays involved in authorising emergency loans. One staff member of the Bank of Industry and Mines of Iran has commented. Often the clients need to have quick access to fresh funds for the immediate needs

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Islamic Finance & Its Needs to prevent possible delays in the project¶s implementation schedule. According to the set regulations, it is not possible to bridge-finance such requirements and any grant of financial assistance must be made on the basis of the project¶s appraisal to determine type and terms and conditions of the scheme of financing. The enormity of the damage or hindrance caused by the inability to provide financing to this sector will become clear if we realise that running businesses and enterprises are the mainstay of the country¶s very economic survival. Government borrowing In all countries the Government accounts for a major component of the demand for credit -- both short-term and long-term. Unlike business loans these borrowings are not always for investment purposes, nor for investment in productive enterprises. Even when invested in productive enterprises they are generally of a longer-term type and of low yield. This latter only multiplies the difficulties in estimating a rate of return on these loans if they are granted under the PLS scheme. In Iran it has been decreed that financial transactions between and among the elements of the public sector, including Bank Markazi [the central bank] and commercial banks that are wholly nationalised, can take place on the basis of a fixed rate of return; such a fixed rate is not viewed as interest. Therefore the Government can borrow from the nationalised banking system without violating the Law. While the last claim may be subject to question, there is another serious consequence. Continued borrowing on a fixed rate basis by the Government would inevitably index bank charges to this rate than to the actual profits of borrowing entities. Legislation Existing banking laws do not permit banks to engage directly in business enterprises using depositors¶ funds. But this is the basic asset acquiring method of Islamic banks. Therefore new legislation and/or government authorisation are necessary to establish such banks. In Iran a comprehensive legislation was passed to establish Islamic banks. In Pakistan the Central Bank was authorised to take the necessary steps. In other countries either the banks found ways of using existing regulations or were given special accommodation. In all cases government intervention or active support was necessary to establish Islamic banks working

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Islamic Finance & Its Needs under the PLS scheme. In spite of this, there is still need for further auxiliary legislation in order to fully realise the goals of Islamic banking. For example, in Pakistan, ... the new law has been introduced without fundamental changes in the existing laws governing contracts, mortgages, and pledges. Similarly no law has been introduced to define modes of participatory financing, that is Musharakah and PTCs. It is presumed that whenever there is a conflict between the Islamic banking framework and the existing law, the latter will prevail. In essence, therefore, the relationship between the bank and the client, that of creditor and debtor is left unchanged as specified by the existing law. .... The existing banking law was developed to protect mainly the credit transactions; its application to other modes of financing results in the treatment of those modes as credit transactions also. Banks doubt whether some contracts, though consistent with the Islamic banking framework, would be acceptable in the courts. Hence, incentives exist for default and abuse. In Iran, although the law establishing interest-free banking ... is comprehensive, the lack of proper definitions of property rights may have constrained bank lending. Thus far there has been no precise legislative and legal expression of what is viewed as ³lawful and conditional´ private property rights. This may also have militated against investment lending in agricultural and industrial sectors and thus encouraged increased concentration of assets in shortterm trade financing instruments. Iran and Pakistan are countries committed to ridding their economies of riba and have made immense strides in towards achieving it. Yet there are many legal difficulties still to be solved as we have seen above. In other Muslim countries the authorities actively or passively participate in the establishment of Islamic banks on account of their religious persuasion. Such is not the case in non-Muslim countries. Here establishing Islamic banks involves conformation to the existing laws of the concerned country which generally are not conducive to PLS type of financing in the banking sector. We will see some of these problems below Involvement in specialised non-bank activities Dr Hasanuz-Zaman, lists the traditional tasks of the bank and then questions its ability to take on the additional functions it is called upon to perform under the

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Islamic Finance & Its Needs PLS scheme: It is due to historical reasons that banks have evolved purely as a financial institution. They are suited to attract money, keep it in safe custody, lend it under safety, invest it profitably and enjoy the capacity to create the means of payment. A bank has to maintain a balance between income, liquidity and flexibility. While allocating its funds it has to be meticulously sensitive about the factors like capital position and rate of profitability of various types of loans, stability of deposit, economic conditions, influence of monetary and fiscal policy, ability and experience of bank¶s personnel and credit needs of the area. So far these banks thrive on a fixed rate of return a portion of which is passed on by them to the depositor. Thus the entire effort of a bank is directed towards money management and it is not geared to act as an entrepreneur, trader, industrialist, contractor or caterer. The question arises: with all these limitations can a bank claim any competence in trading or entrepreneurship which is necessary for musharakah or mudarba22 contract, or can it act as an owner of a large variety of heavy machinery, transport vehicles or real estate to take the position of a lessor or, can it act as a stockist to buy and resell the entire stock of imports and exports that are needed by genuine traders? Then he raises the even more serious question: In case the bank is historically and practically not competent to do all these jobs its claim to share a portion of profits as a working partner, trader or lessor becomes questionable. Traditional banks do perform a certain amount of project evaluation when granting large medium- and long-term loans. But doing such detailed evaluation as would be required to embark on a PLS scheme, such as determining the rates of return and their time schedule, is beyond the scope of conventional banks. So is the detailed accounting and monitoring necessary to determine the actual performance. Under Islamic banking these exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank. Yet, widely acceptable and reliable techniques are yet to be devised. This is confounded by the fact that no consensus has yet been reached on the principles. Both the unprecedented nature of the task as well as the huge amount of work that

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Islamic Finance & Its Needs need be done and the trained and experienced personnel needed to carry them out seems a daunting prospect. Re-Training Of Staff As was seen in the previous section, the bank staff will have to acquire many new skills and learn new procedures to operate the Islamic banking system. This is a time consuming process which is aggravated by two other factors. One, the sheer number of persons that need to be re-trained and, two, the additional staff that need to be recruited and trained to carry out the increased work. Principles are still to be laid down and techniques and procedures evolved to carry them out. It is only after the satisfactory achievement of these that proper training can begin. This delay and the resulting confusion appears to be among the main reasons for the banks to stick to modes of financing that are close to the familiar interest-based modes. Other Disincentives Among the other disincentives from the borrower¶s point of view are the need to disclose his accounts to the bank if he were to borrow on the PLS basis, and the fear that eventually the tax authorities will become wise to the extent of his business and the profits. Several writers have lashed out at the lack of business ethics among the business community, but that is a fact of life at least for the foreseeable future. There is a paucity of survey or case studies of clients to see their reaction to current modes of financing. As such we are not aware of further disincentives that might be there. Accounts When a business is financed under the PLS scheme it is necessary that the actual profit/loss made using that money be calculated. Though no satisfactory methods have yet been devised, the first requirement for any such activity is to have the necessary accounts. On the borrowers¶ side there are two difficulties: one, many small-time businessmen do not keep any accounts, leave alone proper accounts. The time and money costs will cut into his profits. Larger businesses do not like to disclose their real accounts to anybody. On the banks¶ side the effort and expense involved in checking the accounts of many small accounts is prohibitive and will again cut into their own share of the profits. Thus both sides would prefer to avoid

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Islamic Finance & Its Needs having to calculate the actually realised profit/loss. To quote Iqbal and Mirakhor: .... the commercial banks do face an element of moral hazard owing to the nonexistence of systematic book-keeping in this sector. Additionally the reluctance of small producers to submit their operations to bank audits and the perceived enormous cost of auditing and monitoring relative to the small size of the potential credits makes banks unwilling to extend credit on the basis of new modes of financing to these small producers. These reduced lending to small producers may also explain the existence of excess liquidity in the banking system. Tax The bank is a big business and it has to declare its profit and loss and is legally required to present an audited account of its operations. Once the bank¶s accounts are known it doesn¶t take much for the tax collectors to figure out the share of the businesses financed by the bank under the PLS scheme. Thus it¶s no surprise that businesses are not too very happy about the situation. The fact that suggestions have been made to use the banks to collect taxes due has not helped the matter either. Excess Liquidity Presence of excess liquidity is reported in nearly all Islamic banks. This is not due to reduced demand for credit but the due to the inability of the banks to find clients willing to be funded under the new modes of financing. Some of these difficulties are mentioned under section 4.3.1 Financing. Here we have a situation where there is money available on the one hand and there is need for it on the other but the new rules stand in the way of bringing them together! This is a very strange situation -- specially in the developing Muslim countries where money is at a premium even for ordinary economic activities, leave alone development efforts. Removal of riba was expected to ease such difficulties, not to aggravate the already existing ones! Uneasy Questions Of Morality The practices in use by the Islamic banks have evoked questions of morality. Do the practices adopted to avoid interest really do their job or is it simply a change of name? It suffices to quote a few authors.24

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Islamic Finance & Its Needs The Economist writes ..... Muslim theoreticians and bankers have between them devised ingenious ways of coping with the interest problem. One is murabaha. The Koran says you cannot borrow $100m from the bank for a year, at 5% interest, to buy the new machinery your factory needs? Fine. You get the bank to buy the machinery for you -- cost, $100m -- and then you buy the stuff from the bank, paying it $105m a year from now. The difference is that the extra $5m is not interest on loan, which the Koran (perhaps) forbids, but your thanks to the bank for the risk it takes of losing money while it is the owner of the machinery: this is honest trading, okay with the Koran. Since with modern communications the bank¶s ownership may last about half a second, its risk is not great, but the transaction is pure. It is not surprising that some Muslims uneasily sniff logic-chopping here. Dr Ghulam Qadir says of practices in Pakistan: Two of the modes of financing prescribed by the State Bank, namely financing through the purchase of client¶s property with a buy-back agreement and sale of goods to clients on a mark-up, involved the least risk and were closest to the old interest-based operations. Hence the banks confined their operations mostly to these modes, particularly the former, after changing the simple buy-back agreement (prescribed by the State Bank) to buy-back agreement with a mark-up, as otherwise there was no incentive for them to extend any finances. The banks also reduced their mark-up-based financing, whether through the purchase of client¶s property or through the sale of goods to clients, to mere paper work, instead of actual buying of goods (property), taking their possession and then selling (back) to the client. As a result, there was no difference between the markup as practised by the banks and the conventional interest rate, and hence it was judged repugnant to Islam in the recent decision of the Federal Shari¶ah court. As banks are essentially financial institutions and not trading houses, requiring them to undertake trading in the form of buy-back arrangements and sale on markup amounts to imposing on them a function for which they are not well equipped. Therefore, banks in Pakistan made such modifications in the prescribed modes which defeated the very purpose of interest-free financing. Furthermore, as these two minimum-risk modes of financing were kept open to banks, they never tried to devise innovative and imaginative modes of financing within the framework of musharakah and mudarba.

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Islamic Finance & Its Needs Prof. Khurshid Ahmad says: Murabaha (cost-plus financing) and bai¶ mu¶ajjal (sale with deferred payment) are permitted in the Shari¶ah under certain conditions. Technically, it is not a form of financial mediation but a kind of business participation. The Shari¶ah assumes that the financier actually buys the goods and then sells them to the client. Unfortunately, the current practice of ³buy-back on mark-up´ is not in keeping with the conditions on which murabaha or bai¶ mu¶ajjal are permitted. What is being done is a fictitious deal which ensures a predetermined profit to the bank without actually dealing in goods or sharing any real risk. This is against the letter and spirit of Shari¶ah injunctions. While I would not venture a fatwa, as I do not qualify for that function, yet as a student of economics and Shari¶ah I regard this practice of ³buy-back on markup´ very similar to riba and would suggest its discontinuation. I understand that the Council of Islamic Ideology has also expressed a similar opinion. Dr Hasanuz Zaman is more scathing in his condemnation: It emerges that practically it is impossible for large banks or the banking system to practise the modes like mark-up, bai¶ salam, buy-back, murabaha, etc. in a way that fulfils the Shari¶ah conditions. But in order to make themselves eligible to a return on their operations, the banks are compelled to play tricks with the letters of the law. They actually do not buy, do not posses, do not actually sell and deliver the goods; but the transition is assumed to have taken place. By signing a number of documents of purchase, sale and transfer they might fulfil a legal requirement but it is by violating the spirit of prohibition. Again, It seems that in large number of cases the ghost of interest is haunting them to calculate a fixed rate percent per annum even in musharakah, mudarba, leasing, hire-purchase, rent sharing, murabaha, (bai¶ mu¶ajjal, mark-up), PTC, TFC, 30etc. The spirit behind all these contracts seems to make a sure earning comparable with the prevalent rate of interest and, as far as possible, avoid losses which otherwise could occur. To sum up, in Dr Hasanuz Zaman¶s words:31 ... many techniques that the interest-free banks are practising are not either in full conformity with the spirit of Shari¶ah or practicable in the case of large banks or
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Islamic Finance & Its Needs the entire banking system. Moreover, they have failed to do away with undesirable aspects of interest. Thus, they have retained what an Islamic bank should eliminate. Islamic Banking In Non-Muslim Countries The modern commercial banking system in nearly all countries of the world is mainly evolved from and modelled on the practices in Europe, especially that in the United Kingdom. The philosophical roots of this system revolves around the basic principles of capital certainty for depositors and certainty as to the rate of return on deposits. In order to enforce these principles for the sake of the depositors and to ensure the smooth functioning of the banking system Central Banks have been vested with powers of supervision and control. All banks have to submit to the Central Bank rules. Islamic banks which wish to operate in nonMuslim countries have some difficulties in complying with these rules. We will examine below the salient features.

Certainty Of Capital And Return While the conventional banks guarantee the capital and rate of return, the Islamic banking system, working on the principle of profit and loss sharing, cannot, by definition, guarantee any fixed rate of return on deposits. Many Islamic banks do not guarantee the capital either, because if there is a loss it has to be deducted from the capital. Thus the basic difference lies in the very roots of the two systems. Consequently countries working under conventional laws are unable to grant permission to institutions which wish to operate under the PLS scheme to functions as commercial banks. Two official comments, one from the UK an the other from the USA suffice to illustrate this. Sir Leigh Pemberton, the Governor of the Bank of England, told the Arab Bankers¶ Association in London that: 


It is important not to risk misleading and confusing the general public by allowing two essentially different banking systems to operate in parallel; A central feature of the banking system of the United Kingdom as enshrined in the legal framework is capital certainty for depositors. It is the most important feature which distinguished the banking sector from the other segments of the financial system;

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Islamic Finance & Its Needs 
 

Islamic banking is a perfectly acceptable mode of financing but it does not fall within the definition of what constitutes banking in the UK; The Bank of England is not legally able to authorise under the Banking Act, an institution which does not take deposits as defined under that Act; The Islamic facilities might be provided within other areas of the financial system without using a banking name.

In the United States, Mr Charles Schotte, the US Treasury Department specialist in regulatory issues has remarked: There has never been an application for an Islamic establishment to set up either as a bank or as anything else. So there is no precedent to guide us. Any institution that wishes to use the word µbank¶ in its title has to guarantee at least a zero rate of interest -- and even that might contravene Islamic laws. Supervision And Control Besides these, there are other concerns as well. One is the Central Bank supervision and control. This mainly relates to liquidity requirements and adequacy of capital. These in turn depend on an assessment of the value of assets of the Islamic banks. A financial advisor has this to say:35 The bank of England, under the 1979 Act, would have great difficulty in putting a value on the assets of an Islamic institution which wanted to operate as a bank in the UK. The traditional banking system has much of its assets in fixed interest instruments and it is comparatively easy to value that. For example, if they are British Government instruments they will have a quoted market value; and there are recognised methods for valuing traditional banking assets when they become non-productive. But it is very difficult indeed to value an Islamic asset such as a share in a joint venture; and the Bank of England would have to send a team of experienced accountants into every Islamic bank operating in the UK as a bank under the 1979 Act, to try to put a proper and cautious value on its assets. Another financial analyst states: Even if a method could be found for assessing the risks to calculate the capital necessary, little comfort could be taken from the profitability which is usually relied upon to cover day-to-day losses arising from the bank¶s business, because a substantial part of an Islamic bank¶s portfolio is venture capital without any guaranteed return.

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Islamic Finance & Its Needs It is evident then that even if there is a desire to accommodate the Islamic system, the new procedures that need be developed and the modifications that need be made to existing procedures are so large that the chances of such accommodation in a cautious sector such as banking is very remote indeed. Any relaxation of strict supervision is precluded because should an Islamic bank fail it would undermine the confidence in the whole financial system, with which it is inevitably identified. As Suratgar puts it. There could be potential dangers for the international system, where the failure of such an institution could bring with it the failure of other associated institutions, or of all the Western banking institutions which come closely tied to with such an operation. The question has engaged the attention of Central Banks in Muslim countries as well. But reliable satisfactory methods are still to developed. Tax Regulations Another important consideration is the tax procedures in non-Muslim countries. While interest is a µpassive¶ income, profit is an earned income which is treated differently. In addition, in trade financing there are title transfers twice -- once from seller to bank and then from bank to buyer -- and therefore twice taxed on this account decreasing the profitability of the venture. The Director of the International Islamic Bank of Denmark says: Tax laws are against the Islamic philosophy and pose the greatest difficulty. In most OECD countries Mudarabha is constrained by fiscal acts which define profits as an after tax item for the profit creator and a fully taxable item for the profit receiver. Discussion And Suggestions People have needs -- food, clothes, houses, machinery, services; the list is endless. Entrepreneurs perceive these needs and develop ways and means of catering to them. They advertise their products and services, peoples expectations are raised and people become customers of the entrepreneur. If the customers¶ needs are fulfilled according to their expectations they continue to patronise the entrepreneur and his enterprise flourishes. Otherwise his enterprise fails and people take to other entrepreneurs. Banks too are enterprises; they cater to peoples¶ needs connected with money -BCCA·s Institute of Management Studies
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Islamic Finance & Its Needs safe-keeping, acquiring capital, transferring funds etc. The fact that they existed for centuries and continue to exist and prosper is proof that their methods are good and they fulfil the customers¶ needs and expectations. Conventional commercial banking system as it operates today is accepted in all countries except the Islamic world where it is received with some reservation. The reservation is on account of the fact that the banking operations involve dealing in interest which is prohibited in Islam. Conventional banks have ignored this concern on the part of their Muslim clientele. Muslims patronised the conventional banks out of necessity and, when another entrepreneur -- the Islamic banker -- offered to address their concern many Muslims turned to him. The question is: has the new entrepreneur successfully met their concerns, needs and expectations? If not he may have to put up his shutters! Broadly speaking, banks have three types of different customers: depositors, borrowers and seekers of bank¶s other services such as money transfer. Since services do not generally involve dealing in interest Muslims have no problem transacting such businesses with conventional banks; neither do Islamic banks experience any problems in providing these services. Among the depositors there are current account holders who too, similarly, have no problems. It is the savings account holders and the borrowers who have reservations in dealing with the conventional banks. In the following paragraphs we will see how well the Islamic banks have succeeded in addressing their customers¶ special concern. Savings Accounts And Capital Guarantee As pointed out earlier, our concern here is the savings account holders. As the name itself indicates the primary aim of the saving account depositor is the safekeeping of his savings. It is correctly perceived by the conventional banker and he guarantees the return of the deposit in toto. The banker also assumes that the depositor will prefer to keep his money with him in preference to another who might also provide the same guarantee if the depositor is provided an incentive. This incentive is called interest, and this interest is made proportional to the amount and length of time it is left with the bank in order to encourage more money brought into the bank and left there for longer periods of time. In addition, the interest rate is fixed in advance so that the depositor and the banker are fully aware of their respective rights and obligations from the beginning. And laws have been enacted to guarantee their enforcement. In Economic theory the interest is often taken to be the ³compensation´ the depositors demand and receive for parting with their savings. The fact that the depositors accept the paid interest and that, given other things being equal, they prefer the bank or the scheme which
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Islamic Finance & Its Needs offers the highest interest proves the banker¶s assumption correct. The scheme is simple, transparent and seems to have satisfied the requirements of all types of savers -- from teenagers to old-age pensioners, from individuals to large institutions, pension funds and endowments, from small amounts to millions, and from a few weeks or months to years -- that it has survived over centuries and operates across national, cultural and religious borders. The situation is very different in the Islamic banks. Here too the depositor¶s first aim is to keep his savings in safe custody. Islamic bankers divide the conventional savings account into two categories (alternatively, create a new kind of account): savings account and investment account. The investment accounts operate fully under the PLS scheme -- capital is not guaranteed, neither is there any pre-fixed return. Under the savings account the nominal value of the deposit is guaranteed, but they receive no further guaranteed returns.39 Banks may consider funds under the savings accounts too as part of their resources and use it to create assets. This is theory. In practice, however, the banks prefer, encourage and emphasise the investment accounts. This is because since their assets operate under the PLS scheme they might incur losses on these assets which losses they cannot pass onto the savings accounts depositors on account of the capital guarantee on these accounts. In the process the first aim of the depositor is pushed aside and the basic rule of commercial banking --capital guarantee-- is broken. It is suggested that all Islamic banks guarantee the capital under their savings accounts. This will satisfy the primary need and expectation of an important section of the depositors and, in Muslim countries where both Islamic and conventional banks co-exist, will induce more depositors to bank with the Islamic banks. At the same time, it will remove the major objection to establishing Islamic banks in non-Muslim countries. But the question is how does the bank make an income from these deposits? We will examine this in the next section. Loans With A Service Charge We have already seen that all the problems of the Islamic banks arise from their need to acquire their assets under the PLS scheme. A simple solution does, in fact, already exist in the current theories of Islamic banking. It need only be pointed out and acted upon. We will examine the provisions in the Iranian, Pakistani and the

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Islamic Finance & Its Needs Siddiqi models. All three models provide for loans with a service charge. Though the specific rules are not identical, the principle is the same. We suggest that the funds in the deposit accounts (current and savings) be used to grant loans (short- and longterm) with a service charge. By doing this the Islamic banks will be able to provide all the loan facilities that conventional banks provide while giving capital guarantee for depositors and earning an income for themselves. Furthermore, and it is important, they can avoid all the problems discussed in section 4.3. This would also remove the rest of the obstacles in opening and operating Islamic banks in non-Muslim countries. The bonus for the borrowers is that the service charge levied by the Islamic banks will necessarily be less than the interest charged by conventional banks. Let us now look at the existing relevant rules in the three models. The Iranian model provides for Gharz-al hasaneh whose definition, purpose and operation are given in Articles 15, 16 and 17 of Regulations relating to the granting of banking facilities. Article 15 Gharz-al-hasaneh is a contract in which one (the lender) of the two parties relinquishes a specific portion of his possessions to the other party (the borrower) which the borrower is obliged to return to the lender in kind or, where not possible, its cash value. Article 16 ... the banks ... shall set aside a part of their resources and provide Gharz-alhasaneh for the following purposes: (a) to provide equipment, tools and other necessary resources so as to enable the creation of employment, in the form of co-operative bodies, for those who lack the necessary means; (b) to enable expansion in production, with particular emphasis on agricultural, livestock and industrial products; (c) to meet essential needs.

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Islamic Finance & Its Needs Article 17 The expenses incurred in the provision of Gharz-al-hasaneh shall be, in each case, calculated on the basis of the directives issued by Bank Markazi Jomhouri Islami Iran and collected from the borrower. Financing by lending: (i) Loans not carrying any interest on which the banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds and provisions for bad and doubtful debts. The maximum service charge permissible to each bank will be determined by the State Bank from time to time. (ii) Qard-e-hasana loans given on compassionate grounds free of any interest or service charge and repayable if and when the borrower is able to pay. Siddiqi has suggested that 50 percent of the funds in the µloan¶ (i.e. current and savings) accounts be used to grant short-term loans.45 A fee is to be charged for providing these loans. An appropriate way of levying such a fee would be to require prospective borrowers to pay a fixed amount on each application, regardless of the amount required, the term of the loan or whether the application is granted or rejected. Then the applicants to whom a loan is granted may be required to pay an additional prescribed fee for all the entries made in the banks registers. The criterion for fixing the fees must be the actual expenditure which the banks have incurred in scrutinising the applications and making decisions, and in maintaining accounts until loans are repaid. These fees should not be made a source of income for the banks, but regarded solely as a means of maintaining and managing the interest-free loans. It is clear from the above that all three models agree on the need for having cash loans as one mode of financing, and that this service should be paid for by the borrower. Though the details may vary, all seem to suggest that the charge should be the absolute cost only. We suggest that a percentage of this absolute cost be added to the charge as a payment to the bank for providing this service. This should enable an Islamic bank to exist and function independently of its performance in its PLS operations. Investment under PLS scheme

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Islamic Finance & Its Needs The idea of participatory financing introduced by the Islamic banking movement is a unique and positive contribution to modern banking. However, as we saw earlier, by making the PLS mode of financing the main (often almost the only) mode of financing the Islamic banks have run into several difficulties. If, as suggested in the previous section, the Islamic banks would provide all the conventional financing through lending from their deposit accounts (current and savings), it will leave their hands free to engage in this responsible form of financing innovatively, using the funds in their investment accounts. They could then engage in genuine Mudaraba financing. Being partners in an enterprise they will have access to its accounts, and the problems associated with the nonavailability of accounts will not arise. Commenting on Mudaraba financing, The Economist says: .... some people in the West have begun to find the idea attractive. It gives the provider of money a strong incentive to be sure he is doing something sensible with it. What a pity the West¶s banks did not have that incentive in so many of their lending decisions in the 1970s and 1980s. It also emphasises the sharing of responsibility, by all the users of money. That helps to make the free-market system more open; you might say more democratic.

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Islamic Finance & Its Needs

Chapter 6 The Islamic Financial System

While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more. At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic rulings to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars. Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork. Islamic funds would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products Its practitioners and clients need not be Muslim, but they must accept the ethical

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Islamic Finance & Its Needs restrictions underscored by Islamic values. Interest-Free Banking System Unlike Western banking institutions the interest-free Islamic banks are endowed with certain inherent features which make them quite distinct. For instance, operate as they do largely on the basis of profit and loss sharing, the majority of their clients are not savers but holders of profit and loss accounts. In this way not only are the holders of PLS accounts enabled to get a much larger share of the investment-return, but are also psychologically converted from traditional savers into investors. It may be mentioned here that unlike a traditional saver who generally saves to finance some expenditure in future, an investor generally thinks of not meeting a particular expenditure in future, but much more in terms of building reproductive assets and services for the purpose of future command over resources in a dynamic sense. The Islamic banks operating to fulfill the latter function contribute towards acceleration of investment activity along with the realization of other concomitant goals of better income distribution, higher efficiency of capital and lesser attraction for demonstrative expenditure. An investor's Weltanschauung is world apart from that of a traditional saver. The efficiency of capital increases under the Islamic banking system, because, unlike the payment of a predetermined rate of interest on deposits, the banks are now forced to work efficiently for considerations of attracting clients on the basis of the rate of profit already announced by them in recent years and in the light of their future profit projections. Under the existing interest-bound savings, the banks are obliged to pay a pre-determined rate of interest which is generally no more than a quarter of the actual rate of profit earned on an average unit of investment. The Islamic banking system has also the advantage of promoting investment habits among the large majority of the people which in the longer perspective lead to lesser consumption and better distribution of income. There is also another advantage bound up with the Islamic banking system. It emerges as a result of the elimination of interest-bearing credit facilities offered to a businessman or a limited company. While under the Western banking system a limited company can meet its additional requirements of capital by obtaining a loan carrying a fixed rate of interest, the same company will, have to obtain funds on profit and losssharing basis under an Islamic banking system. The difference between the two is that while in the case of the former the company directors and shareholders pay the usual rate of interest, in the latter case, they will have to part with the larger part of the profit earned on the funds obtained from the bank under the PLS
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Islamic Finance & Its Needs scheme. In the latter cast, it will not be the directors and shareholders of the company who will be able to appropriate the largest chunk of the profit earned on funds borrowed/ obtained from the bank, but it will be the original savers who by virtue of having opened their PLS accounts with the concerned bank will now become the legitimate recipients of the largest chunk of the profit earned by the company. The maximum that the bank can do in this case would be that it will retain a certain amount as management charge. The practice of the PLS scheme is going to have far reaching impact on the social structure of the population. ' Instead of the earlier capitalistic inequitable distribution of the profits earned on savings between the savers and the investors the Islamic banking system will enable the savers' community to receive a much larger share of the profit earned on their deposits. One must also mention here a special feature bound up with the issuance of credit under the Western banking system. This is that the borrowers of funds from the Western banking system can claim tax exemption on the amount of interest paid by them. In order to enable the Islamic (banks to compete with the Western banks, it would therefore be desirable either to withdraw the above taxexemption or allow similar tax exemption on the basis of the 'profit' passed on by the investors to the savers through the intermediary banks. Prof. Dr. Rittershausen of the Cologne University told me and Ahmed El-Naggar in 1960-both of us were then doctoral students that the tax-exemption granted on the amount of interest paid by the borrowing firm was one of the cardinal privileges enjoyed by the entrepreneurial class under the capitalistic system.

The Concepts Islamic economic principles offers a balance between extreme capitalism and communism. It offers the individual the freedom to produce and create wealth, while surrounding the individual with an environment controlled, not by human rulers, but by Divine Guidance, which sets moral rules and norms of behaviour that must require the utmost sincerity of intention. When these rules and norms are internalised and acted upon by people, peace and prosperity result for the wider society. The Qur'an (2:30) says that man was created as the representative of God on earth. This concept has a considerable effect on Islamic business, since the lack of a sense of absolute ownership promotes a sense working for society, especially the needy. This is not some philosophical concept, removed from the daily life of the society. It manifests itself in all the different aspects of lives. What makes the trader,
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Islamic Finance & Its Needs banker, agriculturist or research and development scientist perform his job to the best of his ability? In capitalist economies, it is the notion of competition. This involves the necessity to constantly produce more new things for profit to keep up with others and this makes for wastage and often generates unbridled greed. But in an economy based on Islamic principles, the idea of man representing God on earth gives businessmen a feeling of co-operating with others for the good of society as a whole, including himself. Thus Quranic guidance enables man to conserve and use prudently all the resources of the earth that God has given mankind. The Essentials Divine Guidance for the economy, as enshrined in the Qur'an and the Sunnah (the living example of Prophet Muhammad), can be summarised as follows: 1. Trusteeship The Qur'an (57:7) emphasises that all the resources of the earth belong to God, the Creator, who has made human beings a trustee for them. Humans are therefore accountable to God for the uses they make of these resources. The idea of trusteeship distinguishes the Islamic approach to economics from materialistic approaches such as extreme capitalism and socialism. It introduces a moral and spiritual element into business life and has been made practicable by creating rules to govern individual behaviour and public policy. 2. Care For Others Care for others tempers self-interest, which is ingrained in human nature. It goes naturally with trusteeship, since, in caring for others, one also serves God, who created all humans. No one can have fulfilment or happiness in his life without interacting with others. Thus individual happiness and collective interests go hand in hand. We gain through giving, since it would be impossible for everyone to acquire while giving nothing. The Qur'an states this in 30:39 and 2:276. It follows that Islam discourages indulgence in luxuries. One is expected to consider what is available to others before acquiring good things for oneself. Moderation in consumption is mentioned in the Qur'an 7:31. People who believe that they can increase their wealth through charging others interest and by reducing charitable giving are under an illusion. The wealth and
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Islamic Finance & Its Needs integrity of a society can only increase when the rich give part of their wealth to the needy for no other motivation than to please God. Those who have faith and a vision of their future life understand this. To think only of how to gain profit for oneself leads to using others as mere instruments. In societies where unbridled self-interest is allowed to dominate unchecked, there is no protection for the weak against the strong. Thus exclusive pursuit of self-interest, when not tempered by charity, is self- defeating. 3. Productive Effort As A Means Of Serving God Islam emphasises the duty of every individual to work for his living. Productive enterprise is looked upon as a means of serving God (2:195). Islam requires wealth to be spent in the cause of God. This realisation moves Muslims to greater efforts in their economic activities. The fourteenth-century thinker Abu Ishaq Shatibi, writing of the companions of the Prophet, said, ³They were expert in business enterprise, keen and persistent in a variety of economic pursuits. They did not do so to amass wealth or save it for themselves; rather their aim was to spend their earnings in good causes.´ (Shatibi, AlMuwafiqaat fi Usul al-Shari'ah, Vol. 2, p188, Cairo, Maktaba al Tijarah al-Kubra.

In the west, it is now considered enough to merely to µenjoy life', work being an unfortunate necessity. But in Islam, it is seen that working for a living gives man a sense of worthiness in his society. To support a family and contribute to others with any surplus enables one to take one's part in consultations on practical, social matters, so that all can benefit. 4. Application Of The Shari'ah Rulings To Business The aim of the Shari'ah rulings is to make the transfer of goods safe and easy and to facilitate economic transactions by eliminating vagueness or misunderstanding in all types of contracts. It prohibits the charging of interest on loans as a form of injustice. The goal is to remove the causes of social tension or litigation and to promote a climate of peace and goodwill. Islam strongly recommends that the terms of financial agreements be put in writing.

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Islamic Finance & Its Needs 5. Mutual Consultation Men are free to make private economic decisions, but decisions concerning the public welfare must be based on consultation. The Qur'an describes Muslims as a people "whose rule (in all matters of common concern) is by consultation among themselves.´ (42:39). Mutual consultation avoids society or local communities coming under the rule of a dictator and makes sure that reasonable decisions acceptable to all are made. 6. Treating Wealth As A Means And Not An End Islam regards economic well being as a means to peace, freedom from hunger and freedom from fear of others, except God. Beyond the satisfaction of basic needs, the ultimate objectives of earning and spending money are moral and spiritual. It is against Islamic rationality to hoard money (9:34, 35). It follows that savings must be put to good use. One who cannot go into business himself can do so in partnership with others, or can supply funds on a profitsharing basis. People can also borrow and lend, but it is forbidden for the lender to claim interest from the borrower as this is unjust (2:275). Islam prohibits gambling, cheating, exploitation, coercion, etc., but freedom to make financial arrangements is constrained only by these few prohibitions and by the Islamic tendency to treat money as a means to the good life.

Proper Functioning Of The Market Islam prohibits dishonesty, fraud and deception, coercive practices, gambling and usurious and injurious dealings. Hoarding, speculation and collusion among producers and traders against the interest of consumers, and such monopolies as are injurious to the socio-economic health of society are all ruled out. The basic principles regulating market operations in an Islamic state are: a) A person should be free to buy, sell or dispose of his possessions and money within the framework of the Shari'ah.
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Islamic Finance & Its Needs b) There is no restriction on the percentage of profit which a trader may make. It is left to him and depends on the business environment and the nature of the goods. However, moderation, contentment and leniency must be taken into consideration. c) The Shari'ah emphasises avoiding illicit acts detrimental to the wellbeing of society or the individual. d) The State should not fix prices except where there are artificial factors in the market which may lead to excessive price increases or decreases or fraud. If there are such, the State should intervene to remove these factors. 7. Protection Of Consumers The State should insure that producers, manufacturers and traders do not exploit each other or the buyers. It should curb adulteration, under-weighing, encroachment of thoroughfares, unhealthy trades and unlawful professions and maintain good, firm employee relationships. 8. Monopolies And Cartels Industrialists in a free and competitive economy can form cartels and monopolies and exploit people and a firm law is needed to control them. No unjust, oppressive or cheating business can be allowed to continue in an Islamic economy. 9. Zakat Or Zakah Zakat is a levy on certain categories of wealth. It can be collected and distributed by the government and is obligatory only on Muslims. It is applicable to income and savings, agricultural harvests, commercial goods, gold and silver over certain amounts, some categories of livestock, excavated treasures, mined wealth, etc. In accordance with the Qur'an (9:60), the proceeds from zakat are paid to the poor, the sick and destitute and to travellers, especially those seeking education or going on pilgrimage. The Islamic view of distributive justice is contained in the three points: a guarantee of the fulfilment of basic needs; equality of opportunity; and elimination of glaring inequalities in personal income and wealth. Zakat also acts as an excellent form of social insurance. 10. Qard Hasan
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Islamic Finance & Its Needs Qard hasan is a Quranic term meaning an interest-free loan. It was the primary source of financing introduced by the Prophet after entering Medina and was used primarily for productive economic purposes, such as setting up qualified, but poor, people in trade and agriculture. Some Distinctive Features Of The Islamic Banking System It is clear from our above analysis that the Islamic banking system is far superior to the Western banking system. This is evident from the special features enjoyed by the Islamic banking system. 1. The Islamic banking system is committed to efficient utilization of 'capital'. Savers being PLS holders force the banks to compete with each other and look for attractive investment opportunities. This leads to higher efficiency of capital. 2. Under an Islamic banking system a large majority of the savers will switch over to PLS accounts, which will earn them better reward than is available under the Western banking system. This will also mean a better distribution of income. 3. The change from a traditional saver to an investor will reduce the propensity to consume and thereby contribute towards increasing the propensity to save/invest. 4. The shift from interest-bearing deposits to PLS will increase the share of the savers and reduce the 'unearned' income of the borrowers under the older system. This egalitarian character of 'investment management' will remove sharp income differentials between different income echelons. The first experiment in interest-free banking was undertaken by Prof. Dr. Ahmad El-Naggar during the early sixties in the Nile Delta. This maiden attempt covered a large number of villages.4 After achieving success in the Nile Delta, Dr. El-Naggar moved to Saudi Arabia and started a campaign for the establishment of Islamic banks throughout the Muslim World. In this struggle he was fortunate to get the support of Prince Muhammad and his illustrious father King Faisal. With hard work and persistent endeavors Dr. El-Naggar was able to steer through many difficulties and saw his efforts crowned with success when the Islamic Development Bank was established in Jeddah in 1975. Over the past few years, he has been instrumental in the establishment of no less than a dozen Islamic banks spread over the wider canvas of the Muslim world. Countries at present having one or more Islamic banks are Egypt, Sudan, Jordan, Kuwait, Dubai, Bahrain and Sharjah. Malaysia and Mauritania have also recently set up one Islamic Bank each. The reports so far received from the Islamic banks reveal that the performance of these banks has been quite satisfactory and it is hoped that they will be able to offer a much better service and reward to their clients than the competing Western banks. Egypt is the leader on the Islamic banking front. A few years ago Dr. ElBCCA·s Institute of Management Studies
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Islamic Finance & Its Needs Naggar set up the International Institute of Islamic Banking and Economics, Lefkosa (Turkish Cyprus)/Cairo to cater for the intellectual and operational needs of the Islamic banks. This institute also offers training facilities to banks staff in Islamic banking. There also exists an International Association of Islamic Banks with headquarters in Cairo. This institution helps member Muslim countries towards the establishment of Islamic banks. Islamic Banks : Both Efficient And Distributive With the successful working of the Islamic banks, the Muslim world is again heading towards a new era of financial institutions and equitable socio-economic development. The results so far obtained from the experience of the few Islamic banks look quite baffling. Not only the new PLS accounts are improving the efficiency of capital, but are also contributing towards the betterment of the existing pattern of income distribution. Even the present high propensity to consume rampant among the Muslim peoples is expected to go down in the long run and in its place there will emerge an overall acceleration of investment. These are revolutionary changes, if properly handled they are sure in due course of time to overshadow older and more sophisticated Western banking institutions. The Islamisation of the banking sector is likely to come of age in the next decade or two. The other thrust of the Muslim countries is likely to be on Zakat and other taxation measures. With proper planning and careful implementation, they too can play their role in changing the unequal relationship perpetrated on social groups. While doing all this, we must not lose sight of the fact that all these great doctrines of Islam are not rituals, they are in fact the foundation-pillars of an egalitarian and development-inducing order.

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Islamic Finance & Its Needs Chapter 7 Problems And Prospects Of Islamic Banking In India ± Road Map Ahead

Banking institutions have emerged as very necessary for everyone, poor as well as rich. It is needed to deposit and protect the saving however meagre it may be. Poor labourers, construction workers and others migrating to the urban centres of the country from remote corners must have access to banking to transfer their earning to the families in far off places. Also several social initiatives, welfare programmes and schemes of the government both state and central do require bank accounts of those targeted ± below poverty line segments ± to receive money safely in their account. Also credit is provided to people through banks. All these requirements have made banking an inevitable part of life of today¶s men and women. Even after forty years, since nationalisation of the banks about 60% population do not have access to formal banking and only 5.2 % of villages have bank branches. Marginal farmers, land less labours, oral lessees, self employed and unorganised sector enterprise, ethnic minority and women, Aam Aadmi of our great country continue to form the financially excluded class. The financial exclusion of a large segment of the population has far-reaching implications for the socio-economic and educational uplift of the masses. These financially excluded classes would not hesitate in sharing a ³return´ on their investment but they often find it difficult to meet the demand of a pre determined return unrelated to the yield. If finance is available without the burden caused by pre-determined interest rates, it will be a welcome development for the marginalized and also especially for SME¶s. Interest-free Islamic Banking can fill up this gap. For Muslims, as per the Sachar Committee report based on census 2001 data, the percentage of household availing themselves of banking facilities is much lower in towns and villages where the Muslim population is high. This is due to a certain mindset prevailing in the banking sector which has categorized Muslims and Muslims dominated areas as µNegative Zones¶ as documented in Sachar report. Prohibition of interest and thus for reasons of faith Muslims are away from the conventional banks as referred to in the report of the Committee on Financial Sector Reforms ±CFSR of the Planning Commission headed by Dr. Raghuram Rajan.

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Islamic Finance & Its Needs Government Initiative Rbi Working Group In 2005, Government of India asked Reserve Bank of India to examine Islamic banking instruments and constituted a Working Group headed by Mr. Anand Sinha, Chief Manager, Department of Banking and Operation and Development along with senior Bankers from SBI, ICICI and Oman International Bank that came up with its report in 2006 which said: In the current statutory and regulatory framework it would not be possible for banks in India to undertake Islamic Banking activities and concluded that if the banks are allowed to do Islamic banking appropriate amendments are required in Banking regulations Act 1949. National Workshop After the GOI announcement that Islamic banking is not feasible in India, several interactive sessions were held by ICIF, one of them was a National Workshop on ³Road Map on Islamic banking´ in Sept 2006, which was participated by prominent National and International Islamic experts and bankers. It passed resolution that Islamic Banking is relevant in the 21st century and India may implement the same by obtaining inputs from the global example in UK, Malaysia and Singapore. It also chalked out a plan of action as well. Cfsr-Planning Commission Recommendation In August 2007, Govt. of India under the Planning Commission constituted a high level committee on Financial Sector reforms (CFSR) under the chairmanship of Dr. Raghuram Rajan, former chief economist, IMF along with other eleven members who are the finest financial and legal minds in the country. CFSR submitted its final report in Sept. 2008 to Prime Minister with the specific recommendation of interest free banking in the country: ³Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also

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Islamic Finance & Its Needs denies India access to substantial sources of savings from other countries in the region. While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.´ Efforts Undertaken ± Meeting Rbi & Fm When it was learnt that RBI is considering implementing a few recommendations of Dr. Raghuram Rajan Committee on Financial Sector Reforms (CFSR), ICIF contacted the Governor RBI and sought an appointment to plead for the case of the recommendation of CFSR regarding Interest-free banking. Accordingly a delegation of ICIF met the Deputy Governor Dr. K.C Chakrabarty on September 11, 2009 and presented a memorandum along with the important documents. RBI conveyed that it has no reservation regarding interest free banking but for that an amendment in the Banking regulations has to be passed in the Parliament which can be done by the Central government. A memorandum was submitted to FM, Mr. Pranab Mukherjee to accept the recommendation of CFSR committee on interest free banking and suitable legislative amendment. Several meetings and interactions have taken place with the officials of the Finance Ministry and RBI in this regard till now. In order to amend the Ranking Regulations Act 1949 and accommodate a level playing field for Islamic banking, a bill has to be passed in Parliament. For this, Banking Amendment Bill has been prepared and vetted by Dar Al Shariah, Dubai Islamic Bank and submitted to Parliament secretariat by an MP to be undertaken as a Private Member¶s Bill in the next session of Parliament. Amendment in banking regulation act 1949 As we know that the urban cooperative banks in india have been incorporated through a separate legislation, islamic banking could be simply allowed in india if the parliament approves addition of a separate chapter in the banking regulation act 1949 to describe and deal with islamic banking and finance. Raghuram rajan committee on interest-free banking
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Islamic Finance & Its Needs Considerably the draft report on µfinancial sector reforms¶ as presented by raghuram rajan committee had nothing about islamic banking. While commenting over that draft report, we had the opportunity to interact with that committee in mumbai where we requested them to include recommendations for islamic banking. Mr. Vijay mahajan gave due attention over financial exclusion of indian muslims and also convinced other committee members to recommend µislamic banking¶ for financial inclusion of indian muslims. We are thankful that first time in india our appeal was listened and due recommendations were made by some high level committee. Missed opportunity for india Definitely this is the case after global financial crisis when muslim investors in gulf region are seeking opportunities to invest through islamic financial products in emerging economies like india. Failing to get such opportunities in india, they are parking their investments in islamic banks of uk and switching to other emerging economies like china, taiwan, indonesia and malaysia, etc. India is definitely missing billion dollars investment funds which could be mobilised in terms of islamic investments. 10-Point Programme Of Action A 10-point programme of action is suggested to this august house for consideration and serious follow up to make the dream of Islamic Finance and Banking become a reality which will change the face and fortune of the community as well as the country, if Almighty wills. 1. Interest free Islamic banking is emerging as a possible alternative to conventional Finance and Banking ± Know why? 2. Start discussion in our circle & make it an integral part of our all programmes. 3. Bring out special issues and supplements in the print media, create space for discussion in electronic media, usage of internet to share the latest development & progress 4. To remove Misconception among Non-Muslims that interest-free banking is not only for Muslims, a group of strong supporters among them- Abu Talibs has to be included in our efforts to spearhead this great cause.

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Islamic Finance & Its Needs 5. Create awareness among Muslim Scholars, Students and the General Public by using Jum¶a Sermons, Conferences, seminars, etc. 6. Human Resource Development ± Skills & Spirits, Competence & Character specific to Islamic Shariah ± Fiqh ul Muamilat and modern finance and banking has to be produced. 7. General awareness in Media ± lobbying for Islamic Banking, Takaful ± Islamic Insurance, Sukuk ± Islamic Bonds. 8. Conduct seminars & symposium ± Contact B-Schools, Professional associations, etc. 9. Create political will ± contact & convince MPs of all parties to enable amending Banking Regulation act, 1949 in Parliament. 10. Planning for Islamic Micro finance & Mega Private Islamic Banks when permission granted. Factors hindering growth of islamic banking Growth of Western Banking System The Western banking system grew as it did historically was supposed to serve the interests of the powerful class of entrepreneurs, whether businessmen, industrialists or stock traders. The banks operated through the ingenious mechanism of dividing the society into savers and investors. Both these groups were assigned a certain role to play in the society. While the savers were encouraged to do a large part of the 'passive capital-formation', the investors were inspired to use initiative and enterprise to make the best use of this capital through investment activity. The result of this 'division of capital-saving and capital-investing' was that while the former class continued to remain condemned vegetating on paltry rewards, the latter class grew in wealth and stature day in and day out. Notwithstanding other factors which led to the emergence of capitalism in Europe, the role of banking institutions seems to have served as the principal agent responsible for having "triggered off this development. It is indeed a great irony of human history that people who saved capital were the least to benefit from it, while those who dexterously collected and used it through the mechanism of investment were the ones who profited the most. The way this system operates, enables the investors to appropriate the lion's share of the earned profit, while only the remainder falls to the lot of the savers. In some cases, as is the situation in Pakistan at present, the savers were condemned to have even a negative rate of return, while the
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Islamic Finance & Its Needs intermediaries, namely, the banks and the final investors were the ones who made fortune on these savings. Other factors Many factors led to the non-emergence of banking institutions along with Islamic principles in the Muslim countries. One was the treatment of the doctrine of ribs more as a religious commandment rather than as an economic imperative. It was this approach which led to theological interpretation of concepts, such as, ribs and, in this way, economic rationality and egalitarian thrust inherent in Islamic principles were thrown overboard. The Muslim scholars unfortunately kept themselves so much immersed with religious obligations and the concomitant trivialities that the great Islamic concepts of economic utility and human welfare were never allowed to be transformed into gigantic institutions serving the greater cause and dynamic pursuits of the larger Ummah. It is, in fact, this nonenterprising spirit of the Muslim people which kept them down on the economic front for centuries, while other nations, although not well endowed in terms of great religious commandments, were quick to set up institutions on the basis of human institution, reflection and endeavor. Max Weber also admits this phenomenon when he says that while the majority of the great ideas were born in the Orient, it was the Occident which transformed them into great institutions. Not only does this verdict apply to riba, it even holds true in the case of Zakat. While the concept of Zakat is fourteen hundred years old, the forerunners of the present 'welfare state' or 'social security system' are no more than two hundred years old. The latter development, it may be mentioned here, wasn't, however, all too natural.' ... it arose as a way to combat socialism by mitigating some of the most conspicuous excesses of capitalism and thus removing the mobilization basis of the Social Democrats. As against this, the Qur'an concepts, such as Zakat and Sadaqat, aimed at offsetting the inequalities inherent in human social and economic order, were taken more or less as rituals rather than as the necessary wherewithal for institutionalizing social justice and social security. Similarly the doctrine of riba was also not understood in its broader and deeper perspective, and, as a result, the great revolution that it was supposed to usher in on the socio-economic front was frustrated. Many factors have given birth to the above situation. One of them, for instance, was the notion that theological doctrines and dogmas were anachronistic in nature. Perhaps there was some truth in this approach as far as it related to older religions like Christainty and Hinduism, but surely it wasn't applicable to Islam, a religion committed to progress and human emancipation. The tragedy that overtook the
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Islamic Finance & Its Needs Muslim world was the time perspective. In the period during which the great banking institutions were established, the Muslim world had become the victim of intellectual decadence or it was forced to come under the influence or hegemony of non-Islamic nations. It is this era of decline which forced the Muslim world to submit itself to alien institutions arid, worse still, to antithetical intellectual concepts. Although many Muslim countries are now sovereign and active as far as the resurgence of Islam is concerned, there is no denying the fact that the century's old Western supremacy in the world of finance and trading is still far from being shaken.

Chapter 8 Future of Islamic banking: Things can only get better

Several countries have started to place an emphasis on a consumer-friendly banking system that has evidently proven its ability to avoid the harsh effects of the global economic crisis. Islamic banking created a shelter for these countries, though a small one, when their economies were hit by the worst economic depression in 80 years. Having proven its robustness, many pundits confidently claim today that Islamic finance has a bright future ahead with growing recognition all around the world. Badlisyah Abdul Ghani, the CEO of CIMB Islamic Bank Berhad, which was voted

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Islamic Finance & Its Needs Best Overall Islamic Bank at the 2010 Islamic Finance News Awards, believes a bright future lies ahead for interest-free banking. Abdul Ghani says the outlook is very positive as Islamic banking is gaining prominence among customers, adding that with greater consumer awareness, the demand will likely grow in tandem. In Malaysia, Islamic finance already commands 20 percent of the total banking sector, 70-80 percent of the primary debt capital market, more than 60 percent of the total outstanding corporate bonds, 88 percent of the listed stock and 10 percent of the asset management industry. ³The expectation is for these market shares to grow further in the next five years,´ Abdul Ghani said. In fact, when it comes to Europe, the UK and France have already introduced Islamic finance into their financial system and the Kuveyt Türk Participation Bank is vying to gain a stronger footing in Germany with its interest-free banking applications. Jamzidi Khalid, CEO of Deutsche Bank AG International Islamic Banking and the head of Islamic Structuring for Asia ex-Japan, said in a bank press release dated March 1 that the bank hopes to increase its leading niche in the market. ³Making our conventional product platform available to clients in a Shariah-compliant format greatly increases our competitive position, while contributing to the market¶s broader development. This is particularly true of the Islamic bond market, where we hope to leverage our position as the number one arranger of conventional international bonds in Asia,´ he said. Islamic banking banks are not confined to commercial and retail banking and have also tremendously expanded in asset management through Shariah-compliant fund management. According to an S&P report, assets of the top 500 Islamic banks expanded by 28.6 percent to total $822 billion in 2009, compared to $639 billion in 2008. Although Islamic finance survived the 2009 economic depression largely undamaged, it was not fully immune. The biggest Islamic banking market is held by Saudi Arabia. However, after the Middle East, Malaysia emerges as the leading nation in the Islamic banking system, due to its organization and long-term vision. Malaysia is recognized as Asia¶s Islamic financial hub by PricewaterhouseCoopers. The firm concluded that as of the end of 2009, Malaysia¶s Islamic banking assets equaled RM113.5 billion ($35.2 billion). In addition to that, according to a 2009 report by the Malaysia International Islamic Financial Center (MIFC), Malaysia had the largest ³sukuk´ -the Islamic equivalent to a bond -- market in the world by 2007 with a total of $25 billion.

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Islamic Finance & Its Needs Islamic banking has a similar rationale as conventional banking except that it operates in accordance with Shariah rules on transactions, forbidding interest as well as investment in businesses that provide goods or services considered haram, or contrary to Islamic principles. The obvious differences between Islamic banking in Malaysia and in the West are its products and services. For example, partly due to the fact that the majority of Malaysians are Muslims, Malaysia has more varied players, including Islamic banks, investment banks, insurance companies, development banks, savings institutions, fund management companies, stock brokerages and trusts. There is also a Pilgrims Management and Fund Board (Tabung Haji) to help people save for hajj, the pilgrimage to Mecca. There is little difference between Islamic banking in Malaysia and in the Middle East as Malaysia works closely and emphasizes strategic alliances through Islamic finance with emerging countries of the Middle East, Africa, Central Asia and Latin America, countries expected to experience the most rapid economic recovery. Malaysia has also taken several initiatives into account, including exempting a wide range of taxes across the Islamic finance spectrum, pioneering numerous global Islamic banking and finance initiatives, adopting a liberal foreign exchange regime and creating a comprehensive regulatory and supervisory framework to ensure transparency and accountability, all of which are important to its Muslim and non-Muslim constituents. Banks from all around the globe have taken an interest in Malaysia¶s Islamic banking market, including Japan¶s Bank of TokyoMitsubishi UFJ (Malaysia) Berhad (BTMU), Germany¶s Deutsche Bank AG and Saudi Arabia¶s Al Rajhi Bank. Abdul Ghani underlines that investors have been confident about investing in Islamic banking in Malaysia. ³Malaysia is one of the most successful and mature Islamic financial markets in the world thanks to our focus on the robustness, integrity and stability of the market -- due to an effective and facilitative legislative, regulatory, legal and Shariah framework. This approach helps build confidence in the industry,´ he added. Islamic banking has its critics. Many doubt, for instance, that its principles and the products are attractive enough to interest non-Muslims. For that reason, therefore, conventional banking is also regarded as a significant part of the financial system in countries where Islamic banking takes place. There is also the issue of human resources and expertise scarcity in Islamic

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Islamic Finance & Its Needs banking, which hinders the system¶s global growth. In Malaysia, the International Shariah Research Academy (ISRA), the Islamic Banking and Finance Institute Malaysia (IBFIM), the International Center for Leadership in Finance (ICLlF) and the International Center of Education in Islamic Finance (INCEIF) were established to ensure a deep pool of talent and expertise to support Islamic financial development. Jordan¶s central bank governor, Umayya Toukan, told Reuters in March that it is important for Islamic banking to be part of the global banking system, noting that it should not be isolated and that the international standards of financial systems such as accounting standards, regulations and capital adequacy requirements must be available for Islamic banking, too. To achieve this standardization, Malaysia has established prudential standard-setting bodies. The Islamic Financial Services Board (IFSB) and the Association of Islamic Banking Institutions Malaysia (AIBIM) have adopted two standardized agreements, which are the Interbank Murabahah Master Agreement (IMMA) and the Master Agency Agreement (MAA) for deposit-taking and placement transactions. Vatican suggests Islamic system as model for Western banks L¶Osservatore Romano, the semi-official newspaper of the Holy See, reported during the global economic crisis that the Vatican favors Islamic financing and noted that banks should use Islamic finance as a model in their efforts to increase consumer confidence. The Vatican suggested that Western banks, which have been negatively affected by the global crisis, should look at rules governing Islamic finance to restore confidence among their clients.

Chapter 9 From media about islamic banking

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Islamic Finance & Its Needs Separate Law Needed For Islamic Banking In India: RBI (TOI) THIRUVANANTHAPURAM: Islamic banking in India is not possible now with the current banking principles based on interest payment, but it can be done though a separate legislation, Reserve Bank of India Governor D Subbarao said here on Thursday. "With the present set of Banking Regulation Act, Islamic banking just cannot take place because many of the banking principles in place are based on interest payments. However, Islamic banking is possible through a separate legislation," Subbarao told reporters here at the end RBI board meeting. Asked about the Kerala High Court ruling asking the state government and its agencies to keep away from a new company that has been registered under the Sharia laws of banking, he said: "Since this is a constitutional issue of whether a government can or cannot enter, we have nothing to say on that." Last month a division bench of the high court asked the Kerala government and its organisations to keep off from the proposed Islamic Bank which has begun preliminary operations in the state. Former union minister Subramaniam Swamy had petitioned the court against the Kerala State Industrial Development Corporation taking the lead to start an Islamic bank with private players. On whether a non-banking financial company can function according to the Sharia laws of banking, Subbarao said the RBI is examining the issue and will soon take a decision. India's First Islamic Bank To Start In Kerala By 2011 The first Islamic bank in the country with active involvement of the Kerala government is likely to start operations in Kochi by next year as the bank's registration formalities are currently being fulfilled on a war footing. The Kerala industries department is actively involved in the new initiative and a high level meeting held at Kozhikode on August 12 had approved a project report prepared by Ernst & Young.

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Islamic Finance & Its Needs Kerala State Industrial Development Corporation, which is the designated agency for the formation of the bank, will have 11 per cent stake in the proposed banking company. According to government officials in the know, it will be registered as a nonbanking finance company in the beginning and later get transformed into a fullfledged Shari'ah-compliant bank. It is likely that the registration formalities will be completed in the current year itself and the NBFC will become operational in 2010. The project proposes to raise an initial capital of Rs 500 crore (Rs 5 billion) from leading non-resident Indians and Indian business houses. According to sources close to the development, leading NRI businessmen such as Mohammed Ali, MA Yusuf Ali, CK Menon and other Kerala-based industrialists such as Azad Mooppan have shown keen interest in the venture. Though an RBI study group had eariler rejected the concept of Islamic banking, it got the backing of the Raghuram Rajan Committee on banking reforms. Purely based on Shari'ah principles, the bank will avoid interest-based business activities. The proposed Kerala-based bank plans to invest funds in infrastructure projects, and two areas, Bai al Salam and Instinsa, under Shari'ah have been identified for such investments. The bank will invest all its funds in wealth generating investment avenues and will distribute profit to its shareholders. The proposed Islamic bank will also set apart a social fund, compulsory under Shri'ah principles and the Islamic banking concept, and will provide interest-free loans to the Gulf returnees to set up business or small scale ventures. The concept is getting widespread support among the Muslim community of the state as a large number of rich Muslims are strictly practicing Shari'ah principles in business. A major chunk of such persons do not have a bank account. A lot of discussion is also going on whether investment in capital market is against Shari'ah principles. A section of the community believes that share trading is against the fundamentals of Islam. So the formation of an Islamic bank will be a relief to them.

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Islamic Finance & Its Needs This concept is very popular in West Asia and in predominantly Muslim nations such as Malaysia and Indonesia. Leading international banks such as HSBC and Standard & Charted have exclusive Islamic banking windows. According to sources, the biggest challenge before the Kerala-based bank will be the formation of a Shai'ah Supervisory Board in order to monitor the activities of the bank. The board should include independent scholars on Shari'ah and banking business. HSBC Plans To Offer Islamic Finance In India, China HSBC Holdings Plc, the largest bank in Europe, plans to offer Shariah-compliant services in India and China to tap economic growth after the countries issue regulations to develop their Islamic financial markets. HSBC Amanah also plans to expand in Egypt and Oman, said Razi Fakih, the deputy chief executive officer of the bank¶s Islamic unit. The lender, which has operations in 10 nations including Malaysia and Saudi Arabia, is seeking to increase bank branches globally to about 125 over the next two years from 100 at the end of 2010, he said. ³Our ability to expand in these markets depends on how the regulatory environment changes in those countries,´ Fakih said in a telephone interview from London today. ³Licensing to foreign banks is restrictive in certain markets. We would certainly like to see ourselves in the entire Middle East.´

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Islamic Finance & Its Needs HSBC is trying to strengthen its brand in a market that has attracted competitors such as Barclays Plc, Citigroup Inc. and Standard Chartered Plc to tap wealth from the world¶s 1.6 billion Muslims. Global assets held by Shariah-compliant financial institutions may climb to $1.6 trillion in 2012 from about $1 trillion, the Kuala Lumpur-based Islamic Financial Services Board said in April. HSBC ranked second among 31 Islamic bond underwriters this year, arranging $2.3 billion of the notes, or 17 percent of the total $13.5 billion, according to data compiled by Bloomberg. The bank had a market share of 13 percent last year. Selling Bonds India has no Islamic finance policies, and that is restricting sales of Shariahcompliant bonds in a nation with 157 million Muslims, according to Paris-based BNP Paribas SA and Standard Chartered. Prime Minister Manmohan Singh said last week during an official visit to Kuala Lumpur that he would ask the central bank to learn more about Islamic finance from Malaysia, the world¶s biggest market for sukuk. Countries with smaller Muslim populations are taking steps to develop Islamic finance. Australia plans to amend laws to ensure products are taxed fairly, the national taxation board said on Oct. 13. South Africa, whose 737,000 Muslims account for 1.5 percent of its population, will forgo charging tax on three Islamic structures to allow home loans that meet Shariah principles, the country¶s Treasury department said in August. HSBC Amanah bank has a ³strong pipeline´ of Islamic bonds over the next six to eight weeks, Fakih said. The bank is in discussions with new issuers in Asia and Europe seeking to sell sukuk next year, he said. µMany Issuers¶ ³We continue to work with many issuers, both sovereigns and financial institutions, and we have a healthy pipeline in place globally,´ he said, declining to provide details. Sales of sukuk fell 29 percent to $13.5 billion so far this year, from $19.1 billion in the same period of 2009, according to data compiled by Bloomberg. Islamic law, or Shariah, bars investment in industries such as gambling and alcohol, while sukuk are typically backed by assets such as real estate.

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Islamic Finance & Its Needs Islamic Banks & Regulatory Framework In India Islamic banks have not been set up in india due to regulatory complainces which are not compatible with Islamic Shariah which cannot be observed by these islamic institutions. We have taken numeruos efforts to practice islamic banking services through Non-Banking Financial Companies (NBFC¶s), cooperative societies, nidhies Islamic Funds etc. the initial capital for a new bank promoters will have a lock in period of 5 years. NRI participation can be upto 40%. Whereas industrial houses can hold upto 10 %. It is very tough task for us to mobilize Rs 300 Crores as initial capital. As regrads to NBFC¶s we need to meet the following conditions: y Paid-Up capital=2 Crores. y Credit rating = AAA. y Capital Adequacy Ratio = 12 to 15 per cent & NPA = 5 per cent. If they have to accept deposits, loans, & bonds they have to deal with interest. Bank has to keep cash reserves with RBI which attracts interest but RBI has stopped interest payent on temperory basis. Bank also needs to keep 29 % of demand & time liability in instruments of SLR. Due to nonfulfilment of the above conditions they cannot be recognised as scheduled banks, therefore RBI cannot play the role of lender of last resort to them. Maintaining 9 % of adequacy ratio bank have to raise capital byequity capital & bonds. Islamic financial institutions have multiple alternatives which can be used to promote islamic financing in India without voilating RBI regulations & Banking Act provisions. Scholar of islamic banking will appreciate that if not pure banking, several financial & related services can be taken by those who desire to do profit & loss based on activities in financial sector. It is also possible for islamic institutions to go for joint financing of infrastructure projects with government in which case the investment will be shariah complaint.

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Islamic Finance & Its Needs

Chapter 10 Islamic Finance Opportunity in India

The world¶s economic centre of gravity is gradually shifting from the established, wealthy economies of Europe, Japan and North America to the emerging economies like China, India and South East Asia, with China and India projected to be the largest economies of the world in the next 50 years. Improving macroeconomic fundamentals, higher disposable incomes, emerging middle class, low cost and highly competitive workforce, investment friendly policies and progressive reform processes are all likely to combine to make a strong case for India to have a larger share in the overall investment pie. With this sound economic base and with hundreds of companies complying to the Shariah laws, India offers a large economic opportunity for Islamic investors, who follow Shariah investment and therefore can¶t invest in interest-based ventures or in Islamically unethical ventures like tobacco, alcohol, fashion, gambling, vulgar entertainment and conventional finances like banks and non-banking financial institutions. Realizing the growing need of Islamic investments in India, the Indian government has recently taken a number of steps in this direction. First, a high-level committee appointed by the government to prepare India¶s future financial structure recommended interest-free banking for inclusion of Muslims in the financial sector. The Report draws its significance from the fact that this is first time an
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Islamic Finance & Its Needs Indian finance committee has said something on the issue, which hitherto was considered quite sensitive in political circles. This is a good sign for Islamic finance in India. Recently the financial crisis in the West and the drought of liquidity in this region has made Indian policy makers look for other alternatives of financing. The recent visit of the Indian Prime Minister, although at the fag end of the tenure of the present government, to a couple of GCC countries assumes more significance in this regard. The Indian Prime Minister visited the region along with his Chief Economic Advisor Professor Raghuram Rajan who had earlier recommended Islamic banking in his report to the government. Taking a cue from these gestures, Indian corporates have also started placing themselves to capitalise on this big opportunity. To measure in detail the scope of Islamic investment opportunities in the Indian stock market, it is imperative to examine stocks which conform to the norms stipulated by the Islamic Shariah principles. A Study On Shariah Compliant Stocks According to the Dr. Shariq Nisar, ³the number of Shariah-compliant stocks in India is much higher than in Islamic countries put together, thus providing immense scope of parking money by Islamic investors´. Out of the 1269 stocks listed in the NSE on which relevant data is available, 265 are Shariah compliant and out of the 491stocks listed in the BSE on which relevant data is available, 125 are Shariah compliant. The table below gives the number of Shariah compliant companies in India and their contribution to the total market capitalization for the last five years. Year 2004 BOMBAY STOCK EXCHANGE (BSE) 465 Data available for BSE 500 listed companies 116 BSE 500 Shariah Compliant companies 116 BSE 500 Shariah Compliant companies % Shariah compliant market 31.61 2005 474 132 132 44.01 2006 484 138 138 41.37 2007 494 123 123 28.46 2008 491 125 125 20.14

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Islamic Finance & Its Needs cap of total NATIONAL STOCK EXCHANGE (NSE) 1272 Data available for NSE listed 1238 companies 297 329 NSE Shariah Compliant companies 45.60 % Shariah compliant market 33.53 cap of total Source: TASIS Research While examining the Shariah investment opportunity in India, it may also be interesting to understand the top sectors that contribute to the Shariah market capitalization in India. Below is a table giving details on the top Shariah compliant sectors, the number of companies in each sector and their contribution to the total Shariah Compliant market cap BOMBAY STOCK EXCHANGE (BSE) Top Sectors Computer Software Drugs & Pharmaceuticals Automobile Ancillaries Industrial Construction Contribution of these top 4 sectors to total Shariah compliant market cap NATIONALSTOCK EXCHANGE (NSE) Computer Software Drugs & Pharmaceuticals Cosmetics, Toiletries, Soaps & Detergents Industrial Construction Contribution of these top 4 sectors to total Shariah compliant market cap Source: TASIS Research (As on November 30, 2008) The above study on Shariah compliant stocks and sectors in India is screened by TASIS (an Indian Shariah advisory firm, which has tied-up with Dar al Shariah of Dubai). Dr. Shariq Nisar added that TASIS norms are very conservative in comparison with other screening norms.
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1301 331 42.92

1310 312 31.84

1269 265 20.41

Number of Companies 45 12 11 8 34.69%

19 6 5 4 40.07%

Islamic Finance & Its Needs

Chapter 11 Conclusion

Islamic banking / financing is a very young concept. Yet it has already been implemented as the only system in two Muslim countries; there are Islamic banks in many Muslim countries, and a few in non-Muslim countries as well. Despite the successful acceptance there are problems. These problems are mainly in the area of financing. With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing -- loans with a service charge and Mudaraba participatory financing -- both of which are fully accepted by all Muslim writers on the subject.

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Islamic Finance & Its Needs Such a system will offer an effective banking system where Islamic banking is obligatory and a powerful alternative to conventional banking where both co-exist. Additionally, such a system will have no problem in obtaining authorisation to operate in non-Muslim countries. Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.

Chapter 12 Bibliography

The information in this project is elicited from the following various sources: y Books y Ahmad, Khurshid, Elimination of riba: concept and problems. In: Elimination of Riba from the Economy. Islamabad: Institute of Policy Studies, 1994. y Studies in Islamic Economics. Leicester: Islamic Foundation, (1980, 1981). y Ahmad, Sheikh Mahmud, Economics of Islam. Lahore: Sh. Muhammad Ashraf, 1952.

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Islamic Finance & Its Needs y Ahmed, Ausaf, Contemporary experiences of Islamic banks: a survey. In: Elimination of Riba from the Economy. Islamabad: Institute of Policy Studies, 1994. y Al-Araby, Muhammad Abdullah, Contemporary Bank Transactions and Islam¶s Views Thereon. Islamic Thought (Aligarh). y Website links y http://www.ameinfo.com/173473.html y http://en.wikipedia.org/wiki/Islamic_banking y http://www.todayszaman.com/tz-web/news-207745-future-of-islamicbanking-things-can-only-get-better.html y http://www.asharq-e.com/news.asp?section=6&id=20720 y http://www.islamic-world.net/economics/finanzkapital.htm y http://indianmuslims.in/problems-and-prospects-of-islamic-banking-inindia-%E2%80%93-road-map-ahead/ y http://timesofindia.indiatimes.com/business/india-business/Separatelaw-needed-for-Islamic-banking-in-India-RBI/articleshow/5954287.cms y http://www.fxnonstop.com/index.php/component/content/article/57600myart37752 y http://www.wealthcity.in/blog/scope-of-islamic-finance-in-india/ y http://www.ameinfo.com/228853.html y Magazines y Islami Tijara Vol, 1, Issue No 7, 2010 (August). y News Paper y Times Of India

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